The Corporation Secretary's Blog

Here are some boardroom basics for entrepreneurs who want to set up a corporation but have no experience with corporate governance:

Most major decisions relating to the operations of a corporation are taken by its board of directors, which bears the primary responsibility for protecting the corporation’s assets and carrying out its mission.  Sometimes particular decisions are delegated to officers of the corporation, but in such cases the delegation should be specific and board should be apprised of the results of such decisions.

Unless so provided in the articles of incorporation or bylaws, the board may form committees, such as finance or audit committees, and may authorize them to carry out certain functions of the board.  Delegation to a committee does not, however, relieve the board members of their responsibility to the corporation.  The board acts by voting at its regular or special meetings.   Typically, the bylaws will describe the percentage of directors’ votes needed to approve an action and the requirements for a quorum.  In most corporations a majority of the directors is needed for a quorum and, if a quorum is present, a majority of those present can approve an action.  If the bylaws do not cover these voting requirements, the laws of the state of incorporation will govern.  Generally, state corporation laws require a majority of the directors for a quorum and majority of those present to approve an action.

The articles of incorporation or bylaws may permit meetings to be held via telephone conference or other electronic means. Each director has one vote, and voting by proxy is generally not permitted. The articles of incorporation or bylaws will specify how muchadvance notice of meetings must be given to board members and the means by which notice must be given.  Again, if the articles of incorporation or bylaws do not provide this notice requirement, it can be found in the applicable state law.  A vote cannot be taken on a proposed action unless it was included in the agenda, absent a waiver of all directors of the advance notice requirement.

The minutes of board and committee meetings document the actions taken and provide an official record that the formal requirements for action (notice, quorum, etc.) were satisfied. In general, the minutes will include:

• the name of the corporation;

• the date, time and place of the meeting;

• members present and absent (including which ones qualify as independent directors);

• who called the meeting to order and who kept the minutes;

• all motions made and the results of all voting; and

• when the meeting ended.

Minutes will be prepared by the secretary, who is appointed by the directors but need not be an employee of the coporation, or by other authorized person and presented for approval at the next meeting.

Matters To Be Covered in Minutes

Aside from the factual matters specified above, the actual substantive content of the minutes require judgment, because meetings may be lengthy and include discussions of many issues.  In general, it is usually not desirable to create a detailed record of all discussions, but rather to include only information sufficient to show that the members acted reasonably in coming to decisions. The minutes of board meetings also should provide evidence of compliance with other good governance practices, which include:

• Discussion of any possible conflict between the personal or professional interests of a director and the interests of the shareholders, and, if appropriate, a notation of the abstention of a director with a conflict of interest on the voting for any relevant actions;

• Approval of related party transactions between the corporation and its officers and directors;

• Approval or ratification of all major contracts and transactions;

• Status of and issues involving the corporation’s regulatory and tax compliance and risk management policies; and

• Board review of the corporation’s financial condition, compliance with debt covenants, and cash flow projections, with special attention to any threats of insolvency.

Directors

The board of directors should have an appropriate number of members to conduct effective oversight.  A board with too few members may not have sufficient resources for proper oversight.  With an overly large board, individual directors may have less sense of responsibility for overseeing financial affairs of the corporation.

Not only the size of the board, but also the existence and the number of independent directors, has become more important. Inspired by SOX related reforms for public companies, having a majority of independent directors on a board is considered sound practice because it is viewed as evidence that the board has the ability to make independent decisions that are in the best interests of the shareholders.

A director’s independence generally means that the director does not receive compensation from the corporation other than as a director, is not affiliated with management and has no personal interest in a specific transaction. 

The existence of a personal interest may influence a transaction directly.  For example, there is a risk that a director who supplies goods or services to the corporation may be awarded a contract on terms more favorable to the contractor (and accordingly, less favorable to the corporation) than the terms that would be obtained from an unaffiliated third party. There is also a risk that the director’s judgment may be influenced, consciously or otherwise.  For example, that director may not voice his or her dissent to improper board actions for fear of losing a customer.

To guard against these risks and the appearance of improper decision making, it is deemed good governance practice to have independent directors on the board and also to institute a conflict of interest policy so that directors with personal interests in specific transactions are excluded from decision making on those matters and there is documented objective evidence of the fairness of the decision making process.  The underlying rational for this principle is that independent and non-management board members are better situated to exercise objective and unbiased judgment in board decision-making and therefore can enhance the board’s ability to oversee the operation and management of the corporation and to make ethical decisions in the best interests of the corporation. In any case, each member of the board of directors of a corporation, whether or not he or she is independent, should understand and fulfill the board’s obligations by objectively evaluating the materials and information provided to him or her, overseeing financial matters of the corporation, and making decisions in the best interest of the corporation’s shareholders.

Financial Statements

Complete and accurate financial statements are essential for a corporation to fulfill its legal responsibilities and for its board of directors to exercise appropriate oversight of the corporation’s financial affairs. Thus, a board that does not have members with financial expertise should retain a qualified accounting professional to review the corporation’s financial statements.  Most small corporations do not have their financial statements fully audited by an independent accountant.  Instead, they use an independent accountant only to review or compile the financial statements.  This independent accountant can be a valuable source of information for board because he or she can discuss new developments, underlying trends, and any amounts appearing in the financial statements that are outside industry norms.

Policies and Procedures to Ensure Sound Financial Management

Assuring sound financial management is among the most important responsibilities of the board of directors. The board should establish clear policies and procedures to protect the corporation’s financial integrity.

