Monday, June 28, 2010

Are LP, GP, LLP and LLC Interests Securities?

One of the biggest mistakes that a securities lawyer can make is fail to recognize a “security”. As a general rule, sale of securities must be registered under federal and state laws unless an exemption from registration is available. Failure to recognize that the deal involves a sale of securities may render the whole transaction invalid and in violation of securities laws.

The term “security” is broadly defined to include the expected stocks, bonds, etc., but also includes interests in pyramid sales schemes and even interests in the development of citrus orchards. The latter two examples are securities because they are “investment contracts”.

In 1946, the U.S. Supreme Court held in SEC v W.J. Howey Co. (328 U.S. 293) that an investment in a transaction or a scheme where a person invests his money in a common enterprise and is led to expect profits solely from the efforts of others is an investment contract, and therefore, a security. This test has been since used and interpreted extensively by the courts. It is this test that a lawyer should use when determining whether an interest in a limited partnership, general partnership, limited liability partnership or a limited liability company is a security.

The Howey test can be summarized as follows: passive investments, where investors do not have any decision-making power and just invest their money, are securities; whereas investments made by the principals, who are actively involved in the management of the enterprise, are not securities. So, limited partnership interests are generally securities because limited partners rely on the general partners to manage the partnership, unless they preserve some veto power, in which case the “investment contract” test would not be met.

Applying the same test to the general partnerships, it appears that generally such interests are not securities because they fail to satisfy the “solely from the efforts of others” part of the test. Although some general partnership or joint venture agreements may vary, usually all general partners exercise full control and decision making power with respect to the affairs of the partnership, they are not passive investors, and therefore, their interests are not securities.

Limited liability partnership interests are typically securities, since, like in limited partnerships, LLP limited interests lack managerial powers and have limited liability. Finally, Howey test also applies to LLC interests to determine whether they are securities. If the LLC is member-managed, then each member is involved in management of the enterprise and has decision-making powers, and therefore their interests would generally not be securities. On the other hand, if the LLC is manager-managed, then members are just passive investors, and their interests are likely to be securities.

Typical exclusions from these rules include gifted limited partnership or LLC interests, where, even though these are securities, there is no sale involved. Also, a grant of a limited liability interest to a general partner in consideration for his or her management of the affairs of the limited partnership, may also not be considered a security.

I have to say that all of the above are not hard rules and depend on a variety of circumstances. A close examination of partnership or operating agreements is necessary in each case. Also, federal circuits may vary in the interpretation of federal laws, and there are also state securities regulations to consider.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Wednesday, June 9, 2010

How you know you’ve got a successful franchise

This morning I attended a presentation on Franchising 101 sponsored by NYC Business Solutions. Not all businesses can growth through becoming franchises and not all businesses that can become franchises become successful revenue-generating enterprises. In other words, franchising may or may not be a successful business path, and it depends not only on the strength of your brand but also on how well the franchisor manages, supervises and coaches its franchisees. Essentially, franchising your business is like growing it with other people’s money (but not through issuing equity or debt). So, instead of investing $$$ into opening another location, franchisor usually gets $$ as an initial payment from the franchisee. Sounds like a great plan! But it is not as easy as it sounds. Here are some advantages and disadvantages of running a franchise that were identified at today’s session.

Only certain businesses can become franchises. A business that can be franchised has the following characteristics:

1. It is already very successful. Strong demand for this product or service and consistent positive margins attract potential franchisees.
2. Business has a strong brand that is recognizable or can become recognizable regionally or nationally.
3. Business has protected and registered intellectual property (trademarks, logos, tradenames).
4. Business can be easily replicated ten, twenty or even more times by the franchisees.

Advantages of having a franchise include:

1. Franchisor does not need to put in cash, seek investors or take out a loan in order to expand his or her brand.
2. Upfront payment (ranging from $10,000 to $30,000) and weekly or monthly royalty payments (approx 5% of revenue) represent a nice stream of income.
3. Smaller time commitment required from the franchisor (as compared to operating multiple locations).
4. Franchise contract provides detailed specifications for all locations, so all locations look like parts of the same business.
5. Franchising (especially through granting a master license to develop certain territory to a master licensor with right to sell and manage sub-franchises in that territory) may be a good cost-effective way for a foreign business to enter a new market.

