LLC Annual Costs by State — Updated

Updated: March 15, 2012

The following discussion of the annual costs of forming an LLC in each state and the District of Columbia apply only to LLC’s that are classified as partnerships for tax purposes.  The discussion does not apply to LLCs that have elected to be treated as corporations for tax purposes.  It also does not apply to single-member LLC’s because there are special rules for such LLCs in several states.  The amounts below are subject to change, especially during times like these when states are looking for ways to increase revenues.

Important reminder:   A LLC must register as a “foreign” LLC in each jurisdiction in which it is “doing business” other than the jurisdiction in which it was formed.  (The question of what constitutes “doing business” in a state is very complex and will be the subject of a future post.)  Thus, finding the lowest cost jurisdiction in which to form an LLC may be counter-productive because in many cases the LLC will still be required to register as a foreign corporation in the state where the principal place of the business is located.  Thus, a LLC might find itself paying fees in two jurisdictions when it could have paid fees in only one.

LLC Annual Costs by State

The Corporation Secretary

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NLRB Poster Requirement: Update

(Further Update:   On April 17th the DC Circuit Court of Appeals temporarily enjoined the NLRB’s rule requiring the posting of employee rights, which had been scheduled to take effect on April 30, 2012.  The NLRB issued a public statement announcing,  “In view of the DC Circuit’s order, and in light of the strong interest in the uniform implementation and administration of agency rules, regional offices will not implement the rule pending the resolution of the issues before the court.”)

In our post of August 30, 2011, we advised that the National Labor Relations Board had adopted a final rule on August 25, 2011 (published on August 30) requiring most private-sector employers to notify employees of their rights under the National Labor Relations Act by posting a notice in a conspicuous location in the workplace.   The poster requirement, designed to notify employees of their rights under the National Labor Relations Act, such as the right to organize a union, had an original deadline of November 14, 2011.  This deadline for posting the notice was subsequently extended to April 30, 2012 because of litigation challenging the rule brought by various plaintiffs including the National Association of Manufacturers, the National Right to Work Legal Defense and Education Fund, Inc., the Coalition for a Democratic Workplace, and the National Federation of Independent Business.  (As noted in our August 30th post:  “This rule will undoubtedly be tested in the courts.”)

On March 2, 2012, the federal district court in Washington, D.C., upheld the statutory authority of the NLRB to require employers to display a poster informing employees of their rights under the National Labor Relations Act.  Significantly, however, the court struck down two of the penalty provisions included in the NLRB’s final rule.

The court held that the National Labor Relations Act includes a “broad, express grant of rulemaking authority” to the NLRB, which permits the NLRB to require employers to post a notice informing employees of their rights under the Act.  But the court agreed with the plaintiffs that two provision in the final rule violated the plain language of the Act:  First, that any failure to post the notice could be deemed an unfair labor practice under the NLRA, and second, that failure to post a notice would allow the NLRB to extend the six‐month limitations for filing a charge against the employer alleging other unfair labor practices. While invalidating these aspects of the NLRB’s rule, the court noted that the NLRB may be able to prove in an appropriate case that a failure to post the notice constitutes an act of interference with protected rights and thus violates the Act. The court also noted that its rejection of the provision calling for tolling the statute of limitations for failure to post the notice did not prohibit a party alleging an unfair labor practice from establishing the elements of “equitable tolling” in a particular case. Moreover, the court did not strike down that part of the rule allowing an employer’s “knowing and willful” failure to post a notice to be considered evidence of unlawful motive.

NLRB Chairman Pearce released a statement on March 2nd, indicating that the NLRB would pursue the alternative left open by the court and make case-by‐case determinations of whether a failure to post the notice constitutes an unfair labor practice.

The plaintiffs’ have appealed the court’s decision to the U.S. Court of Appeals for the D.C. Circuit and have asked the appellate court to enjoin the posting requirement while the appeal is pending. Unless a stay is granted, the deadline remains April 30, 2012.

The Corporation Secretary

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Reg D Accredited Investor: Amended Definition and Surprising SEC Guidance

Regulation D under the Securities Act of 1933 provides a “safe harbor” for private placements from the requirement that any sale of securities must first be registered with the Securities and Exchange Commission.  To qualify for this safe harbor, certain requirements must be met.  One of the requirements is a limitation on the number of purchasers if the total amount of the securities sold in the private placement exceeds $1,000,000.   This limit is 35 purchasers, excluding Accredited Investors, with the further requirement that in the case of any sale of securities exceeding $5,000,000 in the aggregate, each purchaser who is not an Accredited Investor, either alone or with his purchaser representative, must have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer must reasonably believe immediately prior to making any sale that such purchaser comes within this description.

Rule 501 of defines the term “accredited investor”.   In respect of natural persons, the definition is:

  • a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;  (The language in italics was added by the SEC on December 21, 2011)
  • a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year;

The definition of Accredited Investor is important for another reason apart from the limitation on the number of purchasers.  In any private placement over $1,000,000 the issuer must provide certain information, specified in Rule 502, to each purchaser that is not an accredited investor.  In contrast, there is no specific information that need be provided if all the purchasers are accredited investors (subject, of course, to the general Rule 10b-5 requirement that if any information is given, it cannot contain material misstatements or omissions).   Thus, in an private placement over $1,000,000, if (i) there is a purchaser who is not an accredited investor, regardless of the purchaser’s level of financial sophistication, and (ii) the issuer has not provided all the information required by Rule 502, the SEC or a court may take the position that requirements of Regulation D were not met and therefore the securities were offered in violation of the registration requirements of Section 5 of the Securities Act.  This would give the purchaser a right of rescission or a right to recover losses if it had already sold the security.

On December 21, 2011, the SEC adopted amendments to the accredited investor standards in its rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of the Dodd-Frank Act.  Section 413(a) requires that the value of a person’s primary residence be excluded when determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million.

The SEC has issued the following guidance relating to the Section 413(a) amendment:

The individual must have a net worth greater than $1 million, either individually or jointly with the individual’s spouse. Except for the special provisions described below, individuals should include all of their assets and all of their liabilities in calculating net worth. 

  • The primary residence is not counted as an asset in the net worth calculation. The term “primary residence” is not defined in SEC rules but is commonly understood to mean the home where a person lives the most of the time. 
  • In general, debt secured by the primary residence (such as a mortgage or home equity line of credit) is not counted as a liability in the net worth calculation if the estimated fair market value of the residence is greater than the amount of debt secured by it. There is no requirement to obtain a third party estimate of the fair market value of the residence. 
  • However, if the amount of debt secured by the residence has increased in the 60 days preceding the sale of securities to the investor (other than in connection with the acquisition of the primary residence), then the amount of that increase is included as a liability in the net worth calculation, even if the estimated value of the residence is greater than the amount of debt secured by it. The purpose of this provision is to deter individuals from incurring debt secured by their primary residence for the purpose of inflating their net worth to qualify as accredited investors in purchasing securities. 
  • If the amount of debt secured by the primary residence is greater than the estimated fair market value of the residence, then the excess is included as a liability in the net worth calculation. Where the amount of secured debt is greater than the value of the primary residence, such as when a mortgage is “underwater,” the excess is counted as a liability when calculating net worth. This is true even if the borrower may not be personally liable for the excess amount by reason of the contractual terms of the debt or the operation of state anti-deficiency statutes or similar laws.
  • The primary residence can be included in the net worth calculation for certain follow-on investments   The former accredited investor net worth test, under which the primary residence and indebtedness secured by it are included in the net worth calculation, applies to purchases of securities in accordance with a right to purchase such securities, if:  (i) the right was held by a person on July 20, 2010, the day before the enactment of the Dodd-Frank Act; 
(ii) the person qualified as an accredited investor on the basis of net worth at the time the right was acquired; and (iii) the person held securities of the same issuer, other than the right, on July 20, 2010.

