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[288 U.S. 123, 124] Messrs. Richard Reid Rogers and Evan Shelby, both of New York City, for petitioner.
Mr. John W. Davis, of New York City, for respondents.
Petitioner, plaintiff below, owns 200 shares of the common stock of the American Tobacco Company which he acquired prior to the passage of chapter 175, p. 354, New Jersey Laws, 1920 (Comp. St. Supp. 47-183 to 47-187), that is here involved. He also owns 400 shares of common stock B. He brought two suits in the Supreme Court of New York: One against the tobacco company and some of its directors, the other against the trust company, Junius Parker and others. On application of defendants both were removed to the federal court for the southern district of that state. The first was discontinued as to some defendants and the cases were consolidated. The defendants before the court are the two companies, Parker, and five of the seventeen directors of the tobacco company including its president, one of its vice presidents, and its secretary.
The tobacco company was organized under the laws of New Jersey, and in that state maintains its 'principal [288 U.S. 123, 125] and registered office' as designated in its charter, holds the stockholders' meetings, and does a substantial amount of business. It is authorized by the laws of New York to do business there and has in New York City its principal place of business where its directors usually meet, its executives have their offices and most of its records are kept. It carries on business in that and many other states and also in a number of foreign countries.
The grievances alleged by plaintiff concern the issue, allotment, and sale of stock of the tobacco company. June 25, 1930, the board of directors adopted a resolution recommending the reduction by one-half of the par value and the doubling of the number of shares of its common stock and common stock B. It had outstanding 526,997 shares of preferred stock, and, as a result of action in accordance with that recommendation, 1,609, 696 shares of common and 3,077,320 shares of common B. And by another resolution the board advised approval by the stockholders of a plan for the issue and sale of common stock B to employees pursuant to chapter 175, New Jersey Laws, 1920.1 The plan submitted accords to such em- [288 U.S. 123, 126] ployees and others actively engaged in the conduct of the business as may be selected an opportunity to purchase stock 'by way of additional compensation for services to be rendered,' and allots for subscription shares of unissued stock. The board may offer stock to such persons in the service at prices not less than par and upon other terms and conditions determined by the president pursuant to authority granted him for that purpose by the board. No employee or person actively engaged in the conduct of the business of the corporation or its subsidiaries shall be deemed ineligible to its benefits by reason of being also a director of the corporation or of any of its subsidiaries or of holding any office therein.
July 28, 1930, the stockholders adopted the plan. And January 28, 1931, the board authorized a sale of 56,712 shares of common stock B at par value of $25 per share. It directed that there be furnished to the president, to be considered in determining to whom the stock should be allotted for purchase, a list showing the services rendered, and, having regard to the value of the same, the rating on a percentage basis given to each together with the total amount of his compensation for 1930. It recommended that the basis of distribution should be the number of shares having par value equal to one-third of that year's compensation to each allottee rated at 100 per cent. and correspondingly less to those having lower ratings. And there was accorded to each of 535 employees, including directors and others active in the business, the right to subscribe for the new stock on that basis. All [288 U.S. 123, 127] the shares allotted were sold at $25 for cash to the trust company. The trust company allowed each allottee to subscribe at the same price. At that time it was worth $112. The agreement stated that this was by way of additional compensation for service to be rendered between January 31 and December 31, 1931; that until the end of the year no allottee could take up his stock; that he was entitled to have dividends applied on the purchase price; and that, if he should terminate his employment before the end of the year, the trustees were to decide whether he should have his allotment.
The complaint attacked the transaction upon the following grounds: The directors being disqualified by reason of their interest as allottees, the plan was not passed by a valid vote or adopted as required by chapter 175. The subsequent vote of the stockholders, required by the statute to be predicated upon action by the board, was likewise invalid. The plan was ultra vires in that the allotment 'by way of additional compensation for services to be rendered' violated chapter 195, p. 566, New Jersey Laws, 1917 (Comp. St. Supp. N.J. 47-176 et seq.). Under the Company's charter and the statutes of New Jersey-section 124, General Corporation Law as added by section 16 of chapter 318, p. 544, Laws 1926 (Comp. St. Supp. N.J . 47-119i)-every stockholder had the right according to the number of his shares to have pro rata distribution of the stock in question. And the complaint prayed decree that the defendants be enjoined from carrying out the plan; that the stock be declared void and canceled; and that the defendants, other than the tobacco company, be held for costs and damages sustained by that company.
Four defenses were set up: Plaintiff failed to comply with Equity Rule 27 (28 USCA 723). The stockholders including plaintiff ratified the allotments to the directors. The suit is an attempt to regulate the internal affairs of a corporation foreign to New York, and the United States District Court sitting therein should decline to take jurisdiction. The [288 U.S. 123, 128] allotments were fair and reasonable and were made in accordance with the company's by-laws and the statutes of New Jersey. Plaintiff moved for an order striking out the defenses as insufficient and for a decree in accordance with the prayer of the complaint or, in the alternative, for an injunction pendente lite preventing the carrying out of the plan.
The Circuit Court of Appeals, 60 F.(2d) 114, dealing with plaintiff's contentions before it, held that the plan was authorized; that the stock was lawfully issued under New Jersey statutes; and that, for the reasons given in the opinion, the bill was properly dismissed. A dissenting opinion suggests that the plan was not sufficiently in detail to comply with the New Jersey statute. The court affirmed the judgment appealed form, and, upon its mandate, the District Court entered a decree that the bills of complaint be dismissed with costs.
Among the points and contentions raised and pressed by plaintiff in his petition for certiorari and argument here are the following: The plan is not definite and formulated as required by chapter 175. That chapter as construed below is repugnant to the contract clause of the Federal Constitution (Const. art. 1, 10). The decision that the plaintiff failed to comply with Equity Rule 27 is contrary to chapter 175. Chapter 195, New Jersey Laws 1917, does not permit the issue of stock to employees for services to be rendered. The decree of the District Court declining to exercise jurisdiction is contrary to decisions of this court and in conflict with the decision of the Circuit Court of Appeals for the Seventh Circuit in Williamson v. Missouri-Kansas Pipe Line Co., 56 F.(2d) 503.
The authorization, allotment, and sale of the shares in question involved the proportionate ownership of stockholders and their rights inter sese. Unquestionably the steps taken and proposed to formulate and carry out the plan constitute the conduct and management of the internal affairs of the tobacco company. The controversy is solely between the plaintiff and other stockholders not [288 U.S. 123, 130] participating in the distribution on one side and the purchasers of the new stock, the corporation, its directors, and officers on the other. When, by acquisition of his stock, plaintiff became a member of the corporation he, like every other shareholder, impliedly agreed that, in respect of its internal affairs, the company was to be governed by the laws of the state in which it was organized. His rights, whatever the tribunal chosen for their vindication, are to be determined upon the ascertainment and proper application of New Jersey law.
It has long been settled doctrine that a court-state or federal- sitting in one state will, as a general rule, decline to interfere with, or control by injunction or otherwise, the management of the injunction or otherwise, corporation organized under the laws of another state but will leave controversies as to such matters to the courts of the state of the domicile. Wallace v. Motor Products Corporation (C.C.A.) 25 F.(2d) 655, 658; Chicago Title & Trust Co. v. Newman (C.C.A.) 187 F. 573, 576; Eberhard v. Northwestern Mutual Life Ins. Co. (D.C.) 210 F. 520, 522; Powell v. United Association, 240 N.Y. 616, 148 N.E. 728; Sauerbrunn v. Hartford Life Ins. Co., 220 N.Y. 363, 371, 115 N.E. 1001; Jackson v. Hooper, 76 N.J.Eq. 592, 604, 75 A. 568, 27 L.R.A.(N.S.) 658; Guilford v. Western Union Telegraph Co., 59 Minn. 332, 340, 61 N.W. 324, 50 Am.St.Rep. 407; Kimball v. St. Louis, etc., Railway, 157 Mass. 7, 31 N.E. 697, 37 Am. St.Rep. 250; Hogue v. American Steel Foundries, 247 Pa. 12, 15, 92 A. 1073; Babcock v. Farwell, 245 Ill. 14, 33, et seq., 91 N.E. 683, 137 Am.St.Rep. 284, 19 Ann.Cas. 74; Clark v. Life Association, 14 App.D.C. 154, 179, 180, 43 L.R.A. 390; North State Copper & Gold Mining Co. v. Field, 64 Md. 151, 20 A. 1039. Cf. Burnrite Coal Co. v. Riggs, 274 U.S. 208, 212 , 213 S., 47 S. Ct. 578. While the District Court had jurisdiction to adjudge the rights of the parties, it does not follow that it was bound to exert that power. Canada Malting Co. v. Paterson Co., 285 U.S. 413, 422 , 52 S.Ct. 413, and authorities cited. It was free in the [288 U.S. 123, 131] exercise of a sound discretion to decline to pass upon the merits of the controversy and to relegate plaintiff to an appropriate forum. Langnes v. Green, 282 U.S. 531, 535 , 541 S., 51 S.Ct. 243; Heine v. New York Life Ins. Co. (C.C.A.) 50 F.(2d) 382. Obviously no definite rule of general application can be formulated by which it may be determined under what circumstances a court will assume jurisdiction of stockholders' suits relating to the conduct of internal affairs of foreign corporations. But it safely may be said that jurisdiction will be declined whenever considerations of convenience, efficiency, and justice point to the courts of the state of the domicile as appropriate tribunals for the determination of the particular case. Cohn v. Mishkoff-Costlow Co., 256 N. Y. 102, 105, 175 N.E. 529; Travis v. Knox Terpezone Co., 15 N.Y. 259, 263, 109 N.E. 250, L.R.A. 1916A, 542, Ann. Cas. 1917A, 387; Kimball v. St. Louis, etc., Railway, supra.
