“Total Amount Due” Means the Total Amount Due

–by Andriy Troyanovych

Source: Carlin v. Davidson Fink L.L.P., No. 15-3105-cv, 2017 WL 1160887 (2d Cir. Mar. 29, 2017)

Abstract: On March 29, 2017, the Second Circuit held that a letter to a consumer debtor providing a “Total Amount Due” and then following that with small print that states that the amount may include other fees was improper under the Fair Debt Collection Practices Act.


Facts and Procedural History

Davidson Fink, a debt collection and foreclosure firm, instituted collection proceedings against Andrew Carlin, who had allegedly defaulted on a 2005 mortgage. Davidson Fink filed a Foreclosure Complaint against Carlin. Davidson Fink sent a copy of the letter to Carlin, along with a “Notice Required by the Fair Debt Collection Practices Act,” which essentially told Carlin that the debt is assumed valid, unless he disputes it within 30 days. However, the complaint did not state a total amount owed.

Carlin promptly notified Davidson Fink and disputed the validity of the debt by requesting a verification of the total dollar amount owed. Thereafter, in August 2013, Davidson Fink sent Carlin a letter containing a payoff statement including a “Total Amount Due” of $205,261.79. But, just below the payoff statement was small print that read “Total Amount Due may include estimated fees, costs, additional payments and/or escrow disbursements that will become due prior to the ‘Statement Void After’ date, but which are not yet due as of the date this Payment Statement is issued.” Carlin then initiated proceedings against Davidson Fink alleging that the firm violated the FDCPA, particularly the section that requires a debt collector to send the debtor a written notice containing “the amount of the debt.” After reconsideration by the district court led to a dismissal of Carlin’s complaint for failure to state a claim, he appealed that decision to the Second Circuit Court of Appeals.

Second Circuit Decision

The Second Circuit vacated and remanded. The court applied the “least sophisticated consumer” standard to find that “[b]ecause Carlin ha[d] adequately alleged that the August letter [was] an initial communication sent by a debt collector . . .  and that it does not clearly state the amount of the debt,” the lower court decision was vacated and remanded.

In assessing Carlin’s claim, the court looked to whether (1) any of his communications with Davidson Fink were “initial communications” within the meaning of 15 U.S.C. § 1692g(a); (2) any of the communications were “in connection with the collection of any debt”; and (3) whether Davidson Fink provided the amount of debt within five days of such communication.

The court found quite convincingly that the August letter was the initial communication, and also that it was in connection with the collection of a debt as shown by the letter’s unambiguous communication. The court then found that Davidson Fink did not adequately state the amount of the debt Carlin owed in the August letter. Because of the small print after the “Total Amount Due,” the “least sophisticated consumer” would not be likely to determine whether those amounts were properly part of the amount of the debt. The court went on to further reason that “[a]bsent fuller disclosure, an unsophisticated consumer may not understand how these fees are calculated, whether they may be disputed, or what provision of the note gives rise to them.”

The court did point out that it was not forbidding debt collectors to include such fees in their payment statements, however, in order to do so, a debt collector should take special care to include a separate “Total Amount Due” that would “clarify the actual amount due, the basis of the fees, or simply some information that would allow the least sophisticated consumer to deduce the amount she actually owes.” This would satisfy the requirements of the FDCPA, and also provide more clarity to the debtor.

After Two Years of Efforts to Bring Uber Upstate, 2017 May be the Year It Happens

–by Karianne Polimeni


Ben Axelton, Cuomo to Reveal Plan to bring Uber, Lyft to Upstate New York, New York Upstate, (Jan. 8, 2017, 11:23 AM), http://www.newyorkupstate.com/news/2017/01/cuomo_to_reveal_plan_to_bring_uber_lyft_to_upstate_new_york.html; Kevin B. Knott, The Facts Behind Buffalo’s Uber Situation, The Buffalo Scene (2016), http://thebuffaloscene.com/2016/08/22/buffalos-uber-situation/; Jack O’Brien, Uber’s Fight for New York, The Legislative Gazette, (Dec. 27, 2016), http://legislativegazette.com/archives/4182; Jared Meyer, New York’s Dumb War on Uber, Reason.com, (Jan. 11,2017), http://reason.com/archives/2017/01/11/new-yorks-dumb-war-on-uber.

Abstract: Since Uber’s launch in 2014, New York State citizens have been pushing for Uber to be allowed in New York. Despite Assembly opposition, Uber has made its way to New York City and has been nothing but successful. Now, Upstate New York citizens are left wondering when the rest of the state will be allowed to enjoy the cheap, safe ride-sharing company the rest of the nation and even people overseas have come to love.


