Thoits, Love, Hershberger & McLean Law Blog

AB 1396: Commission Agreements, Grammar, and Legislative Pollution

A new California law (AB 1396) requires that all employment relationships that involve payment of commissions “shall be in writing and shall set forth the method by which the commissions shall be computed and paid.”  The employee must be given a signed copy, and the employer must obtain a signed receipt from each employee.  The contract and the commission terms “are presumed to remain in full force and effect until the contract is superseded or the employment is terminated by either party.”  This new law will have a dramatic impact on any employer whose compensation arrangements involve commissions.  At a minimum, the customary annual commission plans published for such employees will need to be incorporated into a contract format and written receipts obtained.  Whether the employer routinely uses commissions or does so only on an intermittent or anecdotal basis, the new law requires new procedures and new written contracts.

Curious legislative drafting makes uncertain the effective date of the law.  So, now, let us have some fun with the legislature’s grammar and syntax.  Should we assume the law goes into effect January 1, 2013?

The only reference in the new statute to any effective date states that “[B]y January 1, 2013, whenever…” an employer enters into such a contract, it must be in writing.  Does this mean that starting immediately and only until January 1, 2013, all such contracts must be in writing; or does it mean that “after” January 1, 2013” such contracts “shall be in writing?”  It cannot mean the latter, because the word “after” was not used.  Even the Legislative Counsel’s digest avoids answering the question.  It states, “[T]his bill would, by January 1, 2013, make this contract requirement applicable to all employers entering into a contract…”  This implies that something must occur between now and then – without explanation.  Maybe the legislature intended to say, “This law takes affect January 1, 2013.”  But, it didn’t.  Maybe it meant to say, “We would like to say this law takes effect on January 1, 2013, but we also would like to say that we want employers to comply with it by January 1, 2013.”  Finally, we should ask the question begged by this semantic construction…what about commission arrangement that are made after January 1, 2013 – are they not covered by this new law?  The preposition “by” in this context means “before or no later than.”  Strict construction of the statutory words then requires that the statute means no later than January 1, 2013, employment relationships must comply by the indicated date – logically that can only include employment relationships now existing or created between now and that date. Even if equal interpretive weight is given to the word “whenever,” it seems to conflict with “by” instead of clarifying its use, i.e. “before January 1, 2013, whenever…” or “no later than January 13, 2013, whenever…” “By” is sometimes confused with “until” but neither application in this sense helps clarify the meaning.  Other commentators suggest the effective date is January 1, 2013.  And, if something is to be done between now and January 13, 2013, it must be using written contracts for commission arrangments, which means the law is not effective January 1, 2013, but sooner.  Maybe the legislature will clear this up with an amendment.

If anyone, grammar nerd or not, has any thoughts on what this phrase means, please comment, for fun, if for no other reason.

Stephen C. Gerrish, Employment Group

Letters of Intent, Part IV: Indemnification and More

In previous posts (March 2010, April 2010, and May 2010, I have discussed various aspects of a letter of intent used for a sale or acquisition of a business or other M&A transactions.   I’ve described how there are significant benefits for both sides in a potential acquisition or merger transaction to using a LOI.  I’ve also explained the rationale behind typical terms found in a sample LOI that is used in an asset sale context.   In this post, I will explain the rationale and reasons behind the remaining terms contained in the sample LOI, which you can view by clicking here. 

In this final installment I will describe the pros and cons of dealing with indemnification obligations of the seller and, to a lesser extent, the buyer, as well as briefly explaining the risk-reduction benefits that can be achieved by the seller under a well-crafted indemnification term in the LOI. Finally, I will examine the last term in the sample LOI, which addresses the seller’s employees.

I would argue that the seller's indemnification obligation is the second-most important of the major terms in an acquisition or merger transaction, just below the transaction pricing and payment terms.  As a seller, what you are being paid for the business is of utmost importance.  However, once the seller is offered a fair price on acceptable terms, the seller’s focus should immediately turn to how much of the deal price is at risk and the terms that govern the likelihood that the seller will be able to retain the full deal price.

As previously discussed, the representations and warranties of the seller that will be part of the definitive acquisition agreement will determine the allocation of risk in the transaction.  In general, the more comprehensive and detailed the representations and warranties of the seller, the more risk the seller will bear, especially if the extensive representations and warranties are absolute and not qualified by knowledge, materiality or other limiting language.  However, even if the seller must yield to the buyer’s demands for extensive and absolute representations and warranties, the seller may be able to reduce risk to an acceptable level by insisting on indemnification provisions that cap the seller’s potential liability for a breach of any representation or warranty.