While day-to-day accounting and financial management should be delegated to management of the corporation, the board should receive regular financial reports, either monthly or quarterly.   The reports should show budgeted and actual expenditures as well as budgeted and actual revenues. By carefully reviewing the regular financial reports, the board will be able to determine whether adjustments must be made in spending to accommodate changes in revenues.  The board of directors should also review and approve the corporation’s annual budget and should monitor actual expenses and performance of the corporation’s financial assets against the budget to determine whether the corporation is allocating its funds appropriately.  Prudent financial oversight requires that the board look beyond periodic financial reports to consider how the corporation’s current financial performance compares with that of previous years and how its financial future appears.  If the corporation’s net assets have been declining over a period of years, or if future revenue seems likely to decrease significantly, the board may need to take proper steps to achieve or maintain the financial solvency of the corporation.

The Corporation Secretary

A ruling last year by the Federal District Court for the District of Delaware raises some very difficult questions about the strength of the “corporate veil” in cases where the plaintiff seeks recovery under a federal statute. In fact, the court may have opened Pandora’s box. The case is Blair et al. v. Infineon Tech. A.G., Civ. No. 09-295 (SLR), 2010 WL 2608959 (D. Del. June 29, 2010).

Plaintiffs, former employees of two wholly-owned subsidiaries of defendant Qimonda AG, which was a subsidiary of defendant Infineon Technologies AG (Infineon), brought a class action alleging, among other things, that the defendants, during mass layoffs, violated the Employee Retirement Income Security Act (ERISA) and the North Carolina Wage Payment Act by terminating their employment without paying severance properly due under the Infineon Group Severance Plan. The Qimonda subsidiaries filed for bankruptcy in February 2009.  The plaintiffs sought to pierce the corporate veil of the Qimonda subsidiaries in order to hold Infineon liable for the unpaid severance benefits. Defendant Infineon made a motion to dismiss on the grounds that the parent was protected from liability by the corporate veil of the bankrupt subsidiaries.

The plaintiffs argued that the corporate veil of the subsidiaries should be pierced and the defendants should be treated as an alter ego or “single employer,” liable for plaintiffs’ back pay and benefits. To support this argument, the plaintiffs claimed that there was a high interdependency of business operations in the form of formal and informal consolidation of financial, strategic, legal, and human resources operations.   In their motion to dismiss, the Infineon defendants argued that plaintiffs failed to adequately plead that the Qimonda Subsidiaries were established for the purposes of committing fraud or visiting injustice upon plaintiffs, and the plaintiffs’ complaint failed to invoke enough of the factors identified by the Third Circuit to warrant piercing of the corporate veil under ‘alter ego’ doctrine. Infineon’s motion to dismiss was denied.

The court began its discussion of the issues by saying, “It is a general principle of corporate law “deeply ingrained in our economic and legal systems that a parent corporation … is not liable for the acts of its subsidiaries.” United States v. Bestfoods, 524 U.S. 51, 61 (1998).  It then went on to discuss exceptions to the general rule. Interestingly, the court made two important statements in footnotes.  First, it said, “The parties’ briefs occasionally refer to separate state and federal alter ego tests without specifying how the alter ego test is different under state law. The alter ego analysis is in fact the same under state or federal law because “[v]eil piercing is not dependent on the nature of the liability. Under both state and federal common law, abuse of the corporate form will allow courts to employ the tool of equity known as veil-piercing.” 18 Francis C. Amendola et aI., C.J.S. Corporations § 14 (2010).”  One wonders if the court’s decision is consistent with that statement.

In a subsequent footnote, the court noted that “Trevino [Trevino v. Merscorp, Inc., 583 F. Supp. 2d 521,528 (D. Del. 2008)] uses the language “shareholders” instead of “subsidiaries” but, for purposes of the single entity test, the same principles apply to corporation/shareholders and parent/subsidiaries. See Laifail, Inc. v. Learning 2000, Inc., 2002 WL 31667861, at 11 (D. Del. Nov. 252002).”   This is a significant footnote because it means that individual shareholders may be personally liable for damages caused by a corporation’s violations of a federal statute if the corporate veil can be pierced. It is one thing to hold the parent corporation liable for the acts of a subsidiary, a concept already expressed in some state and federal environmental laws, but something else altogether to create personal liability for individuals who own shares in a corporation.

More importantly, the court said, “For reasons of public policy, the alter ego standard for piercing the corporate veil is often more lenient for causes of action arising under ERISA, a federal statute, than state law. See United Elec., Radio & Mach. Workers of Am., 960 F.2d at 1092 (1^st Cir. 1992) (“In an ERISA case, the applicable federal standard can sometimes be less rigorous than its state common law counterparts. The rationale … is grounded on [sic] congressional intent.”); Lumpkin [et al.v. Envirodyne Industries], 933 F.2d at 460-61 (‘The underlying congressional policy behind ERISA clearly favors the disregard of the corporate entity in cases where employees are denied their pension benefits.”); Alman v. Danin, 801 F.2d 1,4 (1st Cir. 1986) (“Allowing [the parent] of a marginal [undercapitalized subsidiary] to invoke the corporate shield in circumstances where it is inequitable for them to do so and thereby avoid financial obligations to employee benefits plans, would seem to be precisely the type of conduct Congress wanted to prevent.”). ”

Looking at the three cases cited by the Blair court, United Electrical, Lumpkin and Alman, it is notable that Lumpkin is not a “veil piercing” case.  In fact, the issue arose only because Defendant Envirodyne, the parent corporation, made the argument that it should be treated as the ‘alter ego’ of its subsidiaries so that it would get the benefit of a settlement and release agreement entered into by the subsidiaries. The court quickly disposed of this odd, tangential argument.