Since its launch in 2014, Uber has done nothing but grow. As of today, Uber operates in 45 states and has even expanded rapidly overseas. Although allowed in New York City, Uber has yet to make its way to the rest of New York State (“NYS”). This is not for lack of trying or for lack of demand. This past Thanksgiving-eve alone, more than 40,000 people in Upstate New York launched their Uber app only to find that it does not exist anywhere in the state other than New York City.

Starting in early 2015, there has been a huge push to get Uber and Lyft into Upstate New York. With its demand growing every day, many senators and representatives have been overwhelmed by the letters, phone calls, and petitions that end up on their desks daily from NYS citizens. Citizens are not the only ones pushing for its expansion. In 2016 alone, Uber spent over $750,000 lobbying for its allowance in NYS. In addition, Uber has even teamed up with the Buffalo Bills and the Buffalo Sabres for special rates on transportation to and from games, and free rides for players on the teams. Currently, Buffalo is the largest city in the nation without Uber or Lyft operating in it and is the only city with an NFL team without it. In fact, Buffalo is one of the five largest cities in the world that does not have Uber or Lyft operating within it. In Buffalo alone, more than 2,000 people launch the app daily. Statewide, 60,000 people try to use the app daily.

Governor Andrew Cuomo is even behind the efforts. “Uber is one of these great inventions, startups, of this new economy and it’s taking off like fire to dry grass and it’s giving people jobs. I don’t think the government should be in the business of trying to restrict job growth.” Bringing Uber to the rest of NYS would create an estimated 13,000 jobs. Many worry, however, that these jobs would be at the cost of other jobs, such as taxi drivers or those in other transportations services. This worry is one of the reasons why there is opposition to its expansion.

Another reason it has yet to expand to Upstate NY is that many want every driver to submit to a fingerprint background check. NYS Senate Bill S4108D made its way through the Senate, but stopped in the Assembly, with this being one of the major cited reasons for its opposition. If the Assembly were to get its way and mandate fingerprint background checks for every driver, it would be the only state in the nation to do so. With safety being the Assembly’s concern, many are worried that a regular background check is not enough. Opponents to the fingerprint background check acknowledge the Assembly’s concerns, but point out that fingerprint background checks are only as good as the company that updates them–citing cases where DUI’s and other traffic safety violations often do not show up on the check. Further, they point out, many of the few safety issues that have occurred through ride-sharing companies come from someone posing as a driver, and not an actual hired driver.

Insurance is another reason for its opposition. Having a ride-sharing company in NYS would require a certain group insurance policy that NYS does not currently have. Insurance companies have lobbied with taxi companies in opposition to Uber expanding to the rest of NYS because of it. In light of this opposition, the Assembly has proposed its own bill (A08195) that would require the insurance increase to come from the Uber Drivers. Uber claims that this increase in insurance would make the expansion impossible for its company, so this bill, too, has been halted.

Despite all of the bumps in the road, many are hopeful that Uber will make its way to the rest of New York soon. In 2017, Governor Cuomo has addressed the issue at his State of the State Address and says he has a plan in the works. “It defies logic that ride-sharing isn’t available to New Yorkers who live outside of New York City. My message is Upstate New York matters and it’s not right or fair that Upstate doesn’t have this new innovation that spurs the economy, can save money and save lives.”

Consumer Alleges Deceit; Court Rules that Reasonable Consumers Account for the Ice

–by Erin Shea

Source: Galanis v. Starbucks Corporation, No. 16-C-4705, 2016 WL 6037962 (N.D. Ill. 2016) (all internal citations omitted).

Abstract:  The Northern District of Illinois concluded that a reasonable customer understands the term “fluid ounces” to indicate the volume of a container and not the contents.


Starbucks customer Steven Galanis was recently disappointed with his iced Starbucks beverage. Galanis’ disappointment rose to such a level that he filed a lawsuit, alleging that Starbucks deceives its customers by “misrepresenting the volume of its cold drinks because much of the volume is taken up by ice.” Galanis argued that Starbucks was deceiving the customer by advertising the size of its cups rather than the amount of liquid that a customer receives with the order of an iced beverage. For example, Starbucks advertises that an iced drink has twenty-four fluid ounces. Galanis believes that drink should have twenty-four fluid ounces of beverage before the ice is added.

