October Term 2018 Preview: The Supreme Court’s Class Action Docket
By Alexander M. Smith
The Supreme Court’s next term kicks off next week, when the court re-convenes for its first oral argument since last April. The docket currently features four cases of interest to the consumer law and class action bar:
- In Lamps Plus, Inc. v. Varela, a divided panel of the Ninth Circuit construed a provision stating that “arbitration shall be in lieu of any and all lawsuits or other civil legal proceedings relating to my employment” to authorize class arbitration, even though the plaintiff’s employment agreement with Lamps Plus did not expressly authorize class-wide arbitration. The Supreme Court granted certiorari to determine whether the Federal Arbitration Act “forecloses a state-law interpretation of an arbitration agreement that would authorize class arbitration based solely on general language commonly used in arbitration agreements.”
- In Frank v. Gaos, the district court authorized a class-wide settlement of a lawsuit alleging that Google violated federal and state privacy laws by disclosing users’ search terms to third parties, even though the settlement consisted only of cy pres relief and attorneys' fees. A divided panel of the Ninth Circuit affirmed, rejecting the objectors’ arguments that (1) a settlement that provided no direct relief to the class was inappropriate and (2) that the cy pres beneficiaries, which had previously received settlement funds from Google and which were affiliated with the law schools attended by class counsel, were improper. The Supreme Court granted certiorari to determine “[w]hether, or in what circumstances, a cy pres award of class action proceeds that provides no direct relief to class members supports class certification and comports with the requirement that a settlement binding class members must be ‘fair, reasonable, and adequate.’”
- In Nutraceutical Corp. v. Lambert, the plaintiff filed a motion for reconsideration of the district court’s order decertifying the class twenty days after the district court entered its order, and he filed a Rule 23(f) petition for interlocutory review of the decertification order after the district court denied his motion for reconsideration. Although Rule 23(f) requires that a petition for interlocutory review be filed within fourteen days of the district court’s order, the Ninth Circuit nonetheless granted the Rule 23(f) petition, holding that the fourteen-day deadline in Rule 23(f) was not jurisdictional. The Ninth Circuit also held that the deadline to file a Rule 23(f) petition was tolled because the plaintiff had orally informed the district court that he would seek reconsideration, even though it acknowledged that this outcome conflicted with the law of several other circuits. The Supreme Court granted certiorari to determine whether the Ninth Circuit “erred when it held that equitable exceptions apply to mandatory claim-processing rules—such as Federal Rule of Civil Procedure 23(f), which establishes a 14-day deadline to file a petition for permission to appeal an order granting or denying class-action certification—and can excuse a party’s failure to file timely within the deadline specified by Federal Rule of Civil Procedure 23(f), in conflict with the decisions of the U.S. Courts of Appeals for the 2nd, 3rd, 4th, 5th, 7th, 10th and 11th Circuits.”
- In Home Depot U.S.A. Inc. v. Jackson, a bank filed a debt collection action against the defendant, who brought a third-party class action counterclaim against Home Depot and Carolina Water Systems, Inc., which he alleged had engaged in unfair and deceptive trade practices. After the bank dismissed its debt collection action against the original defendant and counterclaim plaintiff, Home Depot sought to remove the class action counterclaim to federal court under the Class Action Fairness Act, 28 U.S.C. § 1332(d) (“CAFA”). Relying on the Supreme Court’s decision in Shamrock Oil & Gas Corp. v. Sheets, 313 U.S. 100 (1941), the district court granted the counterclaim plaintiff’s motion to remand and held that Home Depot was not a “defendant” eligible to remove the action to federal court under CAFA. The Fourth Circuit affirmed. The Supreme Court granted certiorari to determine (1) whether “an original defendant to a class-action claim can remove the class action if it otherwise satisfies the jurisdictional requirements of the Class Action Fairness Act when the class action was originally asserted as a counterclaim against a co-defendant” and (2) whether the “Court’s holding in Shamrock . . . ‘that an original plaintiff cannot remove a counterclaim against it’ extend[s] to third-party counterclaim defendants.”
We will update the blog with updates on the outcome of these cases, as well as more information on additional class action or consumer law cases the Court adds to its docket.
