Bankruptcy Court Rejects Unfair-Practices Claim Against Insurer Accused of Aiding and Abetting Conversion of Trust Funds

A recent decision reminds us that North Carolina’s bankruptcy courts often rule on claims under N.C. Gen. Stat. § 75-1.1.

In re NC & VA Warranty Co. was an adversary proceeding in the bankruptcy of a warranty company. The company’s bankruptcy trustee tried to amend her complaint to assert breach-of-contract and 75-1.1 claims against the company’s insurer. The bankruptcy court, however, held that the proposed 75-1.1 claim was futile. The court reasoned that the claim didn’t allege egregious or aggravating circumstances in connection with the insurer’s alleged breach of contract.

A Trust Account Gone Bad

NCVA was a North Carolina-based company that sold extended car warranties to consumers. It contracted with an Ohio-based insurer to back up its obligations to pay claims. NCVA paid the insurer a monthly premium based on the number of extended warranties that NCVA sold. It deposited the premiums into a trust account.

NCVA and the insurer had a contract that governed the trust account. The contract barred the insurer from withdrawing funds from the account except to pay warranty claims or to reimburse itself for paying claims.

Despite this contract term, the insurer allegedly allowed the son of NCVA’s owner to divert $4 million from the trust account to an account that the son controlled. This alleged diversion of funds led to NCVA’s bankruptcy filing.

On behalf of NCVA’s bankruptcy estate, the trustee filed an adversary proceeding: a bankruptcy-court lawsuit that is meant to recover assets from third parties for the sake of the bankruptcy estate.

During that adversary proceeding, the trustee sought permission to amend her complaint to add claims—including a 75-1.1 claim—against NCVA’s insurer. The trustee alleged that the insurer knew that the funds had been diverted from the trust account, but took no steps to recover the funds or to alert NCVA that the funds had been transferred.

The bankruptcy court allowed the trustee to add breach-of-contract claims against the insurer. The court, however, rejected the trustee’s proposed extracontractual claims, including her 75-1.1 claim, as futile.

Nothing More Than a Breach-of-Contract Claim

First, the court rejected the trustee’s proposed claim for breach of fiduciary duty. The court held that the insurer’s status as a beneficiary under the trust agreement did not, by itself, give the insurer any fiduciary obligations. Likewise, the insurer’s alleged breaches of the trust agreement did not turn a contractual relationship into a fiduciary relationship. The court also noted that the insurance agreement imposed fiduciary obligations on NCVA, but not on the insurer.

The court also rejected the trustee’s fraud claim against the insurer. The court treated the fraud claim as one based on nondisclosure: the insurer’s failure to disclose that it had breached the insurance contract. This claim failed because, under Ohio law, the insurer had no specific duty to disclose the withdrawal of funds from the trust account.

The trustee’s 75-1.1 claim fared no better.

At the start, the court asked whether the 75-1.1 claim was viable under a per se theory. The court stated that a breach of fiduciary duty “is sufficient to support” a 75-1.1 claim and that fraud “necessarily” establishes a 75-1.1 claim. In this case, though, both of those predicate claims had already failed. Thus, a per se theory under section 75-1.1 had no way to proceed.

The court then asked whether the claim could survive on a non-per-se basis. It could not. In the court’s view, the claim alleged no more than an intentional breach of conduct—one lacking any “egregious or aggravating circumstances.”

The court analogized the case to Broussard v. Meineke Discount Muffler Shops, Inc., a key Fourth Circuit decision that condemns treating intentional breaches of contract as sources of treble damages under section 75-1.1. Broussard, like NCVA, involved allegations that a party withdrew trust-account funds in breach of a contractual limit on the use of those funds. The Broussard court rejected that claim with ringing language:

It has been said that because “[p]roof of unfair or deceptive trade practices entitles a plaintiff to treble damages,” a [75-1.1] count “constitutes a boilerplate claim in most every complaint based on a commercial or consumer transaction in North Carolina.” To correct this tendency, and to keep control of the extraordinary damages authorized by [section 75-1.1], North Carolina courts have repeatedly held that a “mere breach of contract, even if intentional, is not sufficiently unfair or deceptive to sustain an action under [section 75-1.1].” Even though “[i]n a sense, unfairness inheres in every breach of contract when one of the contracting parties is denied the advantage for which he contracted,” North Carolina law requires a showing of “substantial aggravating circumstances” to support a claim under [section 75-1.1]. Given the contractual center of this dispute, plaintiffs’ [75-1.1] claims are out of place.

