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WAKE FOREST JOURNAL OF BUSINESS

AND INTELLECTUAL PROPERTY LAW

VOLUME 17 NUMBER 3

SPRING 2017

WHEN JOINING MEANS ENFORCING: GIVING CONSUMER

PROTECTION AGENCIES AUTHORITY TO BAN THE USE

OF CLASS ACTION WAIVERS

CARA VAN DORN 245

ADAPTING THE USPTO’S UNLAWFUL USE DOCTRINE

FOR THE FEDERAL COURTS

BETHANY RABE 286

THE PEER-TO-PEER BLOCKCHAIN MORTGAGE

RECORDING SYSTEM: SCRAPING THE MORTGAGE

ELECTRONIC REGISTRATION SYSTEM AND REPLACING

IT WITH A SYSTEM BUILT OFF OF A BLOCKCHAIN

THOMAS GAFFNEY 349

TRADEMAKING SOCIAL MOVEMENTS MATTER

MAKENNA ROGERS AND BRITTANY WAGES 372

LIVING IN A MATERIAL WORLD: DOES A VIOLATION OF

ITEM 303 OF REGULATION S-K SATISFY THE

MATERIALITY ELEMENT IN A RULE 10B–5 CAUSE OF

ACTION?

MATTHEW ADY 401

ABOUT THE JOURNAL

The WAKE FOREST JOURNAL OF BUSINESS AND INTELLECTUAL

PROPERTY LAW is a student organization sponsored by Wake Forest

University School of Law dedicated to the examination of intellectual

property in the legal context. Originally established as the Wake

Forest Intellectual Property Law Journal in 2001, the new focus and

form of the Journal, adopted in 2010, provides a forum for the

exploration of business law and intellectual property issues generally,

as well as the points of intersection between the two, primarily through

the publication of legal scholarship. The Journal publishes four print

issues annually. Additionally, the Journal sponsors an annual

symposium dedicated to the implications of intellectual property law

in a specific context. In 2009, the Journal launched an academic blog

for the advancement of professional discourse on relevant issues, with

content generated by both staff members and practitioners, which is

open to comment from the legal community. The Journal’s student

staff members are selected for membership based upon academic

achievement, performance in an annual writing competition, or

extensive experience in the field of intellectual property or business.

The Journal invites the submission of legal scholarship in the form

of articles, notes, comments, and empirical studies for publication in

the Journal’s published print issues. Submissions are reviewed by the

Manuscripts Editor, and decisions to extend offers of publication are

made by the Board of Editors in conjunction with the Board of

Advisors and the Faculty Advisors. The Board of Editors works

closely and collaboratively with authors to prepare pieces for

publication.

Manuscript submissions should be accompanied by a cover letter

and curriculum vitae, and may be sent electronically to

[email protected] or by mail to:

Manuscripts Editor

Wake Forest Journal of Business and Intellectual Property Law

Wake Forest University School of Law

P.O. Box 7206 Reynolda Station

Winston-Salem, North Carolina 27109

COPYRIGHT © 2017

WAKE FOREST JOURNAL OF BUSINESS AND INTELLECTUAL PROPERTY LAW

ISSN 2164-6937 (Print)

ISSN 2164-6945 (Online)

BOARD OF ADVISORS

DANNY M. AWDEH Finnegan Henderson Farabow Garrett & Dunner LLP

Washington, DC

CHARLES W. CALKINS Kilpatrick Townsend & Stockton LLP

Winston-Salem, North Carolina

KENNETH P. CARLSON Constangy, Brooks & Smith, LLP


TRIP COYNE Williams Mullen

Wilmington, North Carolina

RODRICK J. ENNS Enns & Archer LLP


EDWARD R. ERGENZINGER, JR., PH.D.

Ward & Smith, P.A.

Raleigh, North Carolina

JASON D. GARDNER Kilpatrick Townsend & Stockton LLP

Atlanta, Georgia

STEVEN GARDNER Kilpatrick Townsend & Stockton, LLP


ROB HUNTER The Clearing House Payments Company, LLC


BARBARA LENTZ Professor, Wake Forest University School of Law


JAMES L. LESTER MacCord Mason PLLC

Greensboro, North Carolina

JUSTIN R. NIFONG Olive Law Group

Cary, North Carolina

MICHAEL S. MIRELES Professor, University of the Pacific, McGeorge School of Law

Sacramento, California

ALAN PALMITER Professor, Wake Forest University School of Law


ABBY PERDUE Associate Professor, Wake Forest University School of Law


COE W. RAMSEY Brooks Pierce


T. ROBERT REHM, JR. Smith, Anderson, Blount, Dorsett, Mitchell, & Jernigan, LLP


SIMONE ROSE Professor, Wake Forest University School of Law


Editor-in-Chief

JAMES F. LATHROP

Managing Editor

MATTHEW W. SILVERSTEIN

Marketing Editor

RYAN BOWERSOX

Symposium Editor

LAUREN HENDERSON

Development Editor

DIANNA SHINN

Senior Notes and Comments Editor

AMANDA M. BRAHM

Notes and Comments Editors

MARIA COLLINS

LAUREN N. FREEDMAN

KAITLIN G. WESTBROOK

Manuscripts Editor

MOLLY F. MCCARTNEY

Executive Articles Editors

AMELIA E. LOWE

RACHEL A. OPLINGER

ZACHARY L. RHINES

Articles Editors

JENNA COOGLE

CANDICE DIAH

MATTHEW KERSCHNER

LUKE E. KRAUS

SARAH REMES

Editorial Staff

LAURA BROWDER

CHRIS CHOE

ETHAN CLARK

THOMAS GAFFNEY

HUNT HARRIS

DRAKE MASON

NICOLE REGNA

DAVID SWENTON

CARA VAN DORN

Staff Members

CHARITY BARGER ANNA-BRYCE FLOWE DEREK PADILLA

LUKE BASHA DAVID GIESEL MARIA PIGNA

ROBERT BOTKIN DORIYON GLASS KATE RIDDLE

JACKY BRAMMER ISAAC HALVERSON GARRETT ROGERS

EMILY BURKE NAN HU MAKENNA ROGERS

LIBBY CASALE MARK HUFFMAN AMANDA ROMENESKO

MELANIE CORMIER JOE KARAM SAMER ROSHDY

MITCHELL DAVIS DAVID LAYMAN JONATHAN SALMONS

ANDREW DINWIDDIE SAMANTHA LIU HANNAH SMITH

MEGAN DYER EMILY MARCUM JOSEPH SPEIGHT

KERRIE EDMONDSON LEANNA MARINO MARISA STERN

KATHEIRNE ESCALANTE BRANDY NICKOLOFF COURTNEY WACHAL

COLIN FERRITER ALFRED NORRIS, III BRITTANY WAGES

MICHAEL FLEMING BRIANA O’NEIL ZACHARY D. YOUNG

Faculty Advisors

BARBARA LENTZ

SIMONE A. ROSE



VOLUME 17 SPRING 2017 NUMBER 3

WHEN JOINING MEANS ENFORCING: GIVING CONSUMER

PROTECTION AGENCIES AUTHORITY TO BAN THE USE

OF CLASS ACTION WAIVERS

Cara Van Dorn†

I. INTRODUCTION ............................................................. 247

II. BACKGROUND ............................................................. 249 A. ERISA PROPER: PROTECTING [YESTERDAY’S]

WORKERS’ RETIREMENT SAVINGS ............................. 249 B. THE FIDUCIARY RULE: EXPANDING ERISA’S

UMBRELLA TO PROTECT TODAY’S WORKFORCE ....... 252 C. QUALIFYING FOR THE BEST INTEREST CONTRACT

EXEMPTION—NO CLASS ACTION WAIVERS

ALLOWED ................................................................... 253

III. CLASS ACTIONS: PRIVATE ENFORCEMENT OF

PUBLIC CONSUMER PROTECTION REGULATION ......... 256 A. USE OF CLASS ACTION WAIVERS TO ESCAPE

SMALL-SCALE LIABILITY ........................................... 261 B. THE SUPREME COURT’S OVERBROAD POLICY OF

ENFORCING ARBITRATION AGREEMENTS .................. 263 C. THE FAA’S NEGOTIATED CONTRACT: AN

ENDANGERED SPECIES ............................................... 265

IV. THE EFFECT OF CLASS ACTION WAIVERS ON

ERISA & THE NEW FIDUCIARY RULE .......................... 267 A. THE IMPORTANCE OF CLASS ACTIONS IN

ENFORCING THE FIDUCIARY RULE ............................. 268 B. CHALLENGES TO THE FIDUCIARY’S RULE’S

LIMITATION ON CLASS ACTION WAIVERS ................. 277

† J.D. Candidate, Wake Forest School of Law, 2017. Many thanks to Professor

Andrew Verstein, Professor Alan Palmiter, and Joseph Peiffer for their invaluable

guidance.

246 WAKE FOREST J.

BUS. & INTELL. PROP. L.

[VOL. 17

V. MULTI-FRONT FIGHT AGAINST CLASS ACTION

WAIVERS ......................................................................... 280 A. CFPB’S PROPOSED RULEMAKING ............................ 280 B. CLASS ACTION WAIVERS AS UNFAIR LABOR

PRACTICE .................................................................... 282 C. OVERRIDING THE FAA.............................................. 283

VI. CONCLUSION: GIVING FEDERAL AGENCIES THE

TOOLS THEY NEED TO PROTECT TODAY’S

CONSUMERS .................................................................... 285

2017] WHEN JOINING MEANS ENFORCING 247

I. INTRODUCTION

The Employment Retirement Income Security Act of 1974

(“ERISA”)1 and the Department of Labor’s (“DOL”) new Fiduciary

Rule2 seek to assist America’s workforce in retaining each and every

cent saved for retirement. Both public and private enforcement of

ERISA’s protective provisions have pushed retirement plan sponsors

and fiduciaries to monitor plans attentively and to purge investment

menus of high-fee products.3 Class action attorneys have led this

charge by looking closely at the retirement plans, evaluating the

quality and quantity of the investment products available, examining

the disclosures made, and determining whether any conflicts of

interest have infected decisions made by the fiduciaries.4 Because the

financial expertise required to discover violations by plan fiduciaries

exceeds that of the average plan beneficiary, the attorneys and the

experts they enlist are essential to ERISA providing effective

protection for those saving for retirement.5 Class action attorneys will

likely play a similar role in enforcing the DOL’s Fiduciary Rule,

which expands ERISA’s statutory reach to protect more retirement

investors.6

1 Employee Retirement Income Security Act, 29 U.S.C. § 1001 (1974).

2 Definition of the Term “Fiduciary”; Conflict of Interest Rule—Retirement

Investment Advice, 81 Fed. Reg. 20,946 (Apr. 8, 2016) (codified at 29 C.F.R. pts.

2509, 2510, 2550) [hereinafter Fiduciary Rule]. 3 Blaine F. Aikin, Recent Class-Action Surge Ups the Ante for 401(k) Advice,

INVESTMENT NEWS (Jan. 21, 2016),

http://www.investmentnews.com/article/20160121 /BLOG09/160129985/recent-

class-action-surge-ups-the-ante-for-401-k-advice; Amy Whyte, Yale, MIT, NYU

Sued Over DC Fees, CHIEF INVESTMENT OFFICER (Aug. 9, 2016, 4:22 PM),

http://www.ai-cio.com/channel/REGULATION,-LEGAL/Yale,-MIT,-NYU-Sued-

Over-DC-Fees; see Leanna Orr, Litigation v. Innovation: Defined Contribution’s

Sweeping Paralysis, CHIEF INVESTMENT OFFICER (last visited July 21, 2016),

http://www.ai-cio.com/channel/newsmakers/litigation-v--innovation (stating

members of the investment advising industry call these suits frivolous, burdensome

impediments to innovation). 4 Greg Iacurci, How Will the DOL Enforce its Fiduciary Rule?, INVESTMENT

NEWS (Apr. 12, 2016, 2:07 PM),

http://www.investmentnews.com/article/20160412/FREE/160419977/how-will-the-

dol-enforce-its-fiduciary-rule (“The 401(k) market is already well-versed in class-

action litigation – suing for fiduciary breach under ERISA has been one of the main

methods of recourse for plan participants over the past decade.”). 5 See id.

6 Dan Jamieson, Investor Plaintiff Lawyers Expect More Victories With DOL

Rule, SECURITIES ARBITRATION AND LITIGATION (July 20, 2016),

http://www.securitiesarbitration.com/news/2016/07/20/investor-plaintiff-lawyers-

expect-more-victories-with-dol-rule (“In addition to individual arbitrations, the DOL

is counting on class-action claims as an enforcement tool.”).

http://www.securitiesarbitration.com/news/2016/07/20/investor-plaintiff-lawyers-expect-more-victories-with-dol-rule

http://www.securitiesarbitration.com/news/2016/07/20/investor-plaintiff-lawyers-expect-more-victories-with-dol-rule

248 WAKE FOREST J.


[VOL. 17

Claims for breach of fiduciary duty under ERISA are well-suited

to collective litigation. Damages tend to be relatively small to the

individual investor but widespread, and incredibly difficult for the

average person to discern.7 Investment products are complicated.

Relevant information, such as fee schedules and the terms of revenue-

sharing agreements, is often buried or difficult to understand, and

injuries occur and accumulate throughout decades, frequently escaping

notice.8 The combined claims of several injured investors provide an

adequate incentive for attorneys to incur the expense of discovering

breaches of fiduciary duty and to litigate the claims that hold plan

sponsors and plan fiduciaries accountable.9 Class actions are expected

to play a particularly important role in enforcement of the DOL’s new

Fiduciary Rule because the DOL itself lacks authority to enforce some

of its provisions.10

However, the trend of companies using pre-dispute arbitration

agreements to avoid facing class litigation has the potential to

substantially obstruct this important enforcement mechanism for both

ERISA and the new Fiduciary Rule.11

Aware of the potentially

disabling consequences of class action waivers, the DOL included in

the Fiduciary Rule a provision discouraging—but not forbidding—

investment adviser fiduciaries from including such waivers in their

consumer contracts.12

However, the fate of this provision remains

uncertain. The Supreme Court has interpreted the Federal Arbitration

Act (“FAA”) broadly, thwarting any attempt to limit the enforceability

of class waivers found within arbitration clauses, regardless of the

practical consequences.13

While this article argues that the DOL has

constructed a clever work-around that is consistent with the FAA, it

also contends that the Supreme Court’s current position on class action

waivers is ill-conceived, antiquated, and ripe for a change.14

Mounting research shows that in order for consumer protection

agencies to fulfill their statutory objectives, they must have the ability

7 See infra Section V.

8 Jason Furman & Betsey Stevenson, The Effects of Conflicted Investment

Advice on Retirement Savings, The White House President Barack Obama (Feb. 23,

2015, 9:45 AM), https://obamawhitehouse.archives.gov/blog/2015/02/23/effects-

conflicted-investment-advice-retirement-savings [hereinafter CEA Report]. 9 See infra Section V.

10 26 U.S.C. § 4975(a)-(b); see also Iacurci, supra note 4 (“The Labor

Department isn't the government agency with enforcement jurisdiction over IRAs.

That responsibility falls to the Internal Revenue Service, which enforces prohibited

transactions on the part of advisers through excise taxes.”). 11

See discussion infra Sections V.B, V.C, VI 12

See infra Section V.B. 13

See infra Sections IV.B, V.C. 14

See infra Section V.


to regulate arbitration agreements.15

This article argues for preserving the ability of class action

attorneys to assist in enforcing consumer protection regulations, using

as a case study the potential impact of class waivers on the

effectiveness of ERISA and the Fiduciary Rule. Section II provides

background on ERISA and the Fiduciary Rule, including the DOL’s

attempts to curtail the use of class action waivers. Section III

discusses the role of class actions and the attorneys who bring them in

the enforcement of consumer protection regulations, as well as how

the Supreme Court’s interpretation of the FAA has allowed companies

to escape liability for many small-dollar injuries. Section IV examines

the specific impacts of class action waivers on the effectiveness of

ERISA and argues that the Fiduciary Rule permissibly limits their use.

Section V discusses attempts by other federal agencies to rein in the

use of class action waivers in their respective industries. Finally,

Section VI expresses hope that these and other agencies will be

permitted to regulate the use of class action waivers in their quest to

fulfill their consumer protection objectives, either by an adjustment to

the Supreme Court’s position on the FAA or by specific legislative

authorization.

II. BACKGROUND

A. ERISA Proper: Protecting [Some] Workers’ Retirement

Savings

To encourage workers to save for retirement, the federal

government provides several tax-advantaged programs to workers and

their employers.16

When participating in an employer-sponsored

retirement savings plan, a worker pays a portion of his income into a

pooled account.17

The employer appoints a “fiduciary”—an individual

or entity to shoulder the great responsibility of managing and

administrating the investment plans for all of the employees’

accounts.18

Because the fiduciary selects the menu of investment

options made available to the employees, the fiduciary plays a

substantial role in the ultimate success or failure of the accounts.19

15

See infra Sections V.C, VI. 16

Retirement Plans-Benefits & Savings, DEPT. OF LABOR,

https://www.dol.gov/general/topic/retirement (last visited Nov. 15, 2016). 17

Types of Retirement Plans, DEPT. OF LABOR, https://

www.dol.gov/general/topic/retirement/typesofplans (last visited Nov. 15, 2016). 18

Fiduciary Responsibilities, DEPT. OF LABOR, https://

www.dol.gov/general/topic/retirement/fiduciaryresp (last visited Nov. 15, 2016). 19

Id.

250 WAKE FOREST J.


[VOL. 17

Recognizing the potentially severe consequences, in 1974, Congress

saw fit to enact ERISA to ensure the funds that American workers set

aside for retirement were invested and managed responsibly and

safely.20

“ERISA safeguards plan participants by imposing trust law

standards of care and undivided loyalty on plan fiduciaries, and by

holding fiduciaries accountable when they breach those obligations.”21

The operative language requires fiduciaries to act in the best interests

of the plan beneficiaries.22

When originally promulgated, ERISA’s regulation of pensions

encompassed the majority of the retirement savings industry.23

Today,

however, a number of additional vehicles exist to save for retirement,

including Social Security, employer-sponsored retirement savings

plans like 401(k)s and 403(b)s, and, increasingly common, Individual

Retirement Accounts (“IRAs”), some of which were not contemplated

by ERISA at its inception and are not covered.24

The statute defines a

fiduciary as a person who has “authority or control” over a plan’s

assets or “renders investment advice for a fee or other compensation,

direct or indirect, with respect to any moneys or other property of such

plan.”25

The regulations issued alongside ERISA in 1975 significantly

20

ERISA, DEPT. OF LABOR, https://www.dol.gov/ general/topic/retirement/erisa

(last visited Nov. 15, 2016). 21

Fiduciary Rule, supra note 2, at 20,946. 22

29 U.S.C. § 1104(a). In pertinent part, the statute states, “a fiduciary shall

discharge his duties with respect to a plan solely in the interest of the participants

and beneficiaries and—(A)for the exclusive purpose of: (i) providing benefits to

participants and their beneficiaries; and (ii) defraying reasonable expenses of

administering the plan; (B) with the care, skill, prudence, and diligence under the

circumstances then prevailing that a prudent man acting in a like capacity and

familiar with such matters would use in the conduct of an enterprise of a like

character and with like aims.” 23

See 29 U.S.C. §§ 1003, 1101 (2016). EMPLOYEE BENEFIT SECURITY

ADMINISTRATION, FIDUCIARY INVESTMENT ADVICE, REGULATORY IMPACT

ANALYSIS 3 (Apr. 14, 2015), https://www.dol.gov/sites/default/files/ebsa /laws-and-

regulations/rules-and-regulations/proposed-regulations/1210-AB32-

2/conflictsofinterestria.pdf (“Since the Department issued its 1975 rule, the

retirement savings market has changed profoundly. Financial products are

increasingly varied and complex. Individuals, rather than large employers, are

increasingly responsible for their investment decisions as IRAs and 401(k)-type

defined contribution plans have supplanted defined benefit pensions as the primary

means of providing retirement security.”). 24

CEA Report, supra note 8. 25

29 U.S.C. § 1002(21)(A) (2016). (Additionally, the definition includes an

individual who “exercises any discretionary authority or discretionary control

respecting management of such plan or exercises any authority or control respecting

management or disposition of its assets . . . or . . . has any discretionary authority or

discretionary responsibility in the administration of such plan.”).


narrowed the scope of the definition,26

excluding those who rendered

advice to individuals using certain retirement vehicles that are more

common today, such as IRAs and employee-directed defined

contribution plans (those excluded plans are collectively referred to

hereinafter as “individual plans”).27

Advisers to individual plans were not subject to ERISA’s fiduciary

standard and therefore were required only to recommend investments

plans and products “suitable” to the individual investor.28

Non-

fiduciaries advisers could “give imprudent and disloyal advice,”29

recommend products “based on their own interests rather than

customers’30

financial interest,” and “operate with conflicts of interest

that they need not disclose.”31

These practices result in investors

paying higher fees and investing in underperforming products that the

adviser receives a commission for recommending.32

The White House

Counsel of Economic Advisers recently estimated that Americans

receiving retirement advice from non-fiduciaries endure an aggregate

loss of approximately $17 billion each year.33

Yet prior to the

promulgation of the Fiduciary Rule, investors injured by impure

advice of non-fiduciary advisers had no recourse aside from firing the

26

“Before a person can be held to ERISA's fiduciary standards with respect to

their investment advice, he or she must: (1) make recommendations on investing in,

purchasing or selling securities or other property, or give advice as to the

investments’ value; (2) on a regular basis; (3) pursuant to a mutual understanding

that the advice; (4) will serve as a primary basis for investment decisions; and (5)

will be individualized to the particular needs of the plan.” EMPLOYEE BENEFIT

SECURITY ADMINISTRATION, FIDUCIARY INVESTMENT ADVICE, REGULATORY

IMPACT ANALYSIS 2 (Apr. 14, 2015),

https://www.dol.gov/sites/default/files/ebsa/laws-and-regulations/rules-and-

regulations/proposed-regulations/1210-AB32-2/conflictsofinterestria.pdf (citing 29

C.F.R. 2510.3-21(c) (2017); 40 Fed. Reg. 50843 (Oct. 1975) available at

https://www.gpo.gov/fdsys/pkg/CFR-1999-title29-vol9/pdf/CFR-1999-title29-vol9-

sec2510-3-21.pdf). 27

Fiduciary Rule, supra note 2, at 20954. 28

Fiduciary Rule, supra note 2, at 20,971 (describing the “suitability” standard

of conduct established by FINRA Rule 2111 that requires broker-dealers to “have a

reasonable basis to believe that a recommended transaction or investment strategy

involving a security or securities is suitable for the customer, based on the

information obtained through reasonable diligence of the [firm] or associated person

to ascertain the customer’s investment profile”). 29

Id. at 20,946. 30

Id. 31

Id. 32

Sureyya Burcu Avci et al., How Should Retirement Be Organized?, 15 (Ross

School of Business Working Paper Series, Working Paper No. 1332, 2016),

http://ssrn.com/abstract=2847655 [hereinafter “Working Paper”]. 33

CEA Report, supra note 8, at 26.

252 WAKE FOREST J.


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adviser and trying their luck with someone new.34

B. The Fiduciary Rule: Expanding ERISA’s Umbrella to Protect

more of Today’s Workforce

The Fiduciary Rule, promulgated in April 2016, expands the

definition of “fiduciary,” bringing more American workers saving for

retirement under ERISA’s protective umbrella.35

Categorizing more

investment professionals as ERISA “fiduciaries,” first means that they

too must act solely in the best interest of the investors who have hired

them, and second, creates a private right of action for investors if the

professionals fail to meet the standard.36

The Fiduciary Rule also

prohibits the advisor from engaging in transactions on behalf of the

investor that “pose special dangers to the security of retirement . . .

because of fiduciaries’ conflicts of interest.”37

The prohibition on transactions in which the fiduciary has a

conflict of interest limits several practices that have become common

within the industry.38

For example, an investment adviser may work,

34

Fiduciary Rule, supra note 2, at 20,953–54 (noting that while IRAs are

subject to some regulation, “IRA owners do not have a statutory right to bring suit

against fiduciaries under ERISA for violation of the prohibited transaction rules”).

However, as John Bogle noted, some investment advisers, as “registered investment

advisers have been subject to the federal fiduciary duty test ever since 1940.” See

infra note 127. 35

United States Department of Labor, White House Fact Sheet: Strengthening

Retirement Security By Cracking Down on Conflicts of Interest in Retirement

Savings, (Apr. 6, 2016), https://obamawhitehouse.archives.gov/the-press-

office/2016/04/06/fact-sheet-middle-class-economics-strengthening-retirement-

security (“Under the rule, any individual receiving compensation for making

investment recommendations that are individualized or specifically directed to a

particular plan sponsor running a retirement plan (e.g. an employer with a retirement

plan), plan participant, or IRA owner for consideration in making a retirement

investment decision is a fiduciary.”). The term “professionals” or “advisers”

encompasses anyone who, prior to 2016, could legally provide investment advice to

individuals. Both broker-dealers and registered investment advisers (RIAs) could

perform the same services. Governed by the Investment Advisers Act of 1940, RIAs

were subject to a fiduciary standard and were required to cure or disclose conflicts of

interest. Broker-dealers, on the other hand, are regulated by the SEC and remain

subject only to the “suitability” standard. Instead of delving into the differences

between these professionals, this article focuses on comparing the minimum standard

of care for investment advice before the issuance of the Fiduciary Rule to the

minimum standard of care after, which is appropriate because its broad topic is the

availability of remedies for investors injured by industry bad actors. 36


Id. at 20,946. 38

Michael Kitces, Advisor’s Guide to DoL Fiduciary and The New Best

Interests Contract (BIC) Requirement, NERD’S EYE VIEW, (Apr. 11, 2016),

continued . . .


either directly or indirectly, for a financial institution that provides the

adviser with a commission or shared revenues when the adviser sells

the institution’s products.39

If the institution’s products happen to be

subpar or subject to high fees, the adviser’s fiduciary obligations to the

investor starkly conflict with his own interest in drawing a commission

or sharing in the revenues from a sale.40

In the Fiduciary Rule, the

DOL regulates such a “Principal Transaction,” defined as a transaction

in which “an investment advice fiduciary…engages in purchases and

sales of certain investments out of their inventory…with plans,

participants, or beneficiary accounts.”41

These investments include

risky investments, high-fee funds, or “proprietary products”

(specialized investment portfolios, consisting of derivative assets and

private investments which are difficult or impossible to evaluate

because they are not subject to public disclosure laws) and are often

inferior to low-cost funds.42

These risky products generate high fees

for the adviser and his employer but are rarely in the best interest of

the average retirement investor.43

C. Qualifying for the Best Interest Contract Exemption—No

Class Action Waivers Allowed

Some consumer advocates and scholars argue that ERISA would

best protect investors by simply prohibiting fiduciaries from selling

proprietary products to retirement investors or participating in any

conflicted transaction.44

Instead, ERISA allows both activities, but

https://www.kitces.com/blog/best-interests-contract-exemption-bice-and-dol-

fiduciary-bic-requirements/ (discussing the Fiduciary Rule’s goal of a sweeping

culture change in the industry). 39

Fiduciary Rule, supra note 2;. CEA Report, supra note 8, at 7. 40

Fiduciary Rule, supra note 2 at 20,950 (discussing the prevalence and danger

of conflicted advice); Working Paper, supra note 32, at 20-21. 41

Class Exemption for Principal Transactions in Certain Assets Between

Investment Advice Fiduciaries and Employee Benefit Plans and IRAs, 81 Fed. Reg.

21,089 (Apr. 8, 2016) (codified at 29 C.F.R. pt. 2550) [hereinafter Rule Exemption].

Even if the adviser does not make commission on a sale per se, merely receiving

income from two parties with incompatible interests creates a conflict because the

adviser cannot serve one without injuring the other. Working Paper, supra note 32,

at 4. The investor’s interest is best served by a product with a low cost and high

return; the employer’s interest is best served by a product with a high cost, regardless

of return. 42

Working Paper, supra note 32, at 4; CEA Report, supra note 8, at 7. 43

Working Paper, supra note 32, at 4; CEA Report, supra note 8, at 11–13. 44

See Fiduciary Rule, supra note 2 at 20,946 (Some suggest that a blanket

requirement of using only low fee index funds is the answer, but members of the

industry argue that such sweeping restrictions would result in the industry’s

collapse); Beyond Diversification, infra note 193.

254 WAKE FOREST J.


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with strings attached.45

The “Best Interest Contract Exemption”

(“BICE” or the “Exemption”) allows an adviser, rendering advice to

an individual investor for compensation,46

to receive compensation

from his employing firm if: (1) the firm adopts and implements

“policies and procedures reasonably designed to mitigate any harmful

impacts of conflicts of interest”47

; (2) the firm and adviser

acknowledge their fiduciary status in writing;48

(3) the adviser and

firm disclose basic information about any conflicts of interest and the

cost of the services provided49

; and (4) the adviser adheres to

“impartial conduct standards,” including (a) providing prudent advice

in the investor’s best interest,50

(b) receiving no more than “reasonable

compensation” from the employing firm, and (c) avoiding misleading

statements.51

Thus, while permitting Principal Transactions, the DOL

45

Fiduciary Rule, supra note 2, at 20,946 (stating that the DOL created these

exemptions “to preserve beneficial business models for delivery of investment

advice” and therefore “broadly permit firms to continue to receive many common

types of fees, as long as they are willing to adhere to applicable standards aimed at

ensuring that their advice is impartial and in the best interest of their customers”). 46

When advising participants in a plan originally covered by ERISA, the

fiduciary need not enter such a contract because he is already subject to the

enforcement mechanisms set forth in the statute. See Rule Exemption, supra note 41,

at 21,002 (noting that page 21003 provides for enforcement and requiring the

fiduciary to acknowledge his fiduciary status in writing though not in a contract). 47

This provision is “a meaningful attempt for [sic] drive financial services

institutions to change their entire culture…If the firm does not create the proper

environment by establishing mechanisms to police its own conflict of interest, the

Financial Institution can lose its Prohibited Transaction Exemption under BICE,

which instantly renders all of its activity a prohibited transaction breach. Firms will

not want this to happen, and it will drive them to create a more fiduciary culture to

avoid the severe ramifications for failing to do so (out of simple self-interest

preservation of what happens if they don’t).” Kitces, supra note 38. The Rule’s

prohibition of a number of common business practices, such as quotas, bonuses, and

other awards or incentives “that are intended or would reasonably be expected to

cause Advisers to make recommendations that are not in the Best Interest of the

Retirement Investor” is expected to cause a substantial reform in the industry. Rule

Exemption, supra note 41, at 21,003. 48

This provision is a result of the difficulty IRA investors have faced in the past

in proving that the advisor in fact had a fiduciary duty to breach. Iacurci, supra note

4 (explaining that advisers would claim that their advice was not continuous or was

not the primary basis for the ultimate investment decision and this provision

alleviates that problem). 49

Fiduciary Rule, supra note 2, at 20,947. (Financial institutions can make

many of the disclosures on their website and directly to the client only upon request). 50

Id. “Prudent advice” must be “based on the investment objectives, risk

tolerance, financial circumstances, and needs of the Retirement Investor, without

regard to the financial or other interests of the Adviser, Financial Institution, or their

Affiliates, Related Entities, or other parties.” 51

Kitces, supra note 38. “[T]he advisor does not have to be the cheapest, but

continued . . .


requires that advisers who use them “adhere to enforcement standards

of fiduciary care and fair dealing.”52

The BICE includes other requirements calibrated to ensure the

investor a clear path to assert his rights if the advisor, in the course of

providing conflicted advice or engaging in principal transactions,

should breach his fiduciary duty.53

As such, the DOL makes the BICE

safe haven unavailable if the fiduciary’s consumer contract contains

any of the following provisions: (1) an exculpatory provision

disclaiming or limiting the adviser’s liability for a violation of the

contract’s terms; (2) a provision waiving or qualifying the investor’s

right to bring or participate in a class action; or (3) an agreement to

arbitrate or mediate individual claims in distant or otherwise

unreasonable venues.54

With these provisions, the BICE seeks to align

the interests of the investment adviser and his employer with the

investor himself, “giv[ing] the [fiduciary] a powerful incentive to

ensure advice is provided in accordance with fiduciary norms, rather

than risk litigation, including class litigation and liability.”55

Notably,

the DOL has unequivocally not prohibited class action waivers but

instead merely made their absence a prerequisite for fiduciaries to

qualify for the Exemption that allows fiduciaries to use otherwise

prohibited Principal Transactions.56

Preservation of investors’ rights to participate in class action

litigation is important for many reasons discussed in the following

section, but particularly important here because the DOL itself lacks

simply that compensation must not be excessive based on the going market value for

services rendered… Notably, such a standard is actually very accommodating of

advisors providing a wide range of services, for a wide range of costs; it simply

means that the costs must be commensurate to the going rate for such services.” 52

Rule Exemption, supra note 41, at 21,090 (describing such an investor as the

owner of an IRA or a participant in a non-ERISA plan). 53

Id. at 21,101 (“The contractual commitment provides an administrable means

of ensuring fiduciary conduct, eliminating ambiguity about the fiduciary nature of

the relationship, and enforcing the exemption’s conditions, thereby assuring

compliance.”). 54

Id. at 21,115. 55

Id. at 21,111. 56

Id. at 21,118 (“Nor…does Section II(f)(2) prohibit such [class] waivers. Both

Institutions and Advisers remain free to invoke and enforce arbitration provisions,

including provisions that waive or qualify the right to bring a class action or any

representative action in court. Instead, such a contract [with a class waiver] simply

does not meet the conditions for relief from the prohibited transaction provisions of

ERISA and the Code. As a result, the Financial Institution and Adviser would

remain fully obligated under both ERISA and the Code to refrain from engaging in

prohibited transactions. In short, Section II(f)(2) does not affect the validity,

revocability, or enforceability of a class-action waiver in favor of individual

arbitration.”).

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the authority to enforce these provisions against certain fiduciaries,

specifically, those advising the owners of IRAs.57

For these investors,

otherwise unprotected, “the contractual requirement creates a

mechanism for investors to enforce their rights and ensures that they

will have a remedy for misconduct.”58

By way of justification for

these provisions in the Fiduciary Rule, the following section discusses

the general reasons that class actions are essential to the enforcement

of any consumer protection regulation and the current trend of

companies using class action waivers to escape liability for a great

many wrongs.

III. CLASS ACTIONS: PRIVATE ENFORCEMENT OF PUBLIC

CONSUMER PROTECTION REGULATION

Government agencies have come to rely on private class actions in

enforcing regulations, particularly regarding those regulations meant

to protect consumers.59

The class actions allow many potential

plaintiffs to join their claims and share the cost of litigation when each

has suffered injury at the hands of the same party and in a similar

manner.60

The aggregation of similar small claims grants potential

plaintiffs access to the justice system when the damages incurred by

each plaintiff alone would not justify the time, effort, and expense of

bringing an individual action.61

Therefore, the class action mechanism

has a pronounced impact on the substantive rights of litigants with

small-dollar claims because if these claims are not addressed

collectively, they are typically not addressed at all.62

57 Id. at 21,100 (“Unlike participants and beneficiaries in plans covered by Title

I of ERISA, IRA owners and participants and beneficiaries in non-ERISA plans do

not have an independent statutory right to bring suit against fiduciaries for violation

of the prohibited transaction rules. Nor can the Secretary of Labor bring suit to

enforce the prohibited transactions rules on their behalf.”); see also Iacurci, supra

note 4; Nick Thornton, Who Will Enforce the DOL Rule?, BENEFITSPRO (June 1,

2016), http://www.benefitspro.com/2016/06/01/who-will-enforce-the-dol-

rule?t=retirement &page=2&slreturn=1485187487 (explaining that the BICE creates

a contract that IRA owners can enforce through state contract law). 58

Rule Exemption, supra note 41, at 21,100. 59

J. Maria Glover, The Structural Role of Private Enforcement Mechanisms in

Public Law, 53 WM. & MARY L. REV. 1137, 1153-54 (2012). 60

See Amchem Prod., Inc. v. Windsor, 521 U.S. 591, 617 (1997); Justice

Denied: One Year Later: The Harms to Consumers From the Supreme Court’s

Concepcion Decision Are Plainly Evident, PUBLIC CITIZEN & NAT’L ASS’N OF

CONSUMER ADVOC., Apr. 2012, at 5, available at

https://www.citizen.org/documents/ concepcion-anniversary-justice-denied-

report.pdf. 61

Amchem Prod., 521 U.S. at 616. 62

Glover, supra note 59, at 1163 (“The class action device has evolved as a

continued . . .


Many federal consumer protection agencies receive insufficient

funding to effectively police their respective industries.63

Understanding the importance of private enforcement, legislators and

regulators often build class action enforcement into the statute or

regulation.64

Congress has granted enforcement authority to private

individuals by creating private rights of action in many consumer

protection laws.65

For example, the Federal Trade Commission

(“FTC”),66

Securities Exchange Commission (“SEC”),67

and

Consumer Financial Protection Bureau (“CFPB”)68

each actively rely

on private enforcement of their consumer protection regulations,

mostly accomplished through class actions.69

Class actions and the

attorneys who bring them play an important role in enforcing

consumer protection regulations and therefore it is in the public

interest to preserve consumers’ right and ability to participate in class

central mechanism of enforcement for a broad range of laws, including those

governing products liability, securities fraud, consumer fraud, and antitrust

violations.”). 63

Id. at 1146 (“private enforcement has been a consequence of deliberate

statutory design and, further, of functional limitations of public regulatory bodies'

ability to achieve regulatory objectives”). 64

Bureau of Consumer Financial Protection, Proposed Rulemaking, Arbitration

Agreements, 12 C.F.R. § 1040, at 11 (May 5, 2016) [hereinafter CFPB’s Proposed

Rulemaking] (“Congress calibrated enforcement through private class actions in

several of the consumer protection statutes by specifically referencing class actions

and adopting statutory damage schemes that are pegged to a percentage of the

defendants’ net worth.”). 65

Glover, supra note 59, at 1148 (noting that private enforcement of regulation

“was the product of conscious congressional choice: particularly in the last five

decades, Congress has put into place a number of private ex post enforcement

mechanisms—often in the form of statutes creating private rights of action—to help

effectuate its substantive aims. At the same time, Congress has often explicitly

rejected bureaucratic enforcement regimes for the implementation of those

directives.”). 66

Victor E. Schwartz & Cary Silverman, Common-Sense Construction of

Consumer Protection Acts, 54 U. KAN. L. REV. 1, 15–16 (2005). 67

Recall that two pension funds—not the SEC—exposed WorldCom’s fraud.

See In re MCI WorldCom, Inc., Sec. Litig., 191 F. Supp. 2d 778 (2002); In re

WorldCom, Inc. Sec. Litig., No. 02 CIV 3288, 2004 WL 2591402, at *1, *23

(S.D.N.Y. Nov. 12, 2004). 68

See generally Consumer Fin. Prot. Bureau, Arbitration Study: Report to

Congress, pursuant to Dodd-Frank Wall Street Reform and Consumer Protection Act

§ 1028(a) (Mar. 2015), http://files.consumerfinance.gov/f/201503_cfpb_arbitration-

study-report-to-congress-2015.pdf [hereinafter CFPB Study]. 69

Id. at 17–18 (noting the scarcity of overlap in enforcement of consumer

protection laws by public entities and private actors, and when overlap does exist,

lawyers file private class actions ahead of government enforcement in 62% to 71%

of cases).

258 WAKE FOREST J.


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actions.70

In many consumer class action lawsuits, each plaintiff seeks only a

few thousand or even a few hundred dollars in damages,71

so that even

a successful outcome would not justify the cost of hiring an attorney72

and litigating a case, either in court73

or in arbitration.74

Because

consumers can participate in a class action with greater ease and at a

lower cost than bringing an individual claim, consumers with small

injuries are far more likely to do so.75

A recent study of credit card

holders by the Consumer Financial Protection Bureau (“CFPB”) found

that very few consumers would pursue a legal claim for unjustified or

unexplained fees beyond contacting a company’s customer service

department.76

Within a two year period, only 5,566 individual claims

were filed,77

while during a five year period, 160 million consumers

received payment as part of a class action totaling $2.7 billion in gross

relief.78

Indeed, 24 million consumers received distributions as part of

a class action without even having to file a claim.79

Class actions increase enforcement of regulations because the

aggregation of small claims creates an incentive for plaintiffs’

attorneys to take on cases that they otherwise would not.80

Plaintiffs’

attorneys typically work on a contingency fee basis, which means that

the attorney pays for the costs of litigation upfront and only receives

70

Arbitration Agreements, 81 Fed. Reg. 32,856, 32,853 (May 24, 2016) (to be

codified at 12 C.F.R. pt. 1040). 71

CFPB’s Proposed Rulemaking, supra note 64, at 73 (estimating the average

recovery per class member at $32/person in the 236 class settlements analyzed). 72

Forbes estimates that attorneys cost $300-600/hour. Seth Lipner, Is

Arbitration Really Cheaper?, FORBES (July 14, 2009),

http://www.forbes.com/2009/07/14/lipner-arbitration-litigation-intelligent-investing-

cost.html [hereinafter FORBES]. 73

Forbes estimates court filing fees to be $500/day and court reporter fees to be

$2,000/day. Id. 74

Forbes estimates that investors suing in FINRA wind up with an average of

$4,000 to $5,000 in forum fees, which cover the costs of arbitrators, filing fees, and

administrative costs. Id. The CFPB’s study revealed that claimants in individual

arbitration recovered an average of $5,505 when they won, while the average

attorney’s fee topped $8,000. Arbitration Agreements, supra note 70, at 32,856 n.

365. 75

Arbitration Agreements, supra note 70, at 32,847. 76

Id. at 32,856 (“When claims are for small amounts, there may not be

significant incentives to pursue them on an individual basis. As one prominent jurist

has noted, ‘Only a lunatic or a fanatic sues for $30.’”). 77

Id. at 32,855–56 (including 3,462 individual claims in federal court, 870 small

claims disputes, and 1,234 individual arbitrations). 78

Id. at 32,849. 79

Id. at 32,858. 80

See id. at 32,856–58.


payment from the client if the case succeeds, as a percentage of the

damages.81

Under such a fee structure, the cost and risk of litigation is

only logically justified if the potential damages are high.82

In a class

action, an attorney can earn legal fees from multiple clients, making

even small-dollar claims financially feasible to pursue.83

Class actions help to solve another related problem: consumers

may not realize they have been injured if the amount of the injury is

small enough to escape notice or if the injury is hidden or too

complicated for the average consumer to discover.84

For example,

improper or excessive fees by an investment advisor may go

undetected by an individual because they are only disclosed in the fine

print of a complicated contract, because the individual does not

understand that they are illegal, or because they are small.85

However,

even small fees, month after month and consumer after consumer,

amount to a substantial ill-gotten benefit to the company and a

substantial loss to the consumer.86

Consumers often first learn that a

company has injured them as a result of mass litigation: through an

attorney attempting to form a class, required class notification, the

company itself, or the media.87

81

Id. at 32,857. 82

CFPB’s Proposed Rulemaking, supra note 64, at 99. 83

Amchem Prod. v. Windsor, 521 U.S. 591, 617 (1997) (“The policy at the very

core of the class action mechanism is to overcome the problem that small recoveries

do not provide the incentive for any individual to bring a solo action prosecuting his

or her own rights. A class action solves this problem by aggregating the relatively

paltry potential recoveries into something worth someone’s (usually an attorney’s)

labor.”); CFPB’s Proposed Rulemaking, supra note 64, at 258 (“the potential legal

harm per consumer arising from violations of law by providers of consumer financial

products or services is frequently low in monetary terms. Moreover, consumers are

often unaware that they may have suffered legal harm. For any individual, the

monetary compensation a consumer could receive if successful will often not be

justified by the costs (including time) of engaging in any formal dispute resolution

process even when a consumer strongly suspects that a legal harm might have

occurred.”). 84

CFPB’s Proposed Rulemaking, supra note 64, at 97 (“legal harms are often

difficult for consumers to detect without the assistance of an attorney.”). 85

Amended Class Action Complaint at 6, Bodnar v. Bank of America, No. 5:14-

cv-03224-EGS (E.D. Pa. Aug. 26, 2015), available at

http://bankofamericaoverdraftsettlement.com/Content/Documents/Complaint.pdf

(showing that each overdraft fee was $35); see also Costly Mistakes, infra note 148,

at 621–22 (explaining that some investors do not understand the difference that even

a small difference in fees will make over time). 86

Melissa LaFreniere, Bank of America Agrees to $27.5M Overdraft Fee Class

Action Settlement, Top Class Actions (Jan. 18, 2016),

https://topclassactions.com/lawsuit-settlements/lawsuit-news/312241-bank-of-

america-agrees-to-27-5m-overdraft-fee-class-action-settlement/. 87

See, e.g., Settlement Agreement & Release at 15–19, Bodnar v. Bank of

continued . . .

260 WAKE FOREST J.


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In many cases, the inherent complexity of the product and

consumer contract prevents the average consumer from determining

whether they have agreed to reasonable fees or whether the company

has met its obligations under the agreement.88

While individuals are

unable (or have inadequate incentive) to pour over the fine print of

bills, agreements, and financial records in an attempt to find a claim,

the potential for aggregating fees in a class action gives plaintiffs’

attorneys the incentive to spend the time and money to do just that.89

For example, in securities fraud class actions, plaintiffs’ attorneys

often hire professional analysts to monitor the securities markets and

gather information to support a claim when actionable impropriety

becomes evident.90

Once the attorney discovers that an actionable

injury has occurred, the attorney informs those potentially harmed.91

Without attorneys to initiate this process and without class actions to

reimburse the expenses, many misdeeds based on complicated, opaque

facts would go unaddressed and consumers would suffer countless

small injuries without remedy.92

In addition to helping consumers obtain compensation for past

injuries, class actions also benefit consumers by discouraging future

bad actors.93

Class action settlements often include an agreement by

America, No. 5:14-cv-03224-EGS (E.D. Pa. Jan. 13, 2016), available at

http://bankofamericaoverdraftsettlement.com/Content/

Documents/Settlement%20Agreement.pdf (describing the agreed upon requirement

of notifying those effected by the settlement of the class action). 88

See Working Paper, supra note 32, at 11-12 (citing a study finding “that many

individuals also do not understand the most fundamental concepts and terminology

in investing”); see Glover, supra note 59, at 1210 (“the ferreting out of misconduct

like consumer fraud requires expertise frequently not in the hands of consumers.

They are thus unlikely, on their own, to possess or process relevant information in

such a way that will motivate them to arbitrate.”). 89

CFPB’s Proposed Rulemaking, supra note 64, at 32,856 (“[S]ome harms, by

their nature, such as discrimination or non-disclosure of fees, can only be discovered

and proved by reference to how a company treats many individuals or by reference

to information possessed only by the company, not the consumer.”). 90

Market Monitor, MOTLEY RICE, http://www.motleyrice.com/market-monitor-

portfolio-monitoring-service (last visited on Nov. 16, 2016) (describing the law

firm’s portfolio monitoring service that tracks news events, changes in the securities

markets, and other cases in search of indications of fraud and other possible claims). 91

See, e.g. supra note 89. 92

Glover, supra note 59, at 1210 (“It is inconceivable that a private attorney,

who might have sufficient expertise in consumer fraud, will have the economic

incentive to root out consumer fraud if the only economic gain to be had is through

individual arbitrations. The significant investment of resources required to identify

wronged individuals and to pursue their small claims on an individualized basis

likely will not justify any eventual gains.”). 93

Arbitration Agreements, supra note 70, at 32,858; Rule Exemption, supra

note 41, at 21,117 (“Class actions address systemic violations affecting many

continued . . .


the offending company to adopt new policies or eliminate a harmful

behavior from its practices, which provides lasting protection to all

consumers, even those who did not participate in the action.94

The

threat of costly class litigation provides a potent incentive for

companies to comply with regulations and avoid harmful or even risky

behavior.95

For example, many of the “fiduciary best practices” that

protect the beneficiaries of 401(k)s were born from litigation or are

now taken more seriously as a result of active private enforcement by

the plaintiff’s bar.96

A. Use of Class Action Waivers to Escape Small-Scale Liability

Because litigating or settling a class action poses a substantial

monetary threat when compared to individual claims, many companies

use their contracts with customers to minimize the risk of mass

litigation.97

This is accomplished by including boilerplate language

obliging consumers to resolve any disputes in arbitration and waiving

different investors.”). 94

Arbitration Agreements, supra note 70, at 32,858 (noting that court orders and

injunctions forbidding certain actions create a similar benefit to consumers); Rule

Exemption, supra note 41, at 21,117 (“Exposure to class claims creates a powerful

incentive for Financial Institutions to carefully supervise individual Advisers, and

ensure adherence to the Impartial Conduct Standards.”). 95

Ten Fiduciary Duties, 401KHELPCENTER,

http://www.401khelpcenter.com/401k/10_fiduciary_duties.html#.WI-iwn9d-Kw

(“[B]ecause of a number of factor[s sic] including the recent class action lawsuits

and a new focus by the Department of Labor and Internal Revenue Service on a

number of issues including fees, plan sponsors need to be more vigilant.”); CFPB’s

Proposed Rulemaking, supra note 64, at 32,902 (“First, the potential exposure can

cause a provider to devote increased resources to monitoring and evaluating

compliance, which can in turn lead the provider to determine that its compliance is

not sufficient given the risk of litigation. Second, the potential exposure to class

litigation can cause a provider to monitor and react to class litigation or enforcement

actions (that could result in class litigation) against its competitors, regardless of

whether the provider previously believed that its compliance was sufficient.”). 96

The ERISA Litigation Newsletter, Jan. 2016, PROSKAUER,

http://www.proskauer. com/publications/newsletters/erisa-litigation-newsletter-

january-2016/; Best Practices for Plan Fiduciaries, VANGUARD, 2016,

https://institutional.vanguard.com/iam/pdf/ FBPBK.pdf?cbdForceDomain=false (“In

today’s evolving legal, regulatory, and litigation environments, it is more important

than ever that employee benefit plan fiduciaries understand their roles and

responsibilities. This guidebook serves as a roadmap to your fiduciary duties while

providing Vanguard’s perspective on recommended best practices. This book and its

companion pieces provide plan fiduciaries with tools to assist in complying with

ERISA’s fiduciary responsibilities and in mitigating risk.”). 97

Arbitration Agreements, supra note 70, at 32,835.

262 WAKE FOREST J.


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the right to bring or participate in class litigation.98

Such waivers

effectively immunized companies against claims for damages that are

less than the cost of bringing an individual claim in arbitration.99

This

method is successful because the vast majority of consumers enter

these agreements with no opportunity to negotiate the terms (and often

without knowledge), and courts almost universally enforce them.100

Arbitration gained popularity because it offers a faster, simpler,

less expensive way to settle disputes between contracting parties,

apparently benefitting consumers as well as companies.101

However,

the benefits of arbitration are often exaggerated102

and other

characteristics pose significant drawbacks for consumers, including

the confidentiality of the proceedings,103

limited discovery procedures,

potentially biased decision-makers, and decisions that are not subject

to appeal.104

While the procedural limitations of arbitration typically

make it less expensive than litigation, the costs still tally in the

thousands of dollars, even before attorney’s fees, and often exceed the

amount of damages requested.105

It is also worth noting that the rules

98

DIRECTV, Inc. v. Imburgia, 136 S.Ct. 463, 477 (2015) (Ginsberg, J.,

dissenting) (quoting N.Y. Times, Nov. 1, 2015, p. A1, col. 5) (“By inserting

individual arbitration clauses into a soaring number of consumer and employment

contracts, companies [have] devised a way to circumvent the courts and bar people

from joining together in class-action lawsuits, realistically the only tool citizens have

to fight illegal or deceitful business practices.”). 99

CFPB’s Proposed Rulemaking, supra note 64, at 258 (“For any individual, the

monetary compensation a consumer could receive if successful will often not be

justified by the costs (including time) of engaging in any formal dispute resolution

process even when a consumer strongly suspects that a legal harm might have

occurred.”). 100

AT&T Mobility v. Concepcion, 563 U.S. 333, 365 (2011) (Breyer, J.,

dissenting) (“In general agreements that forbid the consolidation of claims can lead

small-dollar claimants to abandon their claims rather than to litigate…The realistic

alternative to a class action is not 17 million individual suits, but zero individual

suits, as only a lunatic or a fanatic sues for $30.”). 101

See FORBES, supra note 72. 102

See id. (explaining that arbitration is not as inexpensive as people might

assume and noting that speed and simplicity are only valuable to the extent that a

just result is achieved). 103

Rule Exemption, supra note 41, at 21,117 (“This incentive [to supervise

individual advisers and ensure adherence to the standards] is enhanced by the

transparent and public nature of class proceedings and judicial opinions, as opposed

to arbitration decisions, which are less visible and pose less reputational risk to

Financial Institutions or Advisers found to have violated their obligations.”). 104

Sean Forbes, Fiduciary Rule has Flaw on Arbitration, Witness Says,

BLOOMBERG BNA (Aug. 11, 2015), http://www.bna.com/fiduciary-rule-flaw-

n17179934554/. 105

See FORBES, supra note 72.


of many arbitration administrators (FINRA,106

for example) do not

permit consolidation of actions.107

Finally, because arbitration is

confidential, consumers are unable to learn about a company’s past

indiscretions and avoid companies with a history of wronging

customers.108

The use of these clauses is rampant: “Class action waivers now

serve as such a powerful tool for companies to avoid liability that it

has become malpractice for corporate counsel not to include such

clauses in consumer . . . contracts.”109

While some states and

regulators have recognized the class action waiver epidemic and

attempted to rein them in, thanks to an antiquated statute from the

1920s and an alarming line of Supreme Court cases, arbitration clauses

with class action waivers remain largely enforceable.110

B. The Supreme Court’s Overbroad Policy of Enforcing

Arbitration Agreements

The Federal Arbitration Act (“FAA”),111

enacted in 1925, declares

agreements to arbitrate “valid, irrevocable, and enforceable, save upon

such grounds as exist at law or in equity for the revocation of any

contract.”112

The Supreme Court has considered the FAA “a

congressional declaration of a liberal federal policy favoring

106

See generally FIN. INDUS. REGULATORY AUTH., http://www.finra.org (last

visited Feb. 2, 2017). 107

Class Action Claims, FINRA Rule 12204 (2007) (amended 2008),

http://finra.complinet.com/en/display/display.html?rbid=2403&element_id=4110;

see also CFPB’s Proposed Rulemaking, supra note 64, at 32 (noting that some

arbitration administrators do have class procedures available, but this is typically

moot because the arbitration agreements preclude class proceedings in arbitration). 108

See also Glover, supra note 59, at 1207 (“[E]xpansive markets enable sellers

to engage in ‘democratized theft,’ whereby a single actor engages in various forms

of wrongdoing—such as misrepresentation, charging usurious rates, and producing

defective products—that result in substantial aggregate gains to that actor but inflict

relatively small harms to any one consumer.”). 109

Aaron Blumenthal, Circumventing Concepcion: Conceptualizing Innovative

Strategies to Ensure the Enforcement of Consumer Protection Laws in the Age of the

Inviolable Class Action Waiver, 103 CAL. L. REV. 699 (2015) (internal quotation

marks omitted) (quoting Myriam Gilles, Opting Out of Liability: The Forthcoming,

Near-Total Demise of the Modern Class Action, 104 MICH. L. REV. 373 (2005)). 110

See infra Section III.C. 111

9 U.S.C. § 2 (1925). 112

As arbitration agreements became more common in the early 1900s, many

people agreed to arbitrate disputes while creating a contract, but later regretted that

decision when they needed to assert a right under its provisions. Congress passed the

FAA as a reaction to the tendency of courts sitting in equity to invalidate arbitration

agreements. See S. REP. NO. 68-536, at 2 (1924).

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arbitration agreements, notwithstanding any state substantive or

procedural policies to the contrary.”113

The Supreme Court also stated

that the FAA “reflects the fundamental principle that arbitration is a

matter of contract”114

and seeks to “ensure judicial enforcement of

privately made agreements . . . .”115

Yet, even as the basic

underpinnings of contract law—that a contract is negotiated by the

parties116

and a contract represents the intentions of the parties at the

time of creation117

—have eroded in the consumerism and corporatism

of modern society, the infallibility of arbitration agreements has

remained untouched to an extent bordering absurdity.118

The landmark case in 2011, AT&T v. Concepcion,119

invalidated a

California common law rule that arbitration clauses with class action

waivers were unconscionable when used in consumer contracts of

adhesion.120

The scope of this rule narrowly targeted nonnegotiable

consumer contracts without disturbing the ability of negotiating parties

to agree to whatever they like.121

Yet the Supreme Court held that the

113

Moses H. Cone Mem’l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24

(1983). 114

Rent-A-Center, W., Inc. v. Jackson, 561 U.S. 63, 67 (2010). 115

AT&T Mobility LLC v. Concepcion, 563 U.S. 333, 345 (2011) (quoting

Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213, 219 (1985)). 116

See id. at 346–47. 117

See CFPB Study, supra note 68, at 11 (“Consumers are generally unaware of

whether their credit card contracts include arbitration clauses. Consumers with such

clauses in their agreements generally either do not know whether they can sue in

court or wrongly believe that they can do so.”). 118

Andrew Cohen, No Class: The Supreme Court’s Arbitration Ruling, THE

ATLANTIC (Apr. 27, 2011), http://www.theatlantic.com/national/archive/2011/04/no-

class-the-supreme-courts-arbitration-ruling/237967/ (“Justice Antonin Scalia's

majority opinion, which overturned the 9th Circuit, voided the intended impact of

California's consumer law and case precedent, and declared that the Federal

Arbitration Act allows corporations to force individuals to adhere to individual

dispute arbitration no matter how unjust the results.”). 119

Concepcion, 131 S.Ct. at 1740. 120

Discover Bank v. Superior Court, 113 P.3d 1100, 1110 (2005). Cal. Civ.