Because of the importance to the seller of negotiating reasonable indemnification provisions, it is critical to address up front with the potential buyer the scope of those provisions.  If the basic scope of seller’s indemnification is left to the definitive agreement negotiations, it is likely that the seller will lose some leverage.  In my experience, the seller generally has more leverage at the LOI stage than later, when the definitive agreement is being prepared. The seller should have a better opportunity to negotiate more favorable dollar caps and time limits, during the LOI negotiation.   As you might expect, the down side to covering the scope of the indemnification up front is the potential delay caused by doing so, especially if the buyer is particularly resistant to addressing indemnification before due diligence is conducted.   And in some cases, with a stubborn buyer, the delay and the acrimony caused by the seller's insistence that the indemnification issue be addressed in the LOI can be substantial.  Nevertheless, I contend that, until the basic scope of seller’s indemnification is addressed, the seller cannot intelligently and accurately assess the overall value of the deal being offered by the buyer.

Leaving out the basics of seller’s indemnification obligation is almost like knowing the price but not the payment terms, or the buyer leaving out a financing contingency that is requested by the buyer at a later stage.  Leaving out important terms creates a hole too big to try to fill later.

Turning to the sample LOI, the seller has limited exposure for breaches of its representations and warranties and for any other liabilities that may be traced to the seller’s operation of the target business prior to the closing of the acquisition to 20% of the acquisition consideration .  In addition, seller’s exposure for any breaches discovered by buyer or claims arising from seller’s operation of the business is limited in time to the one-year period after the date of closing .  Depending upon a multitude of factors, the dollar cap typically ranges from 10% to 50% and the time limit typically ranges from one to three years.  An experienced M&A attorney can provide much needed assistance in negotiating appropriate and reasonable caps, time limits, deductibles (sometimes structured as baskets) and any holdbacks to assure funding of the indemnification obligation (if needed), as well as exceptions  to such items.  An experienced M&A attorney also will make sure that the indemnification obligations of seller are the exclusive remedy so that the buyer is not able to circumvent the risk reduction provisions.

The buyer’s indemnity is typically less contentious to negotiate as the buyer faces much less unknown risk or overall exposure than a seller, and generally accepts the broader and more open-ended indemnification scope that is found in the sample LOI as a necessary and appropriate business risk that comes with acquiring an on-going business.  Nevertheless, to avoid an unexpected hard-line position taken by the buyer when the definitive agreement is being drafted, the buyer’s indemnification should be addressed at the LOI stage, as well.

The final term in the sample LOI (retention of employees) is more typically found in an asset sale transaction in which the buyer is not acquiring the on-going legal entity operating the business, together with all of its property and other assets, and subject to all of its liabilities and other obligations, including its employment obligations. It can be important also to address employment retention in a stock or merger transaction to protect the continuity of the business and its operations and the goodwill value of the business.  Such protection may minimize the likelihood that the target business will suffer a decline in its operations or value or encounter other problems that may lead to the buyer questioning whether full and accurate disclosure was made by the seller, which in turn can lead to possible claims by a disgruntled buyer that the seller breached its representations or warranties, triggering the indemnification  provisions. In addition, if there is an earn-out component of the purchase price for the business being acquired, the seller can increase the likelihood that the earn-out will yield future consideration for the seller if the buyer makes a commitment to retain key management team members for some reasonable period of time.

As indicated in the previous installments of this post, an experienced M&A attorney can provide significant value to the seller when involved at the beginning of any negotiations with a potential buyer over the terms of an LOI.  This also holds true if, as sometimes happens, the buyer sends the seller a signed LOI with a 24 or 48 hour “deadline” for a written, signed acceptance.   If you are a seller, do not make the mistake of signing an LOI that you believe is non-binding in the belief you can negotiate any problems or missing terms later. This will inevitably lead to a less desirable result, and could cause much greater problems, for the seller.

Terrence P. Conner, Business Group

New Businesses Qualify as LLPs and LLCs in California

During the last legislative session, California enacted two new laws that may change the choice of entity decision for licensed contractors, surveyors and engineers. Starting September 30, 2010, SB 1008 allows engineers and land surveyors to operate their businesses as limited liability partnerships (“LLPs”).  Previously, California only allowed attorneys, accountants and, until January 1, 2012, architects to conduct business as an LLP.  This legislation is temporary.  If not extended, surveyors and engineers will lose this privilege on January 1, 2016.  This change in the law allows groups of engineers and surveyors to practice together, but shield each other from personal liability for any errors or omissions of others within the group.  The law does impose insurance requirements, however.  Any LLP offering surveying or engineering services is required to obtain insurance, or provide security, of not less than $100,000 multiplied by the number of licensed persons in the practice, with a minimum of $2,000,000.  This is greater than the $1,000,000 required of architectural firms.  The California Secretary of State’s office has already updated the registration form, which can be found here.