Galanis filed suit in the Northern District of Illinois and argued that this misrepresentation constituted (1) breach of express warranty; (2) breach of implied warranty of merchantability; (3) negligent misrepresentation; (4) unjust enrichment; (5) fraud; (6) a violation of the Illinois Consumer Fraud and Deceptive Business Practices Act; and (7) a violation of the Illinois Uniform Deceptive Trade Practices Act. In response, Starbucks filed a motion to dismiss for failure to state a claim.

In order to succeed on a cause of action under the Consumer Fraud Act, Galanis needed to prove that (1) Starbucks engaged in a deceptive act or practice; (2) Starbucks intended that consumers rely on the deception; (3) this deception involved trade or commerce; (4) the deception caused actual damage to the consumer; and (5) Starbucks’ deception proximately caused the damage to the consumer. A statement will be considered deceptive if it “creates a likelihood of deception,” and “misled a reasonable consumer,” in the totality of the circumstances. A court may dismiss a claim under this theory if the statement was not misleading as a matter of law.

The court sided with Starbucks and concluded that a reasonable consumers knows that the measurement of fluid ounces refers to volume, not content, and “if the consumer chooses an ‘iced’ drink, the reasonable consumer knows that the container (whatever its volume) will be filled with both solid ice and fluid beverage.” The court stated that the mere fact the volume of the drink is measured using a phrase that contains the word “fluid,” does not mean all the contents need to be fluid. A reasonable consumer would expect there to be ice in the iced drink.

The court supported its finding of reasonableness by relying in part on a recent California district court decision that stated, “children have figured out that including ice in a cold beverage decreases the amount of liquid they will receive.” The court noted that sellers do not normally list the fluid ounces available, and simply demonstrate by display the size choices available to the customer. The reasonable consumer understands that even though Starbucks displays its cups and lists the fluid ounces, the ounces indicate the volume of the container, not the contents of the container. The court finished by stating, “including ice, which of course is not fluid (as the parties ‘helpfully’ point out . . . ), in an iced drink does not make a menu listing the size of the drink in terms of ‘fluid ounces’ a deceptive statement.” Since all of Galanis’ claims required a misleading statement, and the court did not find that one existed, the court granted Starbucks’ motion to dismiss on all counts.

Second Circuit Holds that the Discharge Injunction Provisions of the Bankruptcy Code do not Repeal Post Discharge Claims Under the Fair Debt Collection Practices Act

— by Matthew Schutte

Case: Garfield v. Ocwen Loan Servicing, LLC, 2016 U.S.  App. LEXIS 3 (2d Cir. 2016)

Abstract: Plaintiff borrower appealed from District Court’s dismissal of her post discharge Fair Debt Collection Practices Act claims against Defendant loan servicer. The Second Circuit held that the discharge injunction provision of the Bankruptcy Code does not broadly or impliedly repeal FDCPA claims in the post discharge context.


Plaintiff borrower was a former Chapter 13 debtor. Plaintiff sued Defendant loan servicer, alleging that Defendant violated various provisions of the Fair Debt Collection Practices Act (FDCPA) when it tried to collect a debt on her mortgage that had previously been discharged in bankruptcy proceedings. The United States District Court for the Western District of New York granted Defendant’s motion to dismiss for failure to state a claim on the ground that the exclusive remedy for Defendant’s alleged conduct was under the discharge injunction provision in §524(a) of the Bankruptcy Code.

In reviewing the District Court’s dismissal of Plaintiff’s claim, the Second Circuit had to address four issues of first impression: (1) whether § 524(a) of the Bankruptcy Code broadly repeals the FDCPA in the context of FDCPA claims based on conduct that would constitute a violation of the Bankruptcy Code’s discharge injunction; (2) whether § 524(a) of the Bankruptcy Code impliedly repealed Plaintiff’s claim that Defendant’s attempt to collect the discharged debt constituted a violation of §1692e(11) of the FDCPA, requiring a debt collector to provide a mini Miranda warning in its initial communication with a debtor; (3) whether § 524(a) of the Bankruptcy Code impliedly repealed Plaintiff’s claims under § 1692e(11) and § 1692g(a)(3) of the FDCPA, regarding the way in which Defendant tried to collect Plaintiff’s post bankruptcy monthly payments; and (4) whether § 524(a) of the Bankruptcy Code impliedly repealed Plaintiff’s claim that Defendant’s attempt to collect her discharged debt constituted a violation of §§ 1692e, 1692e(2), 1692(e)(5), and 1692e(8) of the FDCPA, which regulate debt collection.