This guidance is surprising in two respects.  First, it requires that if the amount of mortgage debt on a primary residence exceeds the market value, the excess must be treated as a liability in the net worth calculation.  (Note that no third party appraisal is required.  How then is the excess amount determined?)   Second, mortgage debt acquired within 60 days of the purchase of the securities must be included in liabilities for purposes of the net worth test.  This could be problematic because the issuer might not know if the purchaser has acquired new mortgage debt within 60 days of the sale.  The Investor’s Questionnaire that is typically used to verify Accredited Investor status is often completed weeks, even months, before the closing of the private placement.  Presumably, this will lead to a covenant that investors must make to the effect that they will acquire no new mortgage debt without revising their Investor’s Questionnaire.

Corporate Law Advisers LLP



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M&A: Real Estate Transfer Taxes in a Sale of a “Controlling Interest” of a Company

This may be surprising to some, if not counter-intuitive, but sixteen states impose a real estate transfer tax when a controlling interest in a legal entity is transferred.  See the table below.   The real estate transfer tax triggered by these so-called “controlling interest” transfers do not require a change of name, the recordation of a new deed, a bill of sale, or payment of an allocated purchase price.  The mere transfer of a controlling interest is sufficient, although the company directly affected by the transfer (ultimate parent or intermediate parent or the entity holding title to the real estate) as well as the form of entity (corporation, LLC or partnership) can be relevant, depending on the applicable state law.  It is the law of the state or local jurisdiction where the real estate is located that applies, not the law of the jurisdiction of incorporation of the legal entity or the transferee.  The tax rate ranges from 0.1% to as high as 5%, depending on the state.  In some states the transfer tax is not large, assuming the tax is paid in a timely manner.  As with all taxes, late payment can result in significant interest and penalties.

This topic is difficult to discuss in a general way because there are several issues involved and few states treat all those issues in the same way.  For example, some states provide an exemption from the transfer tax for intra-group transfers (e.g., New York, Connecticut and Washington) provided that the ultimate parent remains the same.  Other states have no such exemption, which means that an internal corporate reorganization could result in a real estate transfer tax in one or more jurisdictions.  Similarly, the definition of “controlling interest” varies from state to state.  Many states define a “controlling interest” as more than 50% but other states have a higher threshold.  New Hampshire does not even define “controlling interest”, which can make it challenging to assess the applicability of the law in some circumstances.

Six states and the District of Columbia limit the application of their controlling interest real estate transfer tax to “real estate entities” but, again, the definition of a “real estate entity” varies from one jurisdiction to the next.  Typically, they use an asset test or income test (or both) that compares the percentage of real estate assets against total assets, or income from real estate activities against total income.  A ratio above a specified threshold indicates a real estate entity.  However, an important point of difference among jurisdictions is whether the assets or income are limited to real estate in the state where the tax is imposed or whether the test is applied to all real estate assets or income, wherever located, on a consolidated basis.

Another issue is the valuation against which the transfer tax rate is applied.  If the purchase price is paid to acquire shares (or some other entity-level ownership interest), what is the value of the transferred real estate for purposes of the transfer tax?  This question of value is quite ambiguous in several state laws.  Generally, there is a reference to either fair market value or the appraised value (for property tax purposes) when no part of the purchase price is allocated to specific real estate in the purchase agreement, but this issue is seldom addressed as clearly as one might expect it to be.

Two other issues to consider are the level at which the transfer occurs and the treatment of a transfer of publicly traded shares.  Again, states differ.  Some states look at the transfer of the entity holding title to the real estate, while others include transfers of a controlling interest in a corporate parent, whether the ultimate parent or an intermediary company.  Most states provide an exemption for sales of publicly traded shares, but the exemption applies only to the sales of such shares, not the sale of a subsidiary that holds real estate in a state where the transfer tax applies.

As the foregoing discussion shows, it is hard to generalize about controlling interest real estate transfer taxes.  However, one general statement can be made:  It is important to check the laws of each state where real estate is located when planning any sale of a company or a large (50% or greater) interest in a company.

The states below impose real estate transfer taxes.  Sixteen have a “controlling interest” transfer tax.   Note that only state laws are listed below.  There may be transfer taxes imposed by counties, municipalities or other political subdivisions.  In addition, this chart is likely to change as more states discover this source of additional tax revenue.

Alabama Ala. Code § 40-22-2


Arizona Ariz. Rev. Stat. Ann. § 11-1132


Arkansas Ark. Code Ann. § 26-60-105


California Cal. Rev. & Tax. Code § 11911


No state transfer tax but counties and cities can impose a controllong interest real estate transfer tax (and some do, such as San Francisco and Oakland).
Colorado Colo. Rev. Stat. § 39-13-102


Connecticut Conn. Gen. Stat. § 12-494


No transfer tax if the ultimate ownership remains the same. Threshold for a change of control is more than 50% interest.
Delaware Del. Code Ann. § 5402


Controlling interest transfer tax is imposed only if entity is in real estate business, as defined in the law. Value of transferred property for tax purposes is generally the greater of consideration paid or appraised value (if fair market value is less than appraised, value for tax is the greater of consideration paid or fair market value).  Transfer tax rate is 3% in some jurisdictions.  Tax does not apply to transfers of publicly traded stock.
District of Columbia D.C. Code Ann. §§ 42-1103, 47-903


Controlling interest transfer tax is imposed only if entity is in real estate business, as defined in the law. The transfer tax rate is 2.9%.
Florida Fla. Stat. § 201.02


Georgia Ga. Code Ann. § 48-6-1


Hawaii Hawaii Rev. Stat. § 247-1


Illinois 35 ILCS 200/31-10


Controlling interest transfer tax is imposed only if entity is in real estate business, as defined in the law. Threshold for a change of control is more than 50% interest.
Iowa Iowa Code Ann. § 428A.1


Kansas   Tax on recordation of mortgages, not on conveyances of real estate.
Kentucky Ky. Rev. Stat. Ann. § 142.050


Louisiana   No state tax on transfers but parishes may impose a tax.
Maine Me. Rev. Stat. Ann. § 36-4641-A


Maryland Md. Code Ann. Tax-Prop. §§ 12-102, 13-202


Controlling interest transfer tax is imposed only if entity is in real estate business, as defined in the law. Threshold for a change of control is 80% interest. Recordation and transfer tax rates vary from 1.16% to 3%.  Tax does not apply to transfers of publicly traded stock.
Massachusetts Mass. Gen. L. Ch. 64D, § 1


Michigan Mich. Comp. Laws §207.523


Controlling entity transfer tax is imposed only if entity is in real estate business, as defined in the law.
Minnesota Minn. Stat. §287.21


Nebraska Neb. Rev. Stat. § 76-901


Nevada Nev. Rev. Stat. § 375.020


New Hampshire N.H. Rev. Stat. Ann. § 78-B:1


Controlling entity transfer tax is imposed only if entity is in real estate business, as defined in the law.
New Jersey N.J. Rev. Stat. §§46:15-7, 46:15-7.1, 46:15-7.2


For controlling-interest transfers of entities having more than $1M of classified real estate, tax is imposed on the assessed value of the property determined by a state assessor for property tax purposes times a multiplier based on where the property is located.  Rate is 1%.
New York N.Y. Tax Law §§ 1402, 1402-a


No transfer tax if the ultimate ownership remains the same. Threshold for a change of control is 50% or more interest. Transfer tax rate in New York City (combined state and local rate) is up to 3.025%.
North Carolina N.C. Gen. Stat. § 105-228.30


