Sunday, April 17, 2011

Modern Law Firms May Not Be What They Seem

There is a recent case from March 2011 that caught my attention: a Louisiana personal injury lawyer, who operated an “attorney incubator”, owned $158,000 in back taxes because he misclassified his associates as independent contractors instead of as employees. The U.S. Tax Court decision can be found here:

I found this case to be of interest for two reasons. First, this case highlights a widespread practice in the legal community where small law firms that are essentially solo operations affiliate with other attorneys who they qualify as independent contractors rather than employees. Second, this case brings into spotlight the operations of smaller law firms and raises ethical questions.

I. Employees or independent contractors?

In Donald Cave’s case, his firm had three associates. Mr. Cave did not require associates to work from the office or have set hours or account for their time. He did not require the associates to sign employment contracts or non-compete agreements. The associates received one-half of the gross fees collected in cases they generated and one-third of the gross fees collected in cases referred to them by Mr. Cave. The remainder of the fees went to pay for firm expenses, including support staff salaries, telephone bills, and computer and software expenses, as well as for distributions to Donald Cave. Associates generally decided their legal strategies and were only required to give oral updates with respect to the cases referred to them by Mr. Cave and for which he provided an advance payment of case expenses. In addition, Mr. Cave provided his associates with professional office space, secretarial services, business cards identifying the associates as his attorneys, computers, printers, telephones, copy machines, faxes, offices supplies, access to his law library, internet service and computer server.

The Tax Court looked at the following factors to determine whether these associates were independent contractors or employees: “(1) the degree of control exercised by the principal over the worker, (2) which party invests in work facilities used by the worker, (3) the worker’s opportunity for profit or loss, (4) whether the principal has the right to discharge the worker, (5) whether the work is part of the principal’s regular business, (6) the permanency of the relationship, and (7) the relationship the parties believed they were creating.” The Tax Court also stated in the opinion that “no single factor is determinative, all facts and circumstances must be taken into account, and doubtful questions should be resolved in favor of employee status.”

Interestingly, in discussing the first factor, the Court noted that for professionals, the level of required control is generally lower and there are many lawyers who are employees but who “carry on their professional work with a minimum of direct supervision or control over their methods.” Also, the Court took into account the fact that the associates were expected to help Mr. Cave on his cases and that he referred to them his overflow work in order to help them build their practices. At the end, the Tax Court deemed that the associates were in fact employees and not independent contractors, as Mr. Cave classified them throughout their association with his firm.

II. Attorney Incubator - good practice?

This case is also about the confusing structure of modern small law firms, where the relationship among the attorneys is not always clear. Are attorneys partners, associates or of counsel? Also, how does the relationship among lawyers affect the legal services that such lawyers provide to their clients, if at all? The “attorney incubator” model that Donald Cave practiced is not that rare, but does it raise any ethical concerns?

So, to all the clients out there, - be careful in choosing a law firm to represent you or your business. You should make sure that the attorneys you choose will work as a team rather than as a loosely affiliated group of essentially solo practitioners. There is a lot of value in being represented by a team of attorneys, who can discuss your case and add to it their own perspectives and legal strengths (of course, as long as it is done effectively and cost efficiently).

Huffington Post Class Action Lawsuit: Setting the Tone for the Future?

On April 13, 2011, Jonathan Tasini filed a lawsuit against, AOL, Arianna Huffington and Kenneth Lerer (co-founder) seeking at least $105 million in damages on behalf of approximately 9,000 unpaid bloggers that helped to build the site’s value that culminated in its $315 million sale to AOL in February of this year. A pdf of the complaint is here: The plaintiff makes two claims: deceptive business practices and unjust enrichment.

The lawsuit raises issues that may be of interest to multiple other website owners. In the last decade the internet has provided those who are not in the profession of journalism with an ability to be heard through publishing their own writing online; in other words, the internet has provided many with a public outlet for self-expression. Blogs are used for a variety of purposes, ranging from being a tool in business development to being instrumental in establishing a social network. It is actually difