Entrepreneur Guide To Business Law 1

Legal Ch2 – leaving your employer

•

•

• •

• • • • • •

Classification of employees changes employee’s rights and duties o Key employees (officers, directors, managers) o Skilled employees (software engineers, mktg specialists, sales reps) o Unskilled employees Key and skilled empl. Cannot solicit employees to work for their new business o You can tell people you are starting a new business and leave contact info. Antipiracy or No Raid clauses prohibit employees from soliciting coworkers or hiring them for a stated period of time Noncompete covenenents protects employer from unfair competition from a former employee o Agreement must be ancillary to some other agreement o Must be reasonably limited in scope o Must not be contrary to the interests of the public o Must be supported by adequate consideration Blue Lining Clause – invites the court to enforce a covenenant to the greatest erxtent possible under applicable law and modify the covenant as necessary to enforce it A contract can specify the state law which is to be used in disputes o However, courts can sometimes overrule this portion of the agreement Trade secrets (we’ve already covered this in other areas of the class) UTSA – Uniform Trade Secrets Act prohibits an employee from using or disclosing a trade secret from a former employer Invention assignment (already covered this in another area of the class) Leave on good terms o Be honest with the employer regarding the reason for leaving (to start a competing business) o It may be appropriate to offer the employer an opportunity to invest in the new venture o Avoid soliciting coworkers while still employed, but tell them why you’re leaving and give them contact information

4 - Deciding whether to Incorporate

• •

Goals reduce liability exposure Minimize taxes

• •

•

•

•

• •

Ensure business capable of being financed Conducted efficiently Forms of Business Entity - see 4.1, p 67 Corporation o Distinct legal entity owned by shareholders o May be owned by single person - serve as director and any necessary officer o Shareholders elect board but otherwise not involved o Managed by officers who are elected by board and serve at pleasure of board o Unlimited life o Taxed as legal entity (unless S corp. o Limits liability of shareholders • Under alter ego doctrine - court may disregard corporate entity and hold shareholders personally liable  Was corporation undercapitalized?  Were corporate assets used for personal reasons  Were corporate and personal books kept separate  Corporations actions properly authorized? • To preserve limited liability  Obtain and record shareholder auth. For corporate actions  Keep corporate and personal funds separate  Maintain complete and proper records  Make clear all contract are dealing with corporate entity  Maintain arm's length relationship  Start with sufficient equity S- corporations 0- shareholders operate as a corporation while tax as individuals o Generally pass the tax liability for profits through to shareholders o Profitable and distributes all profits to shareholders o Meet following conditions • No more than 100 shareholders - all of whom are individuals • Only one class of stock General, limited, limited liability partnership - business carried on by at least 2 people; distinct legal entity from partners, can be sued and sue and can own property in its name, dissolves Limited liability company Sole proprietership

Chapter 5 •

Incorporation - much is boiler plate but should understand critical terms Where to incorporate o Generally state where activities take place or DE

DE favorable corporate law, only 1 director, file quickly amendments, specialized, experienced court o If not primary place of business - then maybe higher taxes o California specific restrictions - may only buy back shares or pay dividends to extent that meets certain RE tests, cumulative voting rights, elect board yearly, right of common shareholders to vote as separate class in the event of a proposed merger Certificate of incorporation - - file with secretary of state with filing fee o Name of corporation o Purpose o Authorized capital of corporation o Name and address of agent resident in the state for legal purposes o Provisions for indemnification o Person signing is incorporator Bylaws - operating rules Mechanics of Incorporation o Action by incorporator Splitting the Pie - chart by Shannon o

•

• • •

6 - Forming and Working with the Board Reasons to have board o Legal ones o Variety of skills o Keep eye on big picture o Add perspective o Internal sparring partner o Long term planning Size of board - small enough to be accountable and act as deliberate body, large enough to carry out necessary responsibilities (5-9) ,; outsiders should outnumber insiders Frequency and Duration of Meetings - options include - monthly, only to discuss important matters, quarterly; between 3-5 hours Type of representation Desired o Combination of functional skills to keep business running bring next level of growth, and mix of personalities o Needed Skills - assess own weaknesses and add complementary skills • Age gender cultural background • Outsiders and insiders o Personality mix and board structure • Able to function as group, respect • Practical experiences and business savvy Responsibilities o Duty of loyalty and good faith - best interests of company • Includes executive compensation issues - is in best interest of company

o o

• Remain arms length Duty of care and oversight Limitations on liability and indemnification -

Business Judgment Rule - requires the plaintiff prove the directors were grossly negligent or acted in bad faith before liability will attach Compensation of Board Members - tangible and intangible o Intangible - ideas, learning, personal fulfillment o Tangible - pay for meeting attendance, , equity, salary • •

•

Types of information that directors need Mission, strategy, certificate of incorporation, bylaws, directors CV, director indemnification agreements Annual info - budget, top competition, top 20 customers, distribution channels, 10 venders, 5-10 year balance sheets, history of finances, changes in accounting policy, insurance, employee benefits, corporate charities, org chart, officers/directors, who owns more than 1%, bios of key execs, summary of yearly contracts (union, patents, etc), summary of real estate Monthly - income statement, cash flows, b/s; ROI, ROA, ROS inventory turns, days recvs. Make Effective use of board - strategic planning - big picture questions….

7 - Raising Money and Securities Regulation •

•

•

Sources of Funds Friends and Family o Relatively cheap and quick source of seed capital o Preferred when management wants to maintain control and manage without investor input o Do not have expertise or other strategic value o Unable to invest significant amounts (temporary) o Risk of harming relationships Angel Investors - private sales of debt or equity securities o Relatively quick o Preferred when mgmt wants to maintain control o More money than friends o Generally require no more than right to veto, although may organize into board of angel investors… and want more power o Generally preferred stock o Also do not bring much expertise or talent Venture Capital - money from professional investors for investment in new or developing business o Resources to provide multiple rounds

Can assist in forming business plans, etc Most insist on sharing control of company (seats on board, veto power, management positions, info, registration rights,) o Negotiate more heavily on prices, etc o Exit vehicle - way to get money back without liquidating the company Placement agents - distributes a document describing company and the offering to suitable persons and assists in sale of private securities o Commissions 7 -15% o Do your homework - check references, how make contacts with potential investors o Tail provision - gives placement agent right to be paid for a financing occurring after services complete within a certain timeframe Self-financing ad credit - generate capital by carefully managing company's internal funds (bootstrapping) o Favorable credit terms, obtain payment on goods before paying out o No loss of control o Generally not sufficient funds Strategic alliances/Joint Ventures (collaborative agreement with an established company that has complementary needs or objectives o Minority investment, separate joint venture, fund research, useful when one company has technology other may want o Less costly financing that venture capital o Benefit from technical/business expertise o Requires cooperation and agreement o Each party liable for other's wrongdoing o Antitrust and conflict of interest concerns o o

•

•

•

•

•

•

Pitching to investors Business plan - include all material info and risks o Describe the company - detailed, history and goals o Describe the product and market - stage of dev, patent prospects, obstacles o Describe the strengths and weaknesses of the management team o Identify the risks o Describe the competition o Avoid unsupported statements o Prepare a back up file o Further requirements - describe securities being offered and intended use Private placement memorandum - offering document that meets requirements of federal and state securities laws o Discloses benefits and risks of investment o Not often required except by placement agencies o But useful for avoiding swearing contest later in court Issues related to investment securities o Most investors want preferred stock, sometimes want warrants (options to purchase stock), or right of first refusal

o o o o

•

•

Most require extensive representations and warranties and many conditional on certain corporate changes Investors have greater bargaining power than entrepreneurs Identify acceptable level of dilution of stock (entrepreneur should) Term sheet - spells out terms of agreement; allows the parties to agree before lawyers proceed

Equity Finanacing Classes of stock o Common stock - if all stock has same rights - its common stock(# votes/share; rights to vote, dividends o Preferred stock- additional rights with the stock o Convertible preferred stock - preferred stock that may be converted into common stock at a specified exchange ratio o Warrant - right for a given period of time to purchase a stated amount of stock at a stated price (generally fair market value); like option but sold to investors; sometimes called 'equity sweetener' o Employee compensation plans - generally stock option plan Rights of Holders of preferred stock o Liquidation preference - any assets remaining after payment of all debts are distributed first to preferred stock holders • Participating preferred stock - entitles holder to receive their share of liquidating preferences plus any accrued dividends then to share remaining sale proceeds pro rata with common shareholders o Dividend preference • Sometimes cumulative - amounts not paid one year and paid in addition to next year's o Redemption rights - redemption - corporation buys back shares from stockholder • Investor redemption rights - (put rights) - permit the investor to require the corporation to redeem his/her shares for cash at a specified price (provided corporation is not prohibited by law from doing so) • Company redemption rights - permit the corporation at its option to redeem shares for a specified price either after a given period of time or upon occurrence of certain events; may have the effect of forcing investor to convert shares to common stock to avoid redemption; therefore a company can eliminate liquidation and dividend preferences on preferred stock o Conversion rights - preferred stockholders can convert preferred stock into common stock at any given time, generally automatically converts with IPO, can also be forced by vote of majority • Pay to play provisions - cause an investor's preferred stock to convert to common or to a new series (price based antidilution protection) • Antidilution provisions - adjust conversion prices at which convertible preferred stock can be converted to common stock in the event of certain company actions

•

o

o

•

•

Structural antidilution provisions - company undergoes structural change (stock splits/dividends) • Percentage dilution - protection assures preferred holder that can convert to common at same percentage of total as before dilution • Price based antidilution provision - triggered if corporate issues additional common or preferred shares at price less than conversion price (per share price paid by investor)  Full ratchet method - conversion price is adjusted downward to the issuance price of dilutive financing  Weighted average method - reduces conversion price in proportion to the amount of dilution Voting rights - equal to those of common stockholders and vote as separate class on major events (amending charter), elect certain members to the board without common shareholders input Charter amendment - rights must be set forth in detail in certificate of incorporation; or if not then in certificate of determination

Stock Purchase Agreement and related agreements o Description of security - type of security, purchase price, # shares, date o Representation and warranties - extensive info required; any exceptions listed in statement of exceptions, founders, officers and directors liable if misinformation o Conditions to closing - things that must take place before closing - for example amendments that • Authorize additional class to be purchased and rights of preferred stock • Change bylaws to allow for expanded board • Execution of investors rights agreement (conditions may include items related to operations, or resignation of certain board member's) • Legal opinion of venture capital's counsel • Specified minimum amount of capital to be raised o Covenants - affirmative covenant (promise to do something); negative (promise not to do something) • For example - pay debts, meet obligations, deliver info, maintain minimum net worth, not increase salaries, etc o Investors rights - sit on board, participate in future financing, impose certain controls • Right of co-sale (tag along right) - if one of founders sells shares, investor is entitled to participate pro rata as seller • Registration rights - to require the company to register, under federal and state securities laws, permit investor to sell at IPO o Investors representation - representation that stock is purchased as investment without intent to further distribute Federal Securities Registration and Exemptions Securities act of 1933 - designed to give investors proper info, must register with SEC, provide prospectus

b/c IPO expensive sale of securities by entrepreneur designed to be exempt from regulations o Pooling investors money or buying collectively managed assets = sale of securities under SEC regulation - point = be careful o May be exempt if private offering, limited offering, offering to qualified investors or offering in single state o Failure to comply and investors can rescind and get money back o State securities laws - blue sky laws Exemptions o Private offerings - securities are offered only to limited number of selected qualified investors who can understand and bear risk of investment; must prove that all those offered to had ability to bear risk via extensive questionnaire o Regulation d Safe harbor exemptions for offerings to public of up to $1M and private placements • Accredited investors - national bank; private business development company; corporation, etc not formed for purpose of acquiring the offered securities with total assets not >$5m; director or general partner of issuer, natural person w income >200,000 for last 2 years or joint of >300,000 with reasonable expectation of reaching same level in current year; person whose net worth >$1M; trust with assets >$5M not formed with purpose of acquiring securities offered; or entity in which all equity owners are accredited investors • Integration offerings - in calculating 12month amount of capital raised and # accredited investors, SEC may combine sales within limited period of time - most likely occurs when offerings are part of single plan of financing, made about same time, involve same consideration or type of securities and are made for same purpose  Rule 502 - provides an integration safe harbor for regulation D offerings of 6months before or after sale  Rule 701 - offerings to employees and others not integrated • Rules 504 - exempts offerings of up to $1M within 12 month period, no limit on number of purchasers and general solicitation is permitted (used for friends, family, angels)  Not available to blank check companies - those that have no specific business except to locate and acquire other ones  No prescribed info disclosure requirement  Must file form D within 15 days of first sale  Careful to avoid integration problems • Rule 505 - exempts up to $5M and limits # unaccredited to 35, general solicitations and advertising not permitted (no cold calling must have substantial prior relationship) • Rule 506 - exempts offerings of any amount to not more than 35 unaccredited investors provided that investor is 'sophisticated', requires certain info to purchaser o Interstate offerings - exempts securities offered and sold if everyone lives in same state - doing business and living in o

•

Regulation A - a privately held company may offer and sell up to $5M in 12 months, $1.5M of which may be sold by selling security holders; must file disclosure document; a testing the waters provision permits issuers to solicit indications of interest before filing disclosure docs - no sales may be made during this period, once regulation A offering statement is made all testing the waters must cease, not exempted from blue sky laws o Rule 701 - offerings to employees, consultants and advisors - are exempt pursuant to written compensatory benefit plan or written contract relating to compensation of such peoples, less than $1M and 15% of total assets of issuer and outstanding securities of the class being offered and sold; must provide with copy of plan but no other disclosure doc is required Blue Sky laws - state securities laws must comply where business is headquartered and where offerees live o If posted on web then deemed made in all 50 states - exempt if specifically says not in this state or no sales are made to residents of certain state o Uniform securities act emphasizes disclosure as means to protect investors, some states authorize securities administrator to deny sale if find business plan and issuance unfair, commissioner can also deny - called merit review o

•

8 - Contracts and Leases -

•

Contract - legally enforceable promise or set of promises Choice of law - written contract include choice of law provision which specifies state's law to govern the contract; in the absence of such - will use where strongest contract law is Elements of Contract - written, oral, implied, statue of frauds requires some to be in writing o Implied contract - not explicitly articulated and held to exist based on certain circumstances or on conduct of parties o Requirements of contract • Agreement between parties formed by an offer and acceptance - must be meeting of the minds,  To keep offer open for extended period = option contract  Counter offer - offers new terms; extinguishes original offer • Must be supported by something of value (consideration) • Both parties have capacity to enter (not minor or mentally incompetent)  Authority (necessary) • Contract must have legal purpose o Offer - statement by person indicating a willingness to enter into a bargain on terms stated o Acceptance - offeree indicates willingness to accept

Consideration - anything of value exchanged Illusory promises - do not result in contract - occurs when one party fails to provide anything of value o Requirements contract - buyer's agreement to purchase all of specified commodity it needs from particular seller o Output contract - seller's agreement to sell all of its output to particular buyer o Unilateral contract - promise exchanged for performance of certain act Oral Agreements and Statute of Frauds o Statute of Frauds - must be in writing to be enforceable • Cannot be performed in one year • Involve transfer of real property (land, leases and those options) • Someone who agrees to assume another's debt • Prenups • Contracts for sale of goods >$500 o Advantages of putting in writing • Oral agreements difficult to enforce • Prevents misunderstandings, more reliable • Integration or merger clause - statement in contract that states that it supersedes all previous discussions, etc designed to finalize all disagreements • Nonreliance clause - both parties confirm that they have not relied on any promises made during negotiations other than written ones Preparing Written Contracts o Drafting language - clear specific language, balance time and expense, very literal, set forth all aspects of relationship o Form • Customized long form agreements - purchase and sale of assets require very intense contract • Letter of agreement - format to organize simple agreement, list all important info and get acceptance • Standard form contracts - (many forms including leases or promissory notes); enhances understanding between parties, many terms still remain negotiable, people have duty to read contract • Attachments - additional terms are too extensive to note in margin, drafter should name attachment in main document • Addenda - provide ways to modify the agreement Electronic contracts o Uniform electronic transactions act • A record or signature may not be denied enforceability solely b/c electronic • Contract may not be denied solely b/c electronic • Electronic record satisfies law that requires to be in writing • Electronic signature satisfies law that requires a signature o e-sign act - reiterates uniform electronic transactions act, governs only interstate and foreign commerce, preempts all state laws o o