And finally, some challenges:

1. There is a danger that franchisees are not recording all their revenue in order to decrease royalty payments. Franchisor needs to monitor sales which it may do through royalty audits, sending in mystery shoppers, or monitoring supplies.
2. Costs of complying with federal and state laws can be high, as the laws require franchisors to provide extensive disclosure documents, including audited financials (renewable yearly).
3. Compromises on quality of product or service by the franchisees may damage franchisor’s reputation and brand. Therefore, franchisor must supervise, train and advise franchisees on how to run a successful business on an ongoing basis.
4. Finding the right franchisees and the best franchise locations may be challenging.

Overall, business owners should carefully consider franchising their businesses. For some owners, who want to remain in control, franchising may not be an option, whereas for other owners, franchising may present an ideal solution. There have been many successful franchises (MacDonalds, Subway, Burger King) that set examples for how to grow an empire using other people’s money.

Friday, June 4, 2010

Non-Compete Covenants in Employment Agreements in New York

New York courts rarely enforce non-compete covenants in employment agreements for public policy reasons: they reduce competition and prevent people from being gainfully employed in the area of their expertise. Every case is fact-specific, so it is impossible to know in advance whether a particular non-compete covenant will be enforced. There are circumstances when enforcement is likely: to protect trade secrets or other proprietary information of the employer or if the employer compensates the employee for the time out of the market. Typically, non-competes are common in the hedge fund, computer programming and health service industries.

In reality, most non-competes are never enforced. Enforcing a non-compete may be expensive and is usually an action of last resort. Thus, non-competes often serve as deterrents to future unwanted behavior by the employees.

New York courts will enforce a non-compete covenant only if such covenant is reasonable, which means, it must be (1) no greater than is necessary to protect the employer's legitimate interests; (2) is reasonable in time and area; (3) not unreasonably burdensome to the employee; and (4) not harmful to the general public. See BDO Seidman v. Hirshberg, 712 NE 2d 1220 (N.Y. Ct. App. 1999).

The following interests are legitimate: protection of trade secrets, protection of confidential customer information or database, or protection against irreparable harm if the services of an employee were unique or extraordinary.

Merely preventing competition is not a legitimate business interest. Also, business or financial information, such as market reports or market strategies, do not trigger the trade-secrets legitimate interest. Customer lists are generally not considered to be confidential information unless such lists are discoverable only by extraordinary efforts and not through public sources.

With respect to the uniqueness of the employee’s services, courts examine the relationship between the employee and the employer’s business (whether the employee’s services are so unique and valuable that competition from this employee could irreparably harm the business). Typically, unique employees are musicians, professional athletes, actors and members of a learned profession (ex: accountants).

Even in the absence of non-compete agreements, New York courts can enjoin employees from working for direct competitors of their former employers by using the “inevitable disclosure” doctrine. Under this doctrine, employer can establish a claim of trade secret misappropriation if he shows that in the new job for a direct competitor, the former employee will inevitably rely upon the former employer’s trade secrets. Thus, in PepsiCo, Inc. v Redmond (54 F.3d 1262 (1995), Redmond worked in a senior position at PepsiCo in a highly competitive sport-drinks industry. He signed a confidentiality agreement but not a non-compete agreement. When he joined Quaker Oats, a direct competitor of PepsiCo, the court “converted” Redmond’s confidentiality agreement into a non-compete by prohibiting Redmond to work for Quaker Oats for six months even though there was no proof of an actual misappropriation of trade secrets.

In summary, employers may be well advised to include non-compete covenants in employment agreements for their employees. Of course, such covenants have to be reasonable in terms of duration and geographic scope and cannot serve to limit competition in general. I also recommend including a so-called “blue pencil” provision, giving the court permission to modify the terms of a non-compete covenant to make it enforceable. Also, employers should limit the non-competes to the employees with unique specialized skills and be very specific about the activities in which such employees cannot engage post-employment (have to be narrowly defined and competing directly with employer’s business). Finally, it is always advisable to pay for the employee’s time off the market. After all, employers must take all steps to protect their valuable proprietary information and maintain the critical competitive advantage.