Sunday, January 26, 2003

At Wit's End

Typically, I introduce each posting with a humorous (ok, an attempt at a humorous) caption. On January 24, the IRS issued temporary regulations dealing with the status under IRC § 368 of transactions involving disregarded entities. The temporary regulations are important. They are also impervious to comedic treatment.

In essence, the temporary regulations recognize the use in complex business planning of entities that are disregarded entities for federal income tax purposes. For the sake of brevity, I will describe some of the examples before dealing with the overriding framework established by the regulations.

In Example 2, Y, Inc. is the sole member of X, LLC, a disregarded entity. Z, Inc. merges into X pursuant to the law of State W. All of the following occur simultaneously: (i) Z's assets become assets of X, (ii) the Z shareholders receive Y stock in exchange for all of their Z stock, and (iii) Z's legal existence ceases for all purposes. On these facts, Y and Z are deemed to have effected an A reorganization. In fact, the temporary regulations provide that the result would be the same if Z owned Alpha, LLC, a single member LLC that is a disregarded entity, regardless of whether Alpha ended up as a subsidiary of X or a subsidiary of some other disregarded entity owned by Y.

In Example 3, Z, Inc. owns Beta, Inc. Z is an S corporation and Beta is a qualified S corporation subsidiary. As in Example 2, Y, Inc. is the sole member of X, LLC, a disregarded entity. Z, Inc. merges into X pursuant to the law of State W. As a consequence of this merger, Beta immediately ceases being a qualified S corporation subsidiary. However, the regulations take the position that the transaction is a valid A reorganization, with a deemed contribution of the assets of Beta to X and the immediate deemed contribution of those same assets by X to Beta.

However, as one would expect, the surviving entity cannot be something other than a corporation. Thus, a merger into a disregarded entity that is owned by a partnership doesn't qualify. And, a merger in which interests of the disregarded entity are distributed to the owners of the merged entity will not work.

The temporary regulations set forth two basic elements that must both be present simultaneously in order for a transaction to qualify under § 368.

First, all of the assets of the merged corporation and all of the liabilities of the merged corporation must become assets and liabilities, respectively, of some "unit" of the other entity. In this case, "unit" means either the acquiring corporation or some corporation or disregarded entity owned by it.

Second, the merged corporation (which may be the owner of a disregarded entity) must cease its separate legal existence for all purposes.

The temporary regulations will undoubtedly accelerate the use of disregarded entities in corporate planning. Among their other virtues, they allow businesses to build liability "firewalls" between different aspects of their operations without having to sacrifice being a single entity for income tax purposes.

The temporary regulations were published in the Federal Register on Friday, January 24, 2003 (Vol. 68, No. 16, pages 3384 et seq.). If you cannot locate a copy on the web, send me an e-mail and I will forward a copy to you.

Saturday, January 25, 2003

Goose v. Gander

In response to my posting on the Barranco case, my friend John DeBruyn called my attention to the case of Dixon v. Commissioner. That case discusses the sanctions to be imposed on the IRS when their attorneys were found to have engaged in misconduct in the course of litigation. John’s comments were along the lines of "See, both sides do this stuff." I think that, unfortunately, both sides do make the sort of specious arguments that the taxpayer's attorney made in Barranco. (One day I'll prove it by doing a posting on ridiculous positions taken by attorneys for the State of Maryland in interpreting the recordation and transfer tax statutes.) However, Barranco differs from Dixon in one rather troubling respect.

The actions of the Service's attorneys in Dixon were, without any doubt, more egregious than were those of the taxpayer's attorneys in Barranco. Dixon revolves around a massive action involving about 1300 different investors in an allegedly sham tax shelter. Because of the impossibility of efficiently trying 1300 cases, the taxpayers and the Service agreed to an arrangement wherein the 1300 taxpayers agreed to be bound by a limited number of test cases. Implicit in this arrangement, of course, was the premise that the test cases were representative of the cases of the other taxpayers who had agreed not to litigate but to be nevertheless be bound by the results.