Starting January 1, 2011, SB 392 amends the California Business & Professions Code to allow contractors licenses to be issued to limited liability companies.  The Contractors State License Board is not required to issue those licenses until January 1, 2012, so there is still a bit of a wait for those contractors hoping for non-corporate income tax treatment for their businesses.  This is an important change for a number of reasons.  Previously, any contractor wanting protection from personal liability was forced to form a corporation, which was not always the best alternative from a tax perspective.  Now, those in the construction industry requiring a contractor’s license will have a choice.  There is one significant requirement of LLCs seeking a license that does not apply to other types of business.  SB 392 requires that any LLC holding a license file a surety bond in the amount of at least $100,000 covering damages for claims of employees.  There was concern that, with the lack of personal liability of an LLC, when compared to a general partnership or sole proprietorship, employees would not have a way to guarantee payment of wages.  In contrast, corporations, sole proprietors and partnerships are only required to hold a $10,000 bond.  The cost of this bond may make it difficult for new businesses to operate in the LLC form.

Anne E. Senti-Willis, Business Group

Private Foundations: Public Art, Self-Dealing and the IRS

Private foundations are subject to a number of rules and restrictions designed to ensure that their assets are used exclusively for charitable purposes, and not for the benefit of the organization’s directors or benefactors.  These rules, though, can lead to concern over seemingly innocent actions.  Recently, the Internal Revenue Service (“IRS”) reached the logical, appropriate conclusion in such a case.

Internal Revenue Code Section 4941 prohibits private foundations from engaging in acts of “self dealing” with “disqualified persons.”  Disqualified persons are generally significant donors, 20% or greater owners of significant donors, directors, officers, managers, family members of the foregoing, and entities that are owned 35% or more by any of the foregoing.  Self-dealing is broadly defined, and includes many types of transactions involving a private foundation, on one side, and a disqualified person, on the other.

Because of the broad nature of Section 4941 and the tax of at least 10% of the value of the transaction that is imposed on the disqualified person, a private foundation recently requested a ruling from the IRS that a proposed transaction was not an act of self-dealing.  An individual amassed a significant collection of modern art and, at his death, left the collection to a foundation he established.  After his death, his daughter and son-in-law remained directors of the foundation.  The foundation loaned many of its works to an art center the collector funded, but the art center wasn’t big enough to maintain all of the artwork on display.  Other pieces were loaned to museums worldwide and an airport terminal. 
Still, there were undisplayed pieces in the collection, so the foundation proposed exhibiting five to 10 pieces at a local shopping mall.  This seemed logical, as it would allow hundreds of thousands of people to see the pieces for free, and it would encourage shoppers to view additional portions of the collection at the art center.  A great win for the foundation – more support for the art center, while providing free art for the public to view!

The small problem:  Founder’s daughter and son-in-law, disqualified persons because they are related to a substantial contributor and because they are directors, owned more than 35% of the shopping mall, making it a disqualified person.  Technically, this could be an act of self-dealing.

Happily, in Private Letter Ruling 201029039, the IRS determined that any benefit to the shopping mall, perhaps in the form of increased traffic and sales for those who came to view the art, was incidental and tenuous compared to the benefit to the public.  It also found that displaying the artwork at the shopping center furthered the foundation’s exempt purpose of promoting appreciation and public awareness of 20th century artwork.

While the IRS’ private letter rulings cannot be cited as precedent, they do provide a general indication of how the IRS might rule in other similar situations.  It demonstrates that the IRS does look at the totality of the facts of a situation, and can see where the benefit to the public and furtherance of an exempt entity’s goals outweighs any small benefit to an individual.

Anne E. Senti-Willis, Business Group

NEW LEASE ACCOUNTING STANDARDS COULD HAVE MAJOR IMPACT

Many tenants are likely to see a big shift in their balance sheets in coming years.  The Financial Accounting Standards Board (FASB), together with the International Accounting Standards Board, has proposed a comprehensive set of changes in the generally accepted accounting practices (GAAP) for leases.

In an Exposure Draft issued August 17, 2010, which commentators say is likely to be adopted, FASB has proposed a fundamental shift in lease accounting.  Perhaps most significant is the proposed change from operating to capital treatment of leases – that is, requiring tenants to place the obligation to pay rent over the entire lease term on their balance sheets as a liability, where before only the current rent was booked on the financials, as an expense on the income statement.

In calculating the long-term rental obligation, contingent payments such as “percentage of sales” rent would be required to be estimated and included in the total.  When addressing renewal options, accountants preparing financial statements under the new GAAP standards would be required to use the longest term that is more likely than not to occur.  Tenants will discount the full stream of rent payments to present value, using their borrowing rate.
The rent liability will be offset by an equivalent asset, representing the right to use the leased premises.  Both the asset and liability totals attributable to leases diminish over time as the expense is booked.

While both sides of the balance sheet are grossed up under the new rules, many tenants – especially those with large lease portfolios – will not be happy seeing their debt loads suddenly balloon and their financial picture appear shakier.  And existing leases are not slated to be grandfathered in under current rules, meaning that the predicament may already be somewhat of a foregone conclusion for many companies.

Final comments on the proposed standards are due December 15, 2010 and final standards are estimated to be issued in the middle of 2011.  Actual implementation is estimated to be no sooner than January 1, 2013.  In the meantime, many tenants can be expected to take the new standards into account in structuring and negotiating their lease deals, as tenants seek to alleviate the impact of the new standards.  For example, large retail chains may switch to a policy of shorter lease terms in order to offset the impact of the new standards.

Scott M. Toussaint, Real Estate Group

Valuation of Minority Interests

Kathryn Andrews, a member of our Business Group, gave a presentation to the Sonoma County Bar Association on September 21, 2010, on "Valuation of Minority Interest in an Involuntary Dissolution." This is a hot, but widely misunderstood, topic of particular importance in this economic climate.  You can see a her presentation outline here.

California Senate Rejects Plastic Bag Ban

In the final day of the 2010 legislative session, the California Senate voted down a proposed statewide ban on single use plastic bags, known as AB1998.  The final vote was 14 senators in favor and 21 opposed to the ban.  Governor Schwarzenegger had indicated he would sign the bill into law, if passed.  The legislation could be re-introduced next year.
   
With the defeat of the bill, the California Supreme Court’s decision in Save the Plastic Bag Coalition v. City of Manhattan Beach will guide cities and counties that hope to impose their own bans.  The Save the Plastic Bag Coalition is arguing that local governing bodies must complete an environmental impact report before imposing a ban on the bags.  The Supreme Court will be determining whether or not that step is required.  No date has been set for arguments in the case.  The City of Manhattan Beach and Save the Plastic Bag Coalition have submitted their briefs, as have other groups, including Heal the Bay, the League of California Cities, the Pacific Legal Foundation, Californians Against Waste and the Manhattan Beach Residents Association.  You can follow the case here.

Anne E. Senti-Willis, Business Group

Tax Reporting Requirements for Small California Nonprofits

Starting January 1, 2011, tax-exempt organizations with gross receipts normally under $25,000 will be required to file an electronic annual information return with the California Franchise Tax Board (“FTB”).  The reporting is similar to the Internal Revenue Service requirement that has been in place since 2007.

FTB Form 199-N requires that organizations report:

1. The legal name;
2. Any other name under which it does business;
3. Mailing address;
4. Website (if there is one);
5. Federal and state taxpayer identification numbers;
6. Name and address of a principal officer;
7. Gross receipts for the year;
8. Tax year beginning and ending;
9. Name and phone number for a contact person; and
10.Whether or not the organization has gone out of business.

Starting January 1, 2010, tax-exempt organizations with gross receipts under $50,000 will be able to file Form 990-N with the IRS.  For organizations with gross receipts between $25,000 and $50,000 filing in California, they will be required to file Form 199 with the FTB, not the abbreviated 199-N.

Note the new FTB filing requirement is in addition to biennial statements filed with the California Secretary of State listing the organization’s officers and annual information forms (RRF-1) filed with the office of the California Attorney General.  More information on Form 1990F is available on the FTB website, here.

Anne E. Senti-Willis, Business Group

California Legislature Contemplates Plastic Bag Ban

In a recent post, we discussed the Save the Plastic Bag Coalition’s case against the City of Manhattan Beach, claiming that when a city or county in California adopts a plastic bag ban, it needs to complete an environmental impact report.  The California Supreme Court’s review of that case may become moot.

The California Senate Appropriations Committee is holding hearings on a new bill (AB1998) that would effectively impose a statewide ban on plastic bags for supermarkets, convenience stores, food marts and pharmacies with over 10,000 square feet of retail space.  These retailers would be prohibited from handing out plastic or paper bags to customers at the checkout counter.  Instead, retailers could give away reusable bags or offer recycled paper bags for a fee of not less than 5 cents per bag.  They would be required to offer reusable bags for sale.  In San Francisco (and only San Francisco), retailers will also be able to sell certain compostable bags for at least 5 cents per bag.