•

•

•

inconsistent with it Exclusions - must be voluntary (if not have computer not required to), • UETA - Wills, codicils, trusts; family law contracts, certain provisions of uniform commercial code, • E-sign also excludes: court documents, cancellation of utility services or health/life insurance; notices of recall or regarding credit agreements, docs concerning hazardous materials trasportation General terms to consider o Identification - names and addresses of parties o Signatures o Intent to enter into - statement summarizing parties intent to enter into contract • Date o Terms of agreement • Representation/warranties • Conditions • Logistical considerations • Payment terms • Notice and opportunity to cure • Timing issues o Duration and notice of termination - contracts lacking specific duration may be construed later as terminable at -will by either party, at will contract should be written so neither party has absolute right of termination o When performance must be completed - state special deadlines explicitly o Renewability of the contract - may be automatically renewable, unless one party gives intent not to renew, or may be dependant on • Allocating risk - what events would relieve one or more parties of obligations under contract (natural disasters, unanticipated government actions  Commercial impracticability - belief that event was unforeseen and unforeseeable and that party asserting impracticability must not have expressly or implicitly assumed the risk of occurrence • Arbitration and mediation - avoid costs and time of court, maybe put clause in contract to go to mediation/arbitration first • Choice of law and forum - contract should specify whether disputes are to be adjudicated and which jurisdiction's laws should be used • Attorney's fees - if contract not specify then each pay for own Checklist for contract analysis o Is void b/c illegal or violates public policy? o Is entered into freely? - unlawful explicit or veiled threats make unenforceable o Is unconscionable - onerous terms, lack of bargaining power o

•

•

Has performance become impossible or commercially impracticable if so nonperformance excused unless event making it so was foreseeable o Is clearly worded and structured to prevent ambiguity? If so may be voided if both interpretations are reasonable and both parties knew both or neither interpretation when contracted o Was there a mistake of fact that renders contract voidable? Parties make mistake about facts - has material effect on one or both parties, either party allocated the risks of mistake to self, whether mistake of fact made promptly o Did a party make mistake of judgment? - erroneous assessment about value of come aspect - not grounds for undoing contract o Was there a breach by one party that resulted in damages to other party? o Did the party claiming injury mitigate its damages? Effect of bankruptcy o Automatic stay - creditors are barred from taking any legal action to enforce contract or collect money; neither foreclose nor stop performing obligations without court's permission (bankruptcy clause is not enforceable) o Debtor may also choose which contracts to maintain and which to reject Remedies o Monetary damages • Expectation damages - compensate for amount it lost as result of breach of contract • Reliance damages - compensates for expenditures made in reliance on a contract • Restitution - puts both parties back in same position as before contract • Mitigation - nonbreaching party required to attempt to mitigate circumstances • Consequential damages - damages plaintiff entitled to as compensation for additional foreseeable losses • liquidated damages - agreed on ahead of time, specifies a set figure that the breaching party will pay the injured party in event of breach, must be reasonable o Nonmonetary remedies • Specific performance - order defendant to do what promised  Used if item is unique, contract involved real property or difficult to calculate monetary damages • Injunctions - court orders to do something or refrain from doing something • Rescission - when enforcing contract is unfair, court may rescind contract and order restitution Promissory Estoppel - gives limited relief to person who has reasonably relied, to his detriment, on promises of another o

•

•

•

Most likely when made in course of negotiations which break down before meeting of minds, not supported by consideration or not evidenced by a writing required by statute of frauds o May recover only if • Must be a promise • Reliance on promise genuine and justifiable • Actions taken in reliance must be reasonably foreseeable to person making promise • Grave injustice must result if no relief given Quantum Meruit - can be used to recover the value of products or services provided the absence of a contract in a situation in which the products/services were clearly needed but party receiving benefit could not agree to purchase them (for example, unconscious patient) Leases - contract between landlord and tenant; must include rental charge and restrictions on subleasing space Contracts for purchase of real property - consult property lawyer - highly technical; be wary of rules for cleanup of hazardous waste Loan agreements - watch out for these parts: and what happens to collateral if default o Logistical details of receiving loan - how receive and in installments? o Conditions precedent - conditions must be met by borrower? o Covenants - promises made by buyer to lender which if breached result in default and termination o Repayment terms o

•

• • •

9 - Ecommerce and Sales of Goods/Services •

Sales of Goods Under Article 2 of the UCC o Goods - all things which are movable at the time of identification (by marking or setting aside) to the contract for sale o When sale involves goods and services, it may not be governable under UCC o Contract formation - requires offer, acceptance and consideration but more liberal than contract (most times terms are not explicitly stated but filled in based on situation • Supply contract - details who the parties are and general terms of relationship, if something new or innovative, entrepreneur should ensure that right of exclusivity is protected • Approval clause - specifies not valid contract unless and until approved by home office (waiting on credit approval) • Allows for entering into contracts without payment of consideration • Merchant - has knowledge or skill in selling - not casual seller o Battle of the forms - contract can exist even if parties exchange confirmation forms in disagreement with each other, then what terms govern sale?

•

•

•

•

•

If one party not merchant - then additional terms do not count unless approved of by all parties • If all parties are merchants - additions are automatically part of contract unless: any party expressly objects within reasonable time, materially alter original offer, original offer contains clause expressly limiting acceptance to the terms of offer • Knock out rule - conflicting terms knock each other out and UCC gap filler is substituted o Statue of frauds - provides that contracts for sale of goods >$500 are unenforceable unless at least partially in writing • Elements that must be in writing - statement recognizing agreement exists, signature of party against whom enforcement is sought, and indication of quantity of goods being sold • If between merchants then contract can still be enforces against party who has not signed, if other party sent written confirmation that 1st party not respond to within 10 days Electronic Contracts o Esign and uniform electronic transactions act - see ch 8 - almost any mark counts as signature, including click thru or typed name o UETA says in order to avoid denial of signature party transacting business must - confirm its assent to the terms by other means or to revoke consent if it claims there was a mistake UNCITRAL - UN Commission on International Trade Law promulgated Model law on Electronic Signatures o Agreement on e-signature related issues including how signature requirement met, conduct of signatory, requirements for service providers that certify e-signatures o Adopting by China, Mexico, Thailand and Vietnam and general assembly (CUECIC) • Addresses where e-contract created, where parties located, how party expresses consent, what happens on dispute, what time contract formed, whether displays of goods on web are offers or just invitations UCC Article 2 Warranties Express warranty - explicit guarantee by the seller that goods will have certain qualities; o Seller must make statement relating to goods, provide sample or model or description of goods o And buyer must have relied on seller's statements in making purchase decision o Puffing - expressing opinion about quality of goods (this is a top notch car - puffing) - line hard to draw Implied warrant of merchantability - guarantees that goods are reasonably fit for the general purpose for which they are sold and that they are properly packaged and labeled; applies to all goods in normal course of business - do they do what reasonable person would expect? o Goods must pass without objection in the trade under the contract description o Be fit for the ordinary purpose for which such goods are used o Be within variations permitted by agreement

Be adequately contained, packaged and labeled Be of even kind, quality and quantity within each unit and all units involved o Conform to promises or affirmations of fact on packages Implied warranty of fitness for a particular purpose - guarantees that fit for purpose recommended by seller o Buyer had that particular purpose for goods o Seller knew or had reason to know of that purpose o Buyer relied on seller's expertise o Seller knew or had reason to know of buyer's reliance -( can disprove by buyer's knowledge = to seller's, buyer relied on skill of persons hired by buyer, buyer supplied detailed specs or designs that seller was to follow) Limiting liability and disclaimers - seller need not make express warranties, seller may disclaim any warranties of quality if follows special rules (say 'as is' or 'with all faults' - makes plain there is no implied warranty); refrain from professing expertise, limits remedies to repair or replacement Magnuson-Moss Warranty Act - protects consumers against deception in warranties; if seller engaged in interstate or foreign commerce makes an express warranty to buyer, then seller may not disclaim the warranties of merchantability and fitness for a particular purpose o Full warranty - give consumer right to free repair within reasonable time period or after reasonable number of attempts to fix must offer refund; warrantor must not impose any time limit on warranty's duration, warrantor may not exclude or limit damages for breach of warranty unless exclusions conspicuous o All other warranties - limited International Sale of goods and the convention on contracts for the international sale of goods (CISG) o UCC only within US, CISG governs outside, signed by many of world's largest economies o CISG - sets out provisions to govern international sales contracts; does not apply to goods/services bought for personal or household use unless seller knew was for that use o CISG automatically applies between parties from 2 signing nations o No statute of frauds - so oral arguments allowed o Perfect tender - delivery on goods that are exactly in accordance with the contract on the exact date specified - CISG limits party's right to insist on perfect tender; UCC entitles buyer to insist on perfect tender Strict Liability for Defective Products - product liability extends to anyone in the distribution chain, injured party does not need to show negligence or otherwise at fault just needs to show o Defendant in distribution chain of defective product and Defect caused an injury o Can also sue for negligence if show defendant failed to use reasonable care - receive punitive damages o Not applicable to services o o

•

•

•

•

•

•

•

•

Defective product o Must show defective when left hands of defendant and defect made product unreasonably dangerous o Regulations - failure to comply with regulations often sufficient to prove defective (also means defendant negligent per se), compliance often not conclusive defense o Manufacturing defect - flaw in the product that occurs during a production such as a failure to meet design specs; not like others on assembly line o Design defect - occurs when inadequate design or choice of materials makes dangerous to users; or if product not safe for intended or foreseeable use (Pinto case) o Failure to warn - product must carry adequate warnings of the risks involved in normal use; in absence of these warnings - then defective due to failure to warn; warning will not shield a manufacturer from liability for a defectively manufactured or designed product Who may be liable o Manufacturers - will be held strictly liable for its defective products regardless of how remote it is from the final user of the product; only requirements are that the manufacturer be in the business of selling injury causing product and that product defective when left manufacturer o Wholesaler - strictly liable for defects in the products they sell o Retailers - also generally held strictly liable - although not in some states o Sellers of used goods - usually not held strictly liable b/c not in original distribution chain, custom in used gods is that there are no warranties or expectations relating to the quality of the products; seller is strictly liable for any defective repairs or replacements o Component part manufacturer - not liable if the specs for entire product are questioned o Successor liability - corporation purchasing or acquiring assets of another is liable for its debts if there is: • Consolidation or merger of two corporations • Or an express or implied agreement to assume such obligations • Even if structured as sale of assets may still be successor liability if purchasing corporation is continuation of selling corporation or transaction entered into to escape liability Defenses o Comparative fault - damages may be reduced by the degree to which plaintiff's own negligence contributed to the injury o Assumption of risk - person voluntarily and unreasonably assumes the risk of a known danger, manufacturer is not liable for any resulting injury - that's why there are so many damn warning labels o Obviousness of the risk - if the use of a product carries obvious risk, manufacturer not held liable for injuries that result from ignoring the risk o Misuse of the product - seller assumes will be used in normal manner; not liable for abnormal use

State of the art defense - based on manufacturer's compliance with the best available technology; shields the manufacturer from liability if no safer product design is generally recognized as being possible o Preemption - federal law preempts claims based on state law product liability Consumer Product Safety Commission - charged by congress with protecting the public against unreasonable risks of injury associated with consumer products and assisting consumers in evaluating the comparative safety of such products o Before implementing safety standards - CPSC must find that voluntary standards inadequate (concern that producers motivated by short term profits and unable to self regulate) o Any interested person may petition the CPSC to adopt a standard and may resort to judicial remedies o Can ban sale, manufacture, etc if not free of unreasonable risk of personal injury National Highway Traffic Safety Admin - power to establish motor vehicle safety standards Food and Drug Admin - food, drug, medical devices, cosmetics Dept of agriculture - regulates slaughtering or processing and the labeling of meat, poultry and egg products FTC - has primary responsibility for regulating packaging and labeling of all commodities FCC - broadcasting and telecom Consumer Privacy - under what circumstances can collect email, addresses, names, etc; use of cookies o Legislation • Children's online privacy act - prohibits from children under age 13 without first receiving parental consent • Gramm-Leach -Bliley Financial Services Modernization Act requires financial services firms to notify consumers in writing regarding what info is being collected, how it is being used and with whom it is being shared, must give opportunity to opt out of having info shared • Fair Credit Reporting Act - ensures companies keep accurate credit rating info and use info fairly • Health Insurance Portability and Accountability Act - require health care providers and others with personal medical info to implement appropriate policies and procedures to ensure info kept private • Controlling the Assault of Non-solicited Pornography and Marketing - prohibits spammers from disguising their identities by using false return addresses and using misleading subject lines  Certain types of spyware violate the electronic communications privacy act, the computer fraud and abuse act which prohibits any unfair or deceptive trade practices • California's consumer protection against computer spyware act prohibits the installation of software that  Takes control of a computer o

•

• • • • • •

Modifies a consumer's interaction with the internet Collects personally identifiable information Prevents without authorization a user's effort to block or disable such software  Removes, disables, or renders inoperative security or antispy software • Identity theft - illegal practice of gaining access to other people's credit information and then using if to the thief's advantage is a federal crime FTC and FCC regulations o FTC - company publishes a privacy policy then must abide by it; failure to do so is prosecuted by the FTC; failure to protect sensitive consumer info can itself be an unfair practice even if the promise to keep data secure o FCC - established do not call list; companies may not make unsolicited phone calls to consumers who put names on that registry unless they have done business with the consumer in the recent past European Privacy Directive - requires member states to safeguard the privacy of personal data by giving notice to individuals regarding how their info will be used; offering a choice when disclosing info to a third party; maintaining security of personal information; ensuring data are reliable, accurate, and current; giving individuals access to examine, correct, delete information about them Self-Regulation - to forestall governmental regulations, companies started to institutionalize their privacy policies by appointing privacy officers, adopting online and offline privacy policies, conducting privacy risk assessments to evaluate how personal information is used and collecting, establishing formal complaint resolution program for consumers, training employees, conducting privacy audits, creating formal privacy assessment process for new products and services Advertising o Common law - provides 2 remedies for a consumer who has been misled by false advertising - consumer may sue for breach of contract (proving existence of contract difficult); sue for tort of deceit • Deceit requires proof of several elements - knowledge that misrepresentation is false; misrepresentation must be one of fact/not opinion o Statutory law • Lanham Act - protects consumers from false advertising; forbids use of any false 'description or representation' in connection with any goods or services; provides claim for any competitor who might be injured by false claims; ensure truthfulness in advertising • National advertising Division of the Council Better Business Bureau - handles disputes privately and cheaper o Regulatory Law - The FTC - unfair or deceptive acts or trade practices are illegal • Deceptive pricing - any practice that tends to mislead or deceive consumers about the price they paying for a good or service; bait and switch advertising- refuses to show an advertised item,   

•

•

•

•

•

•

•

fails to have reasonable quantity, fails to promise to deliver within reasonable time or discourages employees from selling item • Quality claims - not make quality claims without having some basis for it; obvious exaggeration and vague generalities considered puffing • False testimonials and mock ups - when person endorsing product does not actually use it; deceptive for endorser to falsely imply that he has superior knowledge or experience in product; also illegal to say actual demonstration when it is a mock up Unfair competition -designed to prevent unlawful, false, deceptive, unfair and unauthorized business practices o Passing off - attempting to fool customers into believing that one's goods are actually those of competitor o Dilution - using another's trade name or trademark to promote noncompeting goods and thereby potentially confusing customers o Disparagement - untrue claims about a competitor that would tend to damage its business o False advertising - untrue, unsupported or deceptive claims are made in advertising o Right of publicity - exclusive right to exploit commercially one's name or likeness Remedies - court order to stop the activity; sometimes carry criminal charges Jurisdiction, choice of forum and choice of law in ecommerce disputes Resolving online disputes in an offline court o Issues include • Which country (state) has authority to require defendant to make a decision about a dispute at location (what is the forum or situs) • What law will govern the dispute • When will court recognize and enforce a judgment in foreign jurisdiction o US approach to jurisdiction - cannot require out of state defendant to submit to its jurisdiction unless defendant has either agreed to do or has sufficient minimum contacts with the state such that the maintenance of the suit does not offend traditional notions of fair play and substantial justice • Nonresident defendant must either - have done something or consummated some transaction in the forum in which it is being sued or have purposefully availed itself of the privilege of conducting activities in the forum • When doing business over internet - US courts have held that us courts have no personal jurisdiction over non resident jurisdiction o In search of global rules - European commission's regulation on jurisdiction and enforcement of judgments in civil and commercial matters - gives consumers right to sue a foreign defendant in the

•

consumer's home country if the defendant pursues commercial or professional activities in member states - or consumers have right to bring a lawsuit relating to contracts executed via the internet in their home country o Many jurisdiction permit parties to use private contract law to establish their own set of rules regarding jurisdiction, choice of forum and choice of law, except in cases involving consumers What to do - company should include in its contracts explicit provisions addressing jurisdiction, choice of forum and applicable law o Firm should assume that if it regularly sells products in a state or country then it will be subject to that jurisdiction's laws and can be required to litigate in that jurisdiction all claims o Keep in mind that any presence in a jurisdiction other than passive website, may be enough to make subject to jurisdiction.