In fact, the Service had cut settlement deals with a number of the "representative" taxpayers involved. Those settlements required that the taxpayers remain as representative parties in the Tax Court proceedings. However, no one informed either the Tax Court or counsel for the other parties involved of the arrangement. Indeed, the attorneys for the Service actively concealed the arrangement. As the Ninth Circuit opinion pointed out, "The Tax Court believed it was hearing a legitimate adversarial dispute when, in fact, the proceeding was a charade fraught with concealed motives, hidden payments, and false testimony. What did occur was clearly designed to defile the court itself, and there is no question that it was carried out by an officer of the court."

Two points are worthy of note.

First, the attorneys involved have already been the subject of administrative sanctions. One of the footnotes in Dixon discloses that these attorneys also face formal grievance proceedings before their respective Bars. Their careers are at an end.

Second, it was senior personnel in the Service who discovered and then disclosed to the Court the scheme perpetrated by the attorneys involved. In other words, professionals representing the same party as the malefactors, came forward and disclosed the scheme.

If, as is clearly the case, the actions of the attorneys in Dixon were more worthy of serious sanction than those in Barranco, why am I more troubled by Barranco? It is this. The attorneys in Dixon knew that what they were doing was wrong and conducted themselves accordingly. That is, they carried out their fraud in secret. In Barranco, resources of the Tax Court and the Government were wasted on a case that was bereft of any intellectual substance. Yet, an attorney felt comfortable arguing this nonsense in full public view with a straight face. And, even though he lost the case, he faced no sanction for making a patently frivolous argument.

I am all too aware that lawyers are lawyers, hired to make their clients' cases, not judges, hired to decide those cases. Yet, there has to be some, if I might use the term, judgment exercised in the arguments one makes. Ultimately, the abandonment of standards debases both the courts and our profession. This corrosive effect is slower, perhaps, than if we allowed rampant fraud, a la Dixon, to continue unabated, but corrosive nevertheless.

Thursday, January 23, 2003

Make No Bones About It

I generally do not share the sentiments of those who rage incessantly about unethical lawyers bringing baseless cases and making frivolous arguments. It is the job of an attorney, after all, to push the envelope of justification for his or her client's position. Indeed, the most often cited cases of purported spurious arguments such as the McDonald's coffee scalding case or the purported cigar/fire insurance case can be shown to present either meritorious claims or an urban legend. (I even feel that there is some validity to the plaintiffs' arguments in the recent "Big Macs made me fat" case. But these claims will more likely be won by consumers voting their wallets.)

However, not all arguments deserve to be made. To paraphrase Dorothy Parker, there are arguments that should not be tossed aside lightly. They should be thrown with great force. Such is the case of the argument of Mrs. Barranco that she was an innocent spouse who should not have to pay the tax liabilities associated with the fraudulent income tax returns she filed jointly with her husband.

Mrs. Barranco's husband is an orthopedic surgeon. From 1983 through 1992, they filed joint income tax returns and reported a total of $732,632 in adjusted gross income. However, as reconstructed by the IRS, it appears that they omitted to report a trifling $5,878,813 in income over this period. In one year, they reported only a little over $5,000 in taxable income, omitting over $805,000 of actual income. In May, 1995, Dr. Barranco pled guilty to conspiracy to commit tax fraud and tax evasion. He was sentence to 27 months in jail.

Now orthopedic surgeons and their families usually live the good life and the Barrancos were no exception. Their four children got nice cars and nice college educations. The three Barranco daughters got nice weddings. There were ski trips to France, Switzerland, and Colorado. There was a trip to Scandinavia and a bus tour of Italy. Mrs. Barranco got furs and jewels. Of course, there was the obligatory boat.

They built their primary residence on a 29 acre parcel of land. Just to protect their privacy, they purchased, in Mrs. Barranco's name, 100.7 acres adjoining that parcel. And, just to get away from it all, they had two parcels of vacation property, on one of which they first built and they remodeled, a vacation home. Ultimately, all of these properties were titled in Mrs. Barranco's name.

Finally, in 1996, after Dr. Barranco had pled guilty, Mrs. Barranco transferred the real property to an LLC owned by her four children in exchange for a promissory note bearing only 3% per annum interest. About a year after that, the residence together with six acres of land was re-conveyed to Mrs. Barranco without consideration.

