Tag: Corporate Law

SEC Proposes to Clear-Up Clearing Agencies’ Governance to Mitigate Directors’ Potential Conflicts of Interest

Clearing agencies registered with the Securities and Exchange Commission (SEC) will have to make governance changes to their boards of directors under a new rule proposed by the SEC on August 8, 2022.

The SEC proposed the new rule1 to mitigate the conflicts of interests inherent in clearing agency relationships. The rule follows episodes of market volatility in 2021 that included large fluctuations surrounding COVID-19 and the meme stock craze.

The new rule would amend Section 17Ad-25 of the Securities Exchange Act of 1934 (Exchange Act) to require additional management and governance requirements for clearing agencies that register with the SEC. The proposed rules provide specific new governance requirements on clearing board composition, independent directors, nominating committees and risk management committees. The rule also requires the board to oversee relationships with critical service providers and includes a board obligation to consider various stakeholder views and inputs.

Rationale

The SEC’s rationale for proposing Rule 17Ad-25, titled Clearing Agency Governance and Conflicts of Interest, is to reduce the risk that conflicts of interest inherent in various clearing agency relationships substantially harm the security-based swaps or larger financial market. The SEC is proposing this rule to mitigate conflicts of interest, promote the fair representation of owners and participants in the governance of a clearing agency, identify responsibilities of the board, and increase transparency into clearing agency governance.

The SEC noted that those episodes of increased market volatility revealed certain vulnerabilities in the US securities market and the essential role clearing agencies play in managing the risk if securities transactions fail to clear.

The SEC observed three potential sets of conflicts of interest that the proposed rule attempts to address.

  1. The proposed rule addresses the different perspectives the various stakeholders involved in clearing agencies might have. In particular, a clearing agency owner’s potential interest in protecting the equity and continued operation of the clearing agency diverges from a participant’s potential interest in avoiding the allocation of losses from another defaulting participant. For instance, in the event of a loss, clearing agency participants might prefer to limit access to clearing, while owners may choose to expand the scope of products offered to collect fees.

  2. Larger clearing agency participants’ priorities may diverge significantly from the interests of smaller clearing agency participants. In particular, when a small number of dominant participants exercise control over a registered clearing agency concerning services provided by that clearing agency, those participants might promote margin requirements that are not commensurate with the risks they take, thereby indirectly limiting competition and increasing profit margins for themselves. In other words, a registered clearing agency dominated by a small number of large participants might make decisions designed to provide them with a competitive advantage.

  3. Certain participants may exert undue influence to limit access to the clearing agency based on their own interests, and thus could limit the benefits of the clearing agency to indirect participants.

Rule Requirements

The proposed rule would impose these seven requirements:

  1. define independence in the context of a director serving on the board of a registered clearing agency and require that a majority of directors on the board be independent, unless a majority of the voting rights distributed to shareholders of record are directly or indirectly held by participants of the registered clearing agency, in which case at least 34 percent of the board must be independent directors;

  2. establish requirements for a nominating committee, including with respect to the composition of the nominating committee, fitness standards for serving on the board, and documenting the process for evaluating board nominees;

  3. establish requirements for the function, composition, and reconstitution of the risk management committee;

  4. require policies and procedures that identify, mitigate or eliminate, and document the identification and mitigation or elimination of conflicts of interest;

  5. require policies and procedures that obligate directors to report potential conflicts promptly;

  6. require policies and procedures for the board to oversee relationships with service providers for critical services; and

  7. require policies and procedures to solicit, consider, and document the registered clearing agency’s consideration of the views of its participants and other relevant stakeholders regarding its governance and operations.

The proposing release will be published on SEC.gov and in the Federal Register. The public comment period will remain open for 60 days following publication of the proposing release on the SEC’s website or 30 days following publication of the proposing release in the Federal Register, whichever period is longer.

FOOTNOTES

1 https://www.sec.gov/rules/proposed/2022/34-95431.pdf

Article By Susan Light of Katten. Jacob C. Setton, an associate in the Financial Markets and Funds practice and candidate for admission to the New York State bar, also contributed to this advisory.

For more SEC and securities legal news, click here to visit the National Law Review.

©2022 Katten Muchin Rosenman LLP

Supreme Court’s Decision In Famous Hale & Norcross Mining Case

Having read Professor Stephen Bainbridge‘s post about the origins of the judicial doctrine that directors must act on an informed basis, I passed along a reference to the California Supreme Court’s in Fox v. Hale & Norcross Silver Mining Co.,  108 Cal. 369, 41 P. 308 (1895).   The Hale and Norcross mine was a famous silver and gold mine in Nevada’s Comstock mining district.  Samuel Clemens (aka Mark Twain), who had worked in Virginia City, Nevada, even bought shares in the mine on margin, as he related in Chapter 15 of his autobiography:

“One day I got a tip from Mr. Camp, a bold man who was always making big fortunes in ingenious speculations and losing them again in the course of six months by other speculative ingenuities. Camp told me to buy some shares in the Hale and Norcross. I bought fifty shares at three hundred dollars a share. I bought on a margin, and put up twenty per cent. It exhausted my funds. I wrote Orion [his brother and the first and only Secretary of the Nevada Territory] and offered him half, and asked him to send his share of the money. I waited and waited. He wrote and said he was going to attend to it. The stock went along up pretty briskly. It went higher and higher. It reached a thousand dollars a share. It climbed to two thousand, then to three thousand; then to twice that figure. The money did not come, but I was not disturbed. By and by that stock took a turn and began to gallop down. Then I wrote urgently. Orion answered that he had sent the money long ago–said he had sent it to the Occidental Hotel. I inquired for it. They said it was not there. To cut a long story short, that stock went on down until it fell below the price I had paid for it. Then it began to eat up the margin, and when at last I got out I was very badly crippled.”

