Complex Litigation Update: Eleventh Circuit Targets “Shotgun Pleadings,” Clarifies Definition

July 28th, 2015

Each court may have its own definition of what constitutes a “shotgun pleading,” but the United States Court of Appeals for the Eleventh Circuit attempted to clarify that term in Christopher J. Weiland v. Palm Beach Co. Sheriff’s Office et al., available here. In doing so, the Court reversed the District Court’s decision, holding that two counts alleged in the pleading were not shotgun pleadings, but instead were informative enough to permit a court to readily determine if they stated a claim upon which relief can be granted. After all, the Court wrote, dismissal under Rule 8(a)(2) and Rule 10(b) is only appropriate when it is “virtually impossible to know which allegations of fact are intended to support which claims for relief,” and this case presented no such impossibility.

Background

Christopher Weiland’s original complaint told a story about two Palm Beach County Sheriff’s Office deputies shooting, tasering, and beating him in his bedroom without warning or provocation. Weiland’s father had called the police and told the 911 dispatcher that his son, who suffered from bipolar disorder, was “acting up,” “on drugs,” and “probably had a gun.” Deputies Christopher Fleming and Michael Johnson were dispatched to the residence. What happened after is disputed by the deputies, but Weiland claims that while sitting on a bed motionless with a shotgun idle in his lap, Johnson fired two rounds at Weiland, knocking him off the bed. Weiland claims Fleming then tasered him when he was immobile and critically injured.

Weiland was charged with two counts of aggravated assault on a law enforcement officer and incarcerated for two years awaiting trial. When trial came around, the officers’ stories fell apart, and Weiland was acquitted.

Weiland filed a lawsuit in state court in January 12, 2011, but then added multiple claims under 42 U.S.C. § 1983 on December 17, 2012 and removed to federal court. In May 2013, the District Court dismissed without prejudice all of Weiland’s § 1983 claims. It concluded that four counts asserting those claims violated Rule 8(a)(2) and Rule 10(b) of the Federal Rules of Civil Procedure. However, even though it dismissed Weiland’s claims, the District Court observed that “viewing the alleged facts in the light most favorable to Weiland … Defendants violated Weiland’s fourth amendment constitutional rights when they shot him.” The District Court gave Weiland time to amend his complaint, and he submitted a third amended complaint, which was the subject of the Eleventh Circuit’s review.

In the third amended complaint, the four counts at issue were presented as follows:

  • Count One claims that Fleming, Johnson, and the deputies, acting under color of state law, violated Weiland’s constitutional rights by “using excessive and unreasonable force.”
  • Count Two claims that the Sheriff’s Office “did not adequately train or supervise its Sheriff Deputies in … [the use of] appropriate and proportioned force” in detaining mentally ill citizens
  • Count Three claims that Fleming, Johnson, and the Sheriff’s Office conspired to cover up their violations of Weiland’s constitutional rights
  • Count Four claims that the Sheriff’s Office had a custom or policy of using its internal affairs investigations to “perpetrate a coverup of any misconduct by Deputies.”

The District Court again dismissed all four of the § 1983 claims, this time with prejudice, because  pleading them “duplicated the violations of Rule 8(a)(2) and 10(b), which formed the basis of the court’s [earlier] dismissal of th[o]se counts.” It concluded that the claims failed to prove any factual support for his allegations beyond referring to alleged practices and policies in the Sheriff’s Office. However, following a similar pattern to the first dismissal, the District Court conceded that the complaint did in fact state a conspiracy claim, even though it was dismissed.

Defining Shotgun Pleadings

The Eleventh Circuit first considered under what authority the District Court relied on in dismissing Weiland’s claims. The Court’s best guess was that the District Court relied on its inherent authority to control its docket and ensure prompt resolution of lawsuits, which in some circumstances includes the power to dismiss a complaint for failure to comply with Rule 8(a)(2) and Rule 10(b). The Court therefore reviewed the dismissal under an abuse of discretion standard of review.

The Court began by explaining that Rule 8(a)(2) required a complaint to include “a short and plain statement of the claim showing that the pleader is entitled to relief.” It also noted that Rule 10(b) provides that

A party must state its claims or defenses in numbered paragraphs, each limited as far as practicable to a single set of circumstances. A later pleading may refer by number to a paragraph in an earlier pleading. If doing so would promote clarity, each claim founded on a separate transaction or occurrence – and each defense other than a denial – must be stated in a separate count or defense.

If a complaint does not meet these standards, the Court wrote that it is commonly referred to as a “shotgun pleading.” But what is a shotgun pleading? The Eleventh Circuit asked the same question.

The Court discussed a “thirty-year salvo of criticism aimed at shotgun pleadings,” writing that “there is no ceasefire in sight.” After sifting through its past opinions, the Court identified four rough types or categories of shotgun pleadings, writing:

The most common type – by a long shot – is a complaint containing multiple counts where each adopts the allegations of all preceding counts, causing each successive count to carry all that came before and the last count to be a combination of the entire complaint.

The next most common type … is a complaint that does not commit the mortal sin of re-alleging all preceding counts, but is guilty of the venial sin of being replete with conclusory, vague and immaterial facts not obviously connected to any particular cause of action.

The third type… is one that commits the sin of not separating into a different count each cause of action or claim for relief.

Fourth and finally, there is the relatively rare sin of asserting multiple claims against multiple defendants without specifying which defendant(s) are responsible for which acts or omissions, or which of the defendant(s) the claim is brought against.

The Court wrote that the unifying characteristics of these four types is that they all fail in some aspect to give the defendants adequate notice of the claims against them and the grounds upon which each claim rests.

Applying Characteristics of Shotgun Pleadings

While the Court did not tackle all four of the counts dismissed by the District Court, it held that the District Court abused its discretion when it dismissed Weiland’s Count One and Count Three claims against Fleming and Johnson on the grounds they did not comply with Rule 8(a)(2) and 10(b). While the Court admitted those two counts might have some faults, it concluded that they were informative enough to permit a court to readily determine if they state a claim upon which relief can be granted. After all, the District Court already recognized Counts One and Three as stating claims upon which relief can be granted by holding that Weiland made valid fourth amendment and conspiracy claims.

The District Court dismissed Weiland’s § 1983 claims in Count One and Three because the counts incorporated “all of the factual allegations contained in paragraphs 1 through 49 inclusive,” and also failed to identify “which allegations are relevant to the elements of which legal theories” and “which constitutional amendment governs which counts.” The Eleventh Circuit wrote that at first glance these counts might appear to have made common mistakes of shotgun pleading, but that is not the case.

The Court wrote that in Weiland’s case, the allegations of each count were not rolled into every successive count on down the line. Furthermore, the Court determined that this was not a situation where a failure to more precisely parcel out and identify the facts relevant to each claim materially increased the burden of understanding the factual allegations in each count. Therefore, the Court held that Count One did adequately put Fleming and Johnson on notice of the specific claims against them because Weiland organized the 49 paragraphs into three clear subsections. As to Count Three, even though only one of Weiland’s alleged deprivations of constitutional rights yields a cognizable claim, the Court held that the count also gave Fleming and Johnson adequate notice.

Finally, the Court disagreed with the District Court’s characterization of Weiland’s complaint as “failing to identify … which constitutional amendments govern which counts.” The Court held that the complaint did identify specific amendments, and just because the count included constitutional amendments under which Weiland is not entitled to relief, that is not dispositive of a Rule 8(a)(2) and 10(b) dismissal. Rather, a dismissal under those two rules is appropriate only where it is “virtually impossible to know which allegations of fact are intended to support which claim(s) for relief.”

The takeaway from this case is in the Court’s clarification of what constitutes a shotgun pleading. The Court accepted two counts from Weiland’s amended complaint, even though not perfectly composed, due to the viability of the claims. This means that when courts have conceded that a case has been made for a certain claim, the courts cannot simply dismiss based on the format of the pleading so long as the pleading gives adequate notice to the other party.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in the areas of complex civil and administrative litigation at both the state and federal levels. Should you have any questions or need further assistance, please contact us by email at contact@fuerstlaw.com or telephone at 305.350.5690.

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Criminal Tax Litigation Update: Seventh Circuit Affirms District Court’s Sentence of Probation for Beanie Babies Creator

July 27th, 2015

On July 10, 2015, the United States Court of Appeals for the Seventh Circuit affirmed the sentence of Ty Warner, the billionaire creator of Beanie Babies who pleaded guilty to evading $5.6 million in taxes by hiding assets in a Swiss bank account. The decision can be found here.

In 1996, Warner traveled to Switzerland and opened an account at UBS, which ultimately held as much as $93 million. In 2002, Warner moved his account from UBS to Zuercher Kantonalbank (ZKB), and placed his assets in the name of a Liechtenstein shell company. By that time, the account had grown to $107 million. Warner, a U.S. taxpayer, failed to report and pay taxes to the IRS on the interest income generated by his Swiss account, which amounted to $24.4 million through 2007. Consequently, Warner underpaid his taxes by $5.5 million.

The U.S. Department of Justice began to investigate UBS in 2008, and in March 2009, the IRS started its Offshore Voluntary Disclosure Program (OVDP)(Please see our prior blogs on the OVDP: available here, here, here, here, here, here, here, and here).

Warner never accessed the funds in his Swiss bank account, and in 2009 Warner applied to the OVDP. However, Warner was rejected from the OVDP because he was already under investigation. In 2011, Warner received a grand jury subpoena requiring him to turn over his Swiss bank records. Warner fought the subpoena, see In re Special Feb. 2011-1 Grand Jury Subpoena Dated Sept. 12, 2011, 691 F.3d 903, 909 (7th Cir. 2012), but ultimately was forced to comply with the subpoena.

Ty Warner was charged in 2013 in the U.S. District Court for the Northern District of Illinois for tax evasion in violation of 26 U.S.C. section 7201, available here.

