LLC Operating Agreement subject to statute of frauds

In a case of first impression, a recent Delaware Chancery Court decision, Olson v. Viking Global Investors LP et al, found as a matter of law that LLC operating agreements are subject to the statute of frauds.  The case involved a dispute among the founders of a hedge fund of what was owed to a founders upon his removal from the company. The founder claimed he was entitled to a multiyear earnout worth over $100 million, based on the provisions of an LLC operating agreement that apparently was unsigned.  In contrast, relevant signed documents provided that the founder was entitled only to his capital account and compensation owed upon leaving the company.  Because the earnout involved a multiyear arrangement, the court considered whether the statute of frauds would govern, and then found in favor of that position as a matter of law.

Liability evolving for user-generated content

 

One of the greatest advances in our use of Web-based technology in the last decade – commonly referred to as “Web 2.0”, and now Web 3.0 around the corner – has been the outburst of online communities, collaboration among users and sharing of information and content. Today, household names like Craigslist help you find everything from Red Sox tickets and used lawnmowers to apartments and roommates. Facebook helps reconnect you with your past and Roommates.com and Match.com help find your future mates and partners. Thanks to Tributes.com – Monster.com founder Jeff Taylor’s most recent venture – even obituaries have become “social.”

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Delaware Supreme Court denies standing to directors to bring derivative action

A recent Delaware Supreme Court decision rules that directors who are not otherwise shareholders of a corporation do not have standing to bring a derivative claim on behalf of the corporation.

The case involved claims by the plaintiff director that the other directors of the corporation were controlled by a single shareholder, who was also the corporation’s CEO and Chairman. The Court held that such standing was not expressly provided by the Delaware statute, and refused to judicially extend such standing pursuant to equitable doctrine.

The decision discusses commentary from the ALI (American Law Institute) specifically recommends that such standing be extended to directors. The Court refuses to adopt this standard in Delaware, while noting that the ALI proposal has only been adopted in one state, Pennsylvania. The Court also referenced the New York corporate statute as being unique in providing directors with a statutory right to sue other directors of the corporation. (I guess that’s another reason not to incorporate in New York, if you need one).

Comment on Changes to Rule 144

In an effort to facilitate companies with raising capital and complying with disclosure and reporting obligations, in December 2007 the SEC unanimously adopted amendments to Rule 144 to reduce the requirements on the resale of restricted securities. Among the significant changes, the new rules reduce the holding period and the resale restrictions applicable to holders of such securities. The SEC has stated that it believes the “amendments will increase the liquidity of privately sold securities and decrease the cost of capital for all issuers without compromising investor protection.” These amendments are effective February 15, 2008 and will apply to securities issued before and after that date.

 There are also changes to Rule 145, which are not discussed here.

Reduction of Holding Period and Resale Limitations

In general, the Securities Act of 1933 requires registration of offers and sales of securities unless an exemption is available. Rule 144 creates a safe harbor for the sale of securities by a person other than an issuer, underwriter, or dealer if certain conditions are met. In common practice, Rule 144 serves as the principal path to allow resales of “restricted securities” – those that were originally issued in private, unregistered transactions, under Regulation D or otherwise.

Under the existing regime, Rule 144 required an issuer’s affiliates (its directors, executive officers and significant beneficial owners) to hold their restricted securities of the issuer for at least one year before they could sell them. Any resale thereafter would be subject various limitations based on publicly available information on the issuer, the manner of sale, volume limitations and certain filing requirements. Non-affiliates of an issuer were subject to the same one-year holding requirement and subject to resale limitations during the following year. However, once securities were held by a non-affiliate for at least two years, the limitations would no longer apply and the securities could be freely resold.

Under the new rules, the holding period for restricted securities of public reporting companies was reduced from one year to six months. For non-affiliate holders of these securities, the new rules effectively eliminate after six months all resale restrictions other than the “current public information” requirement, and eliminate all resale restrictions after one year. Affiliates, however, will still need to comply with all resale limitations after they meet the six-month holding requirement.

For private companies, the holding period was effectively changed to one year. The SEC retained the one-year holding requirement for these companies out of their concern that “the market does not have sufficient information and safeguards with respect to non-reporting issuers.” After the one-year holding period is met, non-affiliates may sell their securities with no other resale limitations. While affiliates of these companies are subject to the same one-year holding period, their transactions will still continue to be subject to various resale limitations under Rule 144, including certain current public information requirements for non-reporting companies.