The complaint shows that as of its date seven directors of the tobacco company were not residents of New York. Only six allottees are before the court. The others, over 525, are not mentioned in the complaint. It appears from the answer that many of them are outside New York, and it may be inferred that a large number of them reside in the other States and countries in which the company does business. At the time, February 23, 1932, of the dismissal of the bill the services of the employees, for which the allotments constitute part compensation, had been fully performed and they were entitled to have and presumably they, or at least some of them, had secured the delivery of the shares so allotted to them. As the tobacco company, in addition to its registered office, has property, operates directly or through subsidiary branch factories in New Jersey and carries on business there and in other states and countries, it may not be deemed to have been organized in that state as a mere matter of convenience for the purpose of carrying on all its business in another state [288 U.S. 123, 132] or be deemed in New York to be a local concern. This case is wholly unlike Williamson v. Missouri-Kansas Pipe Line Co., supra, relied on by plaintiff.
The determination of plaintiff's contentions requires not only the ascertainment of the true meaning and intent of chapter 175 of New Jersey Laws, 1920, but also its constitutional validity. Its provisions have never been construed by the New Jersey courts and they or their like are not familiar in the statute law governing corporations organized in other states. And other New Jersey statutes among which are chapter 195, Laws of 1917, and chapter 318, section 16, Laws of 1926, are claimed by plaintiff to have an important bearing upon this case. But the courts of that state have had no occasion to consider the interrelation, if any, between them and chapter 175 pursuant to which the stock in question purports to have been issued to employees. A mere inspection of the New Jersey statutes directly involved suggests grave doubts as to their proper application to the facts in this case and the difference of opinion expressed below confirms that impression.
So far as concerns the cancellation of the allotted shares and other relief sought by plaintiff the situs of the stock is in New Jersey and all questions relating to the validity of the plan, authorization, issue, allotment, and sale of the same may be conveniently and effectively determined in New Jersey courts, the authoritative and final interpreters of the statutes of that state. A proceeding in rem is authorized, process thereiin may be served by publication and a decree, final and binding upon all, canceling or sustaining the stock, may readily be enforced. New Jersey Practice Act of 1903, 84 (3 Comp. St. N.J. 1910, p. 4076, 84); Jellenik v. Huron Copper Co., 177 U.S. 1, 13 , 20 S.Ct. 559; Andrews v. Guayaquil & Quito Ry. Co., 69 N.J.Eq. 211, 60 A. 568; Holmes v. Camp, 219 N.Y. 359, 114 N.E. 841. The facts and circumstances disclosed by the record clearly bring this case within the general rule and abundantly justify the exer- [288 U.S. 123, 133] cise of discretion on the part of the District Court in dismissing the bills of complaint without prejudice. As the Circuit Court of Appeals considered and decided the merits of the case, its judgment is reversed, the judgment of the District Court entered upon its mandate is vacated, and the case will be remanded to the District Court with directions to reinstate the earlier judgment dismissing the bills of complaint without prejudice.
I think the court should decide this case on its merits in favor of the petitioner.
Respondent, the American Tobacco Company, organized under the laws of New Jersey, is a large and prosperous corporation, engaged in the manufacture and distribution of cigarettes and other forms of tobacco. It has upwards of 40,000 stockholders. At the commencement of this suit it had a board of sixteen directors, including a president, five vice presidents, a secretary and a treasurer, all actively engaged in its management. For many years these officers have receive large annual fixed salaries, as well as large annual cash profit sharing bonuses paid under a by-law of the company, adopted in 1912. See Rogers v. Hill (C.C.A.) 60 F.( 2d) 109. In the year 1930, the profit sharing bonus of the president, added to his fixed salary of $168,000, gave him a total compensation of over $1,010,000, which was further augmented by a special 'credit' of $273, 470. In the same year, four of the five vice presidents received an aggregate annual salary and bonus of more than $2,077,000. In addition, a number of stock subscription plans have from time to time been put into operation by the directors, without authority of the charter of by-laws of the corporation, or the knowledge or ap- [288 U.S. 123, 134] proval of its stockholders, by which they largely benefited. In that of 1926, the respondent Hill, the president and also a director of the company, acquired 8,000 shares of common stock, and other directors, who are respondents here, received substantial amounts. In that of 1929, one year before the transactions now complained of, 46,500 of 51,750 shares of common stock, purchased by the corporation and set aside for the purpose, were sold to the corporate directors at $47 per share less than market value. Convenient arrangements were made for postponed payment of the purchase price. Respondents received 23,050 shares, of which the president received 15,050.
On January 28, 1931, a new allotment of stock was made, which is the subject of this litigation. On that day, the Board of Directors (the president and officers constituting a majority of those in attendance) considered and passed upon the adequacy of the compensation which its members were then receiving for their services to the corporation, and the necessity of conferring further benefits on themselves in order to insure the continuance of those services. Having resolved these questions in their own favor, they proceeded to award additional benefits in the form of the privilege to subscribe to unissued common stock B of the corporation, at a small fraction of its market value. By resolution of that date, they put into effect a stock subscription plan by which 56,712 shares of unissued common stock B of the corporation were distributed in accordance with recommendations made by the president. Of this number 32, 370, more than half, were allotted to the directors, of which 13,440 were allotted to the president. The remaining 24,342 shares were allotted in relatively small amounts to 525 employees. None of the recipients was of lower rank than factory subassistant. Four hundred and seventy-three received allotments of less than 100 shares each, the great majority receiving from 15 to 50 shares. The stated consideration for issue [288 U.S. 123, 135] of the stock was a subscription price of $25 per share, the par value, and the services of the allottee, not specifically described, to be rendered to the American Tobacco Company for the remainder of the year.
The certificates of stock were to be delivered to the respondents, the Guaranty Trust Company of New York and an individual, as trustees. They were authorized to borrow money upon them to the extent of $25 per share, in order to effect immediate payment of the subscription price to the tobacco company, to apply dividends received on account of the purchase price to be paid by the allottees and to deliver the certificates to them after the close of the year, upon payment in full of their subscriptions. They were given discretion to waive performance of the stipulated service by any allottee and in the event that the subscriber was discharged or resigned from the employ of the company within the year, to cancel the subscription agreement or not, as they pleased.
On the day of the resolution allotting the stock, its market price was $112 per share, more than four times the subscription price. It was then paying, and has ever since paid, dividends at the rate of $5 per year, sufficient to pay the subscription price in five years. Valuing the subscription privilege by the difference between the subscription price and the market value of the shares, the president received by the allotment the equivalent of $1,169,280, in addition to his annual compensation of more than $1,000,000. The stock subscription rights awarded the five vice presidents, similarly valued, amounted to $1,451,595. That the subscription privilege, accorded for the avowed purpose of assuring the continuance of these executives in the company's employ, was then and has been ever since of great value, upon any theory of valuation, is not questioned.