Recent Activity Brings Further Clarity to Cryptocurrency Enforcement
By Michael W. Ross and Andrew J. Lichtman
September saw a flurry of activity that will help further define the cryptocurrency regulatory landscape. The Financial Industry Regulatory Authority (“FINRA”) brought its first-ever crypto-fraud case and a court ruling by the U.S. District Court for the Eastern District of New York gave backing to the view that digital assets will be viewed as securities. And, in two enforcements actions, the U.S. Securities and Exchange Commission (“SEC”) branched out beyond actions against fraudulent crypto-schemes and went after crypto companies for failing to register with the SEC. The latter two cases signal that the SEC is committed to enforcing applicable securities law requirements beyond those accused of fraud, and therefore SEC enforcement activity remains an area for legitimate businesses to watch.
A Federal Court Rules On Whether Digital Assets Are Securities
Last October, the U.S. Attorney’s Office in Brooklyn brought charges against Maksim Zaslavskiy alleging that Zaslavskiy made false representations in connection with two cryptocurrencies and their related initial coin offerings (“ICOs”) in violation of U.S. securities law. According to the indictment, Zaslavskiy induced investors to purchase tokens in an ICO for “REcoin” by falsely claiming that REcoin was backed by real estate investments. Similarly, the government alleged, Zaslavskiy falsely claimed that a second cryptocurrency, “Diamond,” was backed by actual diamonds when it was not.
Zaslavskiy moved to dismiss the indictment arguing that the REcoin and Diamond offerings did not involve securities under the Supreme Court’s Howey test. In a seminal ruling on the issue, the court rejected Zaslavskiy’s argument and found that a reasonable jury could conclude that the cryptocurrency transactions were “investment contracts.” Applying the federal securities laws “flexibly,” the court held that a reasonable jury could conclude that: (1) defrauded individuals invested money (2) in a common enterprise and (3) were led to expect that profits from the REcoin and Diamond enterprise would be derived solely from the managerial efforts of Zaslavaskiy. The decision was consistent with recent remarks by William Hinman, the SEC’s Director of the Division of Corporate Finance, with regard to determining whether digital assets are securities.
FINRA Brings a Fraud Action Involving Cryptocurrency
On September 11, 2018, FINRA filed an action against Timothy Tilton Ayre in its “first disciplinary action involving cryptocurrencies.” In its complaint, FINRA alleged that Ayre purchased the rights to a cryptocurrency called HempCoin and repackaged it into a security backed by the stock of Rocky Mountain Ayre, a worthless company Ayre owned. Ayre then marketed HempCoin as “the world’s first currency to represent equity ownership” in a publicly-traded company. FINRA alleges that Ayre defrauded investors by making false statements about Rocky Mountain’s business and failing to register HempCoin as a security.
SEC Extends Enforcement Activity Into Registration Violations
This month also witnessed the expansion of the types of enforcement actions by the SEC, with two actions against crypto companies for failing to register. In one case—In re TokenLot—the SEC brought its first case charging that a company selling digital tokens was an unregistered broker-dealer. According to the SEC’s settlement order, TokenLot, which was a self-described “ICO Superstore,” was promoted as a way to purchase digital tokens during ICOs and also to engage in secondary trading. By soliciting investors and facilitating the sales of digital tokens, TokenLot and its two founders were required to register with the SEC as broker-dealers, but they failed to do so.
In the other case—In re Crypto Asset Management—the SEC brought an enforcement action claiming that a hedge fund manager that invested in digital assets failed to register as an investment company. According to the SEC’s order, the fund raised $3.6 million by marketing itself as the “first regulated crypto asset fund in the United States.” But it had failed to file a registration statement and therefore was operating as an unregistered investment company.
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These cases further cement the view that regulators, and now courts, will continue to treat certain digital assets as securities, with all the attendant securities law requirements. As the SEC actions show, that will mean more than just enforcement actions against those using the new technology to defraud the unwitting. It will also mean that other players in the space—such as those acting as brokers and asset managers—will need to take steps to assure themselves that they are abiding by relevant securities law provisions, lest they invite an enforcement action.
How Blockchain Use Can Block Competition
In an article for Law360, Partners Daniel T. Fenske and Justin C. Steffen examine anti-competition issues with blockchain. The authors explain that anti-competition issues abound now that financial institutions, corporations and other industries are investing in blockchain technology. The issues, they observe, can be mitigated through early planning. The authors discuss the “basics” of blockchain and anti-competition risks. “The antitrust risks of blockchain technology will be clarified as the technology develops and it is put to more uses,” they conclude. “It is critical that you consult competent antitrust counsel when structuring blockchain technology and policies so as to best mitigate antitrust risk.”
To read the full article, please click here.
SEC Take on Tokens Clarifies Some Crypto Community Quandaries
By Jolene E. Negre, Michael W. Ross, Justin C. Steffen and Andrew J. Lichtman
In a June 14 speech William Hinman, the SEC’s Director of the Division of Corporate Finance, began to place additional definition around the raging debate over whether digital assets, including tokens, are securities. Until that speech, much commentary had focused on the repeat statements by SEC officials that digital assets distributed in initial coin offerings (ICOs) are almost always securities in the SEC’s view, with the possible exception of widely disseminated cryptocurrencies like Bitcoin. Hinman’s remarks set out the view that, in their initial phases, tokens are more likely to qualify as securities under the Supreme Court’s Howey test, but in limited circumstances may, over time, shed enough of the characteristics of securities to lose that designation. Under the rubric Hinman laid out, the new hallmark of success for a token project may become the point at which a project’s tokens are so widely used that they function without any centralized efforts and lose their securities status. This post lays out some of the background and considerations under this new framework.
Hinman Lays Out a Framework
In his June 14 speech, Hinman addressed a hotly debated issue in the cryptocurrency world: which tokens, if any, are securities and which aren’t? His remarks started by covering well-trod territory explaining why cryptocurrencies issued in ICOs are generally securities, but, later in his remarks, added important comments that could shift the ground beneath current thinking.
At the outset, and consistent with past comments from Hinman and other SEC staff, Hinman stated that most, if not all, sales of digital assets in ICOs he has seen satisfy Howey’s “investment contract” test and should be treated as securities. In reaching this conclusion, Hinman explained that token promoters tend to tout their ability to create an innovative application of blockchain technology; that investors are passive; that marketing efforts are rarely targeted to token users; and that, although the business model is still uncertain, purchasers usually must rely on the efforts of the promoter to build the network and make the enterprise a success. “At that stage,” Hinman said, “the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”
The ground-shift came in Hinman’s next explanation: that tokens that start out as securities, can later change their characteristics such that they no longer would be securities. He explained, “[i]f the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede.” In other words, issuers may structure their token platforms in a manner that initially requires significant setup and investment, but, if the network and tokens eventually become self-sustaining, the tokens can lose their status as securities.
Having drawn this distinction between more and less mature projects, Hinman then laid out a variety of questions relevant to the analysis of which side of the line a particular project (or a particular project at a particular time) would fall:
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?
Hinman was careful to note that this list of factors was not exclusive, however, and to state that not every factor would need to be present to find that a token was not a security. Indeed, while laying out these factors, Hinman reiterated that the north star of the analysis is the economic substance of the transaction. In Hinman’s words:
Again, we would look to the economic substance of the transaction, but promoters and their counsels should consider these, and other, possible features. This list is not intended to be exhaustive and by no means do I believe each and every one of these factors needs to be present to establish a case that a token is not being offered as a security. This list is meant to prompt thinking by promoters and their counsel, and start the dialogue with the staff—it is not meant to be a list of all necessary factors in a legal analysis.
Based on this framework, Hinman concluded that applying the disclosure regime of the federal securities laws to current transactions in Bitcoin and Ether would add little value because the networks are decentralized and there is no third party whose efforts are a key determining factor in the enterprises. But each project will require its own analysis to determine whether it bears sufficient indicia to not be deemed a security by the SEC.
Clayton Confirms Hinman’s Framework
It appears that Hinman’s view is not a one-off. Testifying before the Committee on Financial Services of the U.S. House of Representatives, SEC Chairman Jay Clayton referred to Hinman’s June 14, 2018 remarks saying, “[o]ur Corporation Finance Division Director recently further outlined the approach staff takes to evaluate whether a digital asset is a security.” Clayton’s reference suggests that Hinman’s framework is not merely his personal view, but rather an approach taken by the staff as a whole.