The information alleged that Warner evaded $885,300 in taxes in 2002 by failing to report income from his Swiss account.  According to the information, Warner fraudulently reported he did not have a foreign bank account on his income tax return, see Schedule B (line 7b), available here, and failed to file a Report of Foreign Bank and Financial Account (FBAR), available (the former version) here, in violation of the Bank Secrecy Act, available here.

Warner pleaded guilty, agreeing to pay full restitution and a civil FBAR penalty in the amount of $53.5 million (equal to 50% of the highest balance in 2008). The plea agreement had the following U.S. Sentencing Guideline (USSG) calculation:

  • Base offense level 24 (based on $5.6 million tax loss (see USSG 2T1.1, available here)
  • a two-level enhancement for sophisticated means (see USSG 2T1.1(b)(2), available here)
  • a two-level reduction for acceptance of responsibility (see USSG 3E1.1(b), available here)
  • and a one-level reduction because the plea relieved the Government of having to prepare for trial (see USSG 3E1.1(b))
  • for a total offense level of 23.

A level 23 offense level, with no prior criminal history, results in a guideline sentence of 46-57 months, see USSG Sentencing table, available here.

Warner’s sentencing occurred in January 2014, and the District Court judge, evidently moved by Warner’s unique characteristics, sentenced Warner to probation (the Government wanted at least one year of incarceration). The Government appealed.

On appeal, the U.S. Court of Appeals for the Seventh Circuit engaged in the standard two-step process.  First, it reviewed the Guidelines calculation to ensure it was properly calculated (procedural reasonableness).  Second, it reviewed the trial judge’s analysis of the 18 U.S.C. section 3553(a) factors, available here (substantive reasonableness). See generally Gall v. United States, 552 U.S. 38 (2007), available here, and Rita v. United States, 551 U.S. 387 (2007), available here.

The 7th Circuit focused on the substantive reasonableness of the sentence and noted that the trial judge properly focused on Warner’s characteristics as an individual, which demonstrated a benevolence that was unique.  For instance, the Court cited to various instances of charitable giving that were extraordinary. As to the seriousness of the offense, the Court noted that the Government sought a sentence well below the guidelines, which was mitigated because

His crime was isolated and uncharacteristic: he had kept only one offshore account containing “a small fraction” (about 6%) of his total wealth. He was 69 years old, had no prior criminal history, and posed no danger to society. In particular, the court found, there was “no question of him violating the tax laws in the future.” Moreover, he cooperated by pleading guilty and promptly paying both full restitution and the FBAR penalty, although, it is true, his cooperation was incomplete (e.g., he resisted the government’s subpoena and did not dis-close the source of his offshore assets). The district court also appropriately took into account Warner’s attempt to enter the OVDP in September 2009.

Slip op. at 21. The Court further noted that Warner paid full restitution and a $53.6 million FBAR penalty.

The Court also recognized that a $53.6 million penalty provided an acceptable level of deterrence for Warner and anyone else considering a similar attempt to evade the payment of a tax. In particular, the Court noted that “Warner’s FBAR penalty was nearly ten times the size of the tax loss he caused (not accounting for interest).”  Slip op. at 25.

And, interestingly, in addressing sentencing disparities, the Court noted that:

probation is a common sentence in offshore tax evasion cases. The evidence introduced below shows that roughly half of the defendants convicted since 2008 have received terms of probation rather than imprisonment. And, of course, thousands more have avoided criminal prosecution altogether by entering the OVDP.

Slip op at 27 (emphasis added). Ultimately the Court affirmed the sentence of probation.

What is the impact of the Warner case? While it remains to be seen how district courts around the country will apply the Warner case, one thing is clear – “roughly half of the defendants convicted since 2008 have received terms of probation rather than imprisonment.”  In other words, district courts appear to be departing downward from the sentencing guidelines (where a sentence of incarceration is presumptively reasonable) and imposing sentences of probation.

What does this mean for taxpayers who have been, or may be, prosecuted for tax evasion and failing to disclosure foreign accounts?  It would appear that if a taxpayer can demonstrate the he is similarly situated with other defendants who have received sentences of probation, he would likewise receive a term of probation instead of incarceration.  Accordingly, it is incumbent upon the taxpayer and his attorneys to develop the facts which will demonstrate a basis to mitigate the sentence and depart from the sentencing guidelines, similar to what occurred in the Warner case. Of course, in order to demonstrate the facts necessary to receive a downward departure, the taxpayer would be wise to engage counsel and avail himself of the IRS’s Offshore Voluntary Disclosure Program.

The attorneys at Fuerst Ittleman David & Joseph have extensive criminal and civil tax litigation experience before the district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the U.S. Courts of Appeal, including representing those with unreported offshore accounts.  You can contact us by email at contact@fuerstlaw.com or by telephone at 305.350.5690.

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Third Circuit Clarifies Mental State Required for Hobbs Act Extortion Conviction

July 23rd, 2015

The United States Court of Appeals for the Third Circuit (“Third Circuit”) in United States v. Fountain, clarified the mental states required of the payor and payee to uphold a conviction for extortion under the Hobbs Act. In its decision, the Third Circuit affirmed the conviction and sentences handed down by the United States District Court for the Eastern District of Pennsylvania. In doing so, the Third Circuit synthesized prior extortion case law and articulated that the evidence must indicate that the payor had a reasonable belief that the payee would perform official acts in return for the money, and the payee knew the payor made the payment because of that belief. In order to fully understand the implications of United States v. Fountain, a brief primer on the classic official right extortion jurisprudence is necessary.

Elements of Hobbs Act Extortion Under Color of Official Right 

Coercion

The Hobbs Act, found at 18 U.S.C. § 1951 et. seq., a federal statute penalizing extortion – often used in cases involving corrupt government officials – provides that “[w]hoever in any way . . . affects commerce or the movement of any article or commodity in commerce, by robbery or extortion . . . shall be fined under this title or imprisoned not more than twenty years, or both.” 18 U.S.C. § 1951.

“Extortion,” in turn, is defined as “the obtaining of property from another, with his consent, induced by wrongful use of actual or threated force, violence, or fear, or under color of official right.” As explained in United States v. Manzo, 636 F.3d 56, 65 (3d Cir. 2011), “a person can only commit extortion in one of two ways: (1) through threatened force, violence or fear or (2) under color of official right. Both of these types of extortion are inherently coercive.”

Generally, “when proceeding under a color of official right theory, the misuse of public office is said to supply the element of coercion.” Id. The “importance of a defendant’s public office or official act to a Hobbs Act charge is its coercive effect on the payor.” United States v. Fountain at 7; see also Evans v. United States, 504 U.S. 255, 268 (1992). The Supreme Court in Evans stated, “the Government need only show that a public official has obtained a payment to which he was not entitled, knowing that the payment was made in return for official acts.”  504 U.S. 268. In other words, it is payee’s position as a government official that is “the coercive effect on the payor.” Fountain, at 7.

The Third Circuit interpreted Evans in United States v. Antico, 275 F.3d 245, 257 (3d Cir. 2001), and found “no official act . . . need be proved to convict under the Hobbs Act.” Further, a Hobbs Act conviction was upheld where jury instructions were given that told to jury to decide “whether the giver gave the payments . . . because he believed the defendant would use his office for acts not properly related to his official duty.” Antico, at 259.

Additionally in United States v. Urban, 404 F.3d 754 (3d Cir. 2005), the Third Circuit expanded the foundation laid in Antico by ruling the following:

 a Hobbs Act conviction [is upheld] where the government adduced substantial evidence that (1) the payors made payments to the defendants knowing they were public officials exercising governmental authority; (2) the payors made payments in order to assure advantageous exercise of that government authority; and (3) the defendants knew that the [payors’] payments were made for an improper purpose, i.e., the influencing of their governmental authority.

Urban, 404 F.3d at 769 (internal quotations omitted).

Reasonable Belief 

The payor’s belief must be considered when determining a Hobbs Act conviction under official right. As articulated in United States v. Mazzei, 521 F.2d 639, 643 (3d Cir. 1975) (en banc), the Third Circuit established that no actual power needed to be had by the payee, only that “a reasonable belief that the state system so operated that the power in fact of defendant’s office included the effective authority.” In other words, the payee need not have statutory power, or actual power, as long as the evidence indicates that the payor reasonably believed that the power existed.

This notion was extended in United States v. Bencivengo, 749 F.3d 205 (3d Cir. 2014), where the Third Circuit ruled that so long as “a payor reasonably believed the defendant possessed ‘influence,’ if not ‘effective power,’” the Hobbs convictions will stand. Fountain at 9 (quotingBencivengo, 749 F.3d. at 212-13). The Third Circuit further wrote:

 a public official has, and agrees to wield, influence over a governmental decision in exchange for financial gain, or where the official’s position could permit such influence, and the victim of an extortion plan reasonably believes that the public official wields such influence, that is sufficient to sustain a conviction under the Hobbs Act, regardless of whether the official holds any [actual] power over the decision.

Bencivengo, 749 F.3d at 212-13.

Collectively, these cases are known as the “classic” official right extortion cases, with reasonableness underlying each decision. While the classic official right extortion cases previously discussed help shape the parameters of the Hobbs Act, the Third Circuit in United States v. Fountain applied the facts before them to clarify the mental states required of the payor and payee to uphold a conviction for Hobbs extortion.

United States v. Fountain

A Factual Overview

Between 2007 and 2012, an IRS employee, Patricia Fountain (“Fountain”), “orchestrated several schemes to fraudulently obtain cash refunds from the IRS.” Fountain, at 3. As an employee for the IRS, Fountain used “her knowledge of the IRS’s fraud detection procedures to avoid suspicion . . . including [the knowledge that] claims below $1,500 would not be flagged for review.” Id. During the five year scheme, Fountain employed various personnel including her significant other, friends, and hairdresser to recruit individuals to provide their personal information to file a claim, and then retain a portion of the refund. Fountain’s hairdresser recruited Deborah Alexander who “provid[ed] personal information so that Fountain could file fraudulent tax returns in [her] name.” Id. at 5.

