Category: Corporate law

Illinois House Bill Requires Corporations to Report to Secretary of State

House Bill 3394, approved by the Governor on August 27, 2019 and effective immediately (Public Act 100-589), amends the Business Corporation Act of 1983 (“BCA”) to add new Section 8.12 and amend Section 14.05.

New BCA Section 8.12 provides that domestic and foreign corporations, as soon as possible but not later than January 1, 2021, to report to the Secretary of State, on its Annual Report:

  1. Whether the corporation is a publicly held domestic or foreign corporation with its principal executive office located in Illinois
  2. Data on specific qualifications, skills and experience that the corporation considers for its board of directors, nominees for the board of directors and executive officers
  3. Whether each member of the corporation’s board of directors self-identifies as a minority person and, if so, which race or ethnicity to which the member belongs
  4. Other information

New BCA Section 8.12 also requires the Secretary to State to make the information public and report the information to the University of Illinois which is to review the reported information and publish, on its website, a report that provides aggregate data on the demographic characteristics of the boards of directors and executive officers of corporations filing an annual report for the preceding year along with an individualized rating (establish by the University of Illinois assessing the representation of women and minorities on corporate boards)  for each such corporation. The University of Illinois’ is also required to identify strategies for promoting diversity and inclusion among boards of directors and corporate executive officers.

BCA Section 14.05 as amended adds new Sections 14.05(k) and 14.05(l).  New BCA Section 14.05(k) requires each corporation or foreign corporation to state on its Annual Report whether the corporation has outstanding shares listed on a major United States stock exchange and is thereby subject to the reporting requirements of new BCA Section 8.12.  New BCA Section 14.05(l) requires corporations subject to new BCA Section 8.12 to provide the information required by new BCA Section 8.12.

It is our understanding that Form 14.05, Illinois Annual Report, is currently being amended to reflect these changes.

© Horwood Marcus & Berk Chartered 2020. All Rights Reserved.

For more on corporate reporting requirements, see the National Law Review Corporate & Business Organizations law page.

California Board Gender Quota Law Challenged In Federal Court

Cydney Posner at Cooley LLP wrote last week about a new challenge to California’s Board Gender Quota law.  The lawsuit, Creighton Meland v. Alex Padilla, Secretary of State of California, was reportedly filed in federal district court in California by a shareholder of OSI Systems, Inc.  According to OSI’s most recently filed Form 10-Q, the company is incorporated in Delaware, its principal executive offices are in California, and its shares are traded on The Nasdaq Global Select Market.  The lawsuit alleges violation of the equal protection clause of the Fourteenth Amendment and seeks declaratory and injunctive relief.

As this case progresses, one question might be whether the plaintiff’s claim is direct or derivative.  OSI is not named as a party to the lawsuit and the plaintiff alleges that the law injures his “right to vote for the candidate of his choice, free from the threat that the corporation will be fined if he votes without regard to sex”.  The Delaware Supreme Court’s test for whether a stockholder’s action for breach of fiduciary duty is derivative or direct asks two questions:

“Who suffered the alleged harm–the corporation or the suing stockholder individually–and who would receive the benefit of the recovery or other remedy?”

Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004).  Although the corporation will be fined and the fine suffered by all of the stockholders, the plaintiff is alleging that he is being injured by being denied the freedom to vote without regard to sex.  Presumably, that injury would be removed if the law is enjoined.

Interestingly, OSI does not appear in the California Secretary of State’s listing of SB 826 corporations published earlier this year.  According to the proxy statement filed by OSI last month, all of the current directors are men, but a female has been nominated for election at the upcoming meeting.

© 2010-2019 Allen Matkins Leck Gamble Mallory & Natsis LLP

More on Corporate Board diversity rules on the Corporate & Business Organizations law page of the National Law Review

How to Write Gender-Neutral Contracts

“Men” is not synonymous to “person”, nor does “he” mean “she.”  It is important for contractual language to be not only precise but also accurate.  Many agreements govern multiple individuals, some of whose gender is unclear or variable.  This article will give you advice and guidance on how to adjust contract language to be gender-neutral.  As society moves towards treating all genders equally, legal contracts should too.

What is gender?

Gender is the socially constructed characteristics of “male” and “female” and includes norms, roles, and relationships of and between groups of men and women.

What is gender-neutral?

Merriam-Webster defines gender-neutral as “not referring to either sex but only to people in general.”

Why it matters:

Conversations around gender and gender-neutrality are becoming more and more mainstream.  Thomson Reuters reported that in the past year (2018), there has been an increase in the number of clients requesting gender-neutral documents.  Startups are at the forefront of change and industry disruption, so it is logical that they stay ahead of the trend.

As you operate business, there are a number of form contracts that you will use regularly.  These form contracts are agreements your attorney drafts with brackets and spaces for you to update depending on each use.  For example, common form contracts include (1) Employee Offer Letters, (2) Confidentiality, Nondisclosure, and Assignment of Inventions Agreements, (3) Equity Incentive Plan, (4) Stock Option Grants, and (5) Restricted Stock Purchase Agreement.

Traditionally, these form contracts used masculine pronouns.  It used to be that progressive contracts simply did not use “he” but rather “she” or “he or she.”  As Thomson Reuters reported:

“In the old days it was almost certain that your senior employees would be men; a contract would be drafted accordingly, and then the ladies would be given a metaphorical pat on the head by including in the boilerplate the reassurance that references to the male gender should be interpreted to include the female.”

Now, the shift towards non-gendered pronouns and away from binary choices of “he” or “she” means attorneys need to adopt new drafting techniques.  As entrepreneurs and leaders of your own business, you can encourage this shift.

What to do:

Replace the masculine pronoun with an article, for example using “the position” in place of “his position”

  1.  Use a neutral word or phrase such as “person” or “individual”

  2. Define the term and repeat that noun

  3. Rewrite the sentence in order to eliminate the pronoun completely

What to be wary of (for now):

  1. Using the singular “they” and its other grammatical forms to refer to indefinite pronouns and singular nouns, for example using “they” in place of “she” and “them,” “themselves,” and “their” in place of “her,” “herself,” and “hers.”