Legal Ch10 – Marshaling Human Resources



Federal Labor Laws  Civil Rights Act of 1964 – prohibits employment discrimination on race, color, religion, sex or national origin Title VII   

does not apply to independent contractors damages include back pay, front pay and compensatory damages 3 types of discrimination • Disparate treatment – intentional discrimination (denying employment or a benefit/privilege) must prove o Member of the protected group o Was denied position or benefit o Employer must prove nondiscriminatory grounds • Disparate Impact – not necessarily intentional o Employer has hiring criteria that disproportionately affected a certain protected group o Employer must prove that the criteria was essential to the job function • Harassment, includes hostile work environment; employee must prove o Was subjected to sexual conduct o Conduct was sufficiently sever or pervasive, altering conditions of employment or abusive environment o Employer is liable for a supervisor’s actions even if the employer had no reason to be aware of the situation, if the supervisor took adverse

employment action against the victim (demotion, etc.) o If no adverse action was taken, employer must prove  Employer exercised reasonable care to prevent and promptly correct behavior  Employee unreasonably failed to take advantage of preventive or corrective opportunities provided by employer • employer may legally hire a person based on religion, sex or national origin only IF it is a Bona Fide Occupational Qualification (does not include stereotypes) Seniority and Merit Systems employer can legally apply different compensation in a bona fide seniority or merit system (purposeful discrimination) Age Discrimination in Employment Act (ADEA)  Applies to all companies in interstate commerce with at least 20 empl.  Covers workers 40+, applicants and current employees  Excludes independent contractors  Employer can require a terminated employee to waive claims in return for extra severance benefits. Waiver must: • Be understandable • Specifically refer to the employee ADEA rights • Not require employee to waive rights to future actions • Offer consideration • Advise employee to consult with attorney • Offer employee 21 days to consider (45 days if more than one employee is discharged at the same time) • Provide employee with 7 days after signing to revoke • If more than one employee is Discharged at the time, waiver must contain separate list of ages and job titles of all employees a)being retained and b) being let go Americans with Disabilities Act (ADA)  Covers employers with 15+ employees working at least 20 calendar weeks in a year  Employer required to provide reasonable accommodations to disabled employees, unless doing so would cause undue hardship to employer  Remedies include back pay, reinstatement and reimbursement of legal fees  Disability mental or physical impairment that substantially limits one or more major life activity (walking, seeing, hearing, procreating…)  If it can be corrected with drugs, it doesn’t count 





Employer can deny employment if the condition imposes a direct threat to health and safety of the employee (or others) Family and Medical Leave Act (FMLA)  Applies to employers with 50+ full time employees  up to 12 weeks unpaid leave per year in connection with adoption, birth, care of an immediate family member, serious health condition  employee must have worked for the company for at least 1 year, 1,250 hours to qualify  employer must continue to provide health care and must restore employee to same (or equivalent level) position upon return  employee cannot contract out of FMLA rights Fair Labor Standards Act (FLSA)  Covers ALL employers in interstate commerce  regulates min. wage, overtime pay and use of child labor  Some types of employees are exempt from min. wage and overtime (salespeople, professional, executive, and admin. And highly skilled computer professionals)  does not cover independent contractors Worker’s Compensation  Can be provided in three ways (based on state laws) • Self-insure by the company • Purchase through state fund • Purchase through private insurer Occupational Safety and Health Act (OSHA)  Applies to all employers in interstate commerce, except federal and state employees  designed to reduce workplace hazards and improve safety National Labor Relations Act (NLRA)  Covers all enterprises with a substantial effect on commerce  gives employees the right (and protection) to organize unions  protects employers by limiting union solicitation, prohibiting employee from disclosing his salary  protection extends to employees, not supervisors or independent contractors Equal Employment Opportunity Commission (EEOC)  Federal administrative agene to enforce Title Vii and other antidiscrimination statues  Person with a grievance must first exhaust procedures of the EEOC before filing law suit  EEOC investigates and if reasonable cause exists, attempts to resolve the issue out of court first Immigration Reform and Control Act of 1986 (IRCA)  Illegal for employer with 4+ employees to discriminate based on national origin or citizenship status 

















An employee can legally be told that a job offer is contingent on passing a job-related medical exam if all candidates go through the same exam

Classifying as Employees or Independent contractors? 

 

Independent contractors are less expensive  No workers comp insurance  No unemployment comp  No job benefits (health insurance, retirement savings plan) Incorrect classification of workers can bring federal and state penalties Worker status can affect employer’s right to copyrightable works or patentable inventions for independent contractors:  Written contract must specify a “work for hire” or assignment of the copyright  Must agree upon the desired work product, but worker controls the manner of achieving the outcome  Contractors offer services to the public at large, not just one business  Determining whether an employment relationship existed, courts asses  Nature and degree of control/supervision of the employer  Are the services in question an integral part of the employer’s business?  Did the employer provide training  Amt of worker’s investment in facilities and equipment  Kind of occupation  Worker’s opportunities for profit or loss  Method of calculating payment for work  Skill, initiative and judgment required for the independent enterprise to succeed  Permanence and duration of the work relationship  Was annual or sick leave given?  Did the worker accumulate retirement benefits or medical benefits?  Did the employer pay SS taxes?  What was the intention of the parties – was there a written agreement?  Courts tend to lean in favor of the worker  Steps to establish nonemployee status  Written contract spelling out • intent • duties • conditions of the service • responsibilities of contractor • services to be performed

• •











time frame for completion give contractor right to hire assistants at his own expense  contractor carries his own liability and workers comp insurance and pays his own taxes  make it clear contractor can offer services to other companies Temporary workers are hired (typically) through a personnel agency  Agency and company are both liable for violations of most employment laws  If possible, client company should have agency agree to indemnify the employer on employment-related liabilities Employee privacy  Employers should have a written policy to bolster the right to examine employee e-mail  Policy should state that computer, etc. is company property and employee has no reasonable expectation of privacy on the system Employment at Will (employee or employer may terminate the relationship at any time for any reason)  Employer can discharge for no reason but not for a bad reason  May states have adopted whistle blower statues  Employment at will exception includes court interpretations of implied contract to limit employer’s right o discharge without good cause  Employee is long-term empl.  Employee has received raises, bonuses and promotions  Employee was assured that employment would continue based on doing a good job  Employee was assured he was doing a good job  Company stated that it did not terminate employees without good cause  Employee had never been formally warned  Implied Covenant of Good Faith – termination of long-term employee without good cause in order to deprive him of commissions is a breach of contract Employment contract should be in writing and clarify terms  Duties  Compensation benefits  Stock options and grants  Duration and termination of employment  Right to work in the U.S. (verification)  Proprietary information (NDA) and assignment of inventions  Noncompetition and nonsolicitation provisions  Integration clause (document is complete and overrides any prior or oral agreements/provisions Mandatory arbitration agreements  Saves the company money in legal fees

Outcome more predictable than a jury ruling Will be enforced as long as it does not require employee to forego statutory rights  Can be condition of employment (not considered duress) Employers hiring foreign nationals must comply with U.S. antidiscrimination laws and U.S. immigration laws and procedures Equity compensation can take many, many forms, but typically stock option Stock options  Terms include number of shares, tax advantaged incentive or not, exercise price, maximum duration of the option, permissible forms of payment, contractual restrictions on purchase or transfer of shares  Types include incentive stock options and nonqualified stock options (difference relates to tax implications)  Maximum duration is typically 10 years, except if the optionee owns more than 10% of the company, then it’s 5 years  Forms of payment – cash or cash equivalent, shares of the stock already owned, proceeds from immediate sale of stock upon exercise, promissory note  Vesting (unrestricted right to purchase stock)  Cliff vesting – no vesting in the first year  Some companies tie vesting to achievement of performance goals  Plan may allow individual to exercise an option immediately even if the shares are not vested (becomes tricky with accounting)  Other plans allow exercise only on vested shares  Company may give itself right to require shares that an optionee wishes to transfer when the company is not publicly traded  Most companies provide right to first refusal in the company’s favor Other employee benefits  Health coverage is bought through an insurance company, HMO or through a broker  Employer providing healthcare coverage must abide by health information privacy regulations  Section401K allows nontaxable contributions; company can take an immediate tax deduction on employee contributions  401K SIMPLE is available (and less expensive) to a company with 100 or less employees  401K plans involve liability of employer to ensure that the investment choices offered are prudent ones  Misclassification of employees as contractors can result in retroactive liability for benefits denied  Employer should make sure benefits plans specifically exclude workers classified as contractors even if a gov’t agency later reclassifies the worker as an employee Employer is liable for his or her own negligence in hiring or supervising an employee  

  





   

Select employees carefully Document the relationship Implement good practices and policies Terminate with care

Chapter 11 – Operational Liabilities and Insurance Tort – civil wrong that injures a person, property, or certain economic interests & business relationships. Companies are vicariously liable for torts committed by employees acting within the scope of their employment. Negligence – conduct that involves an unreasonable risk of causing injury to another person or damage to another person’s property. Must show (1) defendant owed duty to act reasonably; (2) failed to use the care a reasonable person would have; (3) reasonably close causal connection between breach and injury; (4) plaintiff suffered actual loss or injury Duty – person is required to act reasonably to avoid harming other person. Variety of contexts: Duty of Landowner/Tenant – landowner or tenant has legal duty to keep property reasonably safe and may be liable for injury that occurs outside, as well as on, the premises Duty of Employer to Third Parties – employer is liable for any torts committed by employees acting within the scope of their employment. Duty of Professionals to Third Parties – professionals have duty to clients to use reasonable care when rendering their services. Failure to do so can result in liability for negligence (malpractice) Standard of Conduct – person is required to act as a reasonable person or ordinary prudence would act under circumstances. Fact that one complied with the law is not a defense if reasonably prudent person would have done more than law required. However, failing to follow law is prima facie negligence. If harm that follows is the type that law sought to prevent, then you’re guilty of negligence without need to prove standard of conduct. Defenses to Negligence Contributory Negligence – if plaintiff was also negligent, he cannot recover any damages. Most courts have replaced this with doctrine of comparative negligence. Comparative Negligence – plaintiff recovers proportion of loss attributable to defendant’s negligence Intentional Torts – require intent to harm plaintiff, plaintiff’s property, or certain economic interests & business relationships. Automatically liable for intentional torts without regard to duty.

Torts that Protect Persons Battery – harmful or offensive contact with the plaintiff’s body or something touching it. False Imprisonment – intentional restraint of movement, imposed against someone’s will by physical barriers, physical force, or threats of force. Intentional Infliction of Emotional Distress – protects right to peace of mind. Must show (1) defendant’s conduct was outrageous; (2) defendant intended to cause emotional distress; (3) defendant’s actions caused severe emotional suffering Defamation – communication to third party of untrue statement that injures plaintiff’s reputation. Libel is written. Slander is spoken. Invasion of Privacy – individuals are protected against inappropriate invasions of privacy, including public disclosure of private facts and intrusion. Intrusion is objectionable prying, such as eavesdropping of unauthorized rifling of files. Torts that Protect Interests in Property Trespass to Land – intentional invasion of real property without consent of owner. Only requires intent to enter property, not intent to trespass (i.e. if you thought you were standing on a friend’s land with his consent is still liable of trespass if it is, in fact, owned by someone else). Refusing to move something that at one time was permitted is also trespass. Nuisance – non-trespassory interference with use & enjoyment of real property (i.e. annoying odor or noise). Public nuisance is unreasonable & substantial interference with public health, safety, peace, comfort, convenience, or utilization of land (normally brought by government). Private nuisance is unreasonable and substantial interference with individual’s use & enjoyment of his or her land. Conversion – exercise of control over personal property, as opposed to real property, of another. Protects one’s right to have personal property left alone. Trespass to Personal Property – if personal property is interfered with but not converted Torts that Protect Certain Economic Interests & Business Relationships Fraudulent Misrepresentation – also called fraud or deceit. Protects economic interests and right to be treated fairly & honestly. Requires proof that defendant knowingly & intentionally misled plaintiff. Requires that plaintiff suffers injury as a result. Fraud can also be based on defendant’s omission of a material fact when he or she has a fiduciary duty to speak.

Interference with Contractual Relations – protects right to enjoy benefits of legally binding agreements. Provides remedy when defendant intentionally induces another person to breach a contract w/ plaintiff. Interference with Prospective Business Advantage – similar to previous except contract not yet signed. Must prove defendant unjustifiably interfered with relationship plaintiff sought to develop and caused plaintiff’s loss. Interference must be intentional. Usually committed by competitor. Unfair Competition – certain kinds of anti-competitive behavior if it seems egregious & predatory to the court.

Strict Liability – liability without requirement for negligence or intent. Imposed in product liability cases (see Chapter 9) & ultrahazardous activities Ultrahazardous Activities – so dangerous that no amount of care could protect others from risk of harm. Defendant is strictly liable for injuries resulting from the activity (Ex: storing flammable liquids in urban area, blasting, crop dusting, locating oil wells or refineries in populated areas, etc). Court more likely to consider dangerous activity ultrahazardous when it is inappropriate to the location. With ultrahazardous activities, it is irrelevant that defendant observed a high standard of care. Toxic Torts – wrongful act that causes injury by exposure to harmful, hazardous, or poisonous substance. Vicarious Tort Liability & Respondeat Superior – Respondeat Superior (“let the master answer”) establishes concept that employer is vicariously liable for the torts of an employee acting within the scope of his or her employment. (Ex: pizza company is liable if pizza delivery guy hits someone while speeding to deliver a pizza, even if the manager had instructed the employee not to speed.) Scope of Employment – within scope if it (1) is of the nature that he or she was employed to perform; (2) is within the time & space limitations normally authorized by employer; (3) furthers the purpose of the employer. Employer not vicariously liable if employee commits tort while engaged in activity solely for his or her benefit. Aided-in-the-Agency-Relation Doctrine – employer can be vicariously liable for torts committed by employees acting outside the scope of employment if the authority of the employer made it possible for employee to commit the tort. (Ex: if supervisor fires subordinate because subordinate rejected supervisor’s sexual advances, then employer is liable for sexual harassment, even if employer was unaware supervisor harassed subordinate.) Tort Remedies Actual Damages – aka compensatory damages, based on cost to repair/replace item, or decrease in market value caused by tortious conduct.

