Are Private Student Loans Dischargeable in Bankruptcy Court? An In-Depth Examination of Each Sub-Section of Section 523 (a)(8) of the Bankruptcy Code—Part II

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This is a three-part article that explores whether private student loans are excepted from discharge under Section 523 (a)(8) of the Bankruptcy Code. Section 523 (a)(8) includes three categories of non-dischargeable student loan debt. Part I of the blog article discussed Section 523 (a)(8)(A)(i) and can be accessed here. This is Part II of the blog article and discusses Section 523 (a)(8)(A)(ii). Part III of the blog article explores the last category of non-dischargeable student loan debt, Section 523 (a)(8)(B) and can be accessed here.

Section 523 (a)(8)(A)(ii)—What is an “educational benefit”?

The text of Section 523 (a)(8)(A)(ii) (hereinafter “(A)(ii)”) states that an “obligation to repay funds received as an educational benefit, scholarship, or stipend” is non-dischargeable unless repaying the debt would impose an undue hardship on the debtor and the debtor’s dependents.

When determining whether private student loans fall under (A)(ii), Bankruptcy Courts are confronted with two issues.  The Bankruptcy Court must first determine whether the debtor actually received funds from the private lender for educational purposes.  The second prong of the analysis requires a determination of whether the private student loan debt is an “educational benefit, scholarship, or stipend.” 11 U.S.C.S. § 528 (a)(8).  Nearly all private lenders and loan servicers attempt to couch private student loans under the term “educational benefit” and avoid arguing that a private student loan is a scholarship or stipend.  The primary reason is that the terms “stipend” and “scholarship” “signify granting, not borrowing” and generally do not need to be repaid by the debtor, whereas a loan must be repaid.  McDaniel v. Navient Sols. LLC (In re McDaniel), 973 F.3d 1083, 1094 (10th Cir. 2020).  On the other hand, the term “educational benefit” is much broader and leaves room for arguing that private student loans confer an educational benefit on the debtor.  See Crocker v. Navient Sols., L.L.C. (In re Crocker), 941 F.3d 206, 219 (5th Cir. 2019) (“[t]he key phrase, “educational benefit,” is the broadest”).  As a result, the second prong hinges on the Bankruptcy Court’s interpretation of “educational benefit.”

The first element—whether the debtor actually received funds—was discussed in two cases originating in the Ninth Circuit.  In the case of In re Kashikar, the Bankruptcy Court held that the term “funds received” means “cash advanced to or on behalf of the debtor.” Kashikar v. Turnstile Capital Mgmt., LLC (In re Kashikar),567 B.R. 160, 166 (Bankr.9th Cir. 2017) (citations omitted).  The Bankruptcy Court found that the debtor “received the funds” when the private lender disbursed the loan proceeds directly to the institution because the funds were dedicated towards paying for the student’s education. Id at 166-67.

In comparison, a debtor does not receive funds when the educational institution gives the debtor a tuition credit in which the institution agrees to be paid at a later date.  In Inst. of Imaginal Studies v. Christoff (In re Christoff), 527 B.R. 624 (B.A.P. 9th Cir. 2015), the institution offered the debtor $6,000 of financial aid in the form of a tuition credit.  Id. at 625-26.  The debtor was required to repay the credit upon completing her course work. Id.  The Bankruptcy Appellate Panel for the Ninth Circuit found that the institution agreed to discount the student’s tuition by $6,000 for a limited time and agreed to be paid the credit at a later date. Id. at 633-35.  There was no cash advanced to or on behalf of the debtor, nor were any funds exchanged between the student, the institution, or a lender.  Id. Therefore, the Bankruptcy Appellate Panel discharged the student loan debt because the Court found that the debtor did not “actually receive funds.” In summary, in order to satisfy the first prong of the (A)(ii) analysis, the lender must direct the loan proceeds to the debtor or the educational institution.

Before turning to the case law on the second issue, it is important to provide some background information.  Navient Solutions, LLC (“Navient”) is a nationwide student loan servicing corporation and is the adverse creditor in the cases described below.  In each case, Navient argued that the term “educational benefit” was broad enough to encompass private student loans.  The Court of Appeals for the Second, Fifth, Ninth, and Tenth Circuits (the “Circuit Courts”) disagreed and concluded that private student loans do not fall under the umbrella of an “educational benefit” and, as a result, are not excepted from discharge under (A)(ii).

Each Circuit Court started its analysis by examining the statutory text of Section 523 (a)(8).  The Circuit Courts noted that the term “loan” was included in Section 523 (A)(i) and (8)(B)—the other two exceptions in Section 523 (a)(8)—but was omitted from Section 523 (8)(A)(ii).  The Fifth Circuit, in In re Crocker, observed that “Congress sandwiched subsection (A)(ii), which does not mention loans at least by name, between two subsections that explicitly do,” which indicates that “educational benefits are not loans.” In re Crocker, 941 F.3d at 219.  The Second Circuit in Homaidan v. Sallie Mae, Inc. 2021 U.S. App.  LEXIS 20934, at *10 (2d Cir. July 15, 2021, No. 20-1981) reached a similar conclusion and found that the “term “loan” is used several times in Section 523 (8)(A) but is absent from § 523 (a)(8)(A)(ii), signaling that the omission was intentional.”  The Circuit Courts held that the omission of the word “loan” from (A)(ii) suggested that Congress’ intended to create a category of student debts that were not incurred through private or federal loans.  

The Circuit Courts’ analysis continued and they defined the term “educational benefit” as used in (A)(ii).  Because the term was left undefined by Congress, the Circuit Courts applied the statutory canon of noscitur a sociss.  The cannon helps Bankruptcy Courts define a vague word included in a list by examining the other terms surrounding the disputed word.   See Homaidan, 2021 U.S. App.  LEXIS 20934 at *13 (“the meaning of doubtful terms or phrases may be determined by reference to their relationship with other associated words or phrases”) quoting United States v. Dauray, 215 F.3d 257 (2d Cir. 2000) see also In re Crocker, 941 F.3d 206, 218-219 (“noscitur a sociis. . . . tells us that statutory words are often known by the company they keep”).

To repeat, the text of (A)(ii) is: “obligation to repay funds received as an educational benefit, scholarship, or stipend.” 11 U.S.C.S. § 523 (8)(A)(ii).  The Fifth Circuit found that when a student receives a stipend or scholarship, he is not required to repay the entity that awarded him the stipend or scholarship.  As the Tenth Circuit succinctly put it, a “stipend. . . .is a fixed and regular payment, such as a salary, and a scholarship. . . .is a grant of financial aid to a student,” and both do not normally need to be repaid.” In re McDaniel, 973 F.3d at 1097.  Similarly, the word “benefit,” as used in “educational benefit,” implies a payment, gift, or service, that does not need to be repaid.  Id.  

The Circuit Courts’ interpretation of “benefit,” “scholarship,” and “benefit” indicate that (A)(ii) was narrowly tailored to except from discharge “conditional grants” that are required to be repaid if certain service obligations are not satisfied.  See In re McDaniel, 973 F.3d at 1102 (the common quality linking together the items in the statutory phrase “educational benefit, scholarship, or stipend” is that they can all naturally be read to describe “conditional payments”) (citations omitted).  The Circuit Courts further noted that the primary distinction between loans and conditional payments is that loans—whether private or federally backed—require repayment at a specific date by the debtor. In re Crocker, 941 F.3d at 219-221. In comparison, conditional grants must only be repaid if the debtor does not fulfill its responsibilities under the grant.  Id. Thus, the Circuit Courts found that under the doctrine of noscitur a sociss, the term “educational benefit” means “educational funds that a student receives in exchange for agreeing to perform services in the future.” In re McDaniel, 973 F.3d at 1096.   

The Second Circuit stated that an educational benefit could be a military program in which the government pays for the student’s tuition in exchange for the student working for the military for a limited time.  See Homaidan, No. 20-1981, 2021 U.S. App. LEXIS 20934, at *15.  If the student fails to fulfill their obligation, they incur an obligation to repay the funds the military dedicated towards the debtor’s educational benefit.  Id.

The Circuit Courts rejected Navient’s argument that educational benefits encompass private student loans.  The Circuit Courts held that if Navient’s interpretation were correct, (A)(ii) would become a catch-all provision that would consume all loans of any type, which would render Section 523 (A)(i) and (8)(B) superfluous and meaningless.  See e.g., Homaidan, No. 20-1981, 2021 U.S. App. LEXIS 20934, at *11 (“Navient’s broad reading. . . .would draw virtually all student loans within the scope of § 523(a)(8)(A)(ii)”, which would “swallow up” the other sub-section of Section 523 (a)(8)). The Tenth Circuit was a little harsher in its ruling: “no normal speaker of English . . . in the circumstances [ ] would say that student loans are obligations to repay funds received as an educational benefit. . . .likewise[,] no normal speaker of English would say that mortgages are housing benefits or that automobile loans qualify as transportation benefits.” In re McDaniel, 973 F.3d at 1096-97.

In conclusion, the growing trend is that a private student loan is not an educational benefit.  The primary reason, among many others, is that if “educational benefit” was defined to include loans, the remaining sub-sections of Section 523 (a)(8) would become superfluous and meaningless.  Moreover, the words surrounding the term “educational benefit” indicate that (A)(ii) is focused on debts that are incurred as a result of conditional grants, which the Circuit Courts agree are not loans, whether private or otherwise.  As a result, it appears that it is safe to say that private student loans are not excepted from discharge under Section 523 (a)(8)(A)(ii).

This is Part II of a three-part blog article. Part I of this three-part blog article can be accessed by clicking on this link. Part III of this blog article can be accessed by clicking on this link.

