Contract Law - Lewitton v. ITA Software, Incorporated (Seventh Circuit 08-3725)

The Seventh Circuit Holds that An Employer Breached An Employment Contract When It Blocked A Former Employee From Exercising Options To Purchase Stock.

Lewitton was an employee of ITA Software, the Defendant. Three months after he stopped working for ITA Lewitton attempted to exercise options to purchase 138,900 shares of ITA's stock. ITA allowed Lewitton to purchase 34,722 shares, but blocked his effort to exercise the remaining options.

In April 2005, ITA and Lewitton entered into an employment contract under which Lewitton was to serve as ITA's vice president of sales. The contract granted Lewitton the right to purchase up to 200,000 shares of stock. According to the contract the options "'will vest...in equal monthly installments of 4,556 shares each... except that the first twelve months of options will all vest at Lewitton's one-year anniversary.'" The contract also provided that certain of the options were subject to forfeiture depending on whether ITA met certain performance goals. Under the contract, there was to be an assessment period during which sales would be calculated to determine if the company met its revenue goals. However, the contract also specified that the Assessment period would not apply if it were "materially deferred."

Lewitton's job was to supervise the development of the 1U program, a computer program that would apparently allow users to make online reservations for air travel. The software program was not successful and was not accepted by either travel agents or airlines.

The District Court granted summary judgment for Lewitton, holding that the contract unambiguously granted him the right to exercise the options. Under Illinois law, "our primary goal in construing the contract is to give effect to the parties' intent as expressed in the terms of their written agreement." The Court stated: "We first ask if the language of the contract is ambiguous, which is a question we determine as a matter of law...A contract is ambiguous if its terms are indefinite or have a double meaning...If the contract is unambiguous, we must enforce it as written."

ITA argued that the options were subject to forfeiture because the U1 software program did not meet performance goals.

The District Court and the Court of Appeals disagreed. They held that the Assessment Period did not apply (to allow forfeiture) because the U1 program was "materially deferred." "As the district court noted, 'materially deferred' is not a technical term; its ordinary meaning is 'significantly delayed.'" Because the U1 program was not rolled out on time, "the Assessment Period never began and, accordingly, ...the forfeiture provision does not apply."

Accordingly, Lewitton was entitled to exercise the options.

Edward X. Clinton, Jr.
Copyright 2009

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Securities Arbitration - Stern v. Charles Schwab & Co., Inc. (D. Ariz., No. CV-09-1229, October 16, 2009)

COURT REJECTS SECURITIES ARBITRATION WHERE THE BROKER FAILED TO OBTAIN THE CLIENT'S SIGNATURE ON THE ARBITRATION AGREEMENT

Plaintiffs who seek to avoid arbitration and have their claims adjudicated in court are not often successful. There is a recent United States District Court, the District of Arizona, which did not follow the trend. In the case of Stern v. Charles Schwab & Co., Inc. (D. Ariz., No. CV-09-1229-PHX-DGC, 10/16/09), the defendant Schwab filed a Motion To Dismiss and To Compel Arbitration pursuant to the Arizona and Federal Arbitration Acts. In the case, the Sterns invested One Million Nine Hundred Thousand Dollars ($1,900,000.00) with Debra Bennett and Elva Bennett. The Bennetts then transferred the Sterns’ money to a Charles Schwab Brokerage Account and used that account to invest in various investment transactions. The Sterns suffered serious financial losses and alleged that the Bennetts committed fraud, violated various securities law and ran a Ponzi scheme. The case was transferred to the Federal Courts because of diversity of citizenship. The Bennetts opened the Schwab account about one year before the Sterns began investing. The account between the Bennetts and Schwab contained a somewhat standard arbitration clause in which the Schwab account holders agreed to arbitration. The Sterns never signed the Schwab-Bennett contract, but nonetheless Schwab asked the Court to enforce the arbitration provision against them.

The Court noted that to compel arbitration the Court needed to find that the party actually signed a written agreement. A non-signatory may be bound to arbitrate based on “ordinary contract and agency principles” such as a corporation by reference, assumption, agency, veil piercing and equitable estoppel. Schwab also argued that the principles of equitable estoppel and agency bind the Sterns to the arbitration clause of the Schwab-Bennett contract. The court noted that when a non-signatory receives a direct benefit from the underlying contract, Arizona courts apply the doctrine of equitable estoppel and enforce the contract, including arbitration. World Group Secs., Inc., v. Allen, 2007 WL 4168572, *3 (D.Ariz. 2007) (quoting Zurich Am. Ins. Co. v. Watts Indus., Inc., 417 F.3d 682, 688 (7th Cir. 2005). Schwab argued that the Sterns received a direct benefit from the Schwab-Bennett Contract because the contract allowed the Sterns to invest the Bennett’s money.

The Court noted that arbitration can be ordered when a party has received a direct benefit from the arbitration contract. However, the Court stated that the Schwab-Bennett contract merely provided a vehicle through which the Bennetts implemented their investment business. It conferred no direct benefit on the Sterns. All the allegations and evidence suggested that the Sterns elected to invest with the Bennetts, not with Schwab and did so because of the Bennetts’ purported investment expertise and the Bennets’ promise of substantial returns. Because the Sterns received no direct benefit from the Schwab-Bennett contract equity does not require that the Sterns be subject to the arbitration provision which they never signed.
Schwab also argued that an agency relationship existed between them and the Bennetts. The response of the Sterns was that no agency relationship existed when the Schwab-Bennett contract was signed, the Bennetts could not be said to have acted on behalf of the Sterns in signing the contract. Therefore, agency principles also do not bind the Sterns to arbitration.