Punitive Damages – aka exemplary damages, awarded to punish defendant and deter others from engaging in similar conduct. Only in cases of outrageous conduct. Generally, less than 10 times the compensatory damages. Equitable Relief – granted if money award cannot adequately compensate for plaintiff’s loss. (Ex: court can order a newspaper found liable for defamation to print a retraction) Tort Liability of Multiple Defendants Joint and Several Liability – multiple defendant are jointly (i.e. collectively) and severally (i.e. individually) liable. Plaintiff may collect entire judgment from any of multiple defendants regardless of degree of fault. Defendant who played minor role may be required to pay all damages (especially when that defendant is able to pay). Contribution and Indemnification – Contribution distributes loss among several defendants by requiring each to pay proportionate share. Indemnification allows defendant to shift some of its individual loss to other defendants whose relative blame is greater. Concept is worthless is other defendants are insolvent. Antitrust Violations – Sherman Act prohibits any and all activity that restrains trade. Courts interpret this as any activity that “unreasonably restrains” trade. Contract, Combination, or Conspiracy – agreements can be (1) horizontal, between firms that directly compete with one another; or (2) vertical, between firms at different levels of supply chain. Courts view horizontal agreements more harshly because they reduce interbrand competition & result in higher consumer prices. Per se Violations – Practices completely void of redeeming competitive rationales are illegal per se. Horizontal Price-Fixing – includes agreements between competitors (1) setting min prices; (2) setting terms of sale; (3) setting quantity/quality of goods made available for sale. Bid rigging is one form. Horizontal Market Division – market division whereby competitors divide up market according to class of consumers or geographic territory. Group Boycotts – agreement among competitors to refuse to deal with another competitor Rule of Reason – if plaintiff hasn’t proved that restraint is per se violation, then activity is evaluated under rule of reason. Determines whether, on balance, the activity promotes or restrains competition. Court considers structure of market, analyzes anticompetitive & procompetitive effects. (Ex: maximum price-fixing, vertical restraints like exclusive licensing agreements). More likely to be upheld if agreements of limited duration, do not foreclose major share of market, & serve legitimate purpose.

Monopolization – Merely having major share of market doesn’t constitute monopoly. Must have market power (ability to raise prices without losing market share) and have engaged in anticompetitive acts. Environmental Liabilities CERCLA – Comprehensive Environmental Response, Compensation and Liability Act – certain “responsible parties” are strictly liable for cleanup of hazardous waste. Namely, (1) current owners or operators of facility; (2) owners or operators at time hazardous substances disposed of; (3) transporters of hazardous substances to a facility if they selected the facility; (4) persons who arranged for treatment or disposal. Defenses – not liable if contamination caused by (1) act of God, (2) act of war, (3) act of third party. To establish 3rd party defense (or innocent landowner defense), owner of contaminated property must have (1) acquired property after disposal occurred, (2) had no actual knowledge of contamination when it acquired the property, and (3) had no reason to know of the contamination after conducting appropriate inquiries prior to purchase. Courts will consider (1) specialized knowledge/experience of landowner, (2) relationship of purchase price to property’s value, (3) commonly known or reasonably ascertainable information, (4) obviousness of contamination, (5) ability to detect contamination by appropriate inspection, and (6) level of inquiry at time of purchase. RCRA – Resource Conservation Responsibility Act – any person who creates hazardous waste has “cradle to grave” responsibility for its ultimate proper disposal. Liable parties include: (1) generators of waste, (2) persons arranging for transport, treatment or disposal, (3) transporters of waste, & (4) persons who treat/dispose of it. Personal Liability of Operators – individuals responsible for operating a facility that generates hazardous waste are potentially personally liable for violations. Responsible corporate officer doctrine may hold officers liable for misdeeds of subordinates. Bribery and Foreign Corrupt Practices Act (FCPA) Bribes – FCPA prohibits any payments by U.S. company to foreign government official or foreign political party for purpose of improperly influencing government decisions. Statute is violated even if bribe only offered, but never paid. Exceptions: payments to lowranking officials to expedite approvals, payments to foreign businesses Record-Keeping Provisions – all public companies must keep records that accurately reflect disposition of company’s assets & implement internal controls to ensure transactions are completed as authorized by mgmt. Designed to prevent companies from setting up slush funds to make illegitimate payments from.

Tax Fraud – Section 7201 prohibits willful attempts to evade taxes. Section 7206 forbids any false statements in a tax return. Section 7207 prohibits willful submission of fraudulent tax returns. Section 6672 imposes civil penalty equal to amount of corporation’s unpaid employment taxes on those with power & responsibility for seeing that taxes withheld from various sources are remitted in a timely manner. Bottom Line: don’t use taxes withheld from employees’ paychecks to meet a cash crunch. Penalties can be severe and personal. Wire and Mail Fraud – Wire and Mail Fraud Act prohibits (1) scheme intended to defraud or obtain money or property by fraudulent means and (2) the use of mail or interstate phone lines to further the fraud. Supreme Court has broadly construed “fraud” to include representations as to past, present, or suggestions/promises of future performance. Obstruction of Justice & Whistleblowers – O of J: any effort to impede investigations, particularly alteration or destruction of documents. Whistleblowers: crime to retaliate against individuals who provide truthful information to the government about possible violations of federal law. Computer Crime & CFAA – use of computer to steal or embezzle funds. Computer Fraud and Abuse Act (CFAA) prohibits (1) accessing computer without authorization, or (2) knowingly transmitting a program, information, code, or command that results in intentionally causing damage without authorization to use a computer (transmitting a virus, or DoS attacks). Damage is any impairment to integrity/availability of data, program, system, or information. Computer Piracy is theft or misuse of computer software in violation of the licensing program. Insurance – generally divided between first-party and third-party (or liability) insurance First-Party Insurance – protects policyholder in case of damage or loss to insured or its property (i.e. fire, theft, flood.) Business interruption insurance protects against lost revenues resulting from event that interferes with normal conduct of business. Liability Insurance – insures against liabilities arising out of conduct of business (slip-and-fall cases, auto accidents, product defects). Punitive damages are uninsurable because they are intended to punish the wrongdoer. Director and Officer (D&O) insurance protects officers against claims by shareholders & others for breach of fiduciary duty or negligence. Implied Duty of Good Faith and Fair Dealing – interests of insured and insurer may diverge during settlement discussions. Insurer is only liable for damages up to the policy cap. When a lawsuit is for an amount far greater than the policy size, insurer has little incentive to settle for an amount at the policy cap because they will pay the maximum amount in either case. This doctrine is designed to ensure the insurer acts in your interests. Risk Management

Reducing Tort Risks – implement ongoing programs of education & monitoring to reduce likelihood of intentional torts (like defamation). Define scope of work clearly to mitigate vicarious liability. Consult counsel if unsure whether proposed activities might cross line into anticompetitive practices.

14 - Intellectual property and cyberlaw Take precautions to avoid violating others property rights

Trade secret protection - business plans, customer lists, financials, etc; law designed to protect company's business secrets but may not afford many rights where patent and copyright protection not available o Often arise when employee leaves company o Definition - any info that provides a business with a competitive advantage not generally known by company's current or potential competitors or readily discoverable by them through legitimate means, subject of reasonable efforts to maintain secrecy o Virtually any info can be protected o Not generally known - can be reverse engineered o Enforcement - legal remedies protect against improper means of acquiring (theft, misrepresentation, bribery, breach of contract….) o Duty of confidentiality (nondisclosure agreement, confidentiality agreement) - may also arise by operation of law (dr, police officer, etc) o No duty of confidentiality unless gotten through improper means o Legal relief - court orders, criminal acts (Economic espionage protection act) o Establish trade secret protection program (once trade secret not a secret then not protectable) • Identify trade secrets and secure employee commitment - in writing o Protection Measures : Pre-employment clearance and nondisclosure agreements, noncompete agreements (generally unenforceable, many employees refuse to sign), employee education (on policies); mark documents confidential, disclose info on need to know basis, keep info on site, use passwords, lock file cabinets, protect prototypes, avoid discussions when visitors present, extra caution at trade shows, use shredder, prohibit personal software at work, keep records of what software checked out, use precautions when working away from home o Dealing with outsiders - exit interview/agreement; nondisclosure agreements; building security o International considerations Copyrights - gives owner of an original piece of work of authorship the exclusive legal right to obtain certain economic benefits including the right to prevent reproduction or distribution; exclusive rights to -

reproduce copies, develop derivative works based on copyrighted work, distribute copies, perform work publicly, display work publicly o Can copyright wide range of work o Not protect ideas - only protect particular way idea expressed in tangible medium o Fair use - may be allowed to be copied in certain fair use circumstances - depends on • Purpose and character of use • Nature of copyrighted work • Amount and substantiality of portion used • Effect of use on potential market or value • May include parodies of works or reverse engineering o DMCA - digital millennium copyright act - prohibits circumventing access control mechanisms and can limit developer's ability to reverse engineer o Duration - life plus 70 years, work for hire 95 years from year of publication or 120 years from year of creation - whichever first o Requirements - fixed in tangible means of expression; must be original; must contain some level of creativity o Arises automatically when medium used but to pursue infringement must have registered with copyright register; damages limited to 30,000 for each ordinary and 150000 for each willful infringement o Proving • Direct infringement - without consent of copyright holder outside the scope of fair use, violates at least one right • Vicarious infringement - person who has right and ability to supervise a direct infringement • Contributory - person knowingly induces or causes direct infringement o Ownership of and works made for hire - get it in writing • Right to control • Who initiated creation of work • At whose expense was work created • Time spent on project • Who owned facilities where created • Nature and amount of compensation o Copyright in cyberspace - crime to circumvent technological antipiracy measures designed to control access to a copyrighted work • Safe harbor provisions for computer bulletin board services or other ISPs  Registering designated agents with Copyright office  Following specific notice and take down procedures  Adopting policy for terminating repeat infringers  Taking steps to inform users of policy o Generally valid internationally Patents - exclusive right granted by fed that entitles inventor to prevent anyone else from making, using, selling or offering to sell patented

process or product in US for a specific period of time; involves detailed description of how to make but may request patent application to be sealed o Utility patent - cover machinery or a process, articles of manufacture, new composition of materials, human made microorganisms, improvements to any of these o Design patents - ornamental designs o Requirements • Must fall within class of patentable subject matter • Must be useful • Must be novel - it has not been patented or known in US; not been previously patented in another country o Statutory bar - will be denied if disclosed to the public more than one year before the date that the patent application is filed o Duration - utility - 20 years; design - 14 years, can be extended under special circumstances o Procedures for obtaining • Application • Search for prior art (earlier inventions) • Patent examination • Costs - major expense • Other considerations - examiners unfamiliar with technology and slow; frequently challenged or overturned; must obtain written transfer of ownership rights in inventions from employees and independent contractors o Reduction to practice - two or more inventors compete over who first, first one to patent wins unless not diligent in reducing the invention to practice • Produces working prototype • Files application that includes description o Patent infringement - may result in injunction, legal fees, costly, damages o American inventor protection act 1999 - inventors can obtain reasonable royalties from others who make, use, sell or import the invention during time application published and patent granted o b/c costs and disclosure requirements, may not make sense to pursue patents - maybe try trade secret o Strategic aspects include • Bracketing - large co review patent applications, improve on one and block use of improvement to original patent holder • Can provide strategic competitor information Trademarks - any word, name, symbol, etc that identifies and distinguishes one company's products from those made or sold by others o Establishing - seek distinctiveness (inherently distinctive or made up are strongest form, arbitrary are words that have nothing to do with company but are real words

o

o o

o

o

•

Descriptive marks - not inherently distinctive but indicate characteristic of product (Gold Medal), not immediately protectable but are once acquire secondary meaning Perform a trademark search Create rights by using trademark, registering trademark, lasts for 10 years but can be renewed indefinitely, must ensure rights are not lost - by becoming generic 'cornflakes' Trademark infringement - assess damages, bar from using; • Dilution involves - using another's mark on goods or in connection to services if use is likely to cause harm to reputation of mark's owner (tarnishment) or lessen the distinctiveness of the mark (blurring) • Can effectively prove dilution even if - there is not likelihood of confusion between two marks, subject marks do not commercially compete with each other, famous mark owner has not suffered economic harm International issues -

Domain names - anticybersquatting protection act - illegal for person to register or use a domain name with bad faith if domain name is identical or confusingly similar to distinctive or famous trademark ICANN - internet corporation for assigned names and numbers established arbitration process , fast and inexpensive Trade Dress - Lanham Act - protect packaging or dressing of product; must be distinctive and have acquired secondary meaning (or be registered); feature must be functional

• •

Employee Proprietary Info and Invention Agreements Nondisclosure and nonuse of proprietary info - p543 Assignment of inventions - assign to the company all rights to any invention that results from work Table 14.2 (545) Licensing Agreements - gives person the right to do something he would not otherwise be permitted to do but does not transfer related property rights Assignment - typically used to transfer all of one's interests in an item to a new owner Key terms in licensing agreements o Specification of what is to be licensed o Scope of license - exclusive/not exclusive; limited to geography; right to modify, sublicense or share; duration; set performance criteria?, renewal terms o Payments o Representation, warranties and indemnifications o Covenants Shrink wrap (by opening packaging purchaser is bound by terms) and click wrap licenses (user must click' I accept'- then bound by terms)

Open source software - typically distributed in source code form under broad license rights to copy, use, distribute and modify; without warranty or support; examine license terms

16 Buying & Selling a Business

•

•

•

•

Business Combinations o Immediate liquidity, fixed value o No risks associated with changing stock market conditions that may prevent IPO or prevent completion of it o No lockup agreement (requires shareholders of IPO to not sell or transfer for 6 months after IPO) o avoid pressures associated with being a public company o Potential limitations on return for target company's shareholders o Upside is capped at purchase price Types of Acquirers o What is their longterm vision? o What is the allocation of control? Forms of Business Combinations Asset Purchase - acquiring company purchases some or all of the target company's assets and assumes some/all of its liabilities o Acquirer affected how? • Purchase only what wants and only specific liabilities • Never completely eliminate some risks (sometimes required to take on risks not known at time such as all liability for previously sold products) • If not sell everything then completion of the asset purchase should not require shareholder approval or dissenters' rights o Target company affected how? • Not as favorable as stock purchase, forced to retain specific liabilities • Double taxation on the gain of the sale o Need for third party consent • Sometimes spelled out in anti assignment provisions • If almost all then generally requires shareholder approval o Bulk sale laws - target company must give notice to the target company's creditors Purchase of Equity - stock purchase or merger o More favorable than sale of assets - assets and liabilities are sold o Single taxation o Assumes all liabilities (acquiring company) Stock Purchase and Sale - agreement to purchase all outstanding shares for cash, stock or other consideration o No third party consent - all contracts remain in same name o All shareholders must agree to sell Merger - two companies combine o Direct/forward merger - target company merges directly into acquirer and does not survive