Are Private Student Loans Dischargeable in Bankruptcy Court? An In-Depth Examination of Each Sub-Section of Section 523 (a)(8) of the Bankruptcy Code—Part I

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In the United States, student loans have exceeded $1.6 trillion, making student loans a central focus amongst Chapter 7 and 13 debtors. Student loans facilitated or guaranteed by the U.S. government or a non-profit institution are non-dischargeable in bankruptcy court, pursuant to Section 523 (a)(8) of the Bankruptcy Code. A non-dischargeable debt means that the debtor must still repay the debt even after successful Chapter 13 or 7 bankruptcy. The only exception to this iron-clad rule is if the debtor shows that repayment would “impose an undue hardship on the debtor and the debtor’s dependents.” 11 U.S.C.S. § 528 (a)(8).

A common question is whether private student loans facilitated by private lenders—such as, Sallie Mae and Chase Bank—are afforded the same non-dischargeable protections as federal and non-profit student loans. In other words, do private student loans fall under Section 523 (a)(8) of the Code and require a showing of undue hardship to discharge the student debt? This three-part blog article explores each of the three sub-sections of Section 523 (a)(8) and explains how, under certain circumstances, private student loans are also a non-dischargeable debt, absent a showing of undue hardship by the debtor.

A Quick Primer on Section 523 (a)(8) & The Undue Hardship Test

Section 523(a)(8) of the Code is titled “Exceptions from Discharge” and specifies three types of student loan debts that remain with a debtor after a successful bankruptcy case:

(A)(i) an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or

(A) (ii) an obligation to repay funds received as an educational benefit, scholarship, or stipend; or

(B) any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual.

Whether private or federally backed, bankruptcy courts will not discharge the debt if the student loan fits into one of the three categories described above.  The only exception is if the debtor presents evidence that repaying the debt would result in an “undue hardship on the debtor and the debtor’s dependents.” 11 U.S.C.S. § 523 (a)(8) (emphasis added).

The Second Circuit Court of Appeals developed a legal standard to determine whether a debtor would suffer an undue hardship if required to repay the student debt.  See Brunner v. New York State Higher Educ. Servs.  Corp. 831 F.2d 395, 396 (2d Cir. 1987).  The Brunner Test includes three factors, and the debtor must prove that each factor weighs in their favor.  The three factors are: (1) the debtor cannot maintain, based on current income, a minimal standard of living for herself and her dependents; (2) additional circumstances exist that indicate the debtor’s current living condition will persist for a significant period of time; and (3) the debtor has made a good faith effort to repay the debt.  See Brunner 831 F.2d at 396.  Nearly all bankruptcy courts throughout the U.S. apply some form of the Brunner Test when confronted with a debtor that seeks to discharge student loan debt.

The Ninth Circuit Court of Appeals in United Student Aid Funds v. Pena (In re Pena), 155 F.3d 1108 (9th Cir. 1998) applied the Brunner Test and discharged the student loan debt.  In In re Pena, a middle-aged married couple filed for bankruptcy relief and sought to discharge the student loan debt that the husband incurred to attend trade school.  The debtors presented evidence that the husband’s certificate was useless and did not help him find better employment or increase his salary.  To make matters worse, the wife suffered from depression, bipolar disorder, schizophrenia, and other mental ailments that prevented her from retaining a job for longer than six months.  Further, the debtors’ age and limited education indicated that their living situation would not improve.  The Ninth Circuit found that the debtors—living on a monthly income of approximately $1,700—could not maintain a “minimal standard of living.”  The Circuit Court held that it would be impossible for the debtors to repay the debt without resorting to homelessness.  As a result, the 9th Circuit Court found that the debtors satisfied the “undue hardship test” and discharged the student loan debt.

Bankruptcy Courts throughout the U.S. rarely discharge student loan debt unless the facts of the case are similar—or worse than—In re Pena, which has made the Brunner Test an extremely difficult standard to satisfy.  Commercial lenders often argue that private student loan debts also fall under Section 523 (a)(8) of the Bankruptcy Code and, as a result, are nondischagabe absent a showing of undue hardship by the debtor.

The remaining part of this article focuses on analyzing each of the three sub-sections of 523 (a)(8) in the context of private student loan debts.  The first part of this three-part article focuses on Section 523 (a)(8)(A)(i).  The second and third segments discuss Section 523 (a)(8)(A)(ii) and Section 523 (a)(8)(B), respectively.

Section 523 (a)(8)(A)(i)—What does the term “program funded” mean?

Section 523 (a)(8)(A)(i) (hereinafter “AI”) is the first sub-section of Section 523 (a)(8). The text of AI states that a debt incurred by an “an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or non-profit institution” is non-dischargeable. 

The second use of the word “or” separates AI into two clauses.  There are two notable distinctions between the two clauses.  The first distinction is that the first clause is limited to “loans,” whereas “the second clause of AI concerns loan programs, [not] particular loans.” In re O’Brien 318 B.R. 258, 262 (S.D.N.Y. 2004) (emphasis added) (citations omitted). The other notable difference is that the first clause is limited to loans by a “governmental unit,” and the second clause includes governmental units and non-profit institutions.

These two distinctions indicate that private student loans are excepted from discharge under the second clause of AI (and not the first clause) if: (1) the loan was made under a “loan program” and (2) the program is “funded” by a non-profit institution.  See In re Hammarstrom 95 B.R. 160, 165 (Bankr.N.D.Cal. 1989) (“[f]irst, the loan must be made pursuant to a “program” for providing educational loans.  Second, that program must be “funded” at least in part by a non-profit organization”).

Bankruptcy Courts often find that the first element is satisfied if a non-profit entity is part of a program that facilitates the student loan to the debtor.  For example, in Hemar Service Corp., Inc. v. Pilcher 149 B.R. 595 (Bankr.9th Cir. 1993), the debtor received student loans from a loan program funded by multiple non-profit and for-profit entities.  The Bankruptcy Court found that the creditor satisfied the first element because a non-profit entity that was a member of a loan program that provided educational loans to students in need of financial assistance. See Pilcher 149 B.R. at 598.  The first element is very easy to satisfy and, as a result, Bankruptcy Courts often overlook or do not analyze the first prong of the AI analysis.

Turning to the second element, the Bankruptcy Court in In re Hammarstrom held that the term “funded” means a non-profit institution that “plays any meaningful part in providing funds” to the loan program. In re Hammarstrom, 95 B.R. at 165.  Bankruptcy Courts consistently rely on In re Hammarstrom because it was one of the first bankruptcy cases to define the term “funded” as used in the second clause of AI.  However, Bankruptcy Courts are divided on what constitutes “funding” a loan program.  Some Bankruptcy Courts have held that a non-profit institution funds a loan program when it purchases the notes made under the loan program from a private, commercial lender.

For instance, in In re Hammarstrom, the non-profit entity and a private lender entered into an agreement wherein the private lender would execute the notes with the debtors and loan money directly to the students.  After the lender disbursed the loan proceeds, the non-profit entity would immediately purchase the notes from the lender and would become a creditor of the debtors.  The Bankruptcy Court found that the loan program structure made the commercial lender nothing more than an agent for the non-profit entity to help it advance loans for post-secondary education.  The Bankruptcy Court concluded that the non-profit entity funded the loan program because it purchased all of the notes under the program from the original lender and relieved the lender from its duties and obligations under the same.

The Court of Appeals for the Third and Eighth Circuits came to a similar conclusion but required non-profit entities to participate in the loan program.  In the case of Sears v. EduCap, Inc. (In re Sears) 393 B.R. 678 (Bankr.W.D.Mo. 2008) the non-profit entity prepared the loan documents, marketed the loans, processed the loan applications, and facilitated the disbursement of proceeds from the private lender to the student.  The Bankruptcy Court found that the non-profit lender funded the program because it exercised “plenary control” over the loan program and was required to purchase the loans (at one point or another), regardless of whether the loan was current or in default.  See In re Sears, 393 B.R. at 681. Similarly, in Johnson v. Access Grp., Inc. (In re Johnson), Nos.  1:05-bk-00666MDF, 1:05-ap-00162, 2008 Bankr. LEXIS 3325, at *10 (Bankr. M.D. Pa. Dec. 3, 2008), the Bankruptcy Court for the District of Pennsylvania found that the non-profit institution “funded” the loan program because it (1) agreed to purchase the loan prior to the loan being made to the debtor, (2) the non-profit entity administered the program that facilitated the student loans, and (3) the non-profit entity guaranteed the loan while it was held by the private lender.

The Court of Appeals in the First, Second, Seventh, and Ninth Circuits have encountered different loan programs and, as a result, have reached different conclusions from the other Circuit Courts. The Court of Appeals in the First, Second, Seventh, and Ninth Circuits held that a non-profit entity “funds” the loan program if it guarantees the note and repays the debt to the lender upon the debtor’s default.  These Circuit Courts found that without the guarantees from the non-profit entities, private lenders would not participate in the loan programs.

The Second Circuit Court of Appeals in O’Brien v. First Marblehead Educ. Res., Inc. (In re O’Brien), 419 F.3d 104 (2d Cir. 2005) specifically held that a non-profit entity was “clearly devoting some of its financial resources to supporting the program” by guaranteeing all notes made under the loan program.  The Second Circuit Appellate Court was persuaded by the fact that after the debtor defaulted under the note, the non-profit entity fulfilled its obligations and immediately repaid the debt to the private lender, including all interest, fees, and costs.  Bankruptcy Courts throughout the country have reached similar conclusions. See e.g., In re Duits, No. 14-05277-RLM-13, 2020 Bankr. LEXIS 138, at *5 (Bankr. S.D. Ind. Jan. 15, 2020) (“the non-profit’s guaranty helps fund a program because it encourages a lender to extend credit that may not be otherwise available”); see also Educ. Res. Inst. Inc. v. Taratuska (In re Taratuska) (D.Mass. Aug. 25, 2008, No. 07-11938-RCL) 2008 U.S.Dist.LEXIS 93206, at *18 (the non-profit funded the loan program because it guaranteed the loan, paid the loan upon default, and presented evidence that it “maintained money in segregated reserves to support its guaranteed obligations, thus devoting financial resources to the loan program”).