Code Ann. § 1668 (1985) makes unlawful all contracts “which have for their object,

directly or indirectly, to exempt anyone from responsibility for his own . . . violation

of law.” Section 1670.5(a) permits courts to “limit the application of any

unconscionable clause” in a contract so “as to avoid any unconscionable result.” 121

Id. The California Supreme Court narrowly applied the class action waiver

ban: when a class action waiver “is found in a consumer contract of adhesion in a

setting in which disputes between the contracting parties predictably involve small

amounts of damages, and when it is alleged that the party with the superior

bargaining power has carried out a scheme to deliberately cheat large numbers of

consumers out of individually small sums of money, then . . . the waiver becomes in

practice the exemption of the party ‘from responsibility for [its] own fraud, or willful

injury to the person or property of another.’”


FAA preempted this rule and therefore the arbitration clause and

accompanying class action waiver were enforceable.122

The holding

seems to have ignored both practical realities and the clear savings

clause written into the statute but still stands.

C. The FAA’s Negotiated Contract: An Endangered Species

In his vigorous dissent in Concepcion, Justice Breyer explains that

he would have upheld the California rule because the FAA specifically

allows for unenforceability of arbitration agreements “upon such

grounds as exist at law or in equity for the revocation of any

contract.”123

He also argued that the majority’s application of the

FAA went far beyond the legislative intent, noting that in 1925,

Congress likely contemplated “that arbitration would be used

primarily where merchants sought to resolve disputes of fact, not law,

under the customs of their industries, where the parties possessed

roughly equivalent bargaining power.”124

Justice Breyer, the 68th

Congress, the majority in Concepcion, and the disputed California rule

all agree that such an agreement should be enforced. However, this

idealized contract no longer (or only rarely) exists in the consumer

context—a fact that Justice Scalia admitted in his majority opinion.125

However, recognizing this change in the fundamental characteristics

of a contract did not convince Justice Scalia to temper his position on

the application of this eighty-five year-old law about contracts.

Contract theory (and presumably the FAA) assumes that both

parties to an arbitration clause are aware of and understand the clause,

and also that the parties have negotiated and come to an agreement on

that term.126

However, in reality, modern consumers rarely are aware

of or understand this term in the contracts they sign. According to the

CFPB, the vast majority of consumers who hold a credit card

containing a binding arbitration agreement either did not know

whether they could sue the credit card company in court or

erroneously believed that they could.127

Even the savviest consumers

122

Concepcion, 131 S.Ct. at 1747 (Similarly, because the law “would have a

disproportionate impact on arbitration agreements,” the entire law was discarded.). 123

Id. at 1762 (quoting 9 U.S.C. § 2). 124

Id. at 362. 125

Id. at 346–47 (“the times in which consumer contracts were anything other

than adhesive are long past”). 126

CFPB’s Proposed Rulemaking, supra note 64, at 49–50. 127

CFPB Study, supra note 68, at Section 3, at 3 (reporting that 54.4% did not

know whether they could sue and 38.6% thought they could sue, which totals 93% of

customers who do not know about this limitation of their rights, which included

continued . . .

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remain wholly unable to negotiate any term in an adhesion contract,

leaving millions of consumers with no choice but to “agree” to resolve

their concerns through individual arbitration.128

The inability to aggregate claims means that only those with

individual damages high enough to justify the legal and administrative

costs of resolving an individual claim will have access to the justice

system, which “disarm[s] consumers, leaving them without effective

access to justice.”129

Because the type of contract Congress

envisioned when passing the FAA no longer exists in the consumer

context, the law should not be read to hamstring well-reasoned,

narrowly-targeted attempts by states and federal regulators to protect

consumers in the present day.

Opposition to class action waivers is widespread, and in light of

the now well-documented unjust effects of class action waivers,

multiple agencies have limited or attempted to limit their use in

contracts of adhesion.130

However, the particular issue of whether a

federal agency can do so in carrying out a statutory directive presents a

new and active controversy.131

The following section examines the

DOL’s attempt in the Fiduciary Rule to remedy the pandemic of class

action waivers within the Supreme Court’s unfavorable framework.

The DOL’s limitation of the use of class action waivers is consistent

with Congress’s intent in enacting ERISA, and its creative rule

construction successfully circumvents the Supreme Court’s

interpretation of the FAA. In an ideal world, an agency could limit the

use of class action waivers without jumping through FAA hoops.

However, since the DOL has adequately performed, any challenge to

this aspect of the Fiduciary Rule should be rejected.

customers who supposedly had the opportunity to opt out of the arbitration

agreement). 128

DIRECTV, Inc. v. Imburgia, 136 S.Ct. 463, 477 (2015) (Ginsburg, J.,

dissenting) (“Because consumers lack bargaining power to change the terms of

consumer adhesion contracts ex ante, the providers have won the power to impose a

mandatory, no-opt-out system in their own private ‘courts’ designed to preclude

aggregate litigation.”) (quotation omitted). 129

Id. at 471. 130

See infra Section V. 131

Dan Jamieson, Investor Plaintiff Lawyers Expect More Victories With DOL

Rule, AIDIKOFF, UHL & BAKHTIARI, SECURITIES ARBITRATION & LITIGATION, (July

20, 2016), http://www.securitiesarbitration.com/news/2016/07/20/investor-plaintiff-

lawyers-expect-more-victories-with-dol-rule/ (“Whether government agencies can

ban class-action waivers is ‘a much contested question,’ said Edward Sherman, a

professor at Tulane University School of Law and an expert on class actions.”).


IV. THE EFFECT OF CLASS ACTION WAIVERS ON ERISA &

THE NEW FIDUCIARY RULE

Congress passed ERISA with the express purpose of

“protect[ing]…the interests of participants in employee benefit plans

and their beneficiaries.”132

Granting the Secretary of Labor the

authority to create regulations necessary and appropriate to carry out

its objective,133

Congress instructed the Secretary to implement three

specific protections, as follows.

First, Congress requires the Secretary to “establish[] standards of

conduct, responsibility, and obligation for fiduciaries of employee

benefit plans.”134

ERISA’s fiduciary duty imposes the highest

standard of care under the law: those tasked with managing the plan

must act solely in the best interest of the plan’s participants and

beneficiaries.135

The law also provides a strong remedy: a fiduciary

“shall be personally liable to make good to such plan any losses to the

plan resulting from each such breach.”136

Congress’s second layer of protection “require[es] the disclosure

and reporting to participants and beneficiaries of financial and other

information with respect thereto.”137

Mandating transparency and

accessible information, Congress facilitates enforcement of the

fiduciary’s obligations by the regulating agencies and the plan

participants and beneficiaries themselves, which it expressly

authorizes elsewhere in the law.138

Finally, the statute directs the Secretary to “provid[e] for

appropriate remedies, sanctions, and ready access to the Federal

132

29 U.S.C. § 1001(b) (2012). 133

Id. § 1135. See also id. § 1002(13) (defining “Secretary” as the Secretary of

Labor). 134

Id. § 1001(b). 135

Id. § 1104(a)(1) (specifically requiring that a fiduciary act “(A) for the

exclusive purpose of: (i) providing benefits to participants and their beneficiaries;

and (ii) defraying reasonable expenses of administering the plan; (B) with the care,

skill, prudence, and diligence under the circumstances then prevailing that a prudent

man acting in a like capacity and familiar with such matters would use in the conduct

of an enterprise of a like character and with like aims; (C) by diversifying the

investments of the plan so as to minimize the risk of large losses, unless under the

circumstances it is clearly prudent not to do so”). Section 1106 also prohibits certain

types of transactions plagued by conflicts of interest, either between the plan and the

fiduciary or the plan and a “party in interest,” though Section 1108 allows such

transactions under limited circumstances. 136

Id. § 1109(a). 137

Id. § 1001(b). See also, specific statutory provisions, at §§ 1021–1031. 138

Id. § 1132 (empowering the Secretary, as well as plan participants and

beneficiaries, to enforce ERISA through civil action).

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courts.”139

The DOL’s effort to discourage the use of class action

waivers conforms with Congress’s express recognition of the

importance of preserving American workers’ access to mechanisms of

enforcement free from impediments. As the following subsections

explain, the DOL’s preservation of the class action tool is particularly

necessary to the success of the Fiduciary Rule. The Exemption

furthers Congress’s consumer protection goals while fitting within the

confines of the FAA.

A. The Importance of Class Actions in Enforcing the Fiduciary

Rule

Like other regulatory efforts to protect consumers, the success of

the Fiduciary Rule to meet its objectives will depend in no small part

on the ability of individual investors to join as classes in enforcing its

terms.140

Since authority to enforce certain provisions of the Rule lies

not with the DOL but with the notoriously passive IRS, the task of

enforcement will fall heavily on the shoulders of private actors.141

For

the Fiduciary Rule to be adequately enforced, class action attorneys

must have an incentive to hire the experts and perform the research

necessary to discern the claims.142

Because of the complex nature of

the evidence underlying the claims, individuals are unlikely to

discover and initiate their own claims.143

Class actions not only make

remedies more accessible to those injured by an industry full of

complicated, opaque products, but active litigation also acts as a

deterrent and allows the courts to develop more specific rules in

139

Id. § 1001(b) (emphasis added). 140

See supra Section III.A. One commentator aptly described the provision:

Financial services product companies claimed that they can offer

often illiquid and opaque, commission-based, and sometimes even

proprietary products to consumers, while also receiving revenue-

sharing agreements, and simultaneously still act in the client’s best

interests as a fiduciary. And so the Department of Labor’s response

became: ‘Fine. If and when consumers disagree, you’ll have a

chance to prove it to the judge when the time comes.

Kitces, supra note 38. 141

26 U.S.C. § 4975(a)-(b); Iacurci, supra note 4. 142

Robert Rachal, Lindsey Chopin, & Robert Sheppard, View From Proskauer:

401(k) Fee Litigation: Practices to Mitigate Fiduciary Risk, PROSKAUER, THE

ERISA LITIGATION NEWSLETTER (Jan. 2016),

http://www.proskauercom/publications/newsletters/erisa-litigation-newsletter-

january-2016/ (“Because of its dynamics (small individual losses but high litigation

costs), most fee litigation is entrepreneurial, and offers the possibility of ‘incentive

awards’ to named plaintiffs many times greater than any claimed losses.”)

[hereinafter The ERISA Litigation Newsletter]. 143

Id.


response to trends in the industry.

i. Class Action Attorneys Are Necessary to

Adequately Police the Investment Advice Industry

Like companies in many other industries, financial institutions and

investment advisors commonly include class action waivers in their

customer contracts in order to reduce the risk of litigation by blocking

the most convenient and effective path for consumers to access the

court system.144

The American Bar Association itself suggests the use

of class action waivers as the top defense strategy to “thwart[] the

ERISA class action.”145

Prohibiting advisers and institutions that wish

to qualify for the Exemption, which permits conflicted transactions

from including a class action waiver in their customer contracts, is a

controversial rule but a necessary one given the widespread use of

waivers and the complex nature of the breach of fiduciary duty

claim.146

Investment products are complicated and the average investor is

ill-equipped to understand how conflicts of interest could affect the

returns on his investments or ascertain whether his investment adviser

has met his fiduciary duty.147

Average “[i]nvestors lack basic

financial literacy, including the ability to understand the effect of

compounding interest or to construct a diversified portfolio.”148

For

example, research consistently shows that “high-fee funds

underperform both their lower-fee competitors and passively managed

index funds that provide a market rate of return…Nonetheless,

144

Fredrick A. Brodie & Susan P. Serota, Risk of ERISA Class Actions Can Be

Reduced by Use of Plan Arbitration Provisions, LEXOLOGY (July 17, 2014),

http://www.lexology.com/library/detail.aspx?g=9af073b6-96d5-4057-871f-

bf4e3283d760. 145

Jeffrey D. Gardner, Defense Strategies for ERISA Class Actions, AMERICAN

BAR ASSOCIATION (Aug. 28, 2014),

http://apps.americanbar.org/litigation/committees/ classactions/articles/summer2014-

0814-defense-strategies-for-erisa-class-actions.html. 146

Id. 147

CEA Report, supra note 8, at 5 (“The number and complexity of the products

available can make financial decisionmaking difficult . . . Moreover, an abundance

of investment options and the way in which investment decisions are framed may

challenge financial decisionmaking and lead to worse outcomes for savers.”)

(citations omitted). 148

Jill E. Fisch & Tess Wilkinson-Ryan, Why Do Retail Investors Make Costly

Mistakes? An Experiment on Mutual Fund Choice, 162 U. PA. L. REV. 605, 620

(2014), available at

http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=1414&context=faculty

_scholarship [hereinafter Costly Mistakes]

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investors continue to purchase higher-fee funds.”149

The complexity

of the facts underlying a breach of fiduciary duty claim make it

unlikely that the average investor will discover that an injury has

occurred.150

In a study designed to investigate some of the reasons that

investors make costly investment mistakes, the authors noted that

some investors hold a belief that higher fees correlate with better

returns, while others discount the economic effect of seemingly small

differences in fees over time.151

“For others, fees may be presented in

a manner that is too complex or difficult to find,” 152

while still others

engage in an approach called “naïve diversification,” in which the

investor simply spreads his money evenly across every option on the

menu.153

Since the average investor lacks the expertise to choose

lower-fee over higher-fee funds, when he truly has every incentive to

do so, he is unlikely to be able to determine whether his fiduciary has

met the duties required by law.154

While the DOL has laudably attempted to minimize the risk to

investors by attaching conditions to potentially harmful transactions,

some of the vaguer requirements may prove difficult to delineate and

enforce.155

For example, an individual investor may have difficulty

discerning whether his adviser has received only “reasonable

compensation” from his employer, avoided “misleading statements,”

and provided only “prudent advice in [his] Best Interest.”156

149

Id. at 620–21. 150

See Fiduciary Investigations Program, U.S. DEP’T OF LABOR,

https://www.dol.gov/agencies/ebsa/ about-ebsa/our-activities/enforcement/oe-

manual/chapter-48 (last visited Jan. 26, 2017) (describing the protocol for

investigating a breach of fiduciary duty claim and subsequently building a case). 151

Costly Mistakes, supra note 148, at 621–22. 152

Id. at 622 (“As former SEC Chairman Arthur Levitt testified before Congress

in 1998, ‘Our own research shows that fewer than one in five fund investors could

give any estimate of expenses for their largest mutual fund and fewer than one in six

fund investors understood that higher expenses can lead to lower returns.’”). 153

Id. at 623. 154

With the rise in individually directed retirement accounts, investors are

increasingly the masters of their own financial fates. In an attempt to facilitate

investors selecting beneficial options for themselves, regulators have attempted to

increase transparency, requiring public disclosures of certain information in a certain

format. However, given the financial illiteracy of the average investors, these

disclosures have not proved as useful as regulators hoped. Id. at 616 (discussing the

2012 DOL regulation requiring a detailed fee disclosure from investment service

provider to the plan sponsors as well as plan participants). 155


CEA Report, supra note 8, at 7–8 (“Households also express confusion over

the fees that they are charged, reflecting the indirect and sometimes complex pricing

of financial advice, which further widens the scope for abuse. . . . Many savers may

continued . . .


Considering the complexity of law and the products and services at

issue, only investment professionals and experienced attorneys will

have the expertise necessary to discover a claim.157

While the terms of

the BICE make determination of a breach of contract claim somewhat

simpler for an investor to recognize, participation in a class action still

provides many benefits over an individual action.158

In explaining the need to protect investors’ ability to participate

class litigation, the DOL considered that “[o]ften the monetary effect

on a particular investor is too small to justify the pursuit of an

individual claim, even in arbitration.”159

In a 2015 report by the White

House Council of Economic Advisers (“CEA”) on the economic effect

of conflicted investment advice, the results of the studies examined,

“taken together, [] suggests that conflicted advice leads to

underperformance of roughly 100 basis points per year.”160

Retirees

often receive conflicted advice when they rollover the balance of a

401(k) plan into an IRA, with an individual investor “los[ing] an

estimated 12 percent of the value of his or her savings if drawn down

over 30 years.”161

As the average rollover into an IRA had more than

$100,000 in value, an estimated $12,000 would be lost in the

transfer.162

This number provides an apt example of a quantity of

damages that is too small to provide adequate incentive for a

plaintiff’s attorney to bring an individual action but is large enough to

cause serious impairment to the plaintiff.163

Given the expense of

not have full knowledge about their options or a complete understanding of the

detailed regulatory differences between their employer plan and an IRA—most

notably that advice to roll money out of the plan into an IRA is generally subject to

much lower standards of care than advice received in the plan.”). 157

Id. 158

Rule Exemption, supra note 41, at 21,115–16 (“The purpose of Section II(f)

is to ensure that Retirement Investors receive the full benefit of the exemption’s

protections, by preventing them from being contracted away. If an Adviser makes a

recommendation regarding a principal transaction or a riskless principal transaction,

for compensation, within the meaning of the Regulation, he or she may not disclaim

the duties or liabilities that flow from that recommendation. For similar reasons, the

exemption is not available if the contract includes provisions that purport to waive a

Retirement Investor’s right to bring or participate in class actions.”). 159

Id. at 21,117. 160

CEA Report, supra note 8, at 15. 161

Id. at 3. 162

Id. (noting that these findings were for individuals aged 55-64 in 2012). 163

Of course, the amount of the injury will vary depending on the size of the

investment, the time of the rollover, and the particular characteristics of the

investment advice given. See id. at 18 (describing the effect for a retirement saver

who rolls over his 401(k) into an IRA at age 45, estimating “the combined effect of a

17 percent loss leading up to retirement and a 12 percent loss after retirement [at] an

overall loss of more than 25 percent.”).

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hiring the necessary experts, plaintiffs’ attorneys are unlikely to

engage in the requisite research absent the strong financial incentive

provided by class litigation.164

Additionally, since this effect of conflicted advice occurs and

compounds over time, an investor may have difficulty recognizing the

injury, without a close and knowledgeable study of his investment

plan. As research shows that such study by an individual investor is

unlikely,165

discovery of these injuries and claims is a task more

appropriately and realistically left to class action attorneys and the

experts they employ.166

Class actions provide the economic incentive

for attorneys to undertake the expense of hiring experts to investigate

investment products and advice, which will allow the discovery and

remedy of injuries that would otherwise likely remain unaddressed.167

ii. Class Litigation Deters Harmful Behavior and

Results in Better Industry Practices

Active ERISA class action litigation deters fiduciaries from

breaching their duties and incentivizes better behavior within the

investment advice industry.168

A claim by an individual investor can

easily be ignored by financial institutions, but ERISA class actions can

result in monetary consequences on a scale that truly provide an

164

See The ERISA Litigation Newsletter, supra note 142. 165

Costly Mistakes, supra note 148, at 622–624 (discussing the average

investor’s lack of understanding of basic investment concepts). 166

CEA Report, supra note 8, at 2 (“The decision whether to roll over one’s

assets into an IRA can be confusing and the set of financial products that can be held

in an IRA is vast, including savings accounts, money market accounts, mutual funds,

exchange-traded funds, individual stocks and bonds, and annuities. Selecting and

managing IRA investments can be a challenging and time-consuming task,

frequently one of the most complex financial decisions in a person’s life, and many

Americans turn to professional advisers for assistance.”). Economic Analysis in

ERISA Litigation, NERA ECONOMIC CONSULTANTS,

http://www.nera.com/content/dam/nera/publications/2015/AAG_ERISA_Litigation_

0715.pdf (describing the services these experts provide in establishing liability and

damages in ERISA litigation). 167

CFPB Study, supra note 68, at Section 9, at 4 (in 68% of the class action

cases examined, the CFPB was unable to find a corresponding public enforcement

action; similarly, no corresponding public action was found in 82% of the class

actions with settlements of less than $10 million). 168

See Tara Siegel Bernard, Limiting the 401(k) Finder’s Fee, NEW YORK

TIMES, June 21, 2013, http://www.nytimes.com/2013/06/22/your-money/driving-

down-the-cost-of-investing-for-retirement.html?pagewanted=all&_r=0 (“Several

employee benefit experts have said that Mr. Schlichter’s cases and others have

resulted in lower charges as other employers began to fear attracting lawsuits of their

own.”).


incentive to avoid litigation by fulfilling fiduciary duties.169

The ten

largest ERISA class actions in 2014 resulted in $1.3 billion in

settlements and the tally in 2015 was only slightly less at $926.5

million.170

Additionally, Bloomberg BNA recently published an

article discussing the uptick in ERISA 401(k) litigation that has

resulted in an industry-wide shift to lower fee models, suggesting that

the litigation has had a deterrent as well as a compensatory effect.171

Settlements can include an agreement by the company to adjust its

behavior in the future. For example, in a 2014 settlement, Nationwide

settled a breach of fiduciary duty claim for $140 million after the

plaintiffs accused Nationwide of “engag[ing] in a quid pro quo

arrangement with the mutual funds, agreeing to include their funds as

investment options for the plans in exchange for the revenue-sharing

payments.”172

As part of the settlement, Nationwide was “required to

provide extensive fee and expense disclosure forms for all of its group

and individual variable annuity contracts through plan sponsors’

websites. It also agreed to enhance its notification procedures in the

event a fund is added or removed from an annuity.”173

Such

agreements force individual bad actors to improve their behavior and

also help to establish best practices in the industry and, in this case, are

likely to impact how revenue agreements are disclosed in the future.174

Class actions also particularly lend themselves to “addressing

systemic breaches,” which, in the absence of active regulators, would

work towards achieving the DOL’s goal of improving the quality of

the service provided by the industry as a whole.175

As the CFPB noted

169


Nick Thornton, Top 10 ERISA Settlements of 2015, BENEFITSPRO (Jan. 25,

2016), http://www.benefitspro.com/2016/01/25/top-10-erisa-settlements-of-

2015?slreturn =1479603699&page=5&page_all=1 (noting, however, that not all of

these suits were 401(k) actions; some of them were related to health care benefits). 171

Jacklyn Wille, Uptick in Fee Litigation Reshaping 401(k) Industry,

BLOOMBERG BNA (June 9, 2016), http://www.bna.com/uptick-fee-litigation-

n57982073839/ (“Engstrom told Bloomberg BNA that the decline in fees can be

traced to the decadelong series of lawsuits challenging those fees—and in particular,

a handful of large settlements over the past few years, like the $57 million deal

Boeing Co. inked with its workers and the $62 million settlement agreed to by

Lockheed Martin Corp. . . . Plan sponsors are also responding by looking into flat,

per-participant fees that are easier to understand and explain, Wilkerson said.”). 172

Nick Thornton, Nationwide Agrees to $140M ERISA Settlement,

BENEFITSPRO (Dec. 15, 2014), http://www.benefitspro.com/2014/12/15/nationwide-

agrees-to-140m-erisa-settlement?page_all=1. 173

Id. 174

Id. 175

Rule Exemption, supra note 41, at 21,117. The DOL also notes the value of

impartial and transparent proceedings, appealable decisions, and the development of

precedent. See id.

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in its recent Proposed Rulemaking, the deterrent effect and incentive

to reform created by the threat of class litigation provides a benefit to

all customers in the industry, not just members of the class.176

Since

one of the DOL’s goals in promulgating the Fiduciary Rule is to cause

systemic change across the investment advice industry, preserving the

threat of class litigation will be essential to accomplishing it.177

The increased threat of large-scale litigation and greater

transparency work together to hold fiduciaries accountable and

incentivize conscientious fulfillment of their duties to employees.178

For example, BrightScope is a company that uses a proprietary

formula to analyze public information about thousands of employer-

sponsored 401(k) plans and assign ratings depending on the quality of

each plan.179

BrightScope has been arming retirement savers with this

information since 2009, hoping to help investors help themselves.180

The publicity generated by these BrightScope ratings and high profile

litigation has created a strong incentive for employers to make sure

their retirement plans meet both ERISA and BrightScope’s accessible

standards.181

Maintaining the threat of class litigation by preventing

the use of class action waivers provides a continuing incentive for

responsible practices across the industry.182

iii. Common Law Rules that Protect Consumers

The fiduciary duty, on its own, is a vague standard, and the statute

provides little in the way of specific requirements.183

However,

176

See CFPB’s Proposed Rulemaking, supra note 64, at 104 (“[B]ehavioral

relief could be, when provided, at least as important for consumers as monetary

relief.”). 177

Rule Exemption, supra note 41, at 21,117 (“Exposure to class claims creates

a powerful incentive for Financial Institutions to carefully supervise individual

Advisers, and ensure adherence to the Impartial Conduct Standards.”). 178

See Bernard, supra note 168 (“According to BrightScope, a financial

research company that tracks 401(k) plans, the total costs, including fees and

administrative expenses, were 0.8 percent of assets in 2011. That’s down from 0.85

percent in 2009.”). 179

Costly Mistakes, supra note 148, at 617. 180

Id. 181

Id. BrightScope simplifies complex investment concepts and increases

awareness of employers’ behaviors that greatly impact employees’ ability to retire,

but would otherwise be unpalatable. 182

Id. (published before the Fiduciary Rule was promulgated, noting the need

for protections to apply to IRAs to allow the positive impact of litigation to infiltrate

the investment advice industry outside the 401(k) context). 183

Id. at 615 (“In order to obtain the benefit of ERISA’s § 404(c) safe harbor, a

plan must offer investors at least three ‘diversified’ investment options with

‘materially different risk and return characteristics.’”).


decades of ERISA fiduciary duty litigation have developed more

specific common law rules, which ultimately provide stronger

protections for investors as well as clearer guidelines to help well-

meaning fiduciaries avoid lawsuits.184

For example, courts have

recognized that, in order to comply with their duty, fiduciaries should

(1) continually monitor the plan and periodically consider alternative

administrators or products;185

(2) obtain low administrative and record

keeping fees for plan participants;186

(3) choose (or at least consider)

“lower cost funds [over higher cost retail class funds] with identical

managers, investment styles . . . where available;”187

and (4) make

adequate disclosures to employees invested in the employer

company’s stock.188

Many of these common law rules will begin to apply to investment

advisers newly subject to the Fiduciary Rule, and the likely result is a

proportionate shift within the investment advice industry to adopt the

practices that the ERISA litigation inspired in the 401(k) advice

industry.189

For example,

184

Wille, supra note 171. Some of the court-recognized fiduciary duties come

from a court holding, but others are comprised of the facts alleged that are sufficient

to survive a motion to dismiss for failure to state a claim. In this context, a “court-

recognized duty” is one that has formed the basis of a breach of fiduciary duty claim

that survived a motion to dismiss for summary judgment or failure to state a claim. 185

Tibble v. Edison Int’l, 135 S. Ct. 1823, 1828 (2015); In re Am. Int’l Grp.,

ERISA Litig. II, No. 08 Civ. 5722(LTS)(KNF), 2011 WL 1226459, at *10 (S.D.N.Y.

Mar. 31, 2011) (“A duty to monitor is pleaded sufficiently to survive a motion to

dismiss when a complaint alleges that the fiduciaries responsible for appointing

other fiduciaries utterly ‘failed to establish a procedure for monitoring [the appointed

fiduciaries] and [failed] to review those fiduciaries’ performance.’”). 186

See e.g., Tussey v. ABB, Inc., 746 F.3d 327, 335–37 (8th Cir.), cert. denied,

135 S. Ct. 477 (2014); Spano v. Boeing Co., No. 06-CV-743-DRH, 2007 WL

1149192, at *1 (S.D. Ill. Apr. 18, 2007) (Plaintiff’s claim was based on Defendant

allegedly “failing to contain Plan costs and paying unreasonable fees to service

providers to the Plan, as well as [] failing to minimize costs associated with

investment in employer securities under the Plan and holding a portion of the Plan’s

assets in cash.”). 187

Kruger v. Novant Health, Inc., 131 F. Supp. 3d 470, 474–77 (M.D.N.C.

2015); see generally, Braden v. Wal–Mart Stores, Inc., 588 F.3d 585, 595–96 (8th

Cir. 2009). 188

See, e.g., In re Am. Int’l Grp., 2011 WL 1226459, at *8 (“Plaintiffs have

sufficiently alleged that AIG and the Director Defendants were aware of the

increasingly risky financial position maintained by AIG, material weaknesses in

AIG’s financial health and the potential impending erosion of the value of AIG’s

stock.”); In re WorldCom, Inc., ERISA Litig., 263 F. Supp. 2d 745, 765 (S.D.N.Y.

2003) (“Plaintiffs’ allegation that [a fiduciary] failed to disclose to the Investment

Fiduciary and other investigating fiduciaries material information he had regarding

the prudence of investing in WorldCom stock is sufficient to state a claim.”). 189

See David Tobenkin & Steven Miller, How the Fiduciary Rule Affects

continued . . .

276 WAKE FOREST J.


[VOL. 17

many predict that the fiduciary standard will lead

advisors to switch to a flat-dollar fee or percentage-of-

the-assets fee for their services, rather than receiving

payment from commissions or from mutual fund

revenue-sharing arrangements (the behind-the-scenes

transfer of revenue from selected investment funds to

service providers, typically through so-called 12b-1

fees), given ERISA limitations on the latter forms of

compensation for fiduciaries.190

Active class litigation is necessary for effective enforcement of the

common law standards to protect individual investors and

development of new protective standards under the Fiduciary Rule.

iv. Dissatisfaction with the Fiduciary Rule and

Compromises

While some believe the Fiduciary Rule should have been enacted

decades ago, many within the industry have resisted regulation at

every turn.191

Some believe the Fiduciary Rule’s permissive approach

to conflicts of interest lacks teeth192

and that the protections provided

by the fiduciary standard are too vague to induce any real change in a

system where the “problem [is] a matter of widespread overcharging,

rather than a result of a small number of highly abusive plans.”193

Therefore, some argue that the DOL should base ERISA and the

Fiduciary Rule on more concrete, bright-line rules, such as requiring

fiduciaries to set low-cost index funds as the default investment194

or

Retirement Plan Sponsors, SOC’Y. FOR HUMAN RES. MGMT. (Apr. 8, 2016)

https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/fiduciary-rule-

plan-sponsors.aspx. 190

Id. 191

See John C. Bogle, Vanguard’s John Bogle: Ready or Not, An Expanded

Fiduciary Rule Is Coming, INV. NEWS (Sept. 15, 2016, 12:01 AM),

http://www.investmentnews.com/article/20160915/FREE/160919972/vanguards-

john-bogle-ready-or-not-an-expanded-fiduciary-rule-is (noting that registered

investment advisers have been held to a fiduciary standard since 1940 and arguing

that “the Fiduciary standard should go even further and also encompass all

institutional money managers responsible for investing other people’s money”). 192

See generally, Working Paper, supra note 32, at 48–49. 193

Ian Ayres & Quinn Curtis, Beyond Diversification: The Pervasive Problem

of Excessive Fees and “Dominated Funds” in 401(k) Plans, 124 YALE L. J. 1476,

1482 (2015). 194

Id. at 1483.


prohibiting conflicted transactions of any kind.195

These types of

provisions would likely have a significant positive impact by directly

addressing these problems,196

eliminating loopholes, and simplifying

enforcement; but one cannot realistically hope for their enactment in a

universe dominated by lobbying and private interests.

When the Fiduciary Rule was proposed, members of the industry

claimed that an outright prohibition on principal transactions and

common compensation structures such as commission and revenue

sharing would upend business models and cause many to leave the

industry.197

The final rule provisions represent a compromise,

intended to provide the industry with the flexibility requested, while

still protecting the people the Rule is meant to protect.198

While the

temptation to suggest stricter regulation is strong, this article focuses

on ways to optimize the effectiveness of the provisions as written.

Whatever level of restriction and protection the regulators decide to

promulgate, preserving the availability of class actions is essential to

effective enforcement.

B. Challenges to the Fiduciary’s Rule’s Limitation on Class

Action Waivers

Multiple parties, including the Chamber of Commerce and trade

associations representing the financial services industry, have sued the

DOL hoping to invalidate and block enforcement of the Fiduciary

Rule.199

While most claims challenge the Rule’s validity, one suit

brought by Thrivent Financial for Lutherans (“Thrivent”) in U.S.

District Court in the District of Minnesota instead only seeks relief

from BICE’s prohibition on the use of arbitration agreements with

class action waivers.200

Thrivent is a fraternal benefit society that

195

Working Paper, supra note 32, at 48–50. 196

See Jones v. Harris Assocs., 527 F.3d 627, 631 (7th Cir. 2008), vacated, 130

S. Ct. 1418 (2010) (Posner, J., dissenting). 197

The US Department of Labor’s Final “Fiduciary” Rule Incorporates

Concessions to Financial Service Industry but Still Poses Key Challenges,

SHEARMAN & STERLING, 7–8 (Apr. 14, 2016),

http://www.shearman.com/~/media/Files/NewsInsights/Publications/ 2016/04/The-

US-Department-of-Labor-Final-Fiduciary-Rule-Incorporates-Concessions-to-

Financial-Service-Industry-CGE-041416.pdf. 198

See Rule Exemption, supra note 41, at 21,111. 199

Carmen Castro-Pagan, Thrivent Financial Challenges DOL Fiduciary Rule,

Joining Fray, BLOOMBERG BNA (Sept. 29, 2016), http://www.bna.com/thrivent-

financial-challenges-n57982077775/. 200

Nick Thornton, Thrivent Suit Against DOL Pits ERISA vs. Federal

Arbitration Act, BENEFITSPRO (Oct. 10, 2016),

http://www.benefitspro.com/2016/10/10/thrivent-suit-against-dol-pits-erisa-vs-

continued . . .

278 WAKE FOREST J.


[VOL. 17

primarily serves and is owned by investors with modest means—most

of the members have a household incomes of less than $75,000 and a

median IRA balance of only $25,000.201

Thrivent hopes to preserve

its Member Dispute Resolution Program (“MDRP”) because “[it]

reflects Thrivent’s Christian belief system and strives to preserve

Members’ fraternal relationship.”202

The DOL rejected Thrivent’s request for an exemption from

BICE’s prohibition on class action waivers, and Thrivent now seeks an

injunction.203

According to Thrivent’s complaint “[t]he only way that

Thrivent could comply with the DOL’s [Fiduciary] Rule would be to

eliminate or change the MDRP Bylaw requirement from those

insurance contracts that are covered by the [Fiduciary] Rule, and to

permit class action litigation with respect to such products.”204

Thrivent asserts, under the Administrative Procedures Act, that the

DOL exceeded its statutory authority because “[n]othing in ERISA

gives DOL authority to preclude financial institutions and their clients

from entering into and enforcing arbitration agreements that include

class action waivers.”205

However, the DOL has express authority to promulgate rules that

further ERISA’s objective to “provid[e] . . . ready access to the federal

courts,” which was enacted 50 years after the FAA, supplies such

authority.206

Additionally, the DOL asserts that even the Supreme

Court’s vast reading of the FAA does not interfere with its BICE

because “[t]he exemption does not purport to render an arbitration

provision in a contract between a Financial Institution and a

Retirement Investor invalid, revocable, or unenforceable. Nor . . .

does [it] prohibit such waivers.”207

Finally, the DOL points to

Congress’s broad prohibition on principal transactions, coupled with

narrow exemptions and the authority delegated to the DOL to grant

additional conditional or unconditional administrative exemptions.208

While Thrivent strikes a sympathetic figure compared to most

entities subject to the Fiduciary Rule, the effect of Thrivent’s class

federal-ar. 201

Complaint at 10–11, Thrivent Fin. for Lutherans v. Perez, cv-03289 (D.

Minn. Sept. 29, 2016). 202

Id. at 14. 203

Id. at 24. 204

Id. 205

Id. at 27. 206

29 U.S.C. § 1001(b) (2006). 207


Memorandum In Support Of Defendants’ Opposition To Plaintiff’s Motion

For Summary Judgment And Defendants’ Cross-Motion For Summary Judgment, at

3, Thrivent Fin. for Lutherans v. Perez, cv-03289 (D. Minn. Sept. 29, 2016).


action waiver is consistent with the rest of the industry.209

Thrivent’s

suit gets to the heart of the cleverness of BICE’s structure and function

because the DOL has not actually prohibited the use of arbitration

agreements with class action waivers.210

Instead, the Rule, like

ERISA, protects investors from dangerous conflicts of interest by

prohibiting principal transactions and certain fee structures (as

expressly permitted by statute), but presents an option for companies

to exempt themselves from this part of the rule by meeting certain

criteria: one of which is that they not require customers to sign class

action waivers.211

Fiduciaries are free to employ class action waivers,

but if they choose to do so, they may not engage in principal

transactions or use certain fee structures.212

According to Thrivent, the products it sells and the fee structures it

uses leave Thrivent with “no real choice” but to rely on the BICE, and

the Fiduciary Rule’s “financial inducement [is] so coercive as to pass

the point at which pressure turns into compulsion.”213

However, the

Fiduciary Rule does present a choice, although indeed, like many other

companies in the industry, each option will require that Thrivent

change something in its business practices.214

That Thrivent does not

like its choices does not diminish their existence. This systemic

change in industry practices was one of the goals of the Fiduciary

Rule.

209

Thornton, supra note 200 (explaining that between 2011 and 2015, more than

5,400 Thrivent members submitted complaints, that Thrivent resolved 96 percent of

those complaints internally, and that only 16 complaints went to arbitration, to which

the company claims demonstrates “its ability to resolve disputes quickly and

amicably.” However, the question remains whether or not these disputes are properly

and fairly resolved or merely disposed of to the company’s benefit.). 210

Kitces, supra note 38, at 9–10. 211

See supra Section III.B. 212

Rule Exemption, supra note 41, at 21,118 (“Both Institutions and Advisers

remain free to invoke and enforce arbitration provisions, including provisions that

waive or qualify the right to bring a class action or any representative action in court.

Instead, such a contract simply does not meet the conditions for relief from the

prohibited transaction provisions of ERISA and the Code.”). 213

Mem. of Law in Support of P’s Motion for Summary Judgment, filed Nov. 4,

2016, at *25, Thrivent Fin. for Lutherans v. Perez, (D.C. Minn. 2016) (No.

0:16cv3289). 214

Rule Exemption, supra note 41, at 21,093 (“Accordingly, fiduciary advisers

may always give advice without need of an exemption if they avoid the sorts of

conflicts of interest that result in prohibited transactions. However, when they

choose to give advice in which they have a conflict of interest, they must rely upon

an exemption.”).

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[VOL. 17

V. MULTI-FRONT FIGHT AGAINST CLASS ACTION

WAIVERS

The DOL is not the only federal agency that has recognized the

problems presented by the widespread use of class action waivers in

arbitration agreements—the CFPB and NLRB have taken action to

limit the use of class action waivers in adhesion contracts. The

CFPB’s action has the support of express Congressional authority to

regulate pre-dispute arbitration agreements, and the NLRB has implied

similar authority in its implementing statute.215

Class action claims for breach of fiduciary duty under ERISA and

the new Fiduciary Rule represent an intersection of employment and

consumer financial protection law.216

The success of the CFPB or

NLRB will not directly grant the DOL similar license to regulate the

agreements because the DOL has a different authorizing statute.

Hopefully, these agencies’ actions will lend persuasive authority to

uphold the DOL’s Fiduciary Rule, which has already been challenged

in court by industry trade associations and individual regulated

entities. The actions of these agencies represent a marked shift in the

government’s attitude toward arbitration agreements and may re-open

an issue previously considered closed by the Supreme Court’s

definitive position on the FAA.

A. CFPB’s Proposed Rulemaking

In the wake of the 2008 financial crisis, Congress passed the 2010

Dodd-Frank Wall Street Reform (“Dodd-Frank”) and Consumer

Protection Act,217

which created the Consumer Financial Protection

Bureau (“CFPB” or “the Bureau”), to identify and prevent harmful

practices from within the financial industry.218

Specifically, Dodd-

215

See supra, Sections V.A. & V.B. 216

The ERISA Litigation Newsletter, PROSKAUER (Oct. 2012),

http://www.proskauer.com/publications/newsletters/erisa-litigation-newsletter-

october-2012/; Shannon Z. Petersen & Mercedes A. Cook, California Supreme

Court Holds Consumer Class Action Waivers in Arbitration Provisions are

Enforceable Under Federal Law, THE NAT’L LAW REV. (Aug. 6, 2015),

http://www.natlawreview.com/article/california-supreme-court-holds-consumer-

class-action-waivers-arbitration-provisions; Can Employers Prevent ERISA Class

Action Suits?, WINSTON & STRAWN (Dec. 17, 2013), http://www.winston.com

/en/benefits-blast/can-employers-prevent-erisa-class-action-suits.html; U.S. Supreme

Court Upholds Class Action Waivers in Arbitration, DINSMORE (Feb. 10, 2016),

http://www.dinsmore.com/us-supreme-court-upholds-class-action-waivers-in-

arbitration-02-10-2016/. 217

12 U.S.C. § 5301–5641 (2010). 218

Press Release, CFPB Proposes Prohibiting Mandatory Arbitration Clauses

continued . . .


Frank instructed the Bureau to examine the use of mandatory

arbitration clauses in consumer contracts in the financial services

industry219

and also granted the Bureau authority to issue regulations

consistent with the results of the study, in the interest of the public,

and for the purpose of protecting consumers.220

The consumer

financial products and services industry regulated by the CFPB

include companies engaged in money lending, storage, transfer, and

exchange.221

In its study, the CFPB found that members of the financial services

industry widely use pre-dispute arbitration agreements to block

consumers from bringing class actions in court.222

However, most

customers either did not know whether their contract contained an

arbitration clause or erroneously thought they could sue in court.223

Consumers rarely file individual cases in court or arbitration, so

requiring customers to waive their rights to participate in class

litigation has the effect of eliminating litigation altogether.224

The

CFPB concluded that class action litigation encouraged members of

the financial services industry to alter legally questionable activities

that Deny Groups of Consumers Their Day in Court (May 5, 2016),

http://www.consumerfinance.gov/about-us/newsroom/consumer-financial-

protection-bureau-proposes-prohibiting-mandatory-arbitration-clauses-deny-groups-

consumers-their-day-court/. 219

12 U.S.C. § 5518(a) (2010). 220

Id. at § 5518(b) (“The Bureau, by regulation, may prohibit or impose

conditions or limitations on the use of an agreement between a covered person and a

consumer for a consumer financial product or service providing for arbitration of any

future dispute between the parties, if the Bureau finds that such a prohibition or

imposition of conditions or limitations is in the public interest and for the protection

of consumers. The findings in such rule shall be consistent with the study conducted

under subsection (a).”). 221

CFPB’s Proposed Rulemaking, supra note 64, at 4–5. The rule would apply

to most providers that (1) regularly participate in decisions regarding consumer

credit under Regulation B implementing the Equal Credit Opportunity Act; (2)

extend or broker automobile leases as defined in Bureau regulation; (3) assist

consumers with debt or credit management or debt settlement; (4) provide directly to

a consumer a consumer report as defined in the Fair Credit Reporting Act; (5)

provide accounts under the Truth in Savings Act and services subject to the

Electronic Fund Transfer Act; (6) transmit or exchange funds (except when integral

to another product or service not covered by the proposed rule), certain other

payment processing services, and check cashing, check collection, or check guaranty

services consistent with the Dodd-Frank Act; and (7) collect debt arising from any of

the above by a provider of any of the above, their affiliates, an acquirer or purchaser

of consumer credit, or a person acting on behalf of any of these persons, or by a debt

collector pursuant to the Fair Debt Collection Practices Act. Id. 222

CFPB Study, supra note 68, at 9–10. 223

Id. at 11. 224

CFPB’s Proposed Rulemaking, supra note 64, at 95.

282 WAKE FOREST J.


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that harm consumers to avoid future litigation.225

In accordance with Dodd-Frank, the CFPB announced a proposed

rulemaking in May 2016 based upon the results of its study.226

First,

the new rule would prohibit companies from using pre-dispute

arbitration agreements to block consumer class actions.227

Secondly,

the new rule would require those subject to the rule to make records

relating to arbitral proceedings available to the Bureau, allowing the

Bureau to determine whether the proceedings indicate more

widespread or persistent company action that warrants closer

inspection.228

Fortunately, the express Congressional authority in

Dodd-Frank to “prohibit or impose conditions or limitations on” the

use of pre-dispute arbitration agreements within the regulated industry

will override the FAA’s preference for enforcement of arbitration

agreements.229

B. Class Action Waivers as Unfair Labor Practice

In 2012, the National Labor Relations Board (“NLRB”) first took

the position that requiring employees to waive their right to participate

in a class action waivers constitutes an unfair labor practice under the

National Labor Relations Act (“NLRA”).230

According to the NLRB,

the use of class action waivers in employment contracts violates

Section 7 of the NLRA, which guarantees employees the “right . . . to

engage in concerted activities for the purpose of collective bargaining

or other mutual aid or protection” in addition to forming and joining

labor organizations.231

The Seventh and Ninth Circuits adopted the NLRB’s reasoning.232

225

Id. at 103–107. 226

See generally, id. 227

Id. at 4. 228

Id. 229

See Id. at 21, 83. Such a “contrary congressional command” meets even

Justice Scalia’s strict interpretation of something sufficient to override the FAA. See

infra Section V.C. 230

See In Re D. R. Horton, Inc., 357 NLRB 2277, 2288 (2012) (“[W]e hold only

that employers may not compel employees to waive their NLRA right to collectively

pursue litigation of employment claims in all forums, arbitral and judicial.”)

(emphasis omitted). 231

Id. at 2277; 29 U.S.C. § 157 (1947). 232

See Morris v. Ernst & Young, 834 F.3d 975, 980–81 (9th Cir. 2016) cert.

granted No. 16-300, 2017 WL 125665 (U.S. Jan. 13, 2017); Henry D. Lederman et.

al., Seventh Circuit Finds Class Action Waivers in Arbitration Agreements Are

Illegal and Unenforceable Under the NLRA, LITTLER (May 27, 2016),

https://www.littler.com/publication-press/publication/seventh-circuit-finds-class-

action-waivers-arbitration-agreements-are.


In response to the argument that the FAA makes the arbitration

agreement and accompanying class action waiver enforceable, the

Ninth Circuit held that the FAA “does not dictate a contrary result,”

taking the logical position that “[t]he problem with the contract at

issue is not that it requires arbitration; it is that the contract term

defeats a substantive federal right to pursue concerted work-related

legal claims.”233

The Second, Eighth, and Fifth Circuits, on the other

hand, have rejected the NLRB’s position.234

As a result of this

disagreement among the circuits, the NLRB has requested that the

Supreme Court rule on whether class action waivers are illegal under

NLRA and unenforceable under the FAA’s savings clause.235

A

victory for the NLRB would provide persuasive precedent to support

the DOL’s regulation of class action waivers in its Fiduciary Rule, as

each agency’s authority to regulate class action waivers stands upon

similar footing, the authority in both cases being implied from the

statutory language.236

Additionally, any Supreme Court precedent

acknowledging scenarios in which arbitration agreements may be

unenforceable is a step in the right direction.

C. Overriding the FAA

The FAA can be “overridden by a contrary congressional

command” or a judge-made exception “allowing courts to invalidate

agreements that prevent the ‘effective vindication’ of a federal

statutory right.”237

In the face of a challenge, a court would likely

uphold the CFPB’s Proposed Rulemaking under the “contrary

congressional command” exception.238

While the DOL’s authority to

regulate class action waivers could logically be found in ERISA’s

express statutory objective of “provid[ing] ready access to the federal

courts,” the Supreme Court has, so far, narrowly interpreted this

233

Morris, 834 F.3d at 985. 234

See e.g., Murphy Oil USA, Inc. v. NLRB, 808 F.3d 1013 (5th Cir. 2015);

D.R. Horton, Inc. v. NLRB, 737 F.3d 344 (5th Cir. 2013); Sutherland v. Ernst &

Young LLP, 726 F.3d 290, 297 n.8 (2d Cir. 2013); Owen v. Bristol Care, Inc., 702

F.3d 1050, 1055 (8th Cir. 2013). 235

Lawrence E. Dube, NLRB, Employers Urge Justices to Rule on Class

Waivers, BLOOMBERG BNA (Sept. 13, 2016), http://www.bna.com/nlrb-employers-

urge-n57982076885/. 236

However, it is relevant because, like in consumer contracts, “[e]mployment

arbitration agreements now ‘typically’ contain class action waivers.” Id. 237

Am. Express Co. v. Italian Colors Rest., 133 S. Ct. 2304, 2309–10 (2013). 238

Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 105 S. Ct. 3346,

3354–55 (1985) (holding that the exception is met if the law at issue “evinc[es] an

intention to preclude a waiver” of class-action procedure).

284 WAKE FOREST J.


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exception.239

The NLRB’s case pending before the Court may shed

some light on whether such authority can be inferred from a statute.240

The DOL’s authority to limit the use of class action waivers is

more likely found in the “effective vindication”241

exception, which is

the Court’s “willingness to invalidate, on ‘public policy’ grounds,

arbitration agreements that operate as a prospective waiver of a party’s

right to pursue statutory remedies.”242

While Justice Scalia also

interpreted this exception narrowly,243

Justice Kagan’s dissent in

American Express v. Italian Colors Restaurant provides strong

support for a broader application that could easily encompass the

Fiduciary Rule.244

In Italian Colors, the potential recovery for the

plaintiff of $38,549 was inadequate to justify the costs necessary to

establish the necessary elements of the claim, even in arbitration,

which included the cost of an expert report with “an economic analysis

defining the relevant markets, establishing Amex’s monopoly power,

showing anti-competitive effects, and measuring damages.”245

Such a

report costs “between several hundred thousand and one million

dollars”—“ten times what [the plaintiff] could hope to gain.”246

Justice Kagan found this to be “prohibitively expensive” and would

have held that the effective vindication doctrine allowed the Court to

invalidate the arbitration agreement that blocked class action claims.247

Should the Fiduciary Rule’s provisions be considered contrary to

the FAA, the DOL could override the FAA because of the similarities

between the practical realities of Italian Colors and those likely to be

found in a breach of fiduciary duty case. The expense of arbitration

combined with the cost of hiring experts to support the case would far

outstrip the amount a plaintiff could hope to gain. As such, using

Justice Kagan’s reasoning, a court could find that that the effective

vindication doctrine allows invalidation of arbitration agreements in

investment advice contracts.

The Thrivent case may present a unique opportunity for a court to

239 See Am. Express Co., 133 S. Ct. at 2309–10.

240 See Lederman, supra note 232.

241 Am. Express Co., 133 S. Ct. at 2310.

242 Id.

243 Scalia seems to hold that this doctrine would only apply to a provision that

precludes a party’s ability to assert his statutory right, and would “perhaps cover

filing and administrative fees attached to arbitration that are so high as to make

access to the forum impracticable.” He held that not having a financial incentive to

bring an individual case in arbitration was not enough to show elimination of the

right to pursue a remedy. Id. at 2310–11. 244

Id. at 2313 (Kagan, J., dissenting). 245

Id. at 2316. 246

Id. 247

Id.


answer a few relevant questions: Does the BICE violate the FAA

despite the choices it provides to regulated entities? Does ERISA’s

express objective to provide ready access to the federal courts qualify

as a “contrary congressional command” to override the FAA?248

Does

an arbitration agreement with a class action waiver preclude “effective

vindication” of a party’s rights when the costs of litigation are high

and the individual amounts of damages are low?249

Or, is it time to

recognize that class action waivers in consumer contracts of adhesion

have “insulated powerful economic interests from liability” and

resulted “in the deprivation of consumers’ rights”?250

VI. CONCLUSION: GIVING FEDERAL AGENCIES THE

TOOLS THEY NEED TO PROTECT TODAY’S CONSUMERS

The current Supreme Court’s jurisprudence largely ignoring the

practical consequences of a policy of a blanket enforcement of class

action waivers in arbitration agreements in consumer contracts of

adhesion has constructed a hurdle for state and federal consumer

protection agencies. As persuasive research documenting the

crippling effect of class waivers mounts, as more agencies produce

policy limiting their use, and as Congress permits cracks in the FAA’s

shield to form, overcoming the Supreme Court’s hurdle will hopefully

become easier. While the DOL’s shrewd work-around has a fighting

chance of withstanding challenges by the investment industry, a

jurisprudence that requires such convoluted rule construction to

accomplish an express statutory objective signals a need for change.

Perhaps the Supreme Court is poised to adjust its approach to the

FAA, but if Congress indeed recognizes the vast change that has

occurred in the nature of consumer contracts during the last ninety

years and the unjust consequences of permitting companies to write

immunity from small-scale liability into consumer contracts, decisive

legislative action permitting regulation of class action waivers would

provide the simplest, most effective resolution.

248

American Exp. v. Italian Colors Restaurant, 133 S. Ct. 2304, 2309 (2013). 249

Id. at 2316 (Kagan, J., dissenting). 250

DIRECTV, Inc. v. Imburgia, 136 S.Ct. 463, 477 (2015) (Ginsberg, J.,

dissenting).




ADAPTING THE USPTO’S UNLAWFUL USE DOCTRINE

FOR THE FEDERAL COURTS

Bethany Rabe†

I. INTRODUCTION ............................................................. 289

II. DEVELOPMENT OF THE UNLAWFUL USE DOCTRINE

AT THE USPTO AND MODERN UNLAWFUL USE CASE

LAW IN THE FEDERAL COURTS ..................................... 291 A. BACKGROUND ........................................................... 291

1. Trademark Law in the United States ....................... 291 2. Acquiring and Protecting Trademark Rights .......... 292 3. The Role of USPTO & TTAB .................................. 293 4. The Role of the Federal Courts ............................... 296

B. THE UNLAWFUL USE DOCTRINE............................... 298 1. The Unlawful Use Doctrine at the USPTO ............. 298 2. The Unlawful Use Doctrine in the Federal

Courts ....................................................................... 307

III. APPLICATION OF THE UNLAWFUL USE DOCTRINE

IN THE FEDERAL COURTS .............................................. 314 A. IS THERE A HISTORICAL BASIS FOR THE DOCTRINE

IN THE FEDERAL COURTS? ......................................... 315 1. Pre-Lanham Act Treatment of Unlawful Use .......... 315 2. Unlawful Use Under the Lanham Act ..................... 321 3. Pre-CreAgri Federal Case Law .............................. 324

† Bethany Rabe is an attorney practicing in Las Vegas, Nevada. Many thanks to the

people who took the time to comment on drafts of this paper or otherwise support

this effort: Christopher Bavitz, Rebecca Tushnet, Jane Bestor, Susannah Barton

Tobin, Lauri Thompson, Mark Tratos, Shauna Norton, and the editors of the Wake

Forest Journal of Business and Intellectual Property Law. Any errors, however, are

mine alone.

2017] ADOPTING THE USPTO’S UNLAWFUL

USE DOCTRINE

287

B. IS ADOPTING THE UNLAWFUL USE DOCTRINE

GOOD POLICY? ........................................................... 329 1. Consumer Protection as a Policy Objective ........... 330 2. Deterrence and/or Punishment as a Policy

Objective ................................................................... 330

IV. PRACTICAL CONSIDERATIONS FOR APPLYING THE

UNLAWFUL USE DOCTRINE IN THE FEDERAL

COURTS ........................................................................... 333 A. COURTS MUST RESOLVE THE ISSUE OF THE

UNLAWFUL USE DOCTRINE’S INTERACTION WITH

STATE AND FEDERAL LAW ......................................... 334 1. Does the Unlawful Use Doctrine Operate to Put

State Law Over Federal Law? .................................. 334 2. Does the Application of the Unlawful Use

Doctrine Make the Lanham Act a “Back Door”

for Enforcement of Statutes With No Private

Cause of Action? ....................................................... 336 B. PRACTICAL CONSIDERATIONS FOR COURTS

APPLYING THE UNLAWFUL USE DOCTRINE AND

SUGGESTIONS FOR ADDRESSING THEM ...................... 338 1. District Courts Must be Mindful of the Effect of

the Doctrine .............................................................. 338 2. District Courts Must Apply a Clear, Thoughtful,

and Consistent Standard ........................................... 339 3. Evidence/Procedure ................................................ 343 4. What effect should a finding of the USPTO

have? ......................................................................... 345 5. When and How Courts Should Make the

Determination ........................................................... 347

V. CONCLUSION ............................................................... 348

288 WAKE FOREST J.


[VOL. 17

Abstract

This paper examines the unlawful use doctrine in trademark law,

formerly confined to the USPTO, as now being applied in the federal

courts. Specifically, this paper looks at the explosion of cases that

have involved the doctrine since the Ninth Circuit first announced a

federal-court version in 2007. It first examines whether there is a

historical, statutory, or policy basis for the doctrine’s application in

the federal courts. Then, it identifies several issues that should be

addressed before the federal courts move forward with broad

application of the doctrine, and it examines some practical issues

federal courts should consider.