    1. Part of drafting a contract is using precise language.  While there is rising social acceptance of the use of singular “they,” a court has not ruled on its interpretation in contracts.  Likely, it will take legal precedent in Delaware interpreting such use to accept the use of the singular “they.”

    2. This same logic applies to the use of the singular “ze.”

  2. Using the plural “they.”

    1. Similarly, the use of the plural can be misleading.  For an employment offer letter, for instance, the offer is not to a number of people but rather to one individual.

  3. A catch-all clause like “Unless the context otherwise requires, a reference to one gender shall include reference to the other genders”

    1. It was offensive when the use of male pronouns were supposed to encompass women and men. Such use effectively reinforced gender stereotypes.  It is equally offensive when it is used to refer to all genders.

Gender neutrality facilitates accurate, precise contracts.  It is important that an individual who is subject to a contract feel as though the contract applies to that individual.  In addition, that individual should also feel respected.

©1994-2019 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.

ARTICLE BY Kati I. Pajak of Mintz.

Corporate Closedown Does Not Shield Boss From Potential TCPA Culpability

So, your corporation is sued under the Telephone Consumer Protection Act (TCPA). One defense strategy if you are the founder and sole owner: cease operations, terminate your employees, close your offices, formally dissolve the corporation and live in British Columbia. No potential individual exposure for TCPA violations in Alabama – right?

Not so fast, said the United States District Court for the Northern District of Alabama in Eric K. Williams v. John G. Schanck. 2019 U.S. Dist. LEXIS 151778, Case No.:5-15-cv-01434-MHH, decided September 6, 2019. Mr. Williams originally sued Stellar Recovery, Inc., a company founded and solely owned by Schanck, for collection calls made to the plaintiff’s cellphone in Alabama. Mr. Schanck then told the Court in a telephone conference call that “Stellar Recovery had dissolved and did not intend to participate in this lawsuit.” Mr. Williams moved to amend his complaint to add Mr. Schanck individually and Judge Madeline Hughes Haikala granted his motion.

But, wait a minute, countered Mr. Schanck. Service of the amended complaint on me in Vancouver, British Columbia does not afford the Court personal jurisdiction. Furthermore, Mr. Williams is too late because he added me as a defendant after the four-year TCPA statute of limitations had passed. So, Mr. Schanck moved to dismiss under Federal Rules of Civil Procedure (FRCP) 12(b)(2) and 12(b)(6), respectively.

The Court was unconvinced on both counts.

First, on the jurisdictional issue, the Court examined whether Mr. Schanck’s alleged contacts with the State of Alabama were sufficient to satisfy specific jurisdiction (i.e., “contacts within the forum state give rise to the action before the court”). Mr. Williams asserted that Mr. Schanck “guide[d], over[saw], and ratifie[d] all operations of…Stellar” and knew of the “‘violations of the TCPA alleged’ in the complaint and ‘agreed to and ratified such actions of his company.’” Indeed, throughout the complaint, Mr. Williams contended that “Stellar acted on behalf of Defendant Schanck.”

Mr. Schanck did “not challenge the factual allegations concerning his ownership interest in Stellar or his managerial control over the company.” Rather, he contended that the “corporate shield doctrine” precluded the Court from exercising jurisdiction over him. However, Judge Haikala noted that the “express language of the TCPA allows actions against corporate officers who authorize TCPA violations” and Mr. Williams “has alleged just that – that Mr. Schanck directed and authorized the alleged TCPA violations that purportedly occurred in this District.” Motion to dismiss for lack of personal jurisdiction under FRCP 12(b)(2) denied.

Second, the Court also dispensed with the statute of limitations issue. The Court concluded that the claim against Mr. Schanck as an individual arose out of the “conduct, transaction or occurrence set forth or attempted to be set forth in the original pleading.” Under such circumstances, the claims in the amended complaint could relate back to Mr. Williams original complaint.

But, Mr. Schanck argued, Mr. Williams knew about him and his status in Stellar yet chose only to sue the latter. Therefore, there could have been no mistake on his part about the “identity” of the proper party (i.e., Mr. Schanck) to sue and the FRCP 15(c) requirements regarding the timing of serving Mr. Schanck as a new defendant were not met.

Correcting Mr. Schanck’s application of that requirement, the Court noted that the issue was not about Mr. Williams knowledge, but “whether Mr. Schanck himself knew or should have known that he would be named as a defendant ‘but for an error’” by Mr. Williams. And at this stage, “if Mr. Williams contentions about Mr. Schanck’s involvement with Stellar prove correct,” then Mr. Schanck “reasonably should have known that he would be named as a defendant but for an error.” Motion to dismiss for failure to state a claim under FRCP 12(b)(6) denied.

So some TCPAWorld lessons learned about the solidity of the “corporate” shield when one person allegedly runs the company show.

© Copyright 2019 Squire Patton Boggs (US) LLP

“Broken Link in the Chain of Liability”: MTCA Decision Highlights Intricacies of Corporate Law

Last week, in a decision highlighting the overlay of environmental and corporate law, a Washington federal district court dismissed claims seeking remediation costs, attorneys’ fees, and a declaratory judgment on liability under the Model Toxics Control Act (MTCA) by the current owner of a service station in Cle Elem against Chevron Corp., Chevron USA, Inc., and unnamed “predecessor companies and subsidiaries.” Short Stop Shell, LLC v. Chevron Corp., No. 1:19-cv-03103-RMP, Dkt. No. 43 (E.D. Wash. Aug. 27, 2019) (Order Granting in Part & Denying in Part Defendants’ Mot. to Dismiss & Denying Plaintiff’s Mot. for Summ. J.). The court rejected the allegation that the Chevron entities were corporate successors to Texaco, Inc., which was believed to be responsible for contamination at the service station.