Ohio Ohio Rev. Code Ann. § 319.202


Oklahoma Okla. Stat. Ann. tit. 68, § 3201


Oregon Or. Rev. Stat. § 306.815


No state transfer tax but counties and cities with a transfer tax in effect on 3-31-97 may continue the tax.
Pennsylvania Pa. Cons. Stat. § 8102-C


Controlling interest transfer tax is imposed only if entity is in real estate business, as defined in the law. In the case of an covered entity transfer, tax is imposed on the value of the real estate determined by adjusting the property’s assessed value by the common level ratio used for local property tax purposes. Tax rate varies from 2% to 5%, depending on location.  Threshold for a change of control is 90% interest.
Rhode Island R.I. Gen. Laws § 44-25-1


South Carolina S.C. Code Ann. § 12-24-10


South Dakota S.D. Codified Laws Ann. § 43-4-21  
Tennessee Tenn. Code Ann. § 67-4-409


Vermont Vt. Stat. Ann. tit. 32, § 9602


Virginia Va. Code Ann. § 58.1-801


Washington Wash. Rev. Code § 82.45.060


If ‘‘the total consideration for the sale cannot be ascertained or the true and fair value of the property to be valued at the time of sale cannot reasonably be determined, the market value assessment for the property maintained on the county property tax rolls at the time of the sale shall be used as the selling price.’’  Threshold for a change of control is more than 50% interest. No transfer tax if the ultimate ownership remains the same.
West Virginia W. Va. Code § 11-22-2


Wisconsin Wisc. Stat. §77.22  

The Corporation Secretary



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Using Background and Credit Checks when Hiring: Tread Carefully

Companies often use criminal background checks and credit checks when considering an individual for employment.  This practice should be used with caution.  The Equal Employment Opportunity Commission considers it illegal to make an employment decision based on a person’s criminal record or credit history, except in certain circumstances.

In the past few years, the EEOC has brought at least five lawsuits against employers that used criminal background checks and credit histories to make hiring decisions.   In addition, the EEOC, when investigating charges of individual discrimination, has been routinely asking for information about the employer’s policies and practices regarding criminal background checks.

The principal Federal law that prohibits discrimination is Title VII of the Civil Rights Act of 1964.   Under this law, employment practices, including hiring decisions, may constitute unlawful discrimination if they have a disparate impact on a protected group, unless the employer can demonstrate that the practice is both job related and consistent with business necessity.  The EEOC takes the position that a practice of refusing to hire someone merely because he or she has a criminal record will have a disparate impact on African-Americans and Hispanics.  The EEOC defines “disparate impact” as a “substantially different rate of selection in hiring, promotion, or other employment decision which works to the disadvantage of members of a race, sex, or ethnic group.”   This does not prevent an employer from using criminal background checks in all circumstances, but, according to the EEOC, an employer must apply three criteria when using such background checks:  (1) the nature and gravity of the offense; (2) the time that has passed since the conviction and/or completion of the sentence; and (3) the nature of the job held or sought.  As is often when case when governmental agencies provide a list of factors, they is no way of knowing the relative weight of each factor or what combination of factors is sufficient to meet the EEOC threshold for a permitted use of the criminal history.

Similarly, the EEOC considers the use of credit checks as discriminatory. The EEOC has stated:

“Inquiry into an applicant’s current or past assets, liabilities, or credit rating, including bankruptcy or garnishment, refusal or cancellation of bonding, car ownership, rental or ownership of a house, length of residence at an address, charge accounts, furniture ownership, or bank accounts generally should be avoided because they tend to impact more adversely on minorities and females. Exceptions exist if the employer can show that such information is essential to the particular job in question.”

An employer who decides that a background check for criminal history or credit problems is job related and consistent with business necessity must also meet the requirements with the Fair Credit Reporting Act.  FCRA requires that an employer do the following:

  • Advise the applicant in writing that a background check will be conducted;
  • Obtain the applicant’s written authorization to obtain the records; and
  • Notify the applicant that a poor credit history or conviction will not automatically result in disqualification from employment.

Finally, in addition to the Federal laws mentioned above, several states have laws relating to the use of an applicant’s criminal or credit records when making employment decisions.  For example, some states allow employers to consider only criminal convictions, not arrests.

This discussion raises several questions.  What exactly is “business necessity” and how does it relate to a particular type of criminal conviction?   What about registered sex offenders?  What kinds of jobs can be denied to them?   Is there a difference between crimes that suggest psychological aberration (arson) and crimes that require mental acumen (computer fraud)?  What if the criminal convictions are for DUI and the applicant admits to having an alcohol problem?  Can the applicant be denied employment as, say, a forklift operator?  Is the risk of risk of lawsuits against the employer by third parties who may be injured a legitimate consideration?  The list of questions is endless.

All regulations and agency interpretations of statutes serve a legitimate public purpose.  Unfortunately, regulations are often ambiguous or difficult to interpret in particular circumstances, and the interpretation given by a regulator as part of an examination of investigation might be quite outside the logic applied by a practical, profit-oriented business owner.  Worse, agency enforcement personnel today seem more zealous and less inclined to issue warnings than was the case in the past.  This means the hapless business owner is likely to be faced with the unhappy choice of either paying a fine, possible a substantial fine, or paying high legal fees to fight what seems like unfair treatment by a governmental agency.

In terms of the hiring practices discussed above, an employer should have written policies describing when and how background checks will be used in the application process, those policies should be adhered to, and, if a background check is run and the applicant is denied employment, a written record should made to show that either a specific “business necessity” resulted in the denial or that the denial was based on factors other than the results of the background check.   If these decisions are not put in writing and preserved, it can be very hard to convince a government inspector, months or years later, that an applicant was lawfully rejected.  Any explanation given “after the fact” and in the course of an investigation is likely to be viewed as self-serving and therefore unreliable.  Similarly, if advice is sought from an attorney in a particular situation, the advice should be put in writing and retained.   An employer who acts on the advice of counsel (and can show what the advice was) has a much better defense than an employer who made what seemed at the time to be a reasonable interpretation of the regulations, only to learn later that a government examiner completely disagrees.

The Corporation Secretary

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Private Placements: New Source of Liability for Intermediaries (and Directors?)

New Sections 9(a)(4) and 9(f) of the Securities Exchange Act of 1934 were added by the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Although little noticed thus far, these two provisions could soon become very common in lawsuits relating to losses from inadequate disclosure in private placements, especially lawsuits where intermediaries are named as co-defendants with the issuer of the securities.

First, some history.  Under Rule 10b-5, adopted by the SEC in 1942 pursuant to Section 10(b) of the Securities Exchange Act, it is unlawful “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not the misleading” in connection with the purchase or sale of securities.  This clearly applies to issuers and sellers but the perennial question has been extent to which intermediaries in a securities transaction can be found liable for the issuer’s or seller’s primary violation.   Somewhat surprisingly, the U. S. Supreme Court, which limits its review of cases to those with broad significance, has addressed this question three times in the past 17 years.

In Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) the Supreme Court held that private plaintiffs may not maintain “aiding and abetting” suits under the Rule 10b-5 against participants in a sale or purchase of securities, other than the seller or purchaser, for misstatements or omissions in connection with the sale or purchase. The Central Bank decision reversed a long history of court decisions and SEC enforcement actions in which participants in a transaction, including banks, accountants, trustees, and attorneys, were found liable as “aiders and abettors” under Rule 10b-5.  Fourteen years after Central Bank, the Supreme Court reached the same result in Stoneridge Investment Partners, LLC v. Scientific-Atlantic, Inc.  552 U.S. 148 (2008), by holding that plaintiffs do not have a private right of action against secondary parties for “aiding and abetting” securities fraud committed by a primary violator.  Such aiding-and-abetting claims under the federal securities laws may be brought only by the SEC in an enforcement action.