At Fountain’s trial, “a jury convicted Fountain [and the other defendant’s] on multiple counts of conspiracy and filing false claims to the IRS in violation of 18 U.S.C. §§ 286 and 287. Fountain was also convicted on one count of Hobbs Act Extortion . . . .” Id. at 4. The “extortion count against Fountain alleged that she obtained and attempted to obtain money from Alexander under color of official right as an IRS employee.”Id. at 5.

Fountain filed a motion for a judgement of acquittal on the Hobbs Act charges, claiming the evidence was insufficient “to support a conviction for extortion under color of official right.” Id. at 5. However, when appealing the sufficiency of the evidence, evidence is reviewed “in the light most favorable to the Government, afford[s] deference to a jury’s findings, and draw[s] all reasonable inferences in favor of the jury verdict.”Id. (internal quotations omitted).

The Hobbs Act count rested on the jury finding that Fountain received a $400 payment from Alexander, so that Fountain would not “red flag” the claim. However, Fountain contended that this evidence was not sufficient, and Alexander “only knew Fountain worked for the IRS,” but “never directly dealt with Fountain.” Id.

The Court’s Rationale

The Third Circuit ruled that the Hobbs extortion conviction must stand because “the evidence adduced at trial was sufficient to support Fountain’s Hobbs Act Conviction.” Id. at 6. This case combined the precedent previously discussed and applied the facts of his case to the precedent, “while emphasizing different aspects of the payor’s motivation are consistent in accounting for the payor’s reasonable belief as a reflection of the coercive effect of the defendant’s official acts.” Id. at 9.

The Third Circuit further stated:

Thus, our case law articulates a unified standard for official right extortion cases: We will uphold a conviction for Hobbs Act extortion where the evidence indicates (1) that the payor made a payment to the defendant because the payor held a reasonable belief that the defendant would perform official acts in return, and (2) that the defendant knew the payor made the payment because of that belief.

Id. at 10.

Therefore, the Third Circuit “agree[ed] with the District Court that a rational juror could conclude that Alexander paid Fountain $400 with the understanding that Fountain would use her position at the IRS to help her obtain a cash refund, and that Fountain knew that Alexander paid her for that reason.” Id. at 11.

It is important to note that it was not necessary for the Third Circuit to “find that Fountain actually used her position or performed an official act in furtherance of the scheme to uphold her conviction.” Id. Rather, the Court’s focus was on Alexander’s state of mind.

The Third Circuit concluded that it would be easy for the jury to find “that Alexander reasonably believed Fountain would help her obtain the refund” and the jury “could have found that Alexander reasonably feared reprisal.” Id.

Fountain’s Rebuttal

Fountain attempted to argue that “[t]he evidence in support of the Hobbs Act charge was insufficient because the Government failed to prove that she used the power of her employment at the IRS to induce Alexander to pay her in exchange for filing a false claim with the IRS.” Id. at 13. However, as made clear by the Third Circuit, “inducement is not an element of Hobbs Act extortion under color of official right.” Id.

The Third Circuit’s ruling is simple: a conviction under the Hobbs Act will be sustained where the payor made a payment to a defendant with the reasonable belief that the defendant would perform official acts and the defendant knew the payor made the payments because of this reasonable belief.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in the areas of white color criminal defense, criminal tax defense, and criminal appellate practice. Should you have any questions or need further assistance, please contact us by email atcontact@fuerstlaw.com or telephone at 305.350.5690.

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United States Court of Appeals for the First Circuit: United States Bankruptcy Code Preempts Puerto Rico from Providing Municipalities with Statutory Bankruptcy Relief

July 22nd, 2015

On July 6, 2015, the First Circuit held that the United States Bankruptcy Code preempts the Commonwealth of Puerto Rico’s attempt to enact laws to provide its municipalities with bankruptcy relief. More specifically, in its opinion in Franklin California Tax-Free Trust v. Commonwealth of Puerto Rico, the First Circuit held that section 903(1) of Chapter 9 of Bankruptcy Code (“Chapter 9”) preempted the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (“Recovery Act”), which was passed by the Puerto Rican legislature in an effort to provide Puerto Rican municipalities with bankruptcy relief.

1.Background

Under the United States Constitution, States cannot independently provide statutory bankruptcy relief to its municipalities because doing so “would require impairing the obligation of contracts in violation of the Contracts Clause.” See Franklin at 10. Generally speaking, the “Contracts Clause”, found at Art. I, §10, clause 1  of the U.S. Constitution, prohibits States from passing laws that retroactively impair contract rights. As a result of this prohibition, in 1933, Congress enacted Chapter 9 of the Bankruptcy Code to provide state municipalities with bankruptcy relief that the Contracts Clause barred states from enacting themselves.

Chapter 9 provides that a municipality qualifies as a debtor only if it “is specifically authorized . . . to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to [so] authorize.” 11 U.S.C. § 109(c)(2). Therefore, while local municipalities can qualify for bankruptcy relief, the federal government cannot independently authorize a municipality to be a debtor for purposes of Chapter 9 bankruptcy relief because only a State has that power.

In 1938, Congress revised the Bankruptcy Code to give Puerto Rico the ability to authorize its municipalities to obtain federal municipal bankruptcy relief under Chapter 9. However, in 1984, Congress amended the Chapter 9 definition of “State” to include Puerto Rico “except for the purpose of defining who may be a debtor under [C]hapter 9 of [the Bankruptcy Code].” 11 U.S.C. § 101(52). As a result of the Chapter 9 amendment, Congress expressly barred Puerto Rico and its municipalities from obtaining federal bankruptcy relief under Chapter 9.

However, due to the recent and grave financial crisis plaguing the island, in June, 2014, Puerto Rico attempted to allow its utility companies and municipalities to restructure their debt by enacting its own municipal bankruptcy law, called the “Recovery Act”. It was the passage of the Recovery Act and the anticipated bankruptcy of a financially distressed Puerto Rican public utility, the Puerto Rican Electric Power Authority (“PREPA”), that sparked this action.

Here, the plaintiffs, Franklin, Oppenheimer Rochester, Blue Mountain Capital Management, LLC, (collectively “Plaintiffs”), who collectively hold two billion dollars in bonds issued by PREPA, brought suit against the Commonwealth of Puerto Rico, Puerto Rico’s governor, Puerto Rico’s Secretary of Justice, and the Government Development Bank (collectively “Defendants”) to challenge the Recovery Act and enjoin its implementation. The District Court ruled in Plaintiffs’ favor and permanently enjoined the Recovery Act, ruling that the Act is preempted under 11 U.S.C. § 903(1). The First Circuit confronted the issue on appeal.

2.The First Circuit’s Determination

The First Circuit stated that “[t]he primary issue on appeal is whether § 903(1) preempts Puerto Rico’s Recovery Act. That question turns on whether the definition of ‘State’ in the federal Bankruptcy Code—as amended in 1984—renders § 903(1)’s preemptive effect inapplicable to Puerto Rico.” See Franklin at 4.

Section 903(1) provides as follows: “a State law prescribing a method of composition of indebtedness of such municipality may not bind any creditor that does not consent to such composition.” 11 U.S.C. § 903(1). As explained by the First Circuit, “§903(1), ensures the uniformity of federal bankruptcy laws by prohibiting state municipal debt restructuring law that bind creditors without their consent.” Franklin, at 4.

In finding that § 903(1) applies to Puerto Rico, the First Circuit noted that there is no indication in Chapter 9 that suggests that Puerto Rico or its municipalities are exempt from § 903(1) prohibitions. In fact, the 1984 amendment of Chapter 9 explicitly states that Puerto Rico is a “State” “except for the purpose of defining who may be a debtor under chapter 9 of [the Bankruptcy Code].” 11 U.S.C. § 101(52). Thus, under § 903(1), Puerto Rico is barred from restructuring municipal debt without the consent of the municipalities’ creditors.

Here, although Puerto Rico modeled the Recovery Act after Chapter 9, the First Circuit found that it provided less protection for creditors than the federal Chapter 9 counterpart. The Recovery Act provides two ways of obtaining bankruptcy relief: Chapter 2 “Consensual Debt Relief,” and Chapter 3 “Debt Enforcement.” According to the First Circuit, Chapter 2 “permit[ed] a binding modification, including debt reduction, to a class of debt instruments with the assent of creditors holding just over one-third of the affected debt,” which reduced protections for creditors. See Franklin at 18-19. The First Circuit also found that Chapter 3 debtors “may [have] avoid[ed] certain contractual claims,” which again reduced protections for creditors. See Franklin at 19. Additionally, unlike Chapter 9, the Recovery Act allowed the Puerto Rican governor to issue an involuntary proceeding if the Government Development Bank found that it would be in the best interest of both the municipality and the Commonwealth.

The Recovery Act attempted to make municipalities barred from filing for federal bankruptcy relief eligible for bankruptcy relief at the Commonwealth level through the Puerto Rican Government Development Bank. The First Circuit found that the Act made municipalities eligible to seek both Chapter 2 and Chapter 3 relief and request an involuntary proceeding, each of which reduced protections for creditors investing in Puerto Rico by binding them without their consent. Thus, the First Circuit found that the Recovery Act was preempted by § 903(1)’s prohibition.

3.Impact on Industry

Puerto Rico claims that its debt-saddled municipalities and utilities are left with no relief as a result of the First Circuit’s determination. However, the First Circuit indicated that Puerto Rico’s recourse lies with Congress, not the courts. The First Circuit noted that Puerto Rico may request that Congress amend Chapter 9 or enact legislation to provide the territory with federal bankruptcy relief because  Congress, not the courts, maintains the power to grant Puerto Rican municipalities federal bankruptcy protection.

Puerto Rico is currently seeking authorization and other relief directly from Congress. Judge Torruella’s concurrence in Franklin, however, pointed out that Puerto Rico has no political representation in Congress, and therefore, holds little to no bargaining power when requesting aid from the federal legislature. Thus, Puerto Rican municipalities in need of bankruptcy relief hopefully await on Puerto Rico to request relief through Congressional legislation or for Puerto Rico to appeal to obtain a Supreme Court determination.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in the areas of tax, tax litigation, and complex administrative litigation. Should you have any questions or need further assistance, please contact us by email at contact@fuerstlaw.com or telephone at 305.350.5690.

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Tax Litigation Update: DC Circuit Rejects IRS’s Broad Interpretation of Anti-Injunction Act

July 22nd, 2015

On June 19, 2015, the United States Court of Appeals for the District of Columbia Circuit held that a nonprofit organization was not barred by the Anti-Injunction Act from bringing suit against the IRS because it had no other remedy for its alleged injury. In Z Street v. John Koskinen, available here, the IRS argued that the Anti-Injunction Act prohibits any suit aiming to “restrain the assessment or collection of any tax,” but the Court rejected the IRS’s overly broad view. Here, where a nonprofit organization claimed its application for a 501(c)(3) tax exemption was being delayed by the IRS on the basis of the organization’s political views, the Court held that because there was no other statutory procedure available, the nonprofit’s suit could move forward.

Background

Z Street is a nonprofit organization “devoted to educating the public about Zionism” and “the facts relating to the Middle East.” As such, Z Street applied for a section 501(c)(3) tax exemption. However, during its application process, a conversation between Z Street’s lawyer and an IRS agent revealed the agency’s alleged “Israel Special Policy,” which results in “increased scrutiny[y]” for applications from organizations holding “political views inconsistent with those espoused by the Obama ministration.” Z Street claimed it fell under this policy and consequently experienced an unreasonable delay in the processing of its application as compared to organizations with other political views.

Z Street sued the IRS under the Declaratory Judgment Act, 28 U.S.C. § 2201, claiming that the “Israel Special Policy” violated the First Amendment through blatant viewpoint discrimination. The relief Z Street sought was a declaration to that effect, and an injunction barring the IRS from applying its “Israel Special Policy” to Z Street’s pending application, instead requiring the IRS to adjudicate the application “expeditiously and fairly.”

The IRS moved to dismiss for lack of subject-matter jurisdiction and failure to state a claim, arguing that Z Street’s suit was barred by the Anti-Injunction Act, which prohibits suits to “restrain the assessment or collection of any tax,” and the doctrine of sovereign immunity. The IRS further argued that the plaintiff had other remedies at law available, and disputed the existence of the “Israel Special Policy.” However, at the motion to dismiss stage, the District Court was required to assume the truth of all material factual allegations in the complaint, and therefore assumed that the IRS did in fact have an “Israel Special Policy” that delayed the processing of section 501(c)(3) applications.

The District Court denied the IRS’s motion to dismiss, writing that Z Street’s First Amendment claim “cannot be properly characterized as a lawsuit implicating the ‘assessment or collection’ of taxes” because Z Street was only seeking a constitutionally valid process without delay. It also held that the claim for injunctive relief was appropriate because no other remedy at law would cure Z Street’s injury. The District Court then certified an order for interlocutory appeal to the D.C. Circuit.

Proper Scope of the Anti-Injunction Act

The D.C. Circuit began its analysis by summarizing the cases that best describe the purpose of the Anti-Injunction Act. In short, the D.C. Circuit came up with four principles presented through case law:

  • Outside of certain statutorily authorized actions, like those brought pursuant to 26 U.S.C. § 7428, the Anti-Injunction Act bars suits to litigate an organization’s tax status.

The two primary cases the Court cited as support for this proposition were Bob Jones University v. Simon, 416 U.S. 725 (1974), available here, and Alexander v. “Americans United” Inc., 416 U.S. 752 (1974), available here. In Bob Jones, the IRS moved to withdraw Bob Jones’ section 501(c)(3) status because it refused to admit African-American students, and the University sued to maintain its exemption. In “Americans United,” a non-profit group challenged its reclassification from a section 501(c)(3) to a section 501 (c)(4) organization due to its lobbying activities. In both cases, the Supreme Court found that the Anti-Injunction Act barred the suits, because “prior to the assessment and collection of any tax, a court may [not] enjoin the Service from revoking [tax exempt status],” as written in the Bob Jones opinion.

  • The Anti-Injunction Act does not apply in situations where the plaintiff has no alternative means to challenge the IRS’s action.

In South Carolina v. Regan, 465 U.S. 367 (1984), available here, the state challenged an amendment to the Internal Revenue Code that altered the taxation of certain state-issued bonds. South Carolina paid no taxes, and therefore it was unable to utilize any statutory procedure to contest the constitutionality of the tax. Here, the Court held South Carolina’s suit was not barred by the Anti-Injunction Act, because Congress did not intend the Anti-Injunction Act to apply to actions brought by aggrieved parties for whom it has not provided an alternative remedy.

  • The Anti-Injunction Act does not apply in situations where the plaintiff has no “implication[s]” for tax assessment or collection.

The D.C. Circuit considered the Anti-Injunction Act in a different light in Cohen v. United States, 650 F.3d 717 (D.C. Cir. 2011) (en banc), available here. There, taxpayers challenged a special procedure the IRS had established for refunding an unlawfully collected tax. The Court rejected the government’s argument that the case was barred by the Anti-Injunction Act because it held that the case did not involve the “assessment or collection” of taxes because “[t]he IRS previously assessed and collected the excise tax at issue” and the U.S. Treasury already received the money. Therefore, the Court held that the Anti-Injunction Act is not an obstacle to other claims seeking to enjoin the IRS outside the assessment and collection of tax.

  • In administering the tax code, the IRS may not discriminate on the basis of viewpoint.

Finally, the last series of cases cited by the D.C. Circuit in explaining the scope of the Anti-Injunction Act demonstrated that there is a requirement for viewpoint neutrality in the government’s provision of financial benefits, rather than having the tax code “discriminate invidiously … in such ways as to aim at the suppression of dangerous ideas;” see e.g. Regan v. Taxation with Representation of Washington, 461 U.S. 540 (1983), available here.

Applying the Anti-Injunction Act Propositions

The D.C. Circuit in this case disagreed with the positions articulated by the IRS and Z Street. On the one hand, the D.C. Circuit rejected the IRS’s broad approach that this was more in line with Bob Jones/“Americans United.” On the other, the Court disagreed with Z Street’s argument that it was in line with Cohen. The Court reasoned that Bob Jones and “Americans United” were different because in those cases the plaintiffs sought to litigate their tax status, whereas Z Street in this case sought to prevent the IRS from unconstitutionally delaying consideration of its application. Z Street’s suit did not have the obvious purpose of securing assurance that donations will “qualify as charitable deductions” like in “Americans United.”

However, while Bob Jones and “Americans United” did not apply to this particular fact pattern, neither did Cohen. The Court wrote that unlike Cohen, Z Street’s suit could have had implications for assessment and collection, such as obtaining a tax exemption earlier than expected. Instead, the Court resolved that Z Street’s suit fit best with the scenario presented in South Carolina.

The D.C. Circuit held that the Anti-Injunction Act should not bar Z Street’s suit because the plaintiff had no other remedy for its alleged injury. The Court detailed why neither section 7428 (if Z Street had waited 32 additional days to file suit), nor remedies offered by sections 6213 (deficiency petition) or 7422 (refund suit), could provide the relief that Z Street sought. The Court also added that the IRS’s sovereign immunity argument could not bar the suit, because 5 U.S.C. § 702, the Administrative Procedure Act, “waived sovereign immunity with respect to suits for nonmonetary damages that allege wrongful action by an agency or its officers or employees.” The D.C. Circuit affirmed the District Court’s denial of the IRS’s motion to dismiss.

The significance of this D.C. Circuit decision is the interpretation of the Anti-Injunction Act, and subsequently how courts will handle governmental defenses in tax litigation. By rejecting a broad reading of the Anti-Injunction Act, the Court reduced the IRS’s ability to claim that lawsuits are barred on the grounds that they may interfere with IRS’s tax collection efforts.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax and tax litigation.  They will continue to monitor developments in this area of the law. If you have any questions, an attorney can be reached by emailing us at contact@fuerstlaw.com or by calling 305.350.5690.

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Tax Litigation Update: D.C. Circuit Holds Tax Court Required to Articulate Basis for Dismissal Based on Lack of Jurisdiction

July 8th, 2015

On June 19, 2015, the United States Court of Appeals for the District of Columbia Circuit (“D.C. Circuit”) vacated and remanded the decision of the United States Tax Court in Edwards v. Commissioner after the Tax Court failed to “articulate the basis for its jurisdictional dismissal.” In Edwards, available here, the D.C. Circuit determined that while it was in the Tax Court’s powers to dismiss the case before it, the Tax Court was required to explain its grounds for dismissal. Because the Tax Court failed to do so, the D.C. Circuit vacated and remanded the case.

The Tax Court is an Article I court which exercises the judicial power of the United States. See Fraytag v. Commissioner, 501 U.S. 868 (1991). The Tax Court is a court of limited jurisdiction, meaning it can only hear and decide certain issues. One of the issues the Tax Court can decide is the issuance of notices of deficiency and the filing of a petition against the deficiency. The Internal Revenue Service (“IRS”) has the authority to issue a notice of deficiency, informing the taxpayer of his tax deficiency, and if the deficiency goes unchallenged the IRS will assesses and collect the taxpayer’s unpaid debt through an income tax deficiency.

When the IRS issues a notice of deficiency to a taxpayer, the IRS must inform the taxpayer by “send[ing] a notice of deficiency to a taxpayer prior to initiating proceedings to assess a deficiency.” Edwards at 3. After a notice is sent, “a taxpayer typically has ninety days to . . . challenge the deficiency.” Id. So long as the IRS issues the notice, or the taxpayer responds to the notice within the allocated ninety days, the Tax Court has jurisdiction over the matter. However, if the IRS fails to issue a notice of deficiency, or the ninety days has elapsed, “the tax court does not have jurisdiction . . . .” Id. at 4.  In Edwards, the D.C. Circuit was faced with the interesting situation where both parties agreed that the Tax Court lacked jurisdiction, however the issue before the court was why. The taxpayers claimed that no notice of deficiency was ever sent, while the IRS contended the taxpayers missed the ninety day deadline.

Background

At issue in Edwards were two taxpayers whom the IRS claimed had tax deficiencies, and after allegedly sending a notice of deficiency with no challenge from the taxpayers, the “IRS retained several of their tax refunds and applies those funds to their outstanding tax liabilities.” Id. However, the taxpayers filed a petition in the Tax Court “allege[ing] that the IRS violated due process of law by failing to issue notices of deficiency before assessing tax liabilities against the taxpayers and by failing to issue final notices of intent to levy before levying the taxpayers’ assets.” Id.

At a hearing before the Tax Court, the IRS was unable to provide confirmation that the notices of deficiency were actually sent. Therefore, the Tax Court “issued an order in June 2013, granting the taxpayer’s motion and dismissing the case for lack of jurisdiction on ‘the ground that there has been no showing that a notice of deficiency ha[d] been issued to either taxpayer . . . .’” Id.

The taxpayers timely submitted a “claim for litigation and administrative costs.” Id. at 5. However, “[t]he presiding tax court judge insisted that he could not consider the claim for costs unless he reopened the case and vacated his dismissal order.” Id. After the taxpayers allowed for the proceedings to go forward, the Tax Court had to revisit its jurisdictional ruling. In the Tax Court’s second order, the Tax Court “den[ied] the taxpayers’ motion for costs and once against dismiss[ed] the petition for lack of jurisdiction.” Id. at 5-6. However, contrary to the first order, the second order “did not resolve whether the notices had in fact been issued, but merely that is was ‘clear in this matter . . . that the Court has no jurisdiction over [the taxpayers’ petition].’” Id. at 6. Both parties appealed.

D.C. Circuit’s Ruling

While both parties agreed that the Tax Court lacked jurisdiction, they did not agree regarding why. The taxpayers argued that the Tax Court lacked jurisdiction because the IRS never sent the notices of deficiency, while the IRS countered and claimed that jurisdiction was not warranted because the taxpayers exceeded the ninety day limit to file a petition.

The D.C. Circuit recognized that the taxpayers’ and the IRS’ explanation for lack of jurisdiction are “factually mutually exclusive, and, while either leads to jurisdiction-based dismissal, the consequences of dismissal differ depending on the court’s reasoning.” Id. at 7. While the D.C. Circuit agreed with the Tax Court that it was proper for the Tax Judge to resolve this issue, the D.C. Circuit said “[judges] should first decide whether a notice of deficiency was properly issued before turning to whether the petition was timely filed.” Id.

The D.C. Circuit found that this initial determination was critical because the basis of dismissal for lack of jurisdiction “may affect a taxpayer’s rights or the IRS’s ability to collect taxes owed.” Id. Therefore, “it is essential that the tax court clearly state the grounds for its dismissal.” Id. Yet, here the Tax Court failed in its second order to “articulate the basis for its order to inform the parties of the rights and obligations it establishes.” Id.

In holding that the Tax Court must articulate a basis for its dismissal for lack of jurisdiction, the D.C. Circuit rejected the IRS’s interpretation of the Tax Court’s second order in which the IRS argued that “the tax court’s [second] order found as a matter of fact that notices of deficiency were issued and concluded that it lacked jurisdiction because the petition was not timely filed.” Id. at 9. However, the D.C. Circuit “decline[d] to consider the taxpayers’ argument” either in which the taxpayers agued the “tax court was bound by the jurisdictional holding of the [first] order. Id.

The D.C. Circuit’s holding reinforces the premise that the “fact-intensive inquiry” of “whether notices [were] ever issued” is “dependent on evidence of various circumstances” and “[t]he tax court has routine fact-finding capabilities, and expertise and experience in evaluating just such evidence.” Id. at 9-10. Therefore, the Tax Court is in the best position “to determine in the first instance the adequacy of any proof that the notices were in fact issued.” Id. at 10. Accordingly, the D.C. Circuit “vacate[d] the tax court’s decision and remand[ed] for further proceedings consistent with [] opinion.” Id. at 12.

The D.C. Circuit’s message to the Tax Court is simple. If the Tax Court lacks jurisdiction over a particular case, it must explain why it lacks jurisdiction, instead of just issuing an order declaring it does not have jurisdiction.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax and tax litigation. They will continue to monitor developments in this area of the law. Please contact us by email at contact@fuerstlaw.com or telephone at 305.350.5690 with any questions regarding this article or any other issues on which we might provide legal assistance.

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The Supreme Court of the United States: Law Enforcement Must Afford Hotel Owners Precompliance Review before Performing a Warrantless Search Pursuant to a Municipal Code

July 7th, 2015

The provision of the Los Angeles Municipal Code (“LAMC”) that requires hotel owners to provide guest registries to law enforcement on demand is facially unconstitutional due to its failure to provide hotel owners precompliance review of law enforcement demands. On June 22, 2015, in a 5-4 vote, the Supreme Court of the United States issued its opinion in City of Los Angeles v. Patel, holding that Los Angeles Municipal Code § 41.49(3)(a)  is unconstitutional because “a hotel owner must be afforded an opportunity to have a neutral decision maker [sic] review an officer’s demand to search the registry before he or she faces penalties for failing to comply.” See Patel at 11.

1.Background

This case confronts the constitutionality of a provision in LAMC that allows law enforcement to search hotel owners’ records without a warrant. Pursuant to the LAMC, hotel owners are required to record information about their guests for a period of 90 days after their guests check out. Section 41.49(3)(a) states that the guest records “shall be made available to any officer of the Los Angeles Police Department for inspection,” provided that “[w]henever possible, the inspection shall be conducted at a time and in a manner that minimizes any interference with the operation of the business.” Under § 11.00(m), a general provision applicable to the entire LAMC, a hotel owner’s failure to provide his or her guest records to law enforcement is a misdemeanor punishable by up to six months in jail and a $1,000 fine.

In Patel, a group of motel operators and a lodging association (collectively “Hotel Owners”) sued the City of Los Angeles (collectively “the City”) in three connected cases claiming that § 41.49(3)(a)  was facially unconstitutional under the Fourth Amendment of the United States Constitution. The District Court ruled in favor of Los Angeles, and found that Hotel Owners lacked standing because they did not have a reasonable expectation of privacy in the guest records subject to inspection. On appeal, the United States Court of Appeals for the Ninth Circuit affirmed the District Court’s ruling on the same grounds. However, the case was reheard before the entire Ninth Circuit en banc, and the Court reversed the District Court finding § 41.49(3)(a)  was facially unconstitutional. The City of Los Angeles appealed and the Supreme Court of the United States decided to review the case.

2.The Facial Challenge of § 41.49(3)(a)  under the Fourth Amendment

The issues the Supreme Court addressed were “whether facial challenges to statutes can be brought under the Fourth Amendment and, if so, whether [Section § 41.49(3)(a) ] of the Los Angeles Municipal Code is facially invalid.” See Patel at 1. The City of Los Angeles argued under the Court’s standard for granting facial relief, the party seeking facial relief “must establish that no set of circumstances exists under which the [statute] would be valid.” Id. at 7. Thus, because there are instances where warrantless searches are constitutional, the Hotel Owners’ challenge should have failed as a matter of law. In rejecting this argument, the Supreme Court in Patel found that it has both entertained facial challenges under the Fourth Amendment and declared statutes facially invalid under the Fourth Amendment in numerous cases. The Supreme Court in Patel found that the City’s argument was flawed because the standard, endorsed by the City, would preclude relief in every Fourth Amendment facial challenge to a statute authorizing warrantless searches. Instead, the Supreme Court noted that in facial challenges regarding the Fourth Amendment, “the proper focus of the constitutional inquiry is searches that the law actually authorizes, not those for which it is irrelevant.” Id. at 8. In other words, while exceptions to the warrants requirement exist, those recognized exceptions cannot serve as the basis for rejecting a facial challenge. Rather, for a warrantless search statute to pass constitutional muster, the statute must be constitutional in its application, i.e. the search at issue must have been authorized by the statute in question, not an exception to the warrants requirement.

3.Section 41.49(3)(a) constitutes an “administrative search” and thus is unconstitutional under the Fourth Amendment because it fails to provide for the opportunity to obtain precompliance review before a neutral decisionmaker

When examining the merits of the Hotel Owners’ claim, the Supreme Court in Patel held that § 41.49(3)(a)  was facially unconstitutional because the statute would constitute an administrative search under the Fourth Amendment but fails to provide hotel owners with an opportunity for precompliance review before law enforcement restricts their Fourth Amendment rights. The Supreme Court began by explaining the Fourth Amendment of the United States Constitution protects “[t]he right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures” and “no Warrants shall issue, but upon probable cause.” The Supreme Court has repeatedly found that all warrantless searches are presumptively unreasonable, subject to a few expressly established exceptions. However, the Court noted that where the “primary purpose” of the search is distinguishable from the general interest in crime control, no warrant is required. Here, the Court assumed that the searches authorized by § 41.49 served a “special need” other than criminal investigations, to wit: ensuring compliance with the record keeping requirements. Thus, the Court concluded that the searches authorized by § 41.49 would fall within the “administrative search” exception to the warrants requirement.