The Court began its analysis by discussing the general rules regarding implied repeal. If a party claims that a later enacted statute creates an irreconcilable conflict with an earlier statute, then the court must decide whether the later statute has impliedly repealed all or part of the earlier statute. National Ass’n of Home Builders v. Defenders of Wildlife, 551 U.S. 644, 662-63 (2007). The Court noted that courts generally disfavor implied repeal. If there is no affirmative showing of an intent to repeal, then implied repeal is only justified if the earlier and later statutes are irreconcilable. Morton v. Mancari, 417 U.S. 535, 550 (1974).

The Court then went on to apply these rules to the bankruptcy context. If a party claims that a later enacted Bankruptcy Code statute creates an irreconcilable conflict with an earlier statute, then the court must differentiate between claims brought under the earlier statute while bankruptcy proceedings are pending and claims brought after discharge. The Second Circuit had previously decided that the FDCPA does not allow lawsuits on claims that are based on acts that allegedly violated the Bankruptcy Code if they are brought while bankruptcy proceedings are pending. Simmons v. Roundup Funding, LLC, 662 F.3d 93, 96 (2d Cir. 2010).

The Court held first that the § 524(a) of the Bankruptcy Code does not broadly repeal in the FDCPA in the context of FDCPA claims based on conduct that would violate the discharge injunction under § 524(a) of the Bankruptcy Code. The Court found no irreconcilable conflict between post discharge remedies under the Bankruptcy Code and the FDCPA, reasoning, “[t]here is no reason to assume that Congress did not expect these two statutes to coexist in the post discharge context.” In the post discharge context, the bankruptcy court no longer protects the former debtor. This factor was central to the Court’s reasoning in Simmons in holding that the Bankruptcy Code precludes FDCPA claims where they are brought during the pendency of bankruptcy proceedings. Additionally, the Court noted that § 524(a) of the Bankruptcy Code does not provide a clear cause of action for violations of the discharge injunction.

For the second issue, the Court held that the Bankruptcy Code did not impliedly repeal Plaintiff’s claim that Defendant’s attempt to collect her discharged debt violated §1692e(11) of the FDCPA. This statute requires debt collectors to provide mini-Miranda warnings in initial communications with debtors. The Court reasoned that Defendant’s communication constituted an attempt to collect a discharged debt, in violation of the Bankruptcy Code’s discharge injunction, as well as the FDCPA’s mini-Miranda requirement.

In addressing the third issue, the Court held that the Bankruptcy Code did not impliedly repeal Plaintiff’s claims that Defendant’s attempt to collect her delinquent post bankruptcy monthly payments constituted a violation of  § 1692e(11) and § 1692g(a)(3) of the FDCPA. The latter of these provisions requires debt collectors to provide debtors with timely notice of the opportunity to dispute a debt. The Court again found that Defendant’s alleged violations of these provisions did not conflict with any provisions of the Bankruptcy Code.

Finally, the Court held that the Bankruptcy Code did not impliedly repeal Plaintiff’s claim that Defendant’s attempt to collect her discharged debt violated §§ 1692e, 1692e(2), 1692(e)(5), and 1692e(8) of the FDCPA. These provisions regulate the collection of debt. The Court reasoned that a loan servicer could avoid violating the FDCPA provisions as well as the Bankruptcy Code by simply refraining from attempting to collect discharged debt. Thus, when Defendant tried to collect the discharged debt, it risked violating the FDCPA as well as the Bankruptcy Code, and there was no conflict between the statutes.

The Court reversed and remanded the District Court’s dismissal of Plaintiff’s claims and instructed the District Court to reinstate all of Plaintiff’s claims.

Rigano v. Vibar Const., Inc.

The issue decided in the case is whether a notice of mechanic’s lien can be amended nunc pro tunc to reflect the name of the true owner of the property or whether the misnomer invalidates the lien.

George Vigogna (sole shareholder of Vibar Constructions Corp.) and Nick Rigano (sole shareholder of Fawn Builders, Inc.) were business partners for over 35 years up until the dispute at question arose in 2007. Both parties often worked together, split their profits and rarely put their business agreements in writing.

During the project at issue, Vigogna’s company constructed a driveway to access a property and claims that Rigano’s company failed to compensate them for the construction of the road. Vigogna’s company filed a notice of a mechanic’s lien on the property in order to recover costs for construction of the road. Rigano sought to have the lien discharged on the grounds that he, and not his company owned the property, and that the lien was invalid. Vigogna sought to amend the lien. The Supreme Court granted Rigano’s petition and discharged the lien and the Appellate Division affirmed holding that “a misidentification of the true owner is a jurisdictional defect which cannot be cured by an amendment nunc pro tunc.”