Hinman’s and Clayton’s remarks create somewhat more certainty about an approach to regulatory compliance for a group of issuers that has been in regulatory limbo. A class of companies and token holders—mostly related to digital assets issued back at a time when the crypto community was of a view that a “utility token” would not be treated as a security—was caught between a rock and a hard place as it became evident that the SEC Chairman and staff had a broader view of which tokens constituted securities (i.e., most tokens issued in ICOs) than most in the crypto community had originally believed. These issuers who had already conducted ICOs based on the idea that their tokens were not securities were left with few and poor options to develop their platform and transact in their tokens without running into potential securities law violations. Common questions in the community included whether, when, and how the SEC would create a way forward for these companies and digital assets.
Now we know a little more. For platforms designed to run independently after a certain point—or that can be adapted to do so—tokens that the SEC would previously consider securities may transition and become non-securities tokens. The factors laid out by Hinman establish a useful baseline for predicting where the SEC will draw the line, with project participants on notice that they will need to comply with securities laws until platforms are “sufficiently decentralized.”
But numerous issues still remain. The concept of being “sufficiently decentralized” has not yet been tested, and some reports draw into question just how decentralized certain cryptocurrency ecosystems truly are. Recently, for instance, reports indicated that the zCash Foundation paid money to a developer to prevent a fork of the protocol. Likewise, earlier this year, a report prepared by researchers at Cornell indicated that neither Ether nor Bitcoin was as decentralized as initially thought. This issue will likely be tested in the months and years to come. Further, projects may need to add new disclosures around the transition from securities tokens to non-securities tokens, including that the protections of the securities law may, at some point, cease to apply. And, in addition, some commentators have surmised that this new framework may breathe new life into the movement for the use of Simple Agreement for Future Tokens (SAFTs); however, no SEC official has formally endorsed SAFTs and Hinman’s prepared remarks expressly disavowed any view on whether any particular SAFT passed muster, noting that each case is reviewed on its particular economic substance and advising those with questions to contact the SEC.
In all, these and other questions will continue to be debated. And, as the market develops its understanding of the mix of factors that will safely render a token a non-security, any potential distributor of tokens should work closely with counsel to ensure its tokens comply with applicable legal requirements.
SDNY Rules CFPB Unconstitutional, Creating Split of Authority and Raising New Questions
By Joseph L. Noga, Michael W. Ross, Justin C. Steffen and Kashan Pathan
Since its inception, the Consumer Financial Protection Bureau (the “CFPB”) has faced controversy over its structure as an independent agency headed by a single director who can be removed by the President only for cause. Critics have invoked the unitary executive theory to argue that the Constitution permits an agency to enjoy independence from at-will termination by the President only if the agency is headed by multiple commissioners, directors, or board members. About six months ago, the D.C. Circuit took a step toward silencing those critics by rejecting en banc a constitutional challenge to the CFPB’s structure. But in another twist, two weeks ago news broke that the issue may remain unsettled, because in Consumer Fin. Prot. Bureau v. RD Legal Funding, LLC, U.S. District Judge Loretta Preska of the Southern District of New York explicitly rejected the PHH majority opinion and held the CFPB’s structure to be unconstitutional. As discussed below, the new split of authority raises interesting questions going forward.
Judge Preska denied the motion to dismiss but terminated the CFPB as a party to the action. In holding the CFPB’s structure unconstitutional, Judge Preska largely adopted the dissenting opinion of Judge Brett Kavanaugh in PHH. Specifically, Judge Preska agreed with Judge Kavanaugh’s conclusion that the CFPB’s structure is unconstitutional because “it is an independent agency that exercises substantial executive power and is headed by a single Director.” However, Judge Preska disagreed with Judge Kavanaugh’s remedy to cure the constitutional defect. Judge Kavanaugh concluded that the constitutional defect could be cured by invalidating and severing the provision of the Act prohibiting the President from removing the CFPB Director at will. Conversely, Judge Karen LeCraft Henderson’s dissent in PHH concluded that, because this provision is at the heart of Title X of the Dodd-Frank Act, the entirety of Title X should be stricken.  Judge Preska adopted this portion of Judge Henderson’s dissent. Finally, Judge Preska rejected the CFPB’s filing of a Notice of Ratification to cure any constitutional defects. The CFPB argued that the ratification of this enforcement decision by the CFPB’s current Acting Director, Mick Mulvaney, who is removable at will by the President, cured any constitutional defect in the instant action. Judge Preska rejected this argument and found that, even if Acting Director Mulvaney is removable at will by the President, the relevant provisions of Dodd-Frank that render the CFPB’s structure unconstitutional remain intact.