Forward triangular merger - target company merges directly into a subsidiary of the acquirer and does not survive o Reverse triangular merger - subsidiary of acquirer merges into target company and target survives o Variety • Shields acquirer from direct exposure to the target company's liabilities • Optimizes tax treatment • Reduces interference of third party o Shareholder approval required Pricing Issues o Purchase price - fixed dollar amount, post closing adjustment, earn out o Form of consideration • Cash payment at closing • Deferred cash payments or promissory notes • Part cash/part stock or all stock • Shares of the acquirer's stock o Fixed exchange ration v fixed market value formula Effect of Business combo on preferred stock rights - consider them as well as stock option rights Tax Treatment o Taxable purchase and sale of assets o Taxable forward merger o Taxable purchase and sale of stock o Taxable reverse triangular merger o Tax free reorgs • Statutory merger - target company disappears and generally 45% of the consideration must consist of acquirer's stock • Stock for stock exchange - acquirer exchanges its voting stock fo rat least 80% of the stock of target company • Exchange of stock for assets - exchanges its stock for target's assets and then target is liquidated • Forward triangular merger - if 45% of consideration paid to target is stock then tax free • Reverse triangular merger - 80% of consideration must be tax free o Non tax considerations - dilutive effects, inability to finance transaction, key contracts may be unassignable, unwillingness to assume certain liabilities Securities law Requirements o Federal securities laws • Rule 506 under regulation D • Regulation d information requirements • Section 3a10 o State securities laws • Blue sky laws • Acquirer's state, target's state, states where targets shareholder's reside or have principal places of business o

•

Protection from fraud Restrictions from resale • Rules 144 and 145 Accounting Treatment All assets and liabilities must be recorded on acquirer's Balance Any excess over fair value = goodwill All intangibles with finite lives are amortized over useful life Antitrust Compliance Shareholder Approval and Dissenter's Rights o o

•

• • •

•

Merger Process Overview of steps 16.1 - p 634 o Preliminary discussions and financial aspects o Legal counsel work on confidentiality agreements o Due diligence review process and strategic negotiations, letter of intent with terms o Draft merger agreement Exclusivity agreements - target company agrees not to solicit from other acquirers Fiduciary out - allows target board to take steps that might violate exclusivity if completes fiduciary duties Due diligence o Request documents on finances, indebtedness, taxes, employee matters, threatened litigation, IP, environmental issues Merger Agreement o General provisions - securities being acquired, purchase price or exchange ration, description of the structure, treatment of outstanding options, and any terms to purchase price adjustment o Representation and warranties - method for obtaining disclosure, foundation for party's right to indemnification, basis for party's obligations at close o Covenants o Indemnification Provisions • Extent to which shareholders of target liable for potential indemnification • Duration of indemnification o Conditions of closing • Representation and warranties true • Covenants of obligations of parties have been performed or waived • Compliance with federal and state laws • Shareholder and third party consents • Government approval obtained • Key employees in new contracts • No material adverse effects • May be terminated if breach o Disclosure schedule • Disclosure of exceptions - target provides info to disclose any exceptions to representations and warranties

o o

o

Board approval and fiduciary duties Other documents• General release • Employment agreements • Noncompetition agreements • The closing Integration --------------------

P 365 - 376 - tort liability of multiple defendants Joint and Several Liability - collectively and individually liable Contribution distributes loss among several defendants by requiring each to pay a portion Indemnification - allows defendant to shift some individual blame to party more at fault •

•

• •

•

Antitrust Violations Contract, combination, conspiracy o Horizontal - btwn 2 competitors o Vertical - different levels of value chain o Maintain - interbrand competition Per se violations - condemns practices that are considered completely void of redeeming competitive rationales o Horizontal price fixing - set minimum prices, set terms of sale, set quantity or quality o Bid rigging o Horizontal market division o Group boycotts Restraints on trade subject to the rule of reason - does activity on reason promote or restrains competition Monopolization - firm must have market power (generally defined as ability to raise prices without losing market share) and have engaged in anticompetitive acts - not merely having major market share Environmental liabilities o CERCLA - responsible parties are strictly liable for cleanup of hazardous waste specifically current owners, owners at time of disposal, transporters of substance to a facility if they selected it, persons who arrange for treatment or disposal o Defenses • Act of god • Act of war • Act of third part  Defendant must have taken care  Acquired property after disposal  No knowledge of contamination

No reason to know of contamination after conducting appropriate inquiries  Consider - knowledge of new owner, price to value of property, commonly known info about property, obviousness of contamination, ability to detect from investigations, levels of inquiry conducted at time of purchase RCRA - potentially liable parties include - generators of waste, people who arrange for treatment or disposal, transporters of waste, persons who treat/dispose Bribery - prohibited by Foreign Corrupt Practices Act - any payments by a US company or and non-US controlled company or its agents to a foreign government official or foreign political party for the purpose of improperly influencing government decisions Record keeping provisions - every public company must keep records that accurately reflect the disposition of the company's assets and implement internal controls to ensure that its transactions are completed as authorized by management 

o

o

o

CHAPTER 2 – LEAVING YOUR EMPLOYER •

•

• •

• • • •

Classification of employees changes employee’s rights and duties o Key employees (officers, directors, managers) o Skilled employees (software engineers, mktg specialists, sales reps) o Unskilled employees Key and skilled empl. Cannot solicit employees to work for their new business o You can tell people you are starting a new business and leave contact info. Antipiracy or No Raid clauses prohibit employees from soliciting coworkers or hiring them for a stated period of time Noncompete covenenents protects employer from unfair competition from a former employee o Agreement must be ancillary to some other agreement o Must be reasonably limited in scope o Must not be contrary to the interests of the public o Must be supported by adequate consideration Blue Lining Clause – invites the court to enforce a covenenant to the greatest erxtent possible under applicable law and modify the covenant as necessary to enforce it A contract can specify the state law which is to be used in disputes o However, courts can sometimes overrule this portion of the agreement Trade secrets (we’ve already covered this in other areas of the class) UTSA – Uniform Trade Secrets Act prohibits an employee from using or disclosing a trade secret from a former employer

• •

Invention assignment (already covered this in another area of the class) Leave on good terms o Be honest with the employer regarding the reason for leaving (to start a competing business) o It may be appropriate to offer the employer an opportunity to invest in the new venture o Avoid soliciting coworkers while still employed, but tell them why you’re leaving and give them contact information

Legal Ch10 – Marshaling Human Resources Federal Labor Laws  Civil Rights Act of 1964 – prohibits employment discrimination on race, color, religion, sex or national origin Title VII 

  

does not apply to independent contractors damages include back pay, front pay and compensatory damages 3 types of discrimination  Disparate treatment – intentional discrimination (denying employment or a benefit/privilege) must prove  Member of the protected group  Was denied position or benefit  Employer must prove nondiscriminatory grounds  Disparate Impact – not necessarily intentional  Employer has hiring criteria that disproportionately affected a certain protected group  Employer must prove that the criteria was essential to the job function  Harassment, includes hostile work environment; employee must prove  Was subjected to sexual conduct

Conduct was sufficiently sever or pervasive, altering conditions of employment or abusive environment  Employer is liable for a supervisor’s actions even if the employer had no reason to be aware of the situation, if the supervisor took adverse employment action against the victim (demotion, etc.)  If no adverse action was taken, employer must prove • Employer exercised reasonable care to prevent and promptly correct behavior • Employee unreasonably failed to take advantage of preventive or corrective opportunities provided by employer employer may legally hire a person based on religion, sex or national origin only IF it is a Bona Fide Occupational Qualification (does not include stereotypes) Seniority and Merit Systems 



employer can legally apply different compensation in a bona fide seniority or merit system (purposeful discrimination) Age Discrimination in Employment Act (ADEA)  Applies to all companies in interstate commerce with at least 20 empl.  Covers workers 40+, applicants and current employees  Excludes independent contractors  Employer can require a terminated employee to waive claims in return for extra severance benefits. Waiver must: • Be understandable • Specifically refer to the employee ADEA rights • Not require employee to waive rights to future actions • Offer consideration • Advise employee to consult with attorney • Offer employee 21 days to consider (45 days if more than one employee is discharged at the same time) • Provide employee with 7 days after signing to revoke • If more than one employee is Discharged at the time, waiver must contain separate list of ages and job titles of all employees a)being retained and b) being let go Americans with Disabilities Act (ADA)  Covers employers with 15+ employees working at least 20 calendar weeks in a year  Employer required to provide reasonable accommodations to disabled employees, unless doing so would cause undue hardship to employer  Remedies include back pay, reinstatement and reimbursement of legal fees  Disability mental or physical impairment that substantially limits one or more major life activity (walking, seeing, hearing, procreating…) 





If it can be corrected with drugs, it doesn’t count Employer can deny employment if the condition imposes a direct threat to health and safety of the employee (or others) Family and Medical Leave Act (FMLA)  Applies to employers with 50+ full time employees  up to 12 weeks unpaid leave per year in connection with adoption, birth, care of an immediate family member, serious health condition  employee must have worked for the company for at least 1 year, 1,250 hours to qualify  employer must continue to provide health care and must restore employee to same (or equivalent level) position upon return  employee cannot contract out of FMLA rights Fair Labor Standards Act (FLSA)  Covers ALL employers in interstate commerce  regulates min. wage, overtime pay and use of child labor  Some types of employees are exempt from min. wage and overtime (salespeople, professional, executive, and admin. And highly skilled computer professionals)  does not cover independent contractors Worker’s Compensation  Can be provided in three ways (based on state laws) • Self-insure by the company • Purchase through state fund • Purchase through private insurer Occupational Safety and Health Act (OSHA)  Applies to all employers in interstate commerce, except federal and state employees  designed to reduce workplace hazards and improve safety National Labor Relations Act (NLRA)  Covers all enterprises with a substantial effect on commerce  gives employees the right (and protection) to organize unions  protects employers by limiting union solicitation, prohibiting employee from disclosing his salary  protection extends to employees, not supervisors or independent contractors Equal Employment Opportunity Commission (EEOC)  Federal administrative agene to enforce Title Vii and other antidiscrimination statues  Person with a grievance must first exhaust procedures of the EEOC before filing law suit  EEOC investigates and if reasonable cause exists, attempts to resolve the issue out of court first Immigration Reform and Control Act of 1986 (IRCA)  Illegal for employer with 4+ employees to discriminate based on national origin or citizenship status  

















An employee can legally be told that a job offer is contingent on passing a job-related medical exam if all candidates go through the same exam

Classifying as Employees or Independent contractors? 

 

Independent contractors are less expensive  No workers comp insurance  No unemployment comp  No job benefits (health insurance, retirement savings plan) Incorrect classification of workers can bring federal and state penalties Worker status can affect employer’s right to copyrightable works or patentable inventions for independent contractors:  Written contract must specify a “work for hire” or assignment of the copyright  Must agree upon the desired work product, but worker controls the manner of achieving the outcome  Contractors offer services to the public at large, not just one business  Determining whether an employment relationship existed, courts asses  Nature and degree of control/supervision of the employer  Are the services in question an integral part of the employer’s business?  Did the employer provide training  Amt of worker’s investment in facilities and equipment  Kind of occupation  Worker’s opportunities for profit or loss  Method of calculating payment for work  Skill, initiative and judgment required for the independent enterprise to succeed  Permanence and duration of the work relationship  Was annual or sick leave given?  Did the worker accumulate retirement benefits or medical benefits?  Did the employer pay SS taxes?  What was the intention of the parties – was there a written agreement?  Courts tend to lean in favor of the worker  Steps to establish nonemployee status  Written contract spelling out • intent • duties • conditions of the service • responsibilities of contractor • services to be performed

• •











time frame for completion give contractor right to hire assistants at his own expense  contractor carries his own liability and workers comp insurance and pays his own taxes  make it clear contractor can offer services to other companies Temporary workers are hired (typically) through a personnel agency  Agency and company are both liable for violations of most employment laws  If possible, client company should have agency agree to indemnify the employer on employment-related liabilities Employee privacy  Employers should have a written policy to bolster the right to examine employee e-mail  Policy should state that computer, etc. is company property and employee has no reasonable expectation of privacy on the system Employment at Will (employee or employer may terminate the relationship at any time for any reason)  Employer can discharge for no reason but not for a bad reason  May states have adopted whistle blower statues  Employment at will exception includes court interpretations of implied contract to limit employer’s right o discharge without good cause  Employee is long-term empl.  Employee has received raises, bonuses and promotions  Employee was assured that employment would continue based on doing a good job  Employee was assured he was doing a good job  Company stated that it did not terminate employees without good cause  Employee had never been formally warned  Implied Covenant of Good Faith – termination of long-term employee without good cause in order to deprive him of commissions is a breach of contract Employment contract should be in writing and clarify terms  Duties  Compensation benefits  Stock options and grants  Duration and termination of employment  Right to work in the U.S. (verification)  Proprietary information (NDA) and assignment of inventions  Noncompetition and nonsolicitation provisions  Integration clause (document is complete and overrides any prior or oral agreements/provisions Mandatory arbitration agreements  Saves the company money in legal fees

Outcome more predictable than a jury ruling Will be enforced as long as it does not require employee to forego statutory rights  Can be condition of employment (not considered duress) Employers hiring foreign nationals must comply with U.S. antidiscrimination laws and U.S. immigration laws and procedures Equity compensation can take many, many forms, but typically stock option Stock options  Terms include number of shares, tax advantaged incentive or not, exercise price, maximum duration of the option, permissible forms of payment, contractual restrictions on purchase or transfer of shares  Types include incentive stock options and nonqualified stock options (difference relates to tax implications)  Maximum duration is typically 10 years, except if the optionee owns more than 10% of the company, then it’s 5 years  Forms of payment – cash or cash equivalent, shares of the stock already owned, proceeds from immediate sale of stock upon exercise, promissory note  Vesting (unrestricted right to purchase stock)  Cliff vesting – no vesting in the first year  Some companies tie vesting to achievement of performance goals  Plan may allow individual to exercise an option immediately even if the shares are not vested (becomes tricky with accounting)  Other plans allow exercise only on vested shares  Company may give itself right to require shares that an optionee wishes to transfer when the company is not publicly traded  Most companies provide right to first refusal in the company’s favor Other employee benefits  Health coverage is bought through an insurance company, HMO or through a broker  Employer providing healthcare coverage must abide by health information privacy regulations  Section401K allows nontaxable contributions; company can take an immediate tax deduction on employee contributions  401K SIMPLE is available (and less expensive) to a company with 100 or less employees  401K plans involve liability of employer to ensure that the investment choices offered are prudent ones  Misclassification of employees as contractors can result in retroactive liability for benefits denied  Employer should make sure benefits plans specifically exclude workers classified as contractors even if a gov’t agency later reclassifies the worker as an employee Employer is liable for his or her own negligence in hiring or supervising an employee  

  





   

Select employees carefully Document the relationship Implement good practices and policies Terminate with care

Chapter 12 – Creditor’s Rights and Bankruptcy Types of Loans Term Loans – funds required for a specific purpose, acquisition, or construction project. Borrowed either in a lump sum or in installments. Paid on a specified date. Cannot be reborrowed. Revolving Loans – or revolving line of credit. Firm borrows whatever sums it requires, up to specified maximum. May reborrow amounts it has repaid. Requires commitment fee as consideration because loan is interest-free. Secured Loans – loan backed up by collateral in which lender takes a lien or security interest. If borrower fails to repay, lender may foreclose on collateral and either sell it to pay off debt or keep it in satisfaction of the debt. Secured Transactions Under the UCC – mechanics of taking security interest in personal property and consequences of taking such an interest are governed by Article 9 of the Uniform Commercial code (UCC). Terminology: •

Security Interest – interest in personal property or fixtures put up as collateral

•

Debtor – person who has interest in the collateral

•

Secured Party – lender, seller, or other person

•

Security Agreement – agreement that creates or provides for security interest

Scope of Article 9 – Provides unified, comprehensive scheme for all types of secured transactions. Does not apply to security subject to a landlord’s lien or to certain other exceptions. Formal Requisites – Oral agreement sufficient when secured party takes possession of collateral. Otherwise, authenticated security agreement required. To be enforceable, value must be given in exchange for security interest and debtor must have rights in the collateral. Security Agreements – identify parties & property used as collateral. Specify debtor’s obligations and lenders remedies. Parties – Secured party is the lender. Debtor owns collateral & is also obligor if it owes payment or services.