Samuel Clemens disappointing investment predated by a number of years the litigation that resulted in the California Supreme Court’s opinion.

The Hale and Norcross mine was located in Nevada, but the corporation that owned it was incorporated in California.  That is why the shareholders sued the directors in the Golden, rather than the Silver, state.  The Supreme Court’s decision was big news.  The day after the decision was issued, The San Francisco Call published this lengthy article that not only described the case, but also published the decision itself and a drawing of the plaintiff, M.W. Fox.

Article By Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP

For more Supreme Court and litigation legal news, click here to visit the National Law Review.

© 2010-2022 Allen Matkins Leck Gamble Mallory & Natsis LLP

Why More Than One Commodity May Not Be Commodities

A plural form of a noun usually implies a set having more than one member of the same type.  For example, a reference to “dogs” is understood to refer to more than one dog.  No one understands a reference to “dogs” to mean a dog, a cat and a mouse.  That is not necessarily the case, however, under the California Corporations Code.

Section 29005 of the Corporations Code defines “commodities” to mean “anything movable that is bought or sold”.  Section 29504 assigns a much broader definition to the singular term “commodity”:

“Commodity” means, except as otherwise specified by the commissioner by rule or order, any agricultural, grain, or livestock product or byproduct, any metal or mineral (including a precious metal set forth in Section 29515), any gem or gemstone (whether characterized as precious, semiprecious, or otherwise), any fuel (whether liquid, gaseous, or otherwise), any foreign currency, and all other goods, articles, products, or items of any kind.  However, the term “commodity” shall not include (a) a numismatic coin whose fair market value is at least 15 percent higher than the value of the metal it contains, or (b) any work of art offered or sold by art dealers, at public auction, or through a private sale by the owner of the work of art.

Putting these two definitions together, it is possible for a multiple items to be “commodities” even though a single item is not a “commodity”.  For example, a numismatic coin of the requisite value would not be a “commodity” even more than one such coin would meet the definition of “commodities”.   The explanation for these seemingly inconsistent definitions is that they are found in two different laws.  “Commodities” is defined in California’s Bucket Shop Law while “commodity” is defined in the California Commodity Law of 1990.

Article By Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP

For more corporate law legal news, click here to visit the National Law Review.

© 2010-2022 Allen Matkins Leck Gamble Mallory & Natsis LLP

Which Business Entity is Right For You: Sole Proprietorship, Partnership, LLC, C-Corporation, or S-Corporation?

Introduction

Are you getting ready to launch your business? Or maybe you’re currently operating one and wondering what legal structure is best to use. There are a number of different legal entities to choose from. And each has its own set of pros and cons.

To determine which business entity is the best fit, you’ll want to see which one most applies to your situation and then carefully go over the pros and cons. It’s also a great idea to speak with your tax professional and an attorney.

Some things that will affect your decisions, and your long-term success, are liability protection, taxation, the complexity of management, annual requirements, and the ability to raise money from investors, if applicable.

What are the options?

New businesses in the US have a choice of five basic structures:

  • C-Corporation
  • LLC (Limited Liability Company)
  • S-Corporation
  • Sole Proprietorship
  • Partnership (aka General Partnership)

You’ll want to learn about each business structure and decide which best suits your needs. We’ll explain each type below and will also go over how they are different from each other.

Corporation (aka C-Corporation)

  • A Corporation is a separate legal entity created by state law. A Corporation is formed by filing a document called the Articles of Incorporation. This document is filed in the state where the entity is doing business and is filed with the Secretary of State or a similar government agency.
  • A Corporation must designate a Registered Agent in order to receive service of process and state correspondence.
  • By default, a Corporation is taxed under subchapter C of the Internal Revenue Code. This is often why Corporations are referred to as C-Corporations.
  • On the other hand, a Corporation can elect to be taxed as an S-Corporation (aka being taxed under subchapter S of the Internal Revenue Code) by filing Form 2553 with the IRS.
  • If the Corporation is taxed in its default status (taxed as a C-Corporation), the Corporation will face double taxation. Essentially, the Corporation is taxed at the corporate level on its profits. And then the Shareholders are taxed again, at the individual level, after they receive distributions (their share of profit).
  • C-Corporations are also responsible for paying state corporate income tax, if applicable, where they are domiciled and/or transacting business.
  • Corporations also have statutory requirements, such as electing a board of directors, designating corporate offers, holding annual meetings, and recording meeting minutes.
  • Corporations are not commonly used by small business owners. Instead, they are used by larger companies or tech startups often looking to raise venture capital from investors.

LLC (Limited Liability Company)