The SDNY Ruling
In RD Legal Funding, the defendant companies had offered cash advances to consumers waiting for settlement payouts. The CFPB and the New York Attorney General (the “NYAG”) alleged that these transactions were not sales transactions but loans and that these loans were made in violation of certain provisions of the Consumer Financial Protection Act (the “CFPA” or the “Act”). Defendants moved to dismiss the complaint on three grounds, including that the CFPB is unconstitutionally structured and therefore lacks authority to bring claims under the CFPA.
What the Ruling May Mean
A number of interesting questions and takeaways arise here:
First, one wonders if RD Funding will affect the CFPB’s choice of forum in bringing claims. A federal court in the District of Columbia that is now bound to follow the PHH majority may look more attractive after RD Funding, and that could affect the CFPB’s de facto practice of usually suing in the home district court of the defendant. That said, Judge Preska’s decision does not bind any other court, including any other court in the Southern District of New York. Thus, whether the CFPB will risk bringing other enforcement actions in the Southern District of New York is unclear. However, the opinion may create a strong incentive for the CFPB to forum shop.
Second, RD Funding confirms that the federal bench is unlikely to fall completely into line behind the majority opinion in PHH, and the issue of constitutionality remains ripe for those in the cross-hairs of the CFPB to raise. Even though the D.C. Circuit is influential, other courts may be more inclined to depart from that result now that one judge has already done so. As Judge Preska notes in her decision, several other district courts have addressed the constitutionality of the CFPB’s structure. There also is an appeal currently pending before the Ninth Circuit on this issue, and defendants will likely invoke Judge Preska’s decision to dismiss enforcement actions by the CFPB. Accordingly, the likelihood of a circuit split on this issue has increased following RD Funding.
Third, RD Funding suggests that the seven separate written opinions within the lengthy PHH decision may become something of a menu of options for judges facing the issue to select from. It is striking that Judge Preska wrote relatively little on the constitutional issue and merely adopted the reasoning of certain dissenting opinions in PHH. Most of the opinion focuses on whether the defendants are covered by the CFPA and if the plaintiffs have stated a claim for relief.
Fourth, Judge Preska’s choice to follow Judge Kavanaugh’s dissent is of added significance now that early rumors have Judge Kavanaugh as a leading candidate to take Justice Anthony Kennedy’s recently vacated Supreme Court seat. Such an event would likely heighten the persuasive impact of Judge Kavanaugh’s dissent and increase the likelihood that other judges would adopt his view.
In sum, there appears to be much more to come regarding the constitutionality of the CFPB structure and the impact of any constitutional infirmity.
 See PHH Corp. v. Consumer Fin. Prot. Bureau, 839 F.3d 1, 6 (D.C. Cir. 2016), rev’d en banc, 881 F.3d 75 (D.C. Cir. 2018).
 See PHH Corp. v. Consumer Fin. Prot. Bureau, 881 F.3d 75 (D.C. Cir. 2018). The original panel held the CFPB’s structure to be unconstitutional. PHH Corp. v. Consumer Fin. Prot. Bureau, 839 F.3d 1, 6 (D.C. Cir. 2016).
 No. 17-CV-890, 2018 WL 3094916 (S.D.N.Y. June 21, 2018).
 Id. at *1–2.
 Id. at *1.
 Id. at *35 (quoting PHH Corp. v. Consumer Fin. Prot. Bureau, 881 F.3d 75, 198 (D.C. Cir. 2018)).
 Id. at *35.
 Id. at *36.
 Id. at *35 n.7.
 Consumer Fin. Prot. Bureau v. Future Income Payments, LLC, 252 F. Supp. 3d 961 (C.D. Cal. 2017), appeal filed, No. 17-55721 (9th Cir. May 18, 2017).
Jenner & Block Partners with Chicago-Kent College of Law and FinTEx for Blockchain and Cryptocurrency Conference
Jenner & Block is partnering with Chicago-Kent College of Law and FinTEx, a non-profit, member-driven community of the leading organizations within FinTech and Financial Services, for a first-of-its kind conference focused on the evolving regulatory and legal issues in the blockchain and cryptocurrency space. Co-organized by Partner Justin C. Steffen, the Block(Legal)Tech conference will take place on August 9 at The Law Lab at Illinois Tech Chicago-Kent College of Law. The Block(Legal)Tech conference will feature presentations and panel discussions on the law of distributed ledger systems, tokenized assets and cryptoasset-based funding. The day-long conference will include a number of discussions, interviews and debates, delving deep into the complicated issues that affect the crypto-landscape, such as the future of US regulation of cryptoassets and the government’s role in promoting blockchain adoption. Topics discussed will include minimizing the risks of crypto-litigation, the role of lawyers, the evolution of smart contracts and their impact on the legal profession as well as other legal issues that stem from the use and implementation of blockchain technology.