Then, very recently, the Supreme Court decided Janus Capital Group, Inc. v. First Derivative Traders, No. 09-525 (June 13, 2011).  The Court held in Janus Capital that the investment adviser to the Janus Funds could not be liable in a private action under Rule 10b-5 for false statements in prospectuses issued by the Funds, even though the investment adviser wrote the prospectuses and the employees of the Funds were also employees of the investment adviser.  The Court ruled that only the “maker” of a false statement can be liable under Rule 10b-5 and the “maker” is “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”  The Court concluded that the mutual fund itself was the entity with “ultimate authority” over the prospectuses because it had the statutory obligation to file the prospectuses with the SEC.  Hence, only the mutual funds, not the investment adviser, could be found liable under Rule 10b-5,

Fund managers and other intermediaries, such as broker-dealers, have no doubt taken great comfort from the very literal reading of Section 10(b) expressed in the Janus Capital decision because many commentators thought the Supreme Court would erode, if not reverse, the Central Bank and Stoneridge Investment decisions.

This comfort is probably misplaced.  While Rule 10b-5 may not be a concern for secondary participants, there is a new and bigger threat from new Sections 9(a)(4) and 9(f) of the Securities Exchange Act.  These new provisions are likely to dramatically change the liability exposure of intermediaries in the sale of securities, such as broker-dealers, investment advisers and fund managers.  The new provisions may even apply to accountants and attorneys who participate in securities transactions.  It is even possible that directors of the issuer will be caught in web of these new sections of the Exchange Act.

New Section 9(a)(4) makes it unlawful for any broker, dealer or other person selling or offering to sell (or purchasing or offering to purchase) any security other than a government security, “to make. . . for the purpose of inducing the purchase or sale of such security, . . . any statement which was at the time and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, and which that person knew or had reasonable ground to believe was so false or misleading.” Previously, Section 9 of the Exchange Act applied only to securities traded on an exchange.  Now it applies to any securities, excluding government securities.

Looking only at the new Section 9(a)(4), one might argue that the logic of the Janus Capital decision should still apply, i.e., that the broker, dealer or “other person” must still “make” the false statement to be held liable, and the maker of the statement is the issuer of the relevant document in which the statement is found.  The problem with this line of reasoning is that Dodd-Frank also added new Section 9(f) to the Exchange Act, which says that anyone who “willingly participates” in an act or transaction in violation of Section 9(a) is liable to the person who bought the security.  “Willingly participates” is not defined.  Moreover, there is no requirement in Section 9(f) that the willing participant have knowledge of the false statement, intent to misrepresent a material fact, or even a careless disregard of the facts given to offerees.  Willing participation is what every broker-dealer, banker, attorney, and accountant does when they become involved in a securities transaction.  The language of Section 9(f) also has wording that seems to suggest joint and several liability.  It allows the “willing participant”, if found liable, to seek recovery from any other violator of Section 9(a). Presumably, this allows the plaintiff to seek recovery from the willing participant, rather than an issuer who may be insolvent, and gives the willing participant a right to sue its own client for a recovery.

Courts will have to resolve the apparent conflict between the language of Section 9(a)(4), which requires that the broker, dealer or other person to have “knowledge” that the statement was false or misleading, and Section 9(f), which only requires “willing participation” in the transaction.  But even if courts rule that “willing participation” under Section 9(f) requires knowledge of the false or misleading statement, they may allow plaintiffs to allege that the participant had “reasonable ground to believe” because the participant worked with the issuer in the preparation of the offering documents.  “Reasonable ground to believe” is a jury question.  Did the participant have enough knowledge of the seller and the securities to allow an inference that the participant had reasonable ground to believe that the statement in question was false?  If so, liability attaches.

The burden would then shift to the willing participant to show that it conducted a proper “due diligence” investigation and nothing was discovered that led it to believe that the offering document contained a false or misleading statement.  This would make sense because, without a due diligence defense, participants would be worse off under Section 9(f) than underwriters (and directors) in a public offering under Section 11 of the Securities Act of 1933, where a due diligence defense is available.  In fact, an underwriter of securities in a registered public offering can now be sued under both Section 11 of the Securities Act and Section 9(f) of the Exchange Act.   It would be an absurd result if the “due diligence” defense was sufficient to avoid liability under Section 11 of the Securities Act but not under Section 9(f) of the Exchange Act.  Hence, if the courts require plaintiffs to allege “reasonable ground to believe” based on “willing participation” in the transaction, thereby making it possible for a jury to infer knowledge, then the due diligence defense should be implicit in Section 9(f).

In any event, these amendments to the Exchange Act change the landscape that was created by the Supreme Court in the context of securities cases brought under SEC Rule 10b-5.  It will be interesting to see how the courts interpret the new Sections 9(a)(4) and 9(f) of the Exchange Act and who will be included in the phrase “willing participant”.  Could it include a corporation’s directors?   Plaintiffs’ lawyers will no doubt argue that it does.

Corporate Law Advisers LLP

An affiliate of The Corporation Secretary


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NLRB Adopts Final Rule Requiring Posting of Notice in Workplace

On August 25, 2011, the National Labor Relations Board issued a final rule requiring most private-sector employers to notify employees of their rights under the National Labor Relations Act by posting a notice in a conspicuous location in the workplace.   The poster will notify employees of their rights under the NLRA, specifically:

“Under the NLRA, you have the right to:

  • Organize a union to negotiate with your employer concerning your wages, hours, and other terms and conditions of employment.
  • Form, join or assist a union.
  • Bargain collectively through representatives of employees’ own choosing for a contract with your employer setting your wages, benefits, hours, and other working conditions.
  • Discuss your terms and conditions of employment or union organizing with your co-workers or a union.
  • Take action with one or more co-workers to improve your working conditions by, among other means, raising work-related complaints directly with your employer or with a government agency, and seeking help from a union.
  • Strike and picket, depending on the purpose or means of the strike or the picketing.
  • Choose not to do any of these activities, including joining or remaining a member of a union.”

The notice will also contain the following language:

“Under the NLRA, it is illegal for a union or for the union that represents you in bargaining with your employer to:

  • Threaten or coerce you in order to gain your support for the union.
  • Refuse to process a grievance because you have criticized union officials or because you are not a member of the union.
  • Use or maintain discriminatory standards or procedures in making job referrals from a hiring hall.
  • Cause or attempt to cause an employer to discriminate against you because of your union-related activity.
  • Take adverse action against you because you have joined or do not support the union.”

The rule is scheduled to be printed in the Federal Register today, August 30, 2011, and will take effect 75 days later, i.e., notices must be posted by November 14, 2011.  The final rule can be found at:

NLRB Final Rule

This final rule adopts the proposed rule, issued on December 22, 2010 (see our post of February 22, 2010), with only a view changes.  The Board received a total of 7,034 comments from employers, employees, unions, employer organizations, worker assistance organizations, and other concerned organizations and individuals, including two members of Congress. The majority of comments, as well as Board Member Hayes’ dissent, opposed the rule or aspects of it.

The notice of rights will be provided at no charge by NLRB regional offices or can be downloaded from the NLRB website and printed in color or black-and-white.  It is expected to be available by November 1, 2011.  Translated versions will be available, and must be posted at workplaces where at least 20% of employees are not proficient in English.

The 11-by-17-inch notice is similar in content and design to a notice of NLRA rights that must be posted by federal contractors under a Department of Labor rule.  Federal contractors who post the notice required by DoL are not required to also post the NLRB notice.