Conceiving himself aggrieved by this transaction, petitioner, a nonassenting stockholder, brought two suits in [288 U.S. 123, 136] the Supreme Court of New York, the state in which he resides, joining as defendants the American Tobacco Company, the trustees of the allotted stock, and certain of the directors, including the president, secretary, treasurer, and five vice presidents, one of whom has since died and two of whom were not served with process. Included in the relief sought was a decree that the corporation, its officers and directors be enjoined from carrying out the stock allotments and that the stock allotted to the directors be surrendered to the company. On motion of defendants, the tobacco company and a nonresident director, the causes were removed to the District Court for Southern New York on grounds of diversity of citizenship of the parties to a separable controversy, and there consolidated.
Thus called upon in this suit to account for their stewardship and to justify their action, the defendants, the respondents here, place their whole reliance upon a statute of New Jersey in conformity with which, they contend, they secured, in advance, the authorization of the stockholders to make the challenged allotments of stock.
Section 1, c. 175, of the New Jersey Laws for 1920 (Comp. St. Supp. N. J. 47-183(a), authorizes any New Jersey corporation to provide and carry out a plan for '(a) the issue or the purchase and sale of its capital stock to any or all of its employees and those actively engaged in the conduct of its business or to trustees on their behalf ... and for aiding any such employees and said other persons in paying for such stock by contributions, compensation for services, or otherwise. ...' Section 2(b), Comp. St. Supp. N.J. 47-184(b) provides that, where, as in this case, the corporation has been formed without charter or by-law provisions authorizing the issuance or the purchase and sale of stock for such purposes, 'the board of directors shall first formulate such plan or plans and pass a resolution declaring that in its opinion the adoption thereof is advisable, and shall call a meeting of the stockholders to [288 U.S. 123, 137] take action thereon. ...' It requires an affirmative vote of two-thirds in interest of each class of stockholders, present at the meeting, for the adoption of the plan.
In June, 1930, the directors, purporting to act under this statute, presented to the stockholders, by notice of a special meeting, a so-called 'plan' under which the employees of the corporation and those actively engaged in its business were to be permitted to subscribe to unissued shares of its common stock B. The notice of the meeting was accompanied by a document designated 'Employees' Stock Subscription Plan,' and by a copy of resolutions of the board of directors authorizing the submission of the plan to the stockholders, proposing a reduction in the par value of the common stock and the non-voting common stock B from $50 to $25 per share, and an increase of the authorized common stock from 1,000,000 to 2,000,000 shares, and of the authorized common stock B from 2,000,000 to 4,000,000 shares, each stockholder to receive two shares of the new stock for one of the old. By thus increasing the authorized, unissued shares of common B, stock was to be made available for subscription by employees.
Moved, perhaps, by these inducements, the proposal was approved at the meeting by vote of the requisite number of shares of each class.
With all these facts presented by the pleadings, the District Court, acknowledging its jurisdiction both as a federal court and a court of equity to decide the cause on its merits, nevertheless, held that as the suit concerns the internal affairs of a New Jersey corporation, discretion should be exercised to dismiss it without prejudice to its maintenance in the courts of New Jersey. On appeal, the Circuit Court of Appeals for the Second Circuit, Judge Swan dissenting, considered the merits and upheld the legality of the stock allotments. The decree of dismissal was affirmed on the merits and the trial court has entered a final decree accordingly. This court now reverses that judgment, reestablishing the original decree of the trial court, on the ground that a proper exercise of judicial discretion requires that the cause should not be heard. Thus after approximately two years of litigation in state and federal courts, all of which could, and I think should, have decided the case on the merits, the plaintiff must now start the litigation afresh in the courts of New Jersey.
In determining whether the federal courts should decline to exercise the jurisdiction conferred on them by removal, the nature of this controversy and its merits cannot be ignored. I do not stop to consider numerous objections to the stock allotments, urged by petitioner, which are not without weight. It suffices for present purposes that no plan of sufficient definiteness to comply with the New Jersey statute was ever submitted to the stockholders for their approval; and that even if it be conceded that a 'plan' was approved, the action of the directors in allotting the stock to themselves, in violation of their duty as fiduciaries, exceeded the authority con- [288 U.S. 123, 140] ferred upon them by the stockholders, and was, therefore, ultra vires.
The statute directs that the board of directors shall 'first formulate such plan,' declare it 'advisable,' and call a meeting of stockholders to act on it. Without presenting for the consideration of the stockholders any workable plan of stock allotment, the directors, in effect, asked the stockholders to confer plenary authority on them to formulate a plan and to carry it into execution without any disclosure of its provisions. After the meeting, as before, no stockholder, not in the confidence of the directors, knew in what the plan consisted, who were the persons to participate in it, what principle was to control their selection or determine the amount of stock they were to receive, or the price they were to pay. It is a misuse of words of plain meaning to speak of such a proposal as a 'plan,' much less a formulated plan for stock allotment to employees, or as one which, in the form presented to the stockholders, the directors could have pronounced advisable or have carried into operation. It was no more than an invitation to stockholders to abrogate the discretion which the statute vested in them to approve a formulated plan, having at least some aspects of definiteness, and vest in the directors powers which could be conferred on them only by charter amendment in the manner prescribed by the statute. The invitation was accompanied by a skillfully phrased suggestion that it was necessary to accept it in order to hold the services of employees, and that, if accepted, the directors would cause new benefits to flow into the pockets of stockholders in the form of extra and increased dividends. Such a maneuver cannot rightly be regarded as a compliance with the plain language of the statute, which requires the directors first to formulate a plan for stock allotment and declare it advisable, and then to submit it to the stockholders for [288 U.S. 123, 141] their approval. If it were, it would be difficult to suggest any conceivable purpose of the statute which could not be thwarted by a similar procedure.
The respondents stand in no better position, even if we assume that the proposal submitted to the stockholders was a formulated plan, within the meaning of the New Jersey statute. For in that case, authority for the directors' action must be found in the stockholders' approval of the proposal which they submitted, and we must interpret the proposal and the action taken by the stockholders in terms of their legitimate expectation that the directors were complying with their duty as fiduciaries and not dealing with them at arm's length. They were entitled to read the proposal in the light of the fundamental duty of directors to derive no profit from their own official action, without the consent of the stockholders, obtained after full and fair revelation of every circumstance which might reasonably influence them to withhold their consent. Wardell v. Railroad Co., 103 U.S. 651 ; General Investment Co. v. American Hide & Leather Co., 97 N.J.Eq. 230, 233, 127 A. 659; see United States Steel Corp. v. Hodge, 64 N.J.Eq. 807, 813, 54 A. 1, 60 L.R.A. 742; Globe Woolen Co. v. Utica Gas & Electric Co., 224 N.Y. 483, 489, 121 N.E. 378; compare Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545, 62 A.L.R. 1; Wendt v. Fischer, 243 N.Y. 439, 154 N.E. 303. They were entitled to assume that the proposal involved nothing which did not fairly appear on its face and above all that it was not a cloak for a scheme by which the directors were to enrich themselves in great amounts at the expense of the corporation, of whose interests they were the legal guardians.
The respondents must, therefore, rest their case on the bare statement in their proposal to the stockholders that no employee or person actively engaged in the business of the company 'shall be deemed ineligible to the bene- [288 U.S. 123, 142] fits of the Plan,' because a director or officer. But it would be extravagant to say that these words, addressed by men in the position of trustees to their beneficiaries, gave warning of the wholesale gratuities which the directors subsequently bestowed upon themselves. No more extensive authority could be derived from this language than the disclosure which it made. By consenting that the directors should be 'eligible' to share in a plan avowedly for the benefit of employees, the stockholders did not consent that they should be the chief beneficiaries of their own unrestrained munificence, or that they should add any new bounties to the unrevealed stock allotments and bonuses which the directors had previously enjoyed in secrecy. Even if the stockholders consented that some of the directors should be eligible to benefit from action taken by other disinterested directors, they certainly did not consent that the allotments should be made by a group of directors who, because of the magnitude of the benefits they anticipated for themselves, were obviously incapable of passing an independent and unbiased judgment upon the propriety of the distribution which they co-operated in making to each other. Respondents' contention that if the directors were unable to vote on each other's participation no plan could be put into effect under which a majority of the directors were to participate, is without weight, for it obviously could be if the statute were followed and the plan revealed in its entirety to the stockholders.