Given that there is little historical, statutory, or policy support for

the doctrine’s application in the federal courts, and especially that the

doctrine would seem to create results counter to the consumer

protection function of trademark law, I argue that the doctrine should

be carefully considered and rarely applied.


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I. INTRODUCTION

Suppose I have been using the otherwise-valid-and-protectable

mark ACME in connection with a nutritional supplement for many

years. I have a loyal customer base and have invested in the quality

and reputation of my goods. A new market entrant emerges, also

using ACME in connection with supplements. Concerned, I file a

trademark infringement lawsuit; the new entrant defends by arguing

that I have no rights at all. How could I have no rights? I’ve been

using a valid and protectable mark in connection with my supplements

for years. Consumers know my product and rely upon the ACME

mark as an indication of origin and quality. But I have overlooked

something in the course of starting my business: the label on my

product does not comply with federal law.

Will my opponent succeed in voiding my rights and becoming the

senior user? The answer depends on whether and how the court

applies the “unlawful use” doctrine. Formerly confined to the United

States Patent and Trademark Office (“USPTO”), where the stakes are

registration-only and the doctrine is narrowly applied, in recent years

the doctrine has begun to migrate to the federal courts, where it is

being used in a much broader context to affect priority of use.

Unfortunately for consumers who rely upon the ACME mark, it is

quite possible that my inadvertent labeling violation could strip me of

my rights, leaving only the junior user in the marketplace.

One of the first things a budding trademark lawyer learns is the

difference between registration and use. Registration permits someone

using (or intending to use) a trademark to register that mark with the

USPTO, and there are certainly benefits to registration that make

doing so worthwhile.1 However, there is no requirement to register

the mark in order to use it, or even to enforce rights in it.2 Moreover,

the mere fact that a mark has proceeded to registration is not a

guarantee that the mark is not infringing.3 Even if there were no

similar marks on the register, persons with unregistered (common law)

rights in the mark can sue for infringement and, depending on who

started using the mark first, can potentially strip the registrant of both

his registration and his right to use the mark.4

This paper focuses on a doctrine that impacts both registration and

1 U.S. PATENT & TRADEMARK OFFICE, PROTECTING YOUR TRADEMARK:

ENHANCING YOUR RIGHTS THROUGH FEDERAL REGISTRATION 9–10 (2014),

http://www.uspto.gov/sites/default/files/trademarks/basics/BasicFacts.pdf

[hereinafter Protecting Your Trademark]. 2 Id.

3 Id. at 8.

4 Id.

290 WAKE FOREST J.


[VOL. 17

use: the unlawful use doctrine. As a policy of the USPTO, it can

operate to prevent a mark from registering where the mark is used in a

way that is considered unlawful.5 This could be an attempt to register

a mark in connection with heroin, or it could be that the specimen

submitted with the application is not in compliance with FDA labeling

regulations. The USPTO construes the doctrine fairly narrowly and

when it does apply the doctrine, the result is that registration is either

denied or cancelled.6 The user’s ability to actually use the mark in

connection with his or her goods and services is not affected by a

USPTO determination of unlawfulness.7

In recent years, however, this cousin of the unclean hands doctrine

has made its way from the USPTO to federal court, where its

implications are much broader. The Ninth Circuit has essentially

adopted the USPTO’s doctrine, but has applied it to infringement

instead of registration.8

Now, unlawful use of a mark affects not just

whether a mark can be registered, but whether a mark can be used at

all: the Ninth Circuit has in effect held that rights cannot develop

during periods of time when a use is unlawful.9 This represents a

significant expansion of the doctrine; junior users could become senior

users, and senior users could potentially find themselves without rights

in marks that they’ve used for years. Consumers—the supposed

beneficiaries of trademark law—could face confusing market

conditions, often in areas where trademark protection is most

important such as nutritional supplements, food, or drugs.

Despite the seriousness of the consequences, there has not been an

in-depth analysis on this topic. As such, in this paper, I examine

whether the unlawful use doctrine can and should be applied in the

federal courts, in light of history and policy. I also examine: practical

considerations for courts faced with applying the unlawful use

doctrine, such as which aspects of the USPTO’s policy should be

imported and which should not; evidentiary considerations such as

burden of proof and what evidence will support an unlawful use

argument; timing within a lawsuit; and whether USPTO findings in

this area should have a preclusive effect. Overall, I argue that the

application of the doctrine in the federal courts should be careful and

rare.

5 Kieran G. Doyle, Trademark Strategies for Emerging Marijuana Businesses,

WESTLAW J. INTELL. PROP., May 14, 2014, at 1. 6 Id.

7 See id. at 3.

8 CreAgri, Inc. v. USANA Health Scis., Inc., 474 F.3d 626, 630 (9th Cir. 2007).

9 Id. at 630, 633–34 (9th Cir. 2007); S. Cal. Darts Ass’n v. Zaffina, 762 F.3d

921, 931 (9th Cir. 2014).


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II. DEVELOPMENT OF THE UNLAWFUL USE DOCTRINE AT THE

USPTO AND MODERN UNLAWFUL USE CASE LAW IN THE FEDERAL

COURTS

A. Background

To fully understand the complexities of the unlawful use doctrine

and the role, if any, it should play in the federal courts, it is important

to understand the structure of trademark law in the United States. A

complete review of this topic is beyond the scope of this paper, but a

brief summary will serve to orient the reader so as to better understand

the discussion and suggestions in subsequent sections.

1. Trademark Law in the United States

“Trademark law” refers to the body of law governing the use of

trademarks. A trademark is essentially anything—although most often

a word or symbol—that someone selling goods or services uses to

signal the origin of those goods or services to consumers.10

In

layman’s terms, most trademarks are brand names or logos.11

While other protections for intellectual property (i.e., patents and

copyrights, right of publicity, trade secret) serve largely to protect the

owner of that intellectual property, trademark law primarily serves a

consumer protection function.12

Essentially, trademark law attempts

to ensure that when a consumer encounters a particular mark in the

marketplace, she can rely on that mark to inform her that the goods she

is purchasing come from a particular source.13

The purpose of

trademark law is to “protect the public so it may be confident that, in

purchasing a product bearing a particular trade-mark which it

favorably knows, it will get the product which it asks for and wants to

get.”14

It also protects trademark owners, in that “where the owner of

a trade-mark has spent energy, time, and money in presenting to the

public the product, he is protected in his investment from its

misappropriation by pirates and cheats.”15

10 Protecting Your Trademark, supra note 1, at 1.

11 Id.

12 Graeme B. Dinwoodie, The Death Of Ontology: A Teleological Approach To

Trademark Law, 84 IOWA L. REV. 611, 628–30 (1999). 13

Michael S. Mireles, Jr., Towards Recognizing and Reconciling the

Multiplicity of Values and Interests in Trademark Law, 44 IND. L. REV. 427, 429

(2011) (citing Two Pesos, Inc. v. Taco Cabana, Inc., 505 U.S. 763, 767–68 (1992)). 14

Two Pesos, Inc. v. Taco Cabana, Inc., 505 U.S. 763, 782 n.15 (1992)

(Stevens, J., concurring) (quoting S. REP. NO. 79-1333, at 3 (1946)). 15

Id.

292 WAKE FOREST J.


[VOL. 17

2. Acquiring and Protecting Trademark Rights

In the United States, trademark rights develop based on use in

commerce, regardless of whether or not a person registers that mark

with the federal or state government.16

These rights are called

“common law” trademark rights.17

Unlike a copyright owner, for

example, a trademark owner may sue to enforce his common law

trademark rights without a registration.18

Of course, there are benefits

to federal registration, the most significant being the exclusive right to

use the mark nationwide in connection with the goods and services in

the registration, as well as a legal presumption of validity of the

mark.19

Other important benefits include: public notice of the claim to

ownership of the mark, the ability to record the registration with the

Customs and Border Protection Service to prevent importation of

infringing goods, and the ability to use the mark to facilitate

registration in foreign countries.20

In the last twenty years or so,

another key benefit has been the ability to use the registration as a

basis for speedy removal of infringing domain names and other

infringing content online.21

Whether registered or not, the most important date in trademark

law is the date of first use in commerce. Because the principle

underlying trademark protection is that distinctive marks can help

consumers distinguish one artisan’s goods from another, the person

who uses the mark in commerce first acquires priority rights in and to

the mark.22 This person is often referred to in trademark law as being

the “senior user” or having “priority of use.” 23 In the event of a

conflict between two parties who are using similar marks, the party

16

U.S. DEP'T OF COMMERCE, U.S. PAT. & TRADEMARK OFF., TRADEMARK

MANUAL OF EXAMINING PROCEDURE § 901.03 (2017),

https://tmep.uspto.gov/RDMS/TMEP/current#/current/TMEP-900d1e1.html

[hereinafter TMEP]. 17

Common Law Trademark Rights, BITLAW,

http://www.bitlaw.com/trademark/common.html (last visited Feb. 18, 2017). 18

Trademark, Patent, or Copyright?, U.S. PAT. & TRADEMARK OFF.,

https://www.uspto.gov/trademarks-getting-started/trademark-basics/trademark-

patent-or-copyright (last visited Feb. 18, 2017). 19

See B & B Hardware, Inc. v. Hargis Indus., Inc., 135 S. Ct. 1293, 1300

(2015). 20

Protecting Your Trademark, supra note 1, at 9–10. 21

See In re Tam, 785 F.3d 567, 576 (Fed. Cir. 2015) (noting the ability to

prevent cybersquatters from misappropriating domain name). 22

B & B Hardware, Inc., 135 S. Ct. at 1299 (2015). 23

What is Trademark Priority and Why Should I Care?, TINGEN & WILLIAMS,

https://tingenwilliams.com/2015/trademark-priority-care/3876 (last visited Feb. 18,

2017).


USE DOCTRINE

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with the earlier date of use is said to have priority of use and can stop

competing users from using the mark.24 This date is hotly contested in

litigation, as each party attempts to show that it began using the mark

before its rival.

There is thus an incentive for trademark users to claim the earliest

supportable date of first use and there is also an incentive for those

contesting that date to challenge it by any means possible. Frequently,

a challenger will claim that his rival’s first uses were “token” uses, or

inconsistent, or not used as an actual trademark, or used in a different

form that shouldn’t “count” toward the development of his rights.25

This paper focuses on one particular method of challenging priority

that has become very popular in the last ten years: claiming that the

use that gives rise to priority was in some way unlawful, because

according to the modern unlawful use doctrine, unlawful use cannot

give rise to trademark rights.26

3. The Role of USPTO & TTAB

Because the unlawful use doctrine was originally a creature of the

USPTO and the Trademark Trial and Appeal Board (“TTAB”), and

because so many of the decisions that are influential in this area are

TTAB decisions, it is important to briefly review how the TTAB (and

by extension, the USPTO) fits into the overall framework of trademark

law in the United States.

The USPTO is a federal agency that falls under the executive

branch of government.27

When a business owner decides to adopt a

particular mark in connection with her goods, she can apply to register

her trademark with the USPTO.28

If the mark is already in use in

commerce, the applicant must attach evidence (called a “specimen”) to

the application showing how the mark is used in commerce.29

If she

has not begun using the mark, she can file an intent-to-use

application.30

An intent-to-use application basically reserves the mark,

so that if the application does proceed to registration, the priority date

(the date from which the registrant has exclusive nationwide rights)

24

Common law rights are limited to the geographic area of use. A registration

will operate to prevent use by others across the nation. Id. 25

Margreth Barrett, Article & Essay: Finding Trademark Use: The Historical

Foundation For Limiting Infringement Liability To Uses “In The Manner Of A

Mark”, 43 WAKE FOREST L. REV. 893, 955 (2008). 26

See infra Section III. 27

See generally Protecting Your Trademark, supra note 1. 28

Id. at 1–2. 29

Id. at 18–19. 30

Id.

294 WAKE FOREST J.


[VOL. 17

will be the date of filing of the application.31

After she files her application, an examining attorney reviews it

and alerts her to any problems.32

If there are no problems with the

application (or if all problems are resolved in the course of the

application process), the application is published for opposition in the

Official Gazette of the USPTO; during this thirty-day window, anyone

who believes that he or she would be damaged by the registration of

the mark can file an opposition (discussed infra).33

If no one opposes,

the application proceeds to registration.34

The next step in the

registration process differs slightly depending on whether the

application is an intent-to-use or use-based application.

The TTAB is an administrative tribunal of the USPTO that is

empowered to determine the right to register a mark.35

It can be

thought of as the judicial branch of the USPTO (although it is not an

Article III court), and issues written orders much like a federal court

would.36

For the purposes of this paper, the TTAB enters the process

in several different ways.

First, the TTAB sometimes acts as an appellate court.37

It has

jurisdiction over ex parte appeals, i.e., appeals from the examining

attorney’s refusal to register the mark.38

As noted above, as the

trademark application proceeds through the registration process, it is

reviewed by the examining attorney.39

If there are problems with the

application, the examining attorney may issue an office action denying

registration.40

Some of these office actions are easily fixed; for

example, the description of the goods and services may need to be

amended. Some, however, are more complex; the examining attorney

31

Id. at 19. 32

Id. at 22. 33

15 U.S.C. § 1063(a) (2012); U.S. DEP'T OF COMMERCE, PAT. & TRADEMARK

OFF., TRADEMARK TRIAL AND APPEAL BOARD MANUAL OF PROCEDURE §§ 102.02,

303.01 (2017),

https://mpep.uspto.gov/RDMS/TBMP/current#/current/tbmpd0e18.html [hereinafter

TBMP]. 34

Trademark Process, U.S. PAT. & TRADEMARK OFF.,

https://www.uspto.gov/trademarks-getting-started/trademark-process (last visited

Feb. 6, 2017). 35

TBMP, supra note 33, § 102.01. 36

Hope Hamilton, Parsing the Standard of Review Puzzle: How Much

Deference Should Federal District Courts Afford Trademark Trial and Appeal

Board Decisions?, 12 FED. CIR. B. J. 489, 492 (2003). 37

E.g., 3 J. THOMAS MCCARTHY, MCCARTHY ON TRADEMARKS AND UNFAIR

COMPETITION § 21:1 (4th ed. 2016). 38

Id. 39

Trademark Process, supra note 34. 40

Id.


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295

might find that the mark is likely to result in consumer confusion with

another registered mark.41

Although the applicant has the right to

respond to the office action, if the examining attorney does not change

her mind based on the applicant’s arguments in response, the

examining attorney will issue a final office action denying

registration.42

At that point, the applicant may file an ex parte appeal

to the TTAB.43

In this circumstance, the TTAB acts as an appellate

court; the applicant is the appellant, and the examining attorney acts as

the appellee.44

No new evidence is submitted; the TTAB simply

conducts an appellate review of the examiner’s decision.45

Second, the TTAB sometimes acts as a trial court. It has

jurisdiction over opposition proceedings (where one party challenges

another party’s application to register a mark) and cancellation

proceedings (where one party challenges another party’s right to

maintain its trademark after registration).46

These proceedings are

similar in feel to a civil action in court; the opposing party files a

complaint, the applicant files an answer, and the matter proceeds to

discovery.47

The TTAB takes evidence, including transcribed

testimony, and the parties can request oral argument.48

Finally, and less commonly, the TTAB has jurisdiction over

concurrent use proceedings.49

In a concurrent use proceeding, an

applicant, who knows of others using the mark, files an application for

registration that provides information regarding others who are using

the same or similar mark.50

Assuming that there are no other problems

with the application, proceedings before the TTAB will commence to

determine whether the concurrent use registration will be granted (for

41

Possible Grounds for Refusal of a Mark, U.S. PAT. & TRADEMARK OFF.,

https://www.uspto.gov/trademark/additional-guidance-and-resources/possible-

grounds-refusal-mark# (last visited Feb. 6, 2017). 42

TBMP, supra note 33, § 805. 43

15 U.S.C. § 1070 (2012) (“An appeal may be taken to the Trademark Trial

and Appeal Board from any final decision of the examiner in charge of the

registration of marks upon the payment of the prescribed fee.”); TBMP, supra note

33, § 102.02 (“The Board also has jurisdiction over ex parte appeals, that is, appeals

from an examining attorney’s final refusal to register a mark in an application.”). 44

See TBMP, supra note 33, § 1200. 45

See MCCARTHY, supra note 37, § 21:3. 46

15 U.S.C. § 1064 (2012); TBMP, supra note 33, §§ 102.02, 303.01. 47

TBMP, supra note 33, § 102.03. 48

B & B Hardware, Inc. v. Hargis Indus., Inc., 135 S. Ct. 1293, 1300 (2015). 49

The TTAB also has jurisdiction over interference proceedings. See TBMP,

supra note 33, § 102.02. However, since these proceedings are not relevant to this

paper, they are not discussed here. 50

Id. § 1102.01.

296 WAKE FOREST J.


[VOL. 17

example, via evidence of prior use in a limited geographic area).51

4. The Role of the Federal Courts52

The federal courts come into play in two ways: as courts of appeal

from the TTAB and as courts of first instance. Both are relevant here.

a. The Federal Courts as Courts of Appeal from the TTAB

The federal courts sometimes act as courts of appeal after a TTAB

proceeding. A party that is dissatisfied with a TTAB decision may

appeal to either a U.S. District Court or the Federal Circuit Court of

Appeals.53

In the Federal Circuit, the review is on a closed record,

meaning no additional evidence is presented.54

The review of legal

determinations is de novo, and the review of factual determinations is

conducted pursuant to the Administrative Procedure Act.55

In the district court, there is an opportunity to present additional

evidence and raise additional claims.56

“The district court has

authority independent of the PTO to grant or cancel registrations and

to decide any related matters such as infringement and unfair

competition claims.”57

Where new evidence is submitted, the district

court reviews the entire record de novo.58

b. The Federal Courts as Courts of First Instance

Concurrent With or Separate From the USPTO

The other way in which the federal courts can be involved is

through lawsuits regarding infringement that arise irrespective of (or

concurrently with) proceedings before the USPTO or TTAB. For

example, a competing business may begin using a mark that infringes

upon a registered mark, causing the registered mark owner to sue for

51

TMEP, supra note 16, § 1207.04(e). 52

It is worth noting that state courts can also hear trademark disputes involving

federally registered marks. However, as federal courts are the focus of this article, I

limit this discussion to the role of federal courts. 53

15 U.S.C. § 1071 (2015). 54

Vosk Int’l Co. v. Zao Gruppa Predpriyatij Ost, No. C11–1488RSL, 2013 WL

5588296, at *2 (W.D. Wash. 2013). 55

5 U.S.C. § 706 (2015); MCCARTHY, supra note 37, § 21:17.50. 56

Vosk, 2013 WL 5588296, at *2. 57

Swatch AG v. Beehive Wholesale, LLC, 739 F.3d 150, 155 (4th Cir. 2014). 58

Id. at 156 (citing Kappos v. Hyatt, 132 S. Ct. 1690, 1700 (2012)). This is a

relatively new rule; prior to the Kappos case in 2012, courts acted as appellate

reviewers of the facts found by the TTAB and fact-finders with respect to new

evidence submitted. See MCCARTHY, supra note 37, § 21:22.


USE DOCTRINE

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trademark infringement under the Lanham Act without ever involving

the USPTO in the substance of the case. Or, a party can sue another

party for trademark infringement in federal court while USPTO

proceedings are ongoing.59

There are many reasons why a litigant would choose federal court

over merely proceeding before the USPTO; 60

one key factor (that is

particularly relevant here) is that the USPTO only controls

registration.61

After a TTAB action, the result is that a prevailing

trademark owner has either successfully kept a mark from registering,

or has succeeded in removing the mark from the register; however,

damages and injunctive relief are not available from the TTAB, and

because registration is separate from use, the USPTO cannot stop

anyone from using a particular mark.62

By the same token, causes of

action over which the USPTO would have no authority, such as claims

for unfair competition, right of publicity, or state law trademark

infringement can be brought in federal court.63

Speed is also a factor;

for someone who needs an infringing use to stop now, a temporary

restraining order and preliminary injunction can issue quickly.64

There

is no analogue at the USPTO. It is worth noting, however, that

although the USPTO cannot do what the federal courts can do, the

federal courts can in some ways do what the USPTO does, namely,

cancel registrations during the course of infringement litigation.65

59

See, e.g., B & B Hardware, Inc. v. Hargis Indus., Inc., 135 S. Ct. 1293, 1299

(2015). 60

See, e.g., Elizabeth C. Buckingham, TTAB or Federal Court: Where to

Litigate a U.S. Trademark Dispute? Part Two: Civil Lawsuits in Federal Court,

INTA BULLETIN (February 15, 2012),

http://www.inta.org/INTABulletin/Pages/TTABorFederalCourtWheretoLitigateaUS

TrademarkDisputePartTwoFederalCourt.aspx. 61

Id. 62

Id.; see also About the Trademark Trial and Appeal Board, U.S. PAT. &

TRADEMARK OFF., http://www.uspto.gov/trademark/laws-regulations/trademark-

trial-and-appeal-board (last visited Feb. 18, 2017) (“The Board is not authorized to

determine whether you have the right to use a trademark, just whether you have the

right to register it. Additionally, the Board is not authorized to determine questions

of trademark infringement or unfair competition or to award money damages or

attorney's fees. For anything other than determining the right of federal registration,

you must file a case in federal or state court.”). 63

Id. 64

Buckingham, supra note 60. 65

See, e.g., 15 U.S.C. § 1119 (2012) (“In any action involving a registered mark

the court may determine the right to registration, order the cancelation of

registrations, in whole or in part, restore canceled registrations, and otherwise rectify

the register with respect to the registrations of any party to the action.”); B & B

Hardware, Inc. v. Hargis Indus., Inc., 135 S. Ct. 1293, 1307 (2015). For an

explanation of why one might choose the TTAB over federal court proceedings, see

continued . . .

298 WAKE FOREST J.


[VOL. 17

Federal court infringement cases proceed like any other federal

court case and are subject to appeals in the same way as any other

case. For the most part, the two proceedings—USPTO and federal

court—are separate from one another.66

Likewise, although the

examiner is asking a similar question when she examines the

application—is there a likelihood of consumer confusion?—the

inquiries are conducted using slightly different factors,67

and the

USPTO looks at the marks in isolation, not based on actual use in the

marketplace.68

In rare cases, TTAB decisions can be binding in federal court, but

only if the factors supporting issue preclusion are present.69

In a

recent Supreme Court case, the Court held that a decision as to

likelihood of confusion by the TTAB was binding on the district court

in a concurrent infringement proceeding.70

B. The Unlawful Use Doctrine

The modern unlawful use doctrine, as adopted by the Ninth Circuit

in 2007, has its origins in the USPTO. This section discusses the

development (and subsequent limitation) of the USPTO’s doctrine and

then considers the modern application of the doctrine in the Ninth

Circuit and elsewhere.71

1. The Unlawful Use Doctrine at the USPTO

The current unlawful use doctrine is codified in the USPTO’s

regulations.72

However, two cases that preceded the adoption of the

regulation formed the foundation of the modern unlawful use doctrine.

Buckingham, supra note 60. 66

However, it is common for the TTAB to grant a request to suspend

proceedings pending the outcome of federal court proceedings. See TBMP, supra

note 33, § 510.02(a). Federal courts can also suspend their own proceedings to await

TTAB determination. See id. 67

The TTAB evaluates the thirteen DuPont factors laid out in In re E.I. DuPont

DeNemours & Co., 476 F.2d 1357, 1361 (C.C.P.A. 1973); See B & B Hardware,

Inc., 135 S. Ct. at 1301. The Ninth Circuit, for example, uses the eight-factor test

from AMF Inc. v. Sleekcraft Boats, 599 F.2d 341, 348–49 (9th Cir. 1979). 68

See B & B Hardware, Inc., 135 S. Ct. at 1307–08. 69

Id. at 1302–06. 70

Id. at 1310. 71

There may be valid arguments that the USPTO should not have an unlawful

use doctrine at all; after all, there is no express corollary in patent or copyright law.

Nevertheless, this paper takes as a given the existence of the unlawful use doctrine in

the USPTO setting. 72

37 C.F.R. §2.69.


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299

a. Early Manifestations of the Doctrine

The first case to address the issue as such was Coahoma Chemical

Co., Inc. v. Howerton Gowen Co., Inc., decided in 1957.73

There, two

registrations for BLACK PANTHER in connection with insecticides

were cancelled under what would become the unlawful use doctrine.74

The Assistant Commissioner noted that the issue was “one of first

impression, namely, does the user of a trademark on goods which

could not be lawfully shipped in interstate commerce acquire

registrable rights superior to those of a later user whose goods were

lawfully shipped in interstate commerce?”75

The Assistant

Commissioner examined whether the party using the BLACK

PANTHER mark had acquired rights “either at common law or under

the Federal trademark statute, as a result of its unlawful shipments…in

violation of the North Carolina Insecticide Fungicide and Rodenticide

Act of 1947,76

and shipments interstate in violation of the Federal

Economic Poisons Act[.]”77

On the basis of the conclusion that “use

of a mark in connection with unlawful shipments in interstate

commerce is not use of a mark in commerce which the Patent Office

may recognize,” the petitioner was deemed the first to use its mark,

and the registrations were cancelled.78

Next, the TTAB decided In re Taylor in 1962. There, the

applicant sought to register CHUCK-A-BURGER for various

restaurant and take-out food items.79

The registration was refused, and

the applicant appealed.80

Among its reasons for affirming the

examining attorney’s decision to refuse registration, the TTAB noted

that the specimens submitted with the application did not comply with

the Food, Drug, and Cosmetic Act’s requirements.81

As such, the

TTAB concluded, “their use in interstate commerce cannot be

73

Coahoma Chem. Co., Inc. v. Howerton Gowen Co., Inc., 113 U.S.P.Q. 413

(Com’r Pat. & Trademarks 1957), aff’d on other grounds, 264 F.2d 916 (C.C.P.A.

1959). However, the Smith v. Coahoma Chem. Co., 264 F.2d 916 (C.C.P.A. 1959),

decision notes that there were numerous other cases touching on similar issues. 74

See Coahoma Chem. Co., Inc., 113 U.S.P.Q. 413. 75

Id. at 417. See also Smith, 264 F.2d at 916. 76

Coahoma Chem. Co., Inc., 113 U.S.P.Q. at 417. Interestingly, the decision

mentions this violation of state law and shipments in intrastate commerce. The

USPTO’s doctrine has ultimately evolved to encompass federal law only. Whether

the federal courts’ version of the doctrine can encompass state law is an open

question, discussed infra. 77

Id. 78

Id. 79

In re Taylor, 133 U.S.P.Q. 490 (T.T.A.B. 1962). 80

Id. 81

Id. at 491.

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construed to be a lawful use. Therefore, such use cannot afford a basis

for federal registration.”82

b. The USPTO Formally Adopts the Doctrine

The USPTO first adopted a formal unlawful use doctrine in

1965.83

The regulation, codified at 37 C.F.R. 2.69, stated that:

When the sale or transportation of any product for

which registration of a trademark is sought is regulated

under an Act of Congress, the Office may, before

allowance, make appropriate inquiry as to compliance

with such act for the sole purpose of determining

lawfulness of the commerce recited in the application.84

Not long after, in 1968, the TTAB had the occasion to consider the

relatively new rule. There, an examiner refused registration on the

grounds that the product, a mouth freshener spray, failed to comply

with the Food, Drug, and Cosmetic Act’s provisions on cosmetics.85

The applicant appealed.

The TTAB summarized the issue as whether the fact that the

applicant had not included a quantity term on the labels that were

submitted as specimens to the USPTO rendered the shipments

unlawful shipments from which no trademark rights can be derived:

[T]he failure of applicant to set forth an indication of

the quantity of contents on the labels submitted with the

application render the shipments of goods bearing these

labels “unlawful shipments” in interstate commerce

from which no trademark rights can be derived and, if

so, is applicant barred from registration on the instant

application for this reason?86

82

Id. 83

Compliance with Other Laws, 30 Fed. Reg. 13189, 13198 (Oct. 16, 1965). 84

Id. The current regulation is substantially similar:

When the sale or transportation of any product for which

registration of a trademark is sought is regulated under an Act of

Congress, the Patent and Trademark Office may make appropriate

inquiry as to compliance with such Act for the sole purpose of

determining lawfulness of the commerce recited in the application.

37 C.F.R. §2.69. 85

In re Stellar Int’l, Inc., 159 U.S.P.Q. 48 (T.T.A.B. 1968). 86

Id. at 50.


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301

Although the applicant argued that 2.69 was not meant to operate

such that a violation of other laws would preclude registration, the

TTAB rejected this position, explaining that if the USPTO could not

refuse registration “until and when compliance is effected,” the rule

“would be ineffective and an inquiry thereunder would be nothing

more than a waste of time and effort.”87

However, the TTAB limited its own agency’s authority by then

stating that the authority should be “exercised sparingly,” explaining

that:

This does not mean that the Patent Office should

undertake to police all the different regulatory statutes

to ensure compliance therewith for that is manifestly

not its function nor is it properly equipped to do so.

However, if specimen labels submitted with an

application show on their face that the applicant has not

complied with the labeling provisions of a regulatory

statute governing the shipment in commerce of goods

bearing such labels, a question may be raised under

Rule 2.69 to ascertain whether or not the applicant had

complied with the applicable statute when the

application was filed and that therefore the shipment of

goods bearing the mark was lawfully made in

accordance with the statute controlling the shipment of

such goods in commerce.88

From a policy perspective, the TTAB noted that to agree with the

applicant that unlawful use should not bar registration “would to be to

place the Patent Office in the anomalous position of accepting as a

basis for registration a shipment in commerce which is unlawful under

a statute specifically controlling the flow of such goods in

commerce.”89

The next major TTAB decision on unlawful use was Satinine

Societa in Nome Collettivo Di S.A. E M. Usellini v. P.A.B. Produits et

Appareils de Beaute, decided in 1981.90

There, the TTAB ruled on the

unlawful use question in the context of a cancellation proceeding.91

The petitioner argued that the mark PAB had been abandoned, and that

87

Id. at 51. 88

Id. 89

Id. 90

Satinine Societa in Nome Collettivo Di S.A. E M. Usellini v. P.A.B. Produits

et Appareils de Beaute, 209 U.S.P.Q. 958 (T.T.A.B. 1981). 91

Id. at 960.

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any use of the mark had been unlawful.92

Although the decision is

unremarkable in its outcome—the Board determined that the petitioner

had not met its burden to show unlawful use93

—it is fascinating for its

in-depth analysis of the unlawful use doctrine.

Each member of the Board wrote his own opinion, although all

concurred in the judgment, and two concurred in the opinion.94

Member Rice, writing for the Board, examined the unlawful use

doctrine as it had developed thus far, and sharply criticized it, going so

far as to note that “a very persuasive argument” exists against the

doctrine:

A very persuasive argument can be made for the

proposition that there is in fact no statutory basis for

refusing to grant a registration, or for cancelling a

subsisting registration, on the ground of “unlawful

use,” i.e., use of the mark in connection with

goods/services which may not lawfully be

shipped/performed in commerce because they are not in

compliance with some federal regulatory act pertaining

thereto; and that under Rule 2.69 the Trademark

Attorney should do no more than call the applicant’s

attention to federal statutes regulating the flow of his

goods or services in commerce and point out any

noncompliance therewith so that the applicant may be

aware of the existence of such statutes and take steps to

comply with them.95

Member Rice noted that neither Coahoma nor Stellar relied upon

any statutory authority; on the contrary, while the Lanham Act

mentions “lawful use” in some contexts, no such reference appears in

the sections relevant to registering trademarks, refusal of registration,

cancellation of registration, or in the definitions of the terms

“trademark” and “use in commerce.”96

Indeed, she noted that

“[i]nasmuch as the term ‘lawful’ is specifically used in certain sections

of the Statute, the suggestion that this term should be read into those

sections where it is not used would appear to be a violation of the

basic rules of statutory construction.”97

However, she noted that the

92

Id. at 961. 93

Id. at 966–67. 94

Id. 95

Id. at 964 n.2. 96

Id. 97

Id.


USE DOCTRINE

303

TTAB felt bound by the appellate court’s affirming of Coahoma

without reference to the unlawful use doctrine.98

Member Rice also lamented the “almost endless number of such

acts which the Board might in the future be compelled to interpret in

order to determine whether a particular use in commerce is lawful,”

and explained that it may not be advisable to place the interpretation of

myriad federal statutes in the hands of the TTAB:

Inasmuch as we have little or no familiarity with most

of these acts, there is a serious question as to the

advisability of our attempting to adjudicate whether a

party’s use in commerce is in compliance with the

particular regulatory act or acts which may be

applicable thereto. Rather, it seems that the better

practice would be to hold that a use in commerce is

unlawful only when the issue of compliance has

previously been determined (with a finding of

noncompliance) by an entity, such as a court or

government agency, having competent jurisdiction

under the statute in question, or when there has been a

per se violation of a statute regulating the sale of a

party’s goods, or the rendering of his services, in

commerce, as, for example, when a regulatory statute

requires that a party’s labels must be registered with or

approved by the regulatory agency charged with

administering the statute before his goods may lawfully

enter the stream of commerce, and the party has failed

to obtain such registration or approval (as happened in

the Coahoma case).99

Concurring in the judgment only, Member Lefkowitz (who

authored the opinion in Stellar) disagreed with Member Rice’s take on

the unlawful use doctrine, particularly that the Board does not have

expertise to decide such matters and that unlawful use should only be

considered if the question has previously been determined by a court

or agency.100

Instead, Member Lefkowitz argued that the Board has

just as much expertise as the courts, that “all issues involving

98

Id. It is somewhat surprising that Member Rice read so much into the

affirming Coahoma opinion, which, as she states, does not mention unlawful use at

all. If she had not felt bound by the opinion, perhaps this case would have been a

turning point for the unlawful use doctrine. 99

Id. at 965. 100

Id. at 968. (Lefkowitz, Member, concurring in judgment only).

304 WAKE FOREST J.


[VOL. 17

registration” should be before the Board, and that “the safeguards of

appeal are always available to a party if he believes that the Board

exceeded its statutory authority.”101

Finally, Member Kera also wrote a concurring opinion, to “add a

thought to the principal and concurring opinions.”102

He suggested

that although the policy considerations behind the doctrine are strong:

[W]e should not refuse registration or order the

cancellation of a registration because of some purely

collateral defect…there must be some nexus between

the use of the mark and the alleged violation before it

can be said that the unlawfulness of the sale or

shipment has resulted in the invalidity of an application

or registration.103

Member Kera also noted the incongruity between the Lanham

Act’s requirement of lawful use for registration on the Supplemental

Register and the lack of such requirement on the Principal Register.104

c. The Modern Unlawful Use Doctrine at the USPTO

Despite the dissention, later TTAB cases adopted the reasoning

from Satinine, ultimately resulting in the development of a fairly

cohesive statement of the doctrine. In General Mills v. Health Valley

Foods, the Board held that when “a party seeks to show that use by the

adverse party was unlawful by virtue of noncompliance with a labeling

statutory provision,” that party must show, by clear and convincing

evidence, not only that there was an instance of noncompliance with

applicable law, but also that: (1) the noncompliance was material,

“that is, was of such gravity and significance that the usage must be

considered unlawful–so tainted that, as a matter of law, it could create

no trademark rights–warranting cancellation of the registration of the

mark involved,”105

and (2) “that there must be some nexus between the

use of the mark and the alleged violation before the unlawfulness of a

shipment can be said to result in the invalidity of a registration,” such

that a “collateral defect” is not enough.106

The “per se” requirement

101

Id. 102

Id. at 969. (Kera, concurring in opinion of Member Rice). 103

Id. 104

Id. 105

Gen. Mills Inc. v. Health Valley Foods, 24 U.S.P.Q.2d 1270, 1274 (T.T.A.B.

1992). 106

Id. at 1274.


USE DOCTRINE

305

has also been adopted, such that an unlawful use will only be found “if

the issue of compliance has previously been determined (with a

finding of noncompliance) by a court or government agency having

competent jurisdiction under the statute involved, or where there has

been a per se violation of a statute regulating the sale of a party’s

goods.”107

This formulation of the doctrine is in use today.108

Despite the original mention in Coahoma of North Carolina’s

statute, the current formulation of the TTAB’s doctrine (consistent

with 2.69) provides that only “statutes and regulations issued pursuant

to Acts of Congress” are to be considered when determining whether a

use is lawful, not state or foreign statutes.109

Likewise, the current

Trademark Manual of Examining Procedure (“TMEP”) discusses

lawful use in a number of places, but specifically, section 907 provides

detailed guidance to examiners on applying the doctrine.110

Although

it provides that “[u]se of a mark in commerce must be lawful use to be

the basis for federal registration of the mark . . . [t]hus, the goods or

services to which the mark is applied, and the mark itself, must

comply with all applicable federal laws,”111

it also states that the use is

generally presumed lawful, and that unlawful use will not form the

basis of a refusal to register unless, citing Kellogg, “a violation of

federal law is indicated by the application record or other evidence,

such as when a court or the responsible federal agency has issued a

finding of noncompliance under the relevant statute or regulation, or

when there is a per se violation of a federal law.”112

The TMEP

further limits the authority of the examining attorneys by requiring that

examining attorneys “obtain approval from their managing attorney or

senior attorney, who may seek additional guidance from the

Administrator for Trademark Policy and Procedure” before issuing an

inquiry or refusal “pertaining to the lawfulness of goods or

services.”113

The TMEP goes on to state that in determining whether to further

inquire or refuse registration, “the USPTO will not regard apparent

technical violations, such as labeling irregularities on specimens, as

107

Id. at 1273. 108

See, e.g., Netcloud LLC v. East Coast Network Serv. LLC, No. 91210559,

2015 WL 1518045 (T.T.A.B. Mar. 11, 2015) (not precedential); see also Churchill

Cellars, Inc. v. Graham, No. 91193930, 2012 WL 5493578 (Oct. 19, 2012) (not

precedential). 109

See, e.g., Netcloud, LLC, 2015 WL 1518045, at *6 (citing W. Worldwide

Enters. Grp. Inc. v. Qinqdao Brewery, 17 U.S.P.Q.2d 1137 (T.T.A.B. 1990)). 110

See TMEP, supra note 16, § 907. 111

Id. 112

Id. 113

Id.

306 WAKE FOREST J.


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violations.”114

It further states that:

For example, if a package fails to show all required

labeling information, the examining attorney should not

take any action. Likewise, the USPTO does not

routinely solicit information regarding label approval

under the Federal Alcohol Administration Act or

similar acts. However, if the record indicates that the

mark itself or the goods or services violate federal law,

an inquiry or refusal must be made. For example,

evidence indicating that the identified goods or services

involve the sale or transportation of a controlled

substance or drug paraphernalia in violation of the

Controlled Substances Act (“CSA”), 21 U.S.C. §§801-

971, would be a basis for issuing an inquiry or refusal.

Subject to certain limited statutory exceptions, the CSA

makes it unlawful to manufacture, distribute, or

dispense a controlled substance; possess a Schedule I

controlled substance; or sell, offer for sale, or use any

facility of interstate commerce to transport drug

paraphernalia. Note that, regardless of state law,

marijuana and its psychoactive component, THC,

remain Schedule I controlled substances under federal

law and are subject to the CSA’s prohibitions.115

In both the guidance given to the examiners and the TTAB’s more

recent decisions, the position of the USPTO is now considerably

restrained with respect to the unlawful use doctrine.116

114

Id. 115

Id. (internal citations omitted). 116

It is worth noting that in July of 2016, after this paper was completed, the

TTAB issued a precedential decision determining that use in connection with an

illegal substance (marijuana) was a “per se” unlawful use and affirmed the denial of

registration, despite the fact that marijuana is legal under Washington law, where the

applicant was based. See Morgan Brown, Serial No. 86362968 (T.T.A.B. 2016),

http://ttabvue.uspto.gov/ttabvue/ttabvue-86362968-EXA-10.pdf. The TTAB held

that because the applicant’s services included the provision of an illegal substance

(even though registration was not sought for marijuana specifically, but for “retail

store services featuring herbs”), the use was unlawful. See id. This appears to be

consistent with the TMEP language cited supra note 115: “if the record indicates

that the mark itself or the goods and services violate federal law, an inquiry or

refusal must be made.” The specimens in Morgan Brown indicated that the mark was

in use in connection with marijuana. Likewise, in October of 2016, the TTAB

issued a precedential decision rejecting a number of rationales for registration of

what it referred to as “drug paraphernalia” (what the applicant characterized as

continued . . .


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307

2. The Unlawful Use Doctrine in the Federal Courts

Although a handful of federal courts had considered or applied the

unlawful use doctrine prior to 2007,117

the Ninth Circuit’s decision in

CreAgri118

(as later clarified by Southern California Darts119

in 2014)

marked a turning point for the doctrine. Since CreAgri, an increasing

number of federal courts have addressed the issue.

a. CreAgri

In CreAgri, the plaintiff manufacturer of a dietary supplement sued

a competitor for trademark infringement, unfair competition, and

unjust enrichment, and the competitor counterclaimed for declaratory

relief and cancellation of the registration.120

The plaintiff admitted

that during the relevant timeframe (roughly, the year prior to the

defendant’s priority of use date), the plaintiff’s labels were inaccurate,

claiming the supplement contained more of the key ingredient than

was actually present.121

The district court granted summary judgment

on the issue of unlawful use and dismissed the plaintiff’s claims,

entered declaratory judgment in favor of the defendant, and ordered

the mark cancelled from the Supplemental Register.122

The Ninth Circuit affirmed, holding that “the inquiry does not stop

with use in commerce. It has long been the policy of the PTO’s

Trademark Trial and Appeal Board that use in commerce only creates

trademark rights when the use is lawful.”123

The Ninth Circuit noted

that the Tenth Circuit “has adopted and applied this rule,” citing to

United Phosphorus,124

and held that “we also agree with the PTO’s

policy and hold that only lawful use in commerce can give rise to

trademark priority.”125

The court gave two rationales for the policy: first, that “to hold

otherwise would put the government in the ‘anomalous position’ of

“smokeless cannabis vaporizing apparatus, oral vaporizers for smoking purposes;

vaporizing cannabis delivery device, namely, oral vaporizers for smoking

purposes”). See JJ206, LLC, Serial Nos. 86474701, 86236122 (T.T.A.B. 2016),

http://ttabvue.uspto.gov/ttabvue/ttabvue-86474701-EXA-11.pdf. 117

See infra Section III.A.3. 118

See CreAgri, Inc. v. USANA Health Sci., Inc., 474 F.3d 626, 633–34 (9th

Cir. 2007). 119

S. Cal. Darts Ass’n v. Zaffina, 762 F.3d 921, 931–32 (9th Cir. 2014). 120

CreAgri, 474 F.3d at 629. 121

See id. at 628. 122

See id. at 634. 123

Id. at 630. 124

The flaws in this precedent are discussed. See infra Section III.A.3.a. 125

CreAgri, 474 F.3d at 630.

308 WAKE FOREST J.


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extending the benefits of trademark protection to a seller based upon

actions the seller took in violation of that government’s own laws,”

and second, “to give trademark priority to a seller who rushes to

market without taking care to carefully comply with the relevant

regulations would be to reward the hasty at the expense of the

diligent.”126

The plaintiff argued three things in response, two of which are

relevant here: first, that the nexus between the labeling violation and

the use of the mark was too attenuated to justify depriving the plaintiff

of trademark protection; and second that the violation was not

material.127

With respect to the nexus argument, the Ninth Circuit

found that “the nexus between a misbranded product and that

product’s name, particularly one designed for human consumption, is

sufficiently close to justify withholding trademark protection for that

name until and unless the misbranding is cured.”128

The court

specifically stated that it was neither adopting nor rejecting the nexus

requirement, however.129

As to materiality, the plaintiff cited the

TTAB’s General Mills decision, arguing that de minimis uses will not

prevent the acquisition of trademark rights.130

However, the court

found that the plaintiff’s labeling error was material, and therefore

declined to determine whether to adopt the General Mills test for

materiality.131

In a footnote, the court noted that the cancellation of

the plaintiff’s registration “does not necessarily” render the mark

“forever incapable of being registered on either the principal or

supplemental registers.”132

b. Post-CreAgri Unlawful Use Decisions

Whether the Ninth Circuit knew it was breaking new ground or

not, the CreAgri decision set off a flurry of litigation on the unlawful

use doctrine. Later that year, the explosion in unlawful use assertions

126

Id. 127

Id. at 631. The third argument was that because it was technologically

infeasible to measure the amount of the key ingredient at the time of the mislabeling,

and because the FDA provides for an exemption when that is the case, the sale was

not unlawful. However, as the Ninth Circuit points out, this argument is not very

persuasive since the plaintiff did not even apply for the exemption. Id. at 632–33. 128

Id. at 631–32. 129

Id. at 631. 130

Id. at 633. 131

Id. 132

See id. at 634 n.14. A review of the USPTO’s website via the Trademark

Electronic Search System (“TESS”) search function on January 12, 2016 revealed

that CreAgri’s design mark for OLIVENOL was in fact registered again and is now

on the Principal Register.


USE DOCTRINE

309

began. The Southern District of New York, relying on one of the only

pre-CreAgri unlawful use decisions,133

ruled on a motion for summary

judgment that unlawful use was an affirmative defense that could be

proven by showing, by clear and convincing evidence, that (1) a per se

violation (or a court/agency finding) had occurred, and (2) the non-

compliance was material.134

The court did an in-depth analysis of the

plaintiff’s alleged mislabeled fragrance, but denied the motion for

summary judgment and rejected the request to cancel the registration,

finding that the defendants had not met their burden of proof as to

material non-compliance.135

Shortly thereafter, in 2008, the Ninth Circuit again considered the

doctrine in Cash Processing Services LLC v. Ambient Entertainment,

Inc.136

This not-for-publication decision made brief mention of

unlawful use, noting that the district court properly rejected the

argument where, although the plaintiff companies “obtained the

business in an unlawful manner, and committed various crimes during

the period of ownership, this conduct was unrelated to the

trademark.”137

The court noted that the trademark itself “was not

obtained through fraud, nothing about its use was illegal, and there is

an insufficient nexus between [the companies’] criminal activities and

the trademark to justify a finding of invalidity.”138

In 2009, the Northern District of California considered the doctrine

and again used it to grant a motion for summary judgment in favor of

an allegedly junior user based on the senior user’s unlawful use of a

mark.139

There, the court held that where one party’s predecessor had

violated the Food, Drug, and Cosmetics Act by not applying for

approval prior to introducing the drug into interstate commerce, its use

was unlawful and its rival was entitled to priority.140

In 2011, another California federal court had occasion to rule on

the unlawful use issue. There, the plaintiff sought to strike the

affirmative defense of unlawful use, but the court denied the motion,

133

Erva Pharm., Inc. v. Am. Cyanamid Co., 755 F. Supp. 36, 42 (D. P.R. 1991);

see discussion infra Section III.A.3.b. 134

Dessert Beauty, Inc. v. Fox, 617 F. Supp. 2d 185, 190 (S.D.N.Y. 2007). 135

Id. at 194. 136

Cash Processing Serv., LLC v. Ambient Entm’t, Inc., 320 F.App’x. 494 (9th

Cir. 2008). 137

Id. at 496. 138

Id. 139

GoClear LLC v. Target Corp., No. C 08–2134 MMC, 2009 WL 160624

(N.D. Cal. Jan. 22, 2009). Interestingly, this case was decided by the same district

court judge who decided CreAgri. 140

Id. at *4.

310 WAKE FOREST J.


[VOL. 17

permitting the defense to proceed.141

In 2012, the Western District of Michigan encountered the issue

when a defendant moved to dismiss the plaintiff’s complaint on the

grounds that the plaintiff’s only rights were based on unlawful

activity.142

The owner of the plaintiff company had been named as an

unindicted co-conspirator, in a federal indictment against the supplier

of the plaintiff’s product, on charges of conspiracy to introduce

misbranded drugs into interstate commerce, wire fraud, and mail

fraud.143

This case was the first to note that the doctrine is

controversial, explaining that “[i]ts application in infringement cases

has also been questioned by leading secondary authorities.”144

The

court noted that there had been only an accusation (via the indictment),

and no per se violation, and declined to apply the doctrine.145

The

court also noted that because unlawful use is an affirmative defense, it

was premature to raise the issue on a motion to dismiss.146

On the same day in 2013, two courts on different sides of the

country also issued opinions involving unlawful use. A court in the

Western District of North Carolina held that a user who began selling

wine without an approved Certification of Label/Bottle Approval

(“COLA”) under the Federal Alcohol Administration Act could not

count that pre-COLA use toward its priority date.147

This difference,

although it only amounted to three months, was sufficient to make the

competitor the senior user.148

Meanwhile, a district court in Washington State, acting in its

capacity as an appellate reviewing court of the TTAB,149

affirmed the

141

See Wine Grp. LLC v. L. & R. Wine Co., No. 2:10–cv–02204–MCE–KJN,

2011 WL 1233132 (E.D. Cal. Mar. 31, 2011). 142

Impulsaria, LLC v. United Distrib. Grp., LLC, No. 1:11–CV–1220, 2012 WL

5178147, at *5 (W.D. Mich. Oct. 18, 2012). 143

Id. 144

Id. (citing MCCARTHY, supra note 37, § 19:124) (“I believe that the Ninth

Circuit [in CreAgri] erred in unthinkingly wrenching a draconian version of the

U.S.P.T.O.’s ‘unlawful use’ policy out of its administrative registration setting and

inserting it into federal court infringement lawsuits.”). 145

Id. 146

Id. at *6. 147

Tassel Ridge Winery, LLC v. Woodmill Winery, Inc., No. 5:11–cv–00066–

RLV–DSC, 2013 WL 5567505, at *6 (W.D.N.C. Oct. 9, 2013). 148

Id. What’s especially interesting about this case is that the TTAB has found

no unlawful use on very similar facts. See, e.g., Churchill Cellars, Inc. v. Graham,

No. 91193930, 2012 WL 5493578, at *6–7 (T.T.A.B. Oct. 19, 2012) (not

precedential). 149

See Vosk Int’l Co. v. Zao Gruppa Predpriyatij Ost, No. C11–1488RSL, 2013

WL 5588296 (W.D. Wash. Oct. 9, 2013). It is worth noting that this decision was

under the old system where T.T.A.B. findings received deference from the district

courts.


USE DOCTRINE

311

TTAB’s rejection of an unlawful use argument and rejected the

defense under de novo review of new evidence as well.150

The court

found that the defendant simply had not met its burden of proof with

respect to the alleged unlawfulness (the alleged presence of a

prohibited ingredient in violation of FDA requirements).151

In 2014, unlawful use was invoked in a different context. After

receiving cease-and-desist letters, the plaintiff (a medical marijuana

dispensary) filed an action for declaratory relief and cancellation of the

marks at issue.152

The defendants filed a motion for judgment on the

pleadings, claiming that the plaintiffs lacked standing to seek to cancel

the registrations because the plaintiff should not be able to use the

Lanham Act to protect activities that are illegal under federal law.153

The court rejected this argument, however, finding that the plaintiffs

had standing as someone “who believes that he is or will be

damaged…by the registration of a mark” pursuant to the Lanham

Act.154

The court distinguished CreAgri, explaining that:

Unlike CreAgri, which involved a seller seeking to

benefit from actions taken in violation of the labeling

law in an effort to maintain its trademark, plaintiff,

here, seeks to defend itself against trademark

infringement. Our plaintiff does not seek to challenge

defendants’ marks based on its sale of an illegal drug.

Rather, in marshaling its defense to defendants’

counterclaims, our plaintiff has included cancellation

claims directed at challenging the validity of the

asserted trademarks. It would be unfair to strip plaintiff

of this avenue of defense.

Taken one step further, if we were to recognize

defendants’ theory, then every trademark action would

devolve into a side showing wherein the trademark

owner dredges up various other federal laws

supposedly violated by the accused. This cannot be.155

In other words, a defendant should not lose the opportunity to

150

Id. at *6–7. 151

Id. at *6. 152

Purple Heart Patient Ctr., Inc. v. Military Order of the Purple Heart, No.

C13–00902 WHA, 2014 WL 572366, at *1 (N.D. Cal. 2014). 153

Id. 154

Id. at *2 (citing 15 U.S.C. §1064 (2012)). 155

Id. at *3.

312 WAKE FOREST J.


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defend himself via the avenues available to him simply because he is

an unlawful user.

The Ninth Circuit revisited the unlawful use doctrine in 2014

as well. In Southern California Darts Ass’n v. Zaffina, the court

declined to find unlawful use where the plaintiff had failed to pay a

state corporate franchise tax.156

Unceremoniously (perhaps

unwittingly) adopting the TTAB standards it had carefully avoided

adopting in 2007, the court found no unlawful use, finding that this

particular violation was both immaterial and collateral (meaning no

sufficient nexus).157

The court also rejected the argument because,

“more significantly,” the accusations were unsubstantiated.158

Also in 2014, the Central District of California was faced with the

issue and declined to apply the doctrine.159

There, the court denied

summary judgment on the unlawful use defense, finding that the law

was unsettled as to whether violations of state law (the insurance code)

could support the application of the unlawful use doctrine, and that it

was “sufficiently unclear that the violations at issue were ‘material’

rather than ‘technical…’”160

In 2015, a federal court in Georgia applied the doctrine in FN

Herstal S.A. v. Clyde Armory, Inc.161

The court applied the TTAB’s

version of the doctrine, but also noted that “[t]he Ninth, Tenth, and

Federal Circuits have expressly adopted the unlawful use defense.”162

There, at issue was whether the plaintiff had unlawfully attempted to

associate its rifle sales with the U.S. Special Operations Forces by

displaying the Special Operations emblem on its advertisements.163

Although the plaintiff had apparently sold rifles to the military for use

in the Special Operations Forces, a federal regulation prohibits those

156


Id. 158

Id. at 932. 159

Veronica’s Auto Ins. Serv., Inc. v. Veronica’s Serv., Inc., No. EDCV 13–

01327 DDP, 2014 WL 7149530, at *5 (C.D. Cal. Dec. 15, 2014). In the interest of

disclosure, the author was part of the team that represented the plaintiff. 160

Id. at *6. 161

FN Herstal, S.A. v. Clyde Armory, Inc., No. 3:12–CV–102, 2015 WL

196208, at *9 (M.D. Ga. Jan. 8, 2015). 162

Id. This is not accurate. The Ninth Circuit has expressly adopted the

defense. The Tenth Circuit mentions it in United Phosphorous, but the authorities it

cites to do not stand for the proposition of a federal-court unlawful use defense.

United Phosphorous v. Midland Fumigant, Inc., 205 F.3d 1219, 1225 (10th Cir.

2000). The Federal Circuit case cited, Gray v. Daffy Dan’s Bargaintown, 823 F.2d

522, 526 (Fed. Cir. 1987), is not on point. The problems with relying on United

Phosphorous and Daffy Dan’s to support a federal court unlawful use defense are

discussed infra Section III.A.3.a. 163

FN Herstal, 2015 WL 196208, at *10.


USE DOCTRINE

313

who contract with Special Operations Command from drawing that

association without prior authorization.164

However, the court found

that the defendant failed to establish that the original contract between

the plaintiff and the government incorporated that regulation, and

Special Operations Command acknowledged that the regulation’s

applicability to the contract with the plaintiff was unclear.165

Accordingly, the court held that the advertisements were not a per se

violation of federal regulation.166

Further, the court found that the

violation was immaterial, as there was no consumer protection concern

implicated.167

In 2016, the Southern District of New York was confronted with

the doctrine in Vantone Group LLC v. Yangpu NGT Industrial Co., Ltd

in the context of cancellation of a registration.168

The court noted that

“courts within this district” have recognized the defense, citing

Dessert Beauty and Lane Capital, but determined that the doctrine was

not applicable where the defendant had failed to offer evidence of

either a prior court or agency finding or a per se violation of a statute

regulating the sale of a party’s goods.169

c. Summary: the USPTO’s Doctrine Versus the Federal

Courts’ Doctrine

To summarize, the USPTO’s unlawful use doctrine and the

doctrine as adopted by the federal courts are similar but differ in scope

and application. Under the USPTO’s doctrine, the party claiming

unlawful use must show by clear and convincing evidence that (1)

there was an instance of noncompliance with applicable federal law,

(2) the noncompliance was material, and (3) there is a nexus between

the use of the mark and the alleged violation.170

Further, unlawful use

will only be found if the issue of compliance has previously been

determined by a court or government agency, or where there has been

a “per se” violation.171

The USPTO’s doctrine affects only

164

Id. 165

Id. 166

Id. 167

Id. 168

Vantone Group LLC v. Yangpu NGT Industrial Co., Ltd., 1:13-CV-07639,

2016 WL 4098564, at *1 (S.D.N.Y. July 28, 2016). 169

Id. at *8–9. 170

Gen. Mills, Inc. v. Health Valley Foods, 24 U.S.P.Q.2d 1270, 1274–75

(T.T.A.B. 1992). 171

Id. at 1272.