Based on significant comments from practitioners, one of the significant revisions from the amendments originally proposed in July 2007 was that the SEC chose not to adopt its proposal to suspend (or “toll”) the running of the holding period in the event of hedging of restricted securities. A previous tolling provision in the original Rule 144 was eliminated in 1990. Concerned that hedging activities significantly diminish a holder’s economic investment risk that serves as the basis for the holding period, the SEC again proposed that the holding period be tolled by up to six months for any short sales, puts or other hedging activities. Due to the overall concern over the burden placed on investors from complying with this regime and having to disclose information on their hedging transactions, the SEC has agreed not to adopt the tolling provisions, with the caveat that it will revisit the issue if hedging activities are abused.

Codification of SEC Staff Positions on Tacking

The SEC Staff has previously taken the position that tacking of prior holding periods is allowed in certain circumstances upon conversion or exchange of an issuer’s securities, including cashless exercise of options and warrants. The new rule provides that if the securities were originally acquired from an issuer solely in exchange for other securities of the same issuer, tacking will be allowed, even if the securities surrendered were not convertible or exchangeable by their terms. However, if the original securities did not permit cashless conversion or exchange by their terms and are later amended to cover this aspect, under the new rule tacking will not be allowed if the security holder provides consideration for the amendment other than solely securities of that issuer. In other words, if additional consideration is received for the amendment to provide for a cashless exercise feature, that consideration will be treated as a new investment decision by the holder and will restart the clock on tacking.

However, the new rules also codify that the grant of certain options or warrants that are not purchased for cash or property, such as the grant of employee stock options, does not create any investment risk and, therefore, in a cashless exercise of such options or warrants, the holder would not be allowed to tack the holding period and would be deemed to have acquired the underlying securities on the date of exercise and when the underlying shares were fully paid for.

Written Consent Action Challenged by Mass Court

Lawyers often say that bad facts make bad law. Until the recent passage of the corporate statute for Massachusetts under Chapter 156D, corporate lawyers in Massachusetts would often shy away from incorporating in Massachusetts because of the various statutory limitations and the lack of case law to help interpret corporate conduct. One key issue, one seemingly resolved in the new 156D, was the requirement in the old law that all stockholders must sign a written consent. With clients and investors spread around the world, and often traveling, this requirement delayed many a closing and created other issues. The new statute provides an opt-in procedure for a charter provision to permit the majority to act by written consent in lieu of a meeting. While most practitioners still see this format as being inferior to that in Delaware – where this is the default from which you need to opt out – it is still a major improvement.

A recent decision by a Massachusetts Superior Court involving a renewable energy start-up called Current to Current Corporation (C2C) places this provision in doubt and creates ambiguity around the process of removing directors by written consent.

In Peak Ventures, Inc. v. Manfred Kuehnle et al, Mass. Sup. CV 07-3772 (Gants, J., Aug. 24, 2007), the controlling stockholder group (including the company’s founder, CEO and chairman) sought to remove independent directors from the Board after they accused the CEO, Mr. Kuehnle, of self-dealing and sought to remove him from the Board. The complaint alleges that he failed to disclose the company’s grave financial position to the Board and excluded them from the fundraising process, driving the company into insolvency and into deep debts. The plaintiffs (the other board members who were also minority investors and option holders) upon learning of the alleged wrongdoing, noticed a meeting to remove the CEO from office and to take other emergency action. The CEO asked to delay the meeting, while taking action by written consent to amend the bylaws to give the stockholders additional control over key corporate decisions and to remove the independent directors from the Board and appoint two new directors that plaintiffs claimed to be “loyal” to the CEO. The bylaws for the company followed the 156D statutory language to allow actions by less than unanimous written consent and expressly provided that a “[c]onsent signed under this Section has the effect of a vote at a meeting.”

With the action to take effect on seven days from the notice, the plaintiffs sought a TRO to prevent the effect of the consent action to restructure the Board. The Court agreed with them in part, ruling that removal of directors without a meeting is a special circumstance that requires a live stockholder meeting. Say what? The order does not cite any case law in support of this decision, nor is there any in the plaintiffs motion for TRO. The court held that the specific requirement for a meeting before a director is removed “overrides the more general authorization in 156D, s 7.04 for shareholder actions to be conducted without a meeting.” The court reasoned that “this exception reflects the Legislature’s recognition that, when a director is to be removed, the reasons for such removal should be aired at a meeting, which may not occur if the majority of shareholders are permitted to act without such a meeting through a Consent.”

This decision is troubling for many reasons. Getting entrepreneurs to think about corporate governance issues and to bring on independent directors at an early stage is difficult enough. Decisions like Peak Ventures are only likely to scare founders away from bringing others into their decision-making process, leaving young companies without an experienced sounding board for their decisions. Considering that many venture investors will seek board representation and will ask to add industry experts as independents to the board, founding stockholders would be well-advised to increase the board size to still retain majority of the board. Here the board consisted of 5 directors; now it would seem that 7 or 9 may be the right number – making meetings harder to schedule and conduct.

For practitioners, this decision poses an interesting opinion issue. Since most startups don’t hold formal shareholder meetings and make most, if not all, decisions by written consent, the election of directors on which one relies for providing a corporate authorization representation and opinion could now be placed in doubt. In light of this decision, diligencing for opinion may now include a closer examination of written consents vs. meeting minutes.

Delaware Chancery Court provides helpful drafting tips in Earnout case

After taking the summer off from blogging, its time to write again. I thought I would go back to one of my favorite topics to discuss – one often ripe for dispute – earnouts. An interesting decision by the Delaware Chancery Court last month raises some drafting issues.

The case involves a dispute over an EBITA-based earnout between sellers of a life-sciences startup and buyer, AmerisourceBergen Corporation. The deal involved a $21 million closing payment and an earnout of $55 million based on 2003 and 2004 results. Because Sellers saw this deal as giving them access to a larger marketing platform, they obtained buyer’s agreement to exclusively promote seller’s products as part of AmerisourceBergen’s marketing pitches. The merger agreement also included language expressly requiring buyer to use “good faith” and not undertake any actions that would impede the earnout benefits to the sellers.

Notwithstanding these seller-favorable provisions and a finding by the Court in favor of liability for breaching the agreement, on this issue the Court only awarded nominal damages of 6 cents. (The Court did award $21 million on a separate claim that the earnout metric was miscalcuated, so the sellers did have something to celebrate). So, a liquidated damages clause may have been useful here to the sellers.

Another issue was cost control as related to the earnout computation. The agreement clause did not prevent sellers from controlling (reducing) its expenses during the earnout period. A buyer in this case may consider providing that any reductions in expenses (that are not buyer-approved) will get backed out of the EBITDA or other similar earnout metric. Conversely, sellers should try to control as much of the action as possible, so buyer’s increases in overall corporate spending do not dilute their earnout.

The term “average” was also in dispute. Buyer argued that average meant “weighted average,” while the contract was silent. The court did not find this argument compelling (“the most straightforward usage of the term ‘average’ is an arithmetic mean, or an average in which each term is given equal weight”). So, if you mean weighted average, you need to say so in the agreement and then spell out the rules on how the weighting is going to work.

The case also presents an example where the parties departed from GAAP in defining the Adjusted EBITA and the Court enforced their agreement, as opposed to referring back to what GAAP may require.

When is consent “unreasonably withheld”?

Consent provisions in contracts and leases become hot issues in the context of an acquisition. Landlords and licensors don’t always have to play nice and a badly drafted consent provision in a key contract could kill an entire deal.

In negotiating these provisions, lawyers often try to soften the impact by requiring that the consenting party (such as a landlord, bank, licensor, etc.) does not “unreasonably withhold consent”. What does this clause really mean?

A couple of recent decisions help interpret what protection this clause may actually provide to the party seeking consent in the future. They also provide guidance as to the type of information that a consenting party may reasonably request in order to evaluate whether or not to grant its consent.

A recent Massachusetts Supreme Judicial Court decision, Chapman v. Katz, 448 Mass. 519, 862 N.E.2d 735 (Mass. Mar 16, 2007) restates the law in Massachusetts on when it is reasonable to withhold consent in the context of a commercial lease.

• In a commercial context, only factors which relate to a landlord’s interest in preserving the property or in having the terms of the prime lease performed should be considered. Among the factors properly considered are the financial responsibility of the subtenant, the legality and suitability of the proposed use, and the nature of the occupancy. A landlord’s personal taste and convenience, on the other hand, are not factors properly considered. . . .
• [I]t is unreasonable for a landlord to withhold consent to a sublease solely to extract an economic concession or to improve its economic position.