  • An LLC, aka Limited Liability Company, is a separate legal entity created by state law. An LLC is often formed by filing a document called the Articles of Organization. However, depending on the state, this form is also known as the Certificate of Organization or Certificate of Formation. This document is filed in the state where the entity is doing business and is filed with the Secretary of State or a similar government agency.
  • An LLC must also designate, and maintain, a Registered Agent. A Registered Agent must be located in the state where the LLC is formed. For example, if an LLC is formed in Texas, it must designate a Registered Agent in Texas.
  • The LLC is unique when it comes to tax treatment by the IRS. This means, there is no “LLC tax classification”. Instead, the LLC is taxed based on the number of owners. Alternatively, the LLC can make an election with the IRS, requesting to be taxed as a Corporation (C-Corporation or S-Corporation).
  • An LLC with one owner is known as a Disregarded Entity. This simply means the IRS “looks through” the LLC; looks at who the owner is, and taxes the individual or company accordingly. For example, if an American taxpayer is the single owner of an LLC, the LLC will be taxed as a Sole Proprietorship. If the LLC is owned by two or more people, the LLC will be taxed as a Partnership. And if the LLC is owned by another company, it will be taxed as a branch/division of the parent company.
  • And alternatively, the LLC can elect to be taxed as either a C-Corporation (by filing Form 8832) or an S-Corporation (by filing Form 2553).
  • LLCs taxed as Sole Proprietorship, Partnerships, and S-Corporations are all known as pass-through entities. This means there is no corporate-level taxation (company-level taxation). Instead, the taxes flow through to the owners and are reported and paid on their personal tax returns.
  • In the more uncommon setup – an LLC taxed as a C-Corporation – the LLC would face double taxation, just like a regular Corporation would.
  • And while an LLC may be able to be used for estate planning purposes, it’s often wiser to have your LLC owned by your trust(s). Of course, it’s best to speak with an estate planning attorney on such a matter.
  • In summary, for many small business owners, LLCs are the “best of all worlds”. They receive liability protection, just like a Corporation, but they are, by default, pass-through tax entities. And if the LLC would like to be subject to corporate tax treatment by the IRS, the LLC can make the necessary election. Said another way, while providing liability protection to its owners, the LLC can pretty much choose how it would like to be taxed.
  • LLCs also have more flexible management options and don’t have as many formal, and annual requirements, such as Corporations.
  • LLCs are the most popular type of business entity in the United States, mostly because of their flexibility and the personal liability protection they offer to owners.

S-Corporation (aka S Corp)

  • An S-Corporation is unique because it is not a legal entity, like an LLC or a Corporation. Instead, it’s a tax election made with the IRS.
  • It’s easier to think of it this way: The S-Corporation tax election “sits on top of” a state-level entity, such as an LLC or Corporation.
  • This is one of the most common myths with S-Corporations. People think you can just “form” an S-Corp. You simply cannot. There is no state or federal filing to “form” an S-Corp. Instead, one must first form an LLC or Corporation, and then timely file Form 2553 with the IRS to request to be taxed under Subchapter S of the Internal Revenue Code.
  • Once the IRS grants the elective status, it’s common to refer to the entity as an S-Corporation and its owners as Shareholders.
  • For most, the primary reason to explore S-Corp tax treatment is to save money on self-employment taxes.
  • Owners of an S-Corporation must take a “reasonable salary” (which is subject to self-employment taxes), but any remaining profit can be taken as a distribution (which isn’t subject to self-employment taxes). And that’s the main appeal of S-Corporations right there.
  • It’s important to keep in mind that with an S-Corporation, you must regularly run payroll, withhold taxes, file quarterly payroll returns (federal and state), hire a bookkeeper (or manage your own books), keep an accurate balance sheet (since it’s required to be filed with the IRS), file a corporate tax return (Form 1120S, K-1s for shareholders/owners, and any additional Schedules), and hire an accountant if you don’t have one already.
  • All of the above costs money. And those costs – which average $2,000 – $4,000 for small business owners – need to be compared to the potential self-employment tax savings; in order to make sure the S-Corp tax treatment makes sense.
  • S-Corporations can be owned by US citizens, US trusts (depending on how they’re taxed), US estates, US resident aliens, and US tax-exempt organizations.
  • S-Corporations cannot be owned by Non-US residents (aka non-resident aliens), foreign companies, C-Corporations, Partnerships, financial institutions, or insurance companies.
  • If you’re considering having your entity taxed as an S-Corporation, it’s important to speak with an accountant to make sure the extra cost – and additional filing requirements – are worth the self-employment tax savings. Having your business entity taxed as an S-Corporation can be a good idea for some, but isn’t necessarily a good idea for everyone.

Sole proprietorship

  • A Sole Proprietorship is an informal “business structure” with one owner.
  • There is no paperwork to file with the Secretary of State, or a similar government agency, to create a Sole Proprietorship.
  • You simply are a Sole Proprietorship once you engage in business activities, or engage in activities with the goal of making money.
  • A Sole Proprietor can do business under their own name or they can file a DBA (Doing Business As) Name. For example, John Doe can do business under his name, John Doe, or he can file a DBA called “John’s Painting Company”.
  • The advantage of a Sole Proprietorship is that they are easy to set up.
  • And taxes are pretty straightforward with a Sole Proprietorship. The owner will simply file a Schedule C and report their business income (or loss) on their personal tax return.
  • The largest disadvantage of Sole Proprietorship is that there is no liability protection for the owner. In the eyes of the law, the owner and their business are one and the same. If the business is involved in a lawsuit, the owner’s personal assets (home, cars, bank account, etc.) could be used to settle business debts and liabilities.
  • Another disadvantage of a Sole Proprietorship is that if you eventually form an LLC or Corporation, there is no official “conversion” filing. So you basically have to start all over again – filing paperwork with the state, getting an EIN (Federal Tax ID Number), opening a business bank account, etc. So if you’re on the fence, between an LLC or Sole Proprietorship, for example, it’s often easier to just form an LLC.
  • However, if you believe your business has a low liability risk and you don’t have money to form an LLC or Corporation, starting your business as a Sole Proprietorship may be the best method to getting your business off the ground.

General Partnership (aka Partnership)

  • A General Partnership (Partnership) is pretty much a Sole Proprietorship with 2 or more people. Said another way, it’s an informal “business structure” with multiple owners.
  • In most states, there is no paperwork to file with the Secretary of State, or a similar government agency, to create a General Partnership (there are few states though that require General Partnerships to register).
  • A Partnership can do business under the names of the owners or it can file a DBA (Doing Business As) Name.
  • The advantage of a General Partnership is that it is easy to set up.
  • Partnership taxes are not as straightforward as with a Sole Proprietorship though. For instance, the Partnership must file a Form 1065 and issue K-1s to the partners. Then the partners report their K-1 income on their personal tax returns.
  • The largest disadvantage of a Partnership is that there is no liability protection for the owners. Again, in the eyes of the law, the owners and their businesses are one and the same. If the business is involved in a lawsuit, the owner’s personal assets (home, cars, bank accounts, etc.) could be used to settle business debts and liabilities.
  • While a Partnership may be a good way to save money and get a business off the ground, most people quickly shift to a legal business entity, like an LLC or Corporation.