314 WAKE FOREST J.


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registration, not use of the mark.172

On the other hand, the federal courts have not adopted a consistent

rule. The Ninth Circuit has apparently adopted the requirements of

materiality and nexus, but not the “per se” requirement (although it

declined to consider “unsubstantiated” allegations).173

Other courts

have applied the entire USPTO framework.174

Most importantly, the

federal court rule applies in the broader context of use of a mark, not

simply registration.175

III. APPLICATION OF THE UNLAWFUL USE DOCTRINE IN THE

FEDERAL COURTS

The federal courts’ application of the unlawful use doctrine has not

been without criticism.176

This section examines some of the main

questions that arise when moving the doctrine from the USPTO to the

federal courts: namely, is there a historical or statutory basis for

applying the doctrine in federal courts, and from a policy perspective,

is it wise to do so?

172

Anne Gilson LaLonde & Jerome Gilson, The United States Supplemental

Register: Solace, Substance, or Just Extinct?, 103 TRADEMARK REP. 828, 844–45

(2013) [hereinafter Gilson]. 173


See, e.g., FN Herstal, S.A. v. Clyde Armory, Inc., No. 3:12–CV–102, 2015

WL 196208, at *10 (M.D. Ga. Jan. 8, 2015); Dessert Beauty, Inc. v. Fox, 617 F.

Supp. 2d 185, 190 (S.D.N.Y. 2007). 175

As noted above, there are many benefits to federal registration, one of which

is the ability to bring a federal cause of action for trademark infringement. It is

worth noting that owners of unregistered marks may still bring a federal cause of

action under Section 43(a) of the Lanham Act. 15 U.S.C. § 1125(a) (2012).

However, there is currently some dispute as to whether marks that would be

otherwise ineligible for registration are subject to protection under 43(a). See 2–7

ANNE GILSON LALONDE, GILSON ON TRADEMARKS § 7.02 (2015). Given this

dispute, it is beyond the scope of this article to evaluate when a use subject to the

unlawful use doctrine could be subject to protection under 43(a). 176

For example, in his treatise on trademarks and unfair competition, Professor

McCarthy criticized the CreAgri decision as “unthinkingly wrenching a draconian

version of the U.S.P.T.O.’s ‘unlawful use’ policy out of its administrative

registration setting and inserting it into federal court infringement lawsuits.”

MCCARTHY, supra note 37, § 19:124. McCarthy further noted that the Ninth Circuit

adopted the doctrine without adopting the TTAB’s limits to the doctrine, namely,

that unlawful use is found only where there is a “per se” violation or an agency/court

determination of the same, and that the “nexus” and “materiality” requirements are

also satisfied. Id. He also noted that the doctrine could result in “shelter[ing] a use

which would be likely to confuse the public.” Id. Finally, McCarthy notes that the

CreAgri decision “turns every federal judge hearing a trademark infringement suit

into a potential collateral enforcer of hundreds of labeling and licensing laws.” Id.


USE DOCTRINE

315

A. Is There a Historical Basis for the Doctrine in the Federal

Courts?

When the Ninth Circuit adopted the unlawful use doctrine in

CreAgri, it looked to the USPTO’s policy and the TTAB’s

jurisprudence on the issue.177

Other than mentioning one Tenth

Circuit case (as discussed infra, this case is not strong precedent), it

did not rely upon federal case law although there were some cases that

had discussed and adopted the doctrine prior to 2007.178

However,

there is some historical case law basis for applying the doctrine.

1. Pre-Lanham Act Treatment of Unlawful Use

a. Review of Early Cases

Prior to the passage of the Lanham Act in 1946, trademark law in

the United States was governed by several trademark statutes, some of

which, on their face, appeared to deal expressly with unlawful use.

The United States’ first trademark statute was passed in 1870, creating

a registry of trademarks and a cause of action for trademark

infringement.179

This statute included language prohibiting those

177

CreAgri, Inc. v. USANA Health Serv., Inc., 474 F.3d 626, 630–31 (9th Cir.

2007). 178

Id. at 630. For cases discussing and adopting the unlawful use doctrine, see,

e.g., Lane Capital Mgmt., Inc. v. Lane Capital Mgmt., Inc., 15 F. Supp. 2d 389, 397

(S.D.N.Y. 1998), aff’d, 192 F.3d 337 (2d Cir. 1999) (suggesting that a defendant

might be able to assert an unlawful use defense with proper evidence); Erva Pharm.,

Inc. v. Am. Cyanamid Co., 755 F. Supp. 36, 41 (D.P.R. 1991) (denying a petitioner

standing because the use on which petitioner based its claim of priority was illegal

under the Food, Drug, and Cosmetic Act); Intrawest Fin. Corp. v. W. Nat’l Bank of

Denver, 610 F. Supp. 950, 960 (D. Colo. 1985) (holding that the use of a former

charted trade name of a bank to identify one discrete banking service fails the lawful

use standard, but declining to “establish a general rule distinguishing permissible use

of service marks from impermissible use.”). 179

An Act to Revise, Consolidate and Amend Statutes Relating to Patents and

Copyrights, ch. 230, 16 Stat. 198 (1870). See also 8 LOUIS ALTMAN & MALLA

POLLACK, CALLMANN ON UNFAIR COMPETITION, TRADEMARKS, AND MONOPOLIES §

8:8 (4th ed. 2016). The cause of action for trademark infringement was laid out as

follows: (“That any person or corporation who shall reproduce, counterfeit, copy, or

imitate any such recorded trade--mark, and affix the same to goods of substantially

the same descriptive properties and qualities as those referred to in the registration,

shall be liable to an action in the case for damages for such wrongful use of said

trademark, at the suit of the owner thereof, in any court of competent jurisdiction in

the United States, and the party aggrieved shall also have his remedy according to

the course of equity to enjoin the wrongful use of his trade--mark and to recover

compensation therefor in any court having jurisdiction over the person guilty of such

wrongful use.”). § 79, 16 Stat. 211.

316 WAKE FOREST J.


[VOL. 17

using a mark “in any unlawful business” from bringing an action for

trademark infringement:

[n]o action shall be maintained under the provisions of

this act by any person claiming the exclusive right to

any trade-mark which is used or claimed in any

unlawful business, or upon any article which is

injurious in itself, or upon any trade-mark which has

been fraudulently obtained, or which has been formed

and used with the design of deceiving the public in the

purchase or use of any article of merchandise.180

The Act of 1870 was short-lived, however, as the Supreme Court

ruled it unconstitutional just nine years later (as a result of Congress

resting its authority upon the Patents and Copyrights Clause as

opposed to the Commerce Clause).181

Two years after the original Act was ruled unconstitutional,

Congress passed a trademark statute based upon its Commerce Clause

power.182

This Act was fairly limited in scope, but still retained the

limitation for unlawful business in similar terms as the original Act:

[n]o action or suit shall be maintained under the

provisions of this act in any case when the trade--mark

is used in any unlawful business, or upon any article

injurious in itself, or which mark has been used with

the design of deceiving the public in the purchase of

merchandise, or under any certificate of registry

fraudulently obtained.183

Similar language was included in the Act of 1905.184

The Act of

1920,185

which was “supposed to correct the problem of American

180 § 84, 16 Stat. 212 (emphasis added).

181 In re Trade-Mark Cases, 100 U.S. 82, 93–94 (1879).

182 An Act to Authorize the Registration of Trade-Marks and to Protect the

Same, ch. 138, 21 Stat. 502 (1881); see also ALTMAN & POLLACK, supra note 179, §

8:11. 183

Id. at § 8 (emphasis added). 184

Act of Feb. 20, 1905, 14 U.S.C. § 101 (2012); see also ALTMAN & POLLACK,

supra note 179, § 40:13 (“That no action or suit shall be maintained under the

provisions of this act in any case when the trademark is used in unlawful business, or

upon any article injurious in itself, or which mark has been used with the design of

deceiving the public in the purchase of merchandise, or has been abandoned, or upon

any certificate of registration fraudulently obtained.”). 185

Act of Mar. 19, 1920. Pub. L. No. 163, ch 104, 41 Stat. 533 (1920). Also

available at

continued . . .


USE DOCTRINE

317

citizens registering marks in foreign countries,”186

made no mention of

“unlawful business.”

Very few cases were decided under the “unlawful business”

provisions of these acts,187

although many cases in that time period

invoked the related equitable defense of unclean hands (he who comes

to equity must come with clean hands—in other words, bad conduct

on the part of the plaintiff could be grounds for the court to refuse to

grant the plaintiff relief). The cases that were decided under Section

21, however, construed it narrowly, essentially coextensively with the

unclean hands defense.

One of the earliest cases to apply the provision, American Thermos

Bottle Co. v. W.T. Grant Co., affirmed a finding for the defendant

under Section 21 of the Act.188

There, the plaintiff, who owned and

used the mark THERMOS in connection with vacuum bottles, sued a

defendant who was passing off the defendant’s bottles as Thermos’

bottles.189

All acknowledged that the plaintiff was the owner of the

THERMOS mark and that the mark was valid.190

The court found for

the defendant, however, because THERMOS was not in compliance

with labeling laws requiring marking of foreign origin.191

The law stated that articles of foreign manufacture must be marked

conspicuously with the country of origin, and that this marking should

be as permanent as the nature of the article would permit.192

Thermos,

however, was found to be intentionally marking its imported items

inconspicuously and with labels that could be removed, all while

advertising to the public that “American-made goods for American

people keep American workmen busy.”193

The appellate court

affirmed the lower court’s decision not to enforce Thermos’ rights.194

In the prohibition-era district court case Anheuser-Busch v. Cohen,

the court construed Section 21 narrowly. There, the owner of the

http://ipmall.info/hosted_resources/lipa/trademarks/PreLanhamAct_087_Act_of_192

0.htm; see also ALTMAN & POLLACK, supra note 179, § 40:14. 186

1 J THOMAS MCCARTHY, MCCARTHY ON TRADEMARKS AND UNFAIR

COMPETITION § 5:3 (4th ed. 2016). 187

For additional review of pre-Lanham Act cases, see Iver P. Cooper,

“Unclean Hands” and “Unlawful Use in Commerce”: Trademarks Adrift on the

Regulatory Tide, 71 TRADEMARK REP. 38 (1981). 188

American Thermos Bottle Co. v. W.T. Grant Co., 282 F. 426, 426 (1st Cir.

1922). 189

Id. 190

Id. at 427. 191

Id. at 431. 192

Id. at 429–30. 193

Id. at 430. As background, recall that World War I had ended just a few years

before. 194

Id. at 431.

318 WAKE FOREST J.


[VOL. 17

BUDWEISER mark, who was using the mark in connection with

barley malt syrup, brought suit against a party using the mark BUDD-

WISE in connection with malt sugar syrup.195

The defendant claimed

that because there were no legitimate uses for the BUDWEISER

product other than the illegal manufacture of home-brew, the plaintiff

could not prevail.196

The court held that section 21 was merely a statement of the “long-

established equitable principle” that illegal conduct on the part of a

plaintiff may be a defense.197

Interestingly, the court dismissed

outright the idea of unlawful use of a mark as a bar to the development

of rights, noting that “[u]nlawful use of a trade-mark can give no

license to the general public to infringe that trade-mark, regardless of

whether the infringement be in connection with legitimate or unlawful

trade.”198

The court went on to note that “[t]he restriction on actions for

infringement, contained in the provision of the statute above quoted, is

intended to be confined to such cases where the unlawfulness of the

plaintiff’s business is an established fact,” and explained that mere

allegations of illegality are not sufficient.199

The court enjoined the

defendants from further use of BUDD-WISE and awarded damages

and profits.200

This requirement that the unlawfulness be an

established fact was prescient of the TTAB’s later adoption of the “per

se” requirement for unlawful use.

In 1930, the Second Circuit reviewed the case law on the issue in

ruling on a case involving TROJAN brand condoms.201

There, the

plaintiff contraceptive manufacturer sought relief in the courts for

trademark infringement, but the defendant raised the “unlawful

business” defense, as condoms were at the time illegal unless

prescribed by a physician.202

The defendant presented evidence that

the plaintiff was aware of illegal resale of its products, though the

plaintiff was not reselling the contraceptives themselves.203

The court thoroughly reviewed the “unlawful business” provision

of the Act, finding, as Anheuser-Busch had found, that “section 21

gives a defendant in equity no new or greater defense” than the

195

Anheuser-Busch, Inc., v. Cohen, 37 F.2d 393, 394 (D. Md. 1930). 196

Id. at 394–95. 197

Id. at 395. 198

Id. 199

Id. 200

Id. at 397. 201

Youngs Rubber Corp., Inc. v. C.I. Lee & Co., 45 F.2d 103 (2d Cir. 1931). 202

Id. at 107–08. 203

See id. at 109


USE DOCTRINE

319

already-existing equitable defense of unclean hands.204

The court

imposed what would today be called a nexus requirement (also a

requirement of unclean hands), noting that “[n]umerous cases have

held that violation of the Sherman Act does not bar a plaintiff from

enjoining an infringer of his trade mark…”205

; in other words, general

illegality or improper conduct is not sufficient, “the taint that is

regarded must affect the particular rights asserted in his suit” and not

merely “affect[] the defendant only as it does the public at large.”206

Specifically, the court noted:

In the case before us the plaintiff has a valid trade mark

and under general equitable principles is entitled to

protect its sales, so far as they are legal, against unfair

competition by piracy of the mark. In our opinion

section 21 gives a defendant in equity no new or greater

defense. If the defendants’ unfair competition were

shown to deprive the plaintiff of the opportunity to

make only sales which were illegal, a court of equity

might properly refuse relief….

… If, for example, plaintiff were selling direct to the

public without a physician’s prescription, it could not

complain because defendants by making similar sales

under piracy of plaintiff’s trade mark deprived it of

such illegal business.207

However, the court limited the plaintiff’s recovery to only those sales

“it might legally have made.”208

b. Do These Early Cases Provide Support for the Modern

Unlawful Use Doctrine?

As noted above, the earliest trademark statutes in United States

history specifically contemplated that those using marks “in unlawful

business” would be unable to bring an action, not simply unable to

register.209

Although “unlawful business” on its face sounds as though

it could be limited to someone using a mark in connection with goods

204

Id. at 110. 205

Id. at 108. 206

Id. at 109. 207

Id. at 111. 208

Id. 209

Id. at 107.

320 WAKE FOREST J.


[VOL. 17

or services that are actually illegal (e.g., illegal drugs), one of the

earliest cases decided under the “unlawful business” provision looks

remarkably like current case law refusing to enforce rights in a mark

based on violations of the FDCA or other statutes. In American

Thermos, the court refused to allow a plaintiff to enforce its rights

against an infringing, junior user defendant where the plaintiff had not

complied with labeling laws regarding marking of country of origin.210

In fairness, the plaintiff’s apparent desire to mislead consumers into

believing that its products were American-made played into the

court’s decision, but the fact remains that the business, selling vacuum

bottles, was not itself illegal.211

The court could have simply focused

on the fact that the plaintiff was attempting to mislead consumers;

regardless of other statutes, attempting to mislead consumers can

vitiate trademark rights on its own, either via the unclean hands

doctrine or under the relevant trademark statute. However, the court

instead went through the effort of identifying the labeling statute at

issue and pointing out how the plaintiff had not complied.212

This indicates that from an early time, courts sometimes construed

the unlawful business provisions of the original trademark acts to

include not just marks used in connection with unlawful goods and

services, but also a failure by a lawful business to comply with

standards and regulations such as labeling requirements. Nevertheless,

the existence of these cases is not necessarily evidence of an early

unlawful use doctrine as we know it today. Each of the cases likely

could have reached the same result on the basis of the “unclean hands”

doctrine alone, and indeed several of the cases explicitly construed

Section 21 as an unclean hands provision. From the earliest times,

courts routinely refused to enforce the asserted rights of plaintiffs

based upon the plaintiffs’ own misconduct.213

Historical cases are less clear about the issue of development of

210

American Thermos Bottle Co. v. W.T. Grant Co., 282 F. 426, 430–31 (1st

Cir. 1922). 211

Id. at 31. 212

Id. 213

In addition to the above-cited cases, see Manhattan Med. Co. v. Wood, 108

U.S. 218, 227 (1883). There, the court noted that:

If [plaintiffs] claim relief against the frauds of others, they must

themselves be free from the imputation. If the sales made by the

plaintiff and his firm are effected, or sought to be, by

misrepresentation and falsehood, they cannot be listened to when

they complain that, by the fraudulent rivalry of others, their own

fraudulent profits are diminished. An exclusive privilege for

deceiving the public is assuredly not one that a court of equity can

be required to aid or sanction. To do so would be to forfeit its

name and character.


USE DOCTRINE

321

rights (as opposed to merely the enforcement of rights) based on the

unlawful use of a mark. This distinction is important: if the doctrine

prevents the development of rights, a junior user can win an

infringement lawsuit against the senior (unlawful) user, forcing the

senior user to stop using the mark altogether.214

If the doctrine simply

prevents the enforcement of rights, the result is that the senior

(unlawful) user cannot win an infringement lawsuit against the junior

user; the senior user may not be able to enforce, but he is able to

continue using the mark.215

He may also be able to enforce against

future users once he is in compliance with the law.216

The Anheuser-Busch court noted that “[u]nlawful use of a trade-

mark can give no license to the general public to infringe that trade-

mark, regardless of whether the infringement be in connection with

legitimate or unlawful trade. If the plaintiff is in fact violating the

criminal law, he can be punished in the proper forum.”217

This would

seem to indicate that rights can develop despite unlawful use, i.e., that

one’s priority of use date is not affected by whether the use was lawful

at the time. It’s also worth noting that the issue in this case was a

business that was actually unlawful–alcohol-related products during

prohibition–as opposed to a mere labeling violation. In another case,

however, a court held that sales made without a license did not count

toward establishing priority of use;218

this would seem to indicate that

priority of use was affected by whether the use was lawful or not.219

Although the concept of denying the ability to enforce rights based

on a trademark owner’s misconduct is as old as trademark law itself,220

it is less clear whether these older cases specifically contemplate a

change in priority of use based on noncompliance with regulations.

2. Unlawful Use Under the Lanham Act

The Lanham Act was passed in 1946 and repealed the previous

trademark acts.221

Interestingly, despite the explicit prohibition

214

Id. (emphasis added). 215

Anheuser-Busch, Inc., v. Cohen, 37 F.2d 393, 395 (D. Md. 1930) (emphasis

added). 216

Id. 217

Id. 218

Jackman v. Calvert-Distillers Corp., 28 N.E.2d 430, 432 (Mass. 1940). 219

Id. From a practical standpoint, a key distinction between these cases is that

Budweiser had rights prior to prohibition and was seeking to maintain those rights

during prohibition; Calvert made his first sales of whiskey during prohibition when

they could not have been lawful. 220

See, e.g., Manhattan Med. Co. v. Wood, 108 U.S. 218 (1883). 221

See MCCARTHY, supra note 37, Appendix A1 Title XI.

322 WAKE FOREST J.


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against use in “unlawful business” in both the 1870 and the 1905 Act,

Congress included no similar provision.

Indeed, although the Lanham Act requires “use in commerce” to

register a mark, “lawful use” is only mentioned twice.222

Section 2

makes mention of a “lawful” use requirement only in Section 2(d)’s

concurrent use provision, where it states that:

[I]f the Director determines that confusion, mistake, or

deception is not likely to result from the continued use

by more than one person of the same or similar marks

under conditions and limitations as to the mode or place

of use of the marks or the goods on or in connection

with which such marks are used, concurrent

registrations may be issued to such persons when they

have become entitled to use such marks as a result of

their concurrent lawful use in commerce prior to (1)

the earliest of the filing dates of the applications

pending or of any registration issued under this chapter

. . . 223

The only other place where such a requirement is mentioned is in

the Supplemental Register provisions of 15 U.S.C. 1091.224

There, the

Act states that “[a]ll marks capable of distinguishing applicant's goods

or services and not registrable on the principal register provided in this

chapter . . . which are in lawful use in commerce by the owner thereof

. . . may be registered on the supplemental register . . . ” and goes on to

say that:

[n]othing in this section shall prevent the registration on

the supplemental register of a mark, capable of

distinguishing the applicant's goods or services and not

registrable on the principal register under this chapter,

that is declared to be unregistrable under section

1052(e)(3) of this title, if such mark has been in lawful

use in commerce by the owner thereof, on or in

connection with any goods or services, since before

December 8, 1993.225

222

See generally 15 U.S.C. § 1052(d) (2012). 223

15 U.S.C. § 1052(d) (2012) (emphasis added). 224

15 U.S.C. § 1091 (2012). 225

Id. (emphasis added) (there is one other mention of the term “lawful” in the

Lanham Act. This is in the context of cyberpiracy, providing a safe harbor where a

registrant “believed and had reasonable grounds to believe that the use of the domain

continued . . .


USE DOCTRINE

323

However, the courts interpreting these provisions have not

examined whether the use is “lawful” in the sense of compliance with

the universe of laws, but instead “lawful” with respect to the Lanham

Act’s own provisions. For example, in discussing the concurrent

registration provisions, one court noted that “[a] ‘lawful use’ is the use

of a mark in connection with goods and services in a territory not

covered by another party’s registration.”226

Likewise, in the

supplemental register context, “lawful use” has largely been construed

as “exclusive use.”227

One likely place for a mention of such a requirement would be in

the definitions section of the Act. Nevertheless, no mention of lawful

use is present. “Use in commerce” is defined as “the bona fide use of

a mark in the ordinary course of trade, and not made merely to reserve

a right in a mark.”228

Although “commerce” is defined as “all

commerce which may be lawfully regulated by Congress,” this would

appear to be a restriction upon what can be regulated, not a restriction

on the rights of mark owners.229

As discussed above, one TTAB member was skeptical of the

Lanham Act providing a basis for a lawful use requirement, noting that

“[a] very persuasive argument can be made for the proposition that

there is in fact no statutory basis for refusing to grant a registration, or

for cancelling a subsisting registration, on the ground of ‘unlawful

use.”230

The member pointed out that the case that gave birth to the

practice of doing so claimed no statutory basis, and that “inasmuch as

the term ‘lawful’ is specifically used in certain sections of the Statute,

the suggestion that this term should be read into those sections where

it is not used would appear to be a violation of the basic rules of

statutory construction.”231

Further, she noted, with respect to the

statutory intent to make actionable deceptive and misleading uses of

marks, “the fact that a product label, for example, is not in compliance

name was a fair use or otherwise lawful”); see 15 U.S.C. § 1125(d)(1)(B)(ii); Gilson,

supra note 172, at 849. 226

Fleming Cos., Inc. v. Thriftway, Inc., 809 F. Supp. 38, 42 (S.D. Ohio 1992);

see also Gilson, supra note 172, at 848. 227

Gilson, supra note 172, at 848. 228

15 U.S.C. § 1127 (1988). The definition of “use in commerce” was amended

to include this language in 1988: “to eliminate ‘token use’ as a basis for

registration.” See Chance v. Pac-Tel Teletrac Inc., 242 F.3d 1151, 1156 (9th Cir.

2001). 229

15 U.S.C. § 1127 (2012). 230

Satinine Societa in Nome Collettivo di S.A. e M. Usellini v. P.A.B. Produits

et Appareils de Beaute, 209 U.S.P.Q. 958, 962 n.2 (T.T.A.B. 1981) (Lefkowitz,

Member, concurring). 231

Id.

324 WAKE FOREST J.


[VOL. 17

with a regulatory statute pertaining thereto does not mean that the

mark applied to the goods is being used in a deceptive or misleading

manner but rather only that the label may be deceptive or

misleading.”232

Another member, however, pointed out that “it would

be wholly contradictory to require ‘lawful use’ for an application to

register a mark upon the Supplemental Register but not to require

‘lawful use’ for an application to register a mark upon the Principal

Register, which confers much greater rights upon the registrant.”233

As such, the Lanham Act—while it does not clearly permit the

development of rights based on unlawful use—does not clearly

prohibit them either.

3. Pre-CreAgri Federal Case Law

As noted above, a handful of federal court cases had addressed the

unlawful use doctrine in some manner prior to the Ninth Circuit’s

adoption of it in CreAgri, although the Ninth Circuit did not

acknowledge most of these cases in its opinion.234

Some of these

cases are discussed below.

a. United Phosphorus and Daffy Dan’s: The Precedents

That Aren’t

The one federal case that the Ninth Circuit cited in CreAgri was

United Phosphorous Ltd. v. Midland Fumigant Inc.235

There, the

Tenth Circuit affirmed a district court’s decision not to give an

unlawful use jury instruction where the defendant had “failed to

present one piece of evidence at trial tending to show United’s product

was sold or distributed illegally.”236

Relying on 15 U.S.C. § 1127 (the

definitions section of the Lanham Act), Daffy Dan’s (a Federal Circuit

case discussed below) and a 1982 TTAB decision,237

the court noted

that it was a correct statement of the law that “in order to obtain rights

in the Quick-Phos trademark, United needed to show that the name

was lawfully used in commerce.”238

The court did not expand on its

analysis of the unlawful doctrine.

None of the cited authorities seem to stand for that proposition,

232

Id. 233

Id. at 964 (Kera, Member, concurring). 234

See CreAgri, Inc. v. USANA Health Scis., Inc., 474 F.3d 626 (9th Cir. 2007). 235

Id. at 630. 236

Id. at 1225–26. 237

Clorox Co. v. Armour-Dial, Inc., 214 U.S.P.Q. 850 (T.T.A.B. 1982). 238

United Phosphorus v. Midland Fumigant, Inc., 205 F.3d 1219, 1225 (10th

Cir. 2000).


USE DOCTRINE

325

however. As noted above, the definitions section of the Lanham Act

makes no mention of unlawful use.239

The TTAB decision was by

necessity addressing registration only, not the development of

rights.240

The citation to Daffy Dan’s is erroneous because Daffy

Dan’s is not an unlawful use case.

Gray v. Daffy Dan’s Bargaintown is a Federal Circuit decision

affirming a TTAB decision in a concurrent use proceeding, but the

issue of “lawful use” only arises because of the language used in the

concurrent use portion of the statute; it is not discussed in the same

sense as it’s used in CreAgri or even in the TTAB’s unlawful use

doctrine. In Daffy Dan’s, the court noted, without discussion, that “[a]

valid application cannot be filed at all for registration of a mark

without ‘lawful use in commerce,’ and, where a claim is made of

concurrent rights, such use must begin prior to the filing date of any

application by a conflicting claimant to the mark.”241

The Board in that case was tasked with determining whether a

junior user who was using his mark in the same geographic area as the

senior user could obtain a concurrent use registration.242

The junior

user argued that because the Board had found that the junior user had

initially begun using the mark in good faith outside the territory of the

senior user prior to the senior user’s filing date, the junior user was

entitled to a concurrent use registration.243

The Federal Circuit noted

that while an applicant must be using the mark in commerce outside of

the conflicting claimant’s area prior to the senior user’s filing date in

order to obtain a concurrent use registration, that was only one of

several requirements that must be met for a concurrent use registration

(the key additional requirement being that there is no likelihood of

confusion, as the public’s right to avoid confusion is also

paramount).244

What does this have to do with the unlawful use doctrine as

discussed in this paper? Nothing. They are simply not related.

Because the statute mentions “lawful use in commerce,” the court

quoted that term, but the sentence at issue does not revolve around the

word “lawful”—no one in Daffy Dan’s was questioning whether either

user’s use was “lawful” under any law—the sentence revolves around

the term “use in commerce.”245

The court was essentially saying “of

239 See 15 U.S.C. § 1127 (2012) (failing to define unlawful use).

240 See Clorox, 214 U.S.P.Q. at 851 (sustaining opposition and refusing

registration). 241

Gray v. Daffy Dan’s Bargaintown, 823 F.2d 522, 526 (Fed. Cir. 1987). 242

See id. at 525. 243

See id. at 525–26. 244

See id. at 526. 245

Daffy Dan’s Bargaintown, 823 F.2d at 526.

326 WAKE FOREST J.


[VOL. 17

course you’ve got to have use in commerce—you always need that to

get a registration! And, if you want concurrent rights, your use in

commerce has to predate the other guy’s application.”

In any event, even assuming that (1) this was an actual holding of

the court and (2) the court intended to make a statement about lawful

use in commerce, all the court is saying is that “[a] valid application

cannot be filed at all for registration of a mark without ‘lawful use in

commerce.’”246

Coming from the Federal Circuit, sitting as an

appellate court reviewing the TTAB, this was nothing new. The

USPTO had adopted the policy that an application for registration

must be based on lawful use in commerce years before. Even

Satinine, which refined the doctrine, was decided years earlier.247

b. Other pre-CreAgri cases addressing unlawful use

Some early post-Lanham Act cases applied the doctrine without

much discussion, or as intertwined with the defense of unclean hands.

For example, in Strey v. Devine’s, Inc.,248

decided in 1954, the

Seventh Circuit affirmed a decision denying relief for trademark

infringement to a plaintiff on the basis of unclean hands, but also

affirmed because the plaintiff’s product was a drug that did not

comply with federal labeling requirements.249

The court held that “the

misrepresentations made the by the plaintiff in the use of his trade-

mark and the misbranding of his cream in violation of the Federal

Food, Drug, and Cosmetic Act (“FDCA”) were sufficient reasons for

the District Court to deny him relief.”250

In Cameo v. Plough, decided in 1975, a federal district court in

Ohio ordered a plaintiff’s trademark registration cancelled after

finding that the plaintiff had shipped a misbranded drug (the labeling

failed to disclose that the active ingredient was formaldehyde) in

interstate commerce in violation of the FDCA.251

This would not be

especially notable, as unlawful use as a bar to registration (or grounds

for cancellation) is within the purview of the USPTO’s policy.252

246

Id. (emphasis added). 247

See Satinine Societa in Nome Collettivo Di S.A. E M. Usellini v. P.A.B.

Produits et Appareils de Beaute, 209 U.S.P.Q. 958 (T.T.A.B. 1981). 248

217 F.2d 187 (7th Cir. 1954). 249

Id. 250

Id. at 190. The violation was a failure to list all of the ingredients, in violation

of the Food, Drug, and Cosmetic Act. It is not clear whether the plaintiff was

intentionally avoiding the requirements of the Act. 251

Cameo, Inc. v. Plough, Inc., 185 U.S.P.Q. 228, 229 (N.D. Ohio Jan. 3, 1975). 252

See, e.g., Davidoff Extension S.A. v. Davidoff Int’l, Inc., 612 F. Supp. 4

continued . . .


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327

However, the court went beyond registration and stated that

“[t]rademark rights, either at common law or under the Lanham Act,

are acquired and maintained only by lawful use,” and also stated that

“Plaintiff’s trademark . . . is, therefore, invalid and so is its

registration.”253

This decision was later vacated without opinion.254

In 1985, the court in Intrawest Financial Corp. v. Western

National Bank held, with little discussion, that two banking companies

could not defend against abandonment allegations by claiming they

had used the mark, when their only use of the mark during the time in

question was in violation of national banking laws.255

In 1991, a federal court in Puerto Rico in Erva Pharmaceuticals

accepted an unlawful use defense, dismissing a plaintiff’s complaint

for trademark infringement after granting summary judgment for the

defendant as to the issue of the plaintiff’s unlawful use of a mark.256

There, the plaintiff was selling SUPRA brand erectile dysfunction

treatment and the defendant was selling SUPRAX brand ear infection

treatment.257

The plaintiff brought suit under the Puerto Rico

Trademark Act only, whereas the defendant counterclaimed under the

Lanham Act as well.258

The Puerto Rico statute states that no

trademark shall be registered “which was not lawfully used in Puerto

Rico by the applicant or his predecessor prior to the date of filing the

application.”259

Because of this language, the court reasoned that

“[t]hus, in order to assert protection of the trademark laws, the prior

use upon which the trademark registration was based must have been

lawful . . . ” and perhaps also because of that language in the Puerto

Rico statute, later, “[i]n order to enforce the trademark rights, the prior

use must be lawful.”260

The court relied upon the TTAB’s Satinine decision, finding that

SUPRA was mislabeled.261

The violations at issue concerned typesize

and placement of information; however, the court specifically found

(S.D. Fla. 1984) (rejecting the defendants’ argument that a registration should be

cancelled due to unlawful use where the defendants could not show that the plaintiff

had been shipping cigars containing Cuban tobacco in the United States, and relying

upon Satinine). There is no indication that the ruling went beyond the USPTO’s

policy of denying or cancelling registration on the grounds of unlawful use. 253

Cameo, 185 U.S.P.Q. at 229. 254

Cameo, Inc. v. Plough, Inc., 517 F.2d 1404 (6th Cir. 1975). 255

Intrawest Fin. Corp. v. W. Nat. Bank of Denver, 610 F. Supp. 950, 958–59

(D. Colo. 1985). 256

Erva Pharm., Inc. v. Am. Cyanamid Co., 755 F. Supp. 36 (D.P.R. 1991). 257

Id. at 38. 258

Id. 259

Id. at 39 (citing 10 L.P.R.A. § 194(f) (1978)) (emphasis added). 260

Id. 261

Id. at 40.

328 WAKE FOREST J.


[VOL. 17

that the violations were not de minimis, explaining:

Although the “SUPRA” label may contain all the

information required under the Act, Congress

specifically amended the statute so that the appearance

of the label, which may contain the necessary

information, be visually designed in a certain way in

order to protect consumers (doctors and patients) who

may pay more because they do not realize the product

they are buying is a well-known drug which they could

purchase for a cheaper price. Thus, plaintiff’s labeling,

as filed with the Puerto Rico Secretary of State when it

applied to register for a trademark, failed to comply

with these requirements of the statute and clearly

violated the statute on its face, insofar as it has directly

violated 21 U.S.C. § 352(e) (Supp.1989). Moreover, its

admitted violations of the applicable regulations

concerning typesize and placement of information, are

not de minimis, and constitute a sufficient basis, in

conjunction with its per se violation of the FD & C Act,

upon which to conclude that its use in commerce was

unlawful prior to its registering the trademark.262

The court also noted that the plaintiff had failed to register as a

drug establishment, providing separate grounds for a finding of

unlawful use.263

The Erva case is a bit of an outlier. At a time when few courts

were applying the doctrine at all, and even the TTAB was limiting the

doctrine in its own narrow context of registration, the Erva court chose

to refuse to enforce a plaintiff’s rights based on fairly innocuous

violations of the FDCA.264

In any event, this remains one of only a

handful of cases to accept an unlawful use argument and use such a

finding to refuse to enforce the plaintiff’s rights.265

That same year, a district court in Illinois denied a defendant’s

motion to add an affirmative defense of unlawful use where the

defendant argued that the plaintiff had obtained state licenses to use

the trademarks for manufacturing and selling lottery tickets through

fraudulent representations.266

The court rejected this argument, noting

262

Id. at 41. 263

Id. at 41–42. 264

Id. at 42. 265

Id. 266

Universal Mfg. Co. v. Douglas Press, Inc., 770 F. Supp. 434 (N.D. Ill. 1991).


USE DOCTRINE

329

that “[w]here courts have barred plaintiffs from asserting their

trademark and copyright rights because of their unlawful acts,

plaintiffs’ uses of their trademarks and copyrights themselves, rather

than their conduct in obtaining them, were unlawful.”267

However,

this was not based on the TTAB’s precedent per se, but instead the

court cited to federal cases and unclean hands generally.268

In 1999, the Second Circuit affirmed a district court’s denial of a

motion to amend an answer to add the defense of unlawful use.269

There, the defendant argued that the plaintiff was an investment

adviser who was required to register with the SEC, yet did not, and

that “this failure rendered [plaintiff’s] use of the mark in interstate

commerce unlawful and, thus, that [plaintiff’s] mark was

unprotectable.”270

However, the appellate court essentially found that

the defense was untimely and disclaimed any substantive evaluation of

the merits, explaining that “in affirming, we have not considered, and

we express no view regarding, the merits of the defense or Judge

Chin’s discussion thereof.”271

In 2000, a district court in Illinois considered the issue after

defendants moved for summary judgment on the issue of, among other

things, unlawful use in commerce of the plaintiffs’ perfume.272

Although the court agreed with the defendants that there were several

per se statutory violations of the Food, Drug, and Cosmetic Act, the

court distinguished Erva and found that the violations were de

minimis.273

Until CreAgri, no other case had considered the issue in depth. As

such, although there is some precedent for using the doctrine or

something similar to affect development of rights, CreAgri essentially

broke new ground by formally adopting such a requirement.

B. Is Adopting the Unlawful Use Doctrine Good Policy?

Although there have been a handful of cases that have applied the

doctrine, one way or another, in the years leading up to CreAgri, the

historical basis for a federal court’s unlawful use doctrine is far from

solid. The doctrine suffers from some policy shortcomings as well.

267

Id. at 435. 268

Id. at 435–36. 269

Lane Capital Mgmt., Inc. v. Lane Capital Mgmt., Inc., 192 F.3d 337 (2d Cir.

1999). 270

Id. at 349. 271

Id. at 350. 272

Advert. to Women, Inc. v. Gianni Versace S.p.A., No. 98C1553, 2000 WL

1230461, at *2 (N.D. Ill. Aug. 24, 2000). 273

Id. at *5.

330 WAKE FOREST J.


[VOL. 17

1. Consumer Protection as a Policy Objective

CreAgri laid out two policy considerations in favor of a federal

court’s unlawful use doctrine. First, “as a logical matter, to hold

otherwise would be to put the government in the ‘anomalous position’

of extending the benefits of trademark protection to a seller based

upon actions the seller took in violation of that government’s own

laws.”274

Second, “to give trademark priority to a seller who rushes to

market without taking care to carefully comply with the relevant

regulations would be to reward the hasty at the expense of the

diligent.”275

These policy considerations are reasonable, but they

address only two perspectives: that of the government (having to

extend protection to those who flout its laws) and that of competitors

(who are harmed when a competitor begins using a mark during the

time it takes to review and comply with federal regulations).

One key perspective is missing: consumers. It is hard to ignore a

major shortcoming in the unlawful use doctrine: it would seem to

harm consumers. Using the facts from CreAgri as an example,

consumers who were using the OLIVENOL brand nutritional

supplement were able to purchase that supplement beginning in the

spring of 2001.276

More than a year later, in August of 2002, its

competitor began selling nutritional supplements containing an

ingredient called OLIVOL.277

After the makers of OLIVENOL sued

for trademark infringement, the court cancelled the makers of

OLIVENOL’s registration due to its mislabeling and held that they

could not maintain a trademark infringement action against the makers

of OLIVOL.278

Assuming these marks are confusingly similar, as the

makers of OLIVENOL alleged, consumers are now left with a

confusingly similar product on the market, but it’s not the product they

think it is. This is a major consequence.

2. Deterrence and/or Punishment as a Policy Objective

Another policy question is whether the unlawful use doctrine

captures behavior that other doctrines do not, and if so, is that

additional behavior captured by the unlawful use defense something

that we want to deter and/or punish? Specifically, the doctrines of

274

CreAgri, Inc. v. USANA Health Scis., Inc., 474 F.3d 626, 630 (9th Cir.

2007) (quoting In re Stellar Int’l, Inc., 159 U.S.P.Q. 48, 51 (T.T.A.B. 1968)). 275

Id. 276

Id. at 628. 277

Id. at 629. 278

Id. at 634.


USE DOCTRINE

331

unclean hands279

and fraud on the Patent and Trademark Office bear

on similar behavior.

As to the defense of “fraud on the PTO” or “fraudulent

registration,” that defense allows a defendant, upon proving that the

plaintiff fraudulently obtained a trademark registration, to remove a

mark’s “incontestable” status and cancel the plaintiff’s registration.280

The weight of the authority holds that proof of fraudulent registration

does not affect common law rights, meaning that the mark is still valid

and rights in the mark can still be enforced in court.281

As this defense

affects only registration and not use, it would not seem to have any

real overlap with the federal court version of the unlawful use

doctrine.

Unlawful use is often called a category of or corollary to unclean

hands.282

“Unclean hands” is a shorthand way of referring to the

maxim that “he who comes to equity must come with clean hands;” in

other words, courts can decline to grant relief to a plaintiff that is

acting improperly—at least in regards to the subject matter of the

litigation.283

For example, in one of the oldest and most famous

unclean hands trademark cases, the Supreme Court held that:

when the owner of a trade-mark applies for an

injunction to restrain the defendant from injuring his

property by making false representations to the public,

it is essential that the plaintiff should not in his trade-

mark, or in his advertisements or business, be himself

guilty of any false or misleading misrepresentation; that

if the plaintiff makes any material false statement in

connection with the property which he seeks to protect,

he loses his right to claim the assistance of a court of

equity; that where any symbol or label claimed as a

trade-mark is so constructed or worded as to make or

contain a distinct assertion which is false, no property

can be claimed on it, or, in other words, the right to the

exclusive use of it cannot be maintained.284

279

The unclean hands defense is also sometimes called “trademark misuse.” See,

e.g., MCCARTHY, supra note 37, § 31:44. 280


See id.; see also Dep't of Parks & Recreation for Ca. v. Bazaar Del Mundo

Inc., 448 F.3d 1118, 1131 (9th Cir. 2006) (“[E]ven if Bazaar del Mundo were shown

to have fraudulently obtained federal registration of the marks, its common law

rights in the marks would continue unabated.”). 282

See, e.g., MCCARTHY, supra note 37, § 31:49. 283

Id. 284

Clinton E. Worden & Co. v. Cal. Fig Syrup Co., 187 U.S. 516, 528 (1903).

332 WAKE FOREST J.


[VOL. 17

There, the court collected authorities, noting that courts have

declined to aid trademark holders who misrepresent the manufacturer

and the place the product is manufactured or the contents of the

product.285

The Supreme Court explained that in the case before it, the

plaintiff argued that its SYRUP OF FIGS mark was not descriptive

because it contained very little fig juice, but instead derived its

laxative property from senna, and was thus a fanciful mark.286

The

Court found that the misrepresentations on the packaging (the name as

well as the image of a fig tree and other markings) “are so plainly

deceptive as to deprive the complainant company of a right to a

remedy by way of injunction by a court of equity.”287

As one authority explains, there are several requirements for a

successful unclean hands defense in a trademark case: first, the

plaintiff’s conduct must be inequitable (not necessarily illegal);

second, the misconduct must be intentional; third, “[t]he defendant

must show fraud, unconscionability or bad faith on the part of the

plaintiff”; and finally, there must be “a logical connection between the

trademark right the plaintiff is claiming and the activity that gives rise

to the unclean hands defense.”288

The doctrine tends to be construed

narrowly; the Ninth Circuit, for example, has imposed the requirement

“that the plaintiff used the trademark with the specific intent to

deceive consumers.”289

A federal court in New York noted that

“courts typically only bar recovery under a theory of unclean hands

when a plaintiff’s conduct was egregious, . . . or clear, unequivocal

and convincing” because trademark law involves protecting the public

interest.290

One case, decided in the 1980s, held that the unclean hands

defense would not bar a plaintiff engaged in the sale of drug

paraphernalia from obtaining relief in the courts.291

The court

explained that the defendants failed “to establish any logical nexus

between their claim that [the plaintiff] sells cigarette paper to the drug

285

Id. at 528–32. 286

Id. at 533. 287

Id. at 540. 288

9 ROBERT J. JOSSEN & NEIL A. STEINER, BUSINESS AND COMMERCIAL

LITIGATION IN FEDERAL COURTS § 99:39 (4th ed. 2016). 289

2die4kourt v. Hillair Capital Mgmt., LLC, No. SACV 16-01304

JVS(DFMx), 2016 U.S. Dist. LEXIS 118211, at *25–26 (C.D. Cal. Aug. 26, 2016)

(citing Japan Telecom, Inc. v. Japan Telecom Am., Inc., 287 F.3d 866, 870 (9th Cir.

2002)). 290

Patsy’s Italian Rest., Inc. v. Banas, 575 F. Supp. 2d 427, 461 (E.D.N.Y.

2008) (internal citations and quotations omitted). 291

Bambu Sales, Inc. v. Testini, 12 U.S.P.Q.2d 1479, 1481 (E.D.N.Y. 1988).


USE DOCTRINE

333

trade and the allegations against defendants that they have violated

[the plaintiff’s] trademark.”292

However, the court followed Young’s

Rubber in holding that illegal sales could be taken into account when

computing damages.293

There are several key differences between the

two doctrines. First, unclean hands will prevent a trademark

infringement plaintiff from enforcing his rights against that particular

defendant, whereas unlawful use prevents the development of rights at

all (in other words, the plaintiff cannot enforce against any defendant

if the infringement occurred during a time when the plaintiff’s use is

“unlawful”).294

Second, unclean hands looks at the intent (good faith

or bad faith) of the plaintiff, whereas unlawful use does not.295

Although unclean hands can reach behavior that is merely inequitable

and not illegal, the additional intent requirement makes it likely that

unclean hands will reach a smaller (or at least different) subset of

plaintiffs. In other words, unlawful use appears to be a more severe

version of unclean hands: the punishment is more severe, and the

behavior it captures may be “innocent” wrongdoing. In a Venn

diagram, unlawful use and unclean hands would overlap, with some

conduct that would fall under either theory, some conduct that would

fall only under unclean hands (conduct that is inequitable but not

illegal) and some conduct that would fall only under unlawful use

(conduct that is “illegal,” but not in bad faith).

Does it make sense to punish unlawful use? Perhaps, but those

who would intentionally flout the law are already within the grasp of

unclean hands. Punishing those who lack intent to flout the law more

severely (by loss of all rights) than those who act in bad faith seems

inconsistent. Further, because the doctrine is not well-known (and

inconsistently applied), it seems unlikely to deter noncompliance with

relevant law.

IV. PRACTICAL CONSIDERATIONS FOR APPLYING THE UNLAWFUL

USE DOCTRINE IN THE FEDERAL COURTS

Historical, statutory, and policy support for the unlawful use

doctrine are mixed. However, assuming that federal courts will

continue to apply the doctrine, they should do so thoughtfully,

consistently, and rarely, given the serious nature of consequences for

both the plaintiff and consumers. In this section, I first identify two

issues that should be addressed before the federal courts move forward

292

Id. 293

Id. at 1482. 294

Cooper, supra note 187, at 38–39. 295

Id. at 45, 55.

334 WAKE FOREST J.


[VOL. 17

with broad application of the doctrine—namely, its relationship to

state law and its relationship to other federal laws. Then, I examine

some practical issues federal courts should consider when applying the

doctrine in litigation.

A. Courts Must Resolve the Issue of the Unlawful Use Doctrine’s

Interaction With State and Federal Law

Conspicuously absent from the Ninth Circuit’s CreAgri decision

(and any decision since) is the question of how the unlawful use

doctrine interacts with state and federal law. Two questions arise:

whether state law can operate to restrict federal trademark law, and

whether the application of the unlawful use doctrine is making the

Lanham Act a “back door” for enforcement of federal statutes with no

private cause of action, such as the FDCA.

1. Does the Unlawful Use Doctrine Operate to Put State Law

Over Federal Law?

The first question is whether the unlawful use doctrine restricts

federal trademark law by making compliance with a state statute a

prerequisite to recovery under the Lanham Act. This situation arises

when a plaintiff is violating (or has violated) state law in some way,

but is seeking to enforce its trademark rights under federal law.

Several courts have discussed this issue in the context of unclean

hands. For example, in one early copyright case, Leo Feist v. Young,

the Seventh Circuit reversed a district court’s finding of unclean

hands.296

The district court had found unclean hands where the

plaintiff had failed to comply with a Wisconsin licensing statute.297

296

Leo Feist, Inc. v. Young, 138 F.2d 972, 977 (7th Cir. 1943). 297

Id. at 973–74. Regarding the statute:

The statute, which is captioned ‘Music brokers,’ provides that

no person, association or corporation other than the ‘true or

original composer’ shall directly or indirectly issue licenses or

other agreements for the public rendition of copyrighted musical

numbers by persons within Wisconsin, unless said persons,

association or corporation shall first obtain a license from the

Secretary of State to transact such business; that any applicant

desiring such license, shall file with the Secretary of State certain

information, and at the time of the filing shall pay a franchise tax

equivalent to twenty-five per cent of his or its gross receipts from

persons within Wisconsin for or on account of licenses or other

agreements for the public rendition of copyrighted musical

numbers within Wisconsin for the preceding year. The license is

required to be renewed annually, and the Secretary of State, acting

continued . . .


USE DOCTRINE

335

The Seventh Circuit reversed, noting that “it is familiar doctrine that

the prohibition of a federal statute may not be set at naught by a state

statute . . . Correlatively, the benefits of a federal statute may not be

denied by a state statute.”298

More recently, in the trademark context, the defendant in an

infringement action sought to add an affirmative defense that the

plaintiff “has willfully concealed the true owner of Plaintiff in

violation of numerous statutes and therefore use of its alleged

trademarks and copyrights has not been lawful and does not establish

legal rights thereto for Plaintiff.”299

The court noted that the defendant

was attempting to assert an “unclean hands” defense based on

violations in obtaining state licenses.300

However, the court rejected

this argument, applying Leo Feist: the defendant “is attempting to

make [the plaintiff’s] compliance with state licensing statutes a

condition precedent to [the plaintiff] asserting its federal rights under

the trademark and copyright acts.”301

The court refused to permit the

addition of the affirmative defense.302

Although the USPTO’s very first case involving unlawful use

addressed a state statute,303

the USPTO’s policy expressly limits the

unlawful use doctrine to federal statutes.304

As the TTAB has noted,

“‘unlawful’ must be held to imply only such commerce as is unlawful

under the Acts of Congress.”305

The TTAB held that where a

petitioner for cancellation had failed to plead that a use was “unlawful

under any statute of the United States,” the “use cannot be considered

to violate the ‘in commerce’ requirements . . . ”306

However, it is less clear whether the federal courts intend to import

this restriction. In developing its doctrine thus far, the Ninth Circuit

has not addressed this issue. In the 2014 case that solidified the Ninth

Circuit’s unlawful use doctrine, the conduct that was alleged to be

solely as a ministerial officer, is required to issue the license upon

compliance with the foregoing provisions.

Id. 298

Id. at 974; see also Bell v. Combined Registry Co., 397 F. Supp. 1241, 1245

(N.D. Ill. 1975) (stating “the operation of state law cannot defeat the validity of a

federal copyright”). 299

Universal Mfg. Co. v. Douglas Press, Inc., 770 F. Supp. 434, 435 (N.D. Ill.

1991). 300

Id. at 436. 301

Id. 302

Id. 303

See Coahoma Chem. Co. v. Smith, 113 U.S.P.Q. 413, 417 (P.T.O. 1957). 304

37 C.F.R. § 2.69 (1989). 305

W. Worldwide Enter. Grp. Inc. v. Qinqdao, 17 U.S.P.Q.2d 1137, 1141

(T.T.A.B. 1990). 306

Id.

336 WAKE FOREST J.


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unlawful was the failure to pay a state corporate franchise tax.307

Although the court rejected the unlawful use defense, it did so on the

merits, holding that the alleged unlawful conduct was unrelated to the

purposes of the trademark laws and that the allegations of unlawful

conduct were unsubstantiated.308

One would think that if the Ninth

Circuit intended to adopt the state and federal distinction, it would

have done so at the outset, without looking at the substance of the

alleged violations: you can’t succeed on your unlawful use defense

because you’re only alleging violations of state law. That would have

been a cleaner and easier way to resolve the issue. Instead, it

examined the alleged violations and held that they were unrelated and

unsubstantiated.309

At least one case has referenced criminal law

without noting if the law at issue is state or federal.310

One case noted

that it was not clear whether the unlawful use doctrine could rest upon

state law.311

No other unlawful use cases have considered state

statutes.

If the federal courts are inclined to permit state statutes and

regulations to form the basis of the application of the unlawful use

doctrine, they should first reconcile whether this is permissible.

2. Does the Application of the Unlawful Use Doctrine Make

the Lanham Act a “Back Door” for Enforcement of

Statutes With No Private Cause of Action?

The second question is whether the application of the unlawful use

doctrine makes the Lanham Act a “back door” for the enforcement of

statutes with no private cause of action. In the context of unclean

hands, several courts have refused to find unclean hands where the

purported “uncleanliness” comes from non-compliance with the Food,

Drug, and Cosmetics Act, which contains no private cause of action.

In one case, the court explained that “[t]he unclean hands doctrine

should not bar Lanham Act claims when the doctrine is premised on

allegations of non-compliance with the FDCA because such a use of

the doctrine would essentially permit a private enforcement action—a

power reserved for the FDA.”312

Likewise, in Inmuno Vital, Inc. v.

307

S. Cal. Darts Ass’n v. Zaffina, 762 F.3d 921, 926 (9th Cir. 2014). 308

Id. at 931–32. 309

Id. at 933. 310

See, e.g., Cash Processing Servs. LLC v. Ambient Entm’t, Inc., 320 F.

App’x. 494, 496 (9th Cir. 2008) (not for publication). 311

Veronica’s Auto Ins. Servs. v. Veronica’s Servs., Inc., No. EDCV 13-01327

DDP (DTBx), 2014 WL 7149530, at *5 (C.D. Cal. Dec. 15, 2014). 312

Healthpoint, Ltd. v. Ethex Corp., 273 F. Supp. 2d 817, 849 (W.D. Tex.

2001).


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Golden Sun, Inc., the court rejected non-compliance with regulations

as a defense; the defendant argued that “since the goods are

misbranded, they are not lawfully used in commerce and cannot be the

basis for registering a trademark.”313

The court rejected this argument,

holding that:

[t]o the extent that Golden Sun relies on these federal

statutes, its claims fail as a matter of law because no

private right of action exists to redress alleged

violations of the FDCA . . . Rather, the right to enforce

the provisions of the FDCA lies exclusively within the

federal government’s domain, by way of either the

FDA or the Department of Justice.314

The court noted that Erva Pharmaceuticals was a contrary holding,

but cited a number of cases in support.315

The Supreme Court’s recent decision in POM Wonderful does not

resolve the issue, although it may be instructive. There, the Court

considered “whether a private party may bring a Lanham Act [false

advertising] claim challenging a food label that is regulated by the

FDCA.”316

The defendant argued that since its labels were in

compliance with the FDCA, the plaintiff could not bring a false

advertising action based on the content of those labels because the

FDCA precludes Lanham Act claims challenging food and beverage

labels.317

The Supreme Court disagreed, finding that the Lanham Act

and the FDCA merely complement one another; it ultimately found

that “[t]he position [defendant] takes in this Court that because food

and beverage labeling is involved it has no Lanham Act liability here

for practices that allegedly mislead and trick consumers, all to the

injury of competitors, finds no support in precedent or the statutes.”318

Even assuming that Lanham Act false advertising would be treated

identically to Lanham Act trademark infringement, the case is not

directly on point because it is the reverse of the situation addressed by

the unlawful use doctrine. In unlawful use cases, a party argues that

its competitor has no rights in a mark on the basis that the competitor’s

labels do not comply with the FDCA.319

In the POM case, the

313

Inmuno Vital, Inc. v. Golden Sun, Inc., 49 F. Supp. 2d 1344, 1359 (S.D. Fla.

1997). 314

Id. 315

Id. 316

POM Wonderful LLC v. Coca-Cola Co., 134 S. Ct. 2228, 2236 (2014). 317

See, e.g., id. 318

Id. at 2241. 319

See generally Healthpoint, Ltd. v. Ethex Corp., 273 F. Supp.2d 817 (W.D.

continued . . .

338 WAKE FOREST J.


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defendant sought to defend on the basis that its own labels did comply

with the FDCA.320

The Supreme Court held that even if the labels

complied with the FDCA, the labels could still be misleading under

the Lanham Act.321

However, the Supreme Court noted that, “POM

seeks to enforce the Lanham Act, not the FDCA or its regulations.”322

Despite the cases that hold that misbranding cannot be raised in the

context of trademark infringement, numerous cases have accepted the

unlawful use or unclean hands defense based on the FDCA without

mentioning any such problem.323

As such, it is not clear whether the

unlawful use doctrine impermissibly permits “back door” enforcement

of the FDCA, but it is something courts should consider before

applying the doctrine.

B. Practical Considerations for Courts Applying the Unlawful

Use Doctrine and Suggestions for Addressing Them

In this section, I suggest some best practices for federal courts

applying the unlawful use doctrine. Namely, I suggest that district

courts must be mindful of the harsh effects of the doctrine and that the

doctrine should be applied consistently; I also discuss evidentiary

issues, preclusion, and timing of the inquiry during litigation.