The court’s findings reflect a limitation on the sweeping liability under MTCA and similar statutes, the relevance of corporate transactions in minimizing such liability, and the potential difficulty of identifying proper corporate defendants before filing lawsuits for cost recovery at contaminated sites.

Site Background – Petroleum Contamination at Service Station

The claims alleged that, until 1984, Texaco owned and operated the service station where contamination had been disposed or released at the property. In 2000, Texaco agreed to indemnify an owner of the service station for “actual petroleum contamination originating from the Property in excess of clean up levels [that] originated from Texaco’s operation of a gasoline … facility … or from deliveries of motor fuels to the station ….” Then, in 2001, Chevron Corp. acquired Texaco in a “reverse triangular merger.”

The plaintiff acquired the property in 2012, decommissioned several underground storage tanks alleged to be leaking, and incurred over $275,000 in remediation costs.

Court Decision – “Broken Link in the Chain of Liability”

Ultimately, the court concluded that the “reverse triangular merger,” in which Texaco merged with a subsidiary of Chevron Corp., did not cause Chevron to assume Texaco’s liabilities. Rather, Texaco remained a “separate entity” as a Chevron subsidiary and Chevron was not a successor to Texaco’s liabilities. The Court found further that suing unnamed defendants was a “disfavored practice” and agreed to strike the “John Doe”-style pleading that included a general reference to the defendants’ “predecessor companies and subsidiaries.”

The court also rejected a judicial estoppel theory that the defendants had already accepted liability “through their actions,” which included interactions between Chevron EMC, a Chevron subsidiary “that manages environmental matters for affiliated companies, including Texaco,” and Ecology. Notably, the court determined that even if, in an ambiguous exchange with Ecology in 2003, Chevron had accepted “potentially liable person status,” that such an acceptance did not amount to a “representation” that the defendants had “expressly assumed Texaco’s liabilities.”

However, litigation is likely to continue. In order to “properly allege a theory of liability,” the court granted the plaintiff leave to incorporate allegations in an amended complaint that the defendants “delivered gasoline products to tanks” that they “knew were leaking.”

© 2019 Beveridge & Diamond PC
For more in environmental contamination, see the National Law Review Environmental, Energy & Resources law page.

Can The Secretary Of State Refuse To Enforce California’s Board Gender Quota Law?

The constitutional infirmities of California’s novel board gender quota law have been remarked on by everyone from former Governor Jerry Brown to the legislative consultants who prepared bill analyses.  Now there is a pending constitutional challenge.  See Legal Challenge To California Board Gender Quota Law Filed.  In the meantime, should Secretary of State continue to expend funds to administer and enforce a law that is constitutionally suspect?

It is doubtful that the Secretary of State may refuse to enforce the law even if he concludes that it is unconstitutional.  The reason lies with Article III, Section 3.5(a) of the California Constitution which provides:

“An administrative agency, including an administrative agency created by the Constitution or an initiative statute, has no power:

(a) To declare a statute unenforceable, or refuse to enforce a statute, on the basis of it being unconstitutional unless an appellate court has made a determination that such statute is unconstitutional;”

The California Constitution does not define “administrative agency” and it thus may be argued that this provision does not apply to a constitutional officer per se.  However, a panel of the Court of Appeal has assumed that the Secretary of State is subject to the policy, if not the letter, of Article III, Section 3.5(a). Stirling v. Jones, 66 Cal. App. 4th 277, 288 n.3 (1998).  The California Supreme Court granted, and then withdrew, review of the case.  At the request of the Secretary of State, the Supreme Court ordered the depublication of the case.  Stirling v. Jones, 1998 Cal. LEXIS 6656.

© 2010-2019 Allen Matkins Leck Gamble Mallory & Natsis LLP
Read more about board diversity on the National Law Review Corporate & Business Organizations law page.

Delaware, Consent, And The Adequacy Of Email Notice

Since the turn of this century, Delaware has allowed corporations to give notices to stockholders by electronic transmission.  8 Del. Code § 232(a).  However, the statute is conditioned upon the stockholder’s consent.  California has a similar consent requirement in Corporations Code § 20.  Delaware is now proposing to amend Section 232 to permit a corporation to give notice by electronic mail unless the stockholder has objected.  See Senate Bill No. 88.  The bill would also define “electronic mail” for the first time.

As I was pondering these changes, I came across the following observations about the adequacy of email notifications penned by the estimable and eminently quotable Justice William W. Bedsworth of the California Court of Appeal:

“Email has many things to recommend it; reliability is not one of them. Between the ease of mistaken address on the sender’s end and the arcane vagaries of spam filters on the recipient’s end, email is ill-suited for a communication on which a million dollar lawsuit may hinge.  A busy calendar, an overfull in-box, a careless autocorrect, even a clumsy keystroke resulting in a ‘delete’ command can result in a speedy communication being merely a failed one.”

Lasalle v. Vogel, 2019 Cal. App. LEXIS 533 (footnote omitted).  Justice Bedsworth’s comments were directed to the adequacy of email notice before taking a default judgment and not the Delaware bill.  Nonetheless, his concerns about the adequacy of email are entirely opposite to stockholder notice.

 

© 2010-2019 Allen Matkins Leck Gamble Mallory & Natsis LLP
Read more about Corporate Law on the National Law Review Corporate & Business Law page.

Seller Beware? 4 Key Features of Business Sale Transactions that Sellers Should be Familiar with Before Negotiating

You have prepared your business for sale and have determined an enterprise value with which you are comfortable. Perhaps you have already found a buyer and signed a letter of intent, or at least agreed in principle on the overall purchase price for the business.

While determining the overall value of your company is an important step, negotiating the final terms of the business sale is just as important and oftentimes is far more arduous. Some business owners, especially first-time sellers, are surprised by the complexity of the sale process and are unprepared for negotiating through the many common provisions that affect how, when, and even if the full purchase price is ultimately disbursed to the seller.