Granting Clause – agreement must be signed or otherwise authenticated & expressly grant security interest. Standard operative words: “The debtor hereby grants to the secured party a security interest in…” Description of the Collateral – need not be specific as long as it reasonably identifies property. Frequently, secured party will take security interest in ALL assets of debtor (blanket security interest). Includes things like inventory, receivables, patents, trademarks, etc. After-Acquired Property – property acquired after execution of security agreement. Assets may be specified either in addition to, or as replacements of, currently owned assets covered by agreement. Proceeds – security interest in collateral gives secured party rights to proceeds of collateral if sold, leased, etc. Debtor’s Obligations – obligated to repay debt & interest, fees, charges, expenses. Likely to have non-monetary obligations to maintain prescribed standards of financial well-being (net worth, cash flow, leverage, etc) Cross-Collateralization – collateral for one loan used as collateral for another loan if provided for in agreement Remedies for Default – secured party has right to take possession of collateral without judicial process. Party may (1) dispose of collateral at public or private sale or (2) propose to retain collateral in full or partial satisfaction of debt. Proceeds applied in following order: (1) expenses of foreclosure & attorney’s fees, (2) satisfaction of obligations secured, and (3) satisfaction of any subordinate security interest. Perfecting a Security Interest – to protect rights in collateral, lender must ensure its security interest is perfected, that is, prior to (1) rights of other secured creditors, (2)rights of certain buyers, lessees, licensees, (3) rights of trustee in bankruptcy & other lien creditors. Perfected through one of the means below: By Possession – security interest in money perfected only by taking possession. Interest in goods, documents, chattel paper perfected by either possession or by filing a financial statement. By Filing – file a UCC-1 Financial Statement form. By Control – security in investment property, electronic chattel paper, or deposit accounts perfected by control. Parties agree bank will comply with instructions of secured party without further consent by debtor. Automatic Perfection – neither possession nor filing required. Limited duration. Must be followed by possession or filing if perfection is to survive for longer period. (Ex: Purchase-money security interest taken by seller at time of purchase to secure payment of the purchase price).

Types of Creditors and Their Rights – law gives certain creditors priority over others depending on nature of contract Secured Creditors – generally, the first secured creditor to perfect has priority in payment over all others Unsecured Trade Creditors – have no security interest in any collateral but only a general claim against company Equipment Lessors – entities finance leases and provide extended financing for lease or purchase of equipment Taxing Authorities – IRS & state taxing authorities have right to place liens on property for unpaid taxes & may seize property. Employees – claim for wages, salary, vacation, sick leave is generally treated as unsecured claim. In bankruptcy, given priority claim for up to $10,000 in compensation earned but unpaid in 180 days prior to bankruptcy. Personal Guaranties – some creditors may demand firm’s founder or officers personally guarantee repayment of credit extended. Exposes individual’s home & other assets to creditor’s claim. Strategies for Responding to a Financial Crisis – specific responses depend on nature of crisis, kinds of creditors involved, and amount & type of claims. However, conserving cash and gaining additional time are critical. General Considerations – Consider hiring financial consultant with experience in refocusing business plans, analyzing financial data, & preparing budgets to help persuade creditors that venture can work its way out of crisis. Firm may be forced into involuntary bankruptcy (see below). If personal guarantees have been made, lender may demand payment. Likewise, general partners in partnership are personally liable for firm’s debts. When company enters zone of insolvency, officers and directors owe expanded fiduciary duties to creditors. Must take special care to work in interests of both shareholders and creditors. Out-of-Court Reorganization – Firm contacts creditors to request payment moratorium or negotiate new terms. Secured creditors may be willing to overlook defaults on financial covenants. If company has lost credibility with creditors, may have to use an intermediary who facilitate workouts by organizing committee of creditors to negotiate agreements. Committee usually requires firm to provide intermediary, working on behalf of creditors, with a security interest in all the firm’s assets. Out-of-Court Liquidation – non-bankruptcy liquidation (accomplished by company itself of with help of intermediary) may result in higher payments to creditors. Firm winds down operations over period of time, liquidating assets and distributing proceeds on pro rata basis to creditors. Intermediaries can be appointed to take possession and control of all assets, then liquidating and distributing proceeds.

Secured Creditors and Foreclosure – If liquidation is chosen, secured creditors may opt to repossess its collateral and foreclose. Alternatively, creditor may reach some form of forebearance (debt restructure) agreement to give control of collateral to liquidator who sells and provides distributions to creditors. Types of Bankruptcy – voluntary bankruptcy allows company to retain possession of assets, propose plan to restructure its debts to creditors, and emerge in better financial shape. However, finances become open book to creditors and approval of bankruptcy court is required for any business decision outside ordinary course of business. Chapter 11 Reorganization vs. Chapter 7 Liquidation – Chapter 11 reorganization offers company tools to propose restructure plan & emerge from bankruptcy as a going concern. Chapter 7 liquidation, or straight bankruptcy, liquidates all assets for distribution to creditors. Voluntary vs. Involuntary Bankruptcy – 3 or more creditors with claims aggregating $12,300 can file petition to force company into involuntary bankruptcy, but they will face damages if unsuccessful in convincing the court. Company can respond by (1) objecting to the effort (in which case a court determines outcome), or (2) consenting by filing its own Chapter 11 or 7 petition. If involuntary petition filed in bad faith, company’s can face compensatory and punitive damages. Fiduciary Duties of Officers of Insolvent Company – When a company becomes insolvent, or enters zone of insolvency, fiduciary duty of directors and officers expands beyond shareholders to include creditors. D&O must be careful not to approve or take actions that favor shareholders at expense of creditors. Chapter 11 Bankruptcy Process – designed to permit company to reorganize its business by changing terms on which debt must be paid. Accomplished through plan of reorganization proposed by debtor company & considered by court. Debtor generally stays in possession and control of its assets, known as debtor-in-possession. Costs of Bankruptcy – Negative impact on customer & vendor confidence, stigma associated with filing for bankruptcy, accountant/consultant fees, $100,000-$250,000 in attorney’s fees paid up-front. Automatic Stay – immediately upon filing, automatic stay to prevent creditors from pursuing collection of debts (repossession, foreclosure, termination of contracts). Subject to being lifted by court if (1) debtor does not have equity over & above claims of secured creditors & reorganization prospects are doubtful, or (2) if court finds that other good cause exists. Types of Creditor Claims in Bankruptcy – every creditor has right to file proof of claim by the bar date. If not filed by that date, may be barred from recovering anything in the bankruptcy. Debtor then categorizes claim: • Disputed – company believes claim is not valid

•

Contingent – claim will be valid only if some other event does or does not occur

•

Unliquidated – amount of the claim has not been established

Payment Priority – claims are paid in the following order: • Secured claims •

Administrative claims (include claims of debtor’s attorneys, accountants, & post-bankruptcy claims for business expenses, wages for work performed post-petition, post-petition raw materials, leases, etc.

•

Claims of creditors arising between time of filing & decision to put the company in bankruptcy

•

Pre-petition claims of employees for unpaid salary & benefits up to $10,000 per employee

•

Consumer deposits for personal & household goods

•

Certain pre-petition income & other taxes

•

General unsecured claims (by trade creditors & creditors w/ executory contracts rejected in bankruptcy)

Executory Contracts and Leases – agreement in which both parties to contract have continuing obligations to perform. In bankruptcy, debtor company has right to terminate active performance obligations in executory contracts. Rejection is treated as breach of contract & must be approved by bankruptcy court. Other party can file claim (treated as pre-petition unsecured claim). Debtor company may also assume or assume & assign contract to another person regardless of whether non-debtor approves. Before court allows company to assume contract, it must (1) cure any defaults, (2) compensate for any pecuniary losses (i.e. attorney’s fees) suffered by non-debtor, and (3) provide adequate assurances of ability to perform under contract in future. Preference and Fraudulent Transfer Claims – creditor’s committee may pursue recovery of preferential or fraudulent transfers made by debtor company prior to bankruptcy. Preferences – transfers made by debtor, when insolvent, to creditor on account of pre-existing debt in the 90 days prior to filing of bankruptcy petition (one year prior for payments made to debtor company insiders). All payments may be recoverable. Certain defenses for creditor include: payments made in ordinary course of business, C.O.D., or other exchange. Fraudulent Transfers – transfers made with intent to hinder, delay, or defraud creditors. Include transfers made by debtor when financially impaired and for which debtor did not receive reasonably equivalent value in return. Unlike 90-day rule for preferences, reachback period extends to 4 years prior to bankruptcy.

Creditor’s Committee – committee of unsecured creditors, generally including debtor’s largest unsecured creditors (may also be appointed for bondholders, equity security holders, etc). United States Trustee (division of U.S. Justice Department) appoints committee usually in first month after case is filed. Effect of Bankruptcy on Director & Officer Litigation and Indemnification – no stay of litigation against anyone other than debtor. Directors and officers may be sued in bankruptcy. Running a Business in Bankruptcy – court approval is not necessary for transactions in the ordinary course of business. Notice to interested parties and court approval are required prior to: (1) using, leasing, or selling property outside ordinary course of business, (2) borrowing money on secured or super-priority basis, (3) rejecting or assuming pre-petition contracts, (4) entering into new contracts or settlement agreements that affect property of the company. Cash Collateral – when secured creditor’s collateral includes cash or cash proceeds of other collateral, debtor company may not use the cash collateral without adequately protecting creditor or obtaining its permission. Post-Petition Financing – debtor may obtain post-petition or debtorin-possession financing on such terms as bankruptcy court approves. New post-petition lender receives security interest in post-petition assets as wellas administrative claim ahead of all other administrative claims (including attorney’s & other professionals fees) Chapter 11 Plan of Reorganization – along with plan, debtor company must file disclosure statement informing creditors and equity security holders of material financial and business information used to evaluate plan of reorganization. Statement sent to all creditors along with plan and ballot for voting. After ballots tabulated, court holds hearing on confirmation of reorganization plan. Exclusivity Period – debtor has exclusive right to propose plan of reorganization during first 120 days. Court can extend, but not beyond 18 months. If exclusivity terminated or expires, any creditor can file a proposed plan. Classification of Claims – plan of reorganization must classify creditors into classes. Each secured creditor placed in own class. General unsecured creditors & equity security holders placed into separate classes. Subordinated debt holders placed in separate class or grouped with unsecured. Classes designated as impaired if they will not receive all their state-law rights. Impaired classes may vote on reorg plan, but unimpaired cannot Unasserted, Contingent, and Unliquidated Claims – Unasserted – creditor has a claim & learns of bankruptcy, but fails to file proof of claim, claim may be barred from any recovery & discharged. Contingent & unliquidated claims may unduly delay reorganization in

process of fixing or liquidating them. Court may estimate claim for purposes of bankruptcy case to speed case along. Plan Voting Requirements – at least one impaired class must vote to accept reorganization plan. For a class to accept the plan, two-thirds of the dollar amount of claims actually voting on the plan and a majority of creditors voting on the plan must vote to accept. If all impaired classes accept plan, confirmation is obtained more easily. If one class accepts, debtor company may attempt to “cramdown” the plan on other classes. Cramdown Issues and the Absolute Priority Rule – Absolute priority rule states that for unsecured creditors to be crammed down, either they must be paid in full with interest or all junior classes (including equity holders) must be precluded from receiving ANY property. New Value Exception allows junior class, generally shareholders, to retain shares if they contribute substantial new value to debtor in form of money or property essential to funding reorganization. Rather than rely on this exception, equity holders normally negotiate a plan of reorganization that all classes can vote in favor of. In this case, equity holders may retain whatever percentage of ownership they can negotiate with the debtor. Considerations in the Negotiation and Proposal of a Chapter 11 Plan – Generally, plan must adhere to the payment priority scheme shown above. Interests of shareholders must be subordinated to those of creditors. During first 120 days, when debtor has exclusive right to propose a plan, debtor’s management and board must remember fiduciary duty to all constituents, including creditors. Discharge of Claims – If court approves reorganization plan and debtor remains in business, all debts to creditors are discharged. Creditors must accept property distributed according to reorganization plan as full satisfaction on their claims. Prepackaged Bankruptcy and Plans of Reorganization – often takes months to propose reorganization plan & win approval from court. In prepackaged bankruptcy, Bankruptcy Code permits debtor to prepare disclosure statement and plan, circulate statement and plan to creditors, and complete voting on plan before filing the bankruptcy petition. In prenegotiated bankruptcy, debtor negotiates terms of plan prior to filing for bankruptcy, but solicits votes only after case is filed and disclosure statement is approved. Pre-negotiated may be cheaper because formal disclosure statement and plan are drafted only if bankruptcy is filed. Pre-packaged is most effective for holding companies holding large amounts of public bond or debenture debt they seek to restructure or for companies with insignificant disputed, contingent, or unliquidated claims and no major litigation pending. Business Combination Through Chapter 11 Bankruptcy – reorganization plan may set forth terms of a merger between debtor company and another company and provide for stock of debtor company to be sold to the acquiring company. Disadvantage to this approach is that the acquiring company generally becomes liable for all debts of the debtor.

Payment priority scheme & cramdown rules may make it difficult to direct that debtor’s shareholders receive proceeds of the merger. Alternative to a stock merger is a sale of debtor’s assets free and clear of liens with proceeds paid into the bankruptcy estate. Loss of Control and Other Risks in Bankruptcy – (1) Debtor’s management may lose control of company during bankruptcy because creditors can file motion seeking appointment of independent Chapter 11 trustee to take possession of all assets (typically due to fraud or gross mismanagement). (2) Another risk is that the court convert chapter 11 reorganization into chapter 7 liquidation. Conversion can be ordered for cause, inability to develop a reorganization plan, unreasonable delays prejudicial to creditors, or failure to meet court-imposed deadlines. Bankruptcy Pros & Cons – Advantages

Disadvantages

•

Automatic stay of creditor actions

•

Expensive

•

Power to reject unfavorable executor contracts & limit damages on leases

•

Court approval required for decisions outside ordinary course of business

•

Power to force restructure of debts on non-consenting creditors

•

Potential loss of customer or vendor relationships

•

Ability to recover preferences and fraudulent transfers

•

•

Opportunity to preserve going concern value of company

Possible loss of control through conversion to Chapter 7 or appointment of trustee

•

Risk that shareholder’s equity will be wiped out in favor of creditors

Legal Ch. 17: Going Public Why go public? •

Need capital , access to additional capital after public

•

Belief the public capital markets will facilitate additional funding at higher valuations and therefore result in less dilution to initial investors

•

Public offering is viable

•

Ability to use stock for purchases and incentives

•

Public visibility

•

Investors can receive return on investment

Disadvantages to going public: •

Legal obligations (reporting, etc)

•

Public scrutiny

•

Mandatory compliance to regulatory reforms (Sarbanes-Oxley)

•

Disclosure of stock ownership by officers and board of directors and compensation plans

•

Expensive legal fees

•

Time consuming in a critical period

Impediments to sale of stock in an IPO: •

Investment banks that manage public offering require the shareholders to agree not to sell their stock for 6 months after offering (typically)

•

Rules against insider trading

•

Because the entrepreneur is usually an affiliate (officer, director, or owner of more than 5-20% of outstanding shares) the amount of stock sold during any 3 month period is limited by Rule 144 to 1% of the company’s outstanding stock

•

Officers and affiliates are required to report transactions of their stock to the SEC

Reasons to sell the company vs IPO: •

Slow but steady growth is not favored by investment bankers (underwriters) however larger corporations in the same industry may be interested in an acquisition

•

Potential buyers prefer to buy before IPO because they will pay a premium of 15-30% once the company has gone public

•

Immediate liquidity for shareholders (but higher taxes)

•

All disadvantages to going public

Reasons not to sell the company: •

Limits entrepreneur’s upside to the purchase price of the company

•

If sold before IPO will not receive the premium

•

Liquidation preferences of outstanding preferred stock may eat up profits (in IPO those stocks typically convert to common stock)

•

Loss of control

Timing of an IPO is dependent on: •

If the market is receptive to IPOs at the time

•

If the relevant industry is ‘hot’

•

If the major institutional investors have exceeded the proportion of their portfolios reserved for investment

•

If a competitor or other company in the industry have announced disappointing results

When IPO timing is not ideal, seek bridge financing from existing investors or mezzanine financing from new investors until market conditions improve or product milestones are achieved. IPOs happen more slowly now due to increased regulatory scrutiny Prospectus- detailed selling document which describes the company and its business and management Due Dilligence- a review of the company’s business and legal affairs that is done to ensure the accuracy of the prospectus Pre-effective- the amendments filed prior to pricing the deal before the registration statement has been declared effective by the SEC typically revise the registration statement and prospectus in response to SEC comments Preliminary Prospectus-or Red Herring- Prospectus with red lettering on cover to warn of its preliminary and incomplete status. Price and other items are omitted because they are yet to be determined. Road Show- a series of meeting s with potential investors arranged by the underwriters in a number or major cities during a 2-3 week period Pricing Committee-committee formed from the Board of Directors that approve the managing underwriters’ advice on the number of shares and price at which there is the appropriate demand

Incorporation in Delaware: Corporations tend to reincorporate in Delaware because shareholder protection measures available in Delaware reduce a corporation’s vulnerability to hostile takeover attempts.