1. District Courts Must be Mindful of the Effect of the

Doctrine

As an initial matter, district courts faced with an unlawful use

situation must be mindful of what exactly is at issue. In the past,

courts have cited to TTAB precedent regarding registration without

differentiating between the stakes:324

but, as discussed above,

registration is very different from use.325

Not being able to register a

mark is an inconvenience; not being able to use a mark (because you

are now the junior user) could be disastrous. Unlawful use applies not

just to prevent the trademark holder from enforcing against that

particular defendant in that particular instance, but could alter the

Tex. 2001) (emphasis added). 320

POM, 134 S. Ct. at 2233 (emphasis added). 321

See generally id. at 2228. 322

Id. at 2239. 323

See, e.g., Healthpoint, Ltd., 273 F. Supp. 2d at 847−49. 324

See, e.g., CreAgri, Inc. v. USANA Health Scis, Inc., 474 F.3d 626 (9th Cir.

2007); Erva Pharms., Inc. v. Am. Cyanamid Co., 755 F. Supp. 36 (D.P.R. 1991);

Advert. to Women, Inc. v. Gianni Versace, No. 98 C 1553, 2000 WL 1230461 (N.D.

Ill. Aug. 24, 2000). 325

See generally supra Section II.A.2.


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plaintiff’s rights going forward.326

Courts must be mindful that when they accept an unlawful use

argument, they are changing the priority of use; a junior user is

becoming a senior user, and a senior user is losing its right to use a

mark that it may have used for a long time. Not only does this have a

major effect upon the parties themselves—a senior user who has

invested time and money into developing goodwill in a mark is losing

his investment—but consumers may also be confused. If the senior

user is forced to stop using the mark, consumers will face a

marketplace with only the junior user’s similar mark. The stakes in an

unlawful use determination are high, and courts should remember that

from the outset.

In Southern California Darts, for example, the Ninth Circuit

affirmed the district court’s determination that the plaintiff darts

association had been using the mark lawfully; the plaintiff was able to

obtain summary judgment against a disgruntled former member who

set out to create his own, identically-named darts association.327

However, imagine if the court had found otherwise; an association that

had been using the mark since the 1960s would have lost its rights in

the mark, becoming the junior user vis-a-vis an organization founded

in 2010.

If the new association is inferior (after all, in this instance it

sounded more like revenge than the actual desire to have a viable darts

association), consumers are getting an inferior product and may not

realize that they are no longer dealing with the esteemed association

that has existed for 50 years, but instead an upstart. As to the plaintiff,

it would rebrand and perhaps recover (or not), but goodwill would

certainly be lost along the way. Perhaps harm seems minor in this

circumstance; after all, if consumers show up at the wrong bar for a

darts competition or send their dues to the wrong organization, or if

the original Southern California Darts Association goes belly-up, it’s

unfortunate, but it’s not life or death. However, it is easy to imagine

the same scenario occurring in a field where the stakes are higher—

drugs or supplements, for example.

2. District Courts Must Apply a Clear, Thoughtful, and

Consistent Standard

Over the years, courts have applied a variety of standards to the

unlawful use issue, from simply stating that unlawful use does not

326

CreAgri, Inc., 474 F.3d at 630. 327

See S. Cal. Darts Ass’n v. Zaffina, 762 F.3d. 921, 923–24 (9th Cir. 2014).

340 WAKE FOREST J.


[VOL. 17

create trademark rights,328

to partially adopting the TTAB’s

standard,329

to importing the TTAB standard wholesale.330

I suggest

that the Ninth Circuit’s approach, as recently stated in Southern

California Darts, is most correct in the sense that it appears to adopt

the “nexus” and “materiality” prongs of the TTAB test, but not the

“per se” constraint. Although adopting the USPTO’s test, as is, would

create an immediate body of precedent to which courts and litigants

could look for persuasive authority, the inapplicability of the policy

rationale behind the “per se” constraint (discussed infra) would make

this course unwise.

a. Nexus/Collateral Requirement

The Ninth Circuit has stated that “trademark protection might not

be withheld on account of unlawful conduct that is ‘collateral,’ namely

where there is an insufficient nexus between the unlawful behavior

and the use of the mark in commerce.”331

In Southern California

Darts, allegations of unpaid taxes were deemed unrelated to the

purposes of the federal trademark laws.332

Similarly, in Cash

Processing Services, the fact that the plaintiff committed crimes

during the period of ownership of the business bearing the mark did

not affect ownership.333

The nexus requirement forces litigants—

before spending too much time and money digging up obscure

violations of tangential regulations—to ask themselves whether the

unlawful use is truly related to the purposes of the trademark laws. If

there is no nexus, the court can stop its analysis there, as unrelated

unlawful actions will not bar the establishment or enforcement of

trademark rights.334

b. Materiality

The Ninth Circuit has held that “unlawful conduct [will] not

preclude trademark protection if it [is] ‘immaterial,’ namely if it [is]

328

See United Phosphorus v. Midland Fumigant, Inc., 205 F.3d 1219, 1225

(10th Cir. 2000). 329

See S. Cal. Darts, 726 F.3d at 931; CreAgri, Inc., 474 F.3d at 632–33. 330

See Tassel Ridge Winery v. Woodmill Winery, Inc., No. 5:11-cv-00066-

RLV-DSC, 2013 WL 5567505 (W.D.N.C. Oct. 9, 2013); Advert. to Women, Inc. v.

Gianni Versace S.P.A., No. 98 C 1553, 2000 WL 1230461 (N.D. Ill. Aug. 24, 2000). 331

S. Cal. Darts, 762 F.3d at 931. 332

Id. 333

Cash Processing Servs., LLC v. Ambient Entm’t, Inc., 320 F.App’x. 494,

496 (9th Cir. 2008). 334

Id.


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not ‘of such gravity and significance that the usage of the mark as a

matter of law, can create no trademark rights.’”335

Federal courts

should also adopt this requirement. Materiality speaks to the

seriousness of the unlawful conduct. Perhaps the statutes have a close

connection to the purposes of trademark laws—such as labeling—but

the violations themselves are minor. This requirement gives the court

discretion to decline to find that such violations prevent the

development of rights.

For example, in Dessert Beauty Inc. v. Fox, the court held that

certain labeling violations were immaterial, despite technically

violating the FDCA.336

The court pointed to language in the TTAB’s

General Mills decision that “drew a distinction between material non-

compliance and a violation that was ‘purely technical in nature,’ and

which ‘may be relatively harmless and may be subsequently

corrected.’”337

The court explained that this requirement could serve

as a check against cancellation of registration for minor violations.338

In Erva, however, though not discussing materiality by name, the

court found that labeling violations regarding typesize and placement

of information (though all required information was present on the

label) were sufficient to support a finding of unlawful use.339

The importance of the materiality requirement is evidenced by a

comparison of two cases, both involving the sale of wine and a failure

to obtain the proper Certification of Label/Bottle Approval (“COLA”)

before sale. In Churchill Cellars v. Brian Graham, a TTAB case, an

opposer argued that an applicant’s priority date must be on or after the

date that the COLA was issued; in other words, sales prior to the

issuance of the COLA could not count toward establishing an earlier

date of first use.340

The TTAB disagreed, holding that the violation—

which was rectified a few months later—was not material.341

Permitting the earlier priority date to stand was dispositive.342

On the

contrary, in Tassel Ridge Winery, a federal court in North Carolina

held that “any sale of . . . wine prior to [the issuance date of the

335

S. Cal. Darts Ass’n, 762 F.3d. at 931 (internal brackets and modifications

omitted) (quoting Gen. Mills Inc. v. Health Valley Foods, 24 U.S.P.Q.2d 1270, 1274

(T.T.A.B. 1992)). 336

617 F. Supp. 2d 185, 193 (S.D.N.Y. 2007). 337

Id. (quoting Gen. Mills Inc., 24 U.S.P.Q.2d at 1274). 338

Id. 339

Erva Pharm., Inc. v. Am. Cyanamid Co., 755 F. Supp. 36, 41 (D.P.R. 1991). 340

Churchill Cellars, Inc. v. Graham, Opposition No. 91193930, 2012 WL

5493578, at *6 (T.T.A.B. Oct. 19, 2012). 341

Id. at *9. 342

Id. at *17.

342 WAKE FOREST J.


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COLA], was not lawful for purposes of determining priority.”343

This

was so even though, as in Churchill Cellars, the violation was rectified

a few months later.344

The materiality requirement prevents minor violations of relevant

statutes from having the effect of rendering established rights

unenforceable, and allows courts to use their discretion to refuse to

apply the unlawful use doctrine. As such, the federal courts should

adopt it. Further, both as to materiality and as to the “nexus”

requirement, federal courts should look to TTAB precedent for its

persuasive value in making these determinations.

c. Per Se

There may be allegations of a major violation of a statute relevant

to the purpose of the trademark laws, but how should a court handle

the situation if there has not been a determination that the acts alleged

occurred, or if the parties agree that certain acts occurred, but disagree

as to whether the acts amount to a violation? The modern USPTO

answer is easy: if there is any uncertainty, the violation doesn’t count,

and the rights are unaffected.345

Although initially the policy was not

as stringent,346

the doctrine was eventually narrowed. The USPTO

feared placing authority to interpret and apply the multitude of federal

statutes and regulations, from all manner of agencies, on the trademark

examiner who specializes only in trademark laws.347

Accordingly, the

USPTO imposed a severe restriction—that the violation must be “per

se”—on the doctrine.348

Some courts have adopted this requirement as

well; for example, the Impulsaria court noted that “the unlawful use

defense is not generally applied absent a finding of unlawful use by a

court or appropriate government agency, or a clear per se violation.”349

However, as a practical matter, a federal court need not be subject

to such a restriction. Federal courts do not suffer from the same

limitations as a trademark examiner (or even the TTAB) in applying

federal laws and regulations. A federal court has the knowledge and

resources available to interpret federal statutes and regulations, and is

343

Tassel Ridge Winery v. Woodmill Winery, Inc., No. 5:11-cv-00066-RLV-

DSC, 2013 WL 5567505, at *6 (W.D.N.C. Oct. 9, 2013). 344

Id. 345


See discussion supra Section II.B.1. 347

MCCARTHY, supra note 37, § 19:124. 348

Id. 349

Impulsaria LLC v. United Distrib. Grp., LLC, No. 1:11-CV-1220, 2012 WL

5178147, at *5 (W.D. Mich. Oct. 18, 2012).


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often called upon to do so.350

The Ninth Circuit’s approach does not

inquire as to whether the violation was a “per se” violation, simply

requiring that the evidence of unlawful use be substantiated.351

This is

probably enough.

3. Evidence/Procedure

a. Who has the burden of proof?

Most courts have addressed unlawful use in the context of an

affirmative defense,352

meaning that even if the defendant is otherwise

liable, if the defendant can prove the elements of the affirmative

defense, it would negate the liability. The issue usually arises when a

defendant is sued for trademark infringement and defends by claiming

that the plaintiff’s use is unlawful and therefore the plaintiff does not

have the rights it claims. The court requires the defendant to prove

that the plaintiff’s use is unlawful.

The alternative would be to include lawful use as part of the prima

facie case. A plaintiff claiming priority of use would have to show, as

part of its prima facie case, that the use was lawful. As the Ninth

Circuit has held, “only lawful use in commerce can give rise to

trademark priority.”353

Then, a defendant raising the issue would be

simply raising a defense; i.e., the plaintiff would have to prove that it

complied with the applicable regulations. In asserting trademark

infringement, a plaintiff must show “(1) it has a valid and legally

protectable mark; (2) it owns the mark; and (3) the defendant's use of

the mark to identify goods or services causes a likelihood of

confusion.”354

Typically, a federal registration is prima facie evidence

that the first two elements have been met.355

A federal registration

could also be prima facie evidence of lawful use. Permitting a federal

registration to serve as prima facie evidence of lawfulness would make

sense, as the USPTO is able to evaluate lawfulness during the

350

See LARRY M. EIG, CONG. RESEARCH SERV., 97-589, STATUTORY

INTERPRETATION: GENERAL PRINCIPLES AND RECENT TRENDS 1 (2011). 351

See S. Cal. Darts v. Zaffina, 762 F.3d 921, 932 (9th Cir. 2014). 352

See e.g., GoClear LLC v. Target Corp., No. C 08-2134 MMC, 2009 WL

160624, at *3 (N.D. Cal. Jan. 22, 2009) (referring to the doctrine as an affirmative

defense). 353

CreAgri v. USANA Health Scis., Inc., 474 F.3d 626, 630 (9th Cir. 2007)

(emphasis in original). 354

See, e.g., E.A. Sween Co. v. Deli Exp. of Tenafly, LLC, 19 F. Supp. 3d 560,

568 (D.N.J. 2014) (quoting A & H Sportswear, Inc. v. Victoria’s Secret Stores, Inc.

237 F.3d 198, 210 (3d Cir. 2000)). 355

See id. at 355.

344 WAKE FOREST J.


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registration process and cancel or refuse registrations that do not show

lawful use of the mark.

Overall, it seems that the party asserting that the conduct is

unlawful should have the burden of proof. From a practical

perspective, this will operate to ensure that time and money is spent

looking into unlawful use only where it is warranted, and that the costs

are borne by the person seeking to assert it.

b. Must it be a defense?

Although most unlawful use scenarios arise as a defense to

trademark infringement, and many courts refer to it as the “unlawful

use defense,” must the doctrine operate that way? In other words, the

doctrine is typically a shield: a defendant in an infringement action

says “you can’t enforce against me because you don’t have the rights

you claim, since you’re unlawfully using the mark.” But, in many

cases it is also a sword: proof of unlawful use can eliminate the senior

user’s rights by moving its priority date behind the junior user’s,

leading to cancellation of registrations or even a junior user taking the

senior user’s position.356

Could a junior user sue a senior user for

trademark infringement and claim that the senior user’s use is

infringing because it does not have the rights it claims? It would seem

so. Accordingly, it is probably not completely proper to refer to the

doctrine as the “unlawful use defense” except when it is being used as

such.

c. What kind of proof will suffice?

The already-existing rules governing the admissibility of evidence

should be sufficient to address proof of unlawful use; namely, the

evidence should be admissible either because it is subject to judicial

notice (in the case of a guilty verdict or an agency finding) or because

it is a determination made in the first instance by the court itself based

on argument of the parties.357

No additional framework is necessary.

However, the allegations must be substantiated.358

What types of evidence are available to substantiate allegations of

unlawful use? Expert testimony could be one option, although the

expert testimony proffered in Vosk was rejected.359

The court found

356

See CreAgri, 474 F.3d at 633–34. 357

See FED. R. EVID. 201, 1008. 358

S. Cal. Darts Ass’n v. Zaffina, 762 F.3d 921, 930 (9th Cir. 2014). 359

Vosk Int’l. Co. v. Zao Gruppa Predpriyatij Ost, No. C11-1488RSL, 2013 WL

5588296, at *7 (W.D. Wash. Oct. 9, 2013).


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that the expert did not meet the typical requirements: although an

expert in FDA import operations, she was not an expert in the relevant

field (beverage manufacturing), the opinion was not the product of

reliable principles and methods, and did not address the relevant time

period.360

Perhaps more helpfully, the court found that a conclusion

that labels written in Russian violate FDA regulations “provides no

additional insight beyond the document on which she relies.”361

In GoClear, the court explained that GoClear had offered evidence

(in the form of photographs and declarations) that CLEAR X was

advertised as a product to treat acne, that the product was delivered to

multiple states, and that the product was not the subject of a “new

drug” application with the FDA.362

This was enough for summary

judgment in GoClear’s favor (as to a cancellation claim).363

Likewise,

in Erva Pharmaceuticals, the court found unlawful use based

apparently upon looking at the label for the drug and noting that the

font size was incorrect, the chemical name did not appear where it was

supposed to, and other similar findings.364

4. What effect should a finding of the USPTO have?

It is possible to imagine a situation where a party has been using a

mark for years, and finally decides to register the mark with the

USPTO. The party applies for registration, but the USPTO denies

registration because of a labeling defect, or another party opposes

registration on the grounds that the party has been using the mark

unlawfully. The USTPO determines that the mark should not register

because there has been no lawful use in commerce. What effect

should this determination have in a subsequent federal court

infringement proceeding? Or, more ominously, is this finding a lottery

ticket that the opposer can cash in in federal court for the prize of

becoming the senior user?

This scenario raises the issue of collateral estoppel (now called

issue preclusion). The Supreme Court recently addressed the issue in

another context in B & B Hardware, Inc.,365

finding that a

determination of the TTAB regarding likelihood of confusion was

binding on the district court in a concurrent infringement

360

Id. at *6, 7. 361

Id. at *7. 362

GoClear v. Target Corp., No. C 08-2134 MMC, 2009 WL 160624, at *4

(N.D. Cal. Jan. 22, 2009). 363

Id. at *5. 364

Erva Pharm., Inc. v. Am. Cyanamid Co., 755 F. Supp. 36, 40–41 (D.P.R.

1991). 365

B & B Hardware v. Hargis Indus., Inc., 135 S. Ct. 1293, 1310 (2015).

346 WAKE FOREST J.


[VOL. 17

proceeding.366

There, some of the main concerns were that the

TTAB’s determination on likelihood of confusion should not be

binding upon the district court where the TTAB is tasked with

determining registration, not infringement, and the TTAB uses

different factors than the Eighth Circuit to determine likelihood of

confusion.367

However, the Supreme Court held that neither of these

things mattered; calling the “real question” “whether likelihood of

confusion for purposes of registration is the same standard as

likelihood of confusion for purposes of infringement.”368

The Court

determined that the standard was the same.369

The Court also rejected

other arguments attempting to differentiate the two venues, including

the fact that the TTAB has procedural differences (such as no live

witness testimony) and the idea that the stakes for registration are

much lower than the stakes for infringement.370

Many of these

arguments are similar to those that could be raised in the unlawful use

context.

It is worth noting, however, that the B & B Hardware, Inc.

decision was looking at the effect of a final determination by the

TTAB in an opposition proceeding, where the parties to the opposition

were the same parties litigating the issue of likelihood of confusion in

federal court.371

It is less certain that issue preclusion would apply

where the determination at issue was as a result of an appeal from a

decision of a trademark examiner. The facts that the parties are not the

same and the stakes are much lower than in an opposition

proceeding372

seems likely to impact the application of issue

preclusion.

The Supreme Court’s bottom line in B & B Hardware, Inc. was

“[s]o long as the other ordinary elements of issue preclusion are met,

when the usages adjudicated by the TTAB are materially the same as

those before the district court, issue preclusion should apply.”373

As

such, district courts faced with the issue of whether to give preclusive

effect to a TTAB ruling on unlawful use should evaluate the

considerations from B & B Hardware, Inc., as well as the typical

366

Id. at 1302, 1307. 367

See generally id. at 1301, 1306. 368

Id. at 1307. 369

Id. 370

Id. at 1307–08. 371

See id. at 1299. 372

Id. at 1310 (rejecting this “lower stakes” argument in B & B Hardware, Inc.

as relates to opposition proceedings. The court noted that the stakes are high in an

opposition proceeding because “[w]hen registration is opposed, there is good reason

to think that both sides will take the matter seriously.”). 373

Id.


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347

elements of issue preclusion in the relevant jurisdiction, and proceed

accordingly. Given that it may be harder to prove unlawful use at the

TTAB than in federal court (since the TTAB has the “per se”

requirement), a finding of unlawful use may be more likely to have a

preclusive effect than a finding that a use is lawful. And, since the

USPTO does not routinely inquire into the lawfulness of marks,374

the

mere fact of registration should not have any preclusive effect without

a specific inquiry into that topic (although, as noted in B & B

Hardware, Inc., it may be appropriate to treat the fact of registration as

prima facie evidence of lawful use, subject to rebuttal by the

defendant).375

As with B & B Hardware, Inc., the possibility of giving preclusive

effect to TTAB determinations on this issue may have the effect of

raising the stakes of TTAB proceedings. However, B & B Hardware,

Inc. indicates the Supreme Court is comfortable with that risk,376

and,

as such, courts and litigants should be prepared to apply the same

principles in the unlawful use setting.

5. When and How Courts Should Make the Determination

The final practical consideration for courts applying the unlawful

use doctrine is logistical: when and how to make the determination.

Although at least one court has left the issue for trial,377

most courts

that have faced an unlawful use inquiry have done so as a matter of

law.378

This makes sense given that the findings usually involve

applying a statute or regulation to undisputed facts (e.g., the parties

agree that a law exists, that the plaintiff’s label is what it is, and that

the law governs the plaintiff’s label, but disagree as to the application

of the doctrine).

Since the issue is a matter of law, the usual rules in that regard

apply. A motion to dismiss is probably too early to raise the issue.379

374

TMEP, supra note 16, § 907. 375

B & B Hardware, Inc., 135 S. Ct. at 134–1315 (Thomas, J., dissenting)

(proving the fact of registration could give rise to a rebuttable presumption of lawful

use). 376

Id. at 1306. 377

Dessert Beauty, Inc. v. Fox, 617 F. Supp. 2d 185, 193 (S.D.N.Y. 2007)

(refusing to enter summary judgment on the unlawful use issue “because a

reasonable jury could find that the non-compliance is not material”). 378

See, e.g., GoClear LLC v. Target Corp., No. C 08-2134 MMC, 2009 WL

160624, at *3–5 (N.D. Cal. Jan. 22, 2009) (granting summary judgment on unlawful

use); CreAgri, Inc. v. USANA Health Scis., Inc., 474 F.3d 626, 633–34 (9th Cir.

2007) (affirming summary judgment on unlawful use). 379

See, e.g., Impulsaria, LLC v. United Distrib. Grp., LLC, No. 1:11-CV-1220,

2012 WL 5178147, at *5–6 (W.D. Mich Oct. 18, 2012) (denying a motion to dismiss

continued . . .

348 WAKE FOREST J.


[VOL. 17

Of course, the earlier the determination can be made, the better, as the

ruling will in some cases end the litigation altogether.380

However,

discovery may be necessary on some issues, such as when the problem

was ultimately corrected, if at all, and whether the problem affected all

of the goods offered under the mark. Summary judgment seems to be

an appropriate stage of litigation for the typical unlawful use

determination.

Making a determination before trial will help to avoid the

introduction of potentially damaging and prejudicial evidence about a

business’ practices that are irrelevant to trademark issues (such as tax

evasion) and will also help prevent “mini trials” on unlawful use

during trial.

V. CONCLUSION

This paper traced the development of the unlawful use doctrine in

the federal courts and the USPTO while raising issues of practical

importance to courts and litigators. The historical basis for applying

the doctrine in the federal courts is not airtight. In particular, the lack

of support in the text of the Lanham Act, the Ninth Circuit’s reliance

on the questionably-supported United Phosphorus decision, the federal

courts’ importation of the USPTO’s unique doctrine without

considering the contextual differences, and the seeming lack of

concern for consumer interests in applying the doctrine are troubling.

Stripping senior users of rights and leaving junior users to take their

place should not be undertaken lightly. Nevertheless, assuming that

courts will continue to apply the unlawful use doctrine, I suggest that

they do so carefully and rarely, in line with the proposals detailed

above.

based on unlawful use where the defendant did not present sufficient evidence of

unlawful use and where the applicability of an affirmative defense must appear on

the face of the complaint). 380

See, e.g., CreAgri, Inc., 474 F.3d at 633–34 (affirming summary judgment of

district court ended litigation).




THE PEER-TO-PEER BLOCKCHAIN MORTGAGE

RECORDING SYSTEM: SCRAPING THE MORTGAGE

ELECTRONIC REGISTRATION SYSTEM AND REPLACING

IT WITH A SYSTEM BUILT OFF OF A BLOCKCHAIN.

Thomas Gaffney†

I. INTRODUCTION ............................................................. 350

II. BACKGROUND INFORMATION .................................... 351 A. THE 2008 FINANCIAL CRISIS .................................... 351 B. THE SECURITIZATION PROCESS ................................ 352 C. SECURITIZATION OF SUBPRIME MORTAGE AND

SYSTEMIC COUNTERPARTY RISK ............................... 353 D. THE FORECLOSURES DURING AND FOLLOWING THE

CRISIS ......................................................................... 355 E. PUTTING IT ALL TOGETHER ...................................... 357

III. STATUS OF THE OF CURRENT LAW GOVERNING

MORTGAGE RECORDING AND THE LEGAL EFFECT

OF IMPLEMENTING THE PEER-TO-PEER

BLOCKCHAIN MORTGAGE RECORDING SYSTEM ........ 357 A. MORTGAGE TRANSFER LAW..................................... 357 B. LEGAL EFFECT OF IMPLEMENTING THE PEER-TO-

PEER BLOCKCHAIN MORTGAGE RECORDING

SYSTEM ....................................................................... 365

IV. CONCLUSION .............................................................. 371

† Thomas Gaffney is a third year law student at Wake Forest University school

of law and will graduate in the Spring of 2017. He graduated from the Pennsylvania

State University with a B.A. in Political Science.

Author Note: The author would like the thank the entire staff of Wake Forest’s

Journal of Business and Intellectual Property Law for all of their hard work in

bringing this article to publication as well as a special thanks to his Mom and Dad

for their never-ending love and support.

350 WAKE FOREST J.


[VOL. 17

I. INTRODUCTION

This Comment examines the mortgage recording system and

suggests that the current system—from registering and tracking the

generation of mortgages, to the transfer of mortgages, and the

securitization of those mortgages—is inherently flawed. In order to

overcome these obstacles, the current system should be replaced with

a new decentralized peer-to-peer blockchain network. This form of

peer-to-peer recording technology was first developed in the summer

of 2008 and is the underlying technology for the ever-increasingly

popular cryptocurrency, Bitcoin.1 Bitcoin is completely decentralized

in the sense that the network is not run on one specific server owned

by an entity, but rather it is run by every single person or computer

operating on the Bitcoin network.2 The network is maintained by

Bitcoin “miners” who are rewarded by a distributed consensus system

to confirm and verify transactions between users on the network and

for recording those transactions to the shared public ledger otherwise

known as the Blockchain.3

The biggest challenge facing a cryptocurrency is the threat of

someone making an exact digital copy of the denomination and selling

both the fake copy and real version, which undermines the entire

system of trust in the cryptocurrency.4 The Blockchain eliminates this

issue by creating a system to verify, record, and track the integrity and

chronological order of each transaction on the network. 5 “The

integrity and the chronological order of the [B]lockchain are enforced

with cryptography.”6 Each time a new Bitcoin is created or a Bitcoin

transaction occurs, it must be packed into a block and confirmed by a

third party before it is listed on the public ledger.7 In order for the

1 Frequently Asked Questions, BITCOIN, https://bitcoin.org/en/faq (last visited

Feb. 18, 2017). 2 Id.

3 How Does Bitcoin Work?, BITCOIN, https://bitcoin.org/en/how-it-works (last

visited Feb. 18, 2017). 4 See U.S. GOV’T ACCOUNTABILITY OFFICE, REPORT TO THE COMM. ON

HOMELAND SEC. & GOVERNMENTAL AFFAIRS, U.S. SENATE, VIRTUAL CURRENCIES:

EMERGING REGULATORY, LAW ENFORCEMENT AND CONSUMER PROTECTION

CHALLENGES 6–7 (May 2014). 5 Marco A. Santori, Craig A. DeRidder & James M. Grosser, How Blockchain

Will Revolutionize Commercial Transactions, LAW360 (May 12, 2016, 11:20 AM),

https://www.law360.com/articles/794611/how-blockchain-will-revolutionize-

commercial-transactions. 6 How does Bitcoin work?, BITCOIN, https://bitcoin.org/en/how-it-works (last

visited Feb. 15, 2017). 7 Id.

2017] THE PEER-TO-PEER BLOCKCHAIN

MORTGAGE RECORDING SYSTEM

351

block to be confirmed it must meet strict cryptographic rules and be

verified by the peer-to-peer network.8 Therefore, the entirety of the

Bitcoin network relies completely on the Blockchain. 9 The

cryptographic rules prevent previous blocks from being modified and

secures the integrity of the chain of transaction.10 This ensures that no

individual can control what is included in the Blockchain or replace

parts of the Blockchain to hide previous transactions.11

Put simply, a Blockchain system creates a decentralized

cryptographically secure ledger that records and tracks the

chronological order of a sequence of transactions for any

denomination placed inside of the network, and it makes that

information accessible for view by anyone accessing the peer-to-peer

network. This Comment points out that the modernized use and

securitization of mortgages in the financial industry have similar legal

issues that cryptocurrencies face, and that the Mortgage Electronic

Recording System (“MERS”) should be replaced with a peer-to-peer

Blockchain Mortgage Recording System (“PBMRS” or the

“Blockchain System”).

II. BACKGROUND INFORMATION

A. The 2008 Financial Crisis

The Financial Crisis of 2008 thrust the typically mundane topic of

recording mortgage transfers into the spotlight.12

The primary cause of

the crash was a credit crunch and lack of liquidity causing banks and

insurers to fail.13

As a result, the world economy was crippled,

because Wall Street’s major banks and their regulators that did not fail

were significantly impacted by their exposure to counter party risk.14

8 Id.

9 Id.

10 Id.

11 Id.

12 See generally Kimberly Amadeo, Stock Market Crash of 2008, Follow the

Timeline to Understand Why It Crashed, THE BALANCE (Sept. 8, 2016),

https://www.thebalance.com/stock-market-crash-of-2008-3305535. 13

Id. 14

Antoine Gara, A Quant Startup Made $430 Billion In Banks' Systemic Risk

Vanish In 25 Minutes, INVESTING, FORBES (Oct. 21, 2016, 11:00 AM),

http://www.forbes.com/sites/antoinegara/2016/10/21/a-quant-startup-made-430-

billion-in-bank-trading-risk-vanish-in-25-minutes/#2e849ae23e98; see also

Counterparty Risk, INVESTOPEDIA,

http://www.investopedia.com/terms/c/counterpartyrisk.asp (“Counterparty risk is the

risk to each party of a contract that the counterparty will not live up to its contractual

obligations. Counterparty risk is a risk to both parties and should be considered when

continued . . .

352 WAKE FOREST J.


[VOL. 17

Even if firms had positioned their portfolios smartly for

the looming carnage, they were all linked together

in one giant chain of dominoes to a failing firm, for

instance Lehman Brothers, AIG or Bear Stearns. After

all, what’s the point in having an interest rate, credit, or

commodity hedge if one side of your trade is in

bankruptcy and can’t make good on its payments.15

This is the central reason the Federal Reserve (“FED”) made the

controversial decision to bail out American International Group, Inc.

(“AIG”) and make whole all of its trading counterparts.16

In the midst

of the crisis, banks and regulators had to act quickly and rushed to

address the risk of these “falling dominos.”17

B. The Securitization Process

One of the main factors attributing to the credit crunch, liquidity

issues, failing banks, and counterparty risk was the securitization of

subprime mortgage loans.18

“Securitization is the process in which

certain types of assets are pooled so that they can be repackaged into

interest-bearing securities.”19

A large number of financial institutions

employ securitization to transfer the credit risk of the assets

originating on their balance sheets to other financial institutions, i.e.

banks, insurance companies, and hedge funds.20

At first, this

“originate and distribute” approach appeared to bring broad economic

benefits by spreading out credit exposures and “thereby diffusing risk

concentration and reducing systemic vulnerabilities.”21

The securitization process, in its most basic form, involves two

steps.22 In the first step, a company, bank, or lender generates an

income-producing asset by issuing some sort of loan or debt, for the

evaluating a contract.”). 15

Gara, supra note 14. 16

Id. 17

Id. 18

Andreas Jobst, Back to Basics: What is Securitization?, FIN. & DEV 48 (Sept.

2008), available at

http://www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf. 19

Id. (“Both the scale and persistence of the attendant credit crisis seem to

suggest that securitization–together with poor credit origination, inadequate

valuation methods, and insufficient regulatory oversight–could severely hurt

financial stability.”). 20

Id. 21

Id. 22

Id.



353

specific purposes of this Comment a mortgage, to a borrower.23 The

lender that generates that mortgage is called the originator, and if the

originator does not want to hold on to the risk of any specific

mortgage defaulting, it will pool many different loans into a reference

portfolio.24 The originator then sells these reference portfolios to an

issuer formalized as a special purpose vehicle (“SPV”), which is an

entity that is set up for the specific purpose of purchasing these types

of mortgage portfolios.25 In the second step, the SPV will finance the

purchase of these mortgage portfolios by issuing interest bearing

securities called Collateralized Debt Obligations (“CDOs”) that are

sold into capital markets.26 The holders of the debt securities will

receive interest payments based on a fixed or floating rate from the

cash that is generated by the mortgage reference portfolio.27 Initially,

the impact of securitization appeared to be mostly positive.28 Then the

subprime mortgage crisis unfolded.

C. Securitization of Subprime Mortgage and Systemic

Counterparty Risk

So why does this matter in the case of mortgage recordings? The

securitization process can be a great financial investment tool for

diversifying risk and spreading economic prosperity.29

However,

many opponents of securitization criticize it for compromising the

incentive for originating lenders to ensure minimum standards of

prudent lending, risk management and investment, because this kind

of bad lending practices by originators was the fundamental root of the

cause for the credit subprime mortgage crisis in 2008.30

During the

2000s, originators were selling mortgage reference portfolios to SPVs

completely comprised of subprime mortgages.31

23

Id. 24

Jobst, supra note 18. 25

Id. 26

Id. at 49; see also Collateralized Debt Obligations INVESTOPEDIA,

http://www.investopedia.com/terms/c/cdo.asp (last visited Mar. 16, 2017). A CDO is

a structured financial product that pools together cash flow-generating assets and

repackages this asset pool into discrete tranches that can be sold to investors. A

collateralized debt obligation is so-called because the pooled assets such as

mortgages, bonds, and loans are essentially debt obligations that serve as the

collateral for the CDO. Id. 27

Jobst, supra note 18. 28

See id. 29

Id. at 49. 30

Id. 31

Steve Denning, Lest We Forget: Why We Had a Financial Crisis, FORBES,

(Nov. 22, 2011, 11:28 AM)

continued . . .

354 WAKE FOREST J.


[VOL. 17

Furthermore, almost 84% of the subprime mortgages in 2006 were

issued by private lending firms not subject to the usual mortgage laws

and regulations.32

As one might have guessed, this created many

different problems during the crash. Although the fundamental

problem that triggered the crash was the massive subprime lending,

there was an even bigger overarching systemic problem, namely the

credit crunch and lack of liquidity that was caused by the

interconnectedness of the entire system.33

In essence, “Wall Street’s

major banks and their regulators…were all linked together in one giant

chain of dominos to a failing firm.”34

How it all worked is as follows. Many of these unregulated loan

originators issued mortgages to borrowers with such poor credit

ratings that there was no way they would be able to make the

payments on time and eventually make the mortgage whole.35

Next,

the mortgage originator, not wanting to hold on to these extremely

risky mortgages because they knew how bad the mortgages were,

proceeded to pool them into mortgage reference portfolios and sell

them, sometimes fraudulently, to SPVs.36

The SPV would then

finance these mortgages with incorrect, misleading, and sometimes

fraudulent credit ratings attached to them by issuing debt securities,

a.k.a. CDOs, to investors on the open market.37

Then the investors

holding the CDO securities would hedge38

their bet by entering into a

financial contract called a derivative with another entity, usually an

investment bank, hedge fund, or an insurance agency, such as

AIG.39

To top it all off, government entities, such as Fannie Mae and

http://www.forbes.com/sites/stevedenning/2011/11/22/5086/#71716f115b56; see

also Subprime Mortgage, INVESTOPEDIA,

http://www.investopedia.com/terms/s/subprime_mortgage.asp (last visited Oct. 21,

2016). A Subprime Mortgage is a type of mortgage that is normally issued by a

lending institution to borrowers with low credit ratings. As a result of the borrower’s

low credit rating, conventional mortgage is not offered because the lender views the

borrower as having a larger than average risk of defaulting on the mortgage. Id. 32

Denning, supra note 31. 33

See Gara, supra note 14. 34

Id. 35

Id. 36

See generally Denning, supra note 31. 37

See generally id. 38

See generally “Hedge”, INVESTOPEDIA,

http://www.investopedia.com/terms/h/hedge.asp (last visited Feb. 2017) (“A hedge

in financial terms is an investment to reduce the risk of adverse price movements in

an asset. Normally, a hedge consists of taking an offsetting position in a related

security, such as a futures contract . . . Hedging is analogous to taking out an

insurance policy.”). 39

Ron Hera, Forget About Housing, The Real Cause of the Crisis Was OTC

Derivatives, BUSINESS INSIDER (May 11, 2010, 2:50 P.M.),

continued . . .



355

Freddie Mac, and insurance agencies, such as AIG, would insure and

guarantee the mortgages underlying all of the CDOs.40

This created a

massive, interconnected industry of systemic counterparty risk,

through CDOs and the derivative contracts attached to the underlying

subprime mortgages.41

D. The Foreclosures During and Following the Crisis

Why would these originating lenders, enormous banks,

institutional investors, government agencies, credit rating agencies,

and insurance companies invest in securities that seem fundamentally

flawed? The whole theory of the subprime mortgage industry was

structured on a fatal misconception: the notion that a home never

decreased in value.42

This created a huge problem as the crisis was

unfolding and foreclosures started occurring in the millions.43

Millions of Americans lost their jobs and their homes during the

crisis.44

Many of those homeowners went to their banks hoping to

refinance their mortgages to avoid defaulting on them. However, for

many of those homeowners, their mortgages did not belong to the

originating issuer any longer.45

Their mortgages had been pooled and

sold to SPVs and then resold in the form of CDOs.46

Most of the

borrowers, who originally borrowed money through a mortgage on

their house, did not know that the legal rights to their mortgages could

be sold.47

The resounding question amongst millions of Americans was:

How could this happen? For starters, the law does not require the

mortgage originator to notify the borrower that it is selling the legal

http://www.businessinsider.com/bubble-derivatives-otc-2010-5. 40

See id. 41

Id. 42

Chris Matthews, The Subprime Mortgage Crisis Wasn’t About Subprime

Mortgages, FORTUNE (June 17, 2015),

https://www.fortune.com/2015/06/17/subprime-mortgage-recession/. 43

Bob Sullivan, 7 Million Americans Lost Their Homes During the Recession. Are

They Ready to Buy Again?, BOBSULLIVAN.NET: THE RED TAPE CHRONICLES (Apr.

24, 2015), https://bobsullivan.net/restless/7-million-americans-lost-their-homes-

during-the-recession-are-they-ready-to-buy-again/. 44

Id. 45

See generally Jobst, supra note 18 (“[A] company with loans or other income-

producing assets—the originator—identifies the assets it wants to remove from its

balance sheet and pools them into what is called the reference portfolio. It then sells

this asset pool to an issuer, such as a special purpose vehicle (SPV) . . . .”). 46

See id. at 49. 47

See Adam J. Levitin & Tara Twomey, Mortgage Servicing, 28 YALE. J. ON

REG. 1, 7 (2011).

356 WAKE FOREST J.


[VOL. 17

rights to the mortgage.48

Second, on most occasions the originator

remained the servicer, collecting payments from the original

borrowers of the mortgages in the portfolios and passing them along,

minus a service fee, directly to the SPV.49

Andreas Jobst, a senior

economist at the IMF, described the issue:

Sometimes, the originators do not sell the securities

out-right to the issuer [special purpose vehicle (SPV)]

(called “true sale securitization”) but instead sell only

the credit risk associated with the assets without the

transfer of legal title (“synthetic securitization”).

Synthetic securitization helps issuers [SPVs] exploit

price differences between the acquired(and often

illiquid) assets and the price investors are willing to pay

for them (if diversified in a greater pool of assets).50

This use of synthetic CDOs added to the problem of trying to

discern who exactly owned the rights to the mortgage and who the

borrower needed to speak with in order to refinance the mortgage.

Additionally, many states do not have laws that require the transfer

of mortgage rights to be recorded.51

Therefore, once these mortgages

were pooled and sold, the originator many times did not know who

actually owned the right to the mortgage. This further opened the door

for double selling of the rights in mortgage CDOs, especially in

synthetic CDOs, because the transferor could attempt to sell the

mortgage again simply by producing the mortgage paperwork or

note.52

Lastly, the financial industry was rinsing and repeating this

securitization process thousands and thousands of times.53

To put this

into perspective, one commenter writes, “officially, roughly $604.6

trillion in OTC derivative contracts, more than ten times world GDP

($57.53 trillion), hang over the financial world like the Sword of

Damocles, but to the average investor the derivatives bubble is

invisible.”54

48

See id. at 7–8. 49

See Jobst, supra note 18. 50

Id. at 49. 51

See John Patrick Hunt et al., Rebalancing Public and Private in the Law of

Mortgage Transfer, 62 AM. U.L. REV. 1529, 1538–45 (2013). 52

See Alan M. White, Losing the Paper—Mortgage Assignments, Note

Transfers and Consumer Protection, 24 LOY. CONSUMER L. REV. 455, 472–73

(2012). 53

John Patrick Hunt, Should the Mortgage Follow the Note?, 75 OHIO ST. L.J.

155, 156 (2014). 54

Hera, supra note 39.

http://www.bis.org/statistics/otcder/dt1920a.pdf

http://www.bis.org/statistics/otcder/dt1920a.pdf

https://www.cia.gov/library/publications/the-world-factbook/fields/2195.html

https://www.cia.gov/library/publications/the-world-factbook/fields/2195.html



357

E. Putting it All Together

For the purposes of this Comment, it is very important to

understand how and why the 2008 Financial Crisis occurred to grasp

the severity of the problem. The Crisis absolutely crippled the world’s

economy. The securitization process of subprime mortgages created a

significant amount of systemic counterparty risk further downstream,

because the mortgage transactions were not recorded properly, and the

originator did not issue mortgages in accordance with the regulatory

framework.55

However, the entire Crisis could have been avoided if a better

recording system was in place and if there was more transparency in

the mortgage CDOs and derivatives markets. The current regulatory

framework and recording system is flawed and does not work. This

Comment addresses the legal issues for the ownership, transfer, and

recording of mortgages. It also suggests implementing a new

regulatory framework based off of a peer-to-peer recording network.

The network will replace MERS and is based on blockchain

technology and cryptography third party verification.

III. STATUS OF THE OF CURRENT LAW GOVERNING MORTGAGE

RECORDING AND THE LEGAL EFFECT OF IMPLEMENTING THE PEER-

TO-PEER BLOCKCHAIN MORTGAGE RECORDING SYSTEM

“Although the U.S. mortgage market is about 80% of the size of

the U.S. stock market, the mortgage market does not get anywhere

near 80% of the stock market's attention from the legal academy.”56

It

is important to understand the existing law when deciding how to

implement a new regulatory system. Therefore, this section will

discuss (a) the legal issues that currently exist with mortgage law and

(b) the law that is currently being discussed and potentially offered for

regulating the new phenomenon of Blockchain and Bitcoin.

A. Mortgage Transfer Law

What many people do not know is that “[m]ortgage loans, as

currently structured, typically consist of two instruments: a mortgage

and a promissory note.”57

The mortgage is a security instrument,

which grants a security interest in the underlying real property for the

55

Id. 56

Hunt et. al., supra note 51, at 1531. 57

Id at 1533.

358 WAKE FOREST J.


[VOL. 17

lender, originated between the borrower and lender.58

The note is the

promissory contract originated between the borrower and lender, in

which the borrower promises to pay back the lender the money owed

with interest.59

These recording statutes may provide that a buyer's

interest in the mortgage is at risk if the buyer does not record its

interest in the mortgage in records maintained by a local official.”60

On the opposite side of the equation, the promissory note is

governed by the Uniform Commercial Code (“UCC”).61

The revisions

to Article 9 of the UCC in 1999 were adopted by all fifty states during

the years of 1999 through 2001, and the revisions provide that the

buyer’s interest in the promissory note and the note’s associated

mortgage can be protected without being properly recorded.62

There

has been a tendency for the UCC’s and the states’ real property

recording statutes to give conflicting answers as to whether or not the

buyer’s ownership interest is protected with or without the recording.63

The way that the current system is set up creates a couple of

ambiguities and inconsistencies amongst the states. For example,

states differ as to whether a mortgage buyer must record the transfer in

order to ensure that its ownership interest in the mortgage is protected

from subsequent security interests.64

Also, in many states it is unclear

whether a mortgage buyer must record its interest in the mortgage to

“ensure that the buyer can foreclose on the mortgaged property in case

of default.”65

Some state’s real property laws require “a complete,

recorded chain of title to the mortgage as a prerequisite to foreclosure

(although state courts often circumvent seemingly clear language to

this effect), while the 1999 Article 9 revisions can be read to permit

foreclosure without recording.”66

These ambiguities create large problems and risk for the global

economy and financial markets, because generally, when anyone buys

something he or she wants to make sure he or she owns it. Otherwise,

there is always the fear that someone may “sell it out from under

you.”67

This is exactly what happened during and in the aftermath of

the 2008 Financial Crisis. Resolving these ambiguities and issues are

all the more important in today’s economy, because, as discussed

58

Id at 1536–37. 59

Id at 1536. 60

Id. at 1533. 61

Hunt, supra note 53, at 166. 62


Id. 64

Id. 65

Id. at 1534. 66

Id. 67

Hunt, supra note 53, at 159.



359

before, the mortgage industry is largely financed through the

securitization process. More specifically, “[t]hings can get particularly

tricky when two different types of property, each subject to different

rules, are bundled together.”68

The lack of public information, the

conflicting laws, and the complexity of the securitization process can

be resolved by implementing a cheap, efficient, and secure recording

system and by making mortgage transfer recording mandatory.

This leads to the discussion of two fundamental factors that are

contributing to these issues in the current state of mortgage recording

and transfer law. First, the legal concept codified in Article 9 of the

UCC which is commonly known as the “mortgage follows the note

rule” is discussed. Second, the broken and increasingly outdated

Mortgage Electronic Registration System is discussed.

i. The Mortgage Follows the Note

The current state of law for transferring a title of a mortgage is

codified in Article 9 of the UCC.69

As the UCC explains, “[a] security

interest attaches to collateral when it becomes enforceable against the

debtor with respect to the collateral, unless an agreement expressly

postpones the time of attachment.”70

In legalese, the mortgage follows

the note and the note follows the mortgage, unless otherwise agreed

upon and expressly stated in the contract.71

Explanations why “the mortgage follows the note”

often proceed as follows: (1) the note and mortgage are

two distinct things, the former embodying a personal

promise to pay and the latter embodying the right to sell

real property to satisfy the debt in case of default on the

note; (2) but the note can be enforced without the

mortgage but not vice versa; (3) therefore, the mortgage

is a “worthless piece of paper” without the note; (4)

therefore, the mortgage is “subsidiary” or “incident” to

the note; (5) therefore, “transfer” of the note

automatically transfers the mortgage; (6) and also,

whoever can establish ownership of the note establishes

ownership of the mortgage.72

This rule has become relatively well accepted. However, some

68

Id. 69

U.C.C. §§ 9-102, 9-109 (AM. LAW INST. & NAT’L LAW COMM’N 2014). 70

U.C.C. § 9-203 (AM. LAW INST. & NAT’L LAW COMM’N 2014). 71

See Hunt, supra note 53, at 174. 72

Id. at 174–75.

360 WAKE FOREST J.


[VOL. 17

outlier states have held out and refuse to adopt the rule, and some

scholars question whether it is even a good rule to have. Furthermore,

the phrase and rule that the mortgage follows the note has multiple

usages and meanings within the legal community, and it can stand for

several different legal propositions.73

One of those legal propositions has become the center of some

debate in the recent years following the mortgage crisis—that the

particular meaning of the mortgage follows the note is “that note-

transfer formalities trump mortgage-transfer formalities such as

recording mortgage assignments.”74

This interpretation of the

meaning of “the mortgage follows the note” implies that the law

makes it unnecessary to record mortgage assignments because the

transferee’s interest in the mortgage is already protected.75

This is the

exact proposition that contributed to many of the controversies in the

Mortgage Crisis of 2009.

One such controversy was about which individual held the right to

foreclose on a home, who should the defaulting homeowner speak

with about refinancing, and what mortgages were defaulting in all of

the CDOs that caused the crash.76

It leads one to question: Why have

so many attorneys, financiers, and judges found the theory persuasive

and believe the rule to be fairly established? However, despite

contrary belief, the rule may not be as well-established as one would

think.77

“‘The mortgage follows the note’ is one of the signature phrases of

all these controversies,78

and courts have found the phrase persuasive,

often without serious analysis of whether it is accurate or whether the

rule it reflects is desirable.”79

In the current age of technology and

data collection the rule on its face appears to be outdated. There has

not been sufficient research or evidence to support the rule, and, given

the crisis in 2008, there are significant potential pitfalls. One of the

keys to the success of any complex endeavor is a highly organized and

well-documented system supporting it. Thus, implementing a

mandatory recording rule seems clearly logical. However, opponents

of having a mandatory recording system argue that the costs would

outweigh the benefits—but given the technological advances of the

past decades that argument no longer has merit.80

73 Id. at 158, 173–74.

74 Id. at 157.

75 Id.

76 Id.

77 Id.

78 Id.

79 Hunt, supra note 53, at 157.

80 Id. at 184.



361

In fact, mortgage transfers have become the central issue for the

investigation of and litigation relating to “robosigning” and other

foreclosure abuses, in addition to the propriety issues of the Mortgage

Electronic Registration System (“MERS”).81

Furthermore, local title

recording authorities have attacked the mortgage industry’s practice of

not recording mortgage assignments across all fifty states.82

John

Hunt, a professor at UC-Davis School of Law, notes that, “Mortgage

recording traditionally has been cumbersome and relatively costly, but

it produces records that are useful to the transacting parties, to other

parties who may transact in mortgages, and to the public at large.”83

However, since the current system is loosely guided by Article 9 of the

UCC, which provides that the promissory note in a private security

agreement is not required to be filed publicly, mortgage transfer is

inexpensive and efficient for the parties to the transaction.84

Although

it does not produce the benefit of affording public records, the cost of

litigation over these suits offers evidence to combat the cost-benefit

argument against mandatory recording.85

Thus, the mortgage-follows-

the-note rule creates a recording system that is incomplete,

inconsistent, and fundamentally flawed to its core.

Given the destructive aftermath of the mortgage crisis, one would

hope that regulators would seek more transparency and organization in

the mortgage law system. By numbers alone, the bankruptcies,

government bailouts, and foreclosures (not to mention the outlandish

amount of money spent on litigation following the crisis) seem to

weigh heavily on the pockets of mortgage lenders. However, it

appears that the regulators and financial institutions have forgotten

how bad this issue can be. For a reminder, however, one need only

look to MERS as an example of the inefficiency and risk associated

with a broken mortgage recording system when dealing with the

complexities of financial markets and the securitization of the

mortgage industry.

ii. The Mortgage Electronic Recording System

There are about thirty million mortgages in the United States that

are owned, at least in part, by a company known as Mortgage

Electronic Registration Systems, Incorporated (“MERS, Inc.”), a

major player in the United States mortgage industry.86

MERS, Inc. is

81

Id. at 157. 82

Id. 83


Id. 85

Id. 86

Id. at 1556–57.

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[VOL. 17

a wholly owned subsidiary of a privately held company called

MERSCORP Holdings, Inc.; MERS, Inc. has no employees and

operates for the sole purpose of owning legal title to mortgages as an

agent for others.87

One legal commentator has criticized the

organization:

The system has drawn intense attention during the

foreclosure crisis because mortgage borrowers

frequently contest the issue of mortgage ownership.

Some of the most widely read law review articles of the

past few years criticize MERS. Most of this criticism

comes from the standpoint of mortgage debtors and

examines how MERS's deficiencies may create

defenses for homeowners facing foreclosure. Critics

writing in this vein also often take the part of local land

recording authorities, pointing to fees lost due to the

use of MERS. MERS also has its defenders, who

emphasize the cost and time savings the system offers

its users.88

There have been many operational problems with MERS, Inc.89

These issues have become known to the public and regulatory officials

who are becoming “increasingly hostile to the MERS system.”90

Federal banking regulators have even gone so far as to as to claim

that MERS, Inc. used “‘unsafe or unsounds practices’ and as a result,

the companies operate under a federal consent decree that requires

operational improvements and potential additional capital

contributions from MERS, Inc.’s members.”91

Furthermore, MERS,

Inc. is facing a multitude of lawsuits from: recording offices claiming

it violated fraudulent recording law,92

state attorneys claiming it

committed fraudulent foreclosures,93

and individual borrowers

claiming it fraudulently claimed to be the beneficiary or mortgagee.94

87

John Patrick Hunt, et al., All in One Basket: The Bankruptcy Risk of a

National Agent-Based Mortgage Recording System, 46 U.C. DAVIS L. REV. 1, 4

(2012) [hereinafter “All in One Basket”]. 88

Id. at 4–5. 89


Id. 91

Id. at 1559. 92

Transcript of Motions Hearing at 7, Dallas County v. MERSCORP, Inc., No

3:11-CV-3722-O (N.D. Tex. May 23, 2012). 93

Summons at 6, People v. JPMorgan Chase Bank, N.A., No. 0002768-2012, 2012

WL 361985 (N.Y. Sup. Ct. Feb. 3, 2012). 94

See, e.g., Cervantes v. Countrywide Home Loans, Inc., 656 F.3d 1034, 1038

(9th Cir. 2011).



363

If these lawsuits, or any other economic injury, forced MERS, Inc. to

file bankruptcy, the entire of the mortgage industry would be

jeopardized.

MERS, Inc. owes its entity’s size and rise in significance to the

mortgage securitization process and industry. That industry paid a

high premium for the ability to streamline mortgage transfers.95

As

discussed earlier in this Comment, the mortgage securitization process

involves transferring thousands and thousands of mortgages, from all

over the country, in a relatively short period of time.96

Therefore, the

industry needed some form of system to transfer the mortgages from

the originators into the special purpose vehicle, and with that need

came the rise of MERS, Inc. On its face, MERS’s ability to track

transfers of the underlying promissory note and the rights for servicing

a mortgage through its electronic database seemed like a very

attractive solution for the mortgage securitization process. “Although

MERS undoubtedly seemed like a simple and attractive solution for

the industry, hence its widespread adoption, there is little publicly

available evidence that it was carefully designed to take account of

widely varying state laws relating to mortgage recording, foreclosure

procedure, and the legal form of mortgages.”97

These were just some

of the many problems with MERS, which were exposed during the

mortgage crisis.98

The first problem addressed was MERS’s status as the Nominee

for the Lender in its membership rules, because a nominee does not

provide standing rights to conduct a foreclosure.99

This means that

MERS was only the lender nominee and not the lender-in-fact.

Therefore, it lacked the beneficial interest in the underlying

indebtedness and thus could suffer no injury by default.100

This issue

was resolved by the courts, and arguing that MERS’s status as

mortgagee gave it the authority to act on behalf of the party that holds

that economic interest:101

Courts have explained that, because MERS ‘enforce[s]

the mortgage on behalf of the owner of the note, a party

95 Phyllis K. Slessinger & Daniel McLaughlin, Mortgage Electronic

Registration System, 31 IDAHO L. REV. 805, 808 (1995). 96

See supra Section II.b. 97

All in One Basket, supra note 87, at 12. 98

Shelby D. Green, MERS Remains Afloat in a Sea of Foreclosures, 27 PROB. &

PROP. 18, 19 (2013),

http://digitalcommons.pace.edu/cgi/viewcontent.cgi?article=2005&context=lawfacul

ty. 99

Id. at 20. 100

Id. 101

Id. at 21.

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[VOL. 17

that is unquestionably entitled to enforce the obligation

the mortgage secures[,]’ MERS has the power to

foreclose and that foreclosure can be brought by MERS

even though beneficial ownership of the note is in

another.102

The clear majority of courts have asserted that as a general rule,

“the broad language in a MERS security instrument establishes that

MERS, the record mortgagee as nominee for the lender, possesses and

can assert all the powers of a mortgagee, including the power to

foreclose.”103

Even with courts establishing this rule, MERS still

changed its membership policy to allow MERS these powers.104

A second issue with MERS is whether MERS has the authority to

assign the security instrument. Since MERS merely holds the

mortgage, it often assigns a mortgage or the deed of trust to the note

holder in anticipation of foreclosure upon a default.105

This creates

problems in relation to the “mortgage follows the note” rule. As this

Comment addressed earlier, the general rule is that “a promissory note

and the mortgage securing it are inseparable” and that the transfer of

the note is deemed as a transfer of the mortgage as well.106

Courts

seem to have resolved this issue with MERS under agency theory.107

This allowed MERS to act as an agent and that MERS’s members

“‘shall cause [MERS] to appear in the applicable public land records

as the Mortgagee of Record as Nominee for the Note Owner and its

successors and/or assigns with respect to each Mortgage loan that the

Member registers on the MERS System.’”108

Furthermore, courts

have found that in the absence of specific instruction in the note,

MERS may rely on the instruction from the MERS servicer shown on

the MERS System “with respect to transfers of legal title of the note or

mortgage, transfers of contractual servicing rights, and releases of any

security interests applicable to such mortgage loan.”109

Despite these resolutions of rules, the public still does not have

faith in this system. “This is contentious business, as the many

lawsuits now pending against MERS, Inc. and its parent MERSCORP

demonstrate. Moreover, the MERS entities apparently have not

102

Id. 103

Id. 104

Id. 105

Id. 106

Id. See supra Section II.b. 107

Green, supra note 98, at 19. 108

Id. at 23 (quoting MERS SYS. RULES OF MEMBERSHIP Rule 2 §§ 4 & 5

(2013)). 109

Id.