This article analyzes key deal terms of a business sale and provisions that affect the timing and ultimate payment of the purchase price. This article also reviews the responsibilities of the parties after the deal closes, so that sellers can anticipate what the buyer is likely to demand and how to negotiate from a position of strength. It is important for sellers to keep in mind that nearly all of the items described here are designed to allocate risk. Buyers want to receive the value they expected from purchasing the business and allocate risk to the seller if there is an unexpected obstacle in the transition to new ownership. Sellers want to avoid business-related risks after closing and retain as much of the full purchase price as possible.

Understanding these key provisions allow sellers to identify early in the process which provisions may be more or less risky based on their understanding of the business, which provisions to prioritize, and how to build a negotiating platform that fits their expectations and goals. Sellers should consult with financial and legal consultants for the most recent market trends and figures related to the topics in this article.

Feature #1: Economic Terms.

Generally, buyers want to avoid going after a seller post-closing to recover funds already disbursed because the funds may no longer be available; to accomplish this, buyers want to maintain control over some portion of the purchase price funds until their window for making claims against the seller has expired. This section outlines common economic terms in purchase agreements that affect the timing of payments to the seller and portion of the overall price ultimately paid by the buyer.

Escrow Holdback. A certain portion of the purchase price will be placed in escrow at closing and held for a period of time in order to fund post-closing claims against the seller without requiring the buyer to go directly after the seller for proceeds already disbursed. The escrow holdback is usually a key provision of the deal and heavily negotiated by both parties given the funds in escrow are at risk and not available to the seller until the escrow holding period expires. The amount of funds held in escrow will vary depending on deal size, industry, business risk, negotiating leverage and other factors.

Escrow Holding Period. In connection with the amount of funds held in escrow, sellers should consider the amount of time that is acceptable to the seller for the escrow funds to be unavailable to the seller at risk for buyer claims. A longer holding period can often be a trade-off on the part of the seller to get a better position on a different priority during negotiations, but the seller must balance their short-term cash needs against the longer holding period. The escrow holding period can range from months to a few years after the closing date.

Target Working Capital. The seller is generally expected to provide working capital to fund the operations of the business immediately after closing, and the seller and buyer should work together to come to a realistic working capital number. At closing, the buyer will calculate the actual working capital in the business using an agreed-upon formula, at which time the parties will “true up” the working capital to match their agreed-upon target number. If the actual working capital at closing is deficient compared to the agreed-upon target working capital, the seller must pay the difference to the buyer. If the actual net working capital is in excess of the targeted amount at closing, the buyer will pay the excess amount to the seller, increasing the seller’s proceeds from the business. Keep in mind that working capital adjustments, unless otherwise agreed to, are generally considered separate from indemnity claims and are usually paid within 90 to 120 days after closing.

Set-off Rights. A purchase agreement may contain broad set-off rights in favor of the buyer, allowing the buyer to set-off funds owed to the seller but still in the buyer’s possession (such as working capital excess, or earned but unpaid earn-outs) against claims the buyer has against the seller. Setoffs are another way for buyers to mitigate risk by controlling funds.  Sellers should be careful that set-off provisions are consistent with indemnity provisions to avoid having more funds at risk than anticipated.

Earn-outs. The parties may agree to pay a portion of the purchase price in future year earn-outs, such as annual bonuses to the seller for meeting certain financial metrics in post-closing business operations. Buyers may favor earn-out provisions if the seller is going to remain an employee of the ongoing business, as it aligns interests in working toward the continued success of the business. For sellers, earn-outs can be a great way to negotiate a better purchase price and push a portion of the seller’s tax liability into future years; however, the benefits must be balanced against the likelihood of meeting the earn-out metrics and the seller’s short-term financial needs. An earn-out can also bridge the gap if the parties disagree about the value of the business.

Feature #2: Indemnification.

Indemnification provisions provide the buyer recourse against the seller for post-closing expenses and liabilities resulting from the seller’s misrepresentations or inaccuracies when providing the buyer with information (or withholding material information) during due diligence. As discussed further below, buyers will often try to expand their indemnity coverage through various legal provisions.

Representations and Warranties (RWs). RWs are assurances that the seller makes and on which the buyer relies when purchasing the business and are the basis for the buyer’s indemnification claims after taking over operations. A seller’s breach of RWs resulting in costs to the buyer triggers indemnification claims to recover the damage caused by the seller’s breach. RWs are generally divided into two types: fundamental and non-fundamental.

  • Fundamental. RWs are critical to the buyer’s willingness to consummate the transaction, and which, if breached, usually call into question the legitimacy or enforcement of the entire business sale. Breaches of fundamental RWs carry higher indemnification liability for the seller in order to place the buyer in a position as if the transaction never occurred. Fundamental RWs commonly include representations regarding ownership of the business equity, authority to enter into the transaction, and non-existence of other ownership claims against the business. They may also include other key issues or risks that the buyer feels are especially important to the deal.

  • Non-fundamental. RWs are statements and disclosures made by the seller that the buyer relies on for a smooth transition of ownership and operations of the business immediately after the closing date; generally, this includes all RWs made by the seller in the purchase agreement that are not fundamental RWs.

Ideally, sellers will want to make as few fundamental RWs as possible; the goal is to (i) limit the seller’s top-end exposure to a handful of statements that the seller is generally comfortable making, and (ii) cap the remainder of its aggregate liability to the indemnity cap amount. Sellers can be creative in reducing the number of fundamental representations they need to make by working with buyers to find alternative ways to mitigate buyer risk and seller liability; for example, exploring insurance options can be a sound strategy.

Indemnity Threshold. The indemnity threshold sets the minimum amount of aggregate damages a buyer must accrue against a seller before the buyer can recover any damages for indemnity claims. There are two main types of indemnity threshold:

  • Deductible. The “deductible” method of indemnity operates much like consumer insurance. The buyer must absorb all aggregate damages up to the “deductible” (indemnity threshold) amount, and the seller indemnifies the buyer for all claims in excess of the indemnity threshold.