In analyzing administrative searches, the Court noted that absent exigent circumstances or consent, for an administrative search to be constitutional, the search must be subject to precompliance review before law enforcement restricts a party’s Fourth Amendment rights by demanding records. The Court defined precompliance review as “an opportunity to have a neutral decisionmaker review an officer’s demand to search [a party’s] registry before he or she faces penalties for failing to comply.” See Patel at 11. Though the Court acknowledged that it has never prescribed exactly what type of precompliance review is sufficient to withstand constitutional muster, it found that the City did not even attempt to argue that § 41.49(3)(a)  granted the Hotel Owners any opportunity for review. Instead, the Court found that if hotel owners refuse to comply, law enforcement can arrest them on the spot. The Court thus determined that hotel owners cannot reasonably decide between relinquishing their records and arrest, and without review, law enforcement can also harass hotel owners by repeatedly and serially demanding the owners’ registries, and hotel owners would have no reasonable choice but to comply.

In finding § 41.49(3)(a) unconstitutional, the Court did provide guidance on what revisions would be needed to make the law constitutionally compliant. For instance, the Supreme Court in Patel found that if law enforcement obtained an administrative subpoena and then performed a search of a hotel’s records, Hotel Owners would be afforded precompliance review. A subpoena is issued by a neutral decision maker and allows a subpoenaed party to “question the reasonableness of the subpoena, before suffering any penalties for refusing to comply with it, by raising objections in an action in district court,” thus, providing for sufficient precompliance review. See Patel at 10.

4.Hotels are not considered a “highly regulated industry.” Thus, a more relaxed search standard does not apply.

In his dissent, Justice Scalia argued that the hotel industry is highly regulated and § 41.49(3)(a)  is facially valid under the relaxed standard that applies to searches of highly regulated industries. However, the majority in Patel pointed out that the Supreme Court has only identified four industries that “have such a history of government oversight that no reasonable expectation of privacy . . . could exist for a proprietor over the stock of such an enterprise[:]” liquor stores, firearms dealing, mining, and automobile junkyards. See Patel at 14. The Supreme Court in Patel found that, unlike those businesses, hotels do not pose a “clear and significant risk to public welfare.” Id. Therefore, there is no relaxed standard that applies to the search of the hotel industry because, without a “clear and significant risk to public welfare,” the hotel industry should not be considered a highly regulated industry. Id.

Even if the Supreme Court found that hotels are highly regulated, according to the Supreme Court in Patel, § 41.49(3)(a)  would need to meet three additional criteria for the statute to be reasonable under the Fourth Amendment. (1) “[T]here must be a ‘substantial’ government interest that informs the regulatory scheme pursuant to which the inspection is made”; (2) “the warrantless inspections must be ‘necessary’ to further [the] regulatory scheme”; and (3) “the statute’s inspection program in terms of the certainty and regularity of its application, [must] provid[e] a constitutionally adequate substitute for a warrant.” Id. at 16. Here, the Supreme Court found that the second and third criteria were not met, and the statute was facially invalid under the Fourth Amendment.

The second criteria was not met because warrantless inspections of hotel registries are not absolutely necessary. For instance, if law enforcement intends to protect the contents of the registries, they can perform a surprise inspection by obtaining a warrant without giving notice to the hotel owner, and they can guard the registry pending a hearing if a hotel owner objects to a subpoena. Additionally, the third criteria was not met because the statute does not limit the inspection to any certainty and regularity requirements. Section 41.49(3)(a) does not sufficiently limit law enforcement discretion as to the location, time, frequency, or circumstances of the search. Therefore, regardless of the level of regulation of the hotel industry, § 41.49(3)(a)   is not facially valid because the warrantless search of hotel registries are not absolutely necessary and the statute does not constrain the search to any certainty and regularity requirements. The Supreme Court in Patel agreed with the Ninth Circuit that § 41.49(3)(a) is facially invalid because it fails to provide hotel owners an opportunity for precompliance review before the owner must relinquish their guest registry to law enforcement for inspection.

5.Impact on the Industry

With the Court’s decision in Patel, the LAMC and similarly worded governmental codes must be revised to provide for some measure of precompliance review prior to requiring the disclosure of records to law enforcement. Whether Los Angeles adopts the Supreme Court’s recommendation of using the administrative subpoena scheme to create a constitutionally compliant statute remains to be seen. Regardless of the precompliance review mechanism chosen, the requirement of precompliance review should provide hotel owners with a level of due process to combat what owners may feel are harassing, burdensome, and irrelevant searches of their business records.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in the areas of complex administrative litigation and white collar criminal defense at both the state and federal levels. Should you have any questions or need further assistance, please contact us by email at contact@fuerstlaw.com or telephone at 305.350.5690.

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U.S. Liability for Foreign Affiliate Activities: Foreign Transactions May Result in U.S. Penalties

July 7th, 2015

The following article was written by Stephen Wagner for the Export Compliance Training Institute. Mr. Wagner is a faculty member for the Institute, and frequently lectures and writes on export compliance and enforcement matters. We repost Mr. Wagner’s article here with the Institute’s permission.

Your U.S.-based company is known for its high-end electronic components, which are used by research and development labs around the world.  Some company products are manufactured at the home office in Chicago, Illinois, while other products are produced at an affiliate company’s facility in Malaysia.  Most of your sales, on-site installation services, and customer and product support are performed by affiliated companies which are located in 22 countries throughout the world.

Recently, you were copied on an email indicating that your company’s affiliate in Abu Dhabi secured a lucrative contract for installation, training, and support services with the state-owned gas company in Iran. The email proudly announced that the winning bid was based on “the outstanding cost and supply analysis provided by the Chicago office.” You’ve done some quick due diligence and determined that no U.S. assets will be involved in the contract:  all of the products used in the contract are manufactured by the Malaysian affiliate, all of the personal services (installation, training, and support) will be provided by Emirati (that is, people from Abu Dhabi), and all of the technical information for the contract comes either from Malaysia or Abu Dhabi.

Given that the U.S. is not involved in any way with this contract, are there any regulatory enforcement risks that your company faces in the United States?
Your definition of “not involved in any way,” may be very different than the definition used by the Office of Foreign Assets Control (OFAC) or the U.S. Department of Justice.

Trade with Iran – both commercial and financial transactions – is subject to sanctions from the U.S. government, sanctions which are enforced by OFAC, a unit within the U.S. Department of the Treasury.  Over the past few years, these trade sanctions have eased in some respects and been strengthened in others.  In January 2014, for example, Iran’s actions toward control of its nuclear program resulted in a slight easing of some sanctions.  Before that, however, the Iran Threat Reduction and Syrian Human Rights Act of 2012 (the “Threat Reduction Act”) expanded sanctions to make U.S. entities directly liable for any such transactions and activities that are undertaken by their foreign subsidiaries.  Specifically, “an entity [including partnerships, trusts, joint ventures, associations, corporations and other organizations] owned or controlled by a United States person and established or maintained outside the United States” cannot be involved in any transaction with the Government of Iran if the transaction would be illegal if carried out in the United States or by a U.S. person.

This extension of Iranian sanctions to foreign affiliates of U.S. companies seems to hinge on the words “owned or controlled by.” Under the Threat Reduction Act, a foreign affiliate is only owned or controlled by a U.S. company if the American company (i) holds more than 50% of the affiliate’s equity (i.e., stock), (ii) holds a majority of seats on the board of directors for the affiliate, or (iii) otherwise controls “the actions, policies or personnel decisions” of the foreign affiliate.

So if a foreign affiliate of a U.S. company does not meet any of these tests, can the foreign affiliate conduct trade with Iran?  At this point, the U.S. company has to consider whether it is really involved in the business of the foreign affiliate when it comes to embargoed countries such as Iran.  At this point, the U.S. company has to think of Schlumberger.

In March 2015, the U.S. Department of Justice, together with OFAC and the Bureau of Industry and Security (U.S. Department of Commerce) announced a $232.7 Million penalty against Schlumberger Oilfield Holdings Ltd. (SOHL), a British Virgin Islands company and a wholly-owned subsidiary of Schlumberger Ltd., which is headquartered in Houston, Texas. SOHL pled guilty to conspiring to violate the International Emergency Economic Powers Act (IEEPA) “by willfully facilitating illegal transactions and engaging in trade with Iran and Sudan.” From 2004 through 2010, a business unit of SOHL provided oilfield services to Schlumberger customers in Iran and Sudan.

In the Schlumberger case, although the main contracts with Iran were performed by the foreign affiliate, SOHL employees residing in the United States approved the company’s capital expenditure requests from Iran for the manufacture of new oilfield drilling tools, made and implemented business decisions specifically concerning Iran, and provided certain technical services and expertise in order to maintain drilling equipment located in Iran.  As stated by U.S. Attorney Ronald C. Machen Jr.:

This is a landmark case that puts global corporations on notice that they must respect our trade laws when on American soil[.]  Even if you don’t directly ship goods from the United States to sanctioned countries, you violate our laws when you facilitate trade with those countries from a U.S.-based office building.  [W]hether your employees are from the U.S. or abroad, when they are in the United States, they will abide by our laws or you will be held accountable.

Returning to the fact pattern involving our U.S. electronics manufacturer, even though all of the equipment and technical expertise for the Iranian contract are slated to come from its affiliates in Malaysia and Abu Dhabi, and even though it is not clear whether these affiliates are “owned or controlled by” the U.S. parent company, the contract itself was won with support from the “Chicago office.” This would clearly imply that U.S.-based persons facilitated transactions involving Iran. This level of involvement exposes the U.S. company to enforcement action and legal liabilities.