The Court of Appeals reversed the Appellate Division’s holding. They referenced Matter of Niagara Venture v. Sicoli & Massaro, where they stated in that case that, “Substantial compliance . . . shall be sufficient for the validity of a lien and to give jurisdiction to the courts to enforce the same . . .  and a failure to state the name of the true owner . . . or a misdescription of the true owner, shall not affect the validity of the lien.” The Court also referenced Article 2 of the Lien Law which says they are to be construed liberally.

Combining these principles, the Court said in these particular circumstances, that the amendment sought was authorized and the defect in the lien was a misdescription, which allowed the amendment, and not a misidentification.

998 N.Y.S. 2d 748 (N.Y. 2014)

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Val Tech Holdings, Inc. v. Wilson Manifolds, Inc.

This appeal addresses damages recoverable under a cross claim for breach of contract. The plaintiff, Val Tech Holdings, contracted with the defendant, Wilson Manifolds, to fabricate plastic injection molds for the production of specialty intake manifold parts to be sold by the defendant to retail customers. When plaintiff commenced an action seeking damages for breach of contract in the Supreme Court of Monroe County, the defendant responded with counterclaims of breach of contract seeking compensatory damages for loss of profits as well as punitive damages. Plaintiff then moved for partial summary judgment dismissing the defendant’s counterclaims. and defendant made a cross motion for leave to serve a second amended answer containing counterclaims breach of implied covenant of good faith and fair deal as well as fraud. In response, the court issued an order denying the plaintiff’s motion and granting the defendant’s cross motion.

Here, the court held that consequential damages for lost profits are recoverable if, at the time of contracting, the loss of profits that would be incurred from a breach are foreseeable and probable. The court rejected plaintiff’s contention that lost profits must be included as a recovery in the contract at time of creation and instead used what it called the “common sense rule” to determine what the parties would have concluded had they considered the subject of damages. Using that rule the court found that plaintiff failed to meet its initial burden of establishing as a matter of law that lost profits were not within the contemplation of the parties at the time the contract was made. The key uncontested fact that the court relied upon was plaintiff’s knowledge of defendant’s intent to use the molds for immediate production and resale of specialty automotive parts.

However, the court did agree with plaintiff that the defendant’s demand for punitive damages was unsupported by allegations and that the lower court erred in denying that part of plaintiff’s motion to strike. The court found that nothing in the allegations satisfied the requirement of egregious conduct directed at the public in general. Furthermore, the court found that defendant’s proposed counterclaim for breach of the implied covenant of good faith and fair dealings was duplicative as it could not exist by itself absent the contract. Therefore, the court held that that counterclaim should have been denied on the ground that it was palpably insufficient on its face. Importantly, the court held that the second proposed counterclaim for fraud properly alleges wrongful conduct and injurious consequences independent of those underlying the breach of contract claim and was therefore properly allowed. Therefore, the court unanimously modified the lower court’s order so as to grant the plaintiff’s motion to strike defendant’s demand for punitive damages but to deny the part of defendant’s cross motion seeking leave to serve a second amended answer adding a counterclaim for breach of the implied covenant of good faith and fair dealing. As modified the lower courts order was affirmed without costs.

990 N.Y.S.2d 379 (4th Dep’t. 2014)

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Article: Sacrificing Functionality for Transparency? The Regulation of Swap Agreements in the Wake of the Financial Crisis

Once the sole province of chief executive officers and hedge fund managers, swap agreements (or “swaps”), most notably credit default swaps,[1] came to the forefront of politicians’ and regulators’ minds with the near-collapse of the U.S. financial system in 2008.  Having operated largely in the shadows of the lightly regulated over-the-counter (OTC) derivatives market, companies went unimpeded when they sold credit default swaps to cover trillions of dollars in securities and bonds.[2] Credit default swaps written by American International Group, Inc. (AIG), for instance, covered more than $440 billion in bonds.[3] Unable to cover the contracts’ costs when they became due at the onset of the financial crisis, the U.S. government, arguably to save the larger financial system,[4] bailed out AIG and some of the largest financial institutions in the world.[5]

In response, and in an effort to gain control over the opaque OTC derivatives market, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in 2010, which, in part, provided authorization to both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to regulate swap agreements.[6]  Acting on its congressional mandate, the SEC in early 2011 released for public comment Regulation SB SEF,[7] which purports to remove many swap agreements from the OTC market and put them on exchanges or swap execution facilities, and thereby inject greater transparency into the OTC derivatives market.