The cases described above signify that the term “funded” takes on many definitions, depending on the non-profit’s obligations and duties in the loan program.  The Court of Appeals for the First, Second, Seventh, and Ninth Circuits found that a non-profit institution “funds” the loan program when it guarantees the loan and repays the loan proceeds to the lender upon the debtor’s default.  On the other hand, a non-profit entity “funds” the loan program when it purchases the note from the lender (see e.g., In re Hammarstrom, 95 B.R. 160) and manages the loan program.  See e.g., In re Sears 393 B.R. 678.

In conclusion, the case law interpreting AI illustrates that Bankruptcy Courts are willing to employ numerous definitions of the term “funded” in order to find that private student loans that are facilitated through loan programs are excepted from discharge under Section 523 (a)(8)(A)(i). 

This is Part I of a three-part blog article. Part II of this three-part blog article can be accessed by clicking on this link. Part III of this blog article can be accessed by clicking on this link.

Prior Publication Does Not Always Bar Trade Secret Protection

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Does a published algorithm bar trade secret protection of that algorithm?  The answer is not as simple as it seems.  Earlier this year, the Federal Circuit in Masimo Corp. held that the prior publication by a third party of trade secret information does not bar trade secret information.  Masimo Corp. v. True Wearables, Inc., No. 2021-2146, 2022 U.S. App. LEXIS 1923, at *17 (Fed. Cir. Jan. 24, 2022).  This seems counter intuitive given that one of the requirements of a protectable trade secret is that the information to be protected is not generally known to the public. 18 U.S.C. § 1839; Cal Civ Code § 3426.1.

This blog will explore the topic of whether prior publication of information by a third party bars trade secret protection.

I recently posted a blog article about where I discussed the laws around trade secrets generally.  To recap:

Trade secrets are defined under 18 U.S.C. § 1839[1] and Cal Civ Code § 3426.1[2].  Boiled down, three things must be true for the information you seek to protect:

  • Derives independent economic value;
  • Not generally known to the public;
  • Reasonable measures were taken to keep the information secret.

Case Background

In Masimo Corp., Masimo Corporation and Ceracor Labortories, Inc. (collectively, “Masimo”) sued True Wearables, Inc. (“True Wearables”) and Dr. Marcelo Lamego for trade secret misappropriation.  Specifically, Masimo alleged that Dr. Lamego misappropriated the trade secret known as “TSS”.  TSS is related to Masimo’s proprietary algorithm used to solve optimization problems surrounding oximeters[3].  Masimo’s TSS uses a simple linear algebraic equation: “SpHb = Ax + By + Cz . . .,” where x, y, and z are absorption measurements (e.g., wavelength readouts) from the oximeter and A, B, and C are coefficients which relay important information to the user.  Masimo Corp. at 2.

Dr. Lamego was employed at Ceracor Laboratories, Inc. before leaving and founding True Wearables.  Id. at 3.  Dr. Lamego the “Oxxiom device” and later received a notice of allowance for a patent for the Oxxiom device.  Id.  Masimo sued True Wearables in district court, moving for preliminary injunction on trade secret claims arguing that the provisional application upon which the nonprovisional application claims priority[4] disclosed a variation of the TSS algorithm, which would eventually become public knowledge.  Id.

The district court followed CUTSA definition of a trade secret mentioned above.  True Wearables argued that the TSS algorithm was “generally known” by the public because it was previously published in a conference paper by the Institute of Electrical and Electronics Engineers (“IEEE”).  Id. at 7.  Specifically, the IEEE paper disclosed “an algorithm equivalent to the TSS and that has been cited over 1,200 times.”  Id.  True Wearables also presented expert testimony stating that “variants of the TSS have appeared in statistics textbooks since the early 1960s” and “an algorithm equivalent to the TSS was ‘widely known and widely used by the statistics community’” prior to the lawsuit.  Id. at 8.  The district court ruled that at best, the publications could be a basis for determining that the TSS was readily ascertainable.  Id. (citing  Masimo Corp. v. True Wearables, Inc., No. SACV 18-2001 JVS (JDEx), 2021 U.S. Dist. LEXIS 88038, at *13 (C.D. Cal. Apr. 28, 2021)).

Analysis

Although True Wearables cited various cases that “display in a single publication of an alleged trade secret in its entirety is conclusive evidence that it is generally known”, the Federal Circuit found those cases to be distinguishable because the cited cases involved either (a) disclosure in an unrelated field or (b) disclosure was authorized by the owner of the trade secret thereby extinguishing trade secret protection.  Masimo Corp. at 10.  The Federal Circuit stated that the mere fact that the trade secret has been published “does not necessarily compel a finding that the information cannot maintain its status as a trade secret for a party in an entirely different field from the one to which the publication was addressed.”  Id. at 12.

The true downfall for True Wearables’ argument was that the algorithm or variants of the algorithm were published to the statistics community, which the Federal Circuit deemed to be far enough removed to be considered unrelated to the medical field.  Just because those in the statistics community were aware of the algorithm does not necessarily mean that the algorithm would be generally known by “entities who develop noninvasive blood content detectors” such that said entities could derive economic value from the disclosure.  Id. at 13.  For example, if the algorithm was disclosed to the healthcare community at large, True Wearables may have had a stronger argument that TSS was “generally known.”  However, the Federal Circuit found this to not be the case.

Takeaway

Although the case is ongoing, the distinction in whether “publication” is damning towards trade secret protection is worth noting.  Here, the inquiry shifted to whether the publication in an unrelated field is far enough removed such that those in the relevant field would not be able to obtain economic benefit of the disclosure.  While the Masimo Corp. ruling might seem surprising on its face, the Federal Circuit’s line of reasoning is not completely unfamiliar.  Interestingly enough, the logic here—although not completely parallel—seems to be consistent with the rules around other areas of intellectual property.  For instance, two trademarks can exist simultaneously in unrelated fields.  Also, a patent publication is not prima facie prior art if the publication exists in an unrelated field and there is no motivation to combine.  At the end of the day, the Federal Circuit is affirming its stance that determinations of the prongs of trade secret protection is fact intensive as seen in Masimo Corp.  It is important to note that despite the preliminary injunction granted in favor of Masimo, True Wearables may still succeed on the merits as the case moves forward.  Masimo Corp. is certainly a case worth keeping an eye on.

[1] (3) the term “trade secret” means all forms and types of financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, procedures, programs, or codes, whether tangible or intangible, and whether or how stored, compiled, or memorialized physically, electronically, graphically, photographically, or in writing if—(A) the owner thereof has taken reasonable measures to keep such information secret; and (B) the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, another person who can obtain economic value from the disclosure or use of the information.

[2] According to the California Trade Secrets Act (“CUTSA”) (d) “Trade secret” means information, including a formula, pattern, compilation, program, device, method, technique, or process, that: (1) Derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use; and (2) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.

[3] Without going into the specifics, oximeters are basically LED emitting fingertip sensors used to measure the concentration of total hemoglobin, i.e., blood oxygen levels, in a patient.

[4] Fun fact: a provisional application allows applicants to basically make adjustments to the application for one year while securing an earlier filing date.  Applicants can then file a nonprovisional application—which is more or less the completed version of the provisional application—and claim the benefit or “priority” of the earlier filing date of provisional application.  In other words, the nonprovisional application would then be considered to have been filed at on the date the provisional application was filed.  The priority/filing date is important because the U.S. moved from a “first to invent” filing system to a “first to file” system.  This means that whoever files first rather than invents first will generally be awarded the patent.  For example, if two applicants filed a patent application for the same or similar invention, the applicant with the earlier filing date will generally be the one to be awarded the patent.

California Supreme Court Says Lenders Owe No Duty of Care in Loan Modification Negotiations

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The 2008 financial and foreclosure crisis—in addition to immiserating a generation of homeowners—led to an explosion in litigation against lenders and loan servicers by aggrieved owners.  Because of the volume of these cases and the diversity of approaches by the plaintiffs, a split of authority between the various Districts of the California Court of Appeal on a key issue developed: do lenders owe a duty of care in reviewing and processing loan modification applications? 

On March 7, 2022, in a unanimous, landmark (and whopping, 54-page) majority opinion authored by Chief Justice Cantil-Sakauye, the California Supreme Court answered that question with a resounding “no.”  In Sheen v. Wells Fargo, the Justices held that “lender[s] [do not] owe borrowers a tort duty sounding in general negligence principles to . . . ‘process, review and respond carefully and completely to a borrower’s loan modification application,’ such that upon a breach of this duty the lender may be liable for the borrower’s [solely] economic losses.”  (Slip Op. at 2.) On June 1, the Court denied Sheen’s petition for rehearing, effectively finalizing the Court’s decision.

In this case, borrower Kwang Sheen took out a second and third mortgage with Wells Fargo on his home in Los Angeles.  Sheen eventually missed payments on both loans and Wells Fargo began foreclosure proceedings, scheduling a trustee’s sale for February 2010.  In January of 2010, Sheen, through his representative, contacted Wells Fargo and applied for a loan modification in an attempt to stave off foreclosure.  A week after his application for modification, Wells Fargo cancelled the trustee’s sale set for February.  Wells Fargo never got back to Sheen directly about the loan modification requests, but did get a set of letters related to the two loans from Wells Fargo in March of 2010, which informed him the loans had been charged off and the balance accelerated.  Sheen interpreted these letters to mean that the loans had been modified to become unsecured such that there would be no foreclosure on his property.  However, as it turned out, Sheen’s interpretation of the letters was incorrect, and both loans remained secured as Wells Fargo went to the market with the distressed loans.