The other two cases are on point, although they are both decisions of the Court of Appeals for the First Circuit (Mass., Maine, NH, RI and Puerto Rico). United Electrical, Radio and Machine Workers of America, Et Al., Plaintiffs, Appellees, v. 163 Pleasant Street Corporation, et al., was primarily a case about personal jurisdiction over a parent corporation for the acts of a subsidiary, although this issue did require an examination of the corporate veil. In United Electrical the Circuit Court of Appeals for the First Circuit said:

“Under Massachusetts common law, disregarding the corporate form is permissible only in rare situations. See Pepsi-Cola Metro. Bottling Co. v. Checkers, Inc., 754 F.2d 10, 15-16 (1st Cir.1985) (lining [sic] criteria to be evaluated in considering veil piercing under Massachusetts law); My Bread Baking Co. v. Cumberland Farms, Inc., 353 Mass. 614, 233 N.E.2d 748, 751-52 (1968) (similar). It would, however, serve no useful purpose to explore the interstices of the state-law standard. This is, after all, a federal question case–and in federal question cases, courts are wary of allowing the corporate form to stymie legislative policies. [citations omitted; emphasis added]. For this reason, a federal court, in deciding what veil-piercing test to apply, should “look closely at the purpose of the federal statute to determine whether the statute places importance on the corporate form, an inquiry that usually gives less respect to the corporate form than does the strict common law alter ego doctrine.” Town of Brookline v. Gorsuch, 667 F.2d 215, 221 (1st Cir.1981) (citations omitted).”

In Alman, the First Circuit said:   “The general rule adopted in the federal cases is that “a corporate entity may be disregarded in the interests of public convenience, fairness and equity,” [citing to Capital Telephone Co. v. FCC, 498 F.2d 734, 738 (D.C.Cir.1974).] In applying this rule, federal courts will look closely at the purpose of the federal statute to determine whether the statute places importance on the corporate form [citations omitted], an inquiry that usually gives less respect to the corporate form than does the strict common law alter ego doctrine….”[emphasis added]

The Blair decision and the cases cited by the Blair court raise three provoking questions.  First, if a defendant can show that its corporate veil should be recognized under a traditional common law test in the relevant state, at what point does the intent of Congress, as expressed in a federal statute, override the state law determination? How does a court weigh the value of “public policy” underlying a federal statute against the state’s interest in promoting limited liability of its corporations’ shareholders? Is it purely a “fairness” test? If so, how can any shareholder ever know that he or she has the protection of the corporate veil, regardless of the steps might be taken to ensure the separate identity of the corporation.

Second, the cases discussed above involved claims brought under ERISA.  But why should the result be limited to ERISA?  There are countless other federal statutes. Isn’t there a “public policy” behind, say, Rule 10b-5 issued pursuant to the Securities Exchange Act of 1934 (making it unlawful to make a material misstatement or omit to state a material a material fact in the purchase or sale of a security)? What about OSHA or the anti-trust statutes or the Consumer Product Safety Act or the Fair Labor Standards Act or the Clean Water Act, to name just a few. Could individual shareholders be held liable for damages under these federal statutes if the corporation was unable to pay the damages?

Finally, why is this doctrine limited to federal statutes? There are innumerable state statutes that express public policy, as determined by the state legislatures, yet no state courts have added “public policy” underlying a state statute as a factor in determining whether the corporate veil should be disregarded. Thus, contrary to the footnote in the Blair decision mention above, it seems that there is a different standard for “veil piercing” in federal court than in state court, at least where the plaintiff’s claim rests on a federal statute. If that is true, shareholders of every insolvent corporation have more to worry about than losing their investment.

The Corporation Secretary

Federal and state tax authorities and labor officials are taking a renewed interest in the misclassification of employees as independent contractors.  Often, the question arises in the context of contractors performing construction work but the very same issues apply to consultants and other service providers.

It is not uncommon for companies, especially small companies, to retain individuals as consultants, rather than hire them as employees, because the amount and duration of work is hard to predict or because their remuneration is based on equity or revenue participation.   These arrangements should be reviewed with care because misclassification of employees can be very costly to the employer.

If the IRS or state tax authority finds that a consultant or contractor should have been classified as an employee and a retroactive reclassification is imposed, the company can be liable for unpaid income taxes as well as Social Security, Medicare and unemployment taxes that were not withheld during the period in question, plus penalties and interest.  Officers of the company can even be held personally liable for some of these payments.

In addition, failure to provide workers’ compensation insurance under state law can result in an assessment for unpaid premiums, plus penalties on a per-day or per-worker basis, depending on the state.  Some states have laws that allow a workers’ compensation board or agency to issue a “stop work order”,  which prevents a company from engaging in business operations until it pays all penalties and brings itself into compliance.

In this era of state and federal budget deficits, the search for misclassified employees has become a growing trend.  President Obama’s budget for 2011 includes a $25 million “Misclassification Initiative” that calls for cooperation and information sharing between the Labor Department and the Department of the Treasury to address this issue (and, not coincidentally, raise revenue).

Adding to the above, in some circumstances misclassification can result in lawsuits against the company by misclassified employees under the Fair Labor Standards Act for failure to pay minimum wages and overtime, which can result in payment of the amounts claimed, plus liquidated damages in an equal amount, plus attorney’s fees.  Individuals who should have been classified as employees might also sue for employment benefits they did not receive, such as pension contributions or health care premiums, and expenses for which they were not reimbursed.

There are several tests to determine whether an individual is an independent contractor or an employee.