The posting requirement applies to all private-sector employers subject to the National Labor Relations Act, which excludes agricultural, railroad and airline employers. Employers in both union and non-union workplaces are subject to the NLRB’s jurisdiction and therefore must comply with the posting requirement, although the NLRB has chosen not to assert its jurisdiction over very small employers whose annual volume of business is not large enough to have a more than a slight effect on interstate commerce.

In addition to the physical posting, the rule requires every covered employer to post the notice on an internet or intranet site if personnel rules and policies are customarily posted there. Employers are not required to distribute the posting by email, Twitter or other electronic means.

Failure to post the notice may be treated as an unfair labor practice under the National Labor Relations Act. The Board investigates allegations of unfair labor practices made by employees, unions, employers, or other persons, but does not initiate enforcement action on its own.

If an unfair labor practice is found because the employer failed to post the required notice, the NLRB may extend the 6-month statute of limitations for filing a charge involving other unfair labor practice allegations against the employer.   In addition, if the NLRB finds that an employer knowingly and willfully fails to post the notice, the failure may be considered evidence of unlawful motive in an unfair labor practice case involving other alleged violations of the NLRA.  The NLRB does not have the authority to levy fines.


 The question remains whether the NLRB has the authority adopt such a posting requirement or to treat non-compliance as an unfair labor practice.  To quote from the dissent of NLRB member Brian E. Hayes:

“Today, my colleagues conjure up a new unfair labor practice based on a new statutory obligation. They impose on as many as six million private employers the obligation to post a notice of employee rights and selected illustrative unfair labor practices. The obligation to post is deemed enforceable through Section 8(a)(1)’s proscription of interference with employees’ Section 7 rights, and the failure to post is further penalized by equitable tolling of Section 10(b)’s limitations period and the possible inference of discriminatory motivation for adverse employment actions taken in the absence of posting. While the need for a more informed constituency might be a desirable goal, it is attainable only with Congressional imprimatur. The Board’s rulemaking authority, broad as it is, does not encompass the authority to promulgate a rule of this kind. Even if it did, the action taken here is arbitrary and capricious, and therefore invalid, because it is not based on substantial evidence and it lacks a reasoned analysis.”

This rule will undoubtedly be tested in the courts.

The Corporation Secretary


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D&O Insurance: Do Private Companies Need it? (Part II of II)

Many privately held companies assume that their indemnification provisions will be sufficient to protect their directors and officers against personal liability as well as the legal costs of defending against claims or responding to investigations.    This assumption may be valid in most situations, but the risk that indemnification might not be available when it is needed, however small that risk might be, is a major issue because of the potential financial consequences of personal liability.  Indeed, the legal fees involved in defending against a lawsuit or responding to an investigation, even if the lawsuit is frivolous or the investigation is unwarranted, can be daunting, and few situations are more infuriating than being compelled to settle a frivolous lawsuit at personal expense just to avoid ongoing legal fees.

One situation where indemnification of directors and officers has little value is during the insolvency of the corporation—a situation where the risk of lawsuits is high, including suits naming the directors and officers personally because they are likely to have more money to satisfy a judgment than the corporation.  Moreover, indemnification of directors and officers is a creature of state law. In many states, the corporation law provides that directors and officers cannot be indemnified for certain acts and related expenses.  This limitation on indemnification overrides any contrary language in the corporation’s articles of incorporation or by-laws or in a separate indemnification agreement.  In addition, even when indemnification is permitted by law, the form of indemnification language adopted by the corporation may grant discretion to the corporation in the application of indemnification, thereby raising the risk that indemnification will be refused when it is needed.  This can occur because attitudes change, depending on circumstances. Everyone is concerned with the best interests of the directors and officers when the indemnification is first granted, but once a director or officer is accused of doing something harmful to the corporation, especially if the accuser is a governmental agency, the views of the “innocent” directors toward the alleged wrongdoer can influence the way the Board of Directors interprets or applies the corporation’s indemnification language.  For example, it is common to see indemnification language that says the corporation may advance legal fees to a director or officer during a legal proceeding or investigation, subject to recoupment if the director or officer is subsequently found to have committed acts for which indemnification is not legally permitted.    This use of the word “may”, as opposed to “shall”, creates a risk for each indemnified director and officer and a troubling situation for those who, when the time comes, must decide whether or not to advance legal expenses.  Finally, payments by a corporation on behalf of its indemnified directors and officers, assuming the indemnification is lawful and the corporation is solvent, can be a major expense for a small private company, an expense that is probably not covered by the corporation’s general liability policy.

Thus, D&O insurance can be an important risk management tool for both the directors and officers in their personal capacity and for the corporation itself.   However, D&O insurance is not a “one size fits all” product.  The corporation should engage a broker who understands this market when seeking coverage and it should engage experienced counsel to review and negotiate the proposed policy.   A D&O policy should always be tailored to meet the needs and circumstances of the corporation.  If the insurance carrier will not negotiate, the broker should find another carrier that will.

What follows is a very basic primer, not legal advice.  It is impossible to provide a good summary of D&O insurance in a space of a few blog posts.   That said, it might be helpful to know some of the terminology and issues relating to coverage and exceptions.


Insurance professionals often refer to “Side A, B, and C” clauses in a typical D&O policy.  Those clauses can be briefly described as follows:

 Side A coverage protects individual directors and officers against liability in situations where the corporation is not legally or financially able to provide indemnification.

 Side B coverage reimburses the corporation to the extent it makes payments, including legal fees, pursuant to its indemnification of its officers and directors.

 Side C coverage is separate coverage for “securities claims.”

All three coverages are typically subject to a single shared limit of liability, and Side B and Side C coverages are usually in excess of a self-retention that must funded by the corporation.   Many policies provide that the corporation’s articles, by-laws and board resolutions will be presumed to indemnify the directors and officers to fullest extent permitted by law.  This is important for two reasons.  First, the corporation’s payments on behalf of directors and officers may be reimbursable under the Side B coverage even if the corporation’s actual indemnification language does not apply to the payments.  And second, if the corporation is permitted to indemnify a director or officer (and is financially able to do so) but elects not to do so, the individual director or officer should be protected by the Side B coverage, including funding of defense costs by the insurer, although the individual would be required to pay up to the amount of the corporation’s self retention.

 Side A DIC coverage:   In addition to the three coverages mentioned above, many companies now purchase Side A-only excess “difference-in-conditions” (DIC) coverage in addition to and on top of the primary Side A insurance. This so-called “Side A DIC coverage” provides broader coverage than that afforded by the primary Side A insuring clause.

Specifically, Side A DIC policies will typically provide coverage for non-indemnifiable claims that are excluded by the primary coverage, such as ERISA and pollution claims, which are often excluded under the primary policy.  In addition, the so-called “conduct” exclusions in primary coverage (discussed below) may be narrower for purposes of Side A DIC coverage.    Side A DIC clauses may also be drafted to fund an individual’s defense when the company wrongfully refuses to advance defense costs.  This is a better alternative for the individual than relying on the Side B coverage because the latter is subject to the corporation’s self-retention, whereas the Side A DIC clause is not.   The market for Side A DIC coverage is very competitive so the terms are open to negotiation, including individual limits for directors (so that one director does not exhaust the policy limit at the expense of the others) and elimination of most, if not all, exclusions.  In fact, obtaining Side A DIC coverage can be a good solution if it becomes difficult to negotiate acceptable terms for the primary policy.

