I have been away from my blog for more than a year. I am hopeful that I can post more often. My goal is to provide timely and useful information to shareholders and management in close corporations. I have not been timely but my hope is that the information has been useful.

Much of what I do involves shareholder litigation in close corporations, preventing the same and the related area of succession planning. The preventative measures and succession planning techniques utilize creative estate planning, gifts, buy-sell agreements, voting trusts and agreements–the usual suspects. I came across a piece in The New York Times which added a new dimension to the discussion. A link is http://nyti.ms/12phzMV

Non competition agreements have long been central to protecting intellectual property and confidential information (together “IP”) of a business against unfair competition.  That may change because of a bill being considered by a committee of the Massachusetts legislature.  The text of the bill may be found here

In brief, the bill provides that a covenant not to compete must among other things:

1.   be in writing, signed by the employee and employer, be supported by fair and reasonable consideration and comply with certain procedural requirements,

2.    be necessary to protect trade secrets, confidential information or goodwill of an employer,

3.    be of a reasonable duration, and with one exception, not exceeding one year after the employee’s termination (6 months is presumptively reasonable),

4.    be reasonable in geographic scope,

5.    be reasonable in scope of prescribed activities in relation to the protected interests, and

6.    be “consonant with public policy.”

In the event that the agreement does not meet 2-6 above, it must be capable of being reformed by a court to meet those requirements.

If certain conditions are not met, the court must award the employee attorneys’ fees if it declines to enforce a material restriction or substantially reforms it. On the other hand, a court  may, if certain conditions are met, award the employer attorneys’ fees in connection with enforcement of the restriction.

The bill, however, does not include in the above, among other things, covenants not to solicit employees, or transact business with customers, of the employer.  These are important exceptions.

In addition, whether or not the bill becomes law, non competition agreements should not be the sole means of protection of a company’s IP.  Non-disclosure and trade secret agreements are also protective.  This is best illustrated by a recent case.  An ex-employer was trying to stop an ex-employee from duplicating its products in a company the ex-employee had just started. The ex-employer brought suit.  The court found that the ex-employee’s non competition agreement had lapsed.  The court, however, let the case progress on the basis of confidentiality agreements the then employer had required the then employee to sign and on the basis of the ex-employee’s possible appropriation of trade secrets.

When a business seeks to enforce the foregoing agreements, courts look carefully and critically at the agreements and systems the business has taken to protect a company’s IP.  Needless to say, these agreements and systems must be carefully crafted.  Thus the court in the above case, on oral argument, focused upon the systems the employer had put in place to protect its trade secrets.

Boston attorney, Theodore A. Lund, Esq., brought to my attention, an excellent discussion regarding non competition agreements.  This may be found here.

When it comes to incorporating a business, there is a mystique that may cause the business owner to want the “benefits” of a Delaware corporation. After all, most public companies are incorporated in Delaware, aren’t they? Most of the time, however, incorporation is best in the state where the principal office of the business is located.
What then, if any, are the benefits of incorporation in Delaware. The main benefit is that the Delaware corporation law is clear, well thought out, predictable and undergoes change gradually. In addition to the law, the Delaware courts are excellent and are experienced in corporate matters. This advantage is somewhat lessened by so-called business litigation courts which have developed in several states. The Business Litigation Session in Massachusetts, for example, is excellent.
Another advantage of a Delaware corporation over a Massachusetts corporation is that, in a plain vanilla corporation, Delaware does not recognize the enhanced fiduciary duty that shareholders owe one another in a close corporation. (See my earlier post of July 25, 2011 discussing fiduciary duty in a Massachusetts corporation). The duty owed fellow shareholders in a Delaware corporation is lower than the duty owed in a Massachusetts corporation.
Some have argued that the Delaware courts are “management friendly” though I have not observed any evidence of that.
Unless a complicated capital structure is planned for the business, I recommend incorporation in Massachusetts, if that is the corporation’s place of business. This is because, in addition to Massachusetts fees and taxes, a Delaware corporation will also incur Delaware taxes, will be required to appoint a representative in Delaware and will be required to qualify as a foreign corporation in Massachusetts. All of this is unnecessarily expensive for a new venture.
Down the road, when it comes to venture capital financing, most VCs will require that the corporation be incorporated in Delaware. Changing the state of incorporation of a corporation at that point, however, is relatively easy.
A business’s choice of state of incorporation as well as choice of entity (LLC or corporation) depends on many factors. One should carefully consider these decisions with the business’s lawyer and accountant.