To register for the event, please click here.
The US Supreme Court Allows Collection of State Sales Tax From Remote Sellers
By Adam G. Unikowsky and Leonard R. Powell
On June 21, 2018, the US Supreme Court issued its much-anticipated decision in South Dakota v. Wayfair, Inc., No. 17-494. In a 5-4 opinion by Justice Kennedy, the Court held that the Dormant Commerce Clause does not bar a state from requiring an out-of-state seller lacking in-state physical presence to collect and remit sales tax. In reaching this conclusion, the Court took the unusual step of overruling two of its own prior opinions: National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753 (1967), and Quill Corp. v. North Dakota, 504 U.S. 298 (1992). The Court held that stare decisis was an insufficient basis to uphold a rule it viewed as anachronistic, particularly in light of the explosive growth of e-commerce.
Wayfair is a major victory for states, who can now collect tax from out-of-state sellers and brick-and-mortar retailers, subjecting the latter to the same tax burdens as their online competitors. Wayfair, however, does not hold that all tax regimes will pass constitutional muster. To the contrary, it holds that such regimes will be subject to traditional Dormant Commerce Clause doctrines designed to prevent undue burdens on interstate commerce.
Wayfair's issue was one the Court had decided twice before. In Bellas Hess, the Court held that states could not impose sales tax collection obligations on out-of-state sellers who relied solely on the mail and common carriers to deliver their goods because the sellers “lacked the requisite minimum contacts with the State required by both the Due Process Clause and the Commerce Clause.” In Quill, the Court overruled Bellas Hess’s due process holding, but reaffirmed Bellas Hess’s holding that the Dormant Commerce Clause forbids the imposition of sales tax collection obligations on sellers lacking an in-state physical presence. In a concurring opinion, Justice Scalia, joined by Justices Kennedy and Thomas, emphasized that his vote was based solely on stare decisis.
As the Court noted in Wayfair, criticism of Quill began as soon as it was decided. The Court pointed to one scholar’s view that Quill was “‘premised on assumptions that are unfounded’ and ‘riddled with internal inconsistencies.’” It further explained that “[e]ach year, the physical presence rule be[came] further removed from economic reality and result[ed] in significant revenue losses to the States.”
Against this background, South Dakota enacted the tax at issue, requiring out-of-state sellers to collect and remit sales taxes—with several caveats. First, the tax applied only to sellers with more than $100,000 of annual sales or more than 200 separate transactions in the state in a single year. Second, the tax had no retroactive application. Third, the tax’s application was stayed until its constitutionality was clearly established.
Seeking to establish the tax’s constitutionality, South Dakota then filed a state declaratory judgment action against Wayfair, Inc., Overstock.com, Inc. and Newegg, Inc. As contemplated by the statute and as requested by the state in its pleadings, the trial court granted summary judgment to the online retailers on the grounds that the issue had been decided in Bellas Hess and Quill. The South Dakota Supreme Court affirmed for the same reason.
The Court Discards the Physical Presence Rule
In a 5-4 decision, the Supreme Court reversed the lower court ruling, holding that the Commerce Clause does not foreclose the collection of state sales tax from remote sellers merely because they lack an in-state presence. The majority opinion—written by Justice Kennedy and joined by Justices Thomas, Ginsburg, Alito and Gorsuch—began by noting that “[a]ll agree that South Dakota has the authority to tax these transactions” under the Due Process Clause. But the Court explained that the Dormant Commerce Clause also forbids states from imposing sales tax obligations on sellers unless the sellers have “a substantial nexus with the taxing State”—and in Bellas Hess and Quill, the Court held that a “substantial nexus” requires in-state physical presence.