To surmount these difficulties, respondents point to the fact that a representative of petitioner stated at the stockholders' meeting that favorable action on the proposal might result in the issuance of a large amount of stock to employees, including officers and directors, without adequate consideration, and that this did not induce the stockholders to express their disapproval. It is unnec- [288 U.S. 123, 143] essary to speculate whether this outcome is to be attributed to the fact that those present, being without the aid of prevision, regarded the prediction as too improbable to be credited, or to the fact that those who attended the meeting were not, for the most part, the stockholders, but the recipients of their proxies selected by the management of the corporation for the occasion. A statement made to them would, as a New Jersey court has said, fall 'upon ears not allowed to hear and minds not permitted to judge; upon automatons, whose principals are uninformed of their own injury.' See Berendt v. Bethlehem Steel Corp., 108 N.J.Eq. 148, 151, 154 A. 321, 322. In any event it is enough that neither in the notice of meeting and accompanying documents, which the stockholders saw and on which they relied, nor at the meeting itself, did the officers and directors disclose that such was their purpose.
We need not conjecture whether, if the directors had had the hardihood to disclose in advance the benefits which they were to award to themselves, the stockholders would nevertheless have given their approval. Nor is it important that these directors have successfully managed the corporation and that under their direction it has earned large profits for its stockholders. Their business competence did not confer on them the privilege of making concealed or unauthorized profits or relieve them of the elementary obligation which the law imposes on all corporate directors to deal frankly and openly with stockholders in seeking their consent to benefit personally by reason of their relationship to the corporation.
The directors, having failed to comply with petitioner's seasonable demand that they exercise their authority to bring this suit in the name of the corporation, petitioner was not required by general equitable principles or by Equity Rule 27 to appeal to the stockholders before bringing it, as the action complained of here was not one which [288 U.S. 123, 144] the stockholders could ratify. Continental Securities Co. v. Belmont, 206 N.Y. 7, 17, 99 N.E. 138, 51 L.R.A. (N.S.) 112, Ann. Cas. 1914A, 777; cf. Delaware & Hudson Co. v. Albany & Susquehanna R.R. Co., 213 U.S. 435 , 29 S. Ct. 540. Authority of the directors to bestow gratuities upon themselves in the form of subscription rights must be found in a plan approved in advance as the statute provides, by two-thirds of each class of stockholders. If no plan was presented to stockholders, as I think was the case, the entire stock issue was ultra vires and cannot be ratified any more than any other unauthorized disposition of corporate assets. If the proposal to the stockholders is regarded as a plan, so far as ordinary employees are concerned, as it plainly does not embrace authority to the directors to confer such extravagant benefits upon themselves, the result is the same, as to the stock allotted to the directors.
I cannot agree that a proper exercise of discretion requires us to deny to the petitioner the relief to which he is so clearly entitled. This is the first time that this court has held that a federal court should decline to hear a case on the ground that it concerns the internal affairs of a corporation foreign to the state in which it sits. We may assume, without deciding, that neither a federal nor a state court of equity will, as a general rule, undertake to administer the internal affairs of a foreign corporation. But the case before us is, in this respect, unlike a suit to dissolve the corporation and wind up its affairs, Wallace v. Motor Products Corp. (C.C.A.) 25 F.(2d) 655, 658; Pearce v. Sutherland (C.C.A.) 164 F. 609; Maguire v. Mortgage Co. of America (C.C.A.) 203 F. 858; cf. Burnrite Coal Co. v. Riggs, 274 U.S. 208, 212 , 47 S.Ct. 578; or compel the declaration of a dividend, Cohn v. Mishkoff-Costlow Co., 256 N.Y. 102, 175 N.E. 529, or interfere with the election of officers or the meetings of shareholders or directors, Wason v. Buzzell, 181 Mass. 338, 63 N.E. 909; State [288 U.S. 123, 145] ex rel. Lake Shore Tel. & T. Co. v. De Groat, 109 Minn. 168, 123 N.W. 417, 134 Am.St.Rep. 764; see Travis v. Knox Terpezone Co., 215 N.Y. 259, 263, 109 N.E. 250, L.R.A. 1916A, 542, Ann. Cas. 1917A, 387.
We are presented with no problem of administration. The only relief which the petitioner merits on the record before us or which he asks here is a decree that certain directors, now before the court, restore to the treasury of the corporation, also before the court, certain shares of stock alleged to have been illegally issued to them, and that certificates for the stock now in possession of the trusteees, who are likewise before the court, be surrendered. There are no more obstacles to the rendition of an effective decree than in any other case in which a stockholder seeks reparation for depredations upon the corporate property committed by directors, some of whom only are before the court. Compare Wineburgh v. United States Steam & Street Ry. Advertising Co., 173 Mass. 60, 53 N.E. 145, 73 Am.St.Rep. 261; Ernst v. Rutherford & B.S. Gas Co., 38 App.Div. 388, 56 N.Y.S. 403; Corry v. Barre Granite & Quarry Co., 91 Vt. 413, 101 A. 38; Ganzer v. Rosenfeld, 153 Wis. 442, 141 N.W. 121. The decree will be completely satisfied by delivery of the certificates, properly endorsed, to the corporation. There is and can be no suggestion that such a decree cannot be pronounced and enforced as effectively by the courts in New York as it could be by those in New Jersey. Cf. American Creosote Works v. Powell (C.C.A.) 298 F. 417, 419; see Babcock v. Farwell, 245 Ill. 14, 34, 91 N.E. 683, 137 Am.St.Rep. 284, 19 Ann.Cas. 74.
The opinion of the court concedes, as, indeed, the authorities which it cites show, that the decision does not rest upon any definite rule of general application. It is said that jurisdiction will be declined whenever considerations of convenience, efficiency and justice point to the courts of the state of the corporate domicile as appropriate tribunals for the determination of the particular [288 U.S. 123, 146] case. Such considerations are said to require that this suit be dismissed though the petitioner is thereby subjected to all the hazards of starting his action anew, in the courts of New Jersey.
To support this conclusion, only two objections to the maintenance of the suit are suggested in the opinion of this court or in that of the district court below. One is that numerous beneficiaries of the stock allotment, most of whom are not officers or directors of the corporation, are not made parties to this suit and presumably can be reached as a group only by suit in New Jersey. Hence, the intimation is, if we decide this case and other suits should subsequently be brought in other jurisdictions, different results may be reached on the same questions, a possibility which can be avoided by forcing the petitioner to bring a single suit in New Jersey. The other objection is that the court would be called upon to decide a novel question of New Jersey law.
As petitioner has chosen to assert demands necessarily restricted to the stock issued by the directors to themselves, he had no occasion to join as parties the several hundred lesser employees, the great preponderance of whom received allotments of less than fifty shares of stock. Indeed, as the unconscionable conduct of the participating directors, a major factor in this case, would afford no basis for proceeding against the other allottees, it is by no means certain that the suit would be cast in any different form if brought in New Jersey.
The somewhat speculative possibility that those of the participating directors who have not been served with process in this suit may be called to answer in some other court and exonerated is of slight importance compared to the considerations favoring the exercise of jurisdiction. Petitioner has chosen to bring his suit in New York. He and all but one of the individual defendants reside there. [288 U.S. 123, 147] The principal office of the American Tobacco Company is in New York City and it is there that its books and records are found, its board of directors meets and the acts complained of took place. There the respondent, Guaranty Trust Company, is located, and its cotrustee resides. Before the decree can be enforced it must be obtained and the litigation must be brought to a successful conclusion. That involves the production in court of the necessary evidence. Of the parties to this case none but the American Tobacco Company is amenable to process in New Jersey; all are amenable in the Southern District of New York. In New York, petitioner can compel them and others connected with the corporation to attend as witnesses; all can be ordered to make complete discovery; and petitioner can compel the production at the trial of the records of both corporate defendants. We cannot assume that compulsion will not be necessary. The tobacco company carried to the highest court of the state its resistance to petitioner's preliminary application to inspect its books. Rogers v. American Tobacco Co., 143 Misc. 306, 257 N.Y.S. 321, affirmed 233 App.Div. 708, 249 N.Y.S. 993, leave to appeal denied. In New York also the individual defendants and the trust company can be reached by injunction pendente lite, restraining the transfer to innocent purchasers of the stock, certificates for which are already issued and in the hands of the trust company. Under the circumstances of this case, only considerations of more compelling force than the possibility of inconsistent decrees should lead a forum, convenient in so many respects, to decline jurisdiction.