Accordingly, the Court held that the motion of Schwab to dismiss would be denied and the Sterns could proceed with the case in the U.S. District Court.

Edward X. Clinton, Sr.
Copyright 2009

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Securities Law - Proposed Amendments to the Investor Protection Act

The House Financial Services Committee voted strictly along party lines on November 4, 2009 to recommend an amendment to the Investor Protection Act that would double the authorized funding of the SEC and increase its enforcement authority. Further, a fiduciary duty would be imposed on all providers of financial advice, create a whistle-blower “bounty” and protection program and end mandatory arbitration of claims against broker-dealers. If this proposed amendment is adopted it would represent a boom to plaintiffs’ lawyers. This bill will be vigorously opposed by the Republicans in the House and, further, even it passes in one form or another, its passage in the more conservative Senate will be much more difficult.

Edward X. Clinton, Sr.
Copyright 2009

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Attorney Client Privilege - Tenth Circuit Rejects Attorney Work Product Claim

United States v. Textron, Inc. 577 F.3d 21 (August 13, 2009)

A recent case raises an important issue. United States v. Textron, Inc., 577 F.3d, 21 (Aug 13, 2009). In the Textron case, the United States filed a petition to enforce an Internal Revenue Service summons served on Textron, Inc., a public company, in connection with an IRS’s examination to determine tax liability. The United States District Court for the District of Rhode Island denied the petition and the IRS appealed. The question before the 11th Circuit was whether attorney-work product doctrine shields from an IRS summons “tax accrual work papers” prepared by lawyers and others in Textron’s tax department to support its calculation of tax reserves for its
audited corporate financial statements.

As a publicly traded corporation, Textron is required to file financial statements certified by an independent auditor. And, in doing so, it must calculate reserves. The present case began with a 2003 audit. In reviewing Textron’s 2001 returns, IRS determined that a Textron subsidiary had engaged in certain transactions which potentially could be considered abusive tax shelters. Textron had shown the work papers to its accountants, Ernst & Young, but refused to show them to the IRS. The IRS then brought an enforcement action in the Federal District Court of Rhode Island. Textron challenged the summons as lacking a legitimate purpose and it also asserted the attorney-client and taxpayer-practitioner privileges and the qualified privilege available for litigation materials under the work-product doctrine. The IRS contested the privileges claims.

After a hearing, the District Court denied the petition for enforcement on the basis that the papers were protected by the work-product privilege. 507 F.Supp. 2d 138. The District Court stated that the privilege derived from a case Hickman v. Taylor, 329 U.S. 495 (1947) and is now embodied in Rule 26(b)(3) of the Federal Rules of Civil Procedure. The District Court pointed out that there would be no need regarding the adequacy if the reserve amount of Textron had not anticipated a dispute with the IRS that was likely to result in litigation or some other adversarial proceeding.

On appeal to the 11th Circuit, a divided panel upheld the District Court’s decision. A petition for an en banc review was granted. Then the panel decision was vacated and additional briefs were submitted. The En Banc Bank panel pointed out that the U.S. Supreme Court has not ruled on the issue, namely, one in which a document is not in any way prepared for “litigation but relates to a subject that might or might not occasion litigation.” In Hickman v. Taylor, 329 U.S. 510, there was ongoing litigation in which one side filed interrogatories seeking from opposing counsel memorandum recording witness interviews the latter had conducted after receiving notice of possible claims. In Hickman the Court declared that the interrogatories conducted by opposing counsel in preparation for litigation was protected by a qualified privilege.

The En Banc panel concluded that the work-product privilege is aimed at protecting work done for litigation – not in preparing financial statements. Textron’s work papers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they would be carefully prepared in their present form. And, IRS access serves the legitimate and important function of detecting and disallowing abusive tax shelters.
The En Banc Panel vacated the initial decision of the District Court and remanded the case. Thus, the IRS prevailed and will obtain access to the withheld materials.

Two of the five Circuit judges on the en banc panel dissented. The dissent made reference to Rule 26(b)(3) and stated that the text of the Rule does not limit its protection to materials prepared to assist at trial. To the contrary, the text of the Rule clearly sweeps more broadly. It expressly states that work-product privilege applies not only to documents “prepared … for trial” but also to those prepared “in anticipation of litigation.” If the drafters of the Rule intended to limit its protection to documents made to assist in preparation for litigation, this would have been adequately conveyed by the phrase “prepared … for trial.” The fact that documents prepared “in anticipation of litigation” were also included confirms that the drafters considered this to be a different, and broader category. Nothing in the Rule states or suggests that documents prepared “in anticipation of litigation” with the purpose of assisting in the making of a business decision does not fall within its scope.

The dissent made reference to United States v. Adlman, 134 F.3d 1194 (2d Cir. 1998) where Judge Leval stated a “prepared for” requirement is not consistent with the plain language of Federal Rule of Civil Procedure 26, which provides protection for documents “prepared in anticipation of litigation or for trial.” Fed.R.Civ.P.26(b)(3)(A).

In short, the dissent agreed with the District Court and took strong exception to the findings of the majority on the en banc panel.
* * *

The case has created uncertainty. Could its rational be extended beyond work product issues? Perhaps the Supreme Court will accept the Textron case in order to put certainty into the area. It is time for SEC reporting companies and other companies to set up standards for handling work-product materials. It would be prudent to mark documents as “work-product being prepared in anticipation of litigation.” Auditors routinely request comment by corporate counsel on the issues of significant litigation and request a view as to the ultimate conclusion. No responding lawyer wants to disclose information that might enlighten a potential or actual adversary.

Edward X. Clinton, Sr.
Copyright 2009

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