Does a negative “Say on Pay” vote trigger a breach of fiduciary duty claim?

The Dodd-Frank Act, passed in 2010, includes the so-called “Say on Pay” provision for publicly traded companies. This provision requires that, at least once every three years, the shareholders of a publicly traded company must vote on its executive compensation arrangements. In addition, the shareholders also vote at least once every six years on the frequency of the “say on pay” vote.  Shareholders are able to elect whether the vote will happen once every one, two, or three years.  In most companies, the shareholders have chosen to have the “say on pay” vote conducted annually.  Publicly traded companies are also required  to disclose, in any proxy solicitation asking for the approval of a merger, acquisition, or other sale of the company, any compensation from “golden parachutes” that would be triggered.  Shareholders also have a chance to “approve” (or not approve) such golden parachute payments. [Read more...]

One More Reason to Comply with Securities Laws: Potential Loss of Your IP

As I’ve mentioned before, it’s very important for growing companies to comply with securities laws, even during the initial seed and friends and family rounds of financing. The possibility of lawsuits and even fines and other criminal penalties give founders a strong incentive to comply with the law. But there’s another consequence that could result from non-compliant sales of securities: loss of the company’s IP.

Often, co-founders are issued stock or other ownership interest in exchange for a contribution of intellectual property. That issuance of stock is a securities transaction. If it is not done in compliance with the law, the purchaser of the security (in this case the co-founder who contributed the IP) has a right of rescission, which means that he can sue in court to have the deal unwound. In most securities transactions, where stock was issued in exchange for cash, this would simply result in a monetary award of damages. However, if the stock was issued in exchange for intellectual property rights, then a successful lawsuit by the founder who contributed the IP could result in the company losing its rights to its intellectual property, potentially crippling the company.

When could this arise? Certainly a partnership dispute could cause a departing co-founder to institute such a lawsuit to gain additional leverage in his or her departure. If a company is doing very well, then normally, even if the departing partner alleges a securities law violation, the company can simply pay him cash for his shares. But if a rescission action for the securities law violation would result in the loss of mission-critical IP, then the departing shareholder will have an enormous amount of leverage in negotiating his departure. He could extract significantly larger concessions than he otherwise would have been able to if his remedy had simply been to have the cash he put into the company returned. In addition, even if there are no disputes, potential investors doing due diligence on the company may be scared away because of the potential cloud hanging over the company’s most important assets.

Therefore, once again it is important to emphasize that start-ups should not ignore securities laws in their early rounds of financing, or even in transactions with their co-founders. Failing to comply with the law creates a ticking time bomb for a company that can threaten its business in the future.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Even in deals with “yourself,” you still need proper legal documents.

One situation I often encounter with small businesses is that sometimes they don’t always document the transactions they enter into with their owners and other related parties. For instance, let’s say that two owners of a corporation decide that their corporation needs more funding. However, they don’t want to invest more equity into the business. They are willing to extend a loan to their company and expect to get paid back over the next few years with interest. Here’s how that should work (assuming this company is a C Corporation):

The corporation would make payments of principal and interest back to the shareholders. The corporation would be able to deduct the interest as an expense. The owners would not need to pay taxes on the principal but would pay taxes on the interest. There are no double taxation issues because the interest expense is deducible to the corporation.

Unfortunately, small business owners often don’t take the time to properly document transactions like this. They may enter it into their accounting books, but the don’t prepare any loan documents, nor do they prepare any board resolution authorizing the company to enter into the loan. After all, from the owners’ perspective, this is a loan to “themselves” and it seems like a waste of time and money to have official documents prepared. This can cause a couple of problems down the road.

First, if the IRS audits the company, they will ask to see the loan documents and resolutions authorizing the transaction. When the owners can’t produce them, the IRS can (and often does) recharacterize the transaction as a dividend. As a consequence, the loan interest is no longer deductible. Therefore the owners will pay double taxation on the interest. In addition, depending on the capital structure, the principal payments could also be deemed a taxable distribution, thus causing the owners to pay income taxes on the return of principal (which never would have happened had the transaction been properly documented as a loan).