In November of 2010, Wells Fargo sold the second loan to a third party, and that loan eventually ended up in the hands of Mirabella Investment Group, LLC (“Mirabella,” a client of Gupta Evans & Ayres who prevailed against Sheen on summary judgment, plaintiff’s appeal of which is pending the resolution of the Wells Fargo appeal).  In 2014, Mirabella foreclosed on the property and it was sold at a foreclosure sale.  Sheen’s lawsuit followed, wherein he brought causes of action for intentional infliction of emotional distress, unfair competition (section 17200), and—most critically—negligence.  The California Court of Appeal held summarily dispatched the emotional distress and unfair competition claims, and, in the bulk of the opinion, held that Wells Fargo owed no duty of care to Sheen in processing his loan modification requests, relying on the “economic loss rule” which states that parties to a contract (or a contract negotiation) do not owe each other a duty not to cause purely economic losses that do not arise from the violation of an independent duty.  Sheen v. Wells Fargo, 38 Cal. App. 5th 346 (2019).  In so doing, the Court of Appeal explicitly noted that “[t]he issue of whether a tort duty exists for mortgage modification has divided California courts for years” and that “[t]he California Supreme Court has yet to resolve this division.”  Id. at 348.  Picking up the thrown-down gauntlet, the California Supreme Court granted review.

Like the Court of Appeal, the California Supreme Court used economic loss rule as its primary rationale, which provides that a party to a contract cannot recover in tort for purely economic damages—“i.e., pecuniary losses unaccompanied by property damage or personal injury” (Slip Op. at 2.)—unless the plaintiff can show a breach of a duty arising independent of the contract between the parties.  Robinson Helicopter v. Dana Corp., 34 Cal. 4th 979, 992-93 (2004).  The court relied heavily on this principle in deciding not to impose a duty on lenders, noting the underlying rationale of the rule is to “‘prevent the erosion of contract doctrines by the use of tort law to work around them.’”  (Slip. Op. at 15 (quoting Restatement, §3 at p. 2).)  The court reasoned that loan modification is just a renegotiation of an existing contract, wherein the lender is attempting to find a way to best enforce and protect the rights established by the original contract. (Id. at 17-18, 23.)

After noting that its approach was consistent with the majority of other jurisdictions (id. at 19-22), the court dispensed with plaintiff’s legal counterarguments.  In particular, the court noted that the economic loss rule is not limited to loan origination, but also modification because of its relation to the original contract between the parties.  (Id. at 23.)  The court also stated that the oft-cited factors from Biakanja v. Irving, 49 Cal.2d 647 (1958)—used to impose a duty of care in certain situations—do not apply when the parties are in contractual privity.  (Id. at 37.)

Lastly, and perhaps most importantly, the court rejected plaintiff’s policy arguments.  The court did recognize the underlying merit in plaintiff’s contention that the bargaining power in loan modification negotiations are lopsided in favor of lenders and servicers (who may have incentives to promote foreclosure and discourage modification), but ultimately stated that it was the role of the Legislature to strike the balance between those competing costs and benefits.  (Id. at 46-55.)  The court was not shy about prodding the Legislature to act to address the concerns raised by plaintiff about home loan modification negotiations, stating that “should it choose to the Legislature can both prescribe whether a lender must act ‘reasonably’ and (in some detail, if it chooses) what constitutes ‘reasonable’ behavior within this sphere.”  (Id. at 55.)  Justice Liu, in his concurring opinion, was more pointed: “[W]hether the mortgage market and affected communities would benefit from manipulative practices and ‘bargaining or information asymmetries’ . . . continues to be ripe for legislative consideration.”  (Id. at 11 (Liu, J., concurring).)  This open signaling from the California Supreme Court could spur the Legislature to act to address the concerns raised by both plaintiff and the court.

The court also seemingly overruled contrary precedent in a sweeping footnote (id. at 55 n.12), but did not delve into the details of the prior cases from the Court of Appeal that did find duties of care applicable to lenders.  One of the handful of cases that did find a duty of care and was heavily relied upon by plaintiffs—Alvarez v. BAC Home Loans Servicing, L.P., 228 Cal. App. 4th 941 (2014)—was addressed in Justice Jenkins’ concurring opinion, wherein he fell on his sword and addressed his participation in that case’s opinion.  In short, Justice Jenkins seemed to admit that he, along with the rest of the majority in Alvarez, misapplied the Biakanja factors and overlooked the fact that that analysis only applies where the parties are not in contractual privity.  (Id. at 2 (Jenkins, J., concurring).)

In granting review and deciding against the existence of a duty, the California Supreme Court has spoken clearly about the lack of a lender’s duty to process, review, and respond to loan modification—avoiding a potential instantaneous sea change in the allocation of risk and liability between lenders and borrowers.  However, at the same time, the Court has also, in asserting its inability to make law on the subject from the bench, laid the groundwork for potential Legislative action.  Finally, although the court seemingly has spoken with an intent to close the book on this issue in the judicial sphere, given the passing remarks made by the concurring Justices pointing out the items not conclusively addressed by the majority opinion (id. at 3-5 (Liu, J. concurring); id. at 2-3 (Jenkins, J., concurring)), lender litigants can reasonably expect that borrower plaintiffs will continue to jam their proverbial feet in the door.

Which State’s Law Governs? Domesticating Out-of-State Judgments in California

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I ran into an interesting legal question regarding the collection of out-of-state judgments: when an out-of-state judgement is domesticated in California, which state’s law controls? Let’s say a creditor secured a judgment against one spouse outside of California in another community property state, but that state’s community property laws prevented the married couple’s community property from being encumbered by the judgment. The rub is that the couple also own property in California. Can the creditor secure a lien against the California property by domesticating the judgment in California?

California Sister State Money Judgments Act and Domesticating Judgments

The California Sister State Money Judgments Act, Code Civ Proc section 1710 deals with sister state judgments and domesticating judgments in California, which states: “Except as otherwise provided in this chapter, a judgment entered pursuant to this chapter shall have the same effect as an original money judgment of the court and may be enforced or satisfied in like manner.” Code Civ Proc § 1710.35. Courts have taken the plain language of section 1710.35 and determined that the legislative intent of the “[a]ct was not intended to alter any substantive rights or defenses which would otherwise be available to a judgment debtor or a judgment creditor in this state.” Washoe Dev. Co. v. Irving Sav. Ass’n, 47 Cal.App.4th 1518, 1524 (1996); see also Kahn v. Berman,198 Cal. App. 3d 1499, 1505-1507 (1988).

In Washoe, a judgment was entered in Nevada and then renewed by court order, which revealed that Respondents had money due from Appellants remaining. 47 Cal.App.4th at 1521. Respondents obtained a judgment in California (domesticated judgment) to recover the remaining amount through the sister-state judgment process under Code Civ Proc section 1710. Id. There was an issue raised regarding whether the California judgment was unenforceable in light of conflicting Nevada law. Id. at 1523. However, the court in Washoe determined that defenses against sister-state judgment enforcement cannot be asserted because “the court rendering the judgment had fundamental jurisdiction”, which in this case, was California. Id. at 1524.

In light of Washoe and section 1710 of the California Sister State Money Judgments Act, the answer seems relatively straightforward. However, not all community property states are created equal, and will sometimes conflict with one another in terms of whether the community property can be encumbered by a judgment lien. For instance, Ariz. Rev. Stat. (“A.R.S.”) section 25-214 states that binding community property for “[a]ny transaction of guaranty, indemnity or suretyship” requires a joinder of both spouses. Ariz Rev. Stat. § 25-214. This effectively prevents the creditor in the situation supra from securing a lien on any of the couple’s community property. However, California has no such rule. In fact, California’s Code of Civil Procedure states that “[a]ll property of the judgment debtor is subject to enforcement of a money judgment.” Code Civ. Proc., § 695.010. This begs the question: if the creditor decides to domesticate the Arizona judgment in California, will the creditor be able to secure a lien on the community property located in California?

True Conflict Test

In Gaughan v. First Cmty. Bank (In re Miller), 517 B.R. 145, 152 (D.Ariz. 2014), a judgment was entered against the husband Larry Miller and not his wife, Kari Miller, in Arizona. 517 B.R. at 147. The judgment was later domesticated in California, and the Arizona District Court determined that Arizona laws should apply under the principles of full faith and credit. Id. at 155. However, the Ninth Circuit reversed this decision in First Cmty. Bank v. Gaughan (In re Miller), 853 F.3d 508, 519 (9th Cir. 2017).

The Ninth Circuit drilled down on this issue of conflicting statutes due to the presence of a choice-of-law provision and applied a three-prong test based on Kearney v. Salomon Smith Barney, Inc., 39 Cal. 4th 95, 111-12 (2006). 853 F.3d at 516. In determining which state’s law applies, they analyzed three questions: (1) does relevant law vary between the potentially affected jurisdictions?; (2) If there is a difference in law, does a true conflict exist such that “each of the states involved has a legitimate but conflicting interest in applying its own law[?]”; (3) If there is a true conflict, “which state’s interest would be more impaired if its policy were subordinated to the policy of the other state[?]” Id.; see also Kearny, 39 Cal. 4th at 111-12.

On paper, there seems to be a “true conflict” between the Arizona and California community property laws—applying Arizona law would mean the community property is exempt or protected from encumbrance, while applying California law would mean the community property can be encumbered. This is exactly what the court in Gaughan concluded prior to the Ninth Circuit’s reversal. However, the Ninth Circuit held that the differences in the two statutes did not necessarily compel the conclusion that a true conflict existed. In re Miller, 853 F.3d at 516. Instead, the “existence of such a conflict turns on whether the circumstances of the case implicate the policies underlying the ostensibly conflicting laws.” Id. at 517.

The Ninth Circuit dove deeper in light of this finding and analyzed the true purpose of each state’s ostensibly conflicting rules to see whether a true conflict actually existed. In doing so, the Ninth Circuit relied on Hamada v. Valley National Bank, 27 Ariz. App. 433 (1976). In Hamada, the Appellees Valley National Bank secured a judgment against the Appellants Hajime and Toshiko Hamada, a married couple. Id. at 436. However, Toshiko Hamada, Hajime’s wife, did not sign the promissory note on which the judgment was based. Id. The Arizona Court of Appeals explained that “[t]he husband, as a member of the community, has no power under the law without the knowledge and consent of his wife, to use community assets to guarantee the payment of a debt of a stranger to the community, it deriving no benefit therefrom.” Id. Therefore, the “policy underlying Arizona’s dual-signature requirement is to ensure that a spouse who lacks knowledge of, and does not acquiesce to, a guaranty is not bound.” In re Miller, 853 F.3d at 516.