(Citations omitted.)  The NCVA court quoted and followed this reasoning when it held that the trustee’s proposed 75-1.1 claim was futile.

NCVA shows that even intentional misconduct, if it is bound up with a contract, often cannot support a 75-1.1 claim. This is especially true where a contract defines the parties’ obligations to each other. In those cases, the search for “substantial aggravating circumstances” will decide whether a 75-1.1 claim stands or falls.

Author: George Sanderson

A Quirky Exemption: “Internal” Business Disputes

A recent decision by the North Carolina Business Court highlights an
important—and counterintuitive—limit on the scope of N.C. Gen. Stat. § 75-1.1.

Section 75-1.1 says expressly that it applies to practices “in or affecting commerce.” Courts have interpreted this phrase as narrowing the fact patterns that the statute covers. The employment exemption, for example, emanates from this phrase.

Another “commerce”-based exemption involves disputes between owners, officers, or directors of a single business. Under this exemption, when a 75-1.1 claim turns on finger-pointing within an organization, the claim falls outside the scope of the statute.

In RCJJ, LLC v. RCWIL Enterprises, LLC, the Business Court addressed an important question on this exemption:  Can a party sidestep the exemption by alleging that the corporate infighting also involved competition?

The Bad Breakup of Do Good

Ryan Crecelius and Jonathan Jackson were the principals of Do Good Real Estate, a real-estate brokerage firm. When they started the company, Crecelius and Jackson signed an operating agreement. The agreement included non-compete and non-solicitation clauses.

The company’s good vibes turned sour. Crecelius and Jackson didn’t see eye to eye, so they negotiated a buyout of Crecelius’s interest in Do Good.

During the buyout negotiations, though, Crecelius was planning his next business venture.

One day after he and Jackson agreed in principle on the buyout, Crecelius formed a new company called Nest Realty. The new company started its operations shortly after the ink dried on the buyout agreement.

During the same period, and unbeknownst to Jackson, Crecelius helped himself to Do Good’s customer database.

When Jackson found out, he sued Crecelius and Nest. Jackson’s amended complaint raised thirteen different claims, including an alleged violation of section 75-1.1.

After a year of discovery, Crecelius and Nest filed a motion for summary judgment on all claims.

On the section 75-1.1 claim, Crecelius and Nest argued that their allegedly wrongful acts were not “in or affecting commerce” because they involved “the internal conduct of individuals within a single business.”

Jackson disagreed. He argued that Crecelius committed his wrongful acts as a competitor, not as an owner of Do Good. On this logic, the 75-1.1 claim involved competition between two businesses, not just conduct within a single business.

Business Court Judge Gregory McGuire decided the motion on June 20.

When Competitive Acts Are Internal in Nature

Judge McGuire’s decision—like the parties’ briefs—focused on the North Carolina Supreme Court’s 2010 decision in White v. Thompson.

In White, one of three business partners formed a new, separate company that steered work and payments away from the partnership. The Supreme Court decided that the departing partner’s conduct was exempt from section 75-1.1 because the conduct “occurred completely within” the partnership. Section 75-1.1, the Supreme Court held, does not apply to intra-business conduct.

Judge McGuire applied White to Jackson’s 75-1.1 claim. That claim, Judge McGuire concluded, was limited to Crecelius’s interactions with Do Good and Jackson—actions that count as intra-business conduct under White. Thus, that conduct was not “in or affecting commerce.”

What, though, about Jackson’s argument that Crecelius was acting as a competitor of Do Good and as an agent of Nest, so that Crecelius’s conduct involved more than a single business?