The Board: Securities Laws and rules of the securities exchanges require that a majority of the board consists of independent directors Board committees: •

Audit- reviews the company’s auditors and evaluates the accounting systems and controls o

Required to be financially literate

o

Subject to more stringent definition of independent

o

Required to have at least one financial expert

•

Compensation- approving compensation plans and strategies

•

Nominate and Corporate Governance- identify and evaluate board candidates and oversee board committees , stockholder communications and other governance matters

IPO Process: 1. Selecting the underwriters and designating managing underwriter and co-managers 2. All hands meeting where the schedule is distributed. 3. Drafting the registration statement for SEC (4-6 weeks) [company council responsible for coordinating the registration statement and getting it through the SEC] 4. Company submits registration statement to SEC ; application to exchange for listing 5. SEC evaluates for adequacy of the disclosure in the prospectus 6. 30 days after registration has been filed: SEC submits comment s to filer 7. Pre-effective written 8. Preliminary Prospectus written by working group (see definition below); draft of comfort letter 9. Prelim Prospectus filed; registration under Securities Exchange Act 1934 10.Managing underwriters organize the Road Show 11.2-3 days after Prelim Prospectus filed – Road show (SEC review must be complete or nearly complete to go on Road Show) 12.Company gives presentation to interested buyers while on the Road Show (2-3weeks) 13.SEC declares the Registration Statement effective; Registration under SEC ACT 1934 effective 14.Pricing and signing of the underwriting agreement 15.Shares are generally traded the next day

16.Closing of the purchase and sale of stocks occurs the 3 business days later 17.Final Prospectus printed and distributed to purchasers of the stock offering (Required by law) includes final pricing and all changes in the IPO

Underwriters: •

Most IPOs are handled by Investment Banks who arrange for the purchase of stock by institutions and individuals for commission

•

Investment banks provide analysts that publish ongoing reports on the company’s progress

•

It is important to evaluate the underwriter’s reputation for its work a relevant industry (recent deal experience, pricing success, failed or aborted offerings, commitment to the deal, staff ability and availability, marketing strength and post IPO support levels)

•

Companies in the IPO process are required to speak to the underwriting investment team and the analysts separately (which was a restriction set in place by the SEC to limit false information being fed to the analysts for their reports)

•

Companies in IPO status typically choose 2-4 investment banks to act as underwriters, designating one as the lead underwriter

•

Companies should seek a firm commitment where the investment bank promises to purchase the shares and then sell them to their clients

•

The managing underwriters typically purchase the shares at a 6-7% discount and then sell them to their clients at full price

•

Managing underwriters will form a syndicate to share in the risk and help with the marketing

•

The syndicate may also have participants that do not share liability with the underwriters such as selling group members or dealers who only agree to purchase a certain # of shares less a commission (typically 55-60% of the gross spread)

•

Company chooses the managing underwriter by Beauty Contest or other method. The underwriter with the highest valuation of the company is not always the correct one to choose

Company Council Role: •

Advise company on corporate governance, disclosure and compliance issues

•

Coordinates the drafting of the registration statement and shepherd’s it throughout the SEC review process

•

Helps company select and coordinate with other participants such as stock exchange reps, printer, transfer agent, bank note company

•

Participates in the underwriting agreement

•

Review the company’s charter documents and legal records to determine what actions the company should take prior to going public

•

Detailed review of the business, addressing any legal problems that may emerge

•

Identifying items that require disclosure in prospectus

•

Conduct detailed review of corporate governance issues such as Sarbanes-Oxley compliance and independence of Board and Board committees

•

Patent and regulatory council are generally asked to participate in discussions with working group and review sections of the prospectus in their area of legal expertise and give opinion

Underwriter’s Council Role: •

Participates on behalf of underwriters in drafting process and due diligence

•

Advising underwriters on legal issues that may arise

•

Prepares underwriting agreement

•

Devil’s advocate role at prospectus drafting sessions

•

Coordinates the review of the underwriting arrangements by the National Association of Securities Dealers (NASD) and any filings required by the state securities authorities

Lead Underwriter or Managing Underwriter- bank designated as the main underwriter Comanagers-the other banks involved in the IPO Firm Commitment Offering- the underwriter offers to purchase the shares (usually at a 6-7% discount) and then resell them to their clients Best Efforts Offering-investment banks are required only to use their best efforts to sell the securities Syndicate- a group of investment banks formed by the managing underwriters to participate in the offering Gross Spread- the difference between the offering price to the public and the proceeds to the company Beauty Contest or Bake Off- Company holds a competition where each investment bank makes a presentation to the Board of Directors about the bank’s strengths and a valuation of the company’s market value and strengths and weaknesses analysis in order to be selected as the managing underwriter First All Hands Meeting- first meeting where all key participants are required to attend and the schedule for the IPO timing is distributed Form S-1- the form most used for the registration statement submitted to the SEC Form SB-2-SEC registration form for smaller companies requiring less disclosure Working Group-Selected members of the company’s management working under the guidance of their underwriters, company council, underwriter’s council and an independent accounting firm to prepare the prospectus Underwriting Agreement-agreement between the company and the managing underwriters which covers the aspects of the offering including the gross spread (done after the SEC declares the registration statement effective) Comfort Letter- letter prepared by the auditors to address SEC comments related to accounting issues. It summarizes the procedures the auditors used to verify financial information in the prospectus and describes the scope of the review in the prospectus

Transfer Agent-a specialized stock transfer company or a commercial bank who issues and effects transfers of the company’s shares and coordinates mailings to the shareholders Bank Note Company-helps design and print the new stock certificates that will be issued to shareholders in the public offering Underwriter’s Book- the collection of potential investor’s nonbinding statement of intent to purchase shares Target Price-the price at which the underwriter (or other holder of stock) hopes to sell the stock Public Float-the value of the shares held by investors other than officers, directors and 10% shareholders Green Shoe-over-allotment option granted to underwriters to purchase additional shares at the IPO price. Typically gives the underwriters the right to purchase an amount of additional shares equal to 15% of the original offering within 30 days Registration Rights-Rights of certain current shareholders to sell shares during an IPO Blue Sky Laws-While the SEC directly, and through its oversight of the NASD and the various Exchanges, is the main enforcer of the nation's securities laws, each individual state has its own securities laws and rules which are known as the Blue Sky Laws and must be met in each state where the underwriter will offer their shares. Federal Law trumps Blue Sky Law Free Writing Prospectus-a written communication that constitutes an offer of securities but does not meet statutory requirements for a prospectus. It is not considered part of the registration statement. Must be used after the prelim prospectus and must be filed with the SEC along with any other marketing documents Recirculation-circulating the revised copy of the prospectus to all persons who received an earlier version, must be done when there are any changes (price, material changes, etc) Friends and Family Shares or Directed Shares-a portion of the shares set aside by the underwriters and sold to purchasers specifically identified by the company. These transactions occur at the same time as the share distribution through the syndicate. Has become less frequent in recent years because the list becomes unmanageable. Also may raise SEC concerns that the reported revenue from these customers are overstated and the SEC will

require disclosure. Raises concerns that the company did not adequately disclose information to these customers Closing-the stock certificates are delivered and the funds are received Lockup Agreements-a condition to the offering where underwriters require most shareholders including all the employees of the company from selling any shares for a specified period of time generally 180 days from the IPO effective date. Most underwriters believe that unless 90-95% of the shares are locked up the IPO may be jeopardized Form S-8-stock issued after the IPO pursuant to employee compensation plans that are unrestricted and freely tradable. Restricted stock-stock not sold in public offering that was not issued under employee plans or for compensatory purposes must generally be resold under compliance with Rule 144 under the 1033 Act Rule 144-requires the securities be held for at least 1 yr after the purchase and be sold in limited quantities through brokers or market makers. Limits the amount that may be sold in a three month period to the greater of 1% of the outstanding shares and the average weekly trading volume in the preceding 4 weeks. Form 144 notice must be filed with the SEC when the order to sell is placed Material Information- information is considered material if its dissemination would be likely to affect the market price of the company’s stock or would likely be considered important by a reasonable investor who is considering whether to trade in the company’s securities

The Prospectus: •

Box Summary

•

Risk Factors

•

Use of Proceeds

•

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)

•

Business Section

•

Management Section

•

Audited Financial Statements

Box Summary-the summary at the beginning of the prospectus which summarizes the key elements of the company’s business, strategy and financial statements MD&A- Management’s Discussion and Analysis of Financial Condition and Results of Operations. At least 3 most recent fiscal years and any applicable interim periods (unless company has short history). Analysis of material changes and reasons for changes, unusual and nonrecurring events that may be misleading, in order to better understand financial situation of company. Forward looking analysis including info that may not be readily evident in financial statements Business Section- narrative description of company (product, manufacturing, marketing, etc), strategy and goals Management Section- biographies of officers, directors and key employees. Describes compensation, employee benefit plans, board committees, board independence and other corporate governance issues Audited Financial Statements-must conform to GAAP FAS 123R-accounting rule effective Jan 2006 under which equity based payments such as stock options generate a current charge to earnings based on their fair value Section 409A-Internal Revenue Code where equity awards will result in adverse tax consequences if they are determined to be granted below fair market value. If the company has granted stock options 12-18 months prior to the IPO significantly below the IPO price an additional charge to earnings to reflect the issuance of ‘cheap stock’ may be required Cheap Stock- Stock issued significantly below the IPO price before the IPO Deemed Dividend- the built in gain achieved when cheap stock sold (to non employees)

Liability for Misstatements in the Prospectus: Section 11 and 12 of the 1933 Securities Act makes the officers who sign the registration statement (CEO, CFO, Chief Accounting Officer), named directors and underwriters civilly liable to the purchasers of shares for any untrue statement of material fact contained in the registration statement or for failure to mention a fact required to be disclosed or one that is necessary to sufficiently explain the information so as to not be misleading. The auditors are also liable for misrepresentation or omission in the financial statements

Pre-filing Publicity: The company’s communications are most significantly restricted during the pre-filing period [Includes verbal communication and Website information] During this period the company may not: •

Issue forecasts, projections or predictions about future performance

Safe Harbor- A period designated by the SEC ending 30 days prior to the filing of a registration statement during which issuers may communicate without risk of violating gun jumping provisions so long as: •

Communication does not reference a securities offering

•

Communication is made by or on behalf of the issuer

•

The issuer takes reasonable steps to prevent further distribution of the information during the 30 days prior to the filing of the registration statement

As long as it doesn’t affect,. the offering, the company is permitted to: •

Continue advertising consistent with past practices

•

Send out customary reports to shareholders

•

Make routine press announcements regarding factual business developments

Gun Jumping Violation-conditioning the market prior to an IPO by making offers to prospective purchasers without delivering a valid preliminary prospectus Any publication of information or publicity effort before a proposed public offering that conditions the public mind or arouses public interest in the issuer or its securities may constitute an impermissible offer to sell under fed securities laws The SEC may delay the public offering until the effect of the violations has dissipated. May also result in criminal and civil actions against the issuer

Post filing Publicity:

Registration Period or Waiting Period- the period between the time the registration statement is filed but before it is declared effective. During this time the company and the underwriters will conduct the road show. Disclosure of material not in the prospectus is not permitted Quiet Period- 25 day period after the effectiveness of the registration statement and the offering where sales of securities can begin and the final prospectus is delivered. Company is not advertising during this time Tombstone Advertisement- traditional advertisement in the financial press placed by the underwriters which is governed by regulation and custom

Due Diligence: •

Due diligence review includes the company, underwriters, all legal council

•

Reviews the information about the company in the registration statement

•

Identify what needs to be disclosed in order to reduce risks

•

Includes discussion with key customers, suppliers, collaborators, licensors, etc

•

Reviews environmental issues, projections, plans and strategy, etc

•

Company must be prepared to back up any claim even if presented as an opinion

•

Underwriters are not permitted to share their research with the analysts

•

Reveal any existing agreements or relationships that should be terminated

Due Diligence Defense-a director or underwriter may avoid liability by establishing that he/she exercised due diligence – after undertaking reasonable investigation they believed the statement to be accurate. It is more difficult for officers to demonstrate that they would not be aware of an inaccuracy or omission If they exercised due diligence. Willful misrepresentations or omissions can result in criminal prosecution and imprisonment

Road Show:

•

Presentations to prospective buyers starts at end of SEC review and ends just before offering (typically 2-3 weeks)

•

Only the preliminary prospectus can be discussed and distributed. No information outside the prospectus may be given

•

Company and underwriters have liability for anything said or presented during this time

Determination of Stock Price and Offering Size •

Generally want the price to be between $10 and $20

•

Actual price will be determined by negotiations between company and underwriters and depends significantly on demand

•

Company will need to effect a stock split of outstanding stock before the offering to bring the expected price per share into normal range

•

Due diligence in the valuation model is preformed before the registration statement is filed and the red herring is printed

•

Final pricing is usually set after the SEC process is complete based on the market’s reaction to the offering as reflected in the potential investor’s nonbinding indications to the underwriters of their intent to purchase shares

•

Underwriters prefer to have several times the indications to purchase than the number of shares available

•

Underwriters tend to purchase the shares at a discount of 15% of the target price

•

The size of the offering depends on the company’s capital needs, dilution to existing shareholders, the level of public float needed to achieve an active trading market and provide liquidity for existing shareholders, market receptivity, proposed price per share

The SEC may grant confidential treatment for a number of years for select portion of the agreements such as royalty rates, payment amounts, volume discount rates, proprietary technical data •

Information in redacted and then the report will be made public

•

Requests for the confidential information are cleared through the SEC prior to the effectiveness of the IPO

Each exchange has its own listing requirements Nasdaq-GM offers real time trading information and is followed by more analysts and shareholders than Nasdaq SmallCap Market. Nasdaq-GM is has more strict listing requirements than Nasdaq SmallCap. NYSE has more strict listing requirements than Nasdaq-GM

Reasons for delayed or terminated IPO: •

Temporary downturn of the stock market or IPO climate

•

Need to incorporate another quarter’s info into the prospectus

•

Acquisition and related disclosure issues

•

Regulatory problems

•

Change in company management

•

Insufficient interest in company’s stock after road show

Offerings are most frequently delayed 1. Before responding to SEC comments and filing an amendment to the registration statement 2. Before printing the prospectus 3. At or near completion of road show If the company and its underwriters decide not to complete the IPO the company asks the SEC to withdraw its registration statement and continues as a private company In the event of a terminated offering, securities laws limit the ability of the company to complete a private financing within 6 months of the termination unless the company follows the rules and requirements of Rule 155 under the Securities Act of 1933 Rule 155 under the Securities Act of 1933 [Not From Book] •

No securities were sold

•

Registration statement withdrawn

•

Waiting period of 30 days

•

Notification that the offering isn’t registered, the securities are restricted under Rule 144 resale, investor protection under Securities Act 11 is not available, registration offering was withdrawn and the date of withdrawal

•

Update disclosures in the private offering memorandum to reflect current conditions

Trading of company stock acquired prior to the IPO is restricted under the federal security laws. Neither common stock previously issued to employees nor common stock is converted to common stock may be sold on the open market unless certain conditions are satisfied. Employee shares issued prior to the IPO under written compensatory plans may generally be sold under Rule 701 of the 1933 Act 90 days after the IPO by employees who are not affiliates of the company and are not otherwise locked up.