The IRS uses a 20-factor test to determine employment status.  While there is no precise number of factors that tip the balance one way or the other, and there are no “weights” assigned to individual factors, the more factors in the “employee” column, the more likely it is that the contractor will be reclassified.   Paraphrasing, the IRS finds that the following factors are indicative of an employer-employee relationship:

1. training provided by the company;
2. close supervision, i.e., instructions from the company on how tasks should be performed;
3. providing services as a contractor that are similar to or integrated with the tasks performed by employees;
4. clerical and administrative support provided by the company;
5. prohibiting delegation or subcontracting by the contractor;
6. a long-term relationship;
7. fixed hours;
8. requiring the individual to work full-time for the company;
9. requiring the individual to work only on the company’s premises;
10. requiring the individual to perform tasks in a certain order;
11. requiring the individual to provide reports to management;
12. payment by the hour, day or month or on a commission basis;
13. payment by the company of all expenses incurred by the individual;
14. tools and equipment provided by the company;
15. little or no investment by the individual in his or her “business”;
16. little or no risk on the part of the individual with respect to profit or loss;
17. working exclusively for the company;
18. absence of advertising or other public promotion of the individual’s services;
19. right of the company to terminate the individual “at will”; and
20. right of the individual to terminate the relationship without penalty.

This 20-factor test is based on decisions of courts over the years.  The case law is not so detailed, of course.   Instead, the emphasis of the courts has been on the nature of the individual’s business.  Has he or she worked for others, conducted marketing and acted the way an independent business person would be expected to act?  Or has the individual been devoted to one company with no expectations of other work?

There is a separate test under the Fair Labor Standards Act to determine if a misclassified employee is entitled to minimum wage and overtime.   Five factors are considered, with the focus being on the question of whether the individual is economically dependent on one company by choice.  The five factors are (1) the degree of control exercised by the company, (2) the extent of the relative investments by the individual and the company, (3) the degree to which the individual’s opportunity for profit or loss is determined by the company, (4) the skill and initiative required in performing the job, and (5) the permanency of the parties’ relationship.

It is possible that different results would be reached under the different tests above on the same set of facts.

Minimizing the risk

As in all matters of tax and regulatory compliance, it is best to be cautious, particularly now in this era of whistleblowing statutes and enhanced enforcement.  Caution means more than adding a clause to a contract.  It is fine to say that it is the intent of the parties that the individual providing services will be deemed an independent contractor, not an employee, but that statement does not count for much if the IRS or Labor Department concludes that the real intent of the employer was to avoid taxes or labor regulations or the administrative burdens associated with either.

Demonstrating the contractor’s independence is not entirely a matter of the actions taken by the company receiving services, even though the company is most at risk.  Indeed, the extent to which the company controls all the indices of the arrangement, such as imposing new contract wording on the “contractor” as a precautionary measure, the more difficult it will be to argue that this is not an employer-employee relationship.

If an individual wants to be an independent contractor, either because he or she wants the freedom associated with independence or because permanent employment is not available, it would be a good idea to offer prospective clients an arrangement that will help the client avoid tax and regulatory scrutiny.   For example, the independent contractor should consider forming a corporation or a single-member limited liability company and offering services through that legal entity.   This defuses the employer-employee issues and it also provides a benefit to the contractor, who, without such an entity, is exposed to personal liability if the recipient of the services later claims that the contractor acted negligently or breached the contract.    It would be even better if the contractor had a website, business cards and a business bank account, all of which are relatively inexpensive.

In the contract describing the arrangement between the service provider and the company, a few clauses are of particular important in the context of “employee vs. independent contractor”.  For example, the contract should not require the contractor to work exclusively for the company.  Quite the contrary, it would be a good idea to expressly state that the arrangement is non-exclusive, although there may be restrictions preventing the contractor from working for the company’s competitors while in possession of the company’s trade secrets.

In the IRS 20-factor test, payment by the hour, week or month can be indicative of an employer-employee relationship.   This view is open to question.  Most companies hire lawyers, accountants, consultants and other service providers on an hourly basis, and many companies outsource services such as IT, data storage and financial management for a monthly fee.  Of course, most of these service providers are organization, not individuals, so the issue of employment status does not arise, but the point remains that it is hard to draw conclusions about the status of a service provider from the fact that the service provider’s compensation is based on units of time.  More important is the nature of the services and the autonomy of the contractor in providing those services.  The issue of “control” probably has more weight than the list of 20 factors suggests.  There is no need to emphasize in the contract that the contractor will work under the close control of a named company employee.   Every independent service provider knows that clients can be demanding and even controlling, even in the absence of such provisions in the contract.  Inserting “control” language adds little but it might indicate to the IRS that there is an employee-employer relationship.

Similarly, the arrangement should not require the contractor to work “full time”.  If a contractor is paid by the hour or upon meeting project milestones, the amount of work and the time available will dictate the commitment needed from the contractor.  Why raise a red flag for the IRS or labor officials by using words like “full time”?

Finally, the termination provisions in a contract are important and relevant to the 20-factor test.  Apart from termination based on contract default or insolvency of the other party, it would not be customary to see a unilateral right of termination without advance notice in a contract with between a company and an independent service provider  (excluding professional services).  The company needs notice, perhaps 60 or 90 days, to find a replacement for the terminating service provider.  Conversely, one would expect to see a provision granting the service provider a chance to complete unfinished tasks or a payment for transition services or a termination fee.

Of course, every situation is different and contract provisions must make commercial sense in the relevant circumstances.  The point, however, is that an agreement for services from a non-employee, if not thoughtfully drafted, can be a damning piece of evidence in the eyes of tax or labor officials, particularly if the service provider is acting in his or her individual capacity.

The Corporation Secretary

The Securities and Exchange Commission has proposed amendments to Rule 506 of Regulation D under the Securities Act of 1933 that would disqualify “bad actors” from participating in private placements that rely on Rule 506 for an exemption from the registration requirements of the Securities Act. The proposed amendments, adopted May 25, 2011, can be found in SEC Release No. 33-9211. A copy of the Release is available at SEC Release No. 33-9211. The comment period for the proposed amendments expires on July 14, 2011.