Rule 506 of SEC’s Regulation D provides a “safe harbor” for the private placement of securities. Under Rule 506, a company is able to raise an unlimited amount of money. One of the requirements of the rule is that the company cannot use general solicitation or advertising to market the securities offering. Rep. Kevin McCarthy (R-Cal.) recently introduced H. R. 2940 which, if enacted, would require the SEC to provide in Rule 506, that the prohibition against general solicitation or advertising would not apply to offers and sales, provided that all purchasers of the securities are accredited investors. Although the definition of “accredited investor” can be complex, with respect to natural persons (humans) other than company insiders, an accredited investor is one (a) with income exceeding $200,000 in each of the last two years, or joint income with a spouse exceeding $300,000 during that period, and a reasonable expectation of the same level in the current year or (b) one who has individual net worth, or joint net worth with a spouse (in each case exclusive of the value of the principal residence) that exceeds $1 Million at the time of purchase.
On the surface, eliminating the requirement of general solicitation or advertising is laudable. In these gritty times, any enhancement to capital formation is helpful. The bill, if enacted, would also provide more precision to Rule 506 compliance. I have always been concerned about what was meant by the term “general solicitation or advertising.” If the SEC were to adopt guidelines, in the rule for the term “general solicitation or advertising,” it might be helpful in constructing the “safe harbor.”
On the other hand, state securities regulators, such as Heath Absure, Arkansas Securities Commissioner, have expressed concern about the bill’s possible effect of increasing fraud under Rule 506. I think this is possible. As noted above, the test for non insider accredited investors who are natural persons is based either on income or net worth. The tests, with one recent modification, were set some time ago and are pretty low bars today. Furthermore, the tests deal with relative wealth and not with the sophistication of the investor. It is quite possible for one to be relatively rich and unsophisticated. Also, Mr. Absure observes, that many purchasers will lie about their income or net worth qualifications and purchase the securities anyway.
The prior paragraph, however, repeats criticisms of the existing regulatory scheme, which have been voiced apart from Rep. McCarthy’s bill. It is difficult to see how general solicitation or advertising (which complied with guidelines provided by the SEC) which would require each purchaser (who must be an accredited investor) to be given, prior to sale, a comprehensive private placement memorandum would significantly increase securities fraud.
The SEC had, in 2007, proposed, but did not enact, a rule that would have permitted limited solicitation or advertising in certain private placements to “large accredited investors.”

Generally, it is unlawful to sell securities unless they are the subject of an effective registration statement and, in most states unless, qualified under their securities laws, unless in either case the transaction or the security is exempt.  An earlier post discussed sales of securities to friends and family and the dangers of running afoul of federal and states’ securities laws.

The start up venture will infrequently have sufficient funds to adequately compensate, officers, directors, consultants and employees.  Issuance of stock or options to purchase stock are an easy and inexpensive way to increase such compensation.  How difficult is it to issue officers,  directors, consultants and employees options or stock within the confines of federal and state securities laws?

SEC Rule 701 offers a safe, direct and simple way to do this.  That rule permits nonpublic companies to issue their securities to, among others, employees, officers, directors and some consultants, under a written benefit plan or compensation contract, without registration, and without filings, if the requirements of the rule are met.  The rule is non exclusive and the Company may claim any other exemption from the registration requirements of the Securities Act of 1933.

First, the total sales price of securities sold under Rule 701 during any consecutive 12 month period can’t exceed the greatest of the following:

a    $1 Million,

b    15% of the total assets of the company, measured at the company’s most recent balance sheet date (if no older than its last fiscal year end), or

c    15% of the outstanding amount of the class of securities being offered and sold in reliance of Rule 701, again measured at the company’s most recent balance sheet date (if no older than its last fiscal year end).

Sales of securities underlying options must be counted as sales on the date of option grant.

Second, the Company must deliver to the investor a copy of the benefit plan or compensation contract.  The preliminary notes to the rule, however, state that the Company and those acting on its behalf  “have an obligation to provide investors with disclosure adequate to satisfy the antifraud provisions of the federal securities laws.”  This is a little tricky and any such disclosure beyond the mere delivery of the plan or contract depends upon the Company and the composition of the proposed sales under Rule 701.

If the aggregate price of securities sold exceed $5 Million during any consecutive 12 month period, the Company must make further disclosures.  For example risk factors, and plan and financial information must be provided.

There are restrictions on transfer of the shares sold under Rule 701.

Not all consultants or advisers may be granted shares or options under the rule. There are restrictions as to which persons may be granted shares or options.

State securities laws should be checked.  By regulation, Massachusetts has a self-executing exemption for shares issued pursuant to Rule 701.

Many start-up ventures raise money from friends and family without regard to compliance with federal or state securities laws.  Many believe that compliance is unnecessary (the company is too small), is too expensive (why should I pay money to a lawyer, when I can put it to work in the company—money is a valuable and scarce resource, after all) or that the offering will fly under regulators’ radar.

This is a mistake.

There are registration (or similar qualification, under state law) requirements and antifraud provisions in securities laws that affect friends and family offerings.  An excellent article by Alexander Davie discusses, in plain English, the foregoing requirements and civil and criminal penalties for non compliance.  I would only add the following.

To comply with the anti fraud provisions of federal and state securities laws, the company must carefully determine what it discloses to potential investors.  It must appraise potential investors of the risks of investing in the company.  These risks are not always obvious.  I recommend that a private placement memorandum (“PPM”) be used.  The PPM describes, among other things, the company, its officers and directors, the use of proceeds of the offering and its risk factors.  The PPM is then given to each of the potential investors.  I, and many corporate lawyers have done a number of these and, except for information peculiar to an offering and to the company, the prior deal can be marked up.  The expense is not  significant, especially considering the risks.  This is especially so as many friends and family offerings often proceed to friends of friends of friends offerings.  In addition to reducing risk the PPM should be a selling document.

As to registration (qualification) requirements, a non-compliant offering could impair further rounds of financing.  At the closing of institutional financings the company’s lawyer will be required to give an opinion that all prior sales of the company’s securities were in compliance with federal and state securities laws.  If the past financings were not compliant, the financing might not take place or a rescission offer (an offer to buy back the securities) to the friends and family might be required.  In any event, the financing, if it took place at all would be messy and expensive.  Where future financings are planned, I recommend that the offering comply with the requirements of Regulation D under the federal Securities Act.  All that is required is a simple filing with the SEC and state securities laws (New York’s filing is a little more difficult) and compliance with certain other requirements.  Properly done, that assures compliance with the registration or qualification requirements.

Posted August 8, 2011 by Edmund Polubinski, Jr.

Many people assume that a corporation or an LLC insulates its principals from liability.  That is not necessarily true.   The principal is protected from contract liability.  He is also shielded from tort liability unless the principal him/herself commits the tort.  For example, if X, the president, director and an owner of stock in a corporation is negligent in an accident, in the course of the corporation’s business, the corporation and X are liable.  If, however, the corporation has an employee who is negligent in such an accident, only the corporation is liable (as long as X was not at fault).

As mentioned above, the law protects the principal from contract liability.  Principals may, however, voluntarily undertake contractual liability.  Banks may require personal guarantees of the principal in connection with loans to the corporation and landlords may require personal guarantees in connection with leases to the corporation.  There are many other instances.  For example, I recommend to my clients that are food wholesalers, when extending terms, to include a personal guaranty of the principal on the corporate credit application.