Side C coverage (securities claims) may or may not be appropriate for a private company.  The decision to obtain this coverage will be based on a balancing of the cost for this coverage versus the level of risk of directors being held personally liable.  The level of risk depends on the corporation’s future financing plans and the nature of its current and prospective investors.  Of course, directors of SEC reporting companies face a much higher risk than those of a private company because Section 11 of the federal Securities Act of 1933 imposes liability, in a registered public offering, on directors and any officers who signed the registration statement for any material misstatements or omissions in the registration statement, unless those directors or officers believed, after reasonable investigation, that the statements in the registration statement were true.    This same standard does not apply in private placements.  However, plaintiffs can and will add directors and officers in a lawsuit to recover losses from a private placement by the company, alleging that the directors and officers knowingly participated in a scheme to defraud investors.  Courts have generally not been sympathetic to such claims, but there are still legal fees involved in defending, and an insolvent corporation may not be able to cover those fees.   In this regard, it is possible to obtain, in lieu of Side C coverage, a version of Side A&B coverage with language allocating loss between the corporation on the one hand, and the directors and officers on the other.  This will not afford coverage for securities claims made solely against the company, but it will treat as a covered loss defense costs and other losses jointly incurred by the company and the directors and officers who are named as defendants.

Conduct Exclusions

D&O policies typically have exclusions for fraud, dishonesty, and illegal profit or advantage—so-called “conduct” exclusions.   While most directors and officers are confident that they would not act in a manner that fell within one of these exclusions, the issue is often raised by the way the plaintiffs characterize their claims.   For example, securities law violations are brought as fraud claims and the individual directors are alleged to have knowingly aided and abetted the fraud.  Similarly, an action by a shareholder to recover, on behalf of the corporation, payments made to directors under back-dated stock options will attempt to characterize the Board’s approval of the options as self-dealing.   In these situations the insurer, after receiving notice of a claim, will typically reserve its rights to deny coverage under the policy, even if it pays the defendants’ legal fees.  The wording of the policy can be critical in these situations where the allegations against the directors and officers, if taken literally, would put their conduct into one of the policy exclusions.   Relevant here is the “trigger” language in the policy that allows the insurer to invoke the exclusion.  Some policies require a court judgment or “final adjudication”, i.e., the insurer cannot deny coverage in the absence of a final adjudication by a court of fraud or illegal profit in the underlying lawsuit.   This is favorable to the insurer in two ways.  First, most cases settle so there is never a “final adjudication”, and second, this type of clause should afford the insured coverage for defense costs, assuming other exclusions do not eliminate coverage.

Other D&O policies have wording that only requires the conduct in question to have occurred “in fact.”  That is, the insurer may invoke the exclusion if there is evidence sufficient to show that the alleged misconduct did in fact occur.  (Note that insurers are not likely to act arbitrarily when applying an “in fact” trigger because, as with any insurance policy, an insurer that unreasonably denies coverage can be sued for “bad faith”, which in many states can result in punitive damages and/or attorney’s fees.)  Some newer policy forms have a variation of the “in fact” trigger for the exclusion:  coverage can be denied if the wrongdoing is evidenced by an insured’s own written statements, documents, or admissions.  This raises the question of whether an admission by one director can be attributed to other indemnified persons.

Obviously, a trigger of “final adjudication” is the best alternative for the directors and officers and the corporation.  This alternative is also consistent with most indemnification clauses adopted by corporations, which require or permit payment of a director’s or officer’s legal expenses until a final adjudication is reached.  By negotiating a “final adjudication” trigger in the D&O policy, the corporation can avoid the risk that it will be advancing legal expenses to its directors or officers after the insurer has denied coverage on the basis of an “in fact” trigger.

 Insured vs. Insured Exclusion

The “insurer vs. insured” exception was originally designed to prevent collusion between the directors of the insured corporation and the corporation itself (which, as a practical matter, is run by the same directors).  For example, a corporation might choose a supplier of parts on the basis of the recommendation of one of its directors.  Suppose the vendor later files for bankruptcy and the corporation cannot get delivery of the parts, thereby falling behind on orders, which in turn leads to a cancellation of major contracts and loss of future business.  Suppose further that the corporation learns, after the fact, that the director who recommended the supplier knew about but did not disclose the supplier’s financial difficulties because the owners of the supplier were close friends of his.  What would prevent the corporation from suing the director on a “friendly” basis for breach of his duty of care as a director, and then reaching a settlement with the director in the expectation that the D&O insurer would cover the settlement?  It is the “insured vs. insured” exception that prevents it.  Fair enough.  But the exception is now often applied in a much broader manner than was originally intended, and it raises several difficult questions.

A typical D&O policy provides coverage for past, present, and future directors and officers.   It is not hard to conceive a situation in which a former director or officer brings legal action against both the corporation and the directors.   Suppose, for example, that a CEO, who is also a shareholder, is terminated by the Board of Directors for his opposition to an important transaction that, in the CEO’s view, could not be approved by the Board without a breach of the directors’ fiduciary duty.   The CEO then brings a lawsuit for wrongful termination against the corporation and a derivative claim against the directors who voted in favor of the transaction.  The “insurer vs. insured” exclusion would apply under most D&O policies, although such a situation was probably not contemplated at the time the exclusion was first developed.  In today’s world, the possible claims by former directors and former officers, including claims based on whistleblower laws, suggest that the exception should be limited to claims by the corporation itself against other insureds.  This type of limitation can usually be negotiated.  Moreover, the “insured vs. insured” exception can often be further narrowed through negotiations with the insurer so that it does not apply to shareholder derivative claims and certain claims brought on behalf of a corporation while it is in bankruptcy.


There are other issues to consider when reviewing a D&O policy but they are beyond the scope of this posting.  Suffice it to say that D&O coverage is not a simple matter and, if sought, should be negotiated on behalf of the corporation by an attorney with the requisite experience.  Of course, threshold question for a privately owned corporation is whether to obtain D&O coverage at all.  This is simply a matter of risk management.   Does the cost outweigh the risk protection?  How significant is the risk in terms of the probability of relevant events occurring and the financial consequences if one of the events does occur?  Different companies will arrive at different answers to these questions, but it certainly makes sense to assess the cost and the level of protection available, and then to make an informed decision.

The Corporation Secretary 


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D&O Insurance: Do Private Companies Need it? (Part I)

The short answer is “probably yes”.   There is an emerging trend in the courts and legislative bodies, as yet in its infancy, to find directors and officers of a corporation personally liable for actions taken on behalf of the corporation.   Perhaps this a reaction to the proliferation of “ten minute” corporations and LLCs established through the Internet, coupled with the notion that an individual should not be able to avoid responsibility for his or her actions so easily.  In any case, as the trend gains momentum, plaintiffs’ lawyers will bring more cases seeking to hold officers and directors personally liable for the acts of the corporation.  If nothing else, this will impose legal costs for defense that, even if borne by the corporation, can have a significant financial impact on the owners of a small corporation (who are often also the directors and officers).

The trend is not hard to see.   Consider:

1. In a recent case the North Carolina Court of Appeals held that a homeowner has a negligence claim against the president of a home construction company in his personal capacity, even though he was acting in the name of a corporation he owned. White v. Collins Building, Inc. et al., No. COA10-216, C.A.N.C., filed January 4, 2011.   The Plaintiffs Andrew and Barbara White (“Plaintiffs”) purchased a beach home from developer, AEA & L, LLC, which in turn had contracted with Defendant Collins Building, Inc. (“Corporation”) to construct the residence. Defendant Edwin E. Collins, Jr. (“Collins”) was the president and sole shareholder of the Corporation.   Plaintiffs brought a series of claims against the Corporation, Collins personally, AEA & L, LLC and various subcontractors, but dismissed all claims except the negligence claim against Collins.  Collins moved to dismiss the negligence claim against him on the ground that he could not be held individually responsible for the acts of the Corporation. The trial court agreed and allowed Collins’ motion to dismiss, but the Court of Appeals reversed the decision and found in favor of the Plaintiffs.  The Court acknowledged that a properly formed and maintained business entity like a corporation or a limited liability company provides a shield of protection from personal liability for an individual member or officer, but the protection is not absolute. There are two ways to hold an individual corporate officer responsible for the actions of the corporate entity; either by piercing the corporate veil or by establishing direct negligence on the part of the individual member or officer. The court said in its decision, “It is well settled that an individual member of a limited liability company or an officer of a corporation may be individually liable for his or her own torts, including negligence.”   What is remarkable about the case is that the decision is directly contrary to the centuries old concept of a “corporate veil”.