The "innocent spouse" doctrine is codified as IRC Section 6015. There are a variety of types of innocent spouse applications available there. In this case the primary basis asserted was under Section 6015(b). In order to qualify for relief under that section, a spouse must establish that she did not know and had no reason to know that on the joint returns there were understatements of income. The purported innocent spouse is charged with the knowledge of what is actually contained on the returns. In deciding whether a spouse had reason to know of an understatement, a key factor is the extent to which family expenditures, of which the spouse had knowledge, exceeded reported income. Other relevant factors include the spouse's education level; her involvement in the family's business and financial affairs; the presence of lavish or unusual expenditures as compared to the family's past income levels, income standards, and spending patterns; and the culpable spouse's evasiveness and deceit concerning the couple's finances.

The Court's conclusion is best summarized in the following passage: "On brief, [Mrs. Barranco] contends that the Barrancos' lifestyle was not lavish or unusual, but it was simply the 'lifestyle of a hard-working orthopedic surgeon's family.' In support of this contention, petitioner states on brief that 'orthopedic surgeons generally do have very good incomes.' Therein lies the rub. Although the Barrancos were enjoying the lifestyle of a 'hardworking orthopedic surgeon’s family' during the years at issue, Dr. Barranco and [his wife] were reporting much less than the 'very good incomes' that orthopedic surgeons might generally be expected to earn to support such a lifestyle. On the basis of all the evidence, we believe that [Mrs. Barranco] should have been aware of this discrepancy."

I've recently had a successful result in an innocent spouse case. However, in that case the income shown on the joint income tax return was consonant with the modest lifestyle the family lead. In the Barrancos' case, the lifestyle was lavish, the returns were modest. Mrs. Barranco should have made no bones about the assessment.

The Barranco case is Barranco v. Commissioner, T.C. Memo 2003-18.

Many Happy Returns

Many business advisors are unaware that personal income tax obligations may, in certain circumstances, be discharged in an individual's bankruptcy. (As used here, "personal income tax obligations" means those obligations that arise as a result of income to the individual who is in bankruptcy. An individual's obligations for the 100% penalty on responsible persons for willful failure to withhold taxes from employee wages, for instance, is not dischargeable.) Such discharges are hedged by numerous exceptions, however.

One exception is where the individual does not file a return at all, but rather has had his or her income computed by the IRS under its power to calculated the tax due as a substitute for a return pursuant to IRC Section 6020(b). Well, what if the taxpayer, in contemplation of bankruptcy, prepares and files a return after the IRS has prepared a substitute for a return?

There are four requirements necessary for such a return to constitute a valid return such that the "no return" exception to discharge does not apply. Specifically, the document filed must (i) purport to be a return; (ii) be executed under penalty of perjury; (iii) contain sufficient data to allow calculation of tax; and (iv) represent an honest and reasonable attempt to satisfy the requirements of the tax law. The first three requirements would seem to be easy to meet--fill out an accurate Form 1040, sign it on the appropriate line (which already has the penalty of perjury language set forth), and file it. However, taxpayers frequently trip over the last requirement, because their returns serve no legitimate tax purpose. Courts have generally held, for instance, that a return that merely restates the substitute for a return prepared by the IRS does not constitute a return that would allow an escape from the "no return" rule.

Timothy Izzo fared better than average, however. The IRS had calculated that he owed $632,617.83 in taxes for six years. Prior to filing bankruptcy, Izzo prepared returns for the years in question showing tax due of only $155,871.61. These returns were apparently an honest reflection of Izzo's income for the years in question, since the IRS accepted them as amended returns. The bankruptcy court allowed his bankruptcy to discharge the tax due for most of the years in question. (It was not clear why the tax obligations in some of the years at issue were not discharged, but the basis was apparently not the "no return" rule.) The Court distinguished similar cases because in these other cases either the Forms 1040 essentially mirrored the IRS's substitutes for returns or they otherwise did not result in any change in tax liability.

The Izzo opinion can be found by going to the website of the United States Bankruptcy Court for the Eastern District of Michigan and drilling down using the Court's search engine. Alternatively, you can get a copy by sending me an e-mail request.