This Article argues that Regulation SB SEF does not adequately consider the fundamental differences between securities and swap agreements that render swap agreements less amenable to securities-like exchanges.  Part I of this Article defines what a swap agreement is and describes the SEC’s attempt to regulate them.  Part II dissects the case for regulating swap agreements and analyzes their fundamentals in order to better understand how to regulate them.  Part III suggests an alternative regulatory structure that will better allow the swaps market to function.

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Reed Schuster: Associate, Faegre Baker Daniels LLP; J.D. 2011, University of Minnesota Law School.

[1]. For a more in-depth discussion of credit-default swaps, see infra Part I.A.1.b.

[2]. See Marco Avellaneda & Rama Cont, Int’l Swaps & Derivatives Ass’n, Transparency in Credit Default Swap Markets 8 (July 2010), available at http://www.isda.org/c_and_a/pdf/CDSMarketTransparency.pdf (“In 1997, the notional open interest in [credit default swaps] was on the order of 200 billion dollars; by 2007 it had grown to approximately USD 60 trillion.”).

[3]. Adam Davidson, How AIG Fell Apart, Reuters (Sept. 18, 2008), http://www.reuters.com/assets/print?aid=USMAR85972720080918.

[4]. Cf. Henry M. Paulson Jr., On the Brink: Inside the Race to Stop the Collapse of the Global Financial System 99 (2010) (“A Bear Stearns failure wouldn’t just hurt the owners of its shares and its bonds.  Bear had hundreds, maybe thousands, of counterparties—firms that lent it money or with which it traded stocks, bonds, mortgages, and other securities.  These firms . . . all in turn had myriad counterparties of their own.  If Bear fell, all these counterparties would be scrambling to collect their loans and collateral. . . .  That was how bank runs started these days.”).

[5]. See, e.g., Steven M. Davidoff, Uncomfortable Embrace: Federal Corporate Ownership in the Midst of the Financial Crisis, 95 Minn. L. Rev. 1733, 1737-44, 1754-55 (2011) (discussing the U.S. government’s assistance to AIG, Citigroup, and Bank of America); Matthew Karnitschnig et al., U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up, Wall Street J. Online (Sept. 16, 2008), http://online.wsj.com/article/SB122156561931242905.html (reporting on the U.S. government’s bailout of AIG).

[6]. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 762, 124 Stat. 1376, 1759 (2010).  Interestingly, save for section 10(b) of the Securities Exchange Act of 1934, see Commodity Futures Modernization Act, Pub. L. 106-554, § 303(d), 114 Stat. 2763, 2763A-454 (2000) (providing for the regulation of swap agreements under section 10(b)); see also Caiola v. Citibank, 295 F.3d 312, 327 (2d Cir. 2002) (“Sections 302 and 303 of the [Commodity Futures Modernization Act] define ‘swap agreements’ and then expressly exclude them from the definition of ‘securities,’ but amend section 10(b) to reach swap agreements.”).  Swap agreements were expressly exempted from regulation in the Securities Exchange Act of 1934.  15 U.S.C. § 78c-1(a)-(b) (2006).

[7].Registration and Regulation of Security-Based Swap Execution Facilities, 76 Fed. Reg. 10,948 (proposed Feb. 28, 2011) (to be codified at 17 C.F.R. pts. 240, 242, 249).

Article: Financing Innovation: Branding, Monitoring, and Uncertainty

A recent breakthrough in contract theory identified the practice of braiding, in which parties weave informal and formal elements of contract together to overcome uncertainty.  These contracts are especially prevalent in the context of collaboration for technological innovation, but they also appear in other contexts with significant uncertainty, such as preliminary agreements in mergers and acquisitions.  Thus far, the literature has focused solely on the core contractual relationship—the crystallized instance of the initial agreement between two companies, such as a research collaboration between a large pharmaceutical company and a small biotechnology company.

This article builds on braiding theory in several ways.  It provides new empirical information by analyzing actual contracts, modifications, and financing arrangements.  It expands braiding theory’s initial inquiry and seeks to understand how modifications to such original agreements affect braiding and how secured lenders finance such uncertain collaborations and monitor debtors.

Modifications reveal how parties gradually resolve uncertainty and how they respond to newly arising uncertainty.  First, modifications have shifted power within the “contract referee mechanism,” suggesting that braiding also works well as a mechanism to deal with ex ante uncertainty of bargaining power, revelation of information throughout the relationship, and ex post reallocation of that power.[1]  Second, modifications have formalized certain switching costs in termination provisions, and have adjusted those costs over time.[2]  This formalization suggests that crowding out of informal elements (here, switching costs) is not a necessary result even when there is a high-powered formal element.  Third, modifications reveal innovative nested option structures[3] that are developed in stages as nested uncertainty is revealed.[4]  Low-powered formal mechanisms[5] appear to be essential in developing an option-based response to these unforeseen uncertainties.