I come then to the only ground which can plausibly be urged for declining the jurisdiction-that in one, but not necessarily a conclusive aspect of the case, the court may be called on to decide questions of New Jersey law which, although novel, can hardly be said to be complicated or [288 U.S. 123, 148] difficult. If there were any principle of federal jurisprudence, generally applicable, that in cases between private parties federal courts of equity may, in their discretionD ecline jurisdiction because called upon to decide an unsettled question of state law, I would willingly acquiesce in declining it here. But this court has not declared such a principle and does not recognize it now. On the contrary, whether jurisdiction rests on diversity of citizenship or on a substantial constitutional question, this court has consistently ruled that it is the duty of a federal court of original jurisdiction, and of this court on appeal from its decree, to pass on any state question necessarily involved, however novel, and that the decision may be rested on that ground alone. Siler v. Louisville & Nashville R.R. Co., 213 U.S. 175 , 29 S.Ct. 451; Risty v. Chicago, R.I. & Pacific Ry. Co., 270 U.S. 378 , 46 S.Ct. 236.
Unless we are now to abandon that long settled practice, I can see much more reason for passing on this question than upon many others which this court has decided. Our judgment would conflict with no local decisions, compare Black & White Taxicab Co. v. Brown & Yellow Taxicab Co., 276 U.S. 518 , 48 S.Ct. 404, 57 A.L.R. 426; Burgess v. Seligman, 107 U.S. 20 , 2 S.Ct. 10; nor apply an alien policy to matters which are the subject of delicate feeling in the state. Compare Gelpcke v. City of Dubuque, 1 Wall. 175; Railroad Commission of California v. Los Angeles Ry. Corp., 280 U.S. 145 , 50 S.Ct. 71. Indeed, we may not even avoid deciding the question of state law by sending the case to New Jersey, for it is not suggested that if petitioner should elect to sue in the federal court for New Jersey, or if the suit should be properly brought there by removal from the state court, either that court or this may decline jurisdiction. Thus we should do no more in deciding the question of New Jersey law now than if the case were brought to us from the federal courts in New Jersey. [288 U.S. 123, 149] Even if decision of the question of New Jersey law were more embarrassing than it appears to be here, a proper exercise of discretion would seem to require that the bill be retained, and that an interlocutory injunction restraining any disposition of the stock by respondents be granted as prayed, pending the diligent prosecution by petitioner of a suit in New Jersey. Compare Mallow v. Hinde, 12 Wheat. 193; Dunn v. Clarke, 8 Pet. 1; Stover v. Wood, 28 N.J.Eq. 253.
If federal courts are to continue the general practice of deciding novel questions of state law whenever there are necessary or convenient grounds for the disposition of cases pending before them, there are peculiarly cogent reasons why there should be no departure from the practice in cases like the present. While a corporation in legal theory has only one domicile, in practice its activities are often nationwide and the legal domicile of the corporation, as in this case, is neither the place of its real corporate life nor the home of its officers and directors. Hence, if stockholders' suits, such as the present, are to be maintained with any hope of success, the practical necessities of making parties, securing evidence, obtaining the production of documents and relief by injunction against individual wrongdoers, justify, if they do not compel, their prosecution in the particular jurisdiction where necessary parties and witnesses may be found, rather than in the place of the technical corporate domicile.
Extension of corporate activities, distribution of corporate personnel, stockholders and directors through many states, and the diffusion of corporate ownership, separated from corporate management, make the integrity of the conduct of large business corporations increasingly a matter of national rather than local concern (cf. A. A. Berle, Jr. and Gardiner C. Means, The Modern Corporation and Private Property (1932)), to which the fed- [288 U.S. 123, 150] eral courts should be quick to respond when their jurisdiction is rightly invoked. We should be slow, indeed, to make a reluctance to decide questions of state law, not exhibited in other classes of cases, the ground for declining to decide this one.
BRANDEIS, J., concurs in this opinion.
Viewing the suit as one to reclaim the shares received by the directors in breach of their fiduciary duties to the corporation and the shareholders, I find no adequate reason for the refusal to exercise jurisdiction, and this though a different conclusion might be thought to be necessary if relief were to be given upon grounds affecting the validity of the issue as a whole.
In the circumstances of this case, the certificates allotted to the directors may be charged with a constructive trust, and surrendered to the corporation to be held in its treasury, without impeaching a single certificate other than their own.
There is no need to consider whether the 'plan' as proposed is insufficient on its face, with the result that the innocent employees as well as the culpable directors will be deprived of its benefits. If it be taken as sufficient, the shareholders who voted for it are not chargeable with notice that fiduciary powers would later be perverted by the award to the fiduciary of extraordinary benefits. Consent will not protect if reason and moderation are not made to mark the boundaries of what is done under its shelter.
I leave the question open whether in other circumstances or with other consequences there may be a cancellation of the shares of a foreign corporation in the absence of an adjudication by the courts of the domicile. Here the or- [288 U.S. 123, 151] ganic structure of the corporation, if affected by the decree at all, will not be changed in such a way as to work substantial detriment to any stranger to the suit, but the fruits of an unjust enrichment will be put back into the treasury. I think we are at liberty to do so much, if nothing more, without waiting upon the judgment of any other court.
The doctrine of forum non conveniens is an instrument of justice. Courts must be slow to apply it at the instance of directors charged as personal wrongdoers, when justice will be delayed, even though not thwarted altogether, if jurisdiction is refused. At least that must be so when the wrong is clearly proved. The overmastering necessity of rebuking fraud or breach of trust will outweigh competing policies and shift the balance of convenience. Equity, it is said, will not be over-nice in balancing the efficacy of one remedy against the efficacy of another when action will baffie, and inaction may confirm, the purpose of the wrongdoer. Falk v. Hoffman, 233 N.Y. 199, 203, 135 N.E. 243. Of the shares allotted to directors as contrasted with those allotted to other employees, most are owned by the defendants sued. Whatever shares belong to others will be untouched by the decree. With all the procedural complexities possible hereafter if jurisdiction be declined, the hazard of inconsistent judgments affecting the directors inter se will not avail without more to halt the processes of justice and the award of such relief as the court is competent to give against those subject to its power.
I agree with Mr. Justice STONE for the reasons stated in his opinion that a breach of the fiduciary duties of the directors is a legitimate inference from the allegations of the bill, and agree with his conclusion that the cause should be remanded to the District Court for a determination of the merits.
[ Footnote 1 ] Section 1 of that act provides for the participation of employees in purchase of stock, profits, welfare work, and management of any corporation organized under the laws of the state, and declares: 'Any stock corporation ... may, upon such terms and conditions as may be determined in the manner hereinafter designated, provide and carry out a plan or plans for any or all of the following purposes: (a) The issue or the purchase and sale of its capital stock to any or all of its employees and those actively engaged in the conduct of its business or to trustees on their behalf, and the payment for such stock in installments or at one time with or without the right to vote thereon pending payment therefor in full, and for aiding any such employees and said other persons in paying for such stock by contributions, compensation for services, or otherwise.' And section 2 provides: 'The board of directors shall first formulate such plan or plans and pass a resolution declaring that in its opinion the adoption thereof is advisable, and shall call a meeting of the stockholders to take action thereon. ... If two-thirds in interest of each class of stockholders present at said meeting and voting shall vote in favor of any such plan or any modification thereof, the said plan shall thereupon become operative.' (Comp. St. Supp. N.J. 47-183, 47-184.) And that section gives to any dissenting stockholder the right upon surrender to receive from the company the appraised value of any stock that was acquired before the passage of the act.

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If you feel like you have heard a lot more about prepaid rules this past year than you would have liked, there's a reason for that. NAFCU's compliance team has blogged, written an article (member-only) and released a final rule alert about the not so final, final prepaid rule and about the rule's delay that pushed the compliance deadline to April 1, 2018. But that is just the start, in the rule's delay announcement, the CFPB stated it would also review a couple of substantive issues through a separate notice and comment rulemaking process. So today's blog focuses on the CFPB's latest proposal to amend the final prepaid rule specifically in regards to the error resolution and limitation of liability sections; credit-related provisions to digital wallets; and certain other clarifications and minor adjustments.
The error resolution section of the final prepaid rule requires credit unions to promptly investigate a member’s notification of unauthorized EFTs on all prepaid accounts. The rule does contain a couple of timing and provisional credit variances if a credit union establishes a member identification and verification process and the member has not concluded or the credit union was unable to verify the member. See, 81 Fed. Reg. 83986. However, the credit union is still supposed to complete the investigation and credit members per the error resolution and liability sections of the rule. The CFPB received many comments from stakeholders on the error resolution and member liability requirements as the current Regulation E process for EFTs is already considered to be expensive and time consuming by many financial institutions.