365

handled their business impeccably in the past.”110

So, if MERS was

to go into bankruptcy, these established rules by the courts could pose

some significant problems.111

One of the most frightening possibilities is the very real risk that

MERS could accidently convey the mortgages recorded in its name to

a bona fide purchaser, using either the owner theory or agency theory

laid down by the courts.112

MERS is a member-run company, and therefore, as the courts have

pointed out, its members are subject to the powers set forth in the

company’s bylaws.113

These powers allow for MERS to act without

authorization from its members in order to comply with any law (i.e.

bankruptcy laws) or custom “to exercise any or all of those rights

including, but not limited to, the right to foreclose and sell the

Property; and to take any action required of Lender including, but not

limited to, releasing and canceling this Security Instrument.”114

Therefore, “[t]he ‘any or all’ language in MERS, Inc.'s standardized

mortgages empowers MERS, Inc. to do anything the original lender

could do with the mortgage.”115

For example, the rights of the lender

include the power to sell the mortgage.116

Thus, it is likely that the

“any or all” language spelled out in the MERS terms and conditions

includes the right to sell the mortgage.117

In keeping with this line of

reasoning, if MERS were to ever go into bankruptcy, the bankruptcy

trustee would have the power to sell the mortgages under MERS’ legal

title in order to pay the debts of MERS creditors.118

One does not

need to be an expert in banking, mortgage, finance, or bankruptcy law

to understand how big of a problem and how absolutely dangerous a

result like this could be.

B. Legal Effect of Implementing the Peer-to-Peer Blockchain

Mortgage Recording System

Up to this point, this article has discussed and addressed many of

the practical and legal issues with the current system of mortgage law,

and it has discussed many reasons why some oppose a mandatory

110


Id. at 22. 112

Id. at 34. 113

Mortg. Elec. Registration Sys., Inc. v. Neb. Dep’t of Banking & Fin., 704

N.W.2d 784, 785 (Neb. 2005). 114

Id. at 788. 115


Id. 117

Id. 118

Id.

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recording system.119

Implementing a peer-to-peer based Blockchain

mortgage system will eradicate some of these problems. Blockchain

technology is still in its infancy regarding development, but even

regulators are beginning to realize that “applications related to the

blockchain technology underlying bitcoin have become increasingly

prominent.”120

Many regulators have already concluded that

“[b]lockchain-focused applications take advantage of certain unique

characteristics of the blockchain such as secure time stamping (secure

time stamps are on newly created blocks), highly redundant storage

(copies of the blockchain are distributed throughout the Internet) and

tamper-resistant data secured by secure digital signatures.”121

Now

regulators must realize that the applications can extend to the

mortgage industry. This section argues that if regulators implemented

the Blockchain system, the risks and problems with the current

recording system and mortgage law would be fixed.

i. A Public Ledger Will Complete and Complement

the “Mortgage Follows the Note” Rule

Following the mortgage crisis, there has been a substantial amount

of evidence for the proposition “that note-transfer formalities trump

mortgage-transfer formalities such as recording mortgage

assignments,”122

is, at least in part, fundamentally flawed and opens

the door to unnecessary risk. This interpretation of the rule implies

that the law makes it superfluous to record mortgage assignments,

since the transferee’s interest is already protected.123

Although this

may be adequate in the case of simple transactions, i.e. John sells his

note to Sally and Sally holds it until its expiration date, the problem

becomes much more apparent once one realizes that the vast majority

of the mortgage industry is financed by the mortgage securitization

process. Advocates against a mandatory recording system have

suggested that “[r]ecording may simply have been impractical:

recording mortgage assignments is burdensome in mortgage

securitizations because of the large volume of assignments and the

relatively tight time frame for each transaction.”124

When developing

Bitcoin, the developers created the peer-to-peer based blockchain

119 See supra Sections I, II, III.

120 Sec. and Exch. Comm’n, Notice of Filing of Proposed Rule Change Relating

to the Listing & Trading of Shares of Solidx Bitcoin Trust Under NYSE Arca

Equities Rule 8.201 (July 27, 2016),

https://www.sec.gov/rules/sro/nysearca/2016/34-78426.pdf. 121

Id. at 9. 122

Hunt, supra note 53, at 156. 123

Hunt et. al, supra note 51, at 1533. 124

Id. at 1538.



367

system to address this specific problem.125

Like mortgage securitization, cryptocurrencies, such as Bitcoin,

must have a way of recording themselves for two reasons. First,

cryptocurrencies require a recording system to prevent a user from

making an exact copy of the Bitcoin and then “double selling” that

specific Bitcoin.126

If there was no way to protect the currency from

this type of double selling then the currency would lose all of its

value.127

Second, keeping a record of every transaction made with a

Bitcoin improves the confidence in the currency, tracks ownership,

confirms legitimate transactions, and provides a way to cheaply

maintain the network.128

To eradicate the threat of double selling, the

creators of Bitcoin created a decentralized peer-to-peer verification

network to keep track of and verify the millions of transactions that

occur daily.129

The problems faced by Bitcoin are analogous to the

problems faced by the mortgage securitization process. Since the

mortgage securitization process involves a large volume of

assignments in a tight time frame for each transaction, it is perfectly

logical to use the same technology underlying Bitcoin in the mortgage

securitization industry.

Given the need for efficiency and speed in the mortgage securities

industry, the “mortgage follows the note” theory, which implies that it

is unnecessary to record mortgage assignments, might have been the

best and most applicable theory during the early 2000s leading up to

the crash. However, technology has caught up with the mortgage

securitization industry, and the argument that note-transfer formalities

trump mortgage-transfer formalities is outdated. With the

development of Blockchain technology, that particular understanding

of the “mortgage follows the note” rule has become obsolete, because

the enhanced security and increased verification speed of a Blockchain

system eliminates the argument that recording is too slow and

inefficient.

ii. Replacing MERS

MERS has more problems than one would ever care to describe.130

One of the main issues is that it is a privately held company, so the

way it is run is not very transparent.131

Another point of contention is

125

Supra note 3. 126

See supra Section I–II. 127

Id. 128

Id. 129

Id. 130

All In One Basket, supra note 87, at 13. 131

See id. at 3 n.2, 62.

368 WAKE FOREST J.


[VOL. 17

that, since it is a centralized system (meaning that it has the sole

control over the network it operates), it is more expensive, less

efficient, and less reliable than a decentralized system.132

Lastly, the

way MERS was structured allows it to own the legal title to over thirty

million mortgages in the United States, which has created a concern

for the implications about what it is legally entitled to do.133

Creating a peer-to-peer Blockchain mortgage recording system

would eradicate these problems almost overnight. Here is a

hypothetical solution on how to implement this new system, which is

based off a detailed explanation of how Bitcoins blockchain works

through its bitcoin wallet software from a proposed rule by the SEC to

regulate the purchase and sale of Bitcoins on self-regulating

exchanges, such as the New York Stock Exchange. Congress would

pass a bill to allow the Securities and Exchange Commission to create

a decentralized peer-to-peer based network software like that of

“Bitcoin Wallet.”134

Anyone in the world can download the software,

create an account, and help maintain the network by verifying

transactions. The incentive to do this would be to get a small fee for

verifying separate mortgage transactions that are being conducted on

the Blockchain.135

In order to transfer or originate a new mortgage,

the transferor or originator must first log into his or her account on the

peer-to-peer network. If it is an originator, the originator must first

generate a new mortgage associated with the relevant secured property

on the peer-to-peer network and create the original block of that

mortgage’s Blockchain. Once the originator wanted to transfer that

mortgage, he or she must request the recipients’ peer-to-peer network

account address. The transferee then uses his or her peer-to-peer

mortgage account software to create a proposed addition to the

Blockchain.136

The proposal would remove the right of ownership of the mortgage

from the transferor’s address and bestow the right onto transferee’s

132

See id. at 49, 59. 133

See id. at 1-2. 134

See Self-Regulatory Organizations; NYSE Arca, Inc.; Notice of Filing of

Proposed Rule Change Relating to the Listing and Trading of Shares of SolidX

Bitcoin Trust Under NYSE Arca Equities Rule 8.201, 81 Fed. Reg. 50764 (Aug. 2,

2016). 135

Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System,

BITCOIN.ORG, 4, https://bitcoin.org/bitcoin.pdf (last accessed Feb. 16, 2017). 136

See See Self-Regulatory Organizations; NYSE Arca, Inc.; Notice of Filing of

Proposed Rule Change Relating to the Listing and Trading of Shares of SolidX

Bitcoin Trust Under NYSE Arca Equities Rule 8.201, 81 Fed. Reg. 50764 (Aug. 2,

2016).



369

address.137

These proposals would be entirely digital in nature, similar

to a file on a computer, and once it is transmitted it will be sent out to

other computers participating in the [Peer to Peer Mortgage recording]

network to be verified by a third party.138

. The contents of the

proposal received by the third party will contain: the transferor’s peer-

to-peer mortgage address, the transferee’s peer-to-peer mortgage

address, the specific mortgage or mortgages to be transferred, the

confirmation fee to be retained by the third party verifiers as

compensation for his or her verification services, and the proposal

parties’ digital signatures.139

A user’s digital signature is generated via usage of the

user’s so-called ‘private key,’ one of two numbers in a

so-called cryptographic key pair. A key pair consists of

a ‘public key’ and its corresponding private key, both

of which are lengthy numerical codes, derived together

and possessing a unique relationship. A user’s [peer-

to-peer mortgage network] address–which is derived

from a public key–may be safely distributed, but a

user’s private key must remain known solely by its

rightful owner. The utilization of a private key is the

only mechanism by which a [mortgage owner] can

create a digital signature to transfer a mortgage from

him or herself to another user.140

When a mortgage owner transfers his or her rights to the mortgage,

he or she sends that mortgage to a destination–the transferees’ peer-to-

peer network address–and the transaction is initially considered

unconfirmed.141

Thereafter,

Confirmation of the validity of the transaction involves

validating the signature of the transferor, as created by

the transferor's private key.142

Confirmation also

involves verifying that the sender has not sold the

[mortgage] (e.g., confirming Party A has not attempted

to sell the same [mortgage] to both to Party B and to

Party C). The confirmation process will occur through

a [peer to peer verification process].143

137

Id. 138

Id. 139

Id. 140

Id. 141

Id. at 50765. 142

Id. 143

Id.

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This is where the decentralized nature of the network comes into

play. Since the system is set up as a Peer-to-peer, meaning that the

individuals on the network controls what goes on it, rather than one

central entity (i.e. MERS, Inc.), the legal rights to access of the

network belongs to anyone with access to a computer and the internet.

Peer to peer verification will utilize “a combination of computer

hardware and software to accomplish a dual purpose: (i) to verify the

authenticity and validity of [mortgage] transactions (i.e., the

movement of [mortgages] between addresses) and (ii) to verify the

creation of new [mortgages].144

Since the system is set up as a Peer-

to-peer, meaning that the individuals on the network controls what

goes on it, rather than one central entity (i.e. MERS, Inc.), the legal

rights to access of the network belongs to anyone with access to a

computer and the internet. The third part verifiers “do not need

permission to participate in verifying transactions. Rather, verifiers

compete to solve a prescribed and complicated mathematical

calculation using computers dedicated to the task of verification.”145

This of course is contrast to the access of information with the current

MERS system, and to encourage the public to participate in the

verification process, verifiers will be rewarded with the fees generated

by each successfully verified mortgage transfer.146

Once the entire

verification process is complete there were be a new timestamped

block generated with on the mortgage’s Blockchain. The verifier then

transmits a copy of the newly-formed block to his or her peers on the

Blockchain mortgage recording network. Once that step is complete

everyone else on the network will have an updated version of their

respective copies of the Blockchain with the appended new block,

thereby acknowledging the confirmation of the transactions that had

previously existed before it was confirm.147

A Blockchain-focused system will “take advantage of certain

unique characteristics of the [B]lockchain such as secure time

stamping . . . highly redundant storage . . . and tamper-resistant data

secured by secure digital signatures.”148

Once implemented, the peer-

to-peer Blockchain mortgage recording system will completely

eradicate the expense and burden of recording mortgage transfers. It

will also significantly upgrade the flawed MERS system, because

recording will be done in a decentralized format. Lastly, it will create a

public ledger for mortgages, and in the process, make the mortgage

144

Id. 145

Id. 146

Id. 147

Id. 148

Id.



371

securities market immensely safer.

IV. CONCLUSION

The systematic risk created by: the ambiguities and irregularities

by the mortgage recording laws; the impracticality and lack of public

information with the “mortgage follows the note” rule; and the threat

of bankruptcy with a privately-run company, MERS, Inc. caused the

global economy to collapse beginning in 2007 and ending in 2009.

Many countries’ markets and economies have not recovered from the

financial crisis, and some may never do so. A peer-to-peer mortgage

Blockchain network is preferable to the current MERS. This

Blockchain would allow for greater transparency through a peer-to-

peer network rather than a centralized one such as MERS. Also, it will

eliminate the need for a mortgage follows the note rule, because the

mortgages and notes will already be recorded on an immutable chain

eliminating any discrepancies in ownership. A peer-to-peer

Blockchain Mortgage Recording System will not be completely

without risk, because no endeavor is ever risk free. However, the

argument that recording is too inefficient, burdensome, slow, or

expensive is no longer logical or sufficient. This system could

eliminate many of the problems that the mortgage market is facing

today and offers to be a far safer alternative than the current regulation

system.




TRADEMARKING SOCIAL MOVEMENTS MATTER

MaKenna Rogers and Brittany Wages†

I. INTRODUCTION ............................................................. 373 A. PAST ATTEMPTS FORESHADOW TODAY'S

PROBLEMS .................................................................. 375 B. MOVEMENTS' RELATION TO TRADEMARK LAW ....... 379

II. ACQUISITION OF RIGHTS PERSPECTIVE ....... 380 A. RULES REGARDING COLLECTIVE GROUPS ............... 381

1. Native American Tribes ........................................... 382 2. Franchisor and Franchisee Relationships ............... 383

3. Church Organizations ............................................. 385 4. Greek Life ................................................................ 387

B. SUGGESTED LEGISLATION FOR WHO IS ENTITLED

TO RIGHTS .................................................................. 390

III. ENFORCEMENT PERSPECTIVE .................................. 394 A. EXISTING LEGISLATION/TEST ................................... 394

IV. CONCLUSION .............................................................. 398

† MaKenna Rogers: BA Journalism, University of Oklahoma 2015. J.D. Wake

Forest University School of Law 2018. † Brittany Wages: BA Political Science and Economics, University of Florida

2015. J.D. Wake Forest University School of Law 2018. †The authors would like to thank Professor of Law Simone Rose for her

guidance and support on this comment. Additionally, thanks must be given to the

hardworking staff and executive members of the Journal of Business and Intellectual

Property Law.

2017] TRADEMARKING SOCIAL MOVEMENTS

MATTER

373

I. INTRODUCTION

People living together in any society will inevitably disagree, take

opposing sides, and ask for change. The changes and campaigns for

change can be classified as social movements1 (also referred to as

movements). Social movements are campaigns in support of a

common goal.2 More specifically, social movements are the coming

together of people, who have a similar social goal, but otherwise

would not be brought together.3 The goal for these social movements

is generally the “implementation or prevention of a change in society’s

structure or value.”4 Groups come together to publicize a social issue,

protest the issue, and create change.

This comment will first discuss social movements and why they

should be protected, as well as examples of recent movements and

their implications on trademark law. This will be followed by a

discussion of who should be able to acquire trademark ownership

rights. This comment determines this by examining four similar but

distinct collective groups. This comment then proposes an addition to

the Lanham Act specifically addressing social movements. Lastly, the

comment discusses how these rights should be enforced after

acquisition and issues with some of the current tests applied by courts.

Social movements can be organized in a variety of ways; however,

most tend to lack structure and have a dispersed organization.5

Generally, these movements are “a mixture of organization and

spontaneity,”6

meaning that social movements have a specific

universal purpose and goal. The goal, however, can encompass a

variety of groups, leaderships, and assortment of plans.7

The simplest way to think of a social movement is to analogize it

to a tree. The foundation of a tree is the tree’s roots, similar to the

foundation of a social movement, which is rooted in the need for

social change. Next, the trunk represents the core of both the tree and

the movement. This core holds the group together through the

universal purpose and goal, and is the overarching motivation for the

movement. Finally, the branches sprout in a variety of directions,

while clinging to the core—the universal purpose and goal. These

1 Lewis M. Killian, Ralph H. Turner & Neil J. Smelser, Social Movement,

BRITANNICA.COM (Jan. 7, 2009), https://www.britannica.com/topic/social-

movement. 2 Id.

3 Id.

4 Id.

5 Id.

6 Id.

7 Killian, supra note 1.

https://www.britannica.com/topic/social-movement


374 WAKE FOREST J.


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branches represent the variety of individual groups who are working to

further the movement. These groups still work toward achieving the

universal purpose and goal; however, they are still individual groups.

These groups likely have individual leadership, promote the goal in

different geographic areas, and potentially further the movement in

different, personalized ways.

Social movements consist of two distinct segments, each affecting

the overall success of the movement.8 The first segment is the group

itself. The group is where much of the support and work take place;

this work is often very individualized but focused toward the universal

purpose and goal.9 Due to the decentralized nature of the group, it is

often difficult to discern any one particular leader.” This leads to the

question: when a movement gains popularity and creates geographical

hubs of organization each with a leader, should there be one individual

in charge? The second segment of a movement is the environment.

The environment affects how the movement will be received. It

determines if the movement will gain popularity and be successful, or

fail to gain momentum and deteriorate.10

This presents another

challenge to the group: whether the movement will gain enough

popularity and stamina to warrant legal trademark protection.

Social movements generally progress through stages of action.11

Often movements start with a controversial occurrence such as: a war,

a crime, or a law. It is when an individual or group believes that the

occurrence calls for change that a movement is born.12

These

movements often begin in a grassroots form, meaning that their origin

is the controversial occurrence, which then sparks a movement that is

devoted to change based on the original principle of injustice.13

If a

movement has support and a proper environment for success, the

movement often grows. It then gains a large membership base, under

individualized leadership, in a variety of geographical regions.

Because of this rapid growth of the membership base,14

the

progression may stall as the group tries to determine what happens

next. Lacking direction, trademark law can assist by giving a group

that typically lacks structure a set of tools to remain true to their

8 Mayer N. Zald & Roberta Ash, Social Movement Organizations: Growth,

Decay, and Change, 44 SOCIAL FORCES 327, 329–30 (1966). 9 Id.

10 Id.

11 Id. at 331.

12 See generally Alicia Garza, Opal Tometi & Patrisse Cullors, A Herstory of the

Black Lives Matter Movement, BLACK LIVES MATTER,

http://blacklivesmatter.com/herstory/ (last visited Nov. 28, 2016). 13

Grassroots, MERRIAM-WEBSTER’S DICTIONARY (2016). 14

Zald, supra note 8.

http://blacklivesmatter.com/herstory/


MATTER

375

grassroots form, while simultaneously granting legal rights that can

further the movements purpose.

However, before gaining access to these tools, the issues of what

trademark rights exist, who owns these rights, and how they should be

enforced must be addressed. Trademark law can be an effective

communication tool that unifies a brand, or in this case, a movement.15

Primarily, trademarks serve as source identification, which in the area

of social movements would promote unanimity in a decentralized

grassroots environment.16

Overall, trademark law has gaps in legal protection for social

movements. These gaps needs to be filled in order to give these

movements the tools needed to succeed and to avoid stalling the

progression of the movement. Based on the most similar cases and

groups in existing trademark law, this comment will suggest how to

fill these gaps via an addition to the Lanham Act (“15 U.S.C § 1142”)

to provide social movements the protection they need to enact social

change. The proposed section addresses two issues: first, who

acquires these trademark ownership rights, and second, once these

rights are acquired, how should the courts and the United States Patent

and Trademark Office (“USPTO”) enforce these rights?”

A. Past Attempts Foreshadom Today’s Problems

Prior to exploring solutions to these questions, it is relevant to look

at past attempts to trademark social movements. This shows the gaps

that exist in trademark law, and why these gaps are problematic. This

section focuses on the progression of three recent social movements:

Occupy Wall Street, Boston Strong, and Black Lives Matter. These

three movements have received different treatment and outcomes from

the USPTO regarding their ability to trademark their sources. These

movements show two major problems with respect to who should

receive trademark rights.17

First, the USPTO should not grant

trademark rights to individuals not affiliated with the movement who

are attempting to exploit it for monetary gain. Second, the USPTO,

15

Abigail Rubinstein, 7 Reasons Why Trademarks are Important to Your

Business, ENTREPRENEUR (July 24, 2014),

https://www.entrepreneur.com/article/235887. 16

Id. 17

See generally Erica Fink, Occupy Wall Street Applies for Trademark, CNN

MONEY (Oct. 31, 2011, 12:03 PM),

http://money.cnn.com/2011/10/31/news/economy/occupy_wall_street_trademark/;

Ian Rubenstrunk, Trademarking Social Change?, REVIEW OF INTELL. PROP. L.

BLOG: J. MARSHALL L. SCHOOL (Oct. 31, 2011),

http://ripl.jmls.edu/2011/10/31/trademarking -social-change/.

https://www.entrepreneur.com/article/235887

http://money.cnn.com/2011/10/31/news/economy/occupy_wall_street_trademark/

http://ripl.jmls.edu/2011/10/31/trademarking-social-change/

376 WAKE FOREST J.


[VOL. 17

flooded with applications, should again consider which party has

proper rights to the mark, beyond simply adhering to the typical “first

to file” priority analysis.18

These problems will be resolved below

with the suggested addition to the Lanham Act, 15 U.S.C § 1142.

Typically, the USPTO grants trademark rights to the first filer of a

mark. However, an issue arises when multiple individuals are applying

for the same registration, sometimes even concurrently. According to

15 U.S.C § 1057(c), the right of a trademark is granted to the first filer

of the mark.19

However, this comment will suggest that the USPTO

look not only to the time of filing to determine rights of trademarks for

social movements, but also the source of the filing. Research shows

that often in social movements, several conflicting marks are under

review at a given time, and are deemed dead based on refusal,

dismissal, or invalidation.20

Equally troublesome, there are also cases

where several, almost identical, live marks exist for the same

movement. According to the USPTO’s Trademark Electronic Search

System (“TESS”), it is not clear as to why each of the marks were

abandoned, although it is clear that the USPTO handled the

applications the same way by refusing, dismissing, or invalidating

them. Because of the conflicting registration attempts and the bad

faith of some of the applicants, the current law is not proper and a

niche standard should be created. The following movements are

contemporary examples of the aforementioned issues.

The general principle of Occupy Wall Street is to protest the top

one percent of society who holds a vast amount of the world’s

wealth.21

This social movement began in an attempt to gain economic

equality and “fight back against the richest [one percent] of people that

are writing the rules of an unfair global economy.”22

Many

individuals, affiliated and unaffiliated with the movement, applied for

trademark applications.23

One such example was an Arizona couple,

18

15 U.S.C. § 1057(c) (2012). 19

Id. 20

See Carl Eppler, Commentary: Trademarking Tragedy, NASHVILLE POST (Jan.

21, 2015), http://www.nashvillepost.com/home/blog/20481213/commentary-

trademarking-tragedy; Roberto Ledesma, Do Not File a Trademark Application For

a Trending Rallying Cry, EVERYTHINGTRADEMARKS.COM, (Jan. 10, 2015),

https://everythingtrademarks.com/2015/01/10/do-not-file-a-trademark-application-

for-a-trending-rallying-cry/. 21

About Us, OCCUPY WALL STREET, http://occupywallst.org/about/ (last visited

Nov. 28, 2016). 22

Id. 23

Erica Fink, Occupy Wall Street Applies for Trademark, CNNMONEY (Oct. 31,

2011, 12:03 PM),

http://money.cnn.com/2011/10/31/news/economy/occupy_wall_street_trademark/;

Rubenstrunk. supra note 17.


MATTER

377

self-identified with the movement, who were looking to gain rights to

the mark and place them on merchandise.24

This couple was denied

by the USPTO.25

However, an Arizona based investment company,

not affiliated with the movement, was granted a trademark right for

merchandise although they, admittedly, wanted the trademark for

business and monetary gain.26

An attorney for the Occupy Wall Street

movement also submitted a trademark application on the same day as

submission and approval of the investment company’s application.27

This clearly shows one of the problems in the acquisition of rights.

Two groups seeking to trademark a movement with which they

identify presents a problem: is one more worthy of the rights than the

other? For example, if one group looks to further the movement, are

they more deserving than a group looking for monetary gain? The

answer to this question is yes, and therefore the Lanham Act should

address this niche for social movements.

The conflicting responses to these applications is a root of the

problem. The USPTO denied the Arizona couple’s application

because the phrase was associated with multiple movements, and

therefore the USPTO determined that the mark was informational,

lacking the function necessary for a trademark, single source

identification.28

However, the two applications that were granted were

from conflicting parties. One party affiliated and one unaffiliated with

the movement. This gives the unaffiliated individuals the ability to

capitalize on the social movement for profit rather than contributing to

the furtherance of the movement.

Boston Strong, another social movement, was spurred by the

bombing at the Boston Marathon in 2013, and created to support the

city and victims of the attack.29

After the bombing, the phrase

“Boston Strong” became very popular and nine trademark applications

were filed with the USPTO.30

Some of the marks were filed just two

24

Fink, supra note 23. 25

Id. 26

Id.; http://tess2.uspto.gov/bin/gate.exe?f=tess&state=4807:u52azx.1.1 (follow

“Basic Work Mark Search” hyperlink; then enter “occupy Wall Street” search term)

(last visited Dec. 2, 2016). 27

Fink, supra note 23. 28

Carl Eppler, Commentary: Trademark Tragedy, NASHVILLE POST (Jan. 21,

2015), http://www.nashvillepost.com/home/blog/20481213/commentary-

trademarking-tragedy. 29

Dustin Kovacic, Are Social Movements Trademarkable? - “Je Suis Charlie”

and the USPTO JETLAW (Mar. 11, 2015), http://www.jetlaw.org/2015/03/11/are-

social- movements -trademarkable-—-je-suis-charlie-and-the-uspto/. 30

Basic Word Mark Search for “Boston Strong,” USPTO TRADEMARK

ELECTRONIC SEARCH SYSTEM (TESS),

continued . . .

http://www.nashvillepost.com/home/blog/20481213/commentary-trademarking-tragedy

http://www.nashvillepost.com/home/blog/20481213/commentary-trademarking-tragedy

http://www.jetlaw.org/2015/03/11/are-social-movements-trademarkable-—-je-suis-charlie-and-the-uspto/

http://www.jetlaw.org/2015/03/11/are-social-movements-trademarkable-—-je-suis-charlie-and-the-uspto/

378 WAKE FOREST J.


[VOL. 17

days after the bombing occurred, and all of the marks were filed

subsequent to the attack.31

All of the applications filed are now listed

as denied or abandoned due to lack of response to the USPTO.32

One

Vanderbilt Journal of Entertainment and Technology Law

commentator noted that this mark was denied because it lacked a

single source and instead was an informational mark, not offering

source identification but mere information.33

Therefore, the USPTO

may be hesitant to grant trademarks such as “Boston Strong” as they

lack a “single source”34

and thus leave the opportunity for uninterested

parties to profit.35

This again exemplifies a gap in trademark law, in

which movements such as “Boston Strong,” and Occupy Wall Street,

have multiple trademark applications by a variety of individuals who

are both affiliated and unaffiliated with the movement. Further, the

TESS filing dates for the Boston Strong trademark applications seem

to be conflicting, showing the USPTO’s hesitation in granting these

types of marks. Both issues stress the need for 15 U.S.C. § 1142,

which will guide the USPTO and prevent opportunists seeking

monetary gain.

Black Lives Matter is the most recent social movement that has

sent shockwaves across the United States.36

This movement is a good

example of how trademark law can affect the progression of a group's

purpose and goals. According to the USPTO, there are four registered

marks for Black Lives Matter.37

Two of the marks are live marks and

two of the marks are dead.38

The two live marks are for “Black Lives

Matter.” (with the period) and “Black Lives Matter” (without the

period); both of the marks are for clothing related items.39

The two

dead marks were deemed abandoned because the marks were “refused,

http://tess2.uspto.gov/bin/gate.exe?f=searchss&state=4806:719gmp.1.1 (Search for

“Boston Strong”) (last updated Feb. 20, 2017) [hereinafter Boston Strong]. 31

Id. 32

Id. 33

Kovacic, supra note 29. 34

Eppler, supra note 28. 35

Kovacic, supra note 29. 36

Sara Sidner & Mallory Simon, The Rise of Black Lives Matter: Trying to

Break the Cycle of Violence and Silence, CNN (Dec. 28, 2015, 8:28 AM),

http://www.cnn.com/2015/12/28/us/black-lives-matter-evolution/. 37

Basic Word Search for Black Lives Matter, USPTO TRADEMARK

ELECTRONIC SEARCH SYSTEM (TESS),

http://tess2.uspto.gov/bin/gate.exe?f=searchss&state=4802:vpwx2w.1.1 (follow

“TESS” hyperlink, then search “Black Lives Matter.”) [hereinafter Black Lives

Matter]. 38

Id. 39

Id.


MATTER

379

dismissed, or invalidated” by the USPTO.40

One of these marks was

registered for greeting cards, calendars, and stationery.41

The other

mark was registered for clothing related items.42

None of the four

registered marks were applied for by the official Black Lives Matter

group.43

Black Lives Matter is now at a stage in its progression as a

social movement where it would consider the use of its name and

determine if it would want trademark protection. This is what spurred

the topic of this paper and our interest in determining who should be

able to acquire ownership rights in social movements and how the

USPTO should enforce these rights. This is what spurred the topic of

this paper and the interest in determining who should be able to

acquire ownership rights in social movements and how the USPTO

should enforce these rights.

B. Movements’ Relation to Trademark Law

Trademark law offers the first registrant of a mark protection from

competing use of that mark or a similar mark that may cause

confusion, mistake, or deception with the original mark.44

Whether a

social movement can be trademarked is a question that is not

specifically addressed in the Lanham Act. Under the Lanham Act,

both goods and services can be registered for protection. In the case of

the social movements discussed above, the marks have been registered

as both goods and services.45

For example, both Occupy Wall Street

and Boston Strong were classified as a service mark and a word mark

in the applications to the USPTO.46

At first glance, social movements may appear to be collective

marks under 15 U.S.C. § 1127, yet social movements are distinct from

collective groups based on the construction, organization, and

structure of social movements.47

Social movements lack the hierarchy

and definitive leadership structure that is present in collective

groups.48

Collective groups gain trademark protection through the

40

Id. 41

Id. 42

Id. 43

Black Lives Matter, supra note 37. 44

15 U.S.C. § 1057(b) (2012). 45

Black Lives Matter, supra note 37. 46

Boston Strong, supra note 30; Basic Word Search for “Occupy Wall Street”,

USPTO TRADEMARK ELECTRONIC SEARCH SYSTEM (TESS),

http://tess2.uspto.gov/bin/gate.exe?f=searchss&state=4802:vpwx2w.1.1 (follow

“TESS” hyperlink, then search “Occupy Wall Street”). 47

15 U.S.C. § 1127 (2012). 48

See supra text accompanying note 5–6.

380 WAKE FOREST J.


[VOL. 17

leadership registering and controlling the mark.49

As this is not

present in social movements, they cannot be treated the same under the

Lanham Act. However, because collective marks are most similar to

social movements, consideration was given to the law regarding

trademark rights for collective marks in drafting 15 U.S.C. § 1142, the

proposed addition to the Lanham Act.

Because of the lack of legislation regarding the ability to register

social movements, there are gaps, which create inconsistent treatment

of applications.50

Some argue that these movements are inherently

created in the public domain and therefore cannot be trademarked.51

However, social movements would benefit from the ability to protect

and control their image, and could also strategically use a mark to

promote specific social movement goals. Just because social

movements are not formed in a traditional sense (like an LLC or a

corporation),52

does not mean the movements should not be able to

receive protection from the USPTO.

Because of the absence of guidance in the Lanham Act regarding

social movements, and social movements prevalence in society,

legislation needs to be added.53

First, attention should be given to the

acquisition of ownership rights for these marks; specifically

determining who within a social movement has the right to register,

control, and monitor the use of a mark. After determining the

acquisition of ownership rights, the USPTO and courts will need

guidance regarding how to enforce such rights.

II. ACQUISTION OF RIGHTS PERSPECTIVE

As discussed above, under the Lanham Act, there is no definition

for an “owner” of a trademark of a social movement group.54

The

Lanham Act grants trademark rights to whoever files to be the owner

49

See 15 U.S.C. § 1054 (2012). 50

See supra, at 5. 51

Ian Rubenstrunk, Trademarking Social Change?, J. MARSHALL REV.

INTELL. PROP. L. (Oct. 31, 2011), http://ripl.jmls.edu/2011/10/31/trademarking-

social-change. 52

See supra, Zald, note 8. 53

See supra text accompanying note 48. 54

See Trademark Manual of Examining Procedure 8-800 TMEP 803 (5th ed.

Sept. 2007) (failing to give guidance because in social movements there may not be

a clear owner of the mark, and also because social movements would not be

classified as a juristic person because they are not capable of suing or being sued in

court).


MATTER

381

first.55

This is problematic for these movements because often there is

not one specific person who creates the mark.56

This is often due to a

lack of structure and lack of a designated leader.57

This can also be

because movements lack formal “membership” per se.58

In essence,

people can simply begin self-identifying with the movement instead of

formally registering as members.59

Examples of this would be African

Americans identifying with Black Lives Matter, or the LGBT

community identifying with Orlando Strong.60

These problems can

present complications for the USPTO in determining when to approve

an application.61

Because the Lanham Act does not address this

issue,62

case law is not necessarily prevalent in this area.63

Therefore,

this comment will look to the most similar case law to determine who

should be able to acquire trademark ownership rights.

A. Rules Regarding Collective Groups

The law necessary for social movements is most similar to

collective groups and therefore can be instructive in solving the issues

presented.64

Because of this, this comment will look to how courts

have handled the acquisition of rights of collective groups to

55

See generally, 15 U.S.C. § 1051 (2012) (other requirements must be met;

however, this comment is specifically focusing on the individual filer and not meant

to explain all the requirements needed to obtain trademark ownership rights). 56

See Robert Burgess, Where Did the Term Boston Strong Come From?,

BOSTON.COM (Apr. 15, 2014), http://archive.boston.com/2014/04/15/bdc-

bostonstrongstart/paU4PMYxb4ayBUwcvBKAQK/story.html (showing that three or

more people – not one specific person – created the Boston Strong slogan). 57

Killian, supra note 1. 58

Id. 59

Id. 60

See Elizabeth Day, #BlackLivesMatter: The Birth of a New Civil Rights

Movement, THE GUARDIAN (July 19, 2015),

https://www.theguardian.com/world/2015/jul/19/blacklivesmatter-birth-civil-rights-

movement; See also Melody Rowell, Orlando Strong: A Community United After

Massacre, NATIONAL GEOGRAPHIC (June 14, 2016),

http://news.nationalgeographic.com/2016/06/orlando-shooting-lgbt-portraits/. 61

See, e.g., Bill Donohue, USPTO Rejects Trademark On ‘I Can’t Breathe’

Protest Slogan, LAW360 (Mar. 18, 2015, 8:05 EST),

https://www.law360.com/articles/633361/uspto-rejects-trademark-on-i-can-t-

breathe-protest-slogan. 62

See generally, 15 U.S.C. §§ 1051, 1054 (2012). 63

See Rubenstrunk, supra note 51. 64

Compare, Lewis M. Killian, Ralph H. Turner & Neil J. Smelser, Social

Movement, BRITANNICA.COM (Jan. 7, 2009),

https://www.britannica.com/topic/social-movement, and Sigma Chi Fraternity v.

Sethscot Collection, No. 98-2102-CIV-SEITZ, 2000 U.S. Dist. LEXIS 6332 (S.D.

Fla. 2000).


382 WAKE FOREST J.


[VOL. 17

determine what legislation should be implemented for the issue of

social movement registration. This comment will examine the

following collective groups: Native American tribes, franchises,

church organizations, and Greek Life.

1. Native American Tribes

Native American tribes can be analogized to social movement

groups. Native American tribal membership varies from tribe to tribe,

but is generally based on lineal relation to someone on the tribe roll

(the original list of tribe members), or relationship to a tribe member

who descended from someone on the tribe roll.65

Other tribes consider

factors such as: blood relations, residency in the tribe, or contact with

the tribe.66

Unlike social movement groups, Native American tribes

are based on relationships, not chosen affiliation.67

Despite this

dissimilarity, the same question applies to both groups: what rights

should members get?

In Mohegan Tribe of Indians of Connecticut v. Mohegan Tribe &

Nation, Inc., the plaintiff and defendant were both registered Mohegan

Tribe groups.68

The plaintiff had a preexisting federally registered

mark and the defendant had a pending registration with the Bureau of

Indian Affairs.69

The defendant was a spin-off group from the

plaintiff’s group and was attempting to register as a group independent

from the plaintiffs in order to conduct tribe business separately.70

The

plaintiff conceded that the registration with the Bureau of Indian

Affairs could not be denied because of the federal registration.71

The

court focused on the ancestry tie necessary to create a tribal

community and found, because of this strict membership criteria, both

groups had rights to the mark.72

In Mohegan, the plaintiff claimed trademark infringement, and the

court concluded that the plaintiff could not prove that they possessed a

valid, legally protectable mark, and that the defendant’s mark was not

likely to confuse as a source identifier.73

The court held that the terms

65

U.S. DEPT. OF THE INTERIOR, TRIBES: TRIBAL ENROLLMENT PROCESS,

https://www.doi.gov/tribes/enrollment (last visited Nov. 28, 2016). 66

Id. 67

Id. 68

Mohegan Tribe of Indians of Connecticut v. Mohegan Tribe & Nation, Inc.,

769 A.2d 34, 39, 44 (Conn. 2001).

69

Id.

70

Id. at 361–63. 71

Id. at 363. 72

Id. at 371–72. 73

Id. at 364–65.


MATTER

383

“Mohegan Tribe” and “Mohegan Tribe and Nation” were not

confusing and in doing so, looked at each phrase as a whole.74

This

appears to be a weak argument by the court. However, the court goes

on to state that the plaintiff failed to establish that they are the “sole

group or community” that can claim rights as a Mohegan Tribe.75

This appears to be the true foundation for the court’s decision. The

court held both plaintiff and defendant have rights to use the Mohegan

Tribal affiliation.76

The outcome of this case highlights the very problem that exists in

social movement groups. Theoretically, a variety of groups who

identify with the movement could attempt to gain rights and use the

movements marks. According to the Mohegan Court, this variety of

use would be permissible.77

However, the Mohegan court may look at

social movement groups differently because of the membership

qualifications present in the Native American Tribe context, which are

not present in social movement membership. This distinction is the

reason social movements should be handled differently than the

Mohegan Case. If social movement groups were handled as the

Mohegan Case, the social movement would likely be very segmented

and lack direction necessary to achieve its goals because, in this case,

the court allowed both groups to use the mark. If multiple social

movement groups could use the same mark the group would lack

cohesion, direction, and a unified front.

2. Franchisor and Franchisee Relationships

Some aspects of social movements are similar to those of business-

franchise relationships. In a franchise, “the franchisee operates its

business under the franchisor’s trade name and under the franchisor’s

business identity. The franchisee is identified as part of a select group

of dealers and is generally required to assume a standard appearance

and to follow standardized methods of operation.”78

In this type of

relationship the franchisee usually pays the franchisor fees such as

initial costs, royalties, and advertising costs in exchange for use of the

74

Id. at 371. 75

Id. at 373. 76

Id. at 375. 77

Id. at 372–374. 78

Daniel C.K. Chow & Thomas J. Schoenbaum, INTERNATIONAL BUSINESS

TRANSACTIONS: PROBLEMS, CASES, AND MATERIALS 335 (Erwin Chemerinsky, et.

al. eds., 3rd ed. 2015); See also 3 MCCARTHY ON TRADEMARKS AND UNFAIR

COMPETITION § 18:66 (4th ed.).

384 WAKE FOREST J.


[VOL. 17

franchisors business model, assistance, and goodwill.79

Here, the

franchisor owns the trademark rights, and grants the franchisee the

right to use those rights through a contractual agreement.80

Under this

agreement, the franchisor decides the number of years the contract will

last, thus determining how long the franchisee will have access to the

trademark rights.81

Franchisors must monitor the franchisee’s use of

the trademarks.82

If the franchisee deviates from the standards set

forth by the franchisor, there is a possibility that the franchisor could

lose its rights to its marks.83

There are many aspects of a franchisor-franchisee relationship that

a social movement may find appealing when dealing with its own

organization. For instance, if social movements adopted this type of

relationship, the main group (i.e. the headquarters) of the movement

would have control of the trademark rights.84

They would then decide

who could use these marks and could actively monitor the groups use

to ensure their message was being portrayed correctly.

However, there are also flaws with this system. With the

unstructured nature of social movements, it can be difficult to regulate

and enforce each individual group's use of the trademarks.85

Further,

the organization may have so little structure that there is no official

headquarters to which individual groups can go to obtain the

information.86

Lastly, with the movement’s potential lack of organization, it

could also be difficult to enter into a contractual agreement with every

group that wants to use the trademarks. This could defeat the purpose

of movements that want to allow everyone to join quickly, or

movements that invoke self-identification, because this could require a

membership process.87

Although the franchisor/franchisee

relationship may seem favorable to social movements due to their

ability to allow independence while also controlling their message,

there would still be additional issues caused by the movement’s

structure. .

79

FEDERAL TRADE COMMISSION, A Consumer’s Guide to Buying a Franchise

(June 2015), https://www.ftc.gov/tips-advice/business-center/guidance/consumers-

guide-buying-franchise. 80

INTERNATIONAL BUSINESS TRANSACTIONS, supra note 80, 335. 81

FEDERAL TRADE COMMISSION, supra note 79. 82

Id. 83

Id. 84

Id. 85

Id. 86

See generally, Killian, supra note 1. 87

Id.


MATTER

385

3. Church organizations

Church organizations88

are very similar to franchises, specifically

because you have to affiliate with the main headquarters, but may

provide more clarity as to the ways that social movements may acquire

rights to trademark use.89

There are two ways that a “startup church”

(i.e. a pastor starting a new branch of the church) can affiliate with the

larger church organization.90

First, the larger church organization can decide it wants to

establish a church in a certain location.91

In that case, it will create the

church, and staff it with members it already has.92

The process is

simple because the church is in control of the entire process. This can

be similar to social movements because the movement may decide it

would like independent branches in certain cities or recognize a lack

of outreach in a certain area and send already committed members to

promote awareness.93

An example of a social movement that has

previously sent members to promote awareness would be the Freedom

Riders in the 1960s, who traveled through the segregated South raising

awareness of racial inequality.94

These social activists realized that

their message needed to travel to citizens of southern states, and the

movement leadership organized and sent individuals already

committed to the cause to travel to those locations.95

The second way is for an individual pastor to reach out to the

headquarters of the church.96

The church will present the pastor with

the affiliation agreement and all of the rules they have to follow.97

Once the pastor signs the agreement, the church will assist the pastor

with establishing his church.98

This can be through providing training,

88

For the purpose of this section, the authors researched Protestant Christian

churches and their structure. However, the authors recognize that different religious

organizations may have slightly different structures. 89

Telephone Interview with James Talmadge Gardner, Bishop, International

Pentecostal Holiness Church, (Oct. 14, 2016). 90

Id. 91

Id. 92

Id. 93

See generally, Jonathan C. Augustine, The Theology of Civil Disobedience:

The First Amendment, Freedom Riders, and Passage of the Voting Rights Act, 21 S.

CAL. INTERDISC. L.J. 255 (2012) (explaining the outreach of civil rights activist into

different locations). 94

Id. 95

Id. 96

See Telephone Interview with James Talmadge Gardner, supra note 89. 97

Id. 98

Id.

386 WAKE FOREST J.


[VOL. 17

materials, assistance, etc.99

The affiliation agreement also gives them

the right to use the larger church organizations’ name.100

Thus, a

church that was originally the “Sacred Heart Church” can thus become

the “Sacred Heart Church of the Pentecostal Church of God in

Christ.”101

This can give the church more credibility and can be a

source identifier for people looking to join a Pentecostal church.102

Along with the name also comes other trademark rights. For example,

in the Pentecostal Church of God in Christ, a member gains access to

all of the church’s trademarks after they affiliate.103

This affiliation

process is what gives churches the right to stop a pastor or church

from using their name and trademarks.104

Courts tend to be protective

of churches’ rights, especially the right to their names. For instance,

in General Conference Corporation of Seventh-Day Adventists v.

Perez, Perez had attempted to affiliate with the Seventh-Day Adventist

Church.105

However, the Church told him that he could not affiliate

until he stopped publicly criticizing the Catholic Church.106

Perez

refused to do this and when the Church denied his affiliation, he

started the Eternal Gospel Church of Seventh Day Adventists.107

The

court held that the inclusion of “Eternal Gospel Church” was not

enough to prevent confusion.108

Therefore, the court enjoined Perez

from using “Seventh-Day Adventist” as well as the Spanish equivalent

“Adventista del septimo dia.”109

The holding of this case illustrates

how protective courts are of a church’s right to its name. It also shows

how easily courts can find confusion and enjoin a group from calling

their church a particular name.

The type of membership process involved with churches may be

similar to social movements because it allows for self-identification

and does not call for a formal membership process. However,

churches are still not exactly like social movements. One reason is

because the national or international headquarters of these churches

99

Id. 100

Id. 101

Id. 102

Id. 103

Affiliated Agreement, PENTECOSTAL CHURCH OF GOD IN CHRIST OF THE

UNITED STATES OF AMERICA, INC.,

http://mychurchwebsite.s3.amazonaws.com/c2215/pcogic_affiliated_agreement.pdf

(last visited Feb. 24, 2017). 104

Telephone Interview with James Talmadge Gardner, supra note 89. 105

Gen. Conference Corp. of Seventh-Day Adventists v. Perez, 97 F. Supp. 2d

1154, 1158 (S.D. Fla. 2000). 106

Id. 107

Id. at 1159. 108

Id. at 1157–58. 109

Id. at 1164.


MATTER

387

have been established for a very long time.110

Therefore, they may

have more clout when enforcing their trademarks and can patrol the

use of their marks more thoroughly and efficiently.111

This is likely

not the case with social movements that can form sporadically and

may not have a headquarters or an ability to police their marks.112

4. Greek Life

Greek Life is more analogous to social movement groups than any

of the other collective groups discussed. Although Greek Life has a

more defined membership than is present in social movements,113

the

way in which courts limit the rights of the individual members

resembles perhaps the most effective way to handle social movement

groups.

Greek life, or sororities and fraternities, are collections of students

on college campuses who come together to hold social, charitable, and

academic functions.114

The functions put on by Greek Life chapters

are affiliated with their national organizations and are bound by

national rules; however each individual chapter operates under its own

leadership and often chooses to vary its procedure slightly from other

chapters.115

Greek Life, like social movement groups, has a basic goal and

purpose which underlies all of the group’s members.116

However,

where social movement groups and Greek Life differ is in their

membership qualifications.117

Members of Greek Life must go

through a formal pledging process to make them a bona fide member

110

David A. Simon, Register Trademarks and Keep the Faith: Trademarks,

Religion, and Identity, 49 IDEA 233, 278–79 (2009). 111

Id. 112

Lewis M. Killian, Ralph H. Turner & Neil J. Smelser, Social Movement,

BRITANNICA.COM (Jan. 7, 2009), https://www.britannica.com/topic/social-

movement. 113

See, e.g., Adam Jazairi, What is Greek Life?, CAMPUS EXPLORER,

http://www.campusexplorer.com/college-advice-tips/AB7769A2/What-is-Greek-

Life/ (last visited Nov. 28, 2016); see, e.g., Killian, supra note 1. 114

Jazairi, supra note 112. 115

See, e.g., Greek Terms, SORORITY EVER AFTER,

http://sororityeverafter.com/greek-terminology/ (last visited Feb. 22, 2016). 116

See Noel Diem, Does Greek Life Serve a Purpose on Today’s College

Campus?, LAW STREET (Nov. 27, 2014),

https://lawstreetmedia.com/issues/education/greek-life-serve-purpose-todays-

college-campus/. 117

See Killian, supra note 1, at 7.



388 WAKE FOREST J.


[VOL. 17

of their affiliated group.118

In contrast, members of social movements

often self-identify with the group because they believe in the

movement and wish to participate.119

This begs the question of who

has the right to identify with a certain group and therefore has the right

to use the group’s mark.

This question is more complex than it may appear. In the

social movement group context, the problem is obvious, as members

do not go through a formal process to become members, and the group

can be comprised of any individuals who wish to join.120

In the Greek

Life context, members are defined,121

however the rights each member

or chapter has are not clear because the national organizations owns

the trademark rights.122

Case law offers some insight to this issue.123

In Sigma Chi Fraternity v. Sethscot Collection, a fraternity brought

an infringement suit against the manufacturer of “Greek goods,” such

as paddles, shirts, picture frames, dining ware, etc.124

Sigma Chi

registered its marks in 1926 in order to protect its name and

insignia.125

The national fraternity registered a variety of merchandise,

badges, charms, and shields, with the purpose of allowing its members

and affiliates to use the marks.126

The fraternity does not manufacture

its own goods; its national headquarters enters into and approves

licensing agreements for the production of goods with Sigma Chi

marks.127

These official licensing agreements are the channels the

chapters must use to get products made for their chapter.128

The

individual Sigma Chi chapter in this case used a non-licensed

manufacture, which presented the issue in this case.129

Once Sigma

Chi Nationals discovered the manufacturer’s use, they sent a letter

explaining the license program and demanding that the defendant

either apply to be a licensor or cease and desist.130

The defendant

118

Adam Jazairi, Should You Join a Sorority?, CAMPUS EXPLORER,

http://www.campusexplorer.com/college-advice-tips/7FE50B65/Should-You-Join-a-

Sorority/ (last visited Feb. 24, 2017); See supra note 118. 119

See Killian supra note 1, at 2. 120

Id. at 1. 121

See e.g. Sigma Chi Fraternity v. Sethscot Collection, No. 98-2102-CIV-

SEITZ, 2000 U.S. Dist. LEXIS 6332, at *4 (S.D. Fla. 2000). 122

Id. at *20–21. 123

See generally id. (addressing the trademark rights possessed by the members

of the fraternity and restrictions on those rights). 124

Id. at *1–2, 5. 125

Id. at *6. 126

Id. 127

Id. at *7. 128

Id. at *7–8. 129

Id. at *16. 130

Id.


MATTER

389

argued that since the chapter had a right to use the mark, it was not

infringing upon the mark by making goods for the Sigma Chi

chapter.131

The question then became: can the individual Sigma Chi

chapter, made up of members of the larger national group, orchestrate

the use of the mark independently?132

The court examined this issue by first applying 15 U.S.C. §

1114(1).133

This section of the Lanham Act allows registrants of a

mark to bring claims against those who infringe upon their marks134

.

The court looked at whether the defendant (1) copied the registered

mark, (2) without consent, (3) used in commerce, (4) in connection

with the sale of goods, and (5) where the use was likely to cause

confusion.135

The court determined that only the second and fifth

elements were at issue here and the remaining elements were clearly

shown by Sigma Chi.136

The court found that the individual members of Sigma Chi were

permitted to use the marks, however they were only granted limited

rights.137

Individual members could not contract with unlicensed

vendors simply because they had the right to use.138

So, the members

did not have authorization to order or purchase trademark bearing

goods from the defendant.139

The court also found that because the

goods being purchased and ordered had the identical trademark,

likelihood of confusion was obvious and therefore the defendant was

infringing upon Sigma Chi’s trademark because they were not a

certified license holder.140

This case offers an interesting interpretation of members’ rights to

a trademark. Often upon joining a Greek organization, an individual

becomes part of that specific organization and is forbidden from ever

joining any other Greek affiliated organization.141

However, even

with this extreme membership status, trademark rights are not

131

Id. at *18. 132

See id. 133

Id. at *19. 134

Id. 135

Id. at *20 (citing Bos. Prof’l Hockey Ass’n, Inc. v. Dall. Cap & Emblem

Mfg., Inc., 510 F.2d 1004, 1009–10 (5th Cir. 1975)). 136

Id. *20. 137

See id. at *21. 138

See id. 139

Id. 140

See id. at *28–29. 141

See generally Manual of Information, NAT’L PANHELLENIC CONFERENCE

(21st ed. 2016),

https://www.rit.edu/studentaffairs/greek/sites/rit.edu.studentaffairs.greek/files/files/i

mages/21st-ed-manual_of_information.compressed.pdf.

390 WAKE FOREST J.


[VOL. 17

definite.142

Here, the court granted the registrant the final say in the

production of goods with the mark, as to allow the trademark holder to

monitor and control the brand, mark, and goods that identify its

source.143

These are very important rights associated with the holding

of a trademark.

In social movement groups, the important trademark rights

mentioned above are not present because the nature of the group lacks

the singular leadership present in Sigma Chi, as established by its

national headquarters.144

Additionally, the rights of the individual

members in Sigma Chi were limited by its leadership.145

This suggests

that trademark rights should be utilized by social movements,146

but

does not mean everyone who identifies with the movement should

have unrestricted rights to use the marks. This offers further proof that

Congressional legislation could be very helpful in guiding courts’

determination of who should be granted and who should control the

trademark rights of social movements.

B. Suggested Legislation for who is Entitled to Rights

In review of case law concerning trademark rights of groups most

similar to social movements, clear distinctions can be drawn from

social movements and Native American tribes, franchises, church

organizations, and Greek Life.147

These distinctions lead to legal gaps

in trademark law, and need to be fixed by concrete legislation. Using

the rights from Native American tribes, franchises, church

142

Sigma Chi Fraternity, 2000 U.S. Dist. LEXIS 6332, at *20–21(S.D. Fla. Apr.

7, 2000). 143

See generally id. (granting the right to control the mark to the headquarters

while noting the group members’ right to use). 144

See id. 145

Id. at *21. 146

See generally id. at *21–25 (discussing the likelihood of confusion as to the

source or sponsorship of products. In order to avoid confusion and limit rights to a

particular group’s leadership, trademark rights should be utilized. However,

trademark rights are limited to those licensed to use registered marks). 147

Compare id. at *9 (concluding each individual member of a Greek

organization has a right to use the registered marks once they are licensed by the

national organization), and Gen. Conf. Corp. of Seventh-Day Adventists, 97 F. Supp.

2d 1154, 1157, 1162 (S.D. Fla. 2000) (holding “Seventh-Day Adventist” is not

generic and other forms of the term does not reduce confusion; therefore, it is unable

to be used to represent other groups), with Mohegan Tribe of Indians of Conn., 769

A.2d at 42–43 (Conn. 2001) (explaining that the two terms were generic and apply to

all; thus, a tribal group is not entitled to trademark protection when another group

chooses to use those words), and FED. TRADE COMM’N, supra note 79 (discussing

the fact that franchise rights involve fees, royalty payments, and limitations, along

with contractual obligations and termination for failure to comply).


MATTER

391

organizations, and Greek Life, this comment will determine the best

approach to who should be able to register and subsequently own

trademark rights for social movement groups.

Looking first at Native American tribes, the membership criteria is

too stringent to be applied to social movement groups. As Native

Americans are members of tribes because of biological lineage,148

the

court found valid reason to protect their rights, despite the existence of

multiple groups.149

However, considering a social movement should

be one cohesive unit seeking to achieve the same goals, it is not

beneficial to segregate the rights of a mark.

Next, franchise criteria are closer to being applicable to social

movements, but are still not a perfect solution. In franchises there is

one entity that owns all of the rights (franchisor) who will then license

those rights to multiple other entities (franchisee).150

The franchisees

use the same name and provide the same services as the original

franchisor, but they are allowed to take on a limited individualization

within their business.151

This would be similar to social movements

where one entity should be in charge of the mark and then license

those rights to the individual groups.152

However, this is not the

perfect solution because franchise agreements are based on contractual

relationships.153

Therefore, you cannot obtain any rights without a contract

licensing the rights.154

This would be difficult for social movements

because it would require any member or individual group who wanted

to use the “franchisors” mark to enter into a contract. This would

defeat the purpose of grassroots social movements and overly

formalize the process.