Monday, January 20, 2003

Within Reason

Remember those postings about whether payments constitute compensation for services rendered, and thus subject to FICA, or whether they’re dividends and thus FICA-free. There is, of course, another facet of that question. In the context of C corporations, contrary to the situation in the S corporation setting, it is often the Service that argues that payments purportedly made to compensate officer/shareholders are unreasonably high. If such payments are not reasonable, they are deemed to be dividends. Thus, they are not deductible to the corporation and, effectively, subject to double taxation.

In Devine Brothers, Inc. v. Commissioner, a Tax Court memorandum decision just handed down, the Tax Court was faced with an attack on payments to an officer/shareholder deemed by the Service to be unreasonably high.

The corporation at issue was a family-owned mechanical contracting business. The senior family member ("Richard, Sr.") was the son and nephew of the two founders who started the business in 1918. However, beginning in the early 1970's, the business fell on hard times. For many years, Richard, Sr., took lower than deserved compensation from the company in order to allow it to maintain its bonding capacity. Beginning in 1986 and concluding in 1996, Richard, Sr., entered into a process of transferring all of the corporation’s stock to his son, Richard, Jr.

Through the fiscal year ending in February, 1994, the salaries paid to both Richard, Sr. and Richard, Jr. were quite modest. However, in that year, their salaries were dramatically increased, with Richard, Sr.'s moving from less than $52,000 to slightly less than $261,000. The Service contended that $65,000 of Richard, Sr.'s salary in that year was excessive and thus a disguised dividend. Oddly, however, the Service stipulated that: "Richard Sr.'s annual salary for the taxable year [in question] falls in the range of salaries paid to presidents/chief executive officers of comparable companies in the same industry during the taxable year."

The Tax Court first noted that there is a division among the circuits as to the appropriate test to be applied in determining whether a salary is reasonable. The traditional test applies a lengthy list of factors that are relevant in the determination of reasonableness, including (i) The employee's qualifications; (ii) the nature, extent, and scope of the employee's work; (iii) the size and complexities of the business; (iv) a comparison of salaries paid with gross income and net income; (v) the prevailing general economic conditions; (vi) comparison of salaries with distributions to stockholders; (vii) the prevailing rates of compensation for comparable positions in comparable concerns; (viii) the salary policy of the taxpayer as to all employees; and (ix) the amount of compensation paid to the particular employee in previous years. More recently, however, courts have substituted instead an independent investor test.

The Tax Court had no difficulty rejecting the Service's attack here. Not only was the compensation paid to Richard, Sr. in line with compensation paid to similarly situated executives, but he was also able to argue persuasively that he had been underpaid in many previous years and the payments in the year in question were made in part to make up for those underpayments.

Before chortling about the Service speaking with forked tongue in comparing cases such as Devine with Veterinary Surgical, it should be noted that the Service only attacked the reasonableness of the Richard, Sr.'s salary after it exceeded $195,000 a year. (And, Richard, Sr., enjoyed a fairly extensive and expensive panoply of non-taxable benefits.) This case gives no succor to those who attempt to recast salary as S corporation dividends, since, in order for that to succeed as a valuable tax planning tool, taxpayers generally have to reduce the officer's wage compensation dramatically.

Sunday, January 19, 2003

Not a Good Alternative

Assume that you're a plaintiff in a lawsuit. To prosecute the lawsuit, you hire an attorney on a contingent fee basis. That is, if there is a recovery, either through a judgment that is collectible or a settlement, the attorney gets paid. Otherwise, he or she does not.

Assume further that any recovery with respect to the lawsuit is taxable, as would be the case, for instance, in an ex-employee's recovery for a claim for wrongful discharge. Certainly, you reason, only the net amount received by the plaintiff would be subject to taxation, with the amount paid to the attorney either being deductible or not included into income in the first instance. That conclusion may not be correct.

In 1993, Raymond was terminated as an employee by IBM. He retained a law firm to file a wrongful termination lawsuit against IBM. Under the fee arrangement between Raymond and the law firm, the law firm was to receive a contingent fee of 1/3 of any amount recovered from IBM, plus its expenses. In the event of an appeal, the law firm was to be paid its standard hourly rate.