So the bureau proposed to revise the error resolution and member liability sections to limit the error resolution requirements of Regulation E to verified prepaid accounts and to all verified and unverified prepaid payroll card or government benefit accounts. See, 82 Fed. Reg. 29632. While helpful, there is a caveat to this limit. If a member is later verified, the credit union would then have to resolve errors with regard to disputed transactions that occurred prior to verification and credit members, consistent with the timing requirements and liability limitations of the prepaid rule. The proposal is attempting to strike a balance between overly burdensome error resolution and liability provisions while still protecting as many consumers from fraudulent transactions.
What are these products exactly? Digital wallets are considered a "card, code, or other device that is capable of accessing two or more payment credentials for purposes of making payment for goods and services at multiple unaffiliated merchants." See, 81 Fed. Reg. 83967. Because of the final prepaid rule's broad definition of prepaid accounts, digital wallets can trigger both Regulation E and certain Regulation Z protections if the technology is capable of holding funds and accessing a separate credit feature. During implementation of the rule, it became apparent that there are some complications with applying the credit provisions of the prepaid rule to credit card accounts linked to digital wallets that can store funds where the credit card accounts are already subject to Regulation Z’s open-end credit card rules.
The credit card account is a credit card account under an open-end (not home- secured) consumer credit plan that a member can access through a traditional credit card.
The prepaid account issuer and the card issuer will not allow the prepaid card to draw, transfer, or authorize the draw or transfer of credit from the credit card in the course of authorizing, settling, or otherwise completing transactions conducted with the card to obtain goods or services, obtain cash, or conduct P2P transfers, except where the prepaid account issuer or the card issuer has received from the member a written request that is separately signed or initialized to authorize the prepaid card to access the credit card account as described above.
The prepaid account issuer and the card issuer do not condition the acquisition or retention of the prepaid account or the credit card account on whether a member authorizes the prepaid card to access the credit card account as described in proposed section 1026.61(a)(5)(iii)(D)(2).
The prepaid account issuer applies the same terms, conditions, or features to the prepaid account when a member authorizes linking the prepaid card to the credit card account as described above in proposed § 1026.61(a)(5)(iii)(D)(2) as it applies to the member's prepaid account when the member does not authorize such a linkage. In addition, the prepaid account issuer applies the same fees to load funds from a credit card account that is linked to the prepaid account as described above as it charges for a comparable load on the member's prepaid account to access a credit feature offered by a person that is not the prepaid account issuer, its affiliate, or a person with which the prepaid account issuer has an arrangement.
The card issuer applies the same specified terms and conditions3 to the credit card account when a member authorizes linking the prepaid card to the credit card account as described above in proposed § 1026.61(a)(5)(iii)(D)(2) as it applies to the member's credit card account when the member does not authorize such a linkage. In addition, the card issuer applies the same specified terms and conditions to extensions of credit from the credit card account made with the prepaid card as with the traditional credit card.
See, 82 Fed, Reg. 29649.
The CFPB's proposed rule would take effect concurrently with the general effective date of the prepaid rule—April 1, 2018. However, the bureau is considering whether this proposal will warrant an additional delay for the implementation of the prepaid rule so that credit unions and other industry stakeholders have time to modify disclosures and procedures or whether the proposed changes would eliminate the need for an additional delay.
These are just some of the proposed changes the bureau is seeking comments. So be sure to read NAFCU's Regulatory Alert (members-only) for more proposed changes and send us your comments so that we can ensure the soon-to-be final final prepaid rule makes sense for your credit union.
Programming Note. In recognition of Independence Day, NAFCU's offices will close early today at noon, and we will be closed on Tuesday, July 4. We'll reopen and be back to blogging on Wednesday. Have a safe and enjoyable holiday weekend… I know the Lyon household will be grilling and viewing the amazing D.C. fireworks!
Exceptions to the Prepaid Rule: What's Missing from the Buffet?
The CFPB’s final rule on prepaid accounts, which is the Bureau's version of all you can eat regulation, was issued near the end of 2016. We have previously blogged on the general application of the rule as well as the definition of a prepaid account. Today’s blog focuses on what's missing from the buffet.
Smaller credit unions have recently asked if the prepaid rule carved out an exception for smaller financial institutions. Unfortunately, the rule does not have an asset size threshold requirement for compliance with the prepaid rule. Hence all credit unions that are issuers of prepaid access will have to comply with the final rule. This requires providing the credit union’s prepaid account agreements to the Bureau for posting on the CFPB’s website on a rolling basis (not quarterly). See, 81 Fed. Reg. 84129.
the member can access credit (i.e. overdraft line of credit) from a covered separate credit feature offered in connection with a prepaid account.
See, 81. Fed. Reg. 84133. Nonetheless, credit unions will still be required to post the prepaid account agreements to their own website and to have the agreement readily available upon request. See, final 12 C.F.R. § 1005.19(c).
This is a great time to communicate with vendor providers of prepaid cards and outside packaging to establish who will lead the compliance efforts for the product so that the credit union can continue to issue prepaid cards to its members without fear of the approaching compliance deadline. After all, compliance cannot be outsourced, but credit unions may contractually require vendors to adhere to regulatory requirements to ease its compliance effort.
According to the most current 5300 call report on the NCUA’s webpage, only about 16% of credit unions issue prepaid cards. Other smaller credit unions however, choose to sell prepaid cards issued by a different financial institution or third-party service provider. Luckily for these credit unions, the CFPB drew a distinction between issuers of prepaid access and other institutions that merely sell prepaid cards.
issue prepaid accounts and agree to provide electronic funds transfer services.
See, 12 C.F.R. § 1005.2(i). Credit unions that merely sell prepaid cards but do not hold the accounts or agree to provide electronic funds transfers for these prepaid accounts would not meet the definition of a financial institution that issues prepaid accounts or access. Specifically, the prepaid rule states, “… the burden of and liability for complying with this final rule would generally fall on the financial institution that issues the prepaid accounts, not on the banks or credit unions selling those products.” 81 Fed. Reg. 83964.
If your credit union is only selling prepaid access, you may still want to review and familiarize yourself with the lengthy requirements of the rule. While the issuer of the card will be primarily liable for prepaid access compliance, the credit union may take an active approach to compliance and create a checklist of the disclosures and information that should be on and off the prepaid card and package to ensure members receive great service.
Is not a checking account, share draft account or negotiable order of withdrawal account.
An account established for distributing needs-tested benefits in a program established under state or local law, or administered by a state or local agency.
Prepaid account acting as a pass-through vehicle for funds. To satisfy § 1005.2(b)(3)(i)(D), a prepaid account must be issued on a prepaid basis or be capable of being loaded with funds. This means that the prepaid account must be capable of holding funds, rather than merely acting as a pass-through vehicle. For example, if a product, such as a digital wallet, is only capable of storing a consumer's payment credentials for other accounts but is incapable of having funds stored on it, such a product is not a prepaid account. However, if a product allows a consumer to transfer funds, which can be stored before the consumer designates a destination for the funds, the product satisfies § 1005.2(b)(3)(i)(D).
In other words, if a service merely operates as a digital wallet that stores payment credentials, the member cannot store funds, and the member cannot access the balance then it would not be a prepaid account. However, further commentary clarifies that to meet the definition of prepaid account, it is not necessary that the account be reloadable by the consumer or a third party. Official Interpretation 1005.2(b)(3)(i)—7.
As with many regulations, including existing Regulation E, the commentary is key here, so this blog is really just a glimpse as some of the intricacies in this 1,689 page rule – and does not even get to what products might be a “hybrid prepaid-credit card” that will be subject to certain provisions in Regulation Z. For more information, NAFCU members can find our Final Regulation summary of this rule here (log in required).
Seem like a lot? The CFPB must have thought so too, since the Bureau created a six page flowchart to help credit unions determine whether a particular product meets the definition of “prepaid account.” You can find it here and other Bureau resources here.
Black Friday. Instead of scrambling against the crowds at stores for discounts, on the day after Thanksgiving my parents and I took Nolan to nearby Great Falls National Park. He kept trying to climb over the railings, but it was a fun trip. Nolan also learned a new word this weekend - pie!
Happy Wednesday! I hope you all had a pleasant Columbus Day weekend, or, as we like to call it in my expat-Canadian household, Thanksgiving weekend. Yes, that’s right. Canadian Thanksgiving is in October. What else is different about Thanksgiving in Canada versus in the U.S.? Not much—just like in America, it’s all about turkey coma and pumpkin pie. Except instead of watching football we watch the Toronto Blue Jays sweep the Texas Rangers to advance to the American League Championship Series (Go Jays!).