Religious groups are more similar to social movements than

Native American tribes and franchises, but again are not a perfect

solution for these movements. As discussed, religious groups can

form in two ways.155

First, the headquarters of a church can start a

church in a new location and staff the church with its current

members.156

Second, an individual pastor can apply to affiliate.157

148

Mohegan Tribe of Indians of Conn., 769 A.2d at 45. 149

Id. at 45–46. 150

MCCARTHY, supra note 78. 151

CHOW, supra note 78. 152

See Zald, supra note 8, at 335. 153

CHOW & SCHOENBAUM, supra note 80. 154

Mac’s Shell Serv., Inc. v. Shell Oil Prod. Co. LLC, 559 U.S. 175, 178–79

(2010). 155

Telephone Interview with James Talmadge Gardner, supra note 89. 156

Id. 157

Id.

392 WAKE FOREST J.


[VOL. 17

The affiliation process is similar to a franchise agreement.158

The

applicant(s) would promise to follow specific guidelines set forth by

the church; in return, they would receive assistance in starting the

church as well as rights to use the main church’s goodwill and

materials (i.e. trademarks).159

This process, although more relaxed

than franchise agreements,160

still presents the same problems.

Individuals would essentially be required to enter into a contract with

the headquarters in order to gain access to these rights.161

The issue of

a headquarters is also presented here. There may not be a

headquarters for social movements, in the early stages or even at all.

Without a headquarters, there is no group to enter into any contracts or

to determine who should be granted these rights.

Lastly, Greek Life appears to be most similar to social movements.

The outcome of the Sigma Chi case also appears to be the most

efficient way to handle the acquisition of rights in social

movements.162

Greek Life identifies a national headquarters that

oversees the brand of the group, yet the court and national

organization recognize that each individual member does have rights

to use the mark of the group that they belong to.163

This is a somewhat

decentralized structure that is also present in social movements.

However, a headquarter type structure does not exist per se in social

movements,164

which creates an issue. Despite this, a leader of a

social movement could act as a leader of the mark and control,

monitor, and allow members of the social group rights of use, like the

individual Sigma Chi members.

The standard that the first to register and use the mark in interstate

commerce gets the rights is problematic for social movements because

it leaves opportunity for exploitation of the movement through

monetary driven registrations.165

Thus, to protect the integrity of the

158

See id. 159

Id. 160

Id. 161

Id. 162

See Sigma Chi Fraternity v. Sethscot Collection, No. 98-2102-CIV-SEITZ,

2000 U.S. Dist. LEXIS 6332 (S.D. Fla. 2000). 163

See generally id. at *7–8 (noting that “active chapters may, however, on their

own authority and with careful attention to the authenticity of reproduction,

authorize local commercial firms to use the above items to produce periodicals and

other printed material for their own chapter needs from time to time.”). 164

See generally Aldon Morris & Suzanne Staggenborg, Leadership in Social

Movements (2002), http://www.sociology.northwestern.edu/documents/faculty-

docs/Morris-Leadership.pdf (describing the decentralized leadership structure of

most social movements). 165

See generally Roger Stronach, Trademarking Social Change: An Ironic

Commodification, 96 J. PAT. & TRADEMARK OFF. SOC’Y 567, 567 (2014) (Showing

continued . . .


MATTER

393

movement, a special rule should be implemented to ensure that the

registrant is a member of the social movement and attempting to use

the mark to further the universal purpose and goal of the movement.

Based on the case law regarding collective groups and the current gaps

in trademark law, this Comment suggests that the following criteria be

met in order for an individual to apply to register a social movement

for a trademark:

Proposed Addition to Lanham Act: Social Movement

Ownership Criteria §75 (15 U.S.C § 1142). (a) A member of the movement, in good faith, who: (1)

has a following of 15 or more, (2) would be recognized

as a leader of the movement, (3) has some type of

online presence in the form of a national movement

website, or sponsorship on such website,166

and (4)

invested in or actively participating in goals of

movement, shall have the right to register for trademark

protection.167

These elements were chosen to ensure that the individual

registering for the trademark has a legitimate interest in the movement.

By requiring a substantial following and the individual to be a

recognized leader, there is assurance that the movement will be

progressed through the work of the individual and their following

members. By requiring a website, national presence and interstate

organization will likely follow, thus again ensuring that the movement

will progress. Lastly, by requiring a showing of investment or active

participation, bad faith monetary gain seekers are eliminated and the

goals of the social movement will be protected. These elements assist

in the filling of the gaps discussed above. Not only would it ensure

that these movements are not being exploited by unaffiliated

individuals for monetary gain, it would guide the USPTO in choosing

who to grant the trademark rights to, when often conflicting

examples of attempts to monetize social movements). 166

The purpose of this element would be to ensure that the registrant still is

required to conduct business in interstate commerce, a key requirement for federal

trademark registration. 167

We realize this statute could create conflicting interests between legitimate

leaders of social movements. In that case, the traditional standard of priority for

trademarks would apply with the hopes that legitimate leaders of social movements

would work together in furtherance of the goals of the social movement. More in-

depth coverage of this topic is outside the scope of this paper; however, it is an

important matter that should be addressed in other works.

394 WAKE FOREST J.


[VOL. 17

applications occur.

III. ENFORCEMENT PERSPECTIVE

As addressed, there is need for individuals of social movements to

be able to protect their brand and image through the registration of

trademarks.168

However, after identifying the right to trademark

ownership, courts must then enforce these rights. The tests currently

available that are used to enforce rights that could potentially be

applicable to social movements are naked use (also called naked

licensing) and nominative use. These tests have potentially

inapplicable components that would make their use in social

movement cases challenging. However, to offer parties who receive

trademark rights for social movements a fair chance to protect their

rights and to offer courts an easier way to monitor these cases, the

naked use test may be the most efficient route.

A. Existing Legislation/Test

First turning to the naked use test, also referred to as naked

licensing,169

“naked licensing occurs when a trademark owner fails to

exercise sufficient quality control over a licensee’s use of a licensed

trademark. When naked licensing is found, the subject trademark is

deemed to have lost its ability to represent the quality of products or

services consumers have come to expect.”170

This could be

detrimental to social movements because it would mean that they

could lose their right to their mark if they did not sufficiently monitor

others use of their mark. This becomes especially problematic when

you consider the unstructured aspect of social movements as well as

the self-identification issues discussed above. An example of how

naked use could detrimentally harm social movements is

Freecyclesunnyvale v. The Freecycle Network.171

The Freecycle

168

See generally Stronach, supra note 164, at 567 (2014) (providing examples

of increased trademarking of social change). 169

Barcamerica Int’l USA Trust v. Tyfield Importers, Inc., 289 F.3d 589, 595–

96 (9th Cir. 2002). 170

Christopher P. Bussert, The Perils of Naked Licensing, KILPATRICK

TOWNSEND L. J. NEWSL. (Mar. 2011),

http://www.kilpatricktownsend.com/~/media/The%20Perils%20of%20Naked%20Li

censing%20Freecyclesunnyvale%20v%20%20The%20Freecycle%20Network%20I

P%20Strategist.ashx (last visited Feb. 24, 2017); see also 3 MCCARTHY ON

TRADEMARKS AND UNFAIR COMPETITION § 18:48 (4th ed.). 171

Freecyclesunnyvale v. The Freecycle Network, 626 F.3d 509, 512 (9th Cir.

2010).


MATTER

395

Network is a grassroots, nonprofit, movement where people give and

get free materials for their neighborhoods.172

The purpose is to reuse

goods and reduce waste in landfills through the process of

“freecycling.”173

The Freecycle Network created internet groups for

the individual groups to use while also being connected to the larger

Freecycle Network.174

Furthermore, Freecycle Network had its own

website where they provided a directory of member groups and

various resources for these groups including an etiquette guide and

information about their democratic leadership structure.175

Freecyclesunnyvale was created in October of 2003 and asked if it

could begin using one of Freecycle Network’s logos in connection

with its activities.176

They were given permission to use the mark as

long as they did not use it for commercial purposes.177

After this

communication, Freecyclesunnyvale received no other restrictions on

the use of Freecycles Network’s mark.178

Freecyclesunnyvale was

subsequently added to the list of online groups as well as received

emails from Freecycle Network welcoming them to the network.179

This lack of guidance for trademark usage is what led to the court

case.180

At trial, the Ninth Circuit court looked at three factors:181

first,

whether the Freecycle Network retained expressed contractual control

over Freecyclesunnyvale’s activities under the trademarks182

; second,

whether the Freecycle Network provided sufficient evidence of actual

control over Freecyclesunnyvale’s activities183

; and third, whether the

Freecycle Network reasonably relied on Freecyclesunnyvale’s own

quality control measures to satisfy the quality control requirement.184

The court held that the prohibition on commercial use was

172

THE FREECYCLE NETWORK, https://www.freecycle.org (last visited Feb. 24,

2017). 173

Id. 174

Id. 175

Bussert, supra note 169. 176

Id. 177

Id. 178

Id. 179

Id. 180

Id. The Freecycle Network failed to implement a uniform rule or guidance

between member groups. Subsequently, when relations between The Freecycle

Network and Freecyclesunnyvale deteriorated, The Freecycle Network terminated

Freecyclesunnyvale’s online group for using its name and logo. Freecyclesunnyvale

filed a declaratory judgement action against The Freecycle Network. 181

Id. 182

Id. 183

Id. 184

Id.

https://www.freecycle.org/

396 WAKE FOREST J.


[VOL. 17

insufficient to constitute an implied license because the prohibition

failed to include a contractual right to inspect or supervise

Freecyclesunnyvale.185

Regarding the second factor, the court found

that Freecycle Network also did not have actual control because they

did not require members to adopt the standard, nor did the individual

groups apply or interpret the standard uniformly.186

Lastly, the court

held that the etiquette guidelines could not be considered adequate

quality controls because they were not required to be adopted and

were not clear guidelines to begin with.187

This case exemplifies the struggles that could come with applying

the naked use test to social movements. Without clear guidelines for

trademark usage, and without the ability to ensure adequate quality

control, social movements could easily lose their ownership rights.

When social movements are growing rapidly and lack structure, naked

use could be extremely problematic for their success.188

However, by

following the above suggested statute regarding acquisition of

trademark rights, the individual who has the right to the trademark will

then have the ability to monitor and control their rights to the mark

through actions such as cease and desist letters.

Turning to the nominative use test, it would be challenging to ever

consider the use of a social movement trademark to fall outside the

nominative use exception to infringement. Nominative use occurs

when a junior user uses the mark to point to the actual protected mark,

but the junior user does so for the purpose of a parody, commentary,

report, or advertisement.189

It would be possible for an infringer to

prove a nominative use exception because according to New Kids on

the Block v. News Am. Publishing, Inc., the “infringer” will be

permitted certain uses of the mark.190

In New Kids on the Block, the band sued because a newspaper was

using the band’s name to conduct a contest.191

The band claimed

consumers would be confused and think the band was affiliated with

185

Id.

186

Id. 187

Id. 188

See Barcamerica Int’l. v. Tyfield Imps., Inc., 289 F.3d 589, 595–96 (9th Cir.

2002). 189

Louis S. Ederer, Nominative Fair Use: Legitimate Advertising or Trademark

Infringement? ARNOLD & PORTER LLP,

http://www.arnoldporter.com/~/media/files/perspectives/publications/2012/12/nomin

ative-fair-use-legitimate-advertising-or-

tr__/files/publication/fileattachment/nominative-fair-use.pdf. 190

New Kids on the Block v. News Am. Publ’g, Inc., 971 F.2d 302, 308 (9th

Cir. 1992). 191

Id. at 305.


MATTER

397

the contest; the court disagreed.192

The court determined that mere

identification of a band is not infringing upon their trademark.193

If the

consumer would only consider the action to be related to the mark

holder, as is the case in New Kids on the Block, then the action is

infringement, not nominative use.194

The court made this

determination using a three-part test for nominative use: (1) “the

[action] must be one not readily identifiable without the use of the

trademark,” (2) “only so much of the mark may be used as is

reasonably necessary to identify the product or service,” and (3) “the

user must do nothing that would . . . suggest sponsorship or

endorsement by the trademark holder.”195

Based on the holding of New Kids on the Block, an individual

using the trademarks of social movements would potentially qualify

for nominative use. Social movements are inherently popular because

they have a strong social following.196

Thus, it would be possible for

consumers to attribute the unauthorized use of a social movements

mark with the social movement itself. Just as the defendant in New

Kids on the Block feared, an individual using the trademark of a social

movement would also likely qualify as nominative use under New

Kids on the Block, thus permitted use.197

As social movements are

inherently popular, nominative use would not enforce their rights.

Another aspect courts consider when deciding if nominative use is

applicable is if a term can be characterized as descriptive of the

person.198

In the case of social movements, individuals self-identify

with a movement rather than receive a designation granted by the

movement. Because of this self-identification in social movement

groups, the standard for protection should be higher than if the term is

simply descriptive.199

This higher standard gives the group more

192

Id. at 308–09. 193

Id. at 306. 194

Id. at 308–09. 195

Id. at 308. 196

Stronach, supra note 164, at 567. 197

See New Kids on the Block, 971 F.2d at 306. 198

See Playboy Enterprises, Inc. v. Welles, 279 F.3d 796, 801–02 (9th Cir.

2002) (finding that the term “Playmate of the Year” could be used because it was

describing the defendant and was designated by the plaintiff). 199

Compare Gen. Conf. Corp. of Seventh-Day Adventists v. Perez, 97

F.Supp.2d 1154, 1160 (S.D. Fla. 2000) (noting that the plaintiff church “has

expended considerable effort and expense over the last 139 years in promoting its

mark SEVENTH-DAY ADVENTIST and Plaintiff's acronym SDA and the products

and services associated therewith,” entitling its trademark to broad protection”), with

FreeCycleSunnyvale v. Freecycle Network, 626 F.3d 509, 517 (9th Cir. 2010)

(noting a lack of consistent self-identification, because member groups could “freely

adopt [the defendant’s] listed rules of etiquette and because of the voluntary and

continued . . .

398 WAKE FOREST J.


[VOL. 17

incentive to control.

For example, in Playboy Enterprises, Inc. v. Welles, Playboy

granted Defendant Welles the title of “Playmate of the Year,”

essentially giving her the right to use the title, which is why the court

found that Welles did not infringe by using the phrase.200

Rather,

individuals in social movements should not receive “free reign” to use

the mark simply because they self-identify with the mark.

Generally, the nominative use exception is not an appropriate

exception with respect to social movements. Because any use of the

mark will likely point to the popular movement, nominative use would

allow unauthorized use. Unlike the finding in Playboy, in social

movements the membership status of a group can be self-proclaiming,

not granted by the group, essentially reducing the control the group

has and giving free range of the group’s mark to self-proclaiming

members. For these reasons, there should be a higher standard for

social movements.

Ultimately, the naked use test is most likely the appropriate test to

apply to social movements. However, considering the harsh

consequences suffered by Freecycle Network in their case,201

an

argument could be made for a more relaxed application of the naked

use test factors for social movements. This could occur by taking into

consideration social movements unstructured aspects as well as how

quickly they become prevalent and the effect this could have on

policing individual members’ use of their marks.202

IV. CONCLUSION

As social movements continue to influence society, the question of

how law can protect these movements from individuals exploiting the

movement for monetary gain is an important consideration. The

inherent problem with this consideration is the very nature of the

amorphous nature of these rules,” which meant that the defendant did not exert

actual control over the trademarks used by the plaintiff). 200

Playboy Enterprises, Inc., 279 F.3d at 799–800. 201

FreeCycleSunnyvale, 626 F.3d at 520 (holding that defendant Freecycle

Network’s claims of copyright infringement failed for lack of contractual and actual

control over plaintiff FreecycleSunnyvale’s quality control measures, and for

Freecycle Network’s unreasonable reliance on plaintiff FreeCycleSunnyvale’s

quality control measures). 202

See Killian supra note 1 (defining a social movement as a “loosely organized

but sustained campaign in support of a social goal,” which is formed when “short-

lived impulses give way to long-term aims”); see also FreeCycleSunnyvale, 626

F.3d 509, 513–14, 520 (illustrating of how current law has a deleterious effect on a

social movement’s ability to police the actions of individual members of that social

movement).


MATTER

399

social movement. That is that social movements are created in an

unorganized and grassroots way with the purpose of mobilizing a

following in a rapid manner.203

However, despite this decentralized

organization, social movements should still be able to receive

protection without forcing extreme hierarchical organization.

Amending the Lanham Act would allow individuals involved in a

movement to trademark the movement only if they meet the criteria.

The criteria will ensure that individuals exploiting the movement

cannot register and individuals who wish to further the movement can

register. This Comment suggests the following criteria:

Proposed Addition to Lanham Act: Social Movement

Ownership Criteria §75 (15 U.S.C § 1142). (a) A member of the movement, in good faith, who: (1)

has a following of 15 or more, (2) would be recognized

as a leader of the movement, (3) has some type of

online presence in the form of a national movement

website, or sponsorship on such website,204

and (4)

invested in or actively participating in goals of

movement, shall have the right to register for trademark

protection.205

Each element adds to the legitimacy of the individual attempting to

register the mark. This is a novel idea as generally trademarks are

“first come and use, first serve,”206

however due to the nature of social

movements this heightened standard is necessary. Therefore, an

individual must meet the above criteria in order to register, and the

first to register holds the rights. Based on the analysis of similar cases,

the authors suggest that each member has rights to use, but again with

the control determined by the owner of the mark, who because of the

criteria suggested is ensured to be invested in the movement's success.

After determining who has the rights, rights should be enforced in a

203

See generally Killiain, supra note 1. 204

The purpose of this element would be to ensure that the registrant still is

required to conduct business in interstate commerce, a key requirement for federal

trademark registration. 205

We realize this statute could create conflicting interests between legitimate

leaders of social movements. In that case, the traditional standard of priority for

trademarks would apply with the hopes that legitimate leaders of social movements

would work together in furtherance of the goals of the social movement. More in-

depth coverage of this topic is outside the scope of this paper; however, it is an

important matter that should be addressed in other works. 206

See 15 U.S.C.A. § 1051(a) (2012).

400 WAKE FOREST J.


[VOL. 17

way similar to naked use. While the standard would be different than

the naked use test, it would take into account the groups rapid growth

and decentralization.

The purpose of creating a niche rule for social movements is to

give decentralized groups a way to protect their movements.

Additionally, trademark protection can offer social movements

validity, control, and progression of source identification.207

Currently,

the vast number of trademarks registered can create confusion and the

motive behind the registration may not be with the intention of

furthering the movement. The addition to the Lanham Act will ensure

that social movements and their universal purpose and goals are

protected.

207

See 1 MCCARTHY ON TRADEMARKS AND UNFAIR COMPETITION § 2:2 (4th

ed.).




LIVING IN A MATERIAL WORLD: DOES A VIOLATION OF

ITEM 303 OF REGULATION S-K SATISFY THE

MATERIALITY ELEMENT IN A RULE 10B–5 CAUSE OF

ACTION?

Matthew Ady†

I. INTRODUCTION ............................................................. 404

II. BACKGROUND ............................................................. 407 A. ITEM 303 DISCLOSURE ANALYSIS ............................ 407 B. ELEMENTS OF A RULE 10B–5 CAUSE OF ACTION ..... 409

III. JUDICIAL TREATMENT OF RULE 10B–5 AND ITEM

303 MATERIALITY .......................................................... 411 A. PRE-2014 CASES ....................................................... 411 B. CIRCUIT SPLIT DEVELOPS ......................................... 414

1. The NVIDIA Case .................................................... 414 2. The Stratte-McClure Case ....................................... 416

C. RESOLVING THE CIRCUIT SPLIT ON COMMON

GROUND ..................................................................... 418 1. Clarification of the “duty” to disclose in Rule

10b–5 ........................................................................ 419 2. Criticism of the Ninth Circuit’s Categorical

Approach to Item 303 Violations and Rule 10b–5 .... 422 3. Abolishing the Categorical Rejection of Item 303

Violations to State a Rule 10b–5 Claim .................... 424

† Executive Symposium Editor, Emory Law Journal, Emory University School

of Law, J.D., 2017; Stetson University, B.A., B.B.A., 2014. I am grateful to my

advisor, Urska Velikonja, who was an endless source of insight and support during

this project. Many thanks to all those who reviewed my drafts, particularly William

Eye, David Rothenberg, Cassie Coolidge, Shelby Hancock, and Jessica Cosgrove,

and to the editors who helped prepare my comment for publication. As ever, I am

profoundly indebted to my parents, Amy and Marc Ady, who sacrificed so much for

me and (as non-lawyers) kindly agreed to read and wade through the technical mire

of a securities topic.

This Comment won third at the 2017 Association of Securities and Exchange

Alumni (ASECA) Securities Law Writing Competition.

402 WAKE FOREST J.


[VOL. 17

IV. THE MATERIALITY SHORTCUT ................................ 425 A. THE INTERPLAY OF ITEM 303 AND RULE 10B–5’S

MATERIALITY REQUIREMENTS .................................. 426 1. First Hypothetical – Demonstrating the Under-

Inclusivity of Item 303............................................... 426 2. Second Hypothetical – Demonstrating the Over-

inclusivity of Item 303 ............................................... 427 B. CRITICISM OF THE MATERIALITY HYPOTHETICALS . 428

1. Adjusting the Confidence Level to Establish

“Reasonable Likelihood” ......................................... 428 2. Ascertaining a Threshold for Materiality of

Statistically Expected Values .................................... 430

V. ADDITIONAL MEANS OF ENFORCING ITEM 303 ........ 431 A. THE SEC’S ITEM 303 ENFORCEMENT AUTHORITY ... 431 B. POTENCY OF FAIR FUND COMPENSATION ................ 433 C. APPLYING SEC ENFORCEMENT OF ITEM 303 ........... 436

VI. CONCLUSION .............................................................. 439

2017] LIVING IN A MATERIAL WORLD 403

ABSTRACT

This Comment considers whether a violation of Item 303 of

Regulation S-K automatically satisfies the materiality element of a

Rule 10b–5 cause of action. Item 303 requires disclosure of all

information that is “reasonably likely” to the have a material effect on

the company’s performance, while Rule 10b–5 limits disclosure to

material information determined by a balancing of the magnitude of

the event and the probability it will occur.

First, this Comment surveys court decisions regarding how

Item 303 materiality relates to Rule 10b–5 and determines that courts

disagree on the implications of Item 303. Although one federal district

court and one federal circuit court of appeals categorically rejected

the notion that violations of Item 303 can support a Rule 10b–5 claim,

this Comment argues that they can, provided the violation meets the

materiality standards outlined by the Supreme Court.

Second, this Comment analyzes the conceptual gap between

the different disclosure requirements of Item 303 and Rule 10b–5

through a series of hypothetical scenarios. Although not ideal for

plaintiffs, these hypotheticals demonstrate both the over- and under-

inclusivity of Item 303 with respect to Rule 10b–5. Accordingly, this

Comment concludes that a shortcut approach to Rule 10b–5 via Item

303 is not feasible. Although Item 303 violations could be material,

not all violations will meet Rule 10b–5. Thus, some plaintiffs would

have to establish materiality separately.

Finally, this Comment provides an alternative, yet weaker,

means of recovery through SEC enforcement and creation of “fair

funds” for plaintiffs whose Rule 10b–5 claims failed because the Item

303 violation did not pass muster under Basic v. Levinson. This

Comment ultimately concludes that Item 303, while indirectly useful to

investors, is not a plaintiff’s silver bullet against companies who fail

to adequately disclose.

404 WAKE FOREST J.


[VOL. 17

I. INTRODUCTION

As an almost twenty trillion dollar industry,1 the complexity of

securities trading is ripe for mismanagement and misappropriation of

information. To address these issues, publicly traded companies must

issue periodic statements regarding their financial condition on a

quarterly and annual basis.2 These financial statements provide a

steady flow of information from publicly traded companies to the

public, which promotes efficient pricing of securities, fosters higher-

quality capital markets, and works to prevent fraud.3

However,

historically, the disclosure requirements for financial statements

created a problem for companies if their predictions were incorrect.4

Namely, the company and its directors could be liable for

misrepresentation under the SEC’s broad-reaching fraud regulations.5

Companies cannot avoid liability by simply neglecting predictions

about future performance—the “Management’s Discussion and

Analysis of Financial Condition and Results of Operations”

(“MD&A”) sections of the Forms 10–Q and 10–K require such

predictions to be included to a certain extent.6 Although the common

law doctrine of “bespeaks caution”7 and the statutory codification of

1 Adam Shell, Mr. Market is Wall Street’s $20 trillion-dollar man, USA TODAY

(Feb. 13, 2017, 12:56 PM),

http://www.usatoday.com/story/money/markets/2017/02/13/sp-500-value-tops-20-

trillion/97851888. 2 17 C.F.R. § 240.13a-1 (2015), 17 C.F.R. § 240.13a-13 (2015) (discussing these

required financial statements by their common names, Forms 10–Q and 10–K,

respectively). 3 Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195 (1976) (“The Securities Act of

1933 . . . was designed to provide investors with full disclosure of material

information concerning public offerings of securities in commerce, to protect

investors against fraud and, through the imposition of specified civil liabilities, to

promote ethical standards of honesty and fair dealing . . . The 1934 Act was intended

principally to protect investors against manipulation of stock prices through

regulation of transactions upon securities exchanges and in over-the-counter

markets, and to impose regular reporting requirements on companies whose stock is

listed on national securities exchanges.”). See 15 U.S.C. § 78b (2012); Basic, Inc. v.

Levinson, 485 U.S. 224, 230 (1988) (“There cannot be honest markets without

honest publicity. Manipulation and dishonest practices of the market place thrive

upon mystery and secrecy.”). 4 Brian Neach, Item 303 Private Causes of Action, 76 NOTRE DAME L. REV.

741, 742 (2001). 5 Id. at 742, 751.

6 U.S. SECURITIES AND EXCHANGE COMM., NOS. 33-8350, 34-48960, FR-72,

INTERPRETATION: COMMISSION GUIDANCE REGARDING MANAGEMENT’S

DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(2003), available at https://www.sec.gov/rules/interp/33-8350.htm#P28_5559. 7 In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357, 364 (3rd. Cir. 1993).

continued . . .


Rule 1758

already protected many of these “forward-looking

statements,”9 Congress passed a statutory safe harbor provision in the

Private Securities Litigation Reform Act of 1995 (“PSLRA”) to assure

companies that they could release projections without the threat of

litigation.10

Subsequently, PSLRA precipitated a two-pronged result.11

First, companies began to disclose significantly more forward-looking

information;12

and second, a large majority of such statements could

not give rise to liability.13

The doctrine of bespeaks caution states that a court may determine that the inclusion

of sufficient cautionary statements in a company disclosure renders any potential

misrepresentations and omissions contained in the disclosures not actionable. See id.

In other words, a company can limit its liability for potentially incorrect statements

made in a disclosure by including language that indicates the lack of certainty with

which the company makes the disclosure. Id. A number of circuits have dismissed

securities fraud claims under Rule 12(b)(6) because cautionary language in the

offering document negates the materiality of an alleged misrepresentation or

omission. See e.g., id. at 371; Sinay v. Lamson & Sessions Co., 948 F.2d 1037, 1040

(6th Cir. 1991); I. Meyer Pincus & Assocs. v. Oppenheimer & Co., 936 F.2d 759,

763 (2d Cir. 1991); Romani v. Shearson Lehman Hutton, 929 F.2d 875, 879 (1st Cir.

1991); Polin v. Conductron Corp., 552 F.2d 797, 806–07, 806 n.28 (8th Cir. 1977). 8 17 C.F.R. § 230.175 (2016). Rule 175 protects companies from liability for

making forward-looking statements in certain areas of a company’s quarterly and

annual reports, provided that the statement was not made or reaffirmed without a

reasonable basis or disclosed other than in good faith. See id. 9 A “forward-looking statement” in the context of securities law is “a statement

describing events or activities that will occur, if at all, at some future date.” James D.

Cox et al., SECURITIES REGULATION: CASES AND MATERIALS 71 (2d ed. 1997). See

also 17 C.F.R. § 230.175(c). 10

15 U.S.C. § 77z-2(c) (2012) (“Except as provided in subsection (b) . . . , in

any private action arising under this subchapter that is based on an untrue statement

of a material fact or omission of a material fact necessary to make the statement not

misleading, a person . . . shall not be liable with respect to any forward-looking

statement, whether written or oral, if and to the extent that . . . the forward-looking

statement is . . . identified as a forward-looking statement, and is accompanied by

meaningful cautionary statements identifying important factors that could cause

actual results to differ materially from those in the forward-looking statement.”)

(emphasis added). 11

See infra text accompanying notes 12–13. 12

Neach, supra note 4, at 743 (arguing that PLSRA “provided a deluge of

forward-looking statements that could potentially result in extensive liability to the

company”) (citing William O. Fisher & Terry Kee, Companies Still Grapple With

Safe-Harbor Issues, NAT'L L.J., June 22, 1998, at B10, B11, n.23 (noting a study that

revealed increased sales and earnings forecasts); NIRI Survey Finds Improved

Disclosure of Soft Info in News Releases, SEC Filings, 30 SEC. REG. & L. REP.

(BNA) 896 (1998) (reporting on a study that indicated a significant increase since

1995 in the number of companies willing to provide "soft information" or

projections)). 13

Neach, supra note 4, at 743 (arguing that the safe-harbor provisions in

PLSRA for forward-looking statements also “turned the deluge [of forward-looking

continued . . .

406 WAKE FOREST J.


[VOL. 17

However, PSLRA’s safe-harbor only protected affirmative

forward-looking representations by the company.14

Omissions

regarding the company’s future predictions were not safeguarded.15

Barred from bringing an action for affirmative forward-looking

misrepresentations, plaintiffs began bringing actions under specific

disclosure requirements promulgated by the SEC, alleging that the

defendant firm failed to disclose projections about the future.16

Item

303 of Regulation S-K (“Item 303”) is one such provision that requires

public companies to discuss known trends and uncertainties that could

affect the company's liquidity, capital resources, and results of

operations in the MD&A section of their Forms 10–Q and 10–K.17

In particular, Item 303 requires public companies to “[d]escribe

any known trends or uncertainties that . . . the registrant reasonably

expects will have a material favorable or unfavorable impact on net

sales or revenues or income from continuing operations.”18

This

requirement principally concerns company management because some

courts have held that violations of mandatory disclosures within Item

303 establish the “duty to disclose” element of a Rule 10b–5 securities

cause of action.19

However, not all courts agree.20

Much of the

confusion revolves around the unclear disclosure requirement that the

SEC constructed for Item 303 and its relation to the duty to disclose

under Rule 10b–5.21

Unfortunately, this confusion has led the Ninth

Circuit, as well as one district court, to improperly suggest that a

violation of Item 303 can never trigger a Rule 10b–5 violation,

regardless of the severity of the omission.22

This Comment considers whether the disclosure requirements of

statements] into a trickle in terms of what could actually result in liability to the

company.”). 14

15 U.S.C. § 77z-2(a), (c) (2012). 15

See id. 16

See Neach, supra note 4, at 743–44. 17

Management's Discussion and Analysis of Financial Condition and Results of

Operations, 17 C.F.R. § 229.303 (2016). 18

Id. (“If the registrant knows of events that will cause a material change in the

relationship between costs and revenues (such as known future increases in costs of

labor or materials or price increases or inventory adjustments), the change in the

relationship shall be disclosed.”). 19

See, e.g., Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 102 (2d Cir. 2015)

(“Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise

to liability under Section 10(b).”). 20

See, e.g., In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1054 (9th Cir.

2014) (holding that Item 303’s disclosure duty is not actionable under Rule 10b–5). 21

Donald C. Langevoort & G. Mitu Gulati, The Muddled Duty to Disclose

Under Rule 10b-5, 57 VAND. L. REV. 1639, 1651 (2004). 22

NVIDIA, 768 F.3d at 1056; In re Enron Corp. Sec., Derivative & “Erisa

Litig.”, 258 F. Supp. 2d 576, 632 n.63 (S.D. Tex. 2003).


Item 303 and Rule 10b–5 are coterminous. It concludes that

substantial conceptual daylight exists between the regulations and

clarifies the gap between the two. Because Item 303 is not

automatically enforceable under Rule 10b–5, this Comment proposes

an alternative means of recovery for plaintiffs.

This Comment proceeds in five Parts. Part II describes the

elements of Item 303 and Rule 10b–5 violations. Because much of the

courts’ disagreement stems from Item 303’s questionable relationship

with the Rule 10b–5 disclosure standard, Part III traces the relevant

case law involving disclosure requirements under Item 303 and Rule

10b–5. Part IV examines the inapposite nature of Item 303 and Rule

10b–5 materiality through a series of hypotheticals. Part V proposes

another means by which the SEC could enforce Item 303 and suggests

a workable approach through which plaintiffs can obtain relief under

Item 303. Ultimately, Part V concludes by applying the alternative

enforcement approach to two examples—one from the real world, and

the other, a hypothetical scenario—to demonstrate how Item 303 fits

into the Rule 10b–5 framework for plaintiffs.

II. BACKGROUND

This Part describes the threshold demonstration to establish an

Item 303 violation. Moreover, this Part details the elements of a Rule

10b–5 cause of action. This Part concludes by contrasting the varying

elements of both securities laws.

A. Item 303 Disclosure Analysis

In 1989, the SEC provided guidance on whether a company needs

to disclose information pursuant to Item 303 by establishing a two-

pronged analysis.23

It indicated, “disclosure duty exists where a trend,

demand, commitment, event or uncertainty [“trend or uncertainty”] is

both presently known to management and reasonably likely to have

material effects on the registrant's financial condition or results of

operation.”24

The SEC then clarified that where a trend or uncertainty

is known, a company’s management must perform a two-step

analysis.25

23

Management’s Discussion and Analysis of Financial Condition and Release

of Operations; Certain Investment Company Disclosures, Securities Act Release No.

6835, Exchange Release No. 26, 831, 54 Reg. 22,427 (May 18, 1989) (codified at 17

C.F.R. pts. 211, 231, 241, 271) [hereinafter 1989 RELEASE]. 24

Id. 25

See id.

408 WAKE FOREST J.


[VOL. 17

In the first step, management must determine if the known trend or

uncertainty is likely to come to fruition.26

If management determines

that the event is not reasonably likely to occur, Item 303 does not

require disclosure.27

For example, assume that any event with a 40%

or greater likelihood of occurrence is considered “reasonably likely” to

occur for the purposes of Item 303.28

If management determines that

there is only a 30% chance that a trend or uncertainty will come to

fruition, then disclosure is not necessary.29

In contrast, if management

determines that there is a 45% chance that the trend or uncertainty will

occur, then management must proceed to the second step in the

analysis.30

Additionally, if management cannot determine whether the

likelihood is below the “reasonably likely” threshold, then it must

proceed to the second step in the analysis.31

In the second step, management must objectively evaluate the

consequences of the known trend or uncertainty on the assumption that

it will realize.32

Item 303 then requires disclosure unless management

determines that the effect of the trend or uncertainty would be

immaterial to investors.33

Accordingly, the Item 303 analysis

framework looks like this:

Step 1: Is the trend or uncertainty “reasonably likely” to occur?

No. Item 303 does not require disclosure.

Yes. Proceed to Step 2.34

Step 2: Assuming the event will occur, would the event be material

to investors?

No. Item 303 does not require disclosure.

Yes. Item 303 requires disclosure.35

Following the scenario above, if management determines that there

is a 45% likelihood of fruition for a trend of uncertainty, then it must

assume the likelihood is 100% and evaluate whether the trend or

26

Id. 27

Id. 28

See infra text accompanying note 194, for an explanation for why it is a good

idea to assume a threshold of 40% for the “reasonably likely” standard. 29

See id. 30

See id. 31

See id. 32

Id. (discussing why in the second step management must assume a 100%

chance of occurrence). 33

Id. 34

If the answer is, “maybe,” companies should proceed to Step 2 as well. See id.

at 10. To avoid passing to Step 2, management must be able to give a resounding

“no” in Step 1. See id. 35

See id.


uncertainty would be material to investors under that assumption.36

Thus, if management determines that there is a 45% likelihood that the

company will experience considerable headwinds due to rising energy

costs in the next quarter, then it must assume those headwinds will

actually result in the estimated negative impact on the company and

then evaluate whether such a risk would be material to investors.37

If

such a risk is material, management must disclose.38

B. Elements of a Rule 10b–5 Cause of Action

Though Item 303 and Rule 10b–5 both aim to prevent fraud on

investors,39

Rule 10b–5 uses a more straightforward evaluation of

materiality and requires elements of scienter and reliance by the

defendant and plaintiff, respectively.40

The rule provides in relevant

part, “[i]t shall be unlawful for any person, directly or indirectly” to do

any of the following three practices: (1) “employ any device, scheme,

or artifice to defraud,” (2) “make any untrue statement of a material

fact or to omit to state a material fact necessary in order to make the

statements made, in the light of the circumstances under which they

were made, not misleading, or” (3) “engage in any act, practice, or

course of business which operates or would operate as a fraud or

deceit upon any person, in connection with the purchase or sale of any

security.”41

Rule 10b–5 boils down to the notion that companies and securities

traders cannot make materially misleading statements or omissions to

investors.42

Thus, Rule 10b–5 prohibits a company from asserting that

36

See id. 37

See id. 38

See id. 39

See SEC v. Zandford, 535 U.S. 813, 821 (2002) (“[W]e recognized that the

interest in ‘preserving the integrity of the securities markets,’ was one of the

purposes animating [Section 10(b)].”). 40

See Wharf (Holdings) Ltd. v. United Int'l Holdings, Inc., 532 U.S. 588, 593

(2001); 17 C.F.R. § 240.10b-5 (2012). 41

17 C.F.R. § 240.10b-5. Subsequent to its promulgation, courts have applied

Rule 10b–5 broadly to address a wide range of fraudulent acts in securities trading.

Under the common law, Rule 10b–5 now extends beyond misleading statements and

omissions by corporate executives to include insider trading. Chiarella v. United

States, 445 U.S. 222, 228–29 (1980) (“In its Cady, Roberts decision, the

Commission recognized a relationship of trust and confidence between the

shareholders of a corporation and those insiders who have obtained confidential

information by reason of their position with that corporation. This relationship gives

rise to a duty to disclose because of the necessity of preventing a corporate insider

from . . . tak[ing] unfair advantage of the uninformed minority stockholders.”)

(internal quotation marks omitted). 42

See 17 C.F.R. § 240.10b-5.

410 WAKE FOREST J.


[VOL. 17

it will earn, for example, $100 million in a fiscal year, when it only

actually expects to make $80 million.43

Similarly, if a company

asserted in good faith that it expected to earn $100 million in a given

year, but later discovers a miscalculation in which the company

determined it will only make $80 million, Rule 10b–5 mandates that

the company correct the discrepancy if the $20 million difference is

considered material.44

Courts have held that to properly state a claim for securities fraud

under Rule 10b–5, a plaintiff must allege that the defendant (1) made

misstatements or omissions of material fact, (2) with scienter, (3) in

connection with the purchase or sale of securities, (4) upon which the

plaintiff relied, and (5) that the plaintiff's reliance was the proximate

cause of its injury.45

With respect to the materiality element, the

Supreme Court has further indicated that material information covers

both the present financial state of the company as well as predictions

about the company’s future performance.46

Specifically, with regard

to speculative predictions, the Supreme Court determined that the test

for materiality of future events depends on a balancing of the

likelihood of the future event’s occurrence and the magnitude of the

future event, whether good or bad.47

In short, the distinction between Rule 10b–5 and Item 303 can be

summarized accordingly: whereas Rule 10b–5 prohibits material

representations or omissions made with scienter, Item 303 prohibits

only the omissions of certain information that are “reasonably likely”

to materialize.48

The interplay between Item 303 and Rule 10b–5 and

43

See Basic, Inc. v. Levinson, 485 U.S. 224, 238 (1988) (“[T]o prevail on a

Rule 10b-5 claim, a plaintiff must show that the statements were misleading as to a

material fact. It is not enough that a statement is false or incomplete, if the

misrepresented fact is otherwise insignificant.”). 44

See id. at 237 (“[O]nce a statement is made denying the existence of any

discussions [about a corporate event], even discussions that might not have been

material in absence of the denial are material because they make the statement made

untrue.”). 45

See Stoneridge Inv. Partners, LLC v. Scientific–Atlanta, Inc., 552 U.S. 148,

157 (2008). 46

See Matrixx Initiatives, Inc. v. Siracusano, 131 S.Ct. 1309, 1318 (2011)

(holding information regarding the slight potential that pharmaceutical company’s

drug was defective and could have future negative effects on the company’s

financials as material under Basic); Basic, 485 U.S. at 231–32 (“[T]o fulfill the

materiality requirement there must be a substantial likelihood that the disclosure of

the omitted fact would have been viewed by the reasonable investor as having

significantly altered the total mix of information made available.”) (internal

quotation marks omitted). 47

See Matrixx Initiatives, Inc., 131 S. Ct. at 1318. 48

Compare Stoneridge Inv. Partners, LLC, 552 U.S. at 157, with 17 C.F.R. §

229.303(a)(3)(ii) and Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 101 (2d Cir.

continued . . .


the varying thresholds at which companies must disclose information

have been the source of much confusion in the courts.49

Specifically,

courts wrestle with the question of whether every violation of Item

303 gives rise to liability under Rule 10b–5, and if not, how great the

space is between the two.50

Although litigation involving Item 303’s relationship to private

securities causes of action is not new, courts have yet to develop a

consensus regarding whether Item 303 creates a cause of action under

Rule 10b–5.51

In 2014, the Ninth Circuit addressed the issue in In re

NVIDIA Corp. Securities Litigation (“NVIDIA”).52

The court held that

Item 303 does not create a duty to disclose, so it could not create a

cause of action under Rule 10b–5.53

A year later, explicitly noting its

disagreement with NVIDIA, the Second Circuit held in Stratte-

McClure v. Morgan Stanley (“Stratte-McClure”) that Item 303 could

create a cause of action under Rule 10b–5, while qualifying its stance

by indicating that the plaintiff must still separately demonstrate

materiality and scienter.54

Ironically, although both courts relied on

the same Third Circuit case, Oran v. Stafford, their interpretation of

the case’s holding led them to different conclusions.55

III. JUDICIAL TREATMENT OF RULE 10B–5 AND ITEM 303

MATERIALITY

This Part chronicles the judicial development of the Rule 10b–5

materiality requirement. Next, it describes the circuit split between the

Ninth and Second Circuits over whether Item 303 satisfies the Rule

10b–5 materiality requirement. Finally, it analyzes the split and finds

common ground between the two opinions to ultimately suggest a

workable approach to Item 303 in a Rule 10b–5 context.

A. Pre-2014 Cases

Prior to the circuit split in 2014, the Supreme Court laid out the

boundaries for Rule 10b–5 materiality claims in a series of cases.

Most importantly, in 1988, the Court in Basic, Inc. v. Levinson

2015). 49

See infra Part III.B. 50

See infra Part III.B–C; In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1054

(9th Cir. 2014); Stratte-McClure, 776 F.3d at 102–03. 51

See infra Part III.C. 52

NVIDIA, 768 F.3d at 1054. 53

Id. 54

Stratte-McClure, 776 F.3d at 103. 55

Id.; NVIDIA, 768 F.3d at 1054–55.

412 WAKE FOREST J.


[VOL. 17

explicitly expanded material information to include omissions.56

Then, in 2001, the Third Circuit addressed Item 303 in a Rule 10b–5

context, which provided the basis of confusion for the Second and

Ninth Circuits.57

This section analyzes the holdings of these cases to

provide context for the circuit split.

Beginning in Basic, the Supreme Court laid the boundaries for

materiality in securities causes of action.58

Plaintiff shareholders

brought action against Basic Inc. (“Basic”) for its failure to disclose

that it was having talks about a potential merger with another

company.59

In fact, Basic denied that it was having merger talks at

all.60

When news of the merger finally went public, shares of the

company increased in value.61

Plaintiffs were shareholders who had

sold their stock while Basic denied the merger talks and they claimed

Basic’s failure to disclose harmed them because they sold shares at

artificially depressed prices.62

Finding support from its previous decision in TSC Industries, Inc.

v. Northway, Inc., the Court explained that “[t]he determination [of

materiality] requires delicate assessments of the inferences a

‘reasonable shareholder’ would draw from a given set of facts and the

significance of those inferences to him.”63

The Court elaborated that

materiality depends on a balancing of the probability that the event

will occur against the magnitude of the event in comparison to the

totality of the company’s activities.64

After explicitly adopting the

Second Circuit’s magnitude/probability balancing test for materiality,

promulgated in Texas Gulf Sulphur,65

the Court held that the merger

56

Basic Inc. v. Levinson, 485 U.S. 224, 243 (1988). 57

See Oran v. Stafford, 226 F.3d 275, 287 (3rd Cir. 2000). 58

Basic, 485 U.S. at 238–40. 59

Id. at 228. 60

Id. at 227. 61

See id. at 228. 62

Id. 63

Id. at 236. (citing TSC Indus., Inc. v. Northway, Inc., 426 U.S. 406, 450

(1976)). 64

Id. (citing SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 849 (2d Cir. 1968))

(holding that materiality “will depend at any given time upon a balancing of both the

indicated probability that the event will occur and the anticipated magnitude of the

event in light of the totality of the company activity”). 65

In Texas Gulf Sulphur, the Second Circuit held that:

[W]hether facts are material within Rule 10b–5 when the facts

relate to a particular event and are undisclosed by those persons

who are knowledgeable thereof will depend at any given time

upon a balancing of both the indicated probability that the event

will occur and the anticipated magnitude of the event in light of

the totality of the company activity.

Texas Gulf Sulphur Co., 401 F.2d at 849.


talks were material to shareholders.66

The Court explained that

because mergers are the single most important event that can occur in

a small corporation’s life, information regarding a potential merger

becomes material much sooner in deal discussions than an everyday

type of transaction, even though mergers often do not come to

fruition.67

More than a decade later, the Third Circuit addressed the

relationship between Item 303 and Rule 10b–5.68

In Oran, the Third

Circuit was asked to decide whether a pharmaceutical company’s

failure to disclose data indicating that one of its products was defective

constituted a breach of its affirmative obligation to disclose known

trends or uncertainties under Item 303, thereby creating a cause of

action under Rule 10b–5.69

The court indicated that “to succeed,

plaintiffs must first establish that either Item 303 creates an

independent cause of action, or the regulation imposes an affirmative

duty of disclosure on the pharmaceutical company that, if violated,

would constitute a material omission under Rule 10b–5.”70

Disposing of the former possibility first, the court quickly reasoned

that “[n]either the language of the regulation nor the SEC's

interpretative releases construing it suggest that it was intended to

establish a private cause of action . . . .”71

In other words, because

neither the statute nor the SEC indicated that Item 303 creates an

independent cause of action for shareholders, it was not within the

court’s authority to interpret a cause of action where there was

previously none.72

Moving to the latter possibility, the court was less clear.73

In

addressing whether Item 303 imposed an affirmative duty of

disclosure, the court indicated “we must examine whether the

disclosure mandated by [Item 303] is governed by standards consistent

with those that the Supreme Court has imposed for private fraud

actions under the federal securities laws.”74

The court suggested that

66

Basic, Inc., 485 U.S. at 236. 67

Id. at 238 (“Since a merger . . . is the most important event that can occur in a

small corporation’s life . . . we think that inside information, as regards a merger of

this sort, can become material at an earlier stage than would be the case as regards

lesser transactions–and this even though the mortality rate of mergers in such

formative stages is doubtless high.”). 68

Oran v. Stafford, 226 F.3d 275, 287 (3rd Cir. 2000). 69

Id. 70

Id. 71

Id. 72

Id. 73


Oran, 226 F.3d at 287.

414 WAKE FOREST J.


[VOL. 17

the materiality standards for Rule 10b–5 might have a higher threshold

than Item 303.75

If Item 303 is more expansive than Rule 10b–5, then

one could not assert that an Item 303 violation automatically meets the

materiality threshold for Rule 10b–5.76

After comparing the SEC’s guidance on Item 303’s disclosure

requirement and the Supreme Court’s materiality requirement for Rule

10b–5 from Basic, the court reasoned that Item 303’s disclosure

obligations “extend considerably beyond those required by Rule 10b–

5.”77

The court also noted that the SEC specifically stated “the

probability/magnitude test for materiality approved by the Supreme

Court in Basic . . . is inapposite to Item 303 disclosure.”78

Because the

disclosure requirements for Item 303 exceeded those of Rule 10b–5,

the court held that the demonstration of a violation of the disclosure

requirements of Item 303 does not automatically lead to the conclusion

that Rule 10b–5 would require such disclosure.79

B. Circuit Split Develops

In 2014, the Ninth Circuit began the split with NVIDIA.80

The

following year, the Second Circuit completed the split with Stratte-

McClure.81

This section details these opinions so that this Comment

can then analyze them and resolve the split.

1. The NVIDIA Case

In NVIDIA, plaintiff shareholders brought a claim against a

publicly-traded technology company, NVIDIA, for failing to disclose

its knowledge of a defect in one of its products.82

When the

information finally went public, the share price plummeted by 31%.83

Plaintiffs argued that Item 303 created a duty to disclose the defect

75

Id. at 288. 76

Id. 77

Oran, 226 F.3d at 288. See infra text accompanying notes 177–197 for a more

detailed analysis of why the materiality thresholds for Rule 10b–5 and Item 303 are

inapposite. 78

Oran, 226 F.3d at 288. 79

Id. (“Because the materiality standards for Rule 10b–5 and SK–303 differ

significantly, the demonstration of a violation of the disclosure requirements of Item

303 does not lead inevitably to the conclusion that such disclosure would be required

under Rule 10b–5. Such a duty to disclose must be separately shown.

id. (internal quotation marks omitted.”). 80

See In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014). 81

See Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015). 82

NVIDIA, 768 F.3d at 1051. 83

Id.


and that the company’s failure to disclose was misleading for purposes

of Rule 10b–5.84

The Ninth Circuit disagreed.85

Relying on the Supreme Court’s opinion in Matrixx Initiatives,86

the Ninth Circuit described the difference between a misleading

statement and omission of material fact.87

Specifically, the court

indicated that a statement might be misleading because it affirmatively

misstates information or because it is made outside the context of

other material information.88

However, with respect to omissions, the

Ninth Circuit indicated that neither Section 10(b) nor Rule 10b–5

creates an affirmative duty to disclose any and all material

information.89

The court clarified its position, stating that disclosure is

required under Rule 10b–5 only when necessary to make statements

not misleading in light of the circumstances under which they were

made.90

Relying on the Supreme Court’s position in Basic, the court

concisely summed up its point, “silence, absent a duty to disclose, is

not misleading under Rule 10b–5.”91

The court reasoned that because

Rule 10b–5 did not create an affirmative duty to disclose absent the

need to correct a prior inconsistent statement, Plaintiffs needed to

demonstrate that Item 303 created a duty to disclose that matched the

Basic magnitude/probability balancing test for the materiality

requirement of a Rule 10b–5 cause of action.92

However, the Ninth Circuit then categorically rejected the notion

that Item 303 created any duty to disclose that was actionable under

Rule 10b–5.93

Relying on the Third Circuit’s decision in Oran, the

Ninth Circuit stated that Item 303’s disclosure requirement varies

considerably from the general test of materiality for securities fraud

84

Id. 85

Id. at 1054. 86

In Matrixx Initiatives, the Supreme Court held that publicly traded companies

have a duty to correct a prior misleading statement. Matrixx Initiatives, Inc. v.

Siracusano, 131 S. Ct. 1309, 1321-23 (2011). Such a failure to apprise the market to

a new material new development constitutes a material omission under Rule 10b–5.

Id at 1323. 87

NVIDIA, 768 F.3d at 1054. 88

Id. 89

Id. 90

Id. (quoting Matrixx, 131 S. Ct. at 1321–22) (internal quotation marks

omitted). 91

NVIDIA, 768 F.3d at 1054 (quoting Basic, Inc. v. Levinson, 485 U.S. 224,

239 n.17). 92

Id. 93

Id. (“In each instance, we strongly suggest that a violation of Item 303 cannot

be used to show a violation of Section 10(b) and Rule 10b–5.”).

416 WAKE FOREST J.


[VOL. 17

that the Supreme Court set out in Basic Inc. v. Levinson.94

The court

reasoned that management’s duty to disclose under Item 303 is much

broader than what is required under the standard pronounced in

Basic.95

It suggested that Item 303 mandates disclosure of specific

forward-looking information, and it specifies its own standard for

disclosure—reasonably likely to have a material effect—meaning the

probability/magnitude test for materiality approved by the Supreme

Court in Basic is inapposite to Item 303 disclosure.96

Accordingly, the Ninth Circuit sided with the Third Circuit and

held that demonstrating a violation of Item 303 disclosure

requirements does not lead inevitably to the conclusion that such

disclosure would be required under Rule 10b–5; such a duty to

disclose must be separately shown.97

In short, the Ninth Circuit

rejected the blanket statement that an Item 303 violation could

automatically satisfy the Rule 10b–5 materiality requirement.98

But it also suggested on its face that an Item 303 violation could

otherwise still be material if the omission surpassed the Basic

threshold.99

2. The Stratte-McClure Case

Ironically, the Second Circuit purported to reach the opposite

result while similarly relying on the Third Circuit’s treatment of the

issue in Oran.100

In Stratte-McClure, plaintiffs brought action against

Morgan Stanley for failing to disclose its exposure to credit risk

related to the U.S. subprime mortgage market in its July and October,

2007 10–Q filings.101

Although Morgan Stanley’s in-house economist acknowledged in

February that the soaring mortgage defaults signaled that the “long-

awaited meltdown in subprime mortgage lending” was now underway,

the company significantly underestimated the magnitude of the

collapse.102

Accordingly, Morgan Stanley’s long position103

94

Id. at 1054–55. 95

Id. at 1055. 96

Id. 97

Id. (quoting Oran v. Stafford, 226 F.3d 275, 288 (3rd Cir. 2000)). 98

Id. at 1056. 99

Id. But see Langevoort & Gulati, supra note 21, at 1651 (arguing that Oran

suggested “there is no duty to disclose under the rule because the materiality

standard of the rule differs from that of the statute”). 100

Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 103 (2d Cir. 2015). 101

Id. at 98, 100. 102

Id. at 97. 103

A “long position” in securities trading indicates an investor has purchased a

continued . . .


hemorrhaged billions of dollars, which ultimately hampered the

company’s share price.104

Plaintiffs alleged that Morgan Stanley did

not disclose the existence of its long position in failing mortgage-

backed securities through its Form 10–Qs.105

They claimed that Item

303’s duty to disclose requirement made Morgan Stanley’s failure to

disclose a material omission subject to Section 10(b) and Rule 10b–

5.106

Following the premise in Basic, that an omission is actionable

under securities laws only when the corporation is subject to a duty to

disclose the omitted facts, the Second Circuit indicated that “such a

duty may arise when there is a corporate insider trading on

confidential information, a statute or regulation requiring disclosure,

or a corporate statement that would otherwise be inaccurate,

incomplete, or misleading without disclosure.”107

After describing the

disclosure requirements of Item 303, the court agreed with the

plaintiffs that Item 303 imposes disclosure requirements on companies

filing SEC-mandated reports.108

Therefore, the court held that Item 303’s affirmative duty to

disclose in Form 10–Qs could serve as a basis for a securities fraud

claim under Section 10(b).109

The court reasoned that “omitting an

item required to be disclosed on a 10–Q can render that financial

statement misleading,” because “the obligatory nature of [Item 303 is

such that] a reasonable investor would interpret the absence of an Item

303 disclosure to imply the nonexistence of ‘known trends or

uncertainties . . . that the registrant reasonably expects will have a

material . . . unfavorable impact on . . . revenues or income from

continuing operations.’”110

However, the court qualified its position by indicating that such an

omission is actionable only if it satisfies the materiality requirements

outlined in Basic.111

Noting the distinction between the SEC’s

“broad” disclosure requirement for Item 303 outlined in the 1989

security with the expectation that its value will increase by the time they are ready to

sell the asset. INVESTOPEDIA.COM, http://www.investopedia.com/terms/l/long.asp

(last visited September 28, 2015). If the investor’s assumption is incorrect, then the

investor will lose money. See id. 104

See Stratte-McClure, 776 F.3d at 96–97. 105

Id. at 98. 106

See id. 107

Id. at 100–01 (emphasis added) (internal quotation marks omitted). See

Basic, Inc. v. Levinson, 485 U.S. 228, 239 n.17 (1988) (“Silence, absent a duty to

disclose, is not misleading under Rule 10b–5.”). 108


Id. 110

Id. at 102 (alteration in original) (quoting 17 C.F.R. § 229.303(a)(3)(ii)). 111

Id. at 100.