The proposed amendment were issued pursuant to Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires the SEC to adopt rules disqualifying certain “felons and other ‘bad actors'” from relying on Rule 506. Rule 506 is part of Regulation D, which was originally adopted in 1982. Regulation D createsan exemption from registration for certain small offerings (Rules 504 and 505) and a safe harbor for offerings greater than $5 million (Rule 506). This is an important distinction, for reasons discussed below. Rule 506 is merely a safe harbor; that is, if the requirements of Rule 506 are met, the private placement will be deemed to fall within the exemption found in the Securities Act itself. However, that is not to say that an offering outside Rule 506 is not also exempt.

Regulation D covers three types of private placements, as follows:

Rule 504

Rule 504 is an exemption for offers and sales of securities up to $1,000,000 in the aggregate in any 12-month period. This Rule is available to issuers that are not subject to the periodic reporting requirements of the Exchange Act of 1934 and are not “blank check” companies (i.e., no business purpose other than acquiring another company). General solicitations are permitted under Rule 504 if they are restricted to accredited investors. The issuer need not restrict purchaser’s right to resell the offered securities. The Rule 504 exemption was created by the SEC pursuant to authority provided by Section 3(b) of the Securities Act.

Rule 505

Rule 505 is an exemption for offers and sales of securities up to $5 million in the aggregate in any 12-month period. Under this Rule, securities may be sold to an unlimited number of “accredited investors” and up to 35 “unaccredited investors”, i.e., investors who do not satisfy the wealth standards found in the definition of “accredited investor” in Rule 501 of Regulation D and who need not be “sophisticated”. The issuer must give non-accredited investors disclosure documents that generally are equivalent to those used in registered offerings. Purchasers must buy for investment only and not for resale. The issued securities are restricted, meaning that the investors may not sell the securities for six months or longer without registering them or selling pursuant to an available exemption from registration. General solicitation or advertising to sell the securities is not allowed. Like Rule 504, this Rule is an exemption from registration created by the SEC pursuant to authority granted by Section 3(b) of the Securities Act.

Rule 506

Rule 506 describes private placements that will be deemed to be exempt from the registration requirements of the Securities Act, regardless of amount. The requirements of Rule 506 are: (i) there can be no general solicitation or advertising to market the securities; (ii) sales of the securities may be made to an unlimited number of accredited investors but not more than 35 sophisticated unaccredited investors; and (iii) certain information must be provided to non-accredited investors. As in the case of Rule 505, there are restrictions on resale. This safe harbor relates to Section 4(2) of the Securities Act, which provides an exemption for “transactions by an issuer not involving any public offering”. The authority of SEC to create exemptions under Section 3(b) of the Securities Act is limited to offerings of not more than $5 million.

The SEC Release states that Rule 506 is “by far the most widely used Regulation D exemption, accounting for an estimated 90-95% of all Regulation D offerings and theoverwhelming majority of capital raised in transactions under Regulation D.” Interesting facts, but Rule 506 is not itself an exemption. Again, this issue is discussed below.

The SEC’s proposed amendments to Rule 506 would prohibit the following persons from participating in Rule 506 offerings if they have been convicted of, or are subject to court or administrative sanctions for, certain specified violations of law (“Disqualifying Events”): (i) issuers, (ii) their directors, officers, general partners, managing members and beneficial owners of more than 10%, (iii) persons paid (directly or indirectly) to solicit purchasers in connection with sales in the offering (e.g., underwriters and placement agents), (iv) directors, officers, general partners and managing members of such compensated solicitors, and (v) certain other persons, such as promoters.

Disqualifying Events include the following:

(i) felony and misdemeanor convictions (A) in connection with the purchase or sale of a security, (B) involving the making of a false filing with the SEC or (C) arising out of the conduct of the business of an underwriter, broker, dealer, investment advisor or paid solicitor, if occurring within the five years (in the case of issuers) or ten years (in the case of other covered persons) before the Rule 506 sale;

(ii) injunctions and court orders against engaging in or continuing conduct or practices (A) in connection with the purchase or sale of a security, (B) involving the making of a false filing with the SEC or (C) arising out of the conduct of the business of an underwriter, broker, dealer, investment advisor or paid solicitor, if issued within the five years before the Rule 506 sale;

(iii) final orders issued by federal banking regulators, the National Credit Union Administration or state securities, banking, credit union or insurance regulators that (A) bar a person from engaging in securities, insurance, banking, saving association or credit union activities, or from association with an entity regulated by the regulator issuing the order, if in effect at the time of the Rule 506 sale, or (B) are based on a violation of any law or regulation prohibiting fraudulent, manipulative, or deceptive conduct, if entered within the ten years before the Rule 506 sale;

(iv) Certain SEC orders (including suspension or revocation of registration as a broker, dealer, or investment advisor, or imposing limitations on such activities) or suspension or expulsion from, or being barred from association with, a national securities exchange or national securities association for “conduct inconsistent with just and equitable principles of trade,” if in effect at the time of the Rule 506 sale;

(v) Being named as an underwriter in, or filing, a registration statement or a Regulation A offering statement as to which a stop order or suspension order was issued within the five years before the Rule 506 sale, or being the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued, if such investigation or proceeding is taking place at the time of the Rule 506 sale; or

(vi) U.S. Postal Service false representation orders entered within the five years before the Rule 506 sale, or being subject, at the time of such sale, to certain U.S. Postal Service temporary restraining orders or injunctions.

The proposal also sets out a “reasonable care” exception, under which an issuer would not lose the benefit of the Rule 506 safe harbor, despite the existence of a Disqualifying Event, if it can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification.