Given that the Millers in In re Miller did not defend on the ground that Kari Miller lacked knowledge or acquiescence to justify her lack of signature on the guaranty, A.R.S. § 25-214 was not invoked and therefore, there was no true conflict between California and Arizona law. Id. at 518. Further, because there was no true conflict, the Ninth Circuit determined that California had a compelling interest in applying its law, one of which is “fostering the growth of commercial activities that require ready access to credit—a policy that would be undermined by limiting the ability of California creditors to enforce obligations for activities undertaken in California and made subject to the operation of California law by consent of the parties.” Id.

In light of the Ninth Circuit’s ruling in In re Miller, if the creditors in the hypothetical supra were to domesticate the out-of-state judgment in California and there are differences in the two states’ statutes, this might trigger the three-prong analysis to determine whether a true conflict actually exists. However, even if the analysis is triggered, it would probably be prudent to assume Washoe and California’s procedural laws would be controlling.

Author: John Ahn

When is a Broker Entitled to his Commission Fee – An Examination of the ‘Procuring Cause’ Requirement in California

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Most, if not all, California real estate brokers (and agents) earn a living by helping people buy and sell homes. Brokers are often paid on a commission basis, usually 2%-3% of the sales price, and do not enjoy the luxury of a steady, bi-weekly paycheck. Given the “feast or famine” nature of the industry, brokers often find themselves in a commission fee dispute with another broker or their client. 

In California, a real estate broker earns his commission fee when he produces a “ready, willing, and able” buyer to purchase the property. The broker must also be the “procuring cause” in effectuating the sale. Most brokers, agents, and lawyers are familiar with the former requirement—we have all heard that phrase before. However, the “procuring cause” element is often overlooked and misunderstood amongst real estate professionals. Although the California Association of Realtors (“C.A.R.”) has released helpful guidelines and even included these requirements in its model rules, confusion remains as to what “procuring cause” means. This blog article fills that void by exploring California’s case law on the ‘procuring cause’ requirement.

Ready, Willing, and Able – A Brief Summary

Under California law, a broker has satisfied the ready, willing, and able requirement when he has produced a buyer willing to purchase the property for the price and terms specified by the seller. (See Steve Schmidt & Co. v. Berry (1986) 183 Cal.App.3d 1299, 1305-06.) The buyer doesn’t need to make an offer to purchase the home, but an offer does indicate that the buyer is ready and willing to buy the home. (See Martin v. Culver Enterprises, Inc. (1966) 239 Cal.App.2d 925, 929.) In addition, the prospective purchaser must have the financial capability to purchase the property, such as the necessary capital, or is pre-approved for a home loan. (See Steve Schmidt, 183 Cal.App.3d at 1305-1306.).

In Steve Schmidt, the broker satisfied the ready, willing, and able requirement because the buyer possessed sufficient funds to purchase the property or, at a minimum, could obtain a loan to finance the transaction. In comparison, in Park v. First American Title Co. (2011) 201 Cal.App.4th 1418, 1426, the buyer was unable to purchase the property, which meant that the broker was not entitled to his commission fee. The buyer did not produce any evidence that indicated he had the financial capability to close the transaction, such as pay stubs and bank statements, nor had he been pre-approved for a home loan. The main takeaway is that a broker satisfies this first requirement if the buyer is serious about purchasing the property and has the financial wherewithal to do so.

Procuring Cause Requirement

The National Association of Realtors (“N.A.R.”) defines procuring cause as the “uninterrupted series of casual events, which results in the successful transaction.” C.A.R. has adopted N.A.R.’s definition and baked the procuring cause requirement into its Multiple Listing Services Rules (“M.L.S. Rules”). M.L.S. Rule 7.13 states that a buyer’s-broker’s offer is accepted by the selling broker “by procuring a buyer which ultimately results in the creation of a sales or lease contract.” The N.A.R.’s and M.L.S.’s respective definitions of procuring cause derive from the century-old landmark case of Sessions v. Pacific Improvement Co. (1922) 57 Cal.App. 1.  

In Sessions, the plaintiff-broker was employed by the defendant-seller for the sole purpose of selling a shipping yard located near the San Francisco Bay. The plaintiff-broker completed all of the due diligence associated with the sale, such as obtaining the necessary maps and surveys and obtaining a permit to dredge the shipping yard, among other things. After the plaintiff-broker left his employ with the defendant-seller, he provided tract maps to the parties and even helped resolve a drainage issue on the shipping yard. The defendant-seller ultimately closed the transaction at the $1 million purchase price plaintiff-broker had previously proposed; however, the plaintiff-broker was not paid his commission fee. 

In reviewing these facts, the California Supreme Court issued the ironclad rule that California Courts rely on to this day: a broker is entitled to his commission fee when he “set[s] in motion a chain of events, which, without a break in their continuity, cause the buyer and seller to come to terms as the proximate result of his peculiar activities.” (Sessions, 57 Cal.App. at 20.) The Supreme Court found that the plaintiff broker was an integral part of the sale because he had “performed the most effective and. . . .hardest and most expensive part of the whole undertaking.” (Id. at 32.) The Court concluded that the plaintiff-broker was entitled to his commission fee for his efforts in helping effectuate the sale of the shipping yard. (Id.)

Although Sessions was decided during the roaring twenties, California Courts have continuously relied on the case. For example, in Duffy v. Campbell (1967) 250 Cal.App.2d 662, the plaintiff-broker was the seller’s agent. The plaintiff-broker introduced the buyer to the seller, negotiated the sales price and contract terms, and even opened an escrow account for the parties. During the escrow period, the buyer and seller held a meeting at the exclusion of the plaintiff-broker and reduced the sale’s price by the amount of the broker’s commission fee. In addition, the parties conveniently closed the sale of the home after the last day the broker could claim a commission fee under the listing agreement. 

The Court held that the plaintiff-broker was the procuring cause in effectuating the sale. (See generally Duffy, 250 Cal.App.2d at 665-57.) Akin to Sessions, the plaintiff-broker did all of the heavy lifting. He introduced the parties, negotiated the sales price, and even opened an escrow account for the parties. (Id.) The fact that the parties amended the agreement, principally to exclude the plaintiff-broker from the transaction, did not preclude the plaintiff-broker from collecting his commission fee. (Id. at 668.)

Although Sessions and Duffy may provide a sigh of relief to a broker currently involved in a commission fee dispute, it is important to examine cases in which the Court found that the complaining broker was not the procuring cause. 

In Westside Estate Agency, Inc. v. Randall (2016) 6 Cal.App.5th 317, the plaintiff-broker made a $42 million offer for a Bel Air home on behalf of his clients. The offer was rejected, but the plaintiff-broker continued to negotiate and exchange offers with the seller’s broker. After the seller conditionally accepted the plaintiff-broker’s offer, the buyer contacted his attorney for additional advice and told the plaintiff-broker to cancel the deal. The plaintiff-broker did not submit any more offers for the buyer. Three months later, the buyer purchased the property for $1.25 million more than the plaintiff-broker’s original offer and used their attorney as the acting broker. The plaintiff-broker sued, claiming that he was entitled to a commission fee based on the new purchase price.

The Court disagreed and held that the plaintiff-broker “merely put the prospective buyer on track to purchase the property,” which did not entitle him to his commission fee. (Westside Estate Agency, Inc., 6 Cal.App.5th at 331.) The Court found that the plaintiff-broker’s efforts, albeit helpful, were too attenuated from the closing date to award him a commission fee because the transaction closed approximately three months after the buyer told the plaintiff-broker to cancel the deal. Moreover, the buyer purchased the home on different terms than those initially negotiated by the plaintiff-broker. (Id.)

In Schiro v. Parker (1955) 137 Cal.App.2d 503, the Court reached a similar conclusion as Westside Estate Agency, Inc. In Schiro, the property’s listed sale price was $366,000. The plaintiff-broker represented the buyer and submitted two offers at $320,000 and $325,000, both of which the seller rejected. The Plaintiff-broker later learned that the seller was inclined to sell the property for $330,000 or $335,000. The Plaintiff-broker communicated this information to the buyer, but the buyer chose not to submit another offer to the seller. A few weeks later, the buyer met with a separate broker, or the closing-broker, and told him that he thought the “deal was off.” Acting at the buyer’s direction, the closing-broker made two offers to the seller, and the seller accepted the closing-broker’s second offer for $330,000. 

Based on these facts, the Court held that the plaintiff-broker was not entitled to his commission fee. The Court focused on the buyer’s state of mind in reaching its decision. The Court was persuaded by the fact that the buyer thought the “deal was off,” and he was, therefore, “free to believe that [plaintiff-broker] was unable to procure an acceptable offer from the seller.” (Schiro 137 Cal.App.2d. at 507-08.)

The holdings in Westside Estate Agency and Schiro teach us the Courts will examine multiple factors when determining whether the complaining broker was the procuring cause in effectuating the sale. In Westside Estate Agency, Inc., the Court focused on the fact that the plaintiff-broker’s efforts were too attenuated from the closing date to be considered the procuring cause. On the other hand, in Schiro, the Court’s relied on the buyer’s beliefs and state of mind concerning the transaction and his relationship with the plaintiff-broker. 

There are noticeable factual differences in the case in which the broker was the procuring cause (i.e., Sessions and Duffy) and the cases in which the Court found the broker was not (i.e., Westside Estate Agency, Inc., and Schiro). In Sessions and Duffy, the plaintiff-brokers completed all of the major tasks related to the sale, and their efforts were closely related to the transactions in time and purpose. In comparison, in Westside Estate Agency, Inc. and Schiro, the brokers’ actions were too attenuated from the transaction (i.e., Westside Estate Agency, Inc.) and were not a significant factor or cause of the buyer and seller completing the sale.