Now that NAFCU’s Compliance team is back in the office, it’s time to start diving into CFPB’s new final rule on prepaid accounts (Prepaid Rule). The Prepaid Rule, which is a healthy 1,689 pages, mandates comprehensive consumer protections for prepaid accounts under Regulation E, which implements the Electronic Fund Transfer Act; Regulation Z, which implements the Truth in Lending Act; and the official interpretations to those regulations.
The final rule modifies Regulation E to create prepaid account provisions governing disclosures, limited liability and error resolution, and periodic statements. It also adds new requirements regarding the posting of account agreements. Additionally, the final rule regulates overdraft credit features that may be offered in conjunction with prepaid accounts. Such credit features, with some exceptions, will be covered under Regulation Z where the credit feature is offered by the prepaid account issuer, its affiliate, or its business partner and credit can be accessed in the course of a transaction conducted with a prepaid card.
The rule is effective October 1, 2017. However, the requirement (in § 1005.19(b)) for prepaid account issuers to submit their prepaid account agreements, which must satisfy the rule’s form and content requirements, to the CFPB for posting on its website is delayed until October 1, 2018.
The final rule was issued by the CFPB last Wednesday and NAFCU’s Regulatory Affairs team will be providing a detailed summary of the final rule shortly, which will be available to NAFCU members on our website (member login required). NAFCU issued a Regulatory Alert on the proposed rule in late 2014, which is currently available to members on our website (14-EA-27). The CFPB has also provided a new implementation web page. In the meantime, this post will provide a high-level overview of the scope of the “prepaid account” definition in the final rule.
The Prepaid Rule adds the term “prepaid account” to the definition of “account” in Regulation E. Accounts within the scope of the rule’s definition of prepaid account are subject to various requirements under amended Regulation E.
Definition. The criteria for whether an account is a prepaid account under the final rule are set forth in 12 CFR 1005.2(b)(3). See p. 1425-1427 of the Prepaid Rule.
An account that meets all of the following: (1) Is issued on a prepaid basis in a specified amount or is capable of being loaded with funds after issuance; (2) Whose primary function is to conduct transactions with multiple, unaffiliated merchants for goods or services, to conduct transactions at ATMs, or to conduct person-to-person (P2P) transfers; and (3) Is not a checking account, a share draft account, or a negotiable order of withdrawal (NOW) account.
An account established for distributing needs-tested benefits in a program established under state or local law or administered by a state or local agency.
Additionally, the P2P functionality of an account established by or through the U.S. government is not a prepaid account under the rule if the account’s primary function is to conduct closed-loop transactions on U.S. military installations or vessels, or similar government facilities.
Also, an account established for a commercial purpose is not a prepaid account because, under the existing definition of account in Regulation E, an account is subject to Regulation E only if it is established primarily for a personal, household, or family purpose. In addition, under the existing definition in Regulation E, an account held under a bona fide trust agreement is not an account subject to Regulation E; therefore, an account held under a bona fide trust agreement is also not a prepaid account.
It is important to note, however, that the definition of prepaid account is not limited to general purpose reloadable cards or prepaid products that otherwise function as transaction account substitutes.
CFPB has provided a flow chart that may help credit unions to determine if an account is a prepaid account under the final rule.
NAFCU’s Regulatory Compliance team is continuing to analyze the new Prepaid Rule to understand its full impact on credit unions. Stay tuned for more information in the coming weeks.
On March 21, 2016, the federal banking agencies, FinCEN, and NCUA issued interagency guidance on applying customer identification program (CIP) requirements to certain prepaid cards issued by banks, savings associations, or credit unions. In general, the guidance states that financial institutions should apply CIP to general purpose prepaid cards that provide a cardholder with the ability to reload funds or access to credit or overdraft features.
For purposes of complying with the CIP rule, the guidance states that banks and credit unions should treat the cardholder as the bank or credit union’s customer even if the cardholder is not the named account holder. This is typically the case when the prepaid program is run by a third-party intermediary who uses a pooled account to fund the prepaid cards. Therefore, the fact that the funds are held in a pooled account “should not affect the status of the cardholder as the bank customer, assuming the cardholder has established an account with the bank [or credit union] by activating the reloadable functionalities…” of the card.
The guidance also discusses how the CIP rule applies to specific prepaid card programs such as payroll, government benefit cards, and health benefit cards. For payroll cards, the guidance states that the bank or credit union should treat the employer as its customer and does not need to apply its CIP to each employee unless the card allows the employee to access credit through the card or reload the payroll card from sources other than the employer. In these cases, the bank or credit union would be required to treat the employee as its customer and apply its CIP to the employee.
For government benefit cards, the guidance reminds banks and credit unions that government agencies are not typically considered “customers” for CIP purposes and therefore the institution is not normally required to apply its CIP to government benefit cards. That being said, if the card program allows the cardholder-beneficiary to load non-government funds onto the card or provides access to credit, then a customer relationship is established and the institution must perform its CIP on the cardholder-beneficiary.
For health benefit cards, the guidance discusses CIP requirements for health savings accounts, flexible spending arrangements, and health reimbursement arrangements. Since employees typically establish health savings accounts, the guidance states that the bank or credit union should treat the employee establishing the account as the institution’s customer for CIP purposes. On the other hand, for flexible spending arrangements and health reimbursement arrangements, the guidance states that banks or credit unions should treat employer as the institution’s customer since no person other than the employer establishes these types of accounts.
Finally, the guidance notes that for banks or credit unions that work with third-party program managers that design, manage, and operate prepaid card programs, the institutions should have “well-constructed, enforceable contracts” with third-party program managers that clearly outline CIP obligations and ensure the bank or credit union has access to all CIP information collected by the third-party program manager.
Ultimately, it is unclear whether this guidance will be particularly useful to credit unions since credit unions may not typically provide services to nonmembers. For credit unions operating prepaid programs, these types of services are usually offered to members whose identities have already been verified at the time the member opened his or her initial share account. That being said, the guidance may be useful to credit unions that offer payroll cards to employees of their business members or for credit unions that may want to administer government benefit programs for state or local governments.
Programming Note: This is just a reminder that NAFCU will be closing at 12:00pm today in celebration of the holiday weekend. We wish a happy holiday to those of you and your families who may celebrate the holiday. Personally, I’m looking forward to the discounted candy sales on Monday.
Arbitration: The CFPB indicated that it will continue the rulemaking process to regulate the use of arbitration clauses, especially those that limit a consumer’s right to bring a class action.
Consumer Reporting: The bureau reported that it will continue to examine and investigate consumer reporting companies and furnishers of information, with a focus on accuracy and dispute resolution processes. The CFPB also stated that it may consider rulemaking around furnisher and consumer accuracy, dispute resolution, and related issues.
Mortgages: The CFPB has restated its commitment to ensure that the Home Mortgage Disclosure Act (HMDA) rule is successfully implemented, and that its supervisory and enforcement programs work to provide equal and fair access to mortgage credit. The CFPB also indicated a particular focus on implementing its mortgage servicing rules. Lastly, the bureau stated that it will begin to assess the effectiveness of significant rules that are already in place.
Overdraft: The bureau makes clear that it fully intends to move forward with the rulemaking process related to overdrafts, with a purported goal of making the overdraft market “fairer and more transparent”.
Small Business Lending: The CFPB confirmed its growing interest in small business lending, and lists its plan to build a small business lending team and begin “market research and outreach for a rulemaking on business lending data collection.” The bureau also indicated that it will continue to examine small business lenders for compliance with fair lending laws. As a reminder, Dodd-Frank amended the Equal Credit Opportunity Act (ECOA), requiring financial institutions to collect and maintain certain information in connection with credit applications submitted by women-owned, minority-owned or small businesses.
As a reminder, this will only be applicable to credit unions directly supervised by the CFPB- those with over $10 billion in assets. For those credit unions not subject to CFPB’s supervision, the priorities may nonetheless be a useful tool. The policy priorities can be found here. Credit unions are also advised to review NCUA’s Supervisory Priorities for 2016.
Home Mortgage Disclosure Act (HMDA) (Regulation C). The CFPB estimates that it will release a final rule amending Regulation C in August 2015. Under the HMDA proposed rule, depository and non-depository institutions meeting all other criteria under Regulation C, and which had originated 25 or more covered loans in the previous calendar year, would be required to report expanded HMDA data.