Choosing the best entity structure for your business

  • Generally speaking, the LLC is the most adaptable corporate structure, and for that reason the most popular choice in the U.S. The LLC can pretty much choose how it would like to be taxed by the IRS, all while providing its owners’ personal liability protection.
  • Having said that, some owners may elect for their LLC to be taxed as an S-Corporation to save money on self-employment taxes.
  • Or larger businesses (or those raising money) may prefer to form a Corporation, especially if they have large healthcare expenses.
  • And while Sole Proprietorships and General Partnerships may be good to start off with, owners may quickly outgrow them or not feel comfortable with the lack of personal liability protection.

Conclusion

Choosing the best legal entity for your business is a game of weighing the pros and cons. Things to consider are liability protection for the owners, tax treatment by the IRS, and the reporting requirements, among other things. Typically, larger companies or those raising money from investors opt for the Corporation, while most small business owners choose to form an LLC.

Article By Matt Horwitz of LLC University

For more corporate and business legal news, click here to visit the National Law Review.

© Copyright 2010 LLC University

Preparing Corporate Messaging in the Wake of Dobbs

The United States Supreme Court (“SCOTUS”), in Dobbs v. Jackson Women’s Health Organization, has held that there is no constitutional right to abortion, overruling Roe v. Wade and Casey v. Planned Parenthood.

Employers, who increasingly are finding themselves on the front lines of many societal issues, will need to decide quickly whether and how they might address the Dobbs decision, as public reaction has been and is likely to remain strong. Board members, employees, and shareholders may advocate for corporations to take a visible stand on the issue of abortion and reproductive rights. And employees may want to speak up themselves (possibly via employer social media accounts).

It is important to remember that company communication decisions and actions regarding the Dobbs ruling, as well as other political and social issues, can have practical and legal implications.

The first question is whether your company will comment on Dobbs. If you decide to comment, there are many factors to consider. Your message is an important starting point. Who is your intended audience? Will your employees consider it an opportunity to join in the conversation? What will you say? Even if your message is internal, keep in mind that it may not stay that way, given the nature of social media. And before you think, “I’ll just stay out of it,” remember that some will view silence or neutrality as a statement in and of itself. If you choose not to speak, are you prepared to deal with any potential reaction from customers, employees, or shareholders?

Internally, employees may have questions about health benefits or other terms and conditions of employment because of Dobbs. It will be important to arm all key stakeholders, including leadership, corporate communications, and human resources, with tools to consistently manage these communications and responses.

Whether it’s internal or external communications, expect feedback! How that feedback is handled is as important as the initial communication (or lack thereof).

Certain industries, like healthcare and insurance, may also feel compelled to make an affirmative statement if the Dobbs decision has a direct impact on services and/or products. In those cases, the need to consider all implications is even more pressing.

In thinking through these decisions, employers should also consider who may need to approve any messaging. The board of directors, senior executives, legal, and marketing and communications teams are among the key stakeholders who may need to be consulted. And don’t forget that your public-facing employees may bear the brunt of your response. Are they prepared?

Employers should also keep in mind various laws that may govern their reaction, including those they might otherwise not consider. For example, the National Labor Relations Act protects employees’ rights to collectively discuss terms and conditions of employment at work and off duty – and that applies to employers with and without a unionized workforce. The current Biden-appointed General Counsel of the National Labor Relations Board has taken an expanded view of topics that are connected to the workplace. Moreover, some states, including California and New York, have enacted off-duty conduct laws that prohibit employers from disciplining employees for lawful conduct outside of work, which may include political advocacy. There may also be anti-discrimination laws and potential civil and criminal liability associated with your statements, depending on their wording.

Reactions to the Dobbs decision may vary. Some reaction may be comparable to what we’ve seen with respect to other recent political and/or social justice movements, such as Black Lives Matter and #MeToo; others may react differently, or not at all. In these rapidly changing times, companies — particularly publicly traded and consumer-facing ones — need to be make informed decisions. Clear, consistent messaging is key to establishing confident and consistent responses to potential concerns by employees and other stakeholders.

Article By M. Carter DeLorme, Frank C. Morris, JR, Susan Gross Sholinsky, Jennifer Barna, and Erin E. Schaefer of Epstein Becker & Green, P.C.

For more civil rights legal news, click here to visit the National Law Review.

©2022 Epstein Becker & Green, P.C. All rights reserved.

Inflation Woes: Four Key Ways for Companies to Address Inflation in the Supply Chain

The U.S. economy is grappling with the highest inflation in decades, with extensive inflation in the supply chain affecting companies worldwide. Supply chain disruptions undoubtedly have contributed to rising inflation, as extensive delays and skyrocketing costs continue to plague the industry.

In March 2022, the consumer-price index (or CPI) — a measure of the prices consumers pay for products — rose at an annual rate of 8.5%, which is the highest increase in 47 years.1 Meanwhile, the producer-price index (or PPI) — a measure of inflation meant to gauge the impact on suppliers — similarly rose significantly at an annual rate of 11.2%.2 Finally, the employer cost index (or ECI) demonstrates that, from March 2021 to March 2022, total compensation rose 4.5%, wages and salaries rose 4.7%, and benefit costs rose 4.1%.3

Because inflation increases the prices of goods or services, negotiations about who bears that risk in business partner relationships and the consequences of that risk allocation will have significantly greater financial impacts than we have seen in recent memory. As a result, ensuring your business teams are well versed on the impacts of and means of mitigating inflation in new contracts has a direct impact on your bottom line.