And the legal liabilities can be great. Under the IEEPA, civil penalties can reach the greater of $250,000 or twice the transaction amount, and criminal penalties can include fines of up to $1,000,000 (per transaction) and imprisonment for not more than 20 years, or both.  (50 U.S.C. § 1705).  In the Schlumberger case, the monetary penalty was $155 Million and an additional $77.6 Million in assets were forfeited to the United States.  Furthermore, SOHL was placed on 3 years’ probation and made to hire an independent consultant who will review the company’s internal sanctions policies, procedures, and company-generated sanctions audit reports.

The bottom line is that a U.S. company with foreign affiliates has to ensure that a rigorous export compliance program extends to the activities of each of those affiliates.  In this digital, interconnected age, because so much information, technical and administrative assistance, and capital resources tends to flow between affiliated companies – both into and out of the United States – in the absence of a strong export compliance program, what a U.S. company doesn’t necessarily know about its foreign affiliates definitely can come back to hurt it.

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Criminal Law Update: Supreme Court Rules that Child’s Statements to Teacher do not Implicate the Sixth Amendment’s Confrontation Clause

July 6th, 2015

On June 18, 2015, the Supreme Court in Ohio v. Clark (slip opinion available here), held that the Sixth Amendment’s Confrontation Clause applies to out-of-court statements by unavailable witnesses to persons other than law enforcements officers. However, while the Court held that such statements are “much less likely to be testimonial than statements to law enforcement officers,” the Court analyzed the statements at issue using the same “relevant circumstances” test it had previously established for analyzing out-of-court statements to law enforcement. In sum, the Court found that to whom the out-of-court declarant was speaking is a relevant consideration in assessing whether the out-of-court statement is “testimonial” in nature, thus triggering the protections of the Sixth Amendment. In its ruling, the Court held that a three-year old’s out-of-court statement to a teacher was not testimonial, and thus, admission of such statements into evidence did not violate the Sixth Amendment. Through this case, the Supreme Court continues to refine the bounds of the Confrontation Clause when dealing with hearsay statements.  In order to fully understand the implications of Ohio v. Clark, a brief primer on recent Supreme Court Confrontation Clause jurisprudence is necessary.

The Confrontation Clause vs. Admissible Hearsay Statements of Unavailable Witnesses

The Sixth Amendment provides that “[i]n all criminal prosecutions, the accused shall enjoy the right . . . to be confronted with the witnesses against him.” This is known as the Confrontation Clause. This clause of the Sixth Amendment allows those standing in a criminal trial the right to cross-examine, question, or confront a witness who is testifying against him.

However, out-of-court statements by unavailable witnesses were historically admissible regardless of whether the out-of-court declarant had ever been subject to cross-examination so long as the statement bore adequate “indicia of reliability.” As Ohio v. Roberts, 448 U.S. 56 (1980) made clear, such reliability could be inferred without more in cases where the out-of-court statement by an unavailable witness fell within a firmly rooted hearsay exception.

The position of the Supreme Court regarding the breadth of the Confrontation Clause was refined inCrawford v. Washington, 541 U.S. 36 (2004), when the Supreme Court “held that the Confrontation Clause generally prohibits the introduction of ‘testimonial statements by a nontestifying witness, unless the witness is ‘unable to testify, and the defendant had had a prior opportunity for cross-examination.’” 541 U.S. at 54. The Supreme Court in Crawford declared that “‘witnesses against the accused” are “‘those who bear testimony’” and testimony is “a solemn declaration or affirmation made for the purpose of establishing or proving some facts.” 541 U.S. at 51. Therefore, the Confrontation Clause, per Crawford, only applies if a witness’s statements are sought to be admitted into court and the witness is unavailable to testify, or the defendant has not had a right to previously cross-exam the unavailable witness. In other words, under Crawford, where an out-of-court declaration is testimonial, the Confrontation Clause prohibits its use at trial unless the declarant is made available for cross-examination regardless of how “reliable” that out-of-court statement may be.

However, the Supreme Court in Crawford failed to define what statements were “testimonial.”  In Davis v. Washington, 547 U.S. 813 (2006) and Hammon v. Indiana, the Supreme Court expanded Crawford to define “testimonial” statements by ruling the following:

[s]tatements are nontestimonial when made in the course of police interrogations under circumstances objectively indicating that a primary purpose of the interrogation is to enable police assistance to meet an ongoing emergency. They are testimonial when the circumstances objectively indicate that there is not such ongoing emergency, and that the primary purpose of the interrogation is to establish or prove past events potentially relevant to later criminal prosecution.

547 U.S. at 822.

This is known as the “Primary Purpose” test. To implicate the Confrontation Clause, a court must decide if the statements given were of the primary purpose to create a record for trial. If the primary purpose was to create a record for trial, then the statements are considered testimonial. If the primary purpose of the statements was not to create a record, then those statements are not considered testimonial. In establishing the primary purpose test, Davis and Hammon help flesh out the Confrontation Clause in relation to persons who are law enforcement officers. However, these cases fail to elucidate the test regarding statements made to those outside of law enforcement.

In the 2011 Supreme Court decision, Michigan v. Bryant, 562 U.S. 344 (2011), the Court further clarified the primary purpose test. The Court held that the primary purpose test is not one-factor determinative. Rather, “[i]n determining whether a declarant’s statements are testimonial, courts should look at all of the relevant circumstances.” 562 U.S. at 369 (emphasis added). The Court in Bryant explained that “all relevant circumstances” matter because “there may be other circumstances aside from ongoing emergencies, when a statement is not procured with a primary purpose of creating an out-of-court substitute for trial testimony.” 562 U.S. at 358. Therefore, ongoing emergencies are a factor, but not the only factor in the primary purpose test. An additional factor is “the informality of the situation and the interrogation.” 562 U.S. at 377. Under Bryant, to apply the primary purpose test, a court must view objectively all relevant circumstances to rule if the purpose of the conversation was to create an out-of-court substitution for trial testimony.  If the Primary Purpose test does not apply thereby not invoking the Sixth Amendment’s Confrontation Clause, then “the admissibility of a statement is the concern of state and federal rules of evidence, not the Confrontation Clause.” 562 U.S. at 358-359.

While the line of Confrontation Clause cases previously discussed help shape the limits of the clause’s implication, the Court until Ohio v. Clark failed to address statements given to individuals outside of law enforcement.

Ohio v. Clark

A Factual Overview:

In March 2010, Darious Clark pimped out his girlfriend—the mother of two young children—to Washington D.C. to prostitute herself. The two young children, a 3-year-old-boy and an 18-month-old girl were left in Clark’s care. Clark sent the oldest child to preschool with a black eye and markings on his body. When his teacher noticed the marks on him, the teacher asked the child what happened. The child responded saying it was Clark who caused them . Upon finding more bruising on the boy, school officials notified the child abuse hotline to alert authorities about the suspected abuse. Clark was subsequently indicted on multiple counts of felonious assault, endangering children, and domestic violence.

At Clark’s trial, “the State introduced [the child’s] statements to his teachers as evidence of Clark’s guilt, but [the child] did not testify.” 576 U.S. at 2. The child did not testify because “under Ohio law, children younger than 10 years old are incompetent to testify if they ‘appear incapable of receiving just impressions of the facts and transactions respecting which they are examined, or relating them truly.” 576 U.S. at 2-3.

Clark motioned the trial court “to exclude testimony about [the child’s] out-of-court statements under the Confrontation Clause.” 576 U.S. at 3. The trial court denied the motion, ruling that the statements were not testimonial. After the jury found Clark guilty on all counts but one, Clark “appealed his conviction, and a state appellate court reversed on the ground that the introduction of [the child’s] out-of-court statements violated the Confrontation Clause.” 576 U.S. at 3. The Supreme Court of Ohio affirmed the state appellate court’s decision stating that “teachers acted as agents of the state” and “the primary purpose of the teachers’ questioning ‘was not to deal with the existing emergency but rather to gather evidence potentially relevant to a subsequent criminal prosecution.’” 576 U.S. at 3.

The Court’s Rationale

The Supreme Court ruled that the statement given by the child was not testimony. In doing so, the Court looked at the earlier precedent set by the Court. The Supreme Court, through its precedent stated “the primary purpose test is a necessary, but not always sufficient, condition for the exclusion of out-of-court statements under the Confrontation Clause.” 576 U.S. at 7. This case is different than the precedent before it though, because the statements given were not given to a law enforcement officer, instead the statements were made to a teacher. Therefore, the Court was “presented with the question [it] [had] repeatedly reserved: whether statements to persons other than law enforcement officers are subject to the Confrontation Clause.” 576 U.S. at 7.

In its holding, the Court did not “adopt a categorical rule excluding” statements to individuals who are not law enforcement officers “from the Sixth Amendment’s reach. Nevertheless, such statements are much less likely to be testimonial than statements to law enforcement officers.” 576 U.S. at 7. Therefore, when considering all of the relevant circumstances before them, the Court found that the child’s “statements clearly were not made with the primary purpose of creating evidence for Clark’s prosecution. Thus, their introduction at trial did not violate the Confrontation Clause.” 576 U.S. at 7.

The Primary Purpose of the Child’s Statements 

When evaluating an out-of-court statement under the Primary Purpose test, the imminence of an ongoing emergency helps determine the context of the statement. The Court found in this instance that the child’s statements “occurred in the context of an ongoing emergency involving suspected child abuse.” 576 U.S. at 7. It was important for the school to determine “whether it was safe to release [the child] to his guardian at the end of the day, they needed to determine who was abusing the child.” 576 U.S. at 8. Using the precedent set forth in Bryant, the Court ruled, “[t]hus the immediate concern was to protect a vulnerable child who needed help . . . [T]he teachers’ questions were meant to identify the abuser in order to protect the victim from future attacks.” 576 U.S. at 8.