The C.A.R. has adopted the case holdings described above and created four categories of factors to guide brokers, arbitrators, and courts in determining whether a broker was the procuring cause in the transaction. The four categories are outlined below:

  • Connection to the Transaction: These factors focus on who showed the property to the client, made offers on the client’s behalf, the amount of time that elapsed between the intro broker’s efforts and the sale of the property, and the services each competing broker provided. These factors were discussed in Westside Estate Agency, Inc., Sessions, and Duffy.
  • Buyer’s Choice: This set pertains to the client’s choice between brokers and his/her state of mind as to who was representing them. This factor was central to the holding in Schiro.
  • Broker’s Conduct: This category relates to the steps the competing brokers took to secure their commission fee and relationship with their clients. In other words, did the closing broker ask the seller if he/she had engaged with another broker? Did the intro-broker know that his/her client was attending open houses on their own? And did the intro-broker tell his client to inform other brokers that he/she was already represented? 
  • Other – Catch-All:  This set solely relates to whether any contractual agreements existed between the broker and the client, such as a Buyer-Representation Agreement.

It is important that California real estate brokers and agents keep these factors, as well as the cases discussed above, in mind when negotiating a sales contract on behalf of their client(s). Any ambiguity on who is entitled to a commission fee may negatively impact a broker’s livelihood and result in an arduous and time-consuming litigation process. Contact a California real estate attorney if you or another agent are involved in a commission-fee dispute.

The materials available at this website are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. Use of and access to this web site or any of the e-mail links contained within the site do not create an attorney-client relationship. The opinions expressed at or through this site are the opinions of the individual author and may not reflect the opinions of the firm or any individual attorney.

Author: Dylan Contreras

Standing to Sue: Possession vs. Ownership of Trade Secrets

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Trade secrets encompass a unique area of intellectual property law that where protection is granted without any formal filings.  Unlike patents, trademarks, and copyrights, which generally require filing an application with a government office, trade secrets are protected via—you guessed it—secrecy.

Once you have a protectable trade secret, you will generally have recourse to sue for misappropriation.  However, the courts have given standing to sue for this cause of action not just to the originator of the trade secret, but also to those who are in possession of the trade secret and have an obligation to protect the confidentiality of the information.

This blog will explore the topic of a third party’s right to bring a cause of action for misappropriation even though the third party is not the owner of the trade secret.

Trade Secret Protections, Generally

Trade secrets are defined under 18 U.S.C. § 1839[1] and Cal Civ Code § 3426.1[2].  Boiled down, three things must be true for the information you seek to protect:

  • Derives independent economic value;
  • Not generally known to the public;
  • Reasonable measures were taken to keep the information secret.

A good way to understand whether the information you want to protect as a trade secret derives independent economic value is to ask whether competitors would be able to gain immediate economic benefits if they got their hands this information.  If so, your information likely derives independent economic value.

As to the second point, it is important to understand that the law only requires the information be not generally known to the public; it does not have to be a secret from everyone. 

Finally, your efforts to protect the information have to reasonable under the circumstances.  This does not mean or require that “confidential information be kept completely clandestine or mandate the use of nondisclosure agreements in all instances.”  BladeRoom Grp. Ltd. v. Facebook, Inc., 219 F. Supp. 3d 984, 992 (N.D.Cal. 2017).  However, if you disclose your information to those who have no obligation to protect that information, you will have extinguished your rights to protection.  In re Providian Credit Card Cases, 96 Cal.App.4th 292, 304 (2002).

Non-originator’s Standing

It is widely understood that owners of intellectual property will be able to seek damages for infringement or misappropriation.  This is true for patents, trademarks, copyrights, and trade secrets.  However, within the realm of trade secrets, courts have ruled that rather than ownership, rightful possession of the protected information can be enough to give a party standing to sue.

Let’s say a ABC Company (“ABC”) has developed a novel, efficient method of producing a widget using proprietary software and machine sequences.  Rather than disclosing this information to the public by attempting to secure a patent, ABC decides to go down the trade secret route and keep this information confidential.  ABC then discloses this information to you, and you are able to incorporate this secret method and incorporate it into your own business practices.  The disclosure is protected by non-disclosure agreements wherein you can use but not disclose the trade secret, and now you have a duty to maintain the secret.  A few years down the line, you discover that despite reasonable efforts, one of your vendors hacked into your servers and pulled information—specifically, ABC’s trade secret—and began using it for economic gain.

The Plaintiff in BladeRoom faced a similar situation.  In BladeRoom, the Plaintiff, as a licensee of another’s trade secret, filed a complaint alleging misappropriation against Facebook.  219 F. Supp. 3d at 989.  Facebook argued, citing Nextdoor.com, Inc.v. Abhyanker, No. C-12-5667 EMC, 2013 U.S. Dist. LEXIS 101440, at *27, (N.D. Cal. July 19, 2013), that in order for plaintiff to bring a viable claim for misappropriation, the plaintiff must own the trade secret.  Id. at 990.  However, the court in BladeRoom stated that the citation denotes recognition of the “first element of a prima facie misappropriation claim” and that the term ownership is over-simplified in the cited text.  Id.

Surprisingly, the court in BladeRoom placed great emphasis on possession rather than ownership of a trade secret.  In following the rulings of courts in other jurisdictions, the court in BladeRoom stated that a party “has standing to bring a trade secrets claim if it has possession of the trade secret.”  Id.  “Those courts reason that ‘fee simple ownership’ as an element of a trade secret misappropriation claim ‘may not be particularly relevant’” because the confidential and proprietary aspect of a trade secret “flows, not from the knowledge itself, but from its secrecy.”  Id. (quoting DTM Research, L.L.C. v. AT&T Corp., 245 F.3d 327, 332 (4th Cir. 2001)).  Rather than ownership, “it is the secret aspect of the knowledge that provides value to the person having the knowledge.”  Id.  Further, although the confidential or proprietary secret information can be transferred, as with personal property, the continued secrecy within the transfer provides value, and any general, unprotected disclosure will destroy value.  Id.  Because trade secrets derive independent economic value from being not generally known to the public, “the better focus for determining whether a party can assert a misappropriation claim is on that party’s possession of secret knowledge, rather than on the party’s status as a true ‘owner.’”  Id.

This emphasis was echoed more recently by the 3rd Circuit in Advanced Fluid Sys. v. Huber, 958 F.3d 168, 177 (3d Cir. 2020).  In Huber, the Respondent obtained a license to use another company’s trade secrets.  958 F.3d at 178.  Appellant Kevin Huber (“Huber”), while employed by Respondent, had access to the licensed trade secret information.  Id. at 175.  After Huber resigned, he continued to use the information he obtained during his employment, and Respondent filed a claim for misappropriation.  Id.  Appellants argued that because Respondent did not actually own the trade secret, Respondent lacked standing.  Id. at 177.  However, the court in Huber stated that while ownership is generally sufficient to bring a claim for trade secret misappropriation, ownership is not a necessary condition.  Id.  “A per se ownership requirement for misappropriation claims is flawed since it takes account neither of the substantial interest that lawful possessors of the secrets have in the value of that secrecy, nor of the statutory language that creates the protection for trade secrets while saying nothing of ownership as an element of a claim for misappropriation.”  Id.  Moreover, Respondent, as a licensee, had standing to sue because it was given possessory interest by the owner of the trade secret, even though full ownership interest was not transferred.  Id. at 179.

Although both cases involve licensees, there is no distinction made by the courts in either BladeRoom or Huber between a licensee and a possessor of trade secret information.  Rather, it appears that anyone who has been granted a possessory interest in a trade secret—and thereby an interest in keeping the information a secret—has standing to sue for misappropriation.  The key takeaway here is that in light of these rulings (and referring back to the hypothetical above), the fact that you possess this information while not owning the trade secret may allow you to sue for misappropriation, as ownership may not be a strict requirement.  It will be interesting to see if these rulings will be further adopted by other courts moving forward.

[1] (3) the term “trade secret” means all forms and types of financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, procedures, programs, or codes, whether tangible or intangible, and whether or how stored, compiled, or memorialized physically, electronically, graphically, photographically, or in writing if—(A) the owner thereof has taken reasonable measures to keep such information secret; and (B) the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, another person who can obtain economic value from the disclosure or use of the information.

[2] (d) “Trade secret” means information, including a formula, pattern, compilation, program, device, method, technique, or process, that: (1) Derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use; and (2) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.

Author: John Ahn

Debtor’s Motion to Dismiss v. Creditor’s Motion to Convert In Chapter 13—The 9th Circuit’s Ruling in In Re Nichols

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On September 1, 2021, the Ninth Circuit issued its ruling in the case of In Re Nichols. The Circuit Court held that a debtor has an absolute right—without exception—to dismiss his Chapter 13 bankruptcy case under Section 1307 (b) of the Bankruptcy Code. In reaching its holding, the Ninth Circuit departed from an established precedent that when the bankruptcy court is confronted with a debtor’s motion to dismiss under Section 1307 (b) on the one hand, and a creditor’s motion to convert under Section 1307 (c) on the other, the court may convert the case from Chapter 13 to a Chapter 7 proceeding if there is evidence of bad faith or abuse of the bankruptcy process by the debtor. In Re Nichols is a significant and impactful holding in the Ninth Circuit because it informs all bankruptcy practitioners and creditors that even when a debtor has abused the bankruptcy process and engaged in bad faith, the debtor may escape the consequences of his actions by filing a motion to dismiss, which, according to In re Nichols, the court must grant.

The Relevant Statutes & Prior Law

The relevant statutes are Sections 1307 (b) and (c) of the Bankruptcy Code. Section 1307 (b) states in pertinent part:

On request of the Debtor at any time, if the case has not been converted under section 706, 1112, or 1208 of this title, the court shall dismiss a case under this chapter. Any waiver of the right to dismiss under this subsection is unenforceable.

(emphasis added).

In comparison, Section 1307 (c) of the Code states:

Except as provided in subsection (f) of this section, on request of a party in interest or the United States trustee and after notice and a hearing, the court may convert a case under this chapter to a case under chapter 7 of this title or may dismiss a case under this chapter, whichever is in the best interests of creditors and the estate, for cause, including— [omitted].

(emphasis added).