2.   In another case in a different state, the Supreme Court of Wisconsin held that a corporate officer may be held liable for non-intentional torts committed in the scope of his or her employment, depending on public policy considerations.   Casper v. American International South Ins. Co., et al. 2011 WI 81 (July 19, 2011).    In 2003, the Casper family minivan was stopped at an intersection when Mark Wearing’s truck struck it from behind going 40 miles per hour. Five passengers in the Casper minivan were injured.  Mark Wearing, co-employed at two of the defendant companies, was under the influence of several prescription drugs when the accident occurred. The court unanimously declined to hold that corporate officers can never be held personally liable for negligent acts committed in the scope of employment, and noted that the business judgment rule, which allows some latitude for wrong decisions, only protects corporate officers and directors for negligent acts that impact shareholders, not third parties.  In this case, a majority of the court (6-2) ruled that public policy considerations precluded liability.  However, the door is now open.

3.  In another recent case the Federal District Court for the Western District of Washington denied a motion for summary judgment and ruled that a corporate officer can be held personally liable for copyright infringement by a corporation.  Blue Nile Inc. v. Ideal Diamond Solutions Inc. d/b/a IDA, et al. (No. C10-380Z, Aug. 5. 2011).  Blue Nile, an online diamond retailer, brought a copyright infringement suit against Ideal Diamond Solutions, claiming that IDS used Blue Nile’s copyrighted images on IDS’ website.  Blue Nile also sought to hold IDS’ founder, Larry Chasin, personally liable.  On cross-motions for summary judgment, the court found Chasin personally liable on the grounds that copyright infringement is a strict liability tort there is no corporate veil protection against copyright infringement for corporate officers.  The court rejected Chasin’s defense that he did not know that the images used on the IDS website infringed on Blue Nile’s copyrights because, the court reasoned, any infringer is strictly liable regardless of whether the infringement is intentional or innocent.  Moreover, the court rejected Chasin’s defense that he did not personally create the infringing website because he had the right and ability to supervise the infringing activity and had a direct financial interest in the infringing activity.

Click to access Blue%20Nile%20v.%20Ideal%20Diamond_Amended%20Order.pdf

4.     There is a well established legal doctrine known as the “responsible corporate officer” (RCO) doctrine that permits the government, in certain circumstances, to pursue officers and directors of a corporation for certain types of misconduct by the corporation.  The RCO doctrine imposes strict liability.   It is not a defense for the RCO to say that he or she did not know of or participate in the wrongful acts of the corporation.  The doctrine is based on two United States Supreme Court decisions.  United States v. Dotterweich, 320 U.S. 277 (1943), and United States v. Park, 421 U.S. 658 (1975) Historically, the RCO doctrine has been applied in cases involving state and federal laws intended to protect the “public welfare”, such as food and drug laws, environmental laws, and even securities laws. Most recently, the government has sought to apply the doctrine to the health care industry, including medical device companies, pharmaceutical companies and hospitals and health systems. The trend is clear.  The government is trying to expand the scope of the RCO doctrine, and the possible applications are as varied as the concept of “public welfare” is broad.

5.   Some Federal statutes allow for a finding of direct liability of directors and officers, such as the Foreign Corrupt Practices Act, 15 U.S. Code § 78m.   A willful violation of the FCPA by an officer, director, employee or agent can result in a fine of up to $100,000 and imprisonment for up to fine years.  Violations by such persons that are not willful can result in a fine of up to $10,000.  The corporation cannot pay these fines on behalf of these individuals.   The FCPA is just one example of this growing legislative trend.  Another example is the FBAR reporting by individuals, such as corporate officers, who have signature authority over the corporation’s foreign bank accounts (see May 6, 2011 post on this blog).  If the individual fails to file the FBAR, there is personally liability even if the individual had no beneficial interest in the corporation’s foreign bank account.

6.  In event of the insolvency of a corporation, directors and officers can be personally liable for certain unpaid corporate tax liabilities, including penalties and interest. The most common types of taxes for which personal liability arises are so-called “trust fund taxes,” such as state sales taxes, income tax and social security withholding and similar obligations, which are deemed held in trust for the government.  The tax collector will argue that the funds were willfully diverted to pay other creditors.

7.  In addition, when the government launches an investigation of alleged violations of law by a corporation, it will often focus its attention on one or more officers who may be found to have personnel liability, in addition to the broader liability of the corporation. This usually results in separate counsel for the corporate officers in question, which can result in significant additional legal fees.

This list is merely illustrative and by no means exhaustive.

While the threat of personal liability is very real for directors and officers, the important question is:  Who pays the fines and the legal defense costs?   Most corporations indemnify its directors and officers against the risk of personal liability, subject to a few exceptions for conduct that is clearly improper, such as self-dealing at the expense of the corporation.

However, there are two situations where the indemnity may not provide much comfort.  The first situation is during the insolvency of the corporation.  What good is an indemnification from an insolvent indemnitor?  Moreover, insolvency is the time when the risk of lawsuits against directors and officers is the highest because the plaintiffs do not have much chance of recovering losses from the corporation.

The second situation is when the government launches an investigation into possible wrongdoing by a corporation and then focuses on one or two officers or directors.  The rest of the directors and management may feel that the corporation itself is blameless and, if any laws were violated, it was wholly the fault of the individuals under suspicion. A consensus may emerge among the “clean” officer and directors to throw the suspects “under the bus” in order to make the corporation look more cooperative in the eyes of the government investigators.  This could raise questions about the legal fees of the officers and directors suspected of wrongdoing.  At the outset of the investigation, the corporation will probably hire independent counsel for the directors and officers under suspicion or, alternatively, agree to pay counsel hired directly by those individuals.  Then, if the corporation decides to shift all blame to the directors and officers being investigated, it may look for a way to stop paying those expensive legal fees.  If the fees are cut-off, the affected officers and directors will have to sue to enforce the indemnity but such a suit can itself be an expensive proposition and, meanwhile, the government’s investigation continues and the counsel for those directors and officers is not being paid.    The answer to these two situations is D&O insurance.  Not only does it provide protection in the case of insolvency of the corporation, but it also can eliminate troubling questions about the limits of a corporation’s indemnification.  Of course, D&O insurance is not a perfect solution.  Like all insurance it has limits on the coverage and exceptions. For example, any conduct that, under state law, could not be covered by a broad indemnification, such as fraud, is usually excluded from D&O coverage.

D&O coverage, which is limited to coverage for the wrongful acts and alleged wrongful acts of directors and officers, is usually part of a broader insurance program that includes a Comprehensive General Liability Policy (“CGL”), which is designed to protect a company from personal injury claims (this often includes coverage for claims of advertising injury, defamation, invasion of privacy, copyright infringement and other intellectual property injuries); and/or Employment Practices Liability Insurance (“EPLI”), which is a specialized insurance policy protecting companies against employment related lawsuits.