  • First Dollar. The first dollar method of indemnity requires the seller to pay all damages once the buyer’s aggregate damages reach the threshold amount. Illustratively, this can be thought of as a tipping bucket. The buyer must “fill” the bucket with damages against the seller. Once the amount of damages fills the bucket (reaches the indemnity threshold amount), the bucket “tips” and all damages down to the “first dollar” become the liability of the seller.

Ideally, sellers want the deductible type of indemnity threshold because it reduces their overall risk. However, sellers may be able to leverage a concession on first dollar indemnity in exchange for a higher threshold amount, which can ultimately produce a better outcome because the likelihood of any liability is reduced as the threshold amount increases. Additionally, sellers should try to negotiate indemnity threshold provisions in tandem with other indemnity provisions.

Indemnity Cap. Whereas the indemnity threshold sets the minimum amount of damages a buyer must accrue before the seller is liable, the indemnity cap limits the maximum amount the buyer can recover due to the seller’s breach of RWs. The indemnity cap is often a heavily negotiated provision, as it caps the risk for the seller, and conversely, raises the cost to the buyer for the most expensive seller breaches. For fundamental representations, the indemnity cap usually equals the full purchase price of the business. For non-fundamental representations, the indemnity cap is commonly a fraction of the deal value. Matching the indemnity cap to the escrow holdback amount can provide benefits to both parties: the buyer does not need to recover any funds directly from the seller; and, barring breach of a fundamental representation, the funds disbursed to the seller at closing are not at risk.

Indemnity Period. The indemnity period is the amount of time that the buyer has to make a claim against the seller for breach of the seller’s RWs. Generally, fundamental representations survive until, at minimum, the statute of limitations expires on the underlying claim. For example, if one of the seller’s fundamental representations is that all taxes have been timely paid, the indemnity period for the seller’s tax representations might be the time limit that the IRS could audit or bring a claim for unpaid tax liability accrued through the closing dates.

Non-fundamental representations often have a much shorter indemnity period, which may match the escrow holding period or expire according to some other defined schedule, usually not longer than a couple of years after closing. Sellers want the shortest possible indemnity period; however, defining which RWs are fundamental versus non-fundamental may be more productive than spending negotiating capital on shortening the indemnity period, where there is often less room to maneuver.

Feature # 3: Legal Provisions.

This section covers terms only a lawyer could love—obscurely worded and buried deep in the bowels of the purchase agreement far removed from the exciting topics like financial terms; however, these legal provisions affect the overall application of the economics and liabilities of the deal, which can have sweeping consequences for the seller if not properly understood and negotiated.

For sellers, ideally both of the terms discussed below – knowledge disclaimers and materiality scrapes – would be removed from any purchase agreement; however, transaction trends show that about half of all purchase agreements contain at least one of these legal provisions, if not both. Depending on the seller’s negotiating leverage, they may have to decide whether to walk away from the deal or get comfortable with these provisions and try to use them as leverage for a better position on other negotiating points.

Knowledge Disclaimers/Sandbagging Provisions. Knowledge disclaimer provisions (commonly referred to as “sandbagging” provisions) generally prescribe that a buyer’s right to recover from a seller is not affected by the buyer’s knowledge, whether by the seller’s disclosure or the buyer’s own due diligence, of the inaccuracy or noncompliance by the seller of a representation or warranty. Stated more simply, the buyer is saying to the seller, “Even though we knew about the inaccuracy of your representations before we closed the deal, we can still sue you for any damages resulting from those misrepresentations after closing.” From the buyer’s point of view, this encourages proper due diligence and may be added protection. From the seller’s perspective, this makes due diligence an expensive but largely meaningless exercise, wherein buyers can identify deal flaws but consummate the transaction anyway and then sue the seller post-closing.

From a practical standpoint, sellers can mitigate this risk by properly disclosing exceptions to their RWs in disclosure schedules, which are incorporated into the purchase agreement and make the seller’s RWs accurate with the incorporated disclosures.

Materiality Scrape. A materiality scrape is a stand-alone provision that purports to eliminate materiality qualifiers from some or all other provisions of the agreement when: determining a breach of a seller representation or warranty; assessing damages for a breach; or both.

Because this concept is a legal art form, the following example will illustrate how this provision operates: The seller represents to the buyer that the company is in material compliance with all required permits at the date of closing. The company requires a permit to store a barrel of industrial cleaning chemicals that the business uses infrequently in its operations. Right before closing the seller files a renewal application for the chemical permit, but the application is filed three days late which results in the buyer being assessed a $20 late application fee after closing when the permit is finally processed and renewed.

Generally, this breach would not be considered material, as the permit is likely not material to operations and the permit is not adversely affected by a late renewal application. Additionally, the damages ($20) would also not be material, as it is a very small amount relative to the business’ day-to-day expenses and operations. Therefore, the seller would not have breached its representation regarding permit compliance. However, if the purchase agreement contains a materiality scrape, then for purposes of determining a breach of the permit compliance representation, we would ignore the word “material” and in theory the buyer would have a claim against the seller for each technical breach of the seller’s RWs, including permit compliance. Additionally, if the materiality scrape also affects the determination of damages, the buyer would include every damage claim, no matter how small (including the $20 late fee in our example above), to its aggregate claims against the seller, potentially filling the indemnity threshold bucket much faster than if only material claims were considered.

In fact, materiality scrapes can have the effect of filling the indemnity threshold quickly, so a seller may want to try to mitigate this risk by pushing for a higher indemnity threshold as a tradeoff.

Feature #4: Ancillary Documents.

Depending on how the business sale is structured, there may be substantial ancillary documentation in connection with the transaction, such as transition agreements, consulting agreements, employment agreements, shareholder agreements, and non-competition/non-solicitation agreements, to name a few. Although an in-depth review of these agreements is outside the scope of this article, it is important for sellers to analyze how the ancillary documentation operates in connection with the purchase agreement and how it affects the financial goals of the seller, such as illiquidity of assets, inability to re-enter the market, ongoing obligations or liabilities, and liquidation event triggers that are out of the seller’s control, among others.