A jury trial resulted in a judgment of over $860,000 for Raymond. Due to post-judgment interest, IBM ultimately paid Raymond about $930,000. From that amount, Raymond paid the law firm that represented him about $340,000.

The conundrum faced by Raymond was succinctly stated by the district court as follows: "Because of the amount of [his] income for that year, [Raymond's] income tax was determined by the Alternative Minimum Tax ('AMT'). Ordinarily [he] would have been able to take a miscellaneous deduction for [his] attorneys' fees to the extent those fees exceeded 2% of [his] adjusted gross income, but miscellaneous deductions are not allowed under the AMT. The effect of the inclusion of the entire amount of the judgment as income and the operation of the AMT was to require [Raymond] to pay income tax on the full $929,585.90, although $306,898.01 of that amount went directly to [his] attorneys." Stated even more succinctly, Raymond had to pay income tax on the fees that he paid to his attorneys.

The good news for Raymond is that he lives in Vermont. Vermont is in the Second Circuit which had not previously addressed this issue. Eight of the other eleven circuit courts of appeal and the Federal Circuit have addressed the question and the score is currently six to three in favor of the IRS. (The Fourth Circuit currently is on the side of the Service.)

In Raymond's case, the U.S. District Court in Vermont found that "the portion of Raymond's recovery that was paid directly to his attorneys under [his] contingent fee agreement was not income to Raymond." The court reasoned that the attorneys had a property interest in the settlement equal to their contingent fee. Thus, the payment to the attorneys was not an anticipatory assignment of income by Raymond. In some measure, the result turned on legal principles under Vermont law pertaining to attorneys' fees and the ability of the attorneys to assert a lien on any recovery. Although I've not research this point closely, it appears that Vermont law is substantially the same as that of Maryland in this area.

The bad news for Raymond is that the case will certainly be appealed. Given the division of opinion among the circuits, the case would seem to be a good candidate for ultimate resolution by the Supreme Court. Due to the uncertain state of the law in this area, any taxpayer faced with the issue should be prepared to file a protective refund claim with respect to any taxes paid as a result of the application of the AMT to a contingent attorneys' fee paid on a taxable settlement.

Because the opinion has not been publicly posted, I cannot yet provide a hyperlink. But I will e-mail a copy upon request.

Saturday, January 18, 2003

How Long Is the Arm?

After my January 6 posting on the personal jurisdiction issue, I began to wonder how well reported decisions in Maryland fit into the parameters set out in that opinion. I came across the case of Christian Book Distributors, Inc. v. Great Christian Books, Inc., 137 Md. App. 367, 768 A.2d 719 (2001). That case held that (i) the "transacting any business in a state" basis for asserting personal jurisdiction would support the assertion of jurisdiction over a corporation that had allegedly committed a tortious injury by sending a misrepresentation into a state via telex or telephone (and, presumably, e-mail as well), but (ii) personal jurisdiction could not be exercised over an individual who allegedly committed the tortious act, so long as the individual was acting in the scope of his or her employment for the corporation. It is of note that the court went to some lengths to point out that even the limited contact that would support an exercise of jurisdiction in a fraud case would not suffice to support jurisdiction with respect to other claims, such as claims for negligence and breach of contract.

Of course, this does not address the exact question the Fourth Circuit was presented with. In that case, the plaintiff was seeking to enforce an alleged settlement agreement that it contended had been negotiated, at least in part, in the forum state.

Thursday, January 16, 2003

Nothing Personal

CEM is a North Carolina corporation with its principal place of business in that state. Personal Chemistry is a Swedish corporation with its principal place of business in Sweden. Personal Chemistry has never registered to do business in North Carolina and, apparently, does not actively conduct operations there.

In late 2000, CEM brought a lawsuit against Personal Chemistry in Sweden, alleging that Personal Chemistry had infringed a patent belonging to CEM. Settlement negotiations ensued, including a meeting in North Carolina attended by several employees of Personal Chemistry and their U.S. affiliate. As a result of that meeting, the two sides negotiated an "agreement-in-principle" to settle their dispute. However, Personal Chemistry's board of directors subsequently refused to approve the agreement.