The Court rejected those holdings, concluding that a seller could have a “substantial nexus” to a state even without a physical presence. It observed that there exists a close relationship between “[t]his nexus requirement” and the minimum-contacts test imposed by the Due Process Clause. And although the two inquiries are not exactly the same, they are not so different as to justify different treatment. Because Quill had already recognized that due process does not impose a physical presence rule, the Court held that the Commerce Clause does not, either.
The Court also emphasized that the physical presence rule was inconsistent with the purpose of the Dormant Commerce Clause. The Dormant Commerce Clause, after all, was meant to prevent states from engaging in “economic discrimination.” But the physical presence rule had become a source of economic discrimination, “guarantee[ing] a competitive benefit to certain firms simply because of the organizational form they choose.” Worse still, the Quill rule “produces an incentive to avoid physical presence in multiple States,” thwarting the Dormant Commerce Clause’s goal of promoting interstate commerce. The Court also pointed out that Quill itself had “acknowledged that the physical presence rule is ‘artificial at its edges.’” In the Court’s opinion, “modern e-commerce does not align analytically with a test that relies on the sort of physical presence defined in Quill.” The Court found it “not clear why a single employee or a single warehouse should create a substantial nexus while ‘physical’ aspects of pervasive modern technology should not.”
The Court emphasized that the Quill rule “is not just a technical legal problem,” but also “an extraordinary imposition by the Judiciary on States’ authority to collect taxes and perform critical public functions.” The Court pointed to Wayfair’s advertising touting the fact that Wayfair does “not have to charge sales tax” and characterized that advertising as a “subtle offer to assist in tax evasion.” The Court concluded that the “physical presence rule … has limited States’ ability to seek long-term prosperity and has prevented market participants from competing on an even playing field.”
Finally, the Court concluded that stare decisis did not warrant retaining the Quill rule. The Court emphasized that the “Internet’s prevalence and power have changed the dynamics of the national economy” and that “[a]ttempts to apply the physical presence rule to online retail sales are proving unworkable.”
The Court concluded that under the “substantial nexus” test, South Dakota’s statute passed constitutional muster: “the nexus is clearly sufficient based on both the economic and virtual contacts respondents have with the State.” The Court remanded for further consideration of whether “some other principle in the Court’s Commerce Clause doctrine might invalidate the Act,” while emphasizing that “South Dakota’s tax system includes several features that appear designed to prevent discrimination against or undue burdens upon interstate commerce.”
Justice Thomas filed a concurring opinion, emphasizing that his views had changed since Quill and expressing disagreement with the Court’s entire body of Dormant Commerce Clause jurisprudence. Justice Gorsuch also filed a concurring opinion questioning the Court’s Dormant Commerce Clause cases. Chief Justice Roberts, joined by Justices Breyer, Sotomayor and Kagan, dissented. While agreeing that Bellas Hess was wrongly decided, he concluded that stare decisis warranted adhering to that precedent. He emphasized the importance of e-commerce to the national economy and concluded that a change to settled law “with the potential to disrupt the development of such a critical segment of the economy should be undertaken by Congress.”
Wayfair is a landmark decision that reshapes decades of settled tax law. But Wayfair will not be the last word in this controversial area. First, the Court observed that state tax laws would still be subject to traditional Dormant Commerce Clause principles barring “discrimination against or undue burdens upon interstate commerce.” The Court explained that several features of the South Dakota law were “designed to prevent” such burdens, including the safe harbor for those who transact limited business in South Dakota; the absence of retroactive tax collection obligations; and a standardized tax administration regime designed to reduce administrative and compliance costs. But the Court did not resolve whether other state laws, lacking these features, may be vulnerable to Dormant Commerce Clause challenges. Moreover, the Court observed that “Congress may legislate to address these problems if it deems it necessary and fit to do so.” Whether Congress takes up that offer remains to be seen.
To learn more about the implications of this case, please contact the authors or a member of Jenner & Block's national, state and local tax practice group.
Ninth Circuit Reaffirms Narrow Scope of Restitution Under California Consumer Protection Statutes
By Alexander M. Smith
In the last three years, the Ninth Circuit and the California Court of Appeal have issued a pair of decisions clarifying that restitution under California’s consumer protection statutes is limited to the difference between the price a consumer paid for the product and the value the consumer received from that product—i.e., the “price premium” attributable to the defendant’s conduct. See In re Tobacco Cases II, 240 Cal. App. 4th 779, 791-802 (2015); Brazil v. Dole Packaged Foods, LLC, 660 F. App’x 531, 534-35 (9th Cir. 2016). Earlier this week, the Ninth Circuit continued this line of cases in Chowning v. Kohl’s Department Stores, Inc., which reaffirmed that “[t]he proper calculation of restitution . . . is price paid versus value received” and rejected a variety of alternative restitution models suggested by the plaintiff. No. 16-56272, 2018 WL 3016908, at *1 (9th Cir. June 18, 2016).