Prepaid Accounts Under the Electronic Fund Transfer Act (Regulation E) and the Truth in Lending Act (Regulation Z). The CFPB also anticipates that it will release a final rule on prepaid products in January 2016. The prepaid accounts proposed rule would establish new consumer protections for the prepaid market that would require market participants to limit consumers’ losses when funds are stolen or cards are lost, investigate and correct errors, provide free access to account information, and follow the practices of credit card protections if a credit product is offered in connection with a prepaid account. The CFPB also proposes new “Know Before You Owe” prepaid disclosures that would provide consumers with clear information about the costs and risks of prepaid products upfront.
The CFPB’s semiannual rulemaking agenda is available in its entirety here.
NAFCU Risk Management Seminar. Shameless Plug Alert! Join us in the Mile High City this summer, August 3-5, 2015, for critical credit union risk training. Developed in part by a taskforce of peers who are experts in the field, this new conference will give you a 360° view of the internal and external risks facing your credit union, and gain a better understanding of how to properly manage them. From credit and interest rate risk to compliance, strategic and reputation risk, NAFCU's new Risk Management Seminar will give attendees the tools needed to properly navigate the most serious risks threatening their credit union. Save $100 with promo code RISKSAVINGS. Offer ends 6/5/15. Click here to enroll.
It was no secret that the CFPB wanted to crack down on prepaid debit cards. After conducting studies, issuing advance notices of proposed rulemaking, and testing various disclosures regimes, at midnight last Thursday, the CFPB dropped a bomb on the prepaid community: a nine hundred page proposed rule on prepaid cards. In this blog post, I hope to capture the high points of the prepaid rule issued by the CFPB on November 13, 2014.
As I type this blog post, know that NAFCU’s Regulatory Affairs attorneys are working on summarizing the prepaid rule in a NAFCU Regulatory Alert. Once the Regulatory Alert is completed, NAFCU will publish it on our website (unfortunately, this is a member’s only publication).
Prepaid Expanded: The proposed rule defines “prepaid account” as a card, code, or other device that is capable of being loaded with funds, which is not otherwise an account under 12 C.F.R. 1005.2(b)(1), established primarily for personal, family, or household purposes, and is redeemable upon presentation at multiple, unaffiliated merchants for goods or services, or useable at either ATMs or for P2P transfers. The definition would specifically exclude gift certificate as defined in § 1005.20(a)(1) and (b); a store gift card as defined in § 1005.20(a)(2) and (b); a loyalty, award, or promotional gift card as defined in § 1005.20(a)(4) and (b); and a general-use prepaid card as defined in § 1005.20(a)(3) and (b) that is both marketed and labeled as a gift card or gift certificate.
Prepaid is the New Credit Card: The proposed rule imposes many credit card protections on to prepaid cards that allow users to spend more money than is deposited on the prepaid account. These protections include ascertaining the consumer’s ability to repay before credit is extended, monthly periodic statements (including the requirement to give users at least 21 days to repay their debt before charging interest or a late fee), limits on first-year total fees, late fee limits, and 45-day advance notice for interest rate increases. In addition to the protections listed above, the rule prohibits the extension of credit within the first 30-days of the consumer registering the prepaid card, and prevents lenders from offsetting a person’s account to pay their prepaid account. Even if consumers affirmatively opted-in to allow such a repayment, lenders are still subject to additional requirements: For instance, the lender cannot take funds more frequently than once per calendar month, and must wait 21 days after the mailing of the periodic statement.
Know Before You Owe: The proposed rule requires prepaid issuers to provide standard easy-to-understand disclosures. The CFPB envisions purchasers will first receive the short form (prior to purchase) and then the long form (after purchase). The proposed rule includes two model forms (safe harbor) that prepaid issuers can use, which discloses information like the monthly fee, fee per purchase, ATM withdrawal cost, and fee to reload cash onto the account. Too boot, the CFPB will be requiring that prepaid issuers post the long form on its website, and give the CFPB a copy of the long form so that the disclosures can be posted on the bureau’s website.
In addition, the proposed rule expands the existing Regulation E account opening disclosures for prepaid accounts by proposing that the new disclosures includes the listing of all fees (not just electronic fund transfer fees).
Liability and Error Resolution: Under the proposed rule, Regulation E liability and error resolution requirements are extended to prepaid accounts registered with the issue. The proposed rule does not apply to unregistered prepaid accounts if the risk of non-registration has been disclosed.
For those of you who are brave enough to read the entire prepaid proposed rule, you can be taken to all 900 pages of the proposed rule by clicking here. In addition to publishing the proposed rule, the CFPB issued a press release, which can be found here, and published comments by Director Cordray, which can be found here. Comments to the proposed rule are due 90 days from the date of publication in the Federal Register.
Prepaid Cards. Last week, the CFPB blogged about a couple of model prepaid card disclosures (Model Form 1 and Model Form 2) currently being tested with consumers. In its blog post, the CFPB provides examples of some of the current prepaid card disclosures out in the market, and suggests that the different styles and formats could make it difficult to find and compare important disclosure information.
The CFPB has had prepaid cards on its radar for some time. Back in May 2012 we blogged about a CFPB Advance Notice of Proposed Rulemaking (ANPR) seeking comments and information from the public about general purpose reloadable prepaid cards. The CFPB intends to issue a proposed rule later this spring addressing consumer protections for prepaid cards, including standardized disclosures.
NCUA Listening Sessions. Online registration is now open for NCUA listening sessions taking place this summer in Los Angeles, Chicago and Alexandria, Va. NCUA Chairman Debbie Matz and Board Member Rick Metsger will attend the sessions. The sessions provide an opportunity for credit union officials to discuss any topics related to the NCUA and are scheduled to take place before NCUA’s proposed risk-based capital rule is finalized. Registration is free, but space is limited and on a first-come, first-served basis. Click here to register.
Financial Literacy Webinar. NCUA is also hosting a free webinar on how credit unions can promote financial literacy. Topics to be covered include: the link between financial literacy and the credit union mission; NCUA financial literacy resources; tips on building a successful financial literacy program based on credit union size and specialized member demographics; information about improving financial literacy efforts through the creation of key local and national financial literacy partnerships; and the Treasury Department’s recent financial literacy pilot research program.
This free webinar will be held on Thursday, April 3, 2014, at 2 p.m. EDT. Register here.
Below are just a couple short items to help you ease into the upcoming long weekend.
CFPB ANPR on Prepaids. The CFPB's ANPR was published today in the Federal Register. Comments are due by July 23, 2012. NAFCU members - our Regulatory Affairs team will have a Regulatory Alert out in the near future.
For more on prepaids, the CFPB's press release is here and Director Cordray's speech is here.
NCUA Grants and Loans. Credit unions with a low-income designation might want to take a look at NCUA grants and loans through their Community Development Revolving Loan Fund (CDRLF). NCUA has a YouTube video with additional details on the program.
Volunteer Income Tax Assistance. (emphasis added).
Additional information on the process can be found in Letter to Credit Unions 12-CU-04 and the Enclosure (which includes the grant guidelines).
NCUA's May Economic Update. NCUA has a new Youtube video with their May 2012 Economic Update.
Flood Insurance. The NAFCU Today has the latest on a possible Flood Insurance extension. If you are interested in having the NAFCU Today emailed to you each day, you can sign up here. The NAFCU Today is open to everyone who is interested.
Prepaid Cards Field Hearing. The CFPB recently announced a field hearing on prepaid cards - which will be held today in Durham, North Carolina starting at 12:00 p.m. EDT. The CFPB's blog indicates to check back if you want to view the live broadcast. [As of now, there is no link to the feed. But, past live feeds were available here if you want to try around noon].
Upcoming Prepaid Card Regulation. In conjunction with today's field hearing, the CFPB announced its intent to regulate the prepaid card market. The CFPB announced an Advanced Notice of Proposed Rulemaking (ANPR) which is an initial step in the rulemaking process and is usually one where an agency gathers information about the market - prepaid cards in this situation - in anticipation of future regulation.
In addition to the ANPR, the CFPB issued a Fact Sheet on Prepaid Cards and a Ask CFPB: Prepaid Cards search function on their website.
By the way - it is good to see the CFPB's website is capable of having a search bar! I can't wait until they upgrade to the third version of their website and provide a search bar to help credit unions and other entities find the information they need.
NAFCU Webcasts. NAFCU has a full slate of webcasts for June. Remember, all of NAFCU's events and conferences are open to anyone - this includes webcasts.
June 27 - BSA for Experts - Registration available soon!
Regulatory Compliance Seminar. Also, don't forget to look at NAFCU's 2012 Regulatory Compliance Seminar in Seattle, Washington. Save $100 when you register by August 31st! For potential topics, check out this past blog post.