For example, if the seller receives the buyer company’s stock as partial consideration for the sale of the business, the seller will likely be required to execute a shareholders agreement which may contain “black out” periods or call options where a buyer can force the seller to sell their shares. Sellers should not wait until just before closing to review and negotiate the terms of ancillary documentation; instead, sellers should request drafts of and review any other ancillary documentation concurrently with the purchase agreement so that all terms of the deal can be analyzed together in connection with the seller’s overall strategy.

Conclusion

When preparing to sell a business, the big issues, such as finding the right buyer and company valuation, are key considerations; however, the terms of the sale can be just as important for the seller, especially as it relates to ongoing risk and short-term financial planning. Buyers want the benefit of their purchase and prefer to hold back some portion of the purchase price until their window for bringing claims against the seller expires. Sellers want to ultimately receive the full purchase price and feel secure in moving on after closing without the threat of claims against their proceeds.

By preparing for key purchase agreement terms ahead of time, sellers can identify which terms to prioritize, which terms to sacrifice for negotiating leverage, and areas where creative solutions may be appropriate. And perhaps more importantly, sellers can plan the terms of the deal around their financial needs and expectations.

Copyright © 2019 Ryley Carlock & Applewhite. A Professional Association. All Rights Reserved.
This post was written by Jessica Ann Benford and Joshua J. Hencik.

What Start-ups Need to Know About Intellectual Property

As any entrepreneur is well aware, the early stages of a new business venture are an incredibly busy time. Entrepreneurs must focus on building the core team, structuring the company, attracting investors, developing the product/service, and developing key partnerships, sales channels and marketing plans. These tasks are typically all-consuming for the founders, taxing both their financial and time resources.

During this time, it may be a challenge to simultaneously focus on intellectual property issues.  However, this early time period is also a critical time for ensuring that a business takes steps to protect its core intellectual property and avoids the risk of third party intellectual property issues. Today, more than ever, having a solid understanding of intellectual property and developing an IP strategy that aligns with the business is a crucial part of building a new venture on a solid foundation.

This article includes an overview of the different types of intellectual property and provides advice to start-up companies on how to secure their own intellectual property as well as protect against intellectual property risks from others.

The three basic types of intellectual property that startups should understand are:

  • Patents
  • Trademarks
  • Copyrights

Patents

Not every startup business will be best-served by investing its resources in building a patent portfolio, but the question of whether to pursue patent protection warrants a hard and early look. Knowledge of the role of patents is critical for two reasons:

  • To protect your own business and inventions from your competitors
  • To avoid the risk of being exposed to assertions of patent infringement by competitors and other third parties

It is important for startups to understand the different kinds of patent protection and how they fit into their business.

Utility patents can be obtained for processes, machines, articles of manufacture, or compositions of matter that are deemed new, useful and non-obvious. The traditional subject matter of such utility patents covers tangible, technical inventions, such as improvements to client-server systems, motors, radios, computer chips and various technical product features. For example, Boeing’s US Patent No. 6,227,447 is a patent that covers methods of remotely controlling a vehicle. Patents can also be directed at new product features and functions. As another example, Facebook’s US Patent No. 8,171,128, titled “Communicating a newsfeed of media content based on a member’s interactions in a social network environment,” protects its News Feed feature.

A separate category of patent, the design patent, may be sought to protect ornamental (non-functional) designs. Some examples of notable design patents include Apple’s D 604,305 covering the design of its iPhone interface and Lululemon’s design patent covering its yoga pants.

The role of patents

Although patents are the most expensive and time-consuming type of intellectual property to obtain, they also provide the best scope of protection. A patent provides its holder with the exclusive right to make, use or sell an invention.  This means that it can exclude a competitor from making or selling the patented invention, irrespective of whether or not the competitor copied the invention or even previously knew of the patent.  For this reason, a patent that covers an important feature that drives consumer demand and/or distinguishes one’s product or service from that of competitors, can be very valuable.

Benefits of patents for a young business

Patents may provide a number of benefits to young businesses. For example, a robust patent portfolio or a key patent can help attract investors, since it may serve as barrier to entry by competitors. Furthermore, the filing of a patent application will enable the company to advertise “patent pending” along with its product or service.  In addition to potentially attracting investors, the “patented” or “patent pending” labels may deter would-be competitors, or force those competitors to adopt different designs and technologies.

As indicated above, once a patent issues it may be used to stop competitors from entering the field and allows for recovery of damages for infringement. Patents can also help the finances of a business by providing an opportunity to generate revenue from licensing.

How to obtain a patent

A patent is obtained by filing an application with the United States Patent and Trademark Office. The application includes a description of the invention accompanied by drawings, followed by a list of the elements that form the invention, called the patent claims. The patent claims set out the metes and bounds of the invention.  Third-party products or services that practice the elements of a claim infringe the patent.

When a patent application is first filed, an examiner is assigned to it. The examiner will reject or allow claims based on an assessment of their patentability, and the patent applicant will have an opportunity to respond to the examiner’s decisions. This back-and-forth with the Patent Office, known as prosecution, can take a number of years and is best done by an experienced patent attorney who understands the procedures, the legal requirements and the art of drafting strong patent claims.

Impact of the America Invents Act

Changes in the patent law implemented by the America Invents Act (AIA) half a decade ago have impacted the leading practices for businesses looking to file for patent protection. First, the U.S. is a “first inventor to file” system. This incentivizes early disclosure of inventions and early filing of patent applications.

When two people independently come up with the same invention, the first inventor to file for a patent on his or her invention is awarded the patent, regardless of which actually invented first. For this reason, it is important for businesses to streamline operations to reduce the time from invention to filing of patent applications.

Early and cost-effective filing can be achieved through provisional applications, which are essentially invention disclosures that can be converted to full patent applications within one year.

In addition, the AIA also provides for a prioritized examination procedure, which expedites the patent examination process. While the use of prioritized examination is more costly up-front, it may reduce overall legal expenses, since a patent can be obtained within one year.