Current and Periodic Reports: Form 10-K- annual report that provides a continuing update of information about the company and its management. Includes description of the company’s business for the preceding year, risk factors, disclosure controls and procedures, internal controls over financial reporting as mandated by Section 404 of Sarbanes-Oxley, management and executive compensation, audited financial statements and MD&A Form 10-Q- quarterly report includes the summary of unaudited financial report statements, an MD&A section, risk factors and information concerning new developments in legal proceedings, disclosure and internal controls and shareholder’s actions taken within the quarter Form 8-K- current report required to be filed within 4 business days following the event giving rise to the reporting obligation. Intended to supplement the normal recurring filing requirements when material events occur that should be brought to the prompt attention of the investing public including: •

Entry into or termination of material agreement

•

Merger, change in control, sale of significant assets or other exit or disposition transaction

•

Bankruptcy

•

Change in accountants

•

Results of operations

•

Creation of or triggering events that accelerate direct financial obligations under, off-balance sheet arrangements

•

Notice of delisting

•

Unregistered sale of securities

•

Departure or election of principal officers or directors

•

Amendments or waivers to the company’s code of ethics

•

Other material disclosures

Effect of Proxy Rules: A company registered under the 1934 Act must send a proxy statement to each shareholder of record in advance of every shareholder’s meeting. This proxy statement must give detailed information regarding the company’s management including related party transactions and executive compensation as well as the matters to be voted on. In some instances the proxy statement and form of proxy must be submitted to the SEC for review and comment before sending it to the shareholders.

Director’s Responsibilities in a Public Company: Directors are bound by duties of loyalty and care imposed by the law of the state where the company is incorporated. These duties are applicable to directors of private companies as well as public companies. Director’s liability for security claims-subject to damage claims for securities fraud under the antifraud rules if: •

their current, quarterly or annual disclosures to the SEC and the public are inaccurate in any material way

•

they knew or should have known that a proxy solicitation issued on their behalf contained false or misleading statements or omissions

•

they issued misleading press releases

•

they issued misleading reports to shareholders

•

they gave misleading speeches

•

they gave misleading information in any other format that can be expected to reach investors and trading markets

•

they purchase or sell their company’s equity during pension fund blackout periods

Indemnification and Liability Insurance for Directors- under the laws of most states, companies have broad and flexible powers to indemnify directors who are made parties to proceedings and incur liability by reason of their status as directors. Delaware law generally gives broader powers to indemnify their directors, officers, employees, and agents than do other states. Delaware permits companies to eliminate monetary liability even for gross negligence and California requires directors to remain liable under certain circumstances for acts or omissions that are deemed reckless. Most companies secure Director and Officer’s (D&O) insurance before completion of an IPO.

Insider Trading: Insider Trading-the purchase or sale of any security on the basis of material nonpublic information about that security or the issuer in breach of a duty of trust or confidence owed the issuer of that security or its shareholders or the source of the information. An insider in possession of nonpublic information must either disclose it before trading or refrain from trading. Insider trading violation may subject the individual to both civil and criminal liability including penalties of 3x the profit or avoided loss on a transaction, fines of up to $1million (up to $42.5 million for companies) and prison sentences. If willful intent (awareness that they are engaging in a wrongful act or that they are profiting to the detriment of others) is proven by the SEC, the individual may be incarcerated for up to 20 years in addition to paying fines up to $5million ($25 million for companies and partnerships). Both the tipper and the tippee may be liable and the tipper may be found liable for the profit or avoided losses of the tippee even if the tipper doesn’t receive anything from the resulting transaction. The impression of taking advantage of undisclosed information is all that a court needs to proceed with prosecution. Parties with fiduciary duty to the shareholders and the company: •

directors

•

officers

•

employees

•

accountants

•

attorneys

•

consultants

•

Temporary insiders o

Investment bankers

o

Rating agencies

Safe Harbor for Preexisting Arrangements or Blind Trusts: Rule 10b5-1- Rule under the 1934 Act which provides that a trade will be deemed to be made on the basis of material nonpublic information if the person making the trade was aware of the information at the time of the trade unless the insider has taken specific measures under Rule 10b5-1c Rule 10b5-1c- provides for a ‘safe harbor’ for traders who otherwise would have been deemed as violators of insider trading. The provisions of the safe harbor are: •

An individual can at a time when he/she has no nonpublic information expressly authorize trades in the future by o

Entering into a binding contract to make the trades

o

Instructing another to make the trades on his/her behalf

o

Adopting a written plan for making trades

•

The contract, instruction or plan must be specific as to the amount of shares and the price and trading date or must include a formula or other specific manner of determining the amount, price, and trading date.

•

An insider using this method must not engage in hedging or any other activity designed to mitigate the risk of the trades

•

An insider must be acting in good faith and not pursuant to a plan or scheme to evade insider trading restrictions

•

An insider may trade by blind trust-empowering another to make trades at their discretion, someone who does not have access to the insider information. The insider is required to implement reasonable

policies and procedures to prevent the trader from obtaining the insider information and to ensure that if they do that they do not act on it

Company Liability: Insider Trading and Securities Fraud Enforcement Act of 1988 (UTSFEA)-Provision that any controlling person who knew or recklessly disregarded the fact that a controlled person was likely to engage in an insider trading violation and failed to take appropriate steps to prevent such acts before they occurred may be independently liable for a civil penalty of up to the greater of $1million or 3x the controlled person’s profits or avoided losses resulting from the violation. Adopting a written policy prohibiting insider trading can reduce the company’s exposure for controlling-person liability. In the event that an employee does violate the law, the policy and related procedures reduce the risk that the company itself will be liable under the ITSFEA Window-Period Policies- prohibit persons (usually directors, officers and principal shareholders) from trading in the company’s stock during a specific period such as two to four weeks prior to the end of a quarter and extending 48-72 hours after the company has released its earnings statement. The company usually retains the right to close the trading window early or not open it at all if there is undisclosed information that would make trades by insiders inappropriate.

Liability for Short-Swing Profits: Section 16 of the 1934 Act- provides for the automatic recovery by the company of any profits made by executive officers, directors, and greater than 10% of the shareholders on securities purchased and sold or vice versa within a six month period regardless of the trader’s intent to use or actual use of insider information (16b). The reports filed by executive officers, directors and greater than 10% shareholders are monitored by professional plaintiff’s attorneys for indications of short swing trading violations.

Insider Reports: Section 16(a)-requires that each executive officer and director of a company involved in an IPO file a Form 3 Form 3-form filed by each officer and director that details the beneficial ownership of securities of the company. Typically filed at the same time the public offering becomes effective. Form 3s are also required within 10 days of the election of any new director or officer of the company

Form 4-filing of any change of beneficial ownership, including gifts and transfers to trusts. Must be filed within 2 business days after the day in which the change occurs Form 5-annual filing to report transactions that were not otherwise reportable or reported The SEC has power to seek monetary fines from individuals for violation of these laws up to the following limits: •

Up to $6k individual or $65k entity per violation for simple violations such as late filing or non-filing of forms under Section 16 [A new violation may occur for each day the filing is late or not corrected]

•

Up to $65k individual or $325k entity per violation involving fraud, deceit, manipulation, or deliberate or reckless disregard of the law

•

Up to $130k individual or $650k entity per violation involving fraud or reckless disregard AND result in or create a risk of substantial losses to others or substantial gain to individual or entity involved

Post IPO Disclosure, Communications with Analysts and Regulation Fair Disclosure (FD): A company must disclose material information when: •

It is necessary to satisfy the SEC’s periodic reporting requirements

•

It is necessary to satisfy the company’s obligation under the listing agreement with the exchange

•

The company or its insiders are trading in the company’s own securities

•

Necessary to correct a prior statement that the company learns was materially untrue or misleading at the time of publication

•

The company is otherwise making a public disclosure and the omission could be misleading

•

Material nonpublic information has been disclosed, intentionally or unintentionally to one or a group of shareholders or to investment professionals such as analysts and not to the general public

•

Necessary to correct rumors in the market place that are attributable to the company

Safe Harbor for Forward-Looking Statements: Federal legislation (Dec 1995) established a safe harbor for certain oral and written forward looking statements such as projections , forecasts and other statements about future operations, plans or possible results. For the company to be protected, they must disclose that it is a forward looking statement and that the company’s actual results may differ materially. In a written statement the company must detail the factors that could result in a discrepancy and in the case of an oral statement refer the audience to a readily available written statement that contains these details.

Communications with Analysts, Selective Disclosure and Regulation Fair Disclosure (FD): No information ever given to an Analyst is off the record Casual or ill-considered disclosure to an analyst of material inside information can lead to shareholder’s lawsuits and SEC investigations for securities fraud and insider trading and violation of Fair Disclosure Selective Disclosure-the release of material information on an individual basis without its simultaneous release to the public generally SEC Regulation FD-Fair Disclosure- regulation designed to prevent and regulate selective disclosure and to reinforce a company’s obligations to keep the public informed in a fair and evenhanded manner. •

Restricts a company’s senior officers and others who regularly communicate with analysts or investors from selective disclosure when it is foreseeable that shareholders will trade on the basis of the information

•

If selective disclosure is unintentional the company must broadly disseminate the information within 24hrs from the selective disclosure of the commencement of the next day’s trading

•

Usually is disseminated on the Form 8-K

The company can be held liable in a suit by the SEC if: •

It knows or should have known that the information selectively disclosed is both material and nonpublic

•

It fails to properly disseminate information to the public

•

Its methods of communication are not reasonably designed to prevent illegal selective disclosure

Individuals can also be held liable for selective disclosure either as direct violators or aiders and abettors The SEC is empowered to sue under Regulation FD Any affected shareholder can sue under Section 10(b) of the 1934 Act is the selective disclosure amounted to illegal tipping by an insider under Rule 10b5.

Liability for an Analyst’s Report: If an analyst provides inaccurate information regarding a company it is generally considered to be the analyst’s assessment and not the company’s unless the company confirms the information or otherwise becomes entangled with the analyst’s report. Disclaimers, warnings and generalities can reduce the risk if the company decides to comment

Notes from Table 4.1 Choice of Business Entity: Pros and Cons

Sole Proprietorsh ip

C Corp

S Corp

General Partnersh ip

Limited Partnersh ip

Limited Liability Compan y

Limited Liability

No

Yes

Yes

No

Yesa

Yes

Flow-through taxation

Yes

No

Yes

Yes

Yes

Yes

Simplicity/low cost

Yes

Yes

Yes

No

No

No

Limitations on eligibility

Yes

No

Yes

No

No

No

Limitations on capital structure

Yes

No

Yes

No

No

No

a

: Limited liability for limited partners only; a limited partnership must have at least one general partner with unlimited liability

Ability to take public

No

Yes

Yesb

Noc

No

No

Flexible charter documents

Yes

No

No

Yes

Yes

Yes

Ability to change structure without tax

Yes

No

No

Yes

Yes

Yes

Favorable employee incentives (including stock options)

No

Yes

Yes/N od

Noe

No

No

Qualified small business stock exclusion for gains and roll-over ability

No

Yesf

No

No

No

No

Special allocations

No

No

No

Yes

Yes

Yes

Tax-free in-kind distributions

Yes

No

No

Yes

Yes

Yes

b

An S corporation would convert to a C corporation upon a public offering because of the restrictions on the permissible number of S corporation shareholders c

Although the public markets are generally available for partnership for LLC offerings, a partnership or LLC can be incorporated without tax and then taken public. d

Although an S corporation can issue ISO’s, the inability to have two classes of stock limits favorable pricing of common stock offered to employees e

Although partnership and LLC interests can be provided to employees, they are poorly understood by most employees. Moreover, ISO’s are not available f

Special low capital gains rate for stock of U.S. C corporations with not more than $50 million in gross assets at the time stock is issued if the corporation is engaged in an active business and the taxpayer holds his or her stock for at least five years

Notes from Table 5.1 Tax Treatment of Restricted Stock Awards, NonQualified Stock Options, and Incentive Please note: 1. The tax consequences described in Table 5.1 may differ as a result of the application of Section 409A of the Internal Revenue Code in the case of a “discounted” stock option (i.e. an option with an exercise price below the underlying stock’s fair market value on the date of grant). For example, an optionee may be required to recognize taxable ordinary income prior to the exercise of a discounted non-qualified stock, option, including associated penalties and interest. Event Employee Tax Consequences Employer Tax Consequences Issuance of stock subject to vesting (restricted stock)

None until shares vest unless file an 83(b) election. If file 83(b) election, ordinary income equal to fair market value of shares at time of issuance minus price paid by employee (the spread)

None, unless an 83(b) election was made, in which case compensation deduction equal to spread.

Restricted Stock Vests

Ordinary income equal to fair market value of the shares on date shares vest minus price paid by employee, unless an 83(b) election was made, in which case no tax is due upon vesting

Compensation deduction equal to spread, unless an 83(b) election was made

Property (including under Certain Circumstances Intellectual Property) is Contributed to Newly Formed Corporation in Exchange for Stock

Under Section 351, as long as the investors (1) contribute property, not services; (2) receive stock in the corporations; and (3) collectively control 80% or more of the corporation after transaction, the investors pay no tax on the gain (i.e., the fair market value of the stock and other property received minus the cost basis of the property contributed), unless they

None

receive cash or other nonstock property (boot). Investors receiving boot are taxed on the lesser of their realized gain and the amount of boot.

Notes from Table 5.1 Tax Treatment of Restricted Stock Awards, NonQualified Stock Options, and Incentive (CONTINUED…) Event

Employee Tax Consequences

Employer Tax Consequences

Founder Contributes Services in Exchange for Stock Issued Upon Incorporation

Ordinary income equal to the fair market value of the stock received.

Compensation deduction equal to fair market value of stock.

Grant of Non-qualified Stock Options (NQO’s)

None.

None.

Grant of Incentive Stock Option (ISO)

None.

None.

Exercise of NQO

Ordinary income equal to fair market value of stock on date of exercise minus option exercise price (the spread)

None.

Exercise of ISO

None, except that the spread will be included as a preference item in calculating the individual’s alternative minimum tax (AMT), which could trigger AMT for the year in which ISO is exercised. The employee will receive a tax credit for any AMT paid, which can be applied against taxes due in future years.

None.

Sales of Stock Acquired Upon Exercise of NQO

Capital gains equal to sale price minus fair market value on date of exercise

None.

Sale of Stock Acquired Upon Exercise of ISO

Capital gains equal to sale price minus exercise price provided that the stock is not disposed of within two years of the grant date or within 12 months after exercise (a disqualifying disposition, the gain (i.e. the sale price minus the exercise price) is taxed as follows; any gain up to the amount of

None, unless a disqualifying disposition. If disqualifying disposition, compensation deduction equal to ordinary

the spread on date of exercise will be ordinary income and the balance of the gain will be capital gains

income recognized by the employee.