In this article, we provide ways for companies in the supply chain to address high inflation and alleviate associated pressures, including (1) how to revisit and use existing agreement provisions to address inflation risk, (2) approaches to negotiating new agreements and amendments to existing agreements, (3) approaches to limit inflationary exposure, and (4) strategies for cost reduction.

Figure 1:

Percent Change in CPI March 2021 versus March 2022

CPI March Chart

Bureau of Labor Statistics, U.S. Department of Labor, Consumer Price Index – March 2022, issued April 12, 2022

Four Key Ways to Mitigate the Effects of Increasing Inflation in the Supply Chain

1. Revisit and Use Provisions in Existing Agreements

Companies faced with rising costs must review their supply agreements to determine if they already contain mechanisms the company can use to address inflation. On the buy side, companies should look in their agreements for terms relating to fixed prices. On the sell side, companies should investigate ways to pass increased costs on to customers. Most supply contracts contain a variety of provisions that may assist in combatting inflationary pressures.

(a) Pricing Provisions

From a seller’s perspective, a contract may include index-based price escalation provisions, which tie contract prices to one or more indices. The underlying indices may be (i) broad economic indices such as the PPI or “market basket” indices tied to all items and all urban consumers, (ii) targeted indices such as ECI for a specific location, or (iii) tied to the cost of a specific commodity used in the underlying product. Contracts will sometimes incorporate several commodity indices based on the percentage those commodities are used in the product that is the subject of the agreement, in order to accurately reflect the costs associated with producing the good.

Allocations under these pricing provisions vary depending on negotiation power. They could put all of the risk on one party, share the risk equally, or share the risk according to particular percentages. The latter two options represent ways to avoid a “win/lose” approach.

Sellers will want to see whether their agreements allow for periodic negotiations for updated prices and take advantage of those opportunities. A buyer, meanwhile, may look for provisions that allow it the flexibility to limit the quantities ordered, enabling it to reduce costs as necessary or to seek a more cost efficient alternative. A buyer also will want to determine if the contract prohibits the seller from changing prices.

Regardless of the existing provisions, the real impact of inflation is likely to trigger commercial discussions to address rising costs; this is true both for hard goods supply agreements and indirect services agreements with longer terms such as outsourcing and managed services relationships.

(b) Force Majeure as a Mechanism to Adjust Price?

Outside of pricing provisions such as the above, however, a party may look to other contract provisions, such as force majeure, to see if its performance under the contract could be excused; increased costs alone are not enough to constitute a force majeure event. In order for a force majeure to arguably apply, the increase in costs must be caused by an event that itself is a qualifying force majeure event under the terms of the applicable contract (which may include events like a labor strike or pandemic).

Force majeure provisions are intended to excuse performance under a contract but not to act as a pricing adjustment mechanism. However, force majeure and its extra-contractual cousin, commercial impracticability, can be used as tools to bring the parties to the negotiating table where events beyond either party’s reasonable control are impacting the ability to produce and deliver products.

2. Negotiate Amendments to Existing Agreements

To the extent sellers have fixed-price contracts with their customers, sellers should consider negotiating with such customers to adjust these contracts in order to keep the prices they charge their customers in line with their input costs. When entering these discussions, companies that wish to implement a price adjustment, or eliminate fixed pricing entirely, should consider meaningful ways to incentivize their customers to agree to such changes. Would the customer be willing to agree to a price adjustment in order extend the agreement or adjust the quantity? Any items that maintain the relationship between the parties while also allocating cost increases in an equitable way should be considered.

Conversely, buyers faced with price-increase requests should carefully consider their options:

  • First, a customer receiving a price-adjustment request should confirm the request is actually tied to inflation and not just an attempt by a supplier to increase its bottom line. Seek detailed calculations supporting the price adjustments, and require suppliers to demonstrate how much their costs have increased above expectations.
  • Second, customers should consider what items they would like to request in return for accepting a given price-adjustment request, such as whether they would like to adjust their quantity or timing of delivery.
  • Third, a customer faced with a price increase request should consider whether the request should include the opportunity for the customer to obtain pricedowns in the future, in the event there are changes in the pricing environment.

3. Pricing Tied to Indexing and Other Ways to Limit Future Inflationary Exposure when Drafting New Agreements

When drafting new agreements, companies should consider how best to mitigate the effects of inflation.

For nearly 40 years, we have enjoyed relatively low and steady levels of inflation, which explains why existing agreements may not adequately address the allocation of significant and unexpected economic change.

Many of those at the upper echelons of leadership today have never dealt with a high inflationary environment. To put it in perspective, the CEO of Walmart, the No. 1 company on the Fortune 500 list for 2021, was 19 years old when inflation was last a newsworthy topic.

In the future, however, we expect far fewer agreements to have long-term fixed prices, as sellers negotiating agreements will want to incorporate a variety of strategies that allow for pricing flexibility and avoid longstanding, fixed prices. One such strategy is tying prices to an index. As discussed above, this could be a general index such as the CPI or PPI or be much more specific depending on the item sold. There are numerous indices for various products and commodities that parties may use to reflect accurately the costs of producing the goods that are the subject of their agreement. Parties may consider incorporating a mechanism for revisiting these provisions, especially in the event that inflation slows. Caps on inflation risk also may be incorporated as a backstop.

If not tying prices to an index, selling parties will want to shorten the term of their agreements or require the parties to renegotiate prices at set points throughout the duration of their agreements. Alternatively, parties may consider price increases of a certain percentage that are automatically implemented periodically. The seller may even want to leave the pricing open and establish pricing at the time the order is placed.

On the other hand, customers will want to incorporate provisions that cause the supplier to bear the inflationary risk. Principally, this means locking in prices for as long of a period as the seller will agree to and ensuring prices are fixed upon the issuance of purchase orders.