The Court noted that there is also “no indication that the primary purpose of the conversation was to gather evidence for Clark’s prosecution.” 576 U.S. at 8. The teachers never eluded to or informed the child what the intent of their questioning was or what the statements made would amount to. Further, the “informal and spontaneous” conversation between the child and the teacher was conducted in the same manner “as a concerned citizen would talk to a child who might be the victim of abuse.” 576 U.S. at 8. The dialogue was in no way formal, as the questioning in Crawford was, the setting was first in a preschool lunchroom and then classroom. The informal atmosphere coupled with the ongoing emergency lead the Court to rule that the primary purpose of the questioning was to protect a child who potentially was a victim of abuse. However, the Court does create dictum when it writes, “[s]tatements by very young children will rarely, if ever, implicate the Confrontation Clause.” 576 U.S. at 9. This statement implies that there may be an age cut off before the Confrontation Clause can be invoked.

Clarke’s Rebuttal

In its opinion, the Court refutes Clark’s effort to analogize teachers with police due to Ohio’s mandatory reporting status. In response, the Court says

[l]ike all good teachers, they undoubtedly would have acted with the same purpose whether or not they had a state-law duty to report abuse. And mandatory reporting statutes alone cannot convert a conversation between a concerned teacher and her students into a law enforcement mission aimed primarily at gathering evidence for a prosecution. 576 U.S. at 11.

Moreover, the Court emphasized that the mandatory reporting law is irrelevant because the child who gave incriminating statements would be unable to testify due to Ohio’s laws of evidence under which, he is deemed incompetent.

The Post-Clark Confrontation Clause

The Supreme Court’s most recent ruling regarding the Confrontation Clause (Ohio v. Clark) adds one more level to the Confrontation Clause scheme. For the first time, the Supreme Court addressed the confrontation clause out of the law enforcement context. While the court fails to adopt a bright-line rule, the court does set some boundaries, to wit:

  1. The primary purpose test is not rigid, and the entire context of the situation must be analyzed.
  2. Statements made to non-law enforcement officers may be subject to the Confrontation Clause, even though such statements are much less likely to be considered testimonial.
  3. The way in which the questioning was conducted (formal v. informal, spontaneous v. planned, location) influences the analysis as to if the statement is considered testimonial.
  4. The relationship between the individual giving the statement and the individual listening matters.
  5. Young children who give statements will likely not implicate the Confrontation Clause because a young child’s understanding of the criminal justice system is not developed.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in the areas of white collar criminal defense, criminal appellate practice, and litigating against the U.S. Department of Justice. Should you have any question or need further assistances, please contact us by email at contact@fuerstlaw.com or telephone at 305.350.5690.

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Natural Products Litigation Update: The FDCA May Not Explicitly Preempt a Judicial Interpretation of the Term “Natural”

July 2nd, 2015

On April, 10, 2015, the United States Court of Appeals for the Ninth Circuit found that the Food, Drug, and Cosmetic Act (“FDCA”) does not explicitly preempt California’s state law causes of action, which provide consumers with remedies for false or misleading cosmetic labels. In Astiana v. The Hain Celestial Group, Inc., a class action suit against The Hain Celestial Group, Inc. and JASON Natural Products (collectively “Hain”), Skye Astiana, Tamar Davis, and Mary Littlehale (collectively “Plaintiffs”) filed a suit alleging that Hain deceived its consumers into purchasing its cosmetics labeled “all natural,” but allegedly contained synthetic and artificial ingredients. (Read the entire Astiana opinion here)

Plaintiffs sought injunctive relief and damages, citing the federal Magnuson-Moss Warranty Act, California’s unfair competition and false advertising laws, and common law theories of fraud and quasi-contract. The district court dismissed the case per the primary jurisdiction doctrine, which allows courts to decide whether a legal claim requires technical or policy answers that should first be addressed by an agency with regulatory authority over an industry, and encourages courts to favor allowing legislatively qualified administrative tribunals to resolve controversies involving technical or policy questions. The relevant issue on appeal was whether “federal preemption or the primary jurisdiction doctrine prevents the district court from deciding when a ‘natural’ label on cosmetic products is false or misleading.” See Astiana at 3-4.

The Ninth Circuit reversed the district court’s dismissal of Plaintiffs’ claims under the primary jurisdiction doctrine. The Ninth Circuit found that the district court correctly invoked the doctrine, but instead of dismissing the case, the district court should have issued a stay to obtain expert guidance from FDA.

Ninth Circuit Decision

Hain manufactures several cosmetic products including moisturizing lotion, deodorant, shampoo, and conditioner. Hain labels these products “All Natural,” “Pure Natural,” or “Pure, Natural & Organic.” Plaintiffs claim that Hain’s cosmetics contain synthetic and artificial ingredients, which include benzyl alcohol and airplane anti-freeze. Although FDA has never regulated the use of the term “natural” on cosmetic products, the FDCA provides a broader requirement that deems cosmetics misbranded if the labeling is “false or misleading.” 21 U.S.C. § 362(a). Additionally, the FDCA states

no State or political subdivision of a State may establish or continue in effect any requirement for labeling or packaging of a cosmetic that is different from or in addition to, or that is otherwise not identical with, a requirement specifically applicable to a particular cosmetic or class of cosmetics. . . . 21 U.S.C. § 379s(a).

The Ninth Circuit in Astiana, nevertheless, found that although the FDCA bars states from creating their own labeling requirements inconsistent with the federal requirements, the FDCA does not bar states from providing remedies for violations of the federal law. The Ninth Circuit further held that FDA’s failure to issue specific regulations for the use of the term “all natural” in cosmetic product labeling does not amount to a decision by the agency to permit a manufacturer to use the term “all natural” without bounds. In fact, in FDA’s Small Business Fact Sheet, the FDA states that, although the agency has not yet established a regulatory definition for the word “natural,” manufacturers should be sure that their “labeling is truthful and not misleading.” The Ninth Circuit found that this statement and the FDCA are consistent and both statements reinforce the court’s determination that “the FDA did not intend to permit indiscriminate use of the word ‘natural’ on cosmetic labels.” See Astiana at 9.

The Ninth Circuit concluded the district court properly invoked the primary jurisdiction doctrine, but erred in dismissing the case, and ruled that the district court should have issued a stay to the proceedings while the parties sought guidance from the FDA. According to the Ninth Circuit, in Clark v. Time Warner Cable, primary jurisdiction is a doctrine that permits courts to determine “that an otherwise cognizable claim implicates technical and policy questions that should be addressed in the first instance by the agency with regulatory authority over the relevant industry rather than by the judicial branch.” (Read the entire Clark opinion here) See Clark at 4700. The Ninth Circuit in Astiana found that the definition of “natural” for cosmetic labeling is “both an area within the FDA’s expertise and a question not yet addressed by the agency.” See Astiana at 12-13. Therefore, obtaining expert advice from FDA is necessary to ensure that a technical question is properly answered by a qualified agency. The agency is only to provide expert advice that would aid the district court in making its determination, not to adjudicate the claims itself.

After the district court dismissed Plaintiffs’ claim, but before appeal, Plaintiffs wrote to FDA, requesting that “FDA render an administrative determination on the meaning of ‘natural’ as applied to personal care products regulated under the FDCA, or advise that the agency declines to make such a determination.” Id. at 11. Plaintiffs argue that, because Hain responded by refusing to make the determination without adequate public participation, Hain declined to take primary jurisdiction over the case. However, the Ninth Circuit found that Plaintiff’s informal letter did not comply with FDA’s citizen petition requirements pursuant to 21 C.F.R. § 10.30 because the district court did not institute an administrative proceeding, but rather dismissed the case before Plaintiffs sent their informal letter to FDA.

Uncertain Future of What “All Natural” Will Mean in the Cosmetic and Food Industry

Three other district courts have invoked the primary jurisdiction doctrine in response to litigation over the use of the term “natural” in food labeling. See In re Gen. Mills, Inc. Kix Cereal Litig., See Barnes v. Campbell Soup Co., See Cox v. Gruma Corp. In a Letter from Department of Health & Human Services (HHS) responding to the district courts’ referrals to FDA, HHS outlined the complexity of regulating the term “natural” on food labels and stated that “priority food public health and safety matters are largely occupying the limited resources that FDA has to address food matters.” See Astiana at 14.  Additionally, FDA “decline[d] to make a determination” at that time with respect to regulating the term “natural” on food labels. Id. at 15. The Ninth Circuit states “[o]n remand, the district court may consider whether events during the pendency of this appeal—including [Plaintiffs’] informal letter, the FDA’s website publication of a Small Business Fact Sheet regarding cosmetics labeling, and the FDA’s response to other courts—affect the need for further proceeding at the FDA or demonstrate that another referral to the agency would be futile,” which indicates that the Court may be willing to grant relief for the misuse of the term “all natural” in cosmetic and food labeling without expert advice from FDA. Id. at 16.

As Hain argues in the case, “Astiana’s suit [can] ultimately require[ ] Hain to remove these allegedly misleading advertising statements from its product labels.” Id. at 8. Nevertheless, the Ninth Circuit found that “such a result does not run afoul the FDCA, which prohibits ‘requirements’ that are ‘different from,’ ‘in addition to,’ or ‘not identical with’ federal rules” because the Court’s determination is merely a remedy for the Plaintiff, not a regulation of Hain’s cosmetic labels. Id.

Ultimately, if Hain is required to cease using “natural” claims on its product labeling as a result of this lawsuit, other companies in the natural products industries could be susceptible to similar consumer litigation.  Due to cases like this one against Hain, and until FDA promulgates a regulatory definition of “natural,” companies in this industry will be at risk of becoming targets of these types of class action lawsuits.

Companies in the cosmetic and food industry will need to stay abreast of these judicial determinations and federal regulatory issues that may affect the way they label their products.  For more information regarding further judicial determinations and how the FDA regulates the use of the term “natural” for cosmetic and food product labels, please contact us at contact@fuerstlaw.com.

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