The secured lender’s behavior in these contracts is initially puzzling: neither the braiding solution nor the traditional secured credit solution is present to resolve uncertainty or even manage the risk of routine opportunism.[6]  The secured credit theory predicts that the lender will take one of two measures to police opportunism: monitor the debtor’s behavior or accept a bonding gesture by the debtor.[7]  Here, neither of those occur in any significant way.  The lender cedes control over the primary assets of the small collaborator, the intellectual property (IP), and allows the big collaborator an exclusive license.  The lender also does minimal monitoring: it might receive financial statements, but it does not actively monitor debtor behavior, the collaborative process, or the collateral.  Instead, the lender’s primary strategy is to take a security interest in the small company’s payment rights from any IP that emerges from the collaboration.

This article solves the puzzle with two steps that refine foundational assumptions in secured credit theory and the theory of transacting around uncertainty.  First, it is not the secured lender who monitors the debtor, but the big collaborator.  The big collaborator’s monitoring acts as a substitute for the secured lender’s expected monitoring.  Secured credit theory typically describes the secured lender as a “cop on the beat,” which allows other unsecured creditors to provide credit without worrying about monitoring.  Here, the big collaborator is the “cop on the beat,” and it is the secured lender who is benefitting from that diligence.  This particular monitoring arrangement is also normatively optimal as the secured creditor does not have the usual combination of countervailing effects—focused monitoring and security’s disincentivizing insulated recovery.[8]

Second, Knightian uncertainty is relative.[9]  The underlying uncertainty problem that braiding contracts attempt to solve is not an absolute attribute of a particular event or series of events as economics literature has typically suggested.  Instead, one’s economic position with regard to specific uncertainties can transform an uncertain event into a risky event.  This result can be seen in the secured lender’s strategy.  The big and small collaborators effectively solve the uncertainty problem in their technological innovation contract, but the uncertainty is not automatically solved for other parties.  Unlike the elimination of risk by monitoring, the uncertainty is still present and will not dissipate until the necessary information is revealed (or created).  The secured lender, however, cares nothing of this uncertainty and instead makes a bet on the exogenous probability of the success of the venture.  The uncertainty endogenous to the collaborative relationship determines that outcome, but need not be a part of the secured lender’s risk calculus.[10]  For example, any collaboration may have a ten percent chance of success, but the direction of each individual collaboration may be radically uncertain.  By having a position outside of that relationship, the secured lender has a different relative position and can avoid the uncertainty problem inherent in braiding contracts.  Portfolio theory provides a more rigorous explanation of this phenomenon by describing how specific uncertainty may be diversified away, a fact previously undeveloped in economic and legal academic literature.

Part II describes the theoretical background for this discussion.  It describes the phenomenon of braiding contracts and how they solve problems of technological and partnership uncertainty.[11]  It also considers alternative theories that seek to explain how the uncertainty problem has been solved, such as modularity theory and relational contracting theory.  It also examines prior empirical literature on collaborative alliances and questions its underlying assumptions about contracts underlying this literature.

Part III examines a new example of a prototypical braiding relationship and its contractual modifications as that relationship developed over time.  Specifically, it examines how modifications affect the contract referee mechanism, switching costs, and the nested options structure.  The modifications of these features reveal that braiding also deals with uncertainty of bargaining power[12] and unforeseen uncertainties which only emerge once the relationship has developed.  The formalization of switching costs through high-powered mechanisms also further undermines the explanatory power of the crowding-out phenomenon in the economics literature, but perhaps only where the formal and informal elements of the contract are tied to different information streams.

Part IV examines the third-party loan agreement with the small collaborator in that relationship.  The actual structure of this loan agreement undermines the standard predictions one would make under current theories of secured credit and policing debtor opportunism.  This analysis discerns a new pattern of monitoring, helps to refine existing secured credit theories and adds a new tool for solving puzzles in explaining the pattern of secured credit.

Part V considers the loan agreement’s approach to the collaboration’s uncertainty, finding that the only plausible explanation is that Knightian uncertainty is positionally relative.[13]  The secured lender is actually operating under a risk-based scenario despite the uncertainty inherent in the collaboration that it is lending into.  After describing intuitive analogies for this argument, this Part adds a first cut at using portfolio theory to establish a rigorous basis for the relativity of uncertainty.  The Part concludes by considering what the relativity of uncertainty means for the role of business lawyers in such transactions.