Avoiding infringement of other patents

A second important aspect that startups should consider with respect to patents is a defensive one, i.e., avoiding infringement of the patents held by others. As a matter of practice, startups should conduct a patent search to verify that their business is free of patents that could be asserted against their product or service. The up-front cost of performing this search and related analysis is relatively minor and is offset by the potential for huge savings, both in terms of litigation costs and wasted investment in an infringing idea. The cautionary tale of Vlingo underscores this point.

Vlingo spent years developing voice recognition technology that led to talk of partnerships with Google and Apple. However, another voice recognition company, Nuance, which held a patent on voice recognition, sued Vlingo for patent infringement. Although Vlingo ultimately won the lawsuit, by then the company had already lost its potential partnerships, and the cost of defending the suit forced Vlingo to sell its business to Nuance. An early patent search could have revealed the Nuance patent and may have allowed Vlingo to take appropriate strategic steps to address the issue. For example, they might have been able to adopt a different design to avoid a run-in with Nuance.

Trademarks

Trademarks take us into the world of branding.  Trademarks serve to build brand awareness and business goodwill. They can impart consumer confidence in a product by its association with a brand the consumer recognizes and trusts. A trademark can be words, symbols, logos, slogans or product packaging and design that identify the source of goods or services. The Coca-Cola logo is one of the more famous trademarks.

Unlike patents, trademark rights are only acquired through use. Even without registration, the symbols “TM” or “SM” may be used to accompany trademarks or service marks to designate products or services. However, only registered marks may be accompanied by the “®” symbol.

Although registration with the US Patent and Trademark Office is not required to gain trademark rights, registration provides certain important benefits to the trademark holder. For example, without a registration, the trademark rights are limited to the geographic area in which the product or service is marketed and sold, and protection begins only after the product or service is available for sale on the market.

In contrast, federally registered marks provide nationwide rights. Registration also creates a prima facie case of validity of the ownership as well as an exclusive right to use the mark for specified goods or services. Once registered, the owner of a mark can stop importation of infringing products through U.S. Customs.

Clearing and registering key trademarks

Just as with patents, when seeking trademarks, businesses should be aware of whether their desired name, logo or domain name is already in use by others. Searching for existing uses is known as trademark clearance, with the goal being to “clear” a desired mark for use. Clearing the name and brand early on will reduce the likelihood of problems down the road.

Startups should look to protect their brand early by clearing and registering key trademarks. Registration is relatively quick and inexpensive, generally a few thousand dollars for a clearance search and subsequent filing for registration. A trademark application must specify the type of mark — i.e., whether the mark consists of just words or includes a stylized design or even an identifying color or sound. The application must also specify the particular goods or services to which the mark will apply.

As the company grows, it will become increasingly important to police infringing uses of its marks. Such efforts will help ensure that the business is not losing customers due to confusion with knock-offs.

Copyrights

Copyright is a form of intellectual property that protects the expression of ideas. Books, music, art, photographs, architecture and even computer software can be protected by copyright.

However, while copyrights protect the expression of ideas, they do not protect ideas or concepts themselves. For example, a copyright can protect a particular photograph of a bird, but others may still create their own photographs of the same type of bird.

Another requirement for copyright eligibility is that the work must be “an original work of authorship.” Facts, titles, phrases, and forms per se cannot be copyrighted.

Exclusive rights to copyright owners

Like trademarks, copyright registration is optional. As soon as a work is written or recorded or otherwise made “tangible”, it is considered to be copyrighted. US law provides various exclusive rights to copyright owners, including the rights to reproduce the work, prepare derivative works and distribute copies, irrespective of registration.

However, registration provides significant procedural benefits. Critically, registration is necessary in order to file a lawsuit for copyright infringement. It is also necessary to receive certain remedies, such as statutory damages and attorney fees. Registration also provides a presumption of originality and ownership, and it allows US Customs to stop the importation of infringing or counterfeit works.

Businesses should include the “©” symbol or the word “Copyright” on all distributed materials. They should also include the year of first publication, the name of the owner, and the language “All rights reserved.”

Businesses should consider registering any important materials so that the option of filing lawsuits is available to address infringement. Registration can be filed online with the US Copyright Office for a nominal fee.

Startups should also be careful to avoid using third-party photos, music, or writings on their website, marketing materials or products. Such use could lead to a potentially costly infringement dispute with the copyright holder.

Finally, because the author is the copyright owner by default, startups should take steps to ensure that they receive the rights to any copyrightable work created by employees or third-party contractors. The Copyright Act lists specific requirements for works for hire, and employment and third-party contractor agreements should include specific language to address ownership of any copyrightable works.

Conclusion

While intellectual property issues may sometimes get brushed aside during the early stages of a business, developing a diligent and intelligent IP strategy early on is important.

Startups should evaluate the types of intellectual property that can impact their business and strategically consider pursuing patent, trademark and copyright protection as appropriate.

Defensively, startups should also assess the intellectual property landscape of their business. That awareness should include clearance efforts to ensure that the company will not infringe the intellectual property of others, as it develops its products and services.

Learn more about Legal Issues for High-Growth Technology Companies. 

© 1998-2018 Wiggin and Dana LLP

Legal Issues for High-Growth Technology Companies: The Series

High-growth technology companies face a unique set of challenges and roadblocks that their leaders must address in order to continue to expand and compete. This article series is intended to provide high-growth companies with a roadmap on how to navigate many of the interdisciplinary legal issues they might face during a particular stage of their life cycle. Below is a preview of what this series will cover. The articles that are currently available are hyperlinked and include:

Please check back in with us over the next couple of months for updates as we plan to publish the remainder of the articles on a regular basis.

Choice of Entity: Tax Implications

This post by Peter Gruen and Amy Drais will provide a high level overview of the tax implications of each type of entity from a variety of perspectives: taxation of the entity, taxation of its owners and employees and concerns of potential investors. The entities to be discussed are limited liability companies, partnerships, C corporations and S corporations.