The prior leading case on this subject was Marrama v. Citizens Bank, 549 U.S. 365 (2007) (“Marrama”). In Marrama, the primary question was whether a debtor’s bad-faith conduct permitted the bankruptcy court to deny the debtor’s motion to convert from a Chapter 7 to a Chapter 13 bankruptcy under Section 706 (a) of the Bankruptcy Code. The paradox was that Section 706 (a) granted the debtor a one-time unqualified right to convert from a Chapter 7 to a Chapter 13; however, Section 706 (d) specified that the debtor’s absolute right was conditioned on his ability to qualify as a debtor under Chapter 13.[1]

The Supreme Court first pointed out that Section 1307 (c) permitted the bankruptcy court to dismiss or convert a Chapter 13 case “for cause,” which encompasses a debtor that engaged in bad faith or abused the bankruptcy process. The Supreme Court reaffirmed that bankruptcy courts are courts of equity and have “broad authority . . . to take any action necessary or appropriate ‘to prevent an abuse of the process.’” Id. at 1111-12 (quoting 11 U.S.C. § 105 (a)). Armed with the expansive powers of Section 105 (a), the Supreme Court bridged the gap between Sections 706 (d) and 1307 (c). The Court held that when a debtor engages in bad faith conduct or abuses the bankruptcy process, the debtor is not a qualified debtor under Chapter 13 and thus, cannot satisfy the requirements of Section 706 (d).

Many courts throughout the country, including the Ninth Circuit, interpreted Marrama to hold that Section 105 (a) permitted bankruptcy courts to abrogate the absolute rights of debtors when there is evidence that the debtor engaged in fraud, bad faith, or abused the bankruptcy process. The expansive interpretation of Marrama paved the way for the Ninth Circuit’s holding in Rosson v. Fitzgerald (In re Rosson), 545 F.3d 764, 777 (Ninth Cir. 2008) (“Rosson”) and other cases throughout the country.

In Rosson, the bankruptcy court ordered the debtor to deposit his arbitration award with the Chapter 13 Trustee to fund his reorganization plan. The debtor failed to do so, and the bankruptcy court moved, sua sponte, to convert the case to a Chapter 7 proceeding. Before the bankruptcy court entered its final order, the debtor filed a motion to dismiss, pursuant to Section 1307 (b). The bankruptcy court denied the debtor’s motion, and the debtor appealed.

Relying on Marrama, the Ninth Circuit held there was no analytical distinction between a debtor’s dismissal rights under Section 1307 (b) and a debtor’s right to convert from a Chapter 7 to a Chapter 13 under Section 706 (a). In other words, the same limitations imposed on a debtor’s right to convert from a Chapter 7 to a Chapter 13 under Section 706 (a) and (d) applied with equal force to a debtor’s right to dismiss his Chapter 13 case under Section 1307 (b). The Ninth Circuit held that the debtor’s “right of voluntary dismissal under Section 1307 (b) is not absolute but is qualified by the authority of a bankruptcy court to deny dismissal on the grounds of bad-faith conduct or to prevent an abuse of process.” Id. at 774. Based on this line of reasoning, the Ninth Circuit affirmed the bankruptcy court’s ruling.

Rosson bolstered the broad interpretation of Marrama and was cited by numerous bankruptcy courts in the Ninth Circuit and elsewhere. See In re Brown, 547 B.R. 846, 853 (Bankr. S.D. Cal. 2016) (“under § 1307 (c), where bad faith is present, the court decides how the case is to proceed, if at all, in the interests of the creditors rather than of the debtor”); see also In re Armstrong (Bankr. E.D.N.Y. 2009) 408 B.R. 559, 569 (same).

The New Law – In Re Nichols & Law v. Seigel

Similar to Rosson, the primary question in Nichols v. Marana Stockyard & Livestock Mkt., Inc. (In re Nichols) (Ninth Cir. Sep. 1, 2021, No. 20-60043) 2021 U.S. App. LEXIS 26366 (“Nichols”) was whether there was an implied exception to the debtor’s right to dismiss its Chapter 13 bankruptcy under Section 1307 (b) of the Bankruptcy Code. The Ninth Circuit held that there was no such exception and overruled its prior decision in Rosson. In reaching its decision, the Ninth Circuit relied heavily on the Supreme Court’s holding in Law v. Siegel 571 U.S. 415 (2014) (“Law”).

In Law, the trustee expended over $500,000 in attorneys’ fees in an adversary proceeding against the debtor. The trustee alleged the debtor fraudulently created a second position lien on his property to preserve his equity in the same. The bankruptcy court found in favor of the trustee. At the conclusion of the proceeding, the bankruptcy court granted the trustee’s motion to surcharge the entirety of the debtor’s homestead exemption to pay for the trustee’s attorneys’ fees. Section 522 (k) of the Bankruptcy Code states that funds safeguarded by the homestead exemption cannot be used to pay for administrative expenses.

In a unanimous decision, the Supreme Court held that Section 105 (a) “does not allow the bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code.” Id. at 11. The Supreme Court found that the lower court “exceeded [the] limits of its authority under Section 105 (a) by surcharging the debtor’s entire homestead exemption,” which the Court found was a clear violation of Section 522 (k) of the Bankruptcy Code. The Supreme Court then turned its attention to clarifying its ruling in Marrama.

Writing for the Supreme Court, the late Justice Scalia wrote that Marrama stands for the limited proposition that courts may use, as a supplement to Section 706 (d), their equitable powers under Section 105 (a) to deny a debtor’s motion to convert from a Chapter 7 to a Chapter 13. The Supreme Court reasoned that Section 105 (a) was only relevant to the holding in Marrama because it allowed the Court to avoid the “procedural niceties” of granting the 706 (a) motion to convert, then dismissing or converting the case pursuant to Section 1307 (c) due to the debtor’s bad faith.  More bluntly put, Section 105 (a) and its application in Marrama “did not endorse . . . the view that equitable considerations permit a bankruptcy court to contravene express provisions of the Code.” Id. at 426.

In Nichols, the Ninth Circuit found that Law rejected the broad sweeping language in Marrama that the Circuit Court relied upon to reach its decision in Rosson. The Ninth Court held that Rosson was no longer good law because Law made clear that even when there is evidence of bad faith, the bankruptcy court cannot utilize its equitable powers under Section 105 (a) to override the debtor’s absolute right to dismiss under Section 1307 (b) of the Bankruptcy Code.

Because Law overruled Rosson, the Ninth Circuit revisited the actual text of Section 1307 (b), which states in pertinent part: “on request of the debtor at any time . . . the court shall dismiss the case under any chapter.” [emphasis added]. The term “shall” “creates an obligation impervious to judicial discretion” and mandates action by the court. Id. at 13. Finding no other exception to Section 1307 (b), the Circuit Court held that Lawoverruled Rosson and that, in the Ninth Circuit, the debtor has an unqualified right to dismiss their Chapter 13 case at any time.

The holdings in Nichols and Law are significant and impactful for all bankruptcy practitioners. For Nichols, it is clear that the debtor has an absolute right to dismiss their case at any time—without exception. On the other hand, Law is entirely expansive. The holding in Law teaches us that the bankruptcy court’s equitable powers under Section 105 (a) are limited. The bankruptcy courts cannot explore the equities of the case when interpreting a statute that uses the terms “shall” or “must”; but, instead, the bankruptcy court must strictly comply with the Bankruptcy Code and, essentially, turn a blind eye to the realities of the case and circumstances. Only time will tell whether Nichols and Law further the spirit of the Bankruptcy Code and provide equal protection to debtors and creditors in bankruptcy court.

[1] Section 706 of the Bankruptcy Code states in pertinent part:

(a) The Debtor may convert a case under this chapter to a case under chapter 11, 12, or 13 of this title at any time, if the case has not been converted under section 1112, 1208, or 1307 of this title. Any waiver of the right to convert a case under this subsection is unenforceable.

(d) Notwithstanding any other provision of this section, a case may not be converted to a case under another chapter of this title unless the Debtor may be a debtor under such chapter.

Author: Dylan Contreras

In Trusts We Trust?: Applying the Alter Ego Doctrine to Trusts

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Most attorneys are familiar with the rigamarole that comes with attempting to reach assets held by the principals of a business entity as a part of analyzing whether a judgment will be collectible—that is, whether the alter ego doctrine will apply such that the creditor may “pierce the corporate veil.”  However, the rules for whether a judgment creditor may “pierce the veil” of a trust to reach the settlor behind that trust are a bit quirkier.   

Indeed, most of the time when trusts are involved, the creditor is interest in proceeding the opposite direction—that is, reaching the assets held in trust for the benefit of a judgment debtor.  Regardless of which direction the creditor may be going, this article discusses the rules of the road for collecting from individual via trust, and trust via individual. 

First, it should be noted that the alter ego doctrine doesn’t even come into play where a judgment debtor transfers assets into a revocable trust.  In that scenario, the judgment creditor can attach and collect upon the assets in the trust because they are treated as assets of the judgment debtor regardless of their placement into a revocable trust.  See Bank One Texas v. Pollack, 24 Cal. App. 4th 973, 980 (1994); Gagan v. Gouyd, 73 Cal. App. 4th 835, 842 (1999), disapproved on other grounds in Mejia v. Reed, 31 Cal. 4th 657, 669 (2003); see also Prob. Code § 18200 (“Property in a revocable trust is subject to creditor claims to the extent of the debtor’s power of revocation.”).     