Part VI concludes.

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Nicholas J. Houpt: Associate, Akin Gump Strauss Hauer & Feld LLP.  J.D., Columbia Law School; B.A. University of Notre Dame.

[1]. Ronald J. Gilson et. al., Braiding: The Interaction of Formal and Informal Contracting in Theory, Practice, and Doctrine, 110 Colum. L. Rev. 1377, 1403 (2010) [hereinafter Gilson, Braiding].  A “contract referee mechanism” is a dispute resolution mechanism used in braiding contracts.  Id.  The mechanism typically requires (near) unanimous consent for certain key decisions in the collaborative relationship.  Id.  Lower-level employees are typically the ones deciding at first, with any unresolved disputes going to higher-level employees.  Id.

[2].Id.  Switching costs are the costs of finding another partner with whom to collaborate.  Gilson, Braiding, supra note 1, at 1403.  These costs include the learning curve that the new partner would have to undergo to catch up to the current partner, and would include a discount for reliability and trust that has not yet been established.

[3]. See id. at 1407-09.  Nested options are a mechanism used to solve potential hold-up problems that may arise once uncertainty is dissipated.  For example, once a technological innovation is developed, the next stage is commercialization.  One can predict these stages beforehand and use an option structure at each stage to prevent opportunism.  One collaborator may have an option of first refusal on the commercialization of any product that is developed, and if that collaborator cannot reach a commercialization agreement with the other, the other has an option to purchase the product and commercialize it through other means.  Without these options, the parties might try to hide their successes from each other and act opportunistically.

[4]. In this article, I challenge the effectiveness of nested options by pointing to evidence of nested uncertainty.  As one type of uncertainty is resolved and a predictable stage is entered, another type of uncertainty may develop that presents its own opportunism problems.  This unpredictable uncertainty can only be dealt with once it arises.

[5]. Low-powered formal mechanisms are soft commitments, like an obligation to negotiate in good faith.  High-powered formal mechanisms are much harder commitments, such as the obligation to perform a certain task at a certain time.  In the context of braiding contracts, low-powered formal mechanisms are used because hard terms, like price, quantity, and typical covenants, do not fit well with uncertain processes.  The options that are typically used are options to negotiate about a particular term or to terminate the agreement.

[6]. I explain other standard theories of secured credit not discussed in the Introduction, such as relational contracting and contextualist theory in Part IV.

[7]. See Saul Levmore, Monitors and Freeriders in Commercial and Corporate Settings, 92 Yale L.J. 49, 50-59 (1982) (describing monitoring and bonding as the two methods secured lenders use to manage agency costs).  See infra Part III.A for a more thorough discussion of the many different theories of secured credit.

[8]. See infra Part IV.C (discussing Richard Squire’s theory of symmetry in creditor’s rights).

[9]. Knightian uncertainty and risk are categories of risk proposed by the economist Frank Knight.  See generally Frank H. Knight, Risk, Uncertainty and Profit 197-232 (1921).  Risk is quantifiable and can be probabilistically allocated, whereas uncertainty is so radically unquantifiable that any allocation of risk would be arbitrary.


[10]. A familiar analogy might be the way that venture capitalists fund start-up firms.  The venture capitalist does not care that the entrepreneur wanted to invent a war-time anesthetic for soldiers and ended up with Novocain, a product that was successful in a different market; the venture capitalist looks for an innovative product with a chance of success.  Once found, the venture capitalist typically provides funds in exchange for equity, and the venture capitalist sells off a large portion of that equity once the product has succeeded.

[11]. Partnership uncertainty is the uncertainty involved in finding a collaborator whom one can trust, who will fit well with one’s working style, and who has the skills and know-how to make a successful collaboration.  Each of these things is difficult to signal before the collaboration begins, leaving these qualities uncertain ex ante.  As the collaboration proceeds, one can establish informational mechanisms to observe these qualities in the partner.


[12]. Uncertainty of bargaining power refers to the parties’ inability ex ante to determine which party is least likely to defect when given an ex post decision right.  In other words, it is not clear which party has the most to gain or most to lose in any future state of the world.

[13]. Positionally relative might mean several things and this article is only a first cut at clarifying the concept.  Uncertainty can be relative to one’s economic position, which would differentiate between the lender and the big collaborator, who each have very different economic transactions with the small collaborator and hence each have different concerns about uncertainty.  The other possibility is that uncertainty is relative to legal position.  The legal structure of the loan can be asset-based or cash-flow based and this structure might change how much uncertainty matters to the lender.