If and when sellers push back on extended fixed-pricing provisions, there are a variety of methods parties may use to meet in the middle:

  • Pricing arrangements that are tied to one or more indices may be capped to a certain percentage, ensuring the customer will know its upward exposure.
  • Include thresholds of index movement such that the price remains static unless and until the percentage threshold is exceeded.
  • Allocate increased cost exposure so a certain percentage range of index movement is allocated to one party and then the next percentage range is allocated to the other party. Parties then may share any exposure above those ranges.
  • Additionally, index-based pricing can be clarified to include both upward and downward movement, ensuring that customers, while risking inflationary costs, may also receive the benefits of deflationary environments.

4. Think Strategically to Reduce Costs

Aside from considering purely contractual methods to combat inflation, companies should think strategically about ways to reduce costs more efficiently.

  • Streamlining. In order to pursue this strategy, companies need to determine which areas are driving increased spending and consider ways those areas may be managed differently. For example, companies may consider whether there are different inputs that can be used to lower costs or processes that may be streamlined. Companies can review their inventory management, labor inputs, and other areas to determine where cost cutting may be an option without sacrificing product or service quality. This streamlining might include ending product lines with lower levels of profitability.
  • Technology & Innovation. In addition, with labor constituting such a high percentage of the cost increases companies are experiencing, a company may want to double down on technology and innovation that reduces headcount. Or, as prices rise, a company may pursue other pricing models. For example, a heavy equipment manufacturer may opt for a pay-per-use model in lieu of the traditional sale model.
  • Diversification of the Supply Chain. Another method companies may use is diversifying their supply chains, ensuring they provide the flexibility and sustainability needed to weather turbulent periods. Though adding links to supply chains will not lower costs in the near term, it can help ensure a business continues to function smoothly even in the event of price shocks, material shortages, or other disruptions.

The stressors driving inflation are unlikely to be relieved any time soon. Companies should use every resource available to leverage their current contracts and negotiate new terms to address inflation’s serious repercussions on their bottom line.

FOOTNOTES

1 How High Is Inflation and What Causes It? What to Know, Wall Street Journal (April 12, 2022).

2 Supplier Prices Rose Sharply in March, Keeping Upward Pressure on U.S. Inflation, Wall Street Journal (April 13, 2022).

3  Employment Cost Index – March 2022, U.S. Department of Labor, Bureau of Labor Statistics (April 29, 2022).

Article By Vanessa L. Miller, Kathleen E. Wegrzyn, Leah R. Imbrogno, James R. Kalyvas, and Austin R. Kissinger of Foley & Lardner LLP

For more financial institutions and banking news, click here to visit the National Law Review.

© 2022 Foley & Lardner LLP

Once More Into The Breach – Or Should That Be Conflict?

A common contractual representation is that the execution and delivery of the agreement does not constitute a breach of one or more other agreements or charter documents.  Sometimes, the representation is that the execution and delivery do not “conflict with” or “violate”.  Is there any difference between a “breach”, a “conflict” or a “violate”?

“Breach” is a word of Old English origin (bryce, meaning a fracture or breaking).  “Conflict” and “Violate” in contrast are of Latin origin.  At the siege of Harfleur,  King Henry V urged his troops to fill the the breach:

“Once more unto the breach, dear friends, once more;
Or close the wall up with our English dead.

W. Shakespeare, Henry V, Act III, Sc. 1.

“Conflict” is derived from conflictus which is the singular, perfect, passive participle of confligere meaning to come together in a collision.  “Violate” is derived from violatus which is the perfect, passive participle of violare meaning to injure or dishonor.  To some, these words may connote different meanings (or shades of meaning) and it is possible that a particular agreement will define what constitutes a breach, conflict or violation.  However, I am not aware of any California precedent that assigns different meanings to these terms as a general matter.

Shakespeare generally preferred to use words of Anglo Saxon origin to those of Latin origin.  This may be attributable to Shakespeare’s reportedly week knowledge of Classical languages.  As Ben Johnson, a rival remarked, Shakespeare knew “small Latin and less Greek”.  However, I believe that the power and appeal of Shakespeare’s plays is partly due to his use of Anglo Saxon and Old English words.

© 2010-2020 Allen Matkins Leck Gamble Mallory & Natsis LLP

ARTICLE BY Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP
For more, visit the NLR Corporate & Business Organizations section.

“Is You Is or Is You Ain’t:” Membership in an LLC

The New Jersey Superior Court, Appellate Division case Giordano DeCandia v. Anthony T. Rinaldi, LLC d/a The Rinaldi Group and Anthony Rinaldi, (N.J. App. Div., Oct. 5, 2020) per curiam, is about whether the plaintiff was or is a member of the LLC, and the economic consequences of that determination. The Appellate Division affirmed the rulings of the trial court (in a bench trial), except for reversing one of the defendants’ counterclaims. The case is most important for two reasons: first, it underscores the potential for chaos resulting from the uncertainties of oral versus written claims; and second, it reveals that the New Jersey judiciary, even at the intermediate appellate level, still finds a limited liability company (even 27 years after the first NJ LLC statute was adopted) a strange and challenging creature. The critical issue of membership is nicely captured by the rather famous old jazz song written by Louis Jordan and Billy Austin and first recorded on October 4, 1943, just over three weeks after your author was born. As its title invokes, when uncertainty abounds, it is difficult to have more than an ephemeral relationship.