To answer that question, Judge McGuire pointed back to White. When the defendant in White diverted work and payments from his partners, he did so to benefit his new, competing business. Given that feature of White, Judge McGuire held that crediting Jackson’s competitor/agent argument would eviscerate the holding in White.

Based on these concerns, Judge McGuire granted summary judgment to Crecelius and Nest on Jackson’s 75-1.1 claim.

Distinguishing White

Business litigators in North Carolina would be wise to study RCJJ, LLC.

Many complex business disputes involve some type of business divorce. As RCJJ, LLC shows, a plaintiff in a business-divorce case cannot just tack a section 75-1.1 claim onto the end of a complaint and assume that the claim will rise or fall with other business torts alleged there. If the complaint involves internal bickering related to the business divorce, the section 75-1.1 claim might well fail as a matter of law.

The key for such a plaintiff is to identify truly external conduct that violates section 75-1.1. To stay out of the vortex of White, moreover, that external conduct will have to involve something more than competition with the defendant’s former business. Identifying and describing that conduct will require careful thought and precise wording.

This careful styling of a 75-1.1 claim might sound like a lot of work, but treble damages provide a strong incentive. As RCJJ, LLC makes clear, those treble damages do not apply to White lies.

Author: Stephen Feldman

Can Failing Antitrust Claims Be Repackaged as Unfair Methods of Competition? The North Carolina Business Court Answers No

Although courts sometimes describe N.C. Gen. Stat. § 75-1.1 as an outgrowth of antitrust law, most 75-1.1 claims do not arise from antitrust fact patterns.

SiteLink Software, LLC v. Red Nova Labs, Inc. is an exception. That case involves overlapping antitrust claims and section 75-1.1 claims.

In this setting, the North Carolina Business Court recently held that the outcome of the 75-1.1 claims tracked the outcome of the antitrust claims.

From Collaborators to Competitors

SiteLink provides software to self-storage facilities (the kind you see on Storage Wars). This type of software, called facility-management software, performs management functions for self-storage facilities. Only a minority of storage facilities use facility-management software. Out of that subset, 35% to 40% use SiteLink’s  software.

SiteLink cooperates with companies that provide complementary services, such as online marketing services. Through license agreements, SiteLink allows these companies to tap into SiteLink’s network and data through SiteLink’s application-programming interface (API).

SiteLink, however, imposes licensing restrictions on its software and its API. SiteLink’s licensing agreements bar licensees from competing with SiteLink. The agreements also bar a licensee from buying any services from SiteLink’s competitors at the same time that the licensee uses SiteLink’s products.

Red Nova is an online marketing company. It had a license to use SiteLink’s API to provide services to SiteLink’s customers.

While Red Nova had this licensing relationship with SiteLink, it developed software that competed with SiteLink’s software. When SiteLink learned this, it terminated Red Nova’s API license. It also unilaterally amended its license agreements with its own customers, inserting a provision that barred those customers from dealing with any company that competes with SiteLink in any line of business.

Finally, SiteLink sent letters to its own customers, urging them to switch from Red Nova to another marketing company that did not compete with SiteLink in any sphere. SiteLink’s campaign allegedly included false statements about Red Nova. It also allegedly included coercive incentives for customers to switch away from Red Nova.

Red Nova’s Counterclaims

SiteLink sued Red Nova in North Carolina state court for violating the API license. Red Nova designated the lawsuit to the North Carolina Business Court. The case was assigned to Chief Judge Gale.

Red Nova then filed four counterclaims against SiteLink. One of the counterclaims had this heading: “Unfair and Deceptive Trade Practices; N.C. Gen. Stat. §§ 75-1, 75-1.1, 75-2, 75-2.1.”

As that heading suggests, this counterclaim mixed claims under section 75-1.1 with claims under North Carolina’s state antitrust statutes:

  • section 75-1, which bars certain anticompetitive agreements,
  • section 75-2, which extends section 75-1 to acts and agreements that violate “the principles of the common law,” and
  • section 75-2.1, which bars monopolization, attempts to monopolize, and conspiracies to monopolize.