What Start-Ups Need to Know About Intellectual Property

Today, more than ever, having a solid understanding of intellectual property and developing an IP strategy that aligns with the business is a crucial part of building a new venture on a solid foundation.  Michael Kasdan’s article will provide an overview of the different types of intellectual property and provide advice tailored to start-up companies on how to both secure your own intellectual property while protecting against intellectual property risks from others.

What Security to Sell to Investors and Why it Matters

Your business is ready for a financing—what security will you issue?  There’s no one right answer and not surprisingly, your investors get to have a say as well. This article by Evan Kipperman and Adam Silverman will discuss the pros and cons of various types of securities an early stage company may sell during a financing, including preferred equity, convertible debt, debt, and lesser known vehicles such as the SAFE and KISS documents.

Risk Considerations in Commercial Contracts with Customers

As an emerging company goes to market with new offerings, it will need to determine the terms and risk profile on which it will sell its services and products. Many companies develop terms of use (generally for products or services provided or sold through the web) or contract templates. An emerging company will want to have terms that are consistent with market norms for the relevant industry and are “sellable” to customers, but are protective of the company’s interests and go-to-market strategy. Having balanced terms can reduce negotiation time and energy, allowing the company to get customers and close sales more quickly. This article by Sarvesh Mahajan focuses on three key area of risk that typically need to be considered in offering services and products: warranties, indemnification, and liability.

Cybersecurity: Starting Your Company with Sound Data Privacy and Security Strategies

In the wake of recent privacy and security issues at major U.S. platforms, the climate for privacy regulation may be changing.  Recent revelations concerning Facebook’s dealings with Cambridge Analytica have regulators on both sides of the Atlantic considering tighter rules for data sharing and secondary data use by social media platforms and their ecosystems of app developers, analytics firms and other business partners.  In addition, the enforcement of the European Commission’s strict General Data Protection Regulation (“GDPR”) also portends a new era of heightened monitoring and enforcement of consumer privacy rights in the global digital economy.  Emerging technology companies with data-driven business models can expect increasing scrutiny of their data practices by users, investors, the plaintiffs’ bar and regulators.   How can emerging companies and startups, with limited resources, focus their efforts to prepare effectively for a heightened regulatory and due diligence environment for data privacy?  The article by John Kennedy will focus in particular on key privacy and security practices that regulators have emphasized and on the usefulness of following principles of privacy and security ‘by design.’

Wage and Hour Law Fundamentals: A Guide for Early Stage Companies

Even early stage companies need to be proactive when it comes to employee relations issues.  In this article Mary Gambardella and Lawrence Peikes will discuss fundamentals in the wage and hour area, including proper job classifications (exempt/non-exempt; independent contractors); pay practices; timekeeping; and equal pay laws.

The Battle for Patent Eligibility in a Changing Landscape

Over the last five years, the United States Supreme Court has changed the landscape of patent eligibility with its decisions in Mayo Collaborative Servs v Prometheus Labs, Inc (132 S Ct 1289 (2012)) and Alice Corp Pty Ltd v CLS Bank Int’l (134 S Ct 2347 (2014)).  While patent eligibility was not a primary focus in the life sciences area, the Supreme Court decisions and their progeny have sent shock waves through the life sciences field.  Numerous biotech and diagnostic patents have been found to be ineligible under the threshold patent statute.  This article by Sapna Palla addresses the changing landscape and key court decisions, suggests new avenues for companies to navigate the changed landscape and provides practical guidelines for companies in protecting and enforcing patents in the life sciences area.

You’ve Been Sued: What to Do (and Not Do)

Your company is doing well and building momentum, but then you get hit with a lawsuit.  What do you do, and what shouldn’t you do?  Litigation doesn’t have to be the death knell of a growing company, but it (and its cost) can quickly spiral out of control if not handled properly.  This article by Joe Merschman will provide an overview of litigation and explore issues to consider when your company is faced with a lawsuit.

Are You an Exporter? You Might Be.  The Often Overlooked Controls on Software with Encryption Capacity

Given the common use of encryption in software today, and an increasingly global market for software products, it is important for companies, particularly emerging ones, to recognize that software with cryptographic functionality is controlled by U.S. export law.  The consequences of not recognizing the export compliance obligations associated with encryption products could be costly, and not only because regulators might catch a company breaking the law (and have the power to impose penalties even for unintentional violations).  Start-ups being acquired by larger companies may have to disclose non-compliance with export law in the due diligence process leading up to purchase, forcing money into holdback escrows to serve as security for the buyer, which will inherit liability for any violations and understandably look to shunt any successor liability and compliance expenses to the seller in the deal.  Luckily, avoiding this outcome is relatively easy, if a company making or selling software expends minimal effort to: (1) know if their product is of the type that concerns the U.S. government; and (2) satisfy their export compliance obligations, which may amount to little more than submitting an annual “self-classification” report to the government by email. Daniel Goren  and Tahlia Townsend explore these issues.

Estate Planning for Founders

Founders have unique needs that necessitate proactive estate planning as early in a company’s existence as possible in order to maximize tax and liquidity options.  This article by Michael Clear and Erin Nicolls will discuss the intersection of the personal planning and startup lifecycle, as well as various milestones for estate planning that impact tax efficiency, business continuity, and asset management and protection.  We will focus on transfer tax strategies to minimize the effect of estate and gift taxes and to set the Founder on a financial path for future success.

Blinded by the Price: From Enterprise Value to Net Payment at Closing

In the sale of a business, the difference between the headline purchase price and the net payment to the equity holders can be significant.  Seller may have negotiated an attractive multiple to determine enterprise value.  But the presence of rollover equity stakes, deferred purchase price, escrows and purchase price adjustments, as well as payments to third parties in connection with payoff of indebtedness and other debt-like items, transaction bonuses, advisor expenses and other deal-specific amounts, may mean that some amounts will come off the top before equity holders get paid. Understanding whether certain items should (or should not) be paid at closing, and why (or why not) is fundamental to structuring the transaction appropriately. James Greifzu and Aaron Baral discuss these issues.

 

© 1998-2018 Wiggin and Dana LLP.