Another area where this can cause problems is when the owners decide to sell their business or sell an interest in it to outsiders. Failing to properly document earlier transactions can cause problems in due diligence, which any sophisticated purchaser or investor would perform on a business he intends to acquire. The process of cleaning the mess up could be expensive (far more expensive than simply having documents prepared from the outset.)

A loan is just one example of the type of transaction that should be documented even when made between related parties. Another example is leases. Many business owners lease their own property to their business. But if they don’t prepare a written lease, the rent payments could be recharacterized as dividends or distributions. Here’s a couple of other examples: employment agreements, service agreements, purchases and sales of assets, and sale-leaseback transactions. All of these transactions between a business and its owners should have some level of legal documentation.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Should new business owners incorporate in Nevada?

Previously, I wrote about the pros and cons of incorporating in Delaware as a small business owner. My conclusion was that, for most small companies, the disadvantages outweigh any advantages. In this piece, I’ll cover my thoughts on another state that is frequently pitched as a good place for incorporation: Nevada.

Like Delaware, Nevada has a special court system for litigating business disputes. Nevada promotes its so-called “Business Court” as efficient and fast in its case management. However, Nevada’s Business Court doesn’t issue written opinions or binding precedent, so it does not provide the predictability that Delaware provides. In addition, as with being incorporated in Delaware, if your business is physically located in a state other than Nevada, the supposed efficiencies are probably outweighed by the hassle of having to litigate cases in a far away state. Therefore, for most business owners, I do not see Nevada’s Business Court as being a major benefit.

The second big selling point to incorporating in Nevada is that Nevada supposedly has greater protections for shareholders against a “piercing the corporate veil” action. Piercing the corporate veil involves holding the owners of a corporation or limited liability company liable for the debts of the company. Generally, piercing the corporate veil can only be done in extreme situations such as when the shareholder commits fraud or when the corporation is deemed the “alter ego” of the shareholder. The standard for successfully piercing the corporate veil in Nevada may be stricter than in your home state. However, it is important to note that if a lawsuit takes place in your home state or in some other state besides Nevada, conflicts of laws principles may cause the law of a state other than Nevada to control whether a piercing the corporate veil action would be successful. In other words, judges often have a lot of discretion as to which state’s laws apply in multi-state cases and often begin with the assumption that the law of the forum applies unless a party can show that another state’s laws have greater contacts or interests in the case. In fact, while Nevada corporations are often promoted as being particularly useful to business owners in California, California has been one of the most aggressive states in applying its own corporate laws to businesses incorporated elsewhere but doing business in California. Therefore, my recommendation is to use your own state’s incorporation statute and take effective precautions against liability, which includes observing all corporate formalities and making sure that you and your company have adequate liability insurance coverage.

Nevada corporations are also promoted for their asset protection abilities. Nevada law provides that the sole remedy available to creditors of owners of Nevada closely held corporations and LLCs is a charging order. A charging order is an order by the court directed to the company ordering the company to send all distributions and dividends that would have gone to the shareholder/owner/debtor to the judgment holder instead. This limitation can make it more difficult for a creditor to collect on their judgment because the creditor will not be able to force the debtor to sell his stock or ownership interest in the company. Usually, after a creditor obtains a judgment against a debtor, the creditor is entitled to sell the debtor’s personal property to satisfy that judgment. However, if the creditor’s sole remedy is a charging order, then the creditor is entitled to whatever distributions or dividends are produced from the ownership interest (if any at all), but the creditor cannot transfer or sell that ownership interest. Having this protection can give a debtor more leverage in negotiating a settlement. However, the charging order limitation is not unique to Nevada. Most states’ LLC statutes provide that the sole remedy to a creditor of a member is a charging order. It is true that Nevada has extended the charging order limitation to situations that other states have not, namely to closely held corporations and single member LLCs. However, as in the case of piercing the corporate veil, you cannot be sure that your own home state won’t go ahead and apply its own law to the situation, notwithstanding whatever Nevada law states. My colleague Jeff Vandrew wrote recently about this issue and has some suggestions for alternative asset protection precautions that can be taken using your own home state’s LLC statute. These precautions are far more likely to accomplish your asset protection goals than simply incorporating in Nevada and hoping that the judge applies Nevada law.

As with Delaware, I don’t think there is much advantage for most businesses to incorporating in Nevada, as opposed to the business owner’s home state. You will end up incurring double the fees, because you will have to pay Nevada’s fees and then pay your own states fees to obtain authorization for your Nevada entity to do business in your own state. Despite this additional cost and complication, it is uncertain whether you will see any of the benefits, such as greater asset protection and liability protection, that are often promised in connection with incorporation in Nevada. As always, your final choice in entity selection should be based on your own specific situation. Therefore, before making any final decisions on your form of business, you should speak with your attorney.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Bill Introduced in Congress to Permit Private Companies to Stay Private for Longer

Representative David Schweikert (R-AZ) recently introduced a bill called the “Private Company Flexibility and Growth Act,” which promises to allow private companies to remain private for a longer period of time.  Currently, if on the last day of a company’s fiscal year, any class of securities of the company is held of record by 500 or more shareholders and the company has total assets of more than $10 million, then it must register under the Securities Exchange Act of 1934.  This brings upon it a multitude of responsibilities and obligations including filing annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and meeting proxy regulation requirements.  With these added obligations, most companies will simply choose to go public (i.e. engage in an IPO), since they might as well gain the advantages of the public markets given that they will now be dealing with all of the compliance expenses that come along with them.  An example of a company that is likely dealing with this issue now is Facebook.  It has been widely reported that it is either past the 500 shareholder limit or soon will be, since its shares are held by many employees, some of which may have sold their shares to other parties.  Many people believe that Facebook has no desire to go public, but will likely be forced to do so early next year.  Is that fair?

Certainly Rep. Schweikert doesn’t think so.  His bill would make a couple of changes.  First, it would increase the shareholder limit to 999 from the existing 499.  Second, accredited investors and persons who received shares pursuant to an employee compensation plan would no longer count towards the limit.  The second change is the far more important one, since it will allow private companies to grow to almost a limitless size without ever being required to go public.  A vast majority of the shares of private companies are issued in one of two ways: (1) private offerings made only to accredited investors and (2) shares issued to employees as compensation.[1]  Since the two largest categories of shareholders in a private company would no longer be counted towards the limit, this bill would effectively do away with the requirement of companies to go public as they expand.

Since I also write a lot on private investment funds, I would also point out that this bill would be of significant benefit to some of the larger hedge funds and private equity funds.  Large private funds tend to be so-called “(3)(c)(7)” funds.  3(c)(7) funds are offered only to qualified purchasers, which general speaking are individual investors with investment assets over $5 million or companies with investment assets over $25 million.  Because of the Exchange Act’s 499 investor limit, these funds cannot have more than 499 investors under current law.  If this bill were passed, there would be no limit to the amount of investors that a 3(c)(7) fund could have, since any qualified purchaser would easily qualify as an accredited investor.  Many people often incorrectly believe that the 3(c)(7) exception itself contains the 499 investor limitation. It does not; the limitation is in the Exchange Act.  Thus this bill would allow the largest private hedge funds, private equity funds, and venture capital funds to get even larger.

I agree with the overall premise of this bill.  I do think that companies should have more control over when and if they go public.  I also think that the bill is unlikely to pass in its current form for a couple of reasons.  First, regulators are likely to lobby against it rather aggressively.  Since accredited investors and employee shareholders will no longer count towards the limit, the limit would be effectively eliminated.  For a lot of people in the securities regulation field, that would be a step too far, potentially undermining the investor protection policy goals of the Exchange Act.  Second, I’ve already pointed out that large hedge funds will be unintended significant beneficiaries of the bill, and it will be too easy to paint this bill as something favored by “Wall Street.” (And we would never want to do anything like that!)

That said, this bill is part of a conversation that is has begun over the last year.  Even Mary Shapiro, chair of the SEC has written about the possibility of loosening the 499 investor limit on private companies.  I think that if some of the concerns mentioned above are addressed, the introduction of this bill moves us closer to the possibility of reforming the Exchange Act’s limits on private companies.

Footnotes

[1] Some may point to Rule 12h-1(f), which exempts employee stock option holders from the 499 investor limit, if certain conditions are met.  But this rule does not exempt actual employee stock holders from counting towards the limit, so the exemption on employee shareholders in this bill is a significant loosening of restrictions.

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© 2011 — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.