In Chowning, the plaintiff alleged that Kohl’s misled consumers by displaying alongside the sale price for its products an inflated “Actual Retail Price,” which was not the prevailing market retail price and which caused consumers to believe that they were receiving a larger discount than they were. As a result, the plaintiff alleged that she and other putative class members were deceived into buying products that they would not have purchased but for Kohl’s misleading price comparisons. In March 2016, Judge Klausner of the Central District of California granted Kohl’s motion for summary judgment. He identified “three limiting principles” that defined the appropriate scope of restitution under California law: (1) that “restitution cannot be ordered exclusively for the purpose of deterrence”; (2) that any proposed method of restitution “must account for the benefits or value that a plaintiff received at the time of purchase”; and (3) that “the amount of restitution ordered must represent a measurable loss supported by the evidence.” No. 15-8673, 2016 WL 1072129, at *6 (C.D. Cal. Mar. 15, 2016).
Applying those principles, Judge Klausner found that the plaintiff’s proposed “actual discount” model—which determined the percentage of the discount between the sale price and the “Actual Retail Price,” applied that percentage discount to the prevailing retail price of the item, and then awarded plaintiffs the difference between what they paid and the price that the item would have sold for if the same discount was applied to the prevailing retail price—was deficient because it was “not actually a measure of restitution.” Id. at *10. Instead, he reasoned, it “seeks to award Plaintiff the full benefit of the transaction she thought she was entering into—a measure more akin to expectation damages than restitution.” Id. Judge Klausner likewise rejected the plaintiff’s argument that a full refund of the purchase price was an appropriate measure of restitution, as it failed to account for the value the plaintiff derived from the products she purchased. Id. at *7-8. And Judge Klausner rejected the plaintiff’s argument that disgorgement of Kohl’s profits was a proper remedy, as it focused on Kohl’s gains rather than the losses the plaintiff may have suffered as a result of Kohl’s conduct. Id. at *9. And because the value of the items exceeded the amount she paid, Judge Klausner concluded that the plaintiff was not entitled to restitution—even if Kohl’s had deceptively inflated the size of the discounts it had offered. Id. at *11-13.
The Ninth Circuit affirmed. Beginning from the premise that “the appropriate calculation for restitution is the price [the plaintiff] paid for the articles versus the value of the articles she received,” the Ninth Circuit held that the plaintiff had not established an entitlement to restitution because she had provided no evidence that the clothes she purchased were worth less than she paid for them. 2018 WL 3016908, at *1. Like Judge Klausner, the Ninth Circuit held that the plaintiff was not entitled to a full refund (because she “received some value from the articles of clothing”) or disgorgement (as “[n]onrestitutionary disgorgement is unavailable in UCL actions”). Id. at *2. Similarly, the Ninth Circuit held that the “actual discount” model of calculating restitution was improper because it “would effectively seek damages sounding in contract,” rather than the equitable remedy of restitution. Id.
In issuing its opinion, the Ninth Circuit distinguished its earlier opinion in Pulaski & Middleman, LLC v. Google, Inc., which held that “restitution is based on what a purchaser would have paid at the time of purchase had the purchaser received all the information” and which approved a creative restitution model based on an internal algorithm Google used to discount per-click advertising prices “to the levels a rational advertiser would have bid if it had access to all of Google’s data about how ads perform on different websites.” 802 F.3d 979, 989 (9th Cir. 2015). The Ninth Circuit reasoned that its holding here was broadly consistent with its holding in Pulaski, as both cases held that restitution was limited to the difference between what the plaintiff paid and what the plaintiff received. Chowning, 2018 WL 3016908, at *1 n.3. And to the extent Pulaski supported the plaintiff’s alternative models of restitution, the Ninth Circuit explained, it was inconsistent with the California Court of Appeal’s In re Tobacco Cases II opinion and was no longer good law. Id.
The decision is available here.