418 WAKE FOREST J.


[VOL. 17

Release and the probability/magnitude bar for materiality set in Basic,

the Second Circuit explained that a plaintiff must first show that a

defendant failed to comply with Item 303 in a 10–Q or other filing to

establish that the defendant had a duty to disclose.112

Second, the

plaintiff must prove the omitted information was material under

Basic’s probability/magnitude test, because Rule 10b–5 only makes

unlawful an omission of material information that is necessary to make

statements made in their Form 10–Qs not misleading.113

The Second Circuit claimed its ruling was directly at odds with the

Ninth Circuit’s opinion in NVIDIA, where the court held that Item 303

does not independently satisfy the duty to disclose requirement for

Rule 10b–5.114

Critiquing the Ninth Circuit’s application of Oran, the Second

Circuit reinterpreted the Third Circuit’s decision to mean, “because the

materiality standards for Rule 10b–5 and Item 303 differ significantly,

a violation of Item 303 does not automatically give rise to a material

omission under Rule 10b–5.”115

Accordingly, the Second Circuit

concluded that Oran actually stood for the proposition that “in certain

instances a violation of Item 303 could give rise to a material 10b–5

omission,” and that it was consistent with the Third Circuit’s decision

that “failure to comply with Item 303 in a Form 10–Q can give rise to

liability under Rule 10b–5 so long as the omission is material under

Basic and the other elements of Rule 10b–5 have been established.”116

C. Resolving the Circuit Split on Common Ground

This Section demonstrates two problems with the current Item

303/Rule 10b–5 legal framework: (1) the Rule 10b–5 duty to disclose

is often misapplied; and (2) the categorical rejection of Item 303 as a

means of establishing materiality is improper. The distinction between

the Ninth and Second Circuits’ opinions primarily reduces to a

disagreement on the elements of a Rule 10b–5 cause of action.117

112

Id. at 103. 113

Id. See Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1321–22

(2011). 114


Id. at 103 (internal quotation marks omitted) (citing Oran v. Stafford, 226

F.3d 275, 288 (3d Cir. 2000)) (emphasis in original). 116

Id. at 103–04. 117

Compare id. at 103 (“[A] plaintiff must first allege that the defendant failed

to comply with Item 303 in a 10-Q or other filing. Such a showing establishes that

the defendant had a duty to disclose. A plaintiff must then allege that the omitted

information was material under Basic’s probability/magnitude test . . .”), with In re

NVIDIA, 768 F.3d at 1054 (“We have never directly decided whether Item 303’s

continued . . .


While the Ninth Circuit treats the “duty to disclose” and the

“materiality” requirements of Rule 10b–5 as a single element, namely

a “duty to disclose only material information,”118

the Second Circuit

creates two elements, namely, (1) whether the company had a duty to

disclose, and (2) whether that information requiring disclosure was

material.119

Although this distinction in approaches may seem trivial, courts

have rendered opposing opinions with respect to Item 303 because it

presumably carries a broader materiality requirement that is

“inapposite” to the Basic definition of materiality.120

Because the

Ninth Circuit lumps the two Rule 10b–5 requirements of disclosure

and materiality into one element, it categorically rejects the notion that

Item 303 automatically creates any duty to disclose for purposes of

Rule 10b–5 because not all required disclosures will meet the Basic

materiality test.121

In effect, it would seem the Ninth Circuit’s ruling

bars Item 303 as an avenue to establish liability under a Rule 10b–5

claim unless a plaintiff could independently demonstrate

materiality.122

1. Clarification of the “duty” to disclose in Rule 10b–5

Both the Ninth and Second Circuit’s use of the term “duty to

disclose” is curious because Rule 10b–5 does not contain “duty” in

any of its language.123

Instead, courts have read the Rule to imply a

“duty” on companies in their reports.124

However, courts are not

consistent in their definitions of the Rule 10b–5 duty.125

It appears

disclosure duty is actionable under Section 10(b) and Rule 10b–5. We now hold that

it is not.”). 118

See In re NVIDIA Corp. Sec. Litig., 768 at 1054. 119

See Stratte-McClure, 776 F.3d at 102. 120

See sources cited supra note 117; see also Bolling v. Gold, No. C13-

0872JLR, 2015 U.S. Dist. LEXIS 120114, at *17–18 (W.D. Wash. Sept. 9, 2015). 121

NVIDIA, 768 F.3d at 1055. 122

See id. 123

See generally 17 C.F.R. § 240.10b-5 (2012) (“It shall be unlawful for any

person, directly or indirectly, by the use of any means or instrumentality of interstate

commerce, or of the mails or of any facility of any national securities exchange, (a)

To employ any device, scheme, or artifice to defraud, (b) To make any untrue

statement of a material fact or to omit to state a material fact necessary in order to

make the statements made, in the light of the circumstances under which they were

made, not misleading, or (c) To engage in any act, practice, or course of business

which operates or would operate as a fraud or deceit upon any person, in connection

with the purchase or sale of any security.”). 124

See Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 103 (2d. Cir. 2015);

NVIDIA, 768 F.3d at 1055. 125

Compare Stratte-McClure, 776 F.3d at 100–01 (suggesting that duty to

continued . . .

420 WAKE FOREST J.


[VOL. 17

some courts treat the “duty” as one that may arise under a list of

situations including a corporate insider trading on confidential

information, implication by statute or regulation, or a corporate

statement that would otherwise be inaccurate, incomplete, or

misleading.126

In contrast, other courts’ opinions suggest that the

“duty” refers specifically to those instances of material omissions in

which a company must disclose information to remedy a previous

statement from becoming misleading.127

However, these definitions of “duty” are not entirely mutually

exclusive of each other. In fact, with respect to inaccurate corporate

statements, these approaches blend quite nicely. Rule 10b–5 makes it

unlawful to “omit to state a material fact necessary in order to make

the statements made, in the light of the circumstances under which

they were made, not misleading.”128

In other words, under Rule 10b–

5, a “duty to disclose,” or not omit, arises only when information

becomes material under Basic to make a previous statement not

misleading.129

Both the Ninth and Second Circuit seem to agree to this

extent.130

However, the Second Circuit’s brief assertion that the duty could

be created by statute is incorrect. First, the court suggested in its two-

step process that Item 303 satisfied the duty to disclose element of

Rule 10b–5.131

Then, it seemed to backpedal from this assertion when

it indicated that materiality must still be independently

demonstrated.132

If that is the case, the first step is irrelevant to the

materiality analysis. The Second Circuit briefly suggests that there is

disclose can be triggered by insider trading, regulation, or to correct a misleading

statement), with Gallagher v. Abbott Labs., 269 F.3d 806, 808 (7th Cir. 2001)

(holding that duty to disclose arises only to correct a prior inconsistent statement). 126

See Stratte-McClure, 776 F.3d at 100–01. 127

See Gallagher, 269 F.3d at 808 (“We do not have a system of continuous

disclosure. Instead firms are entitled to keep silent (about good news as well as bad

news) unless positive law creates a duty to disclose.”). 128

17 C.F.R. § 240.10b-5 (2012). 129

See Oran v. Stafford, 226 F.3d 275, 288 (3rd Cir. 2000); Langevoort &

Gulati, supra note 21, at 1651 (“The duty question is simply whether violations of

this category of disclosure requirements have the potential to mislead. If so, then one

goes to the question of whether the particular violation was material, so as to create

liability under Section 10(b).”). 130

See In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1054 (9th Cir. 2014)

(“[N]either Section 10(b) nor Rule 10b–5 creates an affirmative duty to disclose any

and all material information.”) (internal quotation marks omitted); Stratte-McClure,

776 F.3d at 101 (“[W]e have consistently held that an omission is actionable under

the securities laws only when the corporation is subject to a duty to disclose the

omitted facts.”). 131


Id. at 102–03.


an additional element in a Rule 10b–5 cause of action, which requires

plaintiffs to show a duty to disclose existed in addition to the

materiality of the statement.133

Because Rule 10b–5 implicates a duty

only in the circumstance of an omission,134

it is not difficult to assert

that the Second Circuit overstated the conditions in which a “duty”

arises.

Perhaps the Second Circuit confused the elements of a private

cause of action with the elements the SEC needs to prove in an

enforcement action. To succeed in an enforcement action the SEC

needs to demonstrate two main elements.135

First, it must show that

there is a statute or other regulation that imposes a duty to disclose

information to the public.136

Second, the SEC must demonstrate that

the company violated the individual elements of the statute or

regulation.137

Thus, the duty involved in governmental enforcement of

Item 303 is not the same type of duty implied in Rule 10b–5, which

arises solely out of a determination that information is material under

Basic.138

Under Rule 10b–5, the proper analysis of a duty to disclose

involves a preliminary question of whether the relevant information is

material under Basic.139

Accordingly, the Second Circuit’s two-step

approach to Item 303 disclosures in Stratte-McClure is misapplied.140

Instead of analyzing whether the duty arose out of Item 303 itself, the

question should be whether the duty arose from Basic.141

This

approach is consistent, to an extent, with the Ninth Circuit’s treatment

in NVIDIA.142

There, the court held that Item 303 on its own was not

sufficient to establish a duty to disclose because its threshold for

disclosure was much broader than the materiality bar set by Basic.143

In other words, some of what would be considered necessary

disclosure under Item 303 would not meet the disclosure requirement

133

See id at 103. 134

Id. 135

See infra notes 137–138 and accompanying text. 136


See infra text accompanying note 216. 138

Compare infra text accompanying notes 216–217, with Basic, Inc. v.

Levinson, 485 U.S. 228, 238 (1988). 139

Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 44 (2011). 140

See Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 103 (2d Cir. 2015)

(suggesting that the appropriate approach to an Item 303 omission generating a cause

of action under Rule 10b-5 was first to determine if there was a duty to disclose on

the company, and second, whether that information was material to investors). 141

Matrixx, 563 U.S. at 44. 142

Compare id., with In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1054 (9th

Cir. 2014). 143

NVIDIA, 768 F.3d at 1055.

422 WAKE FOREST J.


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for materiality under Basic.144

As a result, an Item 303 violation could

not automatically fulfill the materiality element of Rule 10b–5.145

Although the Second Circuit misapplied the duty to disclose

requirement, it still reached a similar result when it ruled that certain

violations of Item 303 “could give rise to a material 10b–5

omission.”146

The court’s use of the language “could” indicates that

the Second Circuit understood the limitations of automatically

satisfying Rule 10b–5 materiality using Item 303.147

2. Criticism of the Ninth Circuit’s Categorical Approach to

Item 303 Violations and Rule 10b–5

The Ninth Circuit’s treatment of the interplay between Item 303

and Rule 10b–5 is not without its flaws either. Indeed, its holding in

NVIDIA may be even less permissive than it initially appears.148

Previously, this Comment suggested that the Ninth Circuit’s insistence

that the duty to disclose be shown separately from Item 303 implied

that an Item 303 violation could at least satisfy the Rule 10b–5 duty to

disclose if the omission were sufficiently material.149

However, in

practice, the Ninth Circuit’s ruling is much more stringent.150

In fact,

the District Court for the Western District of Washington read NVIDIA

to the extreme when it flatly rejected a claim that an Item 303

violation was actionable under Rule 10b–5.151

Stated plainly, the

144

Id. 145

Id. 146

Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 103 (2d Cir. 2015). 147

Id. at 103–04 (holding that “failure to comply with Item 303 in a Form 10–Q

can give rise to liability under Rule 10b–5 so long as the omission is material under

Basic . . .”). 148

See Bolling v. Gold, No. C13-0872JLR, 2015 U.S. Dist. LEXIS 120114, at

*17–18 (W.D. Wash. Sept. 9, 2015). 149

See supra text accompanying notes 97–99. 150

See Bolling, 2015 U.S. Dist. LEXIS 120114, at *17–18. See also Jonathan C.

Dickey & Noah F. Stern, Creating a Clear Circuit Split, the Second Circuit Holds

That Failure to Disclose Known Trends or Uncertainties Under Item 303 of

Regulation S-K Creates Liability Under Section 10(b), GIBSON DUNN (Jan. 22, 2015)

http://www.gibsondunn.com/publications/Pages/Second-Circuit--Failure-to-

Disclose-Known-Trends-or-Uncertainties-Under-Item-303--Regulation%20S-K-

Creates-Liability.aspx (“The Ninth Circuit affirmed the district court's dismissal of

the case, holding that Item 303's disclosure duty is not actionable under Section

10(b) and Rule 10b–5. . . . [T]o establish 10(b) liability, must independently allege a

violation of that rule.”). 151

Bolling, 2015 U.S. Dist. LEXIS 120114, at *18 (“Plaintiffs assert that they

pleaded claims based on Item 303 ‘in order to preserve them’ because Plaintiffs

believe that the Ninth Circuit’s decision in NVidia is ‘likely to be reconsidered.’ . . .

Whether reconsideration of the holding in NVidia is likely or not, this court is

continued . . .


NVIDIA ruling effectively rendered Item 303 violations immune to

Rule 10b–5.152

Stated even more plainly, if defendants could show

that the omission was in violation of Item 303, then the omission could

not qualify as material under Rule 10b–5.153

While such a reading of NVIDIA might be jarringly illogical at

first, a closer look at the facts of the case suggests this may have been

the very intention of the court. After information regarding NVIDIA’s

defective products went public, the company’s share price plummeted

31%.154

There was no question that the company’s failure to

acknowledge the product defects in its quarterly reports constituted a

violation of Item 303.155

Moreover, the 31% drop in share price

provides a strong initial indication that the defect would be considered

material under Basic.156

Given that the company knew the defects

existed, there was an almost 100% probability that the company would

experience financial headwinds from correcting the issue.157

Thus, the

argument could not even be made that NVIDIA’s management

discounted the 31% effect on share price substantially through the

probability/magnitude test.158

NVIDIA’s management plainly knew that the defect posed a

massive threat to the value of the company—information that was

undoubtedly material to investors.159

Nonetheless, NVIDIA escaped

remarkably unscathed in court by the grace of Item 303.160

Despite

the glaring material omission regarding NVIDIA’s defective

products,161

the Ninth Circuit never even attempted a Basic balancing

test.162

Perhaps the court merely got lost in its analysis of the

presently bound by it.”). 152

Id. (“Accordingly, the court GRANTS this portion of Defendants’ motion

and DISMISSES with prejudice Plaintiffs’ claims based on Defendants’ alleged

failure to comply with Item 303.”). 153

Id. 154

In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1051 (9th Cir. 2014). 155

See id. at 1056; see also infra text accompanying notes 249–256. 156

See Helwig v. Vencor, Inc., 251 F.3d 540, 546, 561–62 (6th Cir. 2001)

(holding that an omission which resulted in a 30% decline in stock price was

material). 157

NVIDIA, 768 F.3d at 1049–50. 158

See infra notes 189–191. If management conducted the

probability/magnitude balancing test, calculation of the statistically expected effect

on share price would be as follows: 31% magnitude × 100% probability = 31%

statistically expected effect on share price. See infra note 190. 159

NVIDIA at 1049–50. See Helwig, 251 F.3d at 561–62 (holding that an

omission which resulted in a 30% decline in stock price was material). 160

Id. at 1048 (affirming the district court’s dismissal of plaintiffs’ amended

complaint without further leave to amend). 161

See supra notes 156, 158. 162

NVIDIA, 768 F.3d at 1054–56 (analyzing only the theoretical interplay

continued . . .

424 WAKE FOREST J.


[VOL. 17

relationship between Item 303 and Rule 10b–5. Yet, one thing is

certain—NVIDIA’s violation of Item 303, however material it may

have been under Basic, was not considered material for purposes of

Rule 10b–5 by the Ninth Circuit.163

3. Abolishing the Categorical Rejection of Item 303

Violations to State a Rule 10b–5 Claim

With its recent grant of certiorari in Leidos, Inc. v. Indiana Public

Retirement System, the Supreme Court is poised to bring some much

needed clarity to this issue.164

In addition to the Second Circuit’s

rejection of NVIDIA, one other district has explicitly adopted the

Second Circuit’s position in Stratte-McClure.165

There is no logical

support for the proposition that the SEC intended to curtail the right of

shareholders with respect to their Rule 10b–5 omission claims by

promulgating a new law requiring more disclosure. Subsequent

interpretations of Oran within the Third Circuit have concluded that

Item 303 violations are still available to Rule 10b–5 plaintiffs.166

Additionally, district courts from other circuits have recognized the

same.167

One such case, S.E.C. v. Conway, analogized the holding in

between Rule 10b–5 materiality and Item 303, but not actually conducting a Basic

balancing test). 163

Id. at 1056, 1061. 164

Carmen Germaine, High Court to Weigh Disclosure Duty in Leidos Investor

Suit, LAW360 (Mar. 27, 2017, 1:52 PM),

https://www.law360.com/articles/906254/high-court-to-weigh-disclosure-duty-in-

leidos-investor-suit. 165

Beaver Cty. Emps.’ Ret. v. Tile Shop, 94 F.Supp.3d 1035, 1047 (D. Minn.

2015) (adopting the Second Circuit’s position). But see Ash v. PowerSecure Int’l,

Inc., No. 4:14-CV-92-D, 2015 U.S. Dist. LEXIS 122692, at *26–29 (E.D.N.C. Sept.

15, 2015) (adopting the Ninth Circuit’s position in NVIDIA, but softening its

meaning to fall more in line with the Second Circuit). “A plaintiff cannot seek to

bring an action under Rule 10b–5 in the guise of an Item 303 violation when the

same underlying alleged omissions are not sufficient to state a Rule 10b–5

violation.” Id. at *29 (suggesting an Item 303 omission could satisfy Rule 10b–5

nonetheless if the omission were sufficiently material). 166

See, e.g., In re Campbell Soup Co. Sec. Litig., 145 F. Supp. 2d 574, 591

(D.N.J. 2001) (“[T]he unavailability of Item 303 as an independent avenue does not

frustrate Plaintiffs' allegations.”). 167

See, e.g., SEC v. Conaway, 698 F. Supp. 2d 771, 839 (E.D. Mich. 2010)

(“Thus, one could read Oran as excluding from a possible 10b–5 universe all of the

Item 303 disclosure requirements that do not meet the materiality standard of Basic,

Inc. and limiting 10b–5 liability to cases where is there is a separate showing not

only that a MD & A statement is made on a topic required by Item 303, but

additionally that (i.) the missing Item 303 fact is material under Basic, Inc., and (ii.)

that the absence of the fact makes the MD & A statement misleading “in light of the

circumstances under which it was made.”).


Oran to a Sixth Circuit case involving improper accounting

disclosures in a company’s financial statements.168

In Conway, the

court reasoned that if various accounting violations in an annual report

were sufficient to support a Rule 10b–5 claim, then Item 303

violations in a quarterly or annual report could similarly support a

Rule 10b–5 cause of action.169

In light of the body of case law supporting a softer interpretation of

Oran, the Supreme Court will likely soften the Ninth Circuit’s position

upon reconsideration to fall more in line with the Second Circuit by

holding that a violation of Item 303 could serve as a Rule 10b–5 cause

of action only if the omission is also material under Basic.170

Indeed,

even if the courts came to an agreement that Item 303 violations could

generate a Rule 10b–5 cause of action, perhaps they could go a step

further. Part IV considers whether all violations of Item 303 are

automatically material under Basic because of its similarity to the Rule

10b–5 materiality standard. However, Part IV concludes that such a

shortcut is inappropriate because it undermines the distinction and

importance of the Basic disclosure threshold. Because the disclosure

requirements are dissimilar, the Supreme Court is also likely to clarify

the Second Circuit’s brief implication that an Item 303 violation could

proverbially “bootstrap” itself in to a Rule 10b–5 violation without

satisfying Basic. Without clarification, this “bootstrap” approach

implies a dangerous precedent that violations of any SEC promulgated

rule automatically meet the Basic materiality requirement.

IV. THE MATERIALITY SHORTCUT

At least one legal scholar has considered the possibility of

judicially creating a shortcut by which Item 303 violations are

automatic causes of action under Rule 10b–5.171

However, the

analysis is grim, and other legal scholars have criticized this shortcut

approach. In particular, scholars have focused on the 1989 Release’s

168

Id. at 840–41. 169

Conway, 698 F. Supp. 2d at 844 (“If a combination of these general

accounting references with the statements and omissions in Bridgestone's 1999

Annual Report, in light of the disclosure standards drawn from GAAP and FASB, is

sufficient to uphold a Rule 10b–5 misrepresentation claim due to material omissions

in [the Sixth Circuit’s case,] City of Monroe, a similar combination of the

introductory and signature pages of the Kmart 10–Q(3) for 2001, selected portions of

Item 303 Regulation S–K, and the MD & A statements on ‘LIQUIDITY AND

FINANCIAL CONDITIONS’ should support a Rule 10b–5 claim here.”). 170

See Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 103 (2d Cir. 2015); In

re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1055 (9th Cir. 2014). 171

See Neach, supra note 4, at 745–46.

426 WAKE FOREST J.


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guidance regarding the inapposite nature of Item 303 and Basic

materiality standards to demonstrate the fallibility of this approach.172

Although their argument is persuasive, there is room for criticism.

Accordingly, the following sections will (1) describe the legal analysis

of Item 303 and Rule 10b–5 materiality; and (2) evaluate and critique

their claims where appropriate.

A. The Interplay of Item 303 and Rule 10b–5’s Materiality

Requirements

Legal scholars suggest that the shortcut approach does not work

because Item 303 requires disclosure of both material and immaterial

information.173

If they are correct, then the shortcut approach would

allow plaintiffs to bring Rule 10b–5 actions in connection with

immaterial omissions, thereby sidestepping and ignoring the Supreme

Court’s ruling in Basic.174

One scholar argues that Item 303 is both

over- and under-inclusive with respect to Basic.175

To prove his point,

he describes two hypotheticals, for which readers must assume the

threshold for “reasonably likely” under Item 303 is any amount above

a 20% confidence level.176

The following two subsections detail and

explain these hypotheticals.

1. First Hypothetical – Demonstrating the Under-Inclusivity

of Item 303

The first hypothetical involves a company approaching the time

for renewal of a government contract that provides substantially all of

the company’s revenues.177

The company’s management determined

there was only a 20% likelihood that the government would not renew

the contract.178

Since the 20% uncertainty was not “reasonably likely

to occur,” the first prong of the 1989 Release’s analysis would not

require disclosure under Item 303.179

After comparing the result of the

Item 303 analysis to that of the Basic magnitude/probability test, the

author argues, on the contrary to Item 303, that Basic would

172

See id. at 754–56; Langevoort & Gulati, supra note 21, at 1650–55. 173

Neach, supra note 4, at 773; Langevoort & Gulati, supra note 21, at 1645–

51. 174

See Neach, supra note 4, at 773; Basic Inc. v. Levinson, 485 U.S. 224, 238

(1988) (citing SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 849 (2d. Cir. 1968)). 175

Neach, supra note 4, at 755–56. 176

Id. at 754–56. 177

Id. at 755. 178

Id. 179

Id. at 755–56.


necessitate disclosure of the uncertainty because it threatened

“substantially all of the company’s revenues.”180

Therefore, the first

hypothetical suggests that Item 303 is less stringent than Basic.181

In

other words, Item 303 would omit certain uncertainties that Basic

would absolutely require to be disclosed.182

If this is the case, then the

shortcut approach may proceed full steam ahead.

2. Second Hypothetical – Demonstrating the Over-inclusivity

of Item 303

The second hypothetical switches gears to demonstrate the over-

inclusivity of Item 303 with respect to Basic.183

This time, a

company’s management determined that a 30% chance existed that a

lawsuit will render a judgment affecting potentially 15% of the

company’s assets.184

Because the 30% chance is above the stipulated

threshold for reasonable likelihood, the author reasons that

management must assume the loss will occur and consider the

financial effects.185

In this instance, the author argues that

management would probably not be able to say that a potential loss of

15% of the company’s assets is not reasonably likely to have a

material effect.186

Therefore, a la the 1989 Release, Item 303 would

require disclosure.187

In comparison, the author argues the same instance may or may

not be material under Basic because, unlike the second step of the

1989 Release, which forces the company to assume the uncertainty

will occur, the probability/magnitude test discounts the magnitude of

the uncertainty by the probability the uncertainty will actually come to

pass.188

Accordingly, in his scenario, the 15% magnitude would be

reduced by a 30% discount to a 4.5% statistically expected value of

lost assets,189

which might escape Basic.190

The author’s point is not

180

Id. at 755. 181

Id. 182

See id. 183

Id. 184

Id. 185

Id. 186

Id. 187

Id. 188

Id. 189

For a full description on probability weighting and prospect theory and how

they apply to the hypotheticals in this Comment, see INVESTOPEDIA.COM, Prospect

Theory, http://www.investopedia.com/terms/p/prospecttheory.asp (last visited

November 8, 2015); see also WIKIPEDIA.ORG, Prospect Theory,

https://en.wikipedia.org/wiki/Prospect_theory (last visited Nov. 8, 2015). 190

See Neach, supra note 4, at 756.

428 WAKE FOREST J.


[VOL. 17

to demonstrate that Basic materiality would not apply, but simply that

a disclosure necessitated by Item 303 could potentially avoid the Basic

materiality standard.191

If such is the case, then a violation of Item

303 could not serve as an automatic inducement of a Rule 10b–5 cause

of action and the shortcut approach necessarily fails.192

Trial Magnitude Probability

Statistically

Expected

Value193

Material

Under Item

303?

Material Under

Basic?

First

Hypothetical 100.0% 20.0% 20.0%

No. Likelihood is not greater

than 20%.

Yes. 20%

statistically

expected value is material

Second Hypothetical

15.0% 30.0% 4.5%

Yes.

Likelihood is greater than

20%.

Maybe. 4.5%

statistically expected value

might be material.

B. Criticism of the Materiality Hypotheticals

While the argument to limit Item 303 is persuasive, it is not

without its flaws. In response to the preceding hypotheticals, this

section questions: (1) whether adjusting the confidence level to

establish “reasonable likelihood” would affect the outcome of the

hypotheticals; and (2) whether there is a certain distinguishable and

mathematically calculable point at which various events become

material under Basic such that a mathematically-inclined legal scholar

could calculate the magnitude necessary in the second steps of the

1989 Release’s analysis to always trigger Basic materiality.

1. Adjusting the Confidence Level to Establish “Reasonable

Likelihood”

Although the hypotheticals use a 20% threshold for “reasonably

likely,” former commissioner of the SEC, Edward H. Fleischman,

suggested that “reasonably likely” exists in the 40% range.194

If that is

the case, then the discount percentage is less potent. In effect, it would

191

Id. 192

Id. 193

See supra note 189. Magnitude × Probability = Statistically Expected Value.

Id. 194

Edward H. Fleischman, Commissioner, Sec. Exch. Comm’n, The Intersection

of Business Needs and Disclosure Requirements: MD&A, Address at the Eleventh

Annual Southern Securities Institute 12 (Mar. 1, 1991) (transcript available on the

SEC website at https://www.sec.gov/news/speech/1991/030191fleischman.pdf) (last

visited November 8, 2015) (“[S]o, in my own understanding, ‘reasonably likely’ or

purposes of this analysis is somewhere in the range of the 40% probability level . . .

.”).


keep material trends and uncertainties from being so heavily

discounted under the Basic probability/magnitude test. For instance,

using the second example from the hypotheticals above, if

management determines a 30% likelihood that 15% of revenues will

be affected by a forthcoming trend or uncertainty, then the uncertainty

falls below the 40% threshold and does not trigger disclosure under

Item 303.195

In contrast, following the second step of the 1989 Release, if

management determines there is a 50% probability that 15% of

revenues would be affected, then management would have to assume

100% probability and assess the 15% magnitude under those

conditions for materiality.196

As before, a 15% net effect on a

company’s revenues is likely to be considered material information to

shareholders, and thus Item 303 would mandate disclosure of that

uncertainty.197

In contrast, assessment for materiality under Basic

would discount the 15% magnitude by the 50% probability to

determine that there is a 7.5% statistically expected value of lost

revenue, which is greater than the 4.5% statistically expected value

using the 20% threshold.198

Perhaps a 7.5% statistical expectation tips the scales in favor of

Basic materiality. As a result, the difference threatens to subvert the

claim that Item 303’s threshold for required information is broader

than the Basic test for materiality. Nonetheless, use of a 20% instead

of 40% threshold could also just be clerical. Indeed, the discrepancy

results in a 7.5% statistical effect instead of 4.5%. Thus, in this

scenario, the differing discount rates might not have an effect that is

substantial enough to dramatically change the calculation of

materiality under Basic’s probability/magnitude test.

While some companies use a rule of thumb of 5% as a threshold to

determine what counts as material, the SEC has explicitly rejected

such a presumption, reiterating that the test for materiality must be

applied on a case-by-case basis.199

In other words, the SEC’s

interpretation seems to suggest that in some scenarios, a 5%

calculation under the balancing test might be material, whereas in

other scenarios, 5% may not reach the level of materiality expressed in

Basic.200

Certainly, given the SEC’s rulemaking authority, it could

issue a statement suggesting that any statistically expected effect

195



Neach, supra note 4, at 756. 198

See supra text accompanying note 166; Neach, supra note 4, at 756. 199

SEC Staff Accounting Bulletin No. 99, 64 Fed. Reg. 45150 (Aug. 19, 1999). 200

Id.

430 WAKE FOREST J.


[VOL. 17

greater than a certain percentage of revenue, income, or otherwise

counts as material.201

However, the SEC has not yet done so, which

leaves a certain level of ambiguity to the line at which the balance of

probability and magnitude reaches a material level.202

2. Ascertaining a Threshold for Materiality of Statistically

Expected Values

Yet, even if the SEC were to set the threshold at a 5% level, Item

303 would be no closer to being a shortcut to Rule 10b–5. Imagine a

hypothetical scenario in which management determines that there is a

50% likelihood that 6% of its revenues will be lost by shifting market

trends. Assessing whether disclosure is necessary under Item 303

requires management to assume 100% probability because the

likelihood is above the 20% or 40% threshold.203

Accordingly, the 6%

statistically expected value would be material for the purposes of Item

303 since it is greater than this imaginary 5% threshold.204

Conversely, examining the uncertainty for purposes of Rule 10b–5

would result in a statistically expected value of 3% by multiplying the

6% magnitude by the 50% probability.205

Thus, the uncertainty would

not be material under Basic.206

Yet it would be material under Item

303,207

once again demonstrating that Item 303 is more inclusive than

Rule 10b–5.208

Based on the foregoing hypotheticals, under the law as it stands

presently, Item 303 simply cannot be used as a shortcut to establish the

materiality requirement in a Rule 10b–5 cause of action.209

The

shortcut fails because of the distinction between the

magnitude/probability threshold of Basic, which discounts the

201

See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 212–14 (1976) (“More

importantly, Rule 10b–5 was adopted pursuant to authority granted [to] the

Commission under § 10(b). The rulemaking power granted to an administrative

agency charged with the administration of a federal statute is not the power to make

law. Rather, it is the power to adopt regulations to carry into effect the will of

Congress as expressed by the statute.”) (citing Dixon v. United States, 381 U.S. 68,

74 (1965)). 202

See SEC Staff Accounting Bulletin No. 99, 64 Fed. Reg. 45150. 203




This conclusion assumes that a 5% statistically expected value is the

threshold for materiality. In this scenario, the statistically expected value of 3% does

not exceed the 5% threshold. 207


Neach, supra note 4, at 756. 209

See supra text accompanying notes 173–208.


magnitude of events, and the “reasonably likely” threshold of Item

303, which does not.210

V. ADDITIONAL MEANS OF ENFORCING ITEM 303

This Part considers the viability of SEC enforcement as an

alternative means of recovery for plaintiffs injured by Item 303.

Although Item 303 may not serve as a shortcut to Rule 10b–5,

companies are not immune from liability for violations of Item 303.211

For policy reasons, Item 303 must be enforceable by some means to

encourage more accurate reporting on the part of companies, and

reliance on the part of investors.212

Section 10(b) gives the SEC wide

breadth to require disclosure of “any manipulative or deceptive device

or contrivance in contravention of such rules and regulations as the

Commission may prescribe as necessary or appropriate in the public

interest or for the protection of investors.”213

Therefore, even though

the Supreme Court limited materiality in Basic, Congress left the door

wide open for the SEC to require disclosure of any information it finds

necessary to protect the public interest or investors.214

But if private

enforcement of Item 303 is limited to violations meeting Basic, then

the onus is on the SEC to give Item 303 the full force it is intended.

This Part examines the relationship between Item 303, the SEC,

and injured investors by (1) describing the SEC’s Item 303

enforcement capabilities; and (2) surveying viability of the

Commission’s authority to create “fair funds” as a means to

compensate injured investors. Ultimately, SEC enforcement is applied

in two scenarios to demonstrate its feasibility for future plaintiffs.

A. The SEC’s Item 303 Enforcement Authority

The SEC maintains enforcement authority over any violations of

rules promulgated by it or Congress.215

The Securities Exchange Act

of 1934 (“Exchange Act”), which is codified in 15 U.S.C. § 78, grants

the SEC authority to issue an order requiring any person that is in

violation of “any rule or regulation” under the Exchange Act to cease

and desist from committing or causing such violation and any future

210


See infra note 234. 212

See Zohar Goshen & Gideon Parchomovsky, The Essential Role of Securities

Regulation, 55 DUKE L.J. 711, 715 (2006). 213

15 U.S.C. § 78j (2012). 214

See id. 215

See, e.g., In re Bank of Am. Corp., Exchange Act Release No. 72888, 2014

WL 4101590, at *9 (Aug. 21, 2014).

432 WAKE FOREST J.


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violation of the same provision.216

In addition, the SEC may impose a

civil penalty on any person that violated or caused the violation

resulting in the cease and desist order.217

Because Item 303 is a

regulation promulgated to enforce the “records and reports”

requirement of the Exchange Act,218

enforcement of Item 303

violations falls within the SEC’s purview.219

Prior to the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”),

which Congress legislated primarily in response to the WorldCom and

Enron accounting scandals, the SEC’s power to compensate defrauded

investors was limited.220

Sarbanes-Oxley authorized the SEC to add

civil fines that were paid in enforcement actions to disgorgement

funds, which it called “fair funds.”221

These fair funds would then be

distributed to the victims of the securities violations.222

However, to distribute civil fines paid by the defendant under

Sarbanes-Oxley, the SEC had to coextensively order each defendant to

pay disgorgement.223

To order disgorgement, the SEC had to show

216

15 U.S.C. § 78u-3(a) (2012) (“If the Commission finds, after notice and

opportunity for hearing, that any person is violating, has violated, or is about to

violate any provision of this chapter, or any rule or regulation thereunder, the

Commission may publish its findings and enter an order requiring such person, and

any other person that is, was, or would be a cause of the violation, due to an act or

omission the person knew or should have known would contribute to such violation,

to cease and desist from committing or causing such violation and any future

violation of the same provision, rule, or regulation.”). 217

15 U.S.C. § 78u-2(a)(2) (2012) (“In any proceeding instituted under section

78u-3 of this title against any person, the Commission may impose a civil penalty, if

the Commission finds, on the record after notice and opportunity for hearing, that

such person—(A) is violating or has violated any provision of this chapter, or any

rule or regulation issued under this chapter; or (B) is or was a cause of the violation

of any provision of this chapter, or any rule or regulation issued under this

chapter.”). 218

15 U.S.C. § 78q (2012) (“Every national securities exchange [or] member

thereof . . . who transacts a business in securities through the medium of any such

member, registered securities association, . . . shall make and keep for prescribed

periods such records, furnish such copies thereof, and make and disseminate such

reports as the Commission, by rule, prescribes as necessary or appropriate in the

public interest, for the protection of investors, or otherwise in furtherance of the

purposes of this chapter.”). 219

Item 303 is a regulation promulgated pursuant to Chapter 15 of the U.S.

Code. See 15 U.S.C. §§ 78u-2(a)(2), 78u-3(a) (providing that the SEC may enforce

violations of Chapter 15 by cease and desist orders and civil penalties). 220

Urska Velikonja, Public Compensation for Private Harm: Evidence from the

SEC’s Fair Fund Distributions, 67 STAN. L. REV. 331, 341 (2015). 221

Id. 222

Id. 223

Id.


that the particular defendant profited from the securities violation.224

Thus, if the SEC could not demonstrate that the particular defendant

who was ordered to pay civil fines also profited from the fraud, the

civil fines were remitted to the U.S. Treasury, and investors were left

without an option for relief through the SEC.225

Congress closed this loophole in the Dodd-Frank Act of 2010

(“Dodd-Frank Act”), by authorizing the SEC to distribute civil

penalties to victims of securities violations regardless of whether it

orders disgorgement.226

Thus, in cases where the SEC orders a

company to pay a civil fine for a violation of Item 303, that fine is

available to compensate victims as a fair fund distribution.227

B. Potency of Fair Fund Compensation

Despite the common presumption in the legal community that fair

fund distributions are merely smaller and feebler versions of private

securities litigation, emerging research empirically demonstrates that

neither is the case.228

According to one study, which examined all

SEC actions from 2002 to 2014, all issuer reporting and disclosure fair

funds are accompanied by private litigation, and the SEC’s

contribution equals about 15.1% of the aggregate amount distributed

to investors through settlements and judicial decisions.229

In other

words, fair fund contributions represent more than a paltry sum to

harmed investors. More importantly, the study also found that “[i]n

more than half of the fair fund distributions—53.2%—defrauded

investors received no compensation from private litigation . . . .”230

The author of the study theorized that the lack of collections from

private litigation results from the fact that smaller frauds may not be

224

Id.; SEC, REPORT PURSUANT TO SECTION 308(C) OF THE SARBANES OXLEY

ACT OF 2002, at 33 (2003) (describing requirements for disgorgement) [hereinafter

SEC 308(C) REPORT]. 225

SEC 308(C) REPORT, at 33 (“Moreover, if no defendants in a case are ordered

to pay disgorgement, then no penalties may be distributed to injured investors.”);

Velikonja, supra note 220, at 341. 226

15 U.S.C. § 7246(a) (2012) (“Civil penalties to be used for the relief of

victims. If, in any judicial or administrative action brought by the Commission under

the securities laws, the Commission obtains a civil penalty against any person for a

violation of such laws, or such person agrees, in settlement of any such action, to

such civil penalty, the amount of such civil penalty shall, on the motion or at the

direction of the Commission, be added to and become part of a disgorgement fund or

other fund established for the benefit of the victims of such violation.”). 227

Id. 228

Velikonja, supra note 220, at 335. 229

Id. at 359. 230

Id. at 369.

434 WAKE FOREST J.


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litigated at all because the likely recovery is small and the likelihood

of surviving a motion to dismiss pursuant to the strict standards set by

PSLRA and the Supreme Court are low.231

Such a barrier to litigation

is exactly what causes most Item 303 violations to fail to trigger a

Rule 10b–5 cause of action—they simply do not cross the Basic

threshold for materiality, which ultimately bars the plaintiff from

winning a private litigation suit.232

However, while private plaintiffs experience a significant barrier

to properly state a claim under Rule 10b–5 through Item 303, the SEC

has the authority to avoid Rule 10b–5 entirely and directly prosecute a

company for its violation of Item 303.233

Pursuant to the Exchange

Act, the SEC may impose a civil fine on companies that violate Item

303, and it often does.234

Similarly, pursuant to the Dodd-Frank Act,

the SEC may distribute those civil fines to harmed investors through a

fair fund.235

Thus, Item 303 represents a manner by which injured

plaintiffs who are unable to meet materiality under Basic may

ultimately attain some form of relief. This idea that SEC enforcement

could serve as a pipeline for recovery to shareholders injured by Item

303 violations is not entirely novel. In SEC v. Dell, Inc., the District

Court of the District of Columbia agreed with this notion when it

asserted that the SEC could distribute civil fines paid by Dell to

231

Id. 232

See id. at Part IV. 233

See supra text accompanying notes 212–213. See, e.g., In re Presstek, Inc.,

Exchange Act Release No. 997, 1997 WL 784548, at *13–14 (Dec. 22, 1997)

(prosecuting Presstek for inadequate discussion of a trend having a substantial

impact on revenues pursuant to Item 303); In re Shared Med. Sys. Corp., Exchange

Act Release No. 33632, 1994 WL 49960, at *3 (Feb. 17, 1994) (prosecuting Shared

Medical Systems Corporation for inadequate discussion of a poor trend in sales that

could materially affect its business operations pursuant to Item 303); In re Huntway

Partners, L.P., Exchange Act Release No. 578, 1994 WL 386584, at *5 (July 25,

1994) (prosecuting Huntway for failure to adequately discuss a downward trend in

its cash flows); In re Caterpillar Inc., Exchange Act Rel. No. 34-30532, 1992 WL

71907, at *8 (Mar. 31, 1992) (prosecuting Caterpillar, Inc. for inadequate discussion

of known trends and uncertainties that could materially affect its business operations

pursuant to Item 303). 234

See supra text accompanying notes 216–217. See also In re Apple Reit Six,

Inc., Exchange Act Release No. 3535, 2014 WL 547605, at *18–20 (Feb. 12, 2014)

(ordering defendants to pay a combined $1,675,000 in civil fines to the U.S.

Treasury); In re Southpeak Interactive Corp., Exchange Act Release No. 64320,

2011 WL 1506756, at *1, *4 (Apr. 21, 2011) (ordering the defendant to pay a

$10,000 civil penalty to the treasury); In re Elec. Data Sys. Corp., Exchange Act

Release No. 2725, 2007 WL 2778644, at *8 (Sept. 25, 2007) (ordering the defendant

to pay $490,902 in disgorgement and interest to the U.S. Treasury). 235

15 U.S.C. § 7246(a) (2012).


shareholders through a fair fund.236

Despite this avenue of relief and the fact that the SEC often uses

its civil fining capability in connection with Item 303, the Commission

has not yet used fair funds to compensate shareholders injured

exclusively by an Item 303 violation.237

However, in Dell, the SEC

created a fair fund to compensate shareholders for a Rule 10b–5

violation.238

At minimum, the SEC’s opinion suggests that an Item

303 violation could give rise to a Rule 10b–5 cause of action.

Perhaps the reason for never compensating shareholders

exclusively for an Item 303 violation outside of another securities

violation is simply administrative. For instance, identifying all of the

injured shareholders in an Item 303 case could prove extraordinarily

difficult.239

In instances where plaintiffs bring their own successful

private causes of action, the SEC could simply order distribution to

plaintiffs in the suit. However, because Item 303 creates no separate

cause of action, shareholders who are injured by Item 303 and unable

to surpass Rule 10b–5 materiality may never form a discrete and easily

identifiable group of plaintiffs.

Furthermore, the pool of injured shareholders might be so large

that distributions of civil fines would amount to mere pennies for each

share held.240

In Dell, the defendants were ordered to pay a $100

236

No. 10 1245, 2010 U.S. Dist. LEXIS 146632, at *10–11 (D.D.C. Oct. 13,

2010) (“The Commission may by motion propose a plan to distribute the Fund

subject to the Court's approval. Such a plan may provide that the Fund shall be

distributed pursuant to the Fair Fund provisions of Section 308(a) of the Sarbanes-

Oxley Act of 2002.”); Complaint at 26–28, SEC v. Dell Inc., No. 1:10-cv-01245-

RJL, 2010 U.S. Dist. LEXIS 146632 (D.D.C. Oct. 13, 2010) (including in the

violations for which the SEC prosecuted Dell were violations of Item 303). 237

See Distributions in Commission Administrative Proceedings: Notices and

Orders Pertaining to Disgorgement and Fair Funds, U.S. SEC. & EXCH. COMM’N,

http://www.sec.gov/litigation/fairfundlist.htm (last visited Jan. 10, 2016) (noting not

one case listed results from SEC enforcement of Item 303); Dell Inc., 2010 U.S.

Dist. LEXIS 146632, at *2. 238

Order at 1–2, SEC v. Dell Inc., No. 1:10-cv-01245-RJL (D.D.C. July 28,

2014). 239

At the time, Dell had almost 2 billion shares of stock outstanding and an

average daily trading volume of around 27 million shares, identifying injured

shareholders from these figures could have been severely cumbersome. See Dell,

Inc., Annual Report (Form 10–K) (Mar. 18, 2010) (stating that there were

1,957,725,915 share of common stock outstanding as of March 5, 2010); Average

Daily Trading Volume History, YAHOO FINANCE,

http://finance.yahoo.com/quote/DELL/history?period1=1262322000&period2=1275

364800&interval=1mo&filter=history&frequency=1mo (last visited Mar. 25, 2017). 240

$100,000,000 civil fine ÷ 1,957,725,915 shares outstanding = $0.05 per

share. See supra note 239 and accompanying text; see also infra text accompanying

note 242.

436 WAKE FOREST J.


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million civil fine,241

but Dell had almost two billion shares of common

stock currently outstanding.242

If Dell lacked parallel Rule 10b–5

litigation to identify a discrete group of injured shareholders, the

distribution group might have included all shares outstanding. To

divide even a fine as substantial as $100 million would amount to

about five cents per share, which constituted less than one-half of one

percent of the value of Dell’s share price at the time of the order.243

However, this assumption that the SEC makes distributions

pursuant to a straight-line format is overly simplistic. Often, the fair

fund distributions to which shareholders are owed are calculated in

much more complicated manners.244

Through these formulas, the

shareholders’ recovery amount varies based on a number of factors,

including when the investor purchased and sold the securities and the

extent of the investor’s losses as a result of these transactions.245

These funds also impose thresholds based on the amount lost before a

shareholder can actually recover.246

These policies limit collection to

those shareholders who were most dramatically affected by the

violation and are, therefore, in the direst need of recovery.247

Through

these parameters, fair fund recovery for an Item 303 violation is a

workable solution for investors who are unable to meet the Basic

materiality requirement, or for that matter, any other Rule 10b–5

element.

C. Applying SEC Enforcement of Item 303

This section applies SEC enforcement to a case and a hypothetical

scenario to demonstrate how plaintiffs who were unsuccessful in their

Item 303/Rule 10b–5 claims might still obtain some form of relief.

First, this section reexamines NVIDIA in light of the fact that the court

rejected the plaintiffs’ Rule 10b–5 claim, but they might have

nonetheless been able to recover for an Item 303 violation through

241

Dell Inc., 2010 U.S. Dist. LEXIS 146632, at *9. 242

See supra note 239 and accompanying text. 243

See supra note 240. 244

See, e.g., Order Approving Distribution Plan at 20–24, SEC v. Nortel

Networks Corp. & Nortel Networks Ltd., No. 07-CV-8851-LAP (Oct. 10, 2011). 245

See, e.g., id. at 21. 246

See, e.g., Proposed Plan of Distribution at 8, In re Alliance Capital Mgmt.,

L.P., No. 3-11359 (Feb. 22, 2008), http://www.sec.gov/litigation/admin/2008/34-

57489-pdp.pdf (“No settlement payment will be made to a Potentially Eligible

Recipient with less than $10 in losses at the Final Allocation stage. The IDC has

concluded that it is not cost-effective or otherwise commercially reasonable to

attempt to distribute Fair Fund Assets in amounts lesser than the De Minimus

Amount.”). 247

Id. at 7–8.


SEC enforcement. Second, this section considers how potential

plaintiffs to the second Item 303 hypothetical248

might recover by SEC

enforcement, having been unsuccessful in demonstrating that a

company’s Item 303 violation reached the Basic level of materiality.

To assess whether plaintiffs can recover from an Item 303

violation through the SEC, one must determine whether a prosecutable

violation has occurred.249

Such a determination requires the injured

shareholder to perform an Item 303 analysis pursuant to the 1989

Release.250

In NVIDIA, management discovered a defect in one of its

principal products.251

Because management’s certainty of the

existence of the defect made it more than “reasonably likely” that the

company would experience financial headwinds associated with

correcting the defect, the first step of the 1989 Release’s Item 303

analysis would require management to assume a 100% probability that

the company would experience those costs.252

Shareholders determined the magnitude of the cost to correct the

defect to be equivalent to a 31% decrease in the company’s value,

which they reflected in the subsequent decrease in share price.253

The

threat of a 31% decrease in share price, or any similar amount, is

certainly material to investors.254

Therefore, following the second step

of the 1989 Release’s analysis, management had a duty to disclose the

defect in its MD&A section pursuant to Item 303.255

Because it did

not, NVIDIA violated the SEC’s regulations and was justifiably

prosecutable by the Commission pursuant to its authority granted by

the Exchange Act.256

After the Ninth Circuit’s blanket denial of the plaintiffs’ Rule 10b–

5 claims, relief through a private cause of action was unlikely.257

In

response, the SEC could have prosecuted NVIDIA for its violations by

showing that they had a duty to disclose pursuant to Item 303.258

If

successful in its claim, the SEC could then order civil fines to be paid

248

See text accompanying notes 183–192. 249

See, e.g., In re Bank of Am. Corp., Exchange Act Release No. 72888, 2014

WL 4101590, at *8 (Aug. 21, 2014). 250

See, e.g., id. 251

In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1049–50 (9th Cir. 2014). 252

See 1989 Release supra note 23. See also text accompanying notes 26-30. 253

In re NVIDIA, 768 F.3d at 1050–51. 254

See Helwig v. Vencor, Inc., 251 F.3d 540, 546, 561–62 (6th Cir. 2001)

(holding that an omission that resulted in a 30% decline in stock price was material). 255

See 1989 Release, supra note 23. See also supra text accompanying notes

32–37. 256


NVIDIA, 768 F.3d at 1065 (affirming the district court’s dismissal without

leave to amend against the plaintiffs). 258

See supra text accompanying notes 215–19.

438 WAKE FOREST J.


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by NVIDIA and subsequently distribute those fines to the

appropriately injured shareholders through a fair fund.259

In this

manner, injured shareholders could obtain some relief to offset the

31% loss many of them realized as a result of NVIDIA’s failure to

disclose.

A similar outcome could result from the second hypothetical.260

In

that instance, management determined a 30% probability that 15% of

company revenues might be affected by some event.261

Assuming that

after a court conducted the Basic probability/magnitude balancing test,

it deemed the omission immaterial for purposes of Rule 10b–5 because

plaintiffs would still have a means of recovery through SEC

enforcement of Item 303 because the 30% probability is above the

imaginary 20% threshold.262

In this circumstance, the same steps

would follow as in the NVIDIA hypothetical and the result would be

the same—plaintiffs would recover some of their loss despite the fact

that the omission was immaterial under Basic.263

There are two possible drawbacks to SEC enforcement. First, as

previously mentioned, SEC enforcement generally results in relatively

small fines, and in many cases, no fine at all.264

Where there are no

fines, there are correspondingly no funds to be distributed to investors.

But perhaps substantial fines are reserved for those situations in which

the conduct was particularly offensive or significantly damaging.

Second, the SEC maintains discretion over which actions it brings

against companies and whether it will distribute monetary fines to

investors.265

Therefore, based solely on the administrative limitations

259




See supra text accompanying notes 178, 185. 263


See supra notes 233–34. Each case listed in note 233 resulted in cease and

desist orders but not monetary fines. See supra note 233. The SEC also asserts that

its primary goal is to enforce compliance, not make investors whole. Velikonja,

supra note 220, at 340; SEC 308(C) REPORT, at 3 n.2 (“Restitution is intended to

make investors whole, and disgorgement is meant to deprive the wrongdoer of their

ill-gotten gain.”); SEC v. Blavin, 760 F.2d 706, 713 (6th Cir. 1985) (“The purpose of

disgorgement is to force ‘a defendant to give up the amount by which he was

unjustly enriched’ rather than to compensate the victims of fraud.”) (quoting SEC v.

Commonwealth Chem. Sec., Inc., 574 F.2d 90, 102 (2d Cir. 1978)). 265

15 U.S.C. § 78u-2(a)(2) (2012) (“In any proceeding instituted under section

78u-3 of this title against any person, the Commission may impose a civil penalty, if

the Commission finds, on the record after notice and opportunity for hearing, that

such person— (A) is violating or has violated any provision of this chapter, or any

rule or regulation issued under this chapter; or (B) is or was a cause of the violation

of any provision of this chapter, or any rule or regulation issued under this chapter.”)

(emphasis added). See 15 U.S.C. § 7246(a) (2012); Velikonja, supra note 220, at 342

continued . . .


of the SEC, not all qualifying infractions will be pursued by the

Commission.266

However, one should reasonably expect that the

proverbial “squeaky wheel” will get the grease and only those most

egregious and overly reported instances will be brought as actions

against the infringing companies.267

Thus, while Item 303 is not

always a direct resource to injured investors and is certainly a

secondary option to private causes of action, plaintiffs should not

overlook the potential to use the SEC’s enforcement authority to their

advantage.

VI. CONCLUSION

Despite its 30-year pedigree, Item 303 still generates considerable

confusion among courts regarding its relationship with Rule 10b–5.

This confusion directly results from the regulations’ differing

thresholds of materiality for disclosure. Whereas Item 303 requires

disclosure of all material information once it reaches a level of

“reasonable likelihood,” Rule 10b–5 requires a discounted calculation

of magnitude for materiality.268

Rule 10b–5 plaintiffs seeking to

demonstrate materiality must balance the magnitude of the event with

the probability that the event will occur.269

Because of their varied

approaches, there is significant conceptual daylight between the

disclosure requirements of Item 303 and Rule 10b–5. Item 303 is both

over- and under-inclusive with respect to Rule 10b–5.

Three circuits directly grappled with the notion of this conceptual

daylight but reached no consensus on whether Item 303 satisfies the

materiality requirement of Rule 10b–5. While the Second and Third

Circuits held that an Item 303 violation could satisfy Rule 10b–5 as

long as it also satisfied Basic,270

the Ninth Circuit categorically

rejected Item 303 as a mode of establishing materiality for Rule 10b–

(“The decision to distribute funds to investors is at the discretion of the SEC . . . .”). 266

Velikonja, supra note 220, at 342–43 (discussing that the SEC does not even

administer the majority of the fair funds it prescribes because of the inherent

administrative burden of managing the funds). 267

See, e.g., S.E.C. v. WorldCom, Inc., 273 F. Supp. 2d 431, 431 (S.D.N.Y.

2003) (stating WorldCom’s accounting fraud wiped out nearly $200 billion in

shareholder equity, which generated an in-depth investigation by the SEC). 268

See U.S. SEC. & EXCH. COMM’N, Interpretation: Commission Guidance

Regarding Management’s Discussion and Analysis of Financial Condition and

Results of Operations, Release No. 33-8350 (Dec. 29, 2003), available at

http://www.sec.gov/rules/interp/33-8350.htm; Stratte-McClure v. Morgan Stanley,

776 F.3d 94, 102–03 (2d Cir. 2015). 269


See id.; Oran v. Stafford, 226 F.3d 275, 288 (3d Cir. 2003).

440 WAKE FOREST J.


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5.271

The Ninth Circuit reached its conclusion by relying on a Third

Circuit decision in which the court determined that “a duty to disclose

for Rule 10b–5 must be separately shown” from the Item 303

violation.272

In practice, the Ninth Circuit’s ruling renders Item 303

violations immune from Rule 10b–5. This Comment argued that the

Ninth Circuit’s restrictive interpretation of the Third Circuit’s holding

will not survive review by the Supreme Court. This Comment also

proposed that the proper application of Item 303 in a Rule 10b–5

context is more in line with the Second Circuit’s suggestion that Item

303 can serve as a basis of liability for Rule 10b–5.

Unfortunately for plaintiffs, the gap between the disclosure

requirements does not support a shortcut to Rule 10b–5 by which Item

303 violations automatically satisfy Basic materiality. Nonetheless,

while Item 303 does not independently establish materiality, a

violation of Item 303 also does not automatically imply that the

omission was immaterial.273

Such a violation is still actionable if it

satisfies the Basic materiality threshold.274

Additionally, another

alternative exists for plaintiffs who are unable to satisfy Basic with an

Item 303 violation. Namely, plaintiffs might find some form of

recovery through SEC enforcement of Item 303 and distribution of

monetary fines through fair funds.275

However, compensation via

SEC enforcement is not without drawbacks. SEC adjudications

against companies in violation of Item 303 often result in relatively

small fines or no fine at all.276

Moreover, the SEC is limited in its

resources and has administrative discretion over the cases it brings.277

Nonetheless, these limitations may not be so pronounced because the

SEC is likely to bring cases where the Item 303 violation and the harm

were particularly egregious.

Although Item 303 does not directly create a cause of action for

plaintiffs, shareholders still enjoy some protection against fraud

because companies disclose in the shadow of the law. Perhaps this is

the most poignant aspect of SEC enforcement of Item 303. Because

companies fear litigation for violations of securities laws from the

SEC, there is a significant incentive to generate accurate reports and

adequate disclosures.278

In that light, Item 303 acts as a guideline for

companies when determining what information requires disclosure to

271 See In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1054 (9th Cir. 2014).

272 Oran, 226 F.3d at 288.

273 See supra text accompanying notes 263–64.


275 See supra text accompanying note 265.





avoid liability. Rule 10b–5 serves as the weapon with which plaintiffs

can enforce certain violations of Item 303 in private actions. In cases

where plaintiffs are unsuccessful in their claims, the SEC’s

enforcement of Item 303 and use of fair funds ultimately acts as a

failsafe for plaintiffs who need significant relief.

Item 303 is not a toothless law, but it is also not a silver bullet by

which plaintiffs can boundlessly patrol publicly traded companies.

Item 303’s power is nuanced. It serves more as a silent arbiter of

accurate and adequate disclosure, only to rear its head to litigate

egregious violations. Courts must clarify Item 303’s import to Rule

10b–5 in a form primarily pursuant to the Second Circuit’s position.

Such a clarification would solidify Item 303’s utility to investors by

promoting greater dependability of disclosures and improving market

efficiency.