Second, although the alter ego doctrine has been analyzed in the context of trusts rather than business entities, the California Court of Appeal has been careful to note that trusts are in fact not legal entities at all: “‘[A] trust is not a legal person which can own property or enter into contracts . . . It is the trustee or trustees who hold title to the assets that make up the trust estate . . . . [Therefore,] legal proceedings are properly directed at the trustee.’”  Greenspan v. LADT LLC, 191 Cal. App. 4th 486, 521 (2010) (quoting Neno & Sullivan, Planning and Defending Domestic Asset-Protection Trusts, Planning Techniques for Large Estates (Apr. 26-30, 2010) SRO34 ALI-ABA 1825, 1869-70)).  Moreover, “[b]ecause a trust is not an entity, it is impossible for a trust to be anybody’s alter ego.’”  Id. at 522.  However, the Court of Appeal did find that “applying the [alter ego] doctrine to trustees” was acceptable because “it’s entirely reasonable to ask whether a trustee is the alter ego of a defendant who made a transfer into the trust.”  Id.  The court in Greenspan concluded that alter ego doctrine could be applied to a third-party trustee of an irrevocable trust as the potential alter ego of the debtor settlor.  Id.  

The Ninth Circuit, applying California law a month before Greenspan, reached a similar conclusion in In re Schwarzkopf, 626 F.3d 1032 (2010), with a slight variation: the trust itself, rather than the trustee, can be considered the alter ego of a debtor settlor.  In Schwarzkopf, the debtor transferred assets to two irrevocable trusts, naming his minor child as beneficiary and a third party as trustee, but, as to the second trust, “‘dominated and controlled all decisions of the . . . Trust.’”  Id. at 1039.  The Ninth Circuit first held that the California court’s then-current rule1 against “reverse veil piercing”—that is, attaching the assets of a corporation to satisfy the debts of a shareholder—did not prevent them from considering whether “reverse piercing” could be allowed in a trust context.  See id. at 1038 (“In the absence of further guidance from California courts, therefore, we cannot extend the prohibition on reverse piercing to the trust context.”).  The court went on to hold that “under California law, equitable ownership in a trust is sufficient to meet the ownership requirement for purposes of alter ego liability.”  Id.  Although the debtor was not the beneficiary of the trust, nor the trustee, the court still found that the debtor was “an equitable owner of the . . . Trust because he acted as owner of the trust and its assets” because he essentially dictated the actions of the trust to the trustee.  Id.  Accordingly, the Ninth Circuit held that “the bankruptcy court did not err in finding that the . . . Trust is [debtor settlor’s] alter ego.”  Id. at 1040. 

But what if the debtor is the trust—or, more accurately, per the admonitions in Greenspan, the trustee—and the creditor wants to reach the assets of the settlor as the debtor trust/trustee’s alter ego?  To this author’s knowledge, there has been no California or Ninth Circuit case directly answering this question.  One can surmise this is because trusts are used as the vehicle to shield assets of individuals and entities, and do not often themselves incur liabilities.  However, it stands to reason that if a trustee of an irrevocable trust can be the alter ego of a debtor settlor per Greenspan, and an irrevocable trust itself can be the alter ego of a debtor settlor per Schwarzkopf, then the converse is also true—that is, a settlor can be the alter ego of a debtor trust or trustee.  In other words, alter ego liability would seem to imply a two-way street: the trust/trustee is the settlor and the settlor is the trust/trustee.  The waters seem to get murkier if one swaps in the trust beneficiary for the settlor in the foregoing analysis.  However, the Schwarzkopf court’s emphasis on equitable title as forming the basis for alter ego liability would seem to suggest that beneficiaries would be subject to the same rules as Greenspan and Schwarzkopf, as well as the potential extension of those opinions to the converse rule.  See Walgren v. Dolan, 226 Cal. App. 3d 572, 576 (1990) (“[T]he beneficiary [of a trust] holds only equitable title . . . .”).  Of course, the Ninth Circuit’s focus on equitable title, and the California Court of Appeal’s focus on the separation of trust and trustee, could result in a split between state and federal courts in California in how they each handle the trust to settlor liability question. 

In short, the current state of the law regarding trust alter ego theories is as follows: 

  1. Debtor = settlor of revocable trust → assets of trust collectible, no alter ego showing required 
  2. Debtor = settlor of irrevocable trust → assets of trust collectible upon alter ego showing 
  3. Debtor = trust or trustee → assets of settlor likely collectible 
  4. Debtor = trust or trustee → assets of beneficiary may be collectible 

Scenarios 3 and 4 above may remain opaque until the unique scenario of an asset-poor trust and an asset rich beneficiary or settlor come before a relevant court of appeal, but given the relative rarity of that fact pattern, litigants that find themselves in that scenario will likely have to argue by analogy to the existing rules of Greenspan and Schwarzkopf.  

Author: Jake Ayres

Landlord’s Limitations in Preventing Tenant’s Sale of Business

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Landlord-tenant relationships can be difficult.  What should be a relatively simple relationship based on contractual obligations often turns sour.  To make matters worse, COVID-19 has created a litany of financial problems worldwide which has further strained already stressful situations.  Due to the pandemic, many small businesses have struggled to make rent if not already completely shuttered.  Some business owners have been able to successfully sell their business or find a new lessee to take over their tenancy to make ends meet.  However, some business owners, due to unreasonable landlords, have been unable to sell their business and are stuck in a strange predicament where they are seemingly forced to slowly bleed out money.

This article will explore how much power a landlord has in preventing the assignment of a tenant’s lease.

I recently encountered this specific issue with two prospective clients as they were hoping to offload their business and move on with their lives.  Both of these clients each owned and operated a restaurant in the same building with the same landlord.  However, despite their best efforts to work with the landlord and having found viable assignees with solid business plans, the landlord simply refused without any good reason.  The only complaint the landlord presented to these tenants is that he did not trust the potential assignees.  It is difficult enough to find someone to buy your business and take over your lease, but it has unquestionably been a struggle during the pandemic.  Tenant one and tenant two—over the course of twelve and fifteen years, respectively—had dutifully and timely paid rent and continued on with their respective businesses despite other alleged inequities on behalf of the landlord.  However, the landlord in this case likely found the two existing tenants to be very reliable sources of income and refused to take on the uncertainty of new tenants.

Limitless Discretion?

If the situation above seems unreasonable, you are likely not alone.  However, landlord’s do not have unmitigated discretion and cannot prevent the sale of a tenant’s business without good reason or a provision in the lease restricting transfer.  In fact, a tenant’s right to assign her interest in the lease remains unrestricted unless the subject lease includes a restriction.  (Cal Civ Code § 1995.210.)  Conversely, the lease may include restriction provision which may absolutely prohibit transfer.  (Cal Civ Code § 1995.230.)  In either of these situations, the answer is fairly cut and dry; transfer may be fully prohibited or wholly unrestricted depending on the language of the lease.

But what if the restriction provision requires a landlord’s consent?  Does the landlord have full control of the outcome of a tenant’s request to assign the lease?  The courts have discussed this issue at length prior to codifying some of the rulings into law.

For instance, the court in Cohen stated that the duty of good faith and fair dealing prohibits landlords or lessors from arbitrarily or unreasonably withholding consent to an assignment.  (Cohen v. Ratinoff, 147 Cal.App.3d 321, 329 (1983).)  A lease is generally considered both a leasehold conveyance and a contract.  (Medico-Dental etc. Co. v. Horton & Converse, 21 Cal.2d 411, 418 (1942).)  Because a lease is also a contract, “there is an implied covenant that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract, which means that in every contract there exists an implied covenant of good faith and fair dealing.”  (Universal Sales Corp. v. California Press Mfg. Co., 20 Cal.2d 751, 771 (1942).)  “This covenant not only imposes upon each contracting party the duty to refrain from doing anything which would render performance of the contract impossible by any act of his own, but also the duty to do everything that the contract presupposes that he will do to accomplish its purpose.”  (Harm v. Frasher, 181 Cal.App.2d 405, 417 (1960).)

Arguably, being able to sell one’s business for a profit is an eventual fruit of a contract.  As such, the implied covenant of good faith and fair dealing protects a tenant’s right to assignment of a lease.  Although this right is not absolute, assignments are specifically allowed whenever there’s prior written consent from the lessor.  (147 Cal.App.3d at 329.)  “Accordingly, we hold that where, as here, the lease provides for assignment or subletting only with the prior consent of the lessor, a lessor may refuse consent only where he has a good faith reasonable objection to the assignment or sublease, even in the absence of a provision prohibiting the unreasonable or arbitrary withholding of consent to an assignment of a commercial lease.”  (Id. at 330.)  Some examples of a good faith reasonable objection include the “inability to fulfill terms of the lease, financial irresponsibility or instability, suitability of premises for intended use, or intended unlawful or undesirable use of premises.”  (Id. at 329.)  This reasoning was repeated in Schweiso v. Williams, 150 Cal.App.3d 883, 886 (1984) and in Kendall v. Ernest Pestana, 40 Cal.3d 488, 497 (1985) before being codified into law as Cal Civ Code §§ 1995.210-1995.270. 

A key takeaway here is that in a situation where the existing lease contains a provision prohibiting the assignment of a lease without the consent of a lessor, the lessor needs to act reasonably in withholding consent.  This presumption of reasonableness is what allows for freedom of contract between parties of commercial real property leases as intended by Cal Civ Code §§ 1995.210-1995.270.  Determining whether the lessor is unreasonable is a question of fact, and the outcome will depend on whether a lessor’s withholding consent was objectively unreasonable.  (Moore v. Wells Fargo Bank, N.A., 39 Cal.App.5th 280, 291 (2019).)  Going back to the facts of the two tenants above, if the lessor refused consent because he simply did not trust the potential assignees—despite said assignees allegedly having solid business plans, good credit histories, or whatever else positive attributes—the tenants might each have a strong case to show the lessor is being objectively unreasonable.  The burden to prove that will ultimately lie on each tenant and the outcome will depend on the facts surrounding the withholding.

It is also important to note that Cal Civ Code § 1995.230 allows for lease provisions where a tenant may be absolutely prohibited from transfer.  (Cal Civ Code § 1995.230; See also Harara v. ConocoPhillips Co., 377 F.Supp.2d 779, 787 (N.D.Cal. 2005); “A lease term actually prohibiting transfer of the tenant’s interest is not invalid as a restraint on alienation.” Cal Civ Code § 1995.230.)  In light of this, it is imperative that you carefully review the lease before signing to make sure you haven’t unintentionally placed yourself in a bind.

Author: John Ahn

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