The SEC Release asks for comments on the idea of applying the newly proposed provisions uniformly to offerings under (i) Rules 504 and 505 of Regulation D, (ii) Regulation A (providing for simplified disclosure and transactional requirements for companies offering $5 million or less of securities, but which requires the filing of an offering statement subject to review by the SEC) and (iii) Regulation E (exempting from registration under the Securities Act certain offerings of securities by small business investment companies registered under the Investment Company Act of 1940 or closed-end investment companies that are regulated as a business development companies under the 1940 Act).

Under the proposed amendments, the disqualification would apply to sales after the effective date of the amendments, and the “look-back” period for the Disqualifying Events would apply to such sales, regardless of whether the Disqualifying Event occurred before adoption of the amendments or, indeed, before adoption of Dodd-Frank.

Missing Link?

The SEC Release is 91 pages long, yet it fails to address a rather important point—Rule 506 is merely a safe harbor, not an exemption. Hence, if the SEC claims that an issuer failed to meet the registration requirements of Section 5 of the Securities Act because a “bad actor” made Rule 506 unavailable, the issuer can simply say that it was relying on Section 4(2) of the Securities Act, not Rule 506. The SEC’s Enforcement Division would then be in the awkward position of arguing that certain procedures, if followed by some individuals, are within the exemption provided by Section 4(2) of the Securities Act, but if the very same procedures are followed by other individuals they are not within the scope of Section 4(2).  The statute itself makes no such distinction. How, then, can the identity of the participants define a “public offering” for purposes of Section 4(2) when the only factor in the governing statute is procedural, i.e., the “public” nature of the offering. The SEC has never claimed, and is not claiming now, that Rule 506 is the only means of meeting the requirements of Section 4(2). Indeed, countless private placements in amounts greater than $5 million were made before Regulation D was adopted and many more have been made outside Regulation D since the 1982 adoption. (In fact, the only way to be sure a private placement is made in reliance on Regulation D is the filing of Form D, which, apropos of this discussion, in not a requirement for an exemption under Section 4(2) of the Securities Act, it is merely a requirement for reliance on the safe harbor of Rule 506.) To be sure, the traditional “4(2) offerings” were typically made only to institutional investors and did not involve more than a small number of offerees (some Wall Street firms advised that the number of offerees should be limited to 25, some advised a limit of 50, and one prominent firm said that purchasers should be limited to 25 but the number of offerees was not relevant so long as there was no general solicitation). However, those strict requirements reflected an abundance of caution of the part of law firms advising issuers and placement agents.  Regulation D, particularly Rule 506, was an attempt by the SEC to provide some guidance on the type of private placement that would be within the exemption provided by Section 4(2). Thus, when one says that they are relying on Rule 506, they really mean that they are relying on Rule 506 to be certain that they meet the requirements for the exemption provided by Section 4(2). A person could follow the procedures in Rule 506 and simply say they are relying on the exemption in Section 4(2). This is more than a semantic distinction. If the SEC brings an enforcement action for failure to register securities under Section 5 and the defendant claims an exemption under Section 4(2), how will the SEC show that it is the identity of the participants, not just the procedures followed, that creates an exemption under Section 4(2) of the Securities Act?

rwiegley@thecorpsec.com

We often refer to the idea of  “piercing the corporate veil” at this blog.   Many small business owners and investors probably consider the threat too remote to worry about. However,  when lawyers are offered training courses on how to pierce the corporate veil, the threat becomes more apparent.

Piercing the Corporate Veil

Why bear the risk?

The Corporation Secretary

Many companies use non-compete agreements to prevent selected employees from using trade secrets, customer relationships, and commercially sensitive information to the competitive disadvantage of the employer after the employment relationship ends.   These non-compete agreements, sometimes drafted by experienced counsel but often a mark-up of a “template” found on the Internet or from a precedent in the company’s files, range from well drafted to clearly unenforceable. There are some general rules that apply to these agreements, but the operative word is “general”.  Court cases and governing statutes vary from state to state—over a wide spectrum of results—so the “general rules” are really just an a group of common themes that have several important exceptions.

One general rule applied by courts is that a non-compete agreement must balance the rights of the individual to pursue employment or business opportunities matching his or her experience and qualifications against the rights of the employer to protect propriety information and customer relationships that have been developed at the employer’s expense.   No one would quarrel with the need for such a balance but the “balance” of competing interests is quite often a subjective determination.   The balancing is normally expressed as the need for reasonable limits on the term of the non-compete provisions and geographical area to which they apply.   In addition, the restrictions on the individual’s post-employment activities should bear a reasonable relationship to his or her responsibilities at the former employer.   For example, a sales person who sells specialized computer software to banks might be prevented from selling competing software to the same banks post-employment, but that does not mean the courts would uphold a restriction so broadly drafted that it prevented the former employee from selling media services to those same banks.

Another general rule is that there should be some consideration given by the employee for his or her agreement to be bound by non-compete provisions.  Again, the exceptions are just as important as the rule.  Some states, such as New York and Connecticut, consider continuing employment to be adequate consideration for a non-compete agreement.  Other states require that some benefit be given to the employee in exchange for the employee’s agreement.  This benefit might be the commencement of employment, a bonus, an award under a stock or option plan, or access to confidential information.  A third group of states requires that actual value be given by the employer and the courts in those states may scrutinize the exchange to see if what the employee received is something he or she would have received even in the absence of the non-compete agreement.