Red Nova’s antitrust/75-1.1 counterclaim attacked the competition-limiting terms in SiteLink’s API licenses. However, it also attacked SiteLink’s alleged false statements and attempts to coerce Red Nova’s customers to stop using Red Nova.

Given this focus on anticompetitive tactics, Red Nova’s 75-1.1 claim seemed to apply a rarely used aspect of section 75-1.1: its ban on unfair methods of competition.

SiteLink moved to dismiss all of Red Nova’s antitrust claims. It also moved to dismiss Red Nova’s 75-1.1 claim, but only to the extent that the 75-1.1 claim was based on SiteLink’s API licensing practices.

Chief Judge Gale granted SiteLink’s partial motion to dismiss. His extensive opinion discusses several aspects of antitrust law—and the 75-1.1 “unfair methods” theory—that rarely come up in decisions of the North Carolina state courts. Because of this lack of state-court precedents, the opinion draws on federal antitrust decisions throughout.

The court analogized Red Nova’s antitrust theory to a theory of “negative tying.”  Negative tying occurs when a seller agrees to sell a product or service only on the condition that the customer agrees not to buy a different product or service from any other seller, or at least not from specified sellers. (In a conventional tying arrangement, in contrast, the seller imposes a different condition on the sale: he requires that the customer actually buy a second product or service from him.)

The court held that Red Nova’s tying claim omitted at least one element of such a claim: anticompetitive effects in the market for the “tied” services—that is, the market where the seller hopes to coerce or prevent sales. In this case, the allegedly tied market was the market for “other software services offered to self-storage-facility owners or operators.” The court saw no allegations of any effects on that market. For example, Red Nova did not even allege that SiteLink was trying to enter that market.

The court also rejected Red Nova’s claim that the licensing agreements between SiteLink and its customers were anticompetitive in a more general way. Red Nova alleged that these agreements pushed up prices to customers, but the court held that Red Nova’s counterclaim offered no specifics on those alleged price effects.

Red Nova’s claims of monopolization and attempted monopolization failed as well. Those claims required Red Nova to define the allegedly monopolized market, then allege (in non-conclusory terms) that SiteLink had monopoly power (for actual monopolization) or a dangerous probability of gaining monopoly power (for attempt to monopolize). Even if Red Nova’s proposed market definition could survive a motion to dismiss—a point on which the court expressed doubt—the court held that SiteLink’s 35% to 40% market share in this proposed market was not enough to show monopoly power or a dangerous probability of getting it.

Having dismissed all of Red Nova’s antitrust claims, the Business Court also dismissed the 75-1.1 claims to the extent that they were based on SiteLink’s API licensing practices. The court treated these 75-1.1 claims as just another expression of Red Nova’s failed antitrust theories.

In dismissing these 75-1.1 claims, the court held: “When a section 75-1.1 claim derives solely from an antitrust claim, the failure of the antitrust claim also defeats liability under section 75-1.1.” The court based this holding on a 2002 decision by the U.S. District Court for the Middle District of North Carolina.

This is a significant holding. In theory, it would be possible for courts to hold that section 75-1.1 allows parties to pursue antitrust claims that fail one or more standards under antitrust law. In recent years, however, courts have rejected that approach to section 75-1.1. The Business Court has now rejected it as well.

That rejection makes perfect sense. As John Graybeal has pointed out in a helpful article, using section 75-1.1 as an “antitrust lite” statute would pose serious problems. Most importantly, it would require the courts to devise a whole new set of standards to govern these claims. It has taken the federal and state courts 126 years—and considerable struggle—to work out one body of antitrust doctrine. It’s hard to imagine that the North Carolina courts would want to restart that process.

Finally, a word about Red Nova’s surviving 75-1.1 claims. As noted above, SiteLink moved to dismiss Red Nova’s 75-1.1 claim only to the extent that it was based on SiteLink’s API license. The motion to dismiss left the rest of Red Nova’s 75-1.1 claim unchallenged.

Thus, the court and the parties now face the challenge of untangling the strands of Red Nova’s single counterclaim—a counterclaim that (wisely or not) combined section 75-1.1 with state antitrust law. This untangling process might well offer more lessons for all of us.

Author: George Sanderson