CEM then filed suit in North Carolina alleging a breach of the agreement-in-principle, intentional and negligent misrepresentation, and unfair and deceptive trade practices. Personal Chemistry moved to dismiss the complaint due to lack of personal jurisdiction over that company and the motion was granted by the district court.

The Fourth Circuit, in an unpublished opinion, affirmed the district court's dismissal. Most significantly, the Court held that the single meeting of the Swedish company's officials in North Carolina did not constitute "purposeful acts directed. . .to the State of North Carolina sufficient to establish personal jurisdiction" over the company in that state.

A Slip of the Lip Doesn't Sink the Ship

In an unpublished opinion, the Fourth Circuit turned aside a claim that a principal of a company had personally guaranteed a contractual obligation of the company.

Grimes was the CEO of Cyntergy. Cyntergy had leased computer equipment from ePlus. After Cyntergy fell into arrears on its lease obligations, ePlus informed Grimes that it intended to repossess the equipment. In order to forestall the repossession, Grimes promised ePlus that Cynergy would pay the arrearage. He also said that he would "take care of [ePlus]" if they would "give him some slack." Ultimately, ePlus sued Grimes, alleging that Grimes' statements constituted a personal guarantee made in consideration of the agreement by ePlus to forbear its attempts to repossess the equipment. The district court had dismissed ePlus' complaint for failure to state a claim.

The district court's dismissal was affirmed by the Fourth Circuit. The appellate court found that Grimes' statements were insufficient to establish a contractual undertaking to guarantee Cyntergy's obligations to ePlus. Specifically, the court found that there had been no meeting of the minds of Grimes and ePlus because a number of material terms of the purported contract (i.e., the length of time ePlus would defer repossession, how much Grimes would pay ePlus, when those payments would be made, and under what terms Grimes would make the payments) were not specified. Thus, ePlus had failed to allege "any facts to demonstrate that Grimes understood his statements to mean" that he was going to be personally liable for Cyntergy's obligations.

Monday, January 13, 2003

Beware of Springing Liens

If the Internal Revenue Service has a publicly filed lien against a taxpayer, that lien attaches to all real and personal property owned by the taxpayer. However, that lien can be extinguished if a senior lienholder (e.g., a mortgagee or the holder of a security interest) forecloses on his lien rights and the Service does not elect to redeem the property within 120 days. Typically, the owner of the property also has a right of redemption.

Under the facts presented in TAM 200302043, the Service’s right of redemption, in a sense, sprung back into life after it had seemingly been extinguished. There, the mortgagee foreclosed on the real property and the IRS failed to redeem within the statutory 120 day period. However, a third party purchased the owner’s right of redemption. The Service held that because the notice of tax lien had been filed prior to the time the third party purchased the right of redemption, the tax lien attached to the right of redemption. When the third party exercised the right of redemption, the tax lien sprang back into life and reattached to the property.

Sunday, January 12, 2003

No Deal

In an opinion handed down on Thursday, the U.S. Court of Appeals for the Eighth Circuit, applying Minnesota law, determined that a letter of agreement was an unenforceable “agreement to agree” rather than an enforceable contract. It is of some interest that the suit was initiated by a disgruntled broker who believed that it was entitled to a commission even though the contract that was the subject of the alleged commission agreement had never been consummated.

Wednesday, January 08, 2003

Not Just Academic

I have a sneaking suspicion that most of those who read my posting on January 2, concerning the standards applied by the Fourth Circuit with respect to a request for a preliminary injunction, thought that I was discussing some technical issue with only limited relevancy to real world affairs. An unpublished opinion handed down the next day by that court, Ancora Capital & Management Group, LLC v. Gray, makes it clear that the standards are of great practical significance.

The case involved a request for an injunction to enforce a restrictive covenant entered into by an ex-employee. The plaintiff requested that both the former employee and his new employer be bound by the injunction. The lower court found that the ex-employer faced irreparable harm due to the potential loss of goodwill due to its former employee’s competition in violation of the covenant. On the other hand, if the injunction issued, the ex-employee faced only the possibility of a loss of income, which could be remedied by an award of damages. The ex-employee’s ability to satisfy any damage claim could be insured through a bond posted by the plaintiff.