Added to all of this—sometimes superseding it—are statutory requirements imposed by more than twenty states, which range from pro-individual to pro-employer.  Here is a summary (note that these statutes are paraphrased; different restrictions often apply in the sale of a business or an ownership interest, the dissolution of a partnership, and restrictions on the practice of physicians or individuals working in the broadcasting industry):

Finally, there is the “blue-pencil” doctrine and the doctrine of “equitable reformation”.   In states where one of these doctrines applies, the courts may modify a non-complete agreement if it imposes unreasonable restrictions on the former employee.   Under the blue-pencil doctrine, a court can “blue pencil”, or cross out, the words that create the unreasonable restriction, provided that the agreement is otherwise reasonable without the excised portion. Under the doctrine of equitable reformation, the court will rewrite the restriction so that it meets the requirements of reasonableness, even if this rewriting involves more than striking certain words from the agreement.

In states that do not apply the blue-pencil or equitable reformation doctrines, some states hold that a non-compete agreement that goes too far is simply not enforceable.  Other states have not decided the issue.

States that allow blue-lining or equitable reformation, either through statute or case law, are Alabama, Arizona, Connecticut, District of Columbia, Florida, Georgia, Idaho, Illinois, Indiana, Iowa, Kansas, Maryland, Michigan, Minnesota, Mississippi, Missouri, New Hampshire, New Jersey, New York, North Carolina, Oklahoma, Oregon, South Carolina, South Dakota, Texas and Vermont (unless, in the case of Vermont, the covenant as a whole evidences an intention to place an unreasonable and oppressive restraint on the employee, in which case the entire covenant will be invalidated).

“No modification” states are Arkansas, Louisiana, Nebraska, Oklahoma, Virginia, and Wisconsin

Of the remaining 18 states, six have statutes that make non-compete agreements void or subject to very narrow restrictions (California, Colorado, Hawaii, Montana, North Dakota and Oklahoma).   The other 12 states are probably best described as open to argument in terms of modifying overly broad non-compete agreements.  To be sure, non-compete agreements often contain their own “severability” clause with words such as, “If any provision or portion of this Agreement is for any reason held to be invalid, illegal, or unenforceable in any respect, the invalidity, illegality, or unenforceability shall not affect any other provision, and this Agreement shall be equitably construed as if it did not contain the invalid, illegal, or unenforceable provision.”  These clauses may have some influence in states that have not already adopted a position on modification of unreasonable non-compete agreements, but more likely courts in those states will view the severability clause as “boot-strapping” by the employer and they will analyze the issue as a question of whether public policy should favor the business interests of the employer or the employment opportunities of the individual.

Bottom line:   Non-compete agreements are often drafted without much care, but they are frequently one of the first documents an employer looks for when a key employee announces that he or she is leaving.

http://www.thecorpsec.com

It is impossible to describe the vastness or the richness of the Internet as a resource for individuals starting a new business.  Indeed, many new ventures, if not most, are themselves Internet businesses.   The efficiencies offered by the Internet are truly staggering.  That said, there are more than a few risks and shortcomings when one relies too heavily on the promotions offered by many websites.

“Incorporate or Form an LLC Now” or similar Internet offerings is a good example.  The Internet vendors that offer these services will form a corporation or limited liability company very quickly and at a very low fee, sometimes less than $100 plus state filing fees.  In the bygone era of paper documents, a person starting a new business would typically have consulted an attorney about forming a new business.  The attorney would have charged substantially more for the same service as today’s Internet vendor.  Why the difference?   Is it just the outrageous hourly rates charged by attorneys?  (Having been a lawyer for over 30 years, the author can ask the question in that way.)  There may be some of the latter but the real cost is in the time required for the attorney to ask the right questions, review alternatives with the client, and discuss the future requirements for the legal entity chosen.  What type of organization is right for this business (C corp.?, S corp.?, LLC, close corporation?, limited partnership?); in which state should the company be formed?; what other documents are required and in what order and within what time periods should they be filed, if at all (by-laws, organizational minutes, EIN, state employer filings, S corp. election,  bank accounts, filings in other states); and what else should the organizers be thinking about (shareholder agreements?, buy-sell agreements among shareholders?, non-competes among founders?).   Finally, what regulatory compliance issues should the organizers be aware of and address at an early stage?  Good advice from an experienced attorney at the beginning can save many times the cost of a mistake over the long-run.

In contrast, Internet vendors will take some basic information, offer simple advice in a few words on their website (corporation or LLC?), make the state filing, perhaps provide some very basic documents (e.g., one-size-fits-all bylaws or operating agreement), charge the customer’s credit card, and move on to the next name on their list.  What happens going forward?  Well, therein lies the problem.  The principal reason to form a corporation or LLC is to shield the shareholders of a corporation or members of an LLC from personal liability.   If the organizer of a corporation or LLC does nothing further about corporate governance after the act of formation, there is a significant risk that the corporation or LLC will not provide the shield that was intended.  Plaintiffs, creditors and government agencies may be able to “pierce the corporate veil” and reach the assets of the shareholders or members.    The Internet vendors conveniently omit any discussion of this risk because good corporate governance adds to the cost of having a corporation or LLC and such future costs might discourage the act of formation.

Moreover, maintaining a corporation means more than simply holding a five-minute meeting of shareholders once a year to elect directors, followed by a five-minute meeting of directors to appoint officers.   The directors—even if they are the same individuals as the shareholders and the officers—should discuss financial results, any problems, and any proposed changes to the company’s operations or business plan. In addition, good corporate governance means regulatory compliance.  Every business should understand the spectrum of regulations with which it must comply.  In today’s business environment, this is no small matter.  It is not something that the officers of the company can think about from time to time when they are so inclined, relying on web-based business news to tell them about new regulatory developments affecting their business.   Compliance should be handled systematically and should be an important agenda item for meetings of the Board of Directors.  At a minimum,

1. Compliance Program.   Every business should have an internal document that describes the federal and regulations applicable to its operations, lists the policies and procedures of the company that will be followed to meet such regulatory requirements, and identifies the officer or officers of the company who are responsible for compliance.
2. Corporate Governance.   Compliance is ultimately the responsibility of the Board of Directors of a corporation.  The Board should meet regularly and should have a report before each meeting describing any compliance issues and any new regulatory developments or proposals since the last meeting (or a note for the minutes of the meeting that there were none).
3. Risk Integration.   Any proposal to change a company’s business model or expand operations, such as new interstate or overseas activities, should be analyzed in terms of regulatory implications, compliance costs, resource requirements (e.g., the need to train employees, hire consultants, make filings in various jurisdictions), and the risks and consequences of non-compliance.  This analysis should be presented to the Board of Directors along with the discussion of financial and operational factors.