Another decision comes out of California from the auto franchise context . Fladeboe v. American Isuzu Motors Inc., 2007 WL 1191135 (Cal.App. 4 Dist. Apr 23, 2007). Here the court provided as follows:

• [W]ithholding consent to assignment of an automobile franchise is reasonable under California Vehicle Code section 11713.3(e) if it is supported by substantial evidence showing that the proposed assignee is materially deficient with respect to one or more appropriate, performance-related criteria. This test is more exacting than whether the manufacturer subjectively made the decision in good faith after considering appropriate criteria. It is an objective test that requires that the decision be supported by evidence. The test is less exacting than one which requires that the manufacturer demonstrate by a preponderance of the evidence that the proposed assignee is deficient.
• The relevant criteria include, without limitation: (1) whether the proposed dealer has adequate working capital; (2) the extent of prior experience of the proposed dealer; (3) whether the proposed dealer has been profitable in the past; (4) the location of the proposed dealer; (5) the prior sales performance of the proposed dealer; (6) the business acumen of the proposed dealer; (7) the suitability of combining the franchise in question with other franchises at the same location; (8) whether the proposed dealer provides the manufacturer sufficient information regarding its qualifications; and (9) the dealer’s honesty and good faith in relations with the manufacturer.
• The initial burden of explaining the basis for the decision is on the manufacturer, but the ultimate burden of persuasion is on the assigning dealer to demonstrate that the manufacturer’s refusal to consent is unreasonable.”

Final 409A Regulations

A few weeks ago the Final 409A Regulations were released by the IRS. The proposed regulations have been out for over a year, so this is pretty significant development. The final regs can be found here.

Recent Massachusetts decision on director and shareholder duties

A recent decision by the Massachusetts Superior Court for Suffolk county (Boylan v. Boston Sand & Gravel Co., 2007 WL 836753 (Mass.Super.) has a very good synthesis of duties owed by directors and stockholders of Massachusetts corporations:

“[The defendants] as directors of [the company] , owed a fiduciary duty to the corporation, which included both a duty of care and a duty of loyalty. Demoulas v. Demoulas Super Markets, Inc., 424 Mass. 501, 528 (1997). Since they were both directors and shareholders of [the company] and since [the company]was a closely-held corporation, they owed their fellow shareholders, …, “substantially the same duty of utmost good faith and loyalty in the operation of the enterprise that partners owe to one another, a duty that is even stricter than that required of directors and shareholders in corporations generally.” Id. at 529; Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 592-594 (1975).

*7 If [the defendants] wished [the company] to engage in a self-dealing transaction … they must:
1. make full and honest disclosure of all the known material facts of the proposed transaction, including the details of the transaction and their conflict of interest; Demoulas at 531. See Puritan Medical Ctr. Inc. v. Cashman, 413 Mass. 167, 172 (1992); Dynan v. Fritz, 400 Mass. 230, 243 (1987) (“good faith requires a full and honest disclosure of all relevant circumstances to permit a disinterested decision maker to exercise its informed judgment”); ALI Principles of Corporate Governance § 5.02(a) (1994); and
2. “then either receive the assent of disinterested directors or shareholders, or otherwise prove that the decision is fair to the corporation.” Demoulas at 533. The burden of proving that the assenting directors were disinterested rests with the self-dealing directors, see Houle v. Low, 407 Mass. 810, 824 (1990), as does the burden of proving that the self-dealing was “intrinsically fair, and did not result in harm to the corporation or partnership” if the transaction was approved by self-interested directors. Demoulas at 530-531, quoting Meehan v. Shaughnessy, 404 Mass. 419, 441 (1989).

If the self-dealing directors fail to provide full disclosure of the material facts of their proposed transaction, then they breach their fiduciary duty by proceeding with the transaction, regardless of its approval by the Board or its fairness to the corporation. See Geller v. Allied-Lyons PLC, 42 Mass.App.Ct. 120, 128 (1997) (“full disclosure of all material facts respecting the finder’s fee agreement [is] a prerequisite for enforcement”). The Board’s approval is vitiated by the failure of full disclosure.

If the self-dealing directors provide full disclosure to the Board and the transaction is approved by the disinterested directors, then the decision enjoys the deference provided by the business judgment rule. See Harhen v. Brown, 431 Mass. 838, 847 (2000). If the self-dealing directors provide full disclosure to the Board and the transaction is approved by self-interested directors, the decision does not enjoy the benefit of the business judgment rule and must be demonstrated to be fair to the corporation. Demoulas at 533.”

Brown University Venture Forum for Enterprise on Valuation

I recently spoke at a program on valuation and term sheets at Brown University put on by the Brown Forum for Enterprise. I discussed the topic of valuation issues surrounding stock options and 409A. The slide deck can be viewed here.