However, the court also found that the new employer “would suffer irreparable harm if [the injunction issued and the new employer was] precluded from bidding on major contracts.” Thus, the court concluded that the balance of the harms did not tip decidedly in the plaintiff’s favor. In such a case, before the injunction would issue, the plaintiff had to make a “showing of a strong and substantial likelihood of success--one that is clear and convincing.” The lower court concluded that the plaintiff’s evidence had failed to satisfy this standard.

The Fourth Circuit reversed, holding that the district court should not have looked at the defendants jointly when weighing the balance of the relative harms, since the plaintiff actually sought two separate injunctions. Because an injunction against the ex-employee would not have inflicted irreparable injury, the balance of harms “tip[ped] decidedly in favor of the plaintiff.” As a result, the proper standard to be applied was whether “the plaintiff had raised questions going to the merits so serious, substantial, difficult and doubtful, as to make them fair ground for litigation.” The appellate court found that this standard was met and that the requested preliminary injunction should have issued. It therefore reversed the district court and directed that it enter a preliminary injunction against the ex-employee, preventing him from working for the new employer.

The opinion in Ancora Capital was unpublished and is not binding precedent. However, one must assume that the rationale articulated by the court reflects its general approach in these matters. The upshot of the case is that, in restrictive covenant cases (a regular source of supply for the business litigation sausage mill) a preliminary injunction enforcing the covenant will almost always issue, unless the covenant is somehow manifestly unreasonable. And, because preliminary injunctions in such cases often cause the restrained party to raise the white flag, the liberal standard for granting a preliminary injunction will, in many cases, govern the outcome of the entire case.

Thursday, January 02, 2003

Preliminary Matters

One of the most frequent battlegrounds in business litigation involves requests for preliminary injunctions. The importance of the grant or denial of a request for a preliminary injunction cannot be underestimated. Often, a decision on whether such an injunction should be issued is the entire case, with the matter ending in a concession by the party that loses on the issue.

In 1977, in a case entitled Blackwelder Furniture Co. of Statesville, Inc. v. Seilig Mfg. Co., Inc., 550 F.2d 189, the Fourth Circuit prescribed the procedure to be followed in when deciding whether to grant a preliminary injunction: The court must first determine whether the plaintiff has made a strong showing of irreparable harm if the injunction is denied; if such a showing is made, the court must then balance the likelihood of harm to the plaintiff against the likelihood of harm to the defendant. If the balance of the hardships "tips decidedly in favor of the plaintiff," then typically it will "be enough that the plaintiff has raised questions going to the merits so serious, substantial,difficult and doubtful, as to make them fair ground for litigation and thus for more deliberate investigation.” But if the balance of hardships is substantially equal as between the plaintiff and defendant, then "the probability of success begins to assume real significance, and interim relief is more likely to require a clear showing of a likelihood of success."

The Blackwelder formulation was adopted by Maryland in Lerner v. Lerner, 306 Md. 771 (1986).

In a recent case, however, the Fourth Circuit recognized a challenge to Blackwelder. In a footnote, the Court acknowledged that “Blackwelder’s emphasis on the balancing of the harms rather than the likelihood of success has been criticized, even within this court, as inconsistent with Supreme Court precedent. See Safety-Kleen, Inc. v. Wyche, 274 F.3d 846, 868 (4th Cir. 2001) (Luttig, J.,concurring) (arguing that Blackwelder ‘contravene[s] Supreme Court precedents by overvaluing the inquiry into the relative equities of granting and denying a requested injunction to an extent that essentially denies any value whatsoever to the inquiry into the likelihood of success on the merits’ and ‘virtually eliminate[s] altogether the inquiry into the likelihood of success on the merits.’”

In this particular case, The Scotts Co. v. United Industries Corp. the Court sidestepped the issue of whether the Blackwelder procedure is correct. Presumably, however, it will address the issue at some point. If it overturns Blackwelder, the question of whether a preliminary injunction is granted in any particular case might turn on whether the case is in state court (presumably following the Blackwelder formulation via Lerner) or in federal court.