This matter of compliance is more complex and more threatening than it may appear.  See “The ERISA Dragon May Tear Away Your Veil” below (October 2010).

The filing to form a corporation or LLC can be accomplished in fifteen minutes over the Internet.   Do not be seduced into thinking that proper maintenance of a corporation or LLC is so simple.

http://www.thecorpsec.com

On February 24, 2011, the Treasury Department issued new reporting rules, effective March 28, 2011, relating to the filing of an annual Report of Foreign Bank and Financial Accounts, commonly call an FBAR.  New Rules (PDF)

Briefly, United States persons are required to file an FBAR if: (i) the United States person had a financial interest in or signature authority over at least one financial account located outside of the United States; and (ii) the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the calendar year to be reported.  “United States person” means United States citizens; United States residents; entities, including but not limited to, corporations, partnerships, or limited liability companies created or organized in the United States or under the laws of the United States; and trusts or estates formed under the laws of the United States. Returns for calendar year 2010 must be received—received, not mailed–by June 30, 2011.

The new rules are important because the reporting requirement is imposed on individuals and entities who have a financial interest in or signature or other authority over a foreign financial account, with limited exceptions.  This language referring to “signature or other authority” for financial accounts, regardless of financial interest, means that many individuals and organizations who had not previously filed an FBAR will now be required to file.  It is not uncommon for multinational organizations to give signing authority to United States officers and employees over foreign bank accounts maintained by the parent or by foreign affiliates (whether those individuals are expats or residing in the U.S.).

The final rules require the individual employees and officers, if they are U.S. persons and have signature authority over foreign financial accounts, to file an FBAR for all such accounts, even if (i) they have no personal financial interest in the accounts and (ii) the corporate account owner files an FBAR that includes such accounts. Prior to the new rules, the IRS allowed a deferral of the FBAR filing for certain individuals, such as employees and officers, who held signature authority over but no financial interest in foreign financial accounts. Those employees and officers who took advantage of this deferral period for years prior to 2010 now have FBAR filings that are required to be received by June 30, 2011.

A few exceptions to the FBAR filing requirements still apply for officers and employees of companies with signature or other authority for an account owned directly by that company, not the foreign affiliate, where the employee has no financial interest in the account. These exceptions are:

➢An officer or employee of a publicly held company, whether foreign or domestic, with a class of equity securities, listed on any U.S. national securities exchange;

➢An officer or employee of a U.S. subsidiary of a U.S. entity with a class of securities listed on a U.S. national securities exchange if the subsidiary is included in a consolidated report filed by the U.S. parent;

➢An officer or employee of a bank that is examined by federal authorities;

➢An officer or employee of a financial institution that is registered with and examined by the Securities and Exchange Commission or Commodity Futures Trading Commission; and

➢An officer or employee of an authorized service provider where there is an account owned or maintained by an investment company that is registered with the Securities and Exchange Commission.

Given the short time remaining before the filing deadline and the fact that the new rules have not been covered by the mainstream media and may not be widely known, the risk of non-compliance is high.  Companies that are affected should collect information about their foreign financial accounts and those of their foreign affiliates; identify any officers and employees who are U.S. persons and who have signature authority over any of those financial accounts; inform those officers and employees of the reporting requirement and assist them in meeting the requirement before June 30, 2011. Companies and individuals that filed 2010 federal income tax and information returns before the March 28, 2011, have the  choice of using the FBAR regulations that applied before the final rules or the new rules that became effective March 28, 2011.   For others, the new FBAR rules apply.

http://www.thecorpsec.com

On March 4, 2011, the California Franchise Tax Board issued guidance on what constitutes “doing business” in state beginning January 1, 2011.

For taxable years beginning on or after 1/1/2011, a taxpayer is doing business in California if any of the following conditions are satisfied:

—The taxpayer is organized or commercially domiciled in California.

—The taxpayer if actively engages in any transaction for the purpose of financial or pecuniary gain or profit in California or

—Sales of the taxpayer in California, including sales by the taxpayer’s agents and independent contractors, exceed the lesser of $500,000 or 25 percent of the taxpayer’s total sales.

—Real and tangible personal property of the taxpayer in California exceed the lesser of $50,000 or 25 percent of the taxpayer’s total real and tangible personal property.

—The amount paid in California by the taxpayer for compensation exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.

For the conditions above, the sales, property, and payroll of the taxpayer include the taxpayer’s pro rata or distributive share of pass-through entities (partnerships, LLCs treated as partnerships and “S” corporations).

The new law affects out-of-state corporations and pass-through entities and their partners/shareholders/members that have property, payroll or sales in this state. Currently, they may not be considered to be doing business in this state, but may be considered doing business starting in tax year 2011 if they meet any of the thresholds listed above.

An out-of-state taxpayer that is considered to be doing business in California will need to file the appropriate tax return and pay the appropriate tax and fees.   It should also register as a foreign corporation (or LLC or LP) with the Secretary of State of California.

Doing business in a state for tax purposes is not necessarily the same as doing business for purposes of a state court’s jurisdiction over a defendant named in a lawsuit, but it would certainly be an influential factor.