As currently drafted, the law defines a “reusable bag” and a “recycled paper bag.”  Reusable bags must be designed and manufactured to survive at least 100 uses.  The Department of Toxic Substances Control is charged with further requirements for reusable bags and labeling requirements.  Starting January 1, 2013, reusable bag manufacturers will have to be registered with and certified by the state.  Recycled paper bags must have at least 40% post-consumer recycled content and be accepted for recycling in curbside recycling programs.

If passed, the law will become effective for supermarkets and covered pharmacies on January 1, 2012.  It becomes effective for convenience stores and food marts on January 1, 2013.  Governor Schwarzenegger has indicated he will sign the bill if it is approved by the legislature.

In the meantime, Save the Plastic Bag Coalition v. City of Manhattan Beach has been fully briefed but not yet argued.  If AB1998 becomes law, it will preempt all other city, county or local public laws, including Manhattan Beach’s ordinance.  The new law may become effective before the California Supreme Court reaches a decision, possibly causing them to decline to issue a decision.

To follow the progress of AB1998, click here and enter “AB1998” into the search line. You can request automatic e-mail updates on Save the Plastic Bag Coalition v. City of Manhattan Beach, by clicking here.

Anne E. Senti-Willis, Business Group

E-Mail Notice - Valid or Not?

Is electronic mail an acceptable method of notice under a lease?  Maybe not, says a court in California – if the lease language is poorly drafted.  Most of you are no doubt familiar with “notice” provisions that appear in leases and contracts.  They tell us who, how and where to serve any required notification.  Many of you also may have been involved in drafting such clauses, and know that they are not often given the same scrutiny as are the deal points of the transaction.  The California Court of Appeal decision in Culver Center Partners East #1 v. Baja Fresh Westlake Village is an excellent reminder to be careful in drafting a notice provision that includes the use of “electronic means.”

Baja Fresh failed to pay its rent on the first of a month, so Culver Center tried to serve a notice to pay the overdue rent, or to quit the premises.  Culver sent a certified letter to Baja’s manager, at her business office; sent a fax of the notice to the business office; and sent the notice as an attachment to the manager’s e-mail address.  Unfortunately, regarding the certified mailing and the fax, neither were sent to Baja’s actual address for notice purposes.  Baja admitted that it received the e-mail – but disputed that the notice was proper, and in any event proceeded to pay the amount due, which Culver promptly returned without cashing, claiming it was not paid within the required five-day period.  Culver then filed an eviction action.  Baja claimed the case should be dismissed because the notice was invalid.  They won.  Culver might have avoided this problem if it had sent the certified mail or fax to the correct address, but since it did not, the validity of the admittedly received e-mail became the crux of the case.

The notice provision in the lease allowed use of “electronic means” but stated that no matter what method of notice is chosen, the “notice must be delivered to the address provided in the lease.”  The e-mail was received by the recipient at a physical address other than that required by the lease.  This might seem irrelevant or antiquated, given that e-mail messages are not restricted by physical location.  But the court rejected Culver’s argument that it should not matter where the recipient actually receives the message, while acknowledging e-mail can indeed be received anywhere a computer is located.  Unfortunately for Culver, the lease language preempted the argument – it made no reference to an “electronic notification address,” instead requiring service at “address provided in the lease.”  The court stated:

While this focus on the physical location of receipt (or delivery) of an e-mail has some artificiality (and technological naivete) in this age of laptop computers and smartphones, the fault, if there be any, lies in the language of the lease itself, which, while apparently contemplating “electronic service,” nonetheless omits any reference to an electronic notification address to accomplish that service.

The court referenced, by analogy, a California rule that allows electronic service if, among other things, a party indicates its willingness to accept electronic service by signing a notice so indicating that specifically includes the “electronic notification address at which the party agrees to accept service.”  This would seem to be the solution:  the notice provision should provide the specific e-mail address at which the notice will be accepted, regardless of the physical location.  And, that address should be subject to a prompt change-of-address notification.

In the context of an unlawful detainer proceeding, where compliance with notice requirements will be strictly construed, the “actual receipt” of the message was not enough to allow Culver to prevail, given the language of the lease.  In short, Culver “did not comply with the lease’s provisions.”  The cause of the failure can be readily cured by careful attention to the electronic notice provision:  do not link the electronic notification to a physical address, only to an “electronic notification address.”

Stephen C. Gerrish, Real Estate Group