Membership in an LLC

Rinaldi had a construction management and general contracting business in New York and New Jersey. In 2003, he formed the LLC as a manager-managed LLC, with himself as both the sole member and the manager. Plaintiff DeCandia began working for the LLC in 2011, with a compensation package of a salary plus a 10% ownership interest, with the ability (based on the amount of work the plaintiff brought in) to go to 20% of “net profits on that work.” The plaintiff signed an operating agreement on February 14, 2011. The Capital Contribution schedule attached to that 2011 agreement stated that the “plaintiff’s ownership interest is performance-based rather than through capital contributions.” The plaintiff received an LLC membership certificate reciting the arrangement. Rinaldi later testified that “profit-sharing is a prevalent and customary compensation mechanism within the commercial construction industry.” It is worth noting that the LLC’s comptroller also testified that the parties advised of the arrangement and that she had a similar profit-sharing deal. On September 25, 2013, the parties signed an amended operating agreement (the “2013 agreement”), adding two more members as the company grew, and giving them similar percentage interests. The plaintiff received an increase to a 20% interest, and a replacement LLC membership certificate reciting the new terms. The old certificate was voided.

In 2015, Rinaldi and the plaintiff began negotiating a buy-sell agreement, to buy out a deceased member’s interest from the surviving spouse, in case either Rinaldi or the plaintiff died. The Court notes that the initial draft of the agreement said that plaintiff would own “twenty percent of the common stock of the LLC.” On October 19, 2015, the parties, two other LLC “employees” (the Court’s term), and the LLC’s accountant met to discuss the buy-sell agreement, tax implications, and financial liabilities related to being (what the Court calls) “an equity partner.” Plaintiff, per the accountant, purportedly said that he was interested in “profits, not taxes.” The Court also reports, without any clarifying explanation, that plaintiff “wanted to avoid any personal liability on the LLC’s bonds.” The plaintiff may have been referring to payment and performance bonds, which are usual in the construction business, as opposed to debt instruments. In that meeting, Rinaldi disclosed that the LLC was under criminal investigation by the New York City Borough of Manhattan District Attorney after the NY Department of Buildings found that numerous safety violations by the LLC caused death at a construction site. Testimony asserted that the plaintiff became frightened that his LLC membership certificate might expose the plaintiff to criminal liability. Rinaldi told the plaintiff that if he was scared, he should resign and turn his LLC membership certificate over to the LLC’s attorney. Shortly after, the plaintiff did so, without signing the certificate or providing any other “explanatory writing.” No buy-sell agreement was ever entered into with the plaintiff. The Court states that after that October meeting, the plaintiff received his salary plus bonuses, but no “profit-sharing.” The plaintiff never sought to recover his membership certificate.

By March 2017, things had deteriorated to the point that Rinaldi terminated the plaintiff. The plaintiff, apparently anticipating that deterioration had contacted a competitor of the LLC in 2016. On the plaintiff’s last day with the LLC, he sent his wife the LLC’s proposed budget for a job it was bidding on; she forwarded the budget to the competitor, which submitted a rival bid. The plaintiff then met with the executives of the potential customer and urged them to hire the LLC’s competitor. The employment agreement plaintiff signed on April 28, 2017, recited that he did not have an ownership interest in any competitor of his new employer. On September 15, 2017, the plaintiff sued the LLC, and Rinaldi, seeking a declaratory judgment that he was a 20% owner of the LLC and other relief. Defendants counterclaimed that the plaintiff had breached his common law duty of loyalty as an employee AND his duty of loyalty as a member of the LLC. The trial court held against the plaintiff on all claims and granted the defendants’ counterclaims. The Appellate Division upheld the trial court’s rulings on all but the counterclaim for breach of the duty of loyalty as a member of the LLC. That statutory obligation applies to members of a member-managed limited liability company, but the LLC was manager-managed so that the duty applied only to managers; Rinaldi was the sole manager. The plaintiff’s efforts to assert equitable claims relating to minority oppression and the like failed because, as both the trial court and the Appellate Division found, the plaintiff’s double-dealing gave him “unclean hands.”

“Is You Is or Is You Ain’t”

Carefully written documents could have resolved most of the factual ambiguities. But both trial and appeal courts found sufficient basis for concluding that the plaintiff had voluntarily withdrawn from the LLC, one of the acts of dissociation that ends membership. Given the trial, the Court’s determination that the plaintiff was not a member or had withdrawn as a member, it is not clear how the trial court could have found that the plaintiff had violated a duty of loyalty owed by a member of a limited liability company. Even more troubling in both opinions (beyond the occasional inaccurate language, e.g., limited liability companies do not have “common stock;” a member of a limited liability company is not an “equity partner”) is the finding that the concept of a contingent percentage interest in an unincorporated business was mere compensation and did not result in plaintiff owning a membership interest in the LLC. That is simply a misstatement of the law. A person may become a member of a limited liability company with a present, vested interest or with a contingent, earning-based interest. Or as it appears from the recitals noted in the Appellate Division opinion, both. The plaintiff’s original deal was:

  • salary;
  • 10% membership interest; and
  • contingent 10% “profit-sharing” interest based on the work plaintiff brought in

Ultimately, as both courts held that plaintiff had given up “whatever ownership interest he may have held in the LLC,” the issue was moot. But the language in the Appellate Division opinion might well allow a future court to find that someone who is in fact a member of a limited liability company in New Jersey is not a member at law – a troubling risk and a reason to consider forming an unincorporated entity under the law of a jurisdiction other than New Jersey.

©2020 Norris McLaughlin P.A., All Rights Reserved
For more articles on corporate law, visit the National Law Review Corporate & Business Organizations section.

Is A Corporation’s Address A Trade Secret?

“Cryptocurrency” is a hybrid word form from the Greek adjective, κρυπτός, meaning hidden, and the Latin participle, currens, mean running or flowing.  The word “currency” is also derived from currens, perhaps based on the idea that money flows from one person to the next in an economy.  Literally, cryptocurrency, is secret money.  But there are secrets and there a secrets.

Recently, a cryptocurrency exchange sued one of its employees for violating the Defend Trade Secrets Act of 2016, 18 U.S.C. § 1831-39.  Among other things, the company alleged that the erstwhile employee had disclosed the “physical address” of the company in a complaint filed in a state court action.  Until now, I had never considered that a company’s physical address might be a secret.  The company argued that “keeping its physical address secret serves to protect it from ‘physical security threats,’ providing as an example of such threats ‘a recent spate of kidnappings’ of persons who work for cryptocurrency exchanges”.  Payward, Inc. v. Runyon, U.S. Dist.

Judge Maxine M. Chesney ruled for the defendant, finding that the plaintiff had failed to allege how its competitors would gain an economic advantage by knowing the company’s address.  Accordingly, Judge Chesney found that the plaintiff had not pled that the address met the definition of a trade secret under the DTSA.

I was somewhat nonplussed by the idea of an office address being a secret (trade or otherwise).  After all, the plaintiff, a Delaware corporation, had filed a Statement of Information with the California Secretary of State disclosing the address of its principal executive office (which is the same as its principal executive office in California).  That filing is a readily accessible public record.  It may be, however, that the address disclosed by the defendant was for another location not disclosed in the Statement of Information.

Etymologists use the term “hybrid word” to refer to a word that is formed by the combination of words from two different languages.  Greek-Latin hybrids are the most common form of hybrids in English.  English does have hybrids formed from other languages.  For example, “chocoholic” is a hybrid formed from New and Old World languages – Nahuatl, xocolatl, and Arabic, اَلْكُحُول (al-kuḥūl).  

© 2010-2020 Allen Matkins Leck Gamble Mallory & Natsis LLP
For more articles on corporate law, visit the National Law Review Corporate & Business Organizations section.

Amrock Lawsuit Spotlights Consequences of Litigious Gamesmanship

Trade Secret Litigation Commentary

 

On June 3, the Texas Fourth Court of Appeals reversed and remanded the dumbfounding $740 million award in Title Source v. HouseCanary – a welcome development for American innovation and business collaboration. On the back of years-long litigation, a fresh trial of the case can offer important signals for corporations on the risks and rewards of collaboration, as well as deliver much-needed guidance on best practices to navigate already murky trade secret protections.

For the uninitiated, litigation between HouseCanary and Title Source (now Amrock) was borne out of a contract the two companies entered in 2015. The arrangement obligated the delivery of an automated valuation model (AVM) and an app to Title Source at a rate of $5 million per year for HouseCanary’s efforts. Title Source intended to use the software and app as a platform to provide customers the ability to assess property values digitally alongside other services the company offers, like title insurance and closing services. After HouseCanary failed to meet its contractual obligation to deliver a working AVM app, Title Source sued for breach of contract.

HouseCanary then filed a counter claim including allegations that Title Source had misappropriated proprietary information, in this case trade secrets, in an attempt to make an app of its [Title Source’s] own. After a six-week trial that concluded in March 2018, a Texas jury decided in favor of HouseCanary and awarded nearly three-quarters of a billion dollars – one of the largest tort settlements of the year.

Should anyone be keeping score at home, that means the case’s settlement was valued at nearly 150 times the annual payout HouseCanary was to receive from its work with Title Source and dwarfed the firm’s multiple rounds of venture funding by over $600 million. For HouseCanary, litigation proved more profitable than any of its own business ventures, and the settlement certainly outstripped the going market rates on AVMs.

By the conclusion of the original trial, it seemed clear that Title Source had not misappropriated HouseCanary’s trade secrets or proprietary information in building its own app. Further, HouseCanary’s own expert witness testified that there weren’t “any fingerprints, any clues, any reference to any HouseCanary technology” in the app Title Source developed on its own.

Regrettably, the jury’s finding against Title Source was based on inaccurate and incomplete information, unsubstantiated inadmissible character attacks, and back-of-the-napkin math from a questionable damages ‘expert.’ It seemed to be more focused on sticking it to corporate America rather than the actual facts and merits of the case. Not only was the jury gravely mislead, but they also never heard critical information which came to light days after the trial concluded.

Post-trial statements by a former HouseCanary executive turned whistleblower clarified that there was never a “working version” of the app to be delivered to Title Source, and per three more former HouseCanary executives, that the company didn’t have “any IP to steal.” The cogency of HouseCanary’s allegations were further thrown into question when the company, six weeks after the trial’s closure, moved to seal a number of exhibited documents from court record.

As I wrote previously, once the sealing motion was overturned, the documents should “provide another look at the technology in question, which will provide clarity whether there were trade secrets to be stolen.” This is especially important when considered in tandem with the whistleblower testimony.

These and other erroneous inclusions and fatal procedural errors led to a Texas appellate court overturning the verdict and ordering a new trial. The ramifications of the decision in the new trial promise to be immense, especially if HouseCanary invokes Texas’ Uniform Trade Secrets Act for a second time. The Act has been adopted by 47 states total, and significantly broadens the implications of this trial for business operations in all kinds of industries by setting precedent for other lawsuits.

Trade secret litigation has increased tremendously in the past decade, with over 2,700 cases since 2009; add on the massive original settlement and the ruling may very well set the tone for the future of trade secret litigation and the standard of intellectual property protections.

Given the new evidence that has emerged since the jury delivered its decision in 2018, the cards certainly appear stacked against HouseCanary successfully duping the retrial jury. There is little doubt that businesses and innovators everywhere will be awaiting the verdict of the Texas court for clarity on trade secret protections and our court system’s tolerance for overwhelmingly apparent legal gamesmanship.

© George Nethercutt

Authored by George Nethercutt of The George Nethercutt Foundation, a guest contributor to the National Law Review.

For more on trade secrets, see the National Law Review Intellectual Property law section.