The Corporation Secretary

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Issues for the Start-Up

Far too often the founders of a start-up company neglect the issues that can later become contentious if the enterprise does not succeed as everyone hopes and expects.  Indeed, it not uncommon for one or more of the founders to eventually become unhappy and either seek a way out of the venture, on his or her terms of course, or look for ways to take over the company.   This lack of “contingency planning” is not due to carelessness.  It is simply human nature.  Founders who are excited about their future prospects and confident in the strength of their friendship and mutual respect see no reason to address the remote possibility of irreconcilable differences in the years ahead.   However, there are some issues that should be addressed early precisely because the founders are then in a cooperative and collegial frame of mind.  If left for the future, any serious disagreement about the direction of the company, or the allocation of accumulated enterprise value, will make it hard, if not impossible, to reach a common ground because the status quo will favor one party or the other in the dispute.

Here are some issues to include in agreements of the founders at the outset (or at a later stage if not addressed at the time of formation, assuming the founders are still on good terms):

Assign all IP to the Company

Many start-ups begin with an idea or ideas that are unique and innovative.  These ideas are or can become trade secrets, and may even be patentable.  In either case, they have value.  Sometimes one founder has the original concept and others either enhance the concept or bring something else to the venture, such as funding or skills in engineering, marketing, finance, or management.  Typically, the company is formed after the ideas have evolved to the point where their potential commercial value makes it worthwhile to pursue the cost of forming a legal entity and launching a business.  But what happens if one of the founders later decides to leave or is forced out, particularly if he or she was an “inventor” of the company’s proprietary ideas?  Can this former founder use the same or similar intellectual property to start a competing company?  If the question were to be asked when the company is formed, the founders would almost certainly agree that the answer should be “no”.  However, if the question is not asked until the founder leaves the company, it becomes a legal question, probably a complex question, and more likely than not the answer would not please the remaining equity holders in the company.  Hence, the founders should all assign to the company any rights they may have to any IP used by the company and they should sign a non-disclosure agreement with respect to any trade secrets or other IP owned or used by the company.  This non-disclosure agreement should be written so that the obligations survive the individual’s relationship with the company.

Equity Allocation

If there was ever a source of resentment and ill will, this is it.  Founders often start with the egalitarian notion that all founders are equal.  However, success frequently reveals that some founders made and are making a greater contribution to that success than others. For example, the person who conceived the core concept and who has enhanced it through development may be more valuable to the company that a person who brought capital or marketing skills.  Why, the first person will wonder, should both individuals always be treated equally?  The second person will, of course, say that that was the deal.  Maybe so, but more than one company has broken up because the “deal” eventually proved unsatisfactory to a key founder.

This poses a difficult dilemma because most individuals tend to over-value their contribution to a common enterprise and under-value the contributions of others relative to their own.  Hence, it is almost impossible, and certainly awkward, to periodically allocate profits or equity based on relative contributions.  An alternative is to allocate restricted shares to the founders at the outset but assign different forfeiture schedules, depending on each individual’s expected contribution.  For example, each of four founders might be granted 10,000 shares, all with full voting rights and participation in any dividends, but the shares held by the person who conceived and develops the company IP might be subject to a more favorable forfeiture schedule.  Say, if that person leaves the company within four years he or she might forfeit the number of restricted shares determined by multiplying 2,500 times the number equal to the difference between four and the number of full years employed, whereas the others might forfeit the number of restricted shares determined by multiplying 1,250 times the number equal to the difference between eight and the number of full years employed.  If an individual who leaves the company can sell back to the company at fair market value the shares no longer subject to forfeiture, there is an added benefit in the forfeiture schedule granted to the founder who conceived the technology.  This arrangement reflects the fact that an innovative IP contribution is likely to have greater relative value to the company than other contributions in the early years, although everyone will eventually come out equal if they all stay with the company until the restricted shares are longer subject to forfeiture.  Not coincidentally, this also gives the other equity owners an incentive keep the IP developer happy during the period when the technology is having the greatest impact on earnings.

A separate issue related to forfeiture schedules is the question of who gets the “accretion”.  In the example above, most founders assume that if one founder leaves and forfeits some of his or her restricted shares, the forfeiture of restricted shares by the departing founder will increase the value of their shares, and only their shares, by a pro rata commensurate amount. However, if there have been subsequent stock issuances since the restricted shares were originally issued, such as the issuance of shares to management or sold as part of a fund raising effort, all shareholders will see an increase in the per-share value of their shares as a result of the forfeiture.  This outcome, which often comes as a surprise to the remaining founders, can be addressed in a restricted stock plan but it usually is not.

 Buy-Sell Agreements

This is the area where the absence of an agreement can eventually lead to much angst, if not bitter, protracted disputes.  The question is easy to ask but hard to answer:  What happens if the founders reach a point where they cannot or do not want to work together, however remote that may seem at the outset of their common venture?  If there is no written agreement to answer this question, the parties will more likely than not find it extremely difficult to reach a resolution through negotiations.   The agreement most commonly used to address this issue is the Buy-Sell Agreement.  There are two types of Buy-Sell Agreements: traditional and “guts ball”.  In a traditional agreement, each party to the agreement has the right to sell his or her shares, but subject to a right of first refusal held by the company or, if the company does not exercise the right, held by the other shareholders who are parties to the agreement.  In addition, if any event occurs that could cause a party’s shares to be sold or transferred at a price that is not the result of a negotiated price between a willing buyer and a willing seller, such as a bankruptcy or divorce, the company can buy the shares at fair market value, as determined by an independent appraiser appointed by the company.

In a “guts ball” agreement, which is most commonly used in cases where there are two shareholders but can be used with more than two, either of the parties to the agreement can, at any time, offer to buy all the shares of the other party at a stated price.  Once such an offer if made, the party receiving the offer has two choices and only two choices:  either sell at the stated price or buy the offering party’s shares at the same per-share price.  If no decision is made within a specified time, usually 30 days or less, the party receiving the offer will be deemed to have elected to sell his or her shares.  These “guts ball” agreements may seem awkward at an early stage of a company when the founders cannot foresee the day when they might radically disagree on something, but in fact such an agreement can forestall future disagreements because both parties know what might happen if a disagreement turns ugly.

Other Common Provisions in a Shareholder Agreement

There are other issues to be considered for a formal agreement among the founders, and these should not be left for the day when venture capitalists arrive on the scene to dictate the terms of their participation in the company.  For example, when there are more that two initial shareholders, what happens if there is an opportunity to sell the company at an attractive price and the shareholders disagree on the question of whether to proceed with the sale?   This might be easy to answer if the number of shareholders is small and all are equal because decision-making in such a situation usually requires unanimity.  The question becomes more difficult as the number of shareholders or the disparity in voting power increases.  What if there are five shareholders and only four want to sell?  What if there are three 30% shareholders and one 10% shareholder and the latter does not want to sell?   One common solution is a combination of “drag along” and “tag along” rights.  Under the “drag along” rights, if the majority, or some higher required percentage, wants to sell but a minority shareholder does not, the minority shareholder can be “dragged along” and forced to include his shares in the sale at the same price per share as the others.  Conversely, the “tag along” right protects the minority shareholder in the situation where a buyer wants to minimize the purchase price buy acquiring just a majority of the shares and then perhaps reorganizing the acquired company and eventually squeezing out the remaining minority shareholders with a cash out merger.   The “tag along” provision allows, but does not require, each minority shareholder who is a party to the agreement to sell his or her shares in any sale approved by the majority on the same terms and at the same price per share as the majority.

The issues above are merely some points to explore with an experienced attorney and do not constitute legal advice.    Every start-up is different and every situation must be considered in light of all the relevant circumstances, particularly the objectives and interests of the founders.

Corporate Law Advisers, LLP

An affiliate of The Corporation Secretary

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