Courts will also impose liability in certain cases by “piercing the corporate veil.”  This is an equitable doctrine and thus very flexible; courts will use it to make liable principals of corporations in order to prevent fraud or to do justice in particular situations.  The cases in Massachusetts are a little confusing but Massachusetts courts have recently adopted a 12 part test, asking:

  1. In the case of multiple corporations, whether there was common ownership,
  2. Whether there is “pervasive control,”
  3. Whether there is a confused intermingling of assets,
  4. Whether there is thin capitalization (Have the owners enough equity in the business?),
  5. Whether there is a non-observance of corporate formalities (Do directors approve important matters?),
  6. Whether there is an absence of corporate records (Is there a minute book?  Bylaws?  Minutes?),
  7. Whether there is a record of non-payment of dividends,
  8. Whether the corporation was solvent at the time of the transaction that is the subject of the lawsuit,
  9. Whether there was “siphoning” away of corporate funds by the dominant shareholder,
  10. Whether there was non-functioning of corporate officers and directors,
  11. Whether the dominant shareholder used the corporation for personal matters (Are personal bills paid out of the company’s checkbook or are company assets used for personal use?  I was once involved in a lawsuit that involved a corporation paying utility bills for service at the homes of the controlling shareholders),
  12. Whether the corporation was used in promoting fraud.

At least one Massachusetts case has embellished the 12 tests above and adopted further tests. A glance at the twelve factors shows that a lot of the factors are subjective, but the corporation can and should take steps to make sure that the objective factors are met.

The above is applicable to an LLC.  Is it worth it to incorporate or to form an LLC?  The answer is that it depends on the particular circumstances.  Incorporation or formation of an LLC itself is not expensive but it does result in annual fees, taxes and other expenses.  This must be weighed against the benefits of a somewhat limited liability.  This is one more thing that should not be done at home, but at your attorney’s office.

Posted August 4, 2011 by Edmund Polubinski, Jr.

A minority shareholder in a closely held corporation is subject to abuse at the hands of the majority.  Courts and legislatures, however, have given some relief from majority shareholder oppression.

In 1975, the Supreme Judicial Court of Massachusetts held that shareholders in a closely held corporation owe to each other a fiduciary duty of “utmost good faith and loyalty.”  This is because in a close corporation there is potential for abuse and oppression of the minority shareholder.  The minority may be frozen out of dividends, employment opportunities or other benefits.  Because there is no ready market for the shares of a closely held corporation, the minority shareholder cannot readily extricate himself or herself from the corporation.  The Court noted that plight of the minority shareholder was untenable.  After recognizing the fiduciary duty, the Court held that if an opportunity is made available to a controlling shareholder (in that case, the repurchase of the controlling shareholder’s shares), that same opportunity must be made available to the minority shareholders.

In a later case the Court said that the “untempered application of the doctrine might interfere with legitimate corporate action.”  It therefore modified the law to permit controlling shareholders to show that a legitimate business purpose was served by the deed that harmed the minority.  The minority was then free to show that the business purpose could have been achieved by a less harmful alternative.  The Court stated that “[i]f called upon to settle a dispute, our courts must weigh the legitimate business purpose, if any, against the practicability of a less harmful alternative.”

In the more than 35 years since the doctrine was first articulated, many oppressed shareholders in Massachusetts have obtained relief for breach of fiduciary duty.  To circumvent this doctrine (and also for other reasons) many venture capitalists insist that their investments be in corporations incorporated in Delaware where the doctrine does not apply.

While this is the Massachusetts law, other states, either by case law as in Massachusetts or by statute have come to the same conclusion.  I successfully represented minority shareholders in two oppression cases in New Jersey under a statute that provided that, in a corporation having 25 or fewer shareholders, if directors or those in control have “acted oppressively or unfairly toward one or more minority shareholders,” then a court could grant the minority relief.

Posted July 25, 2011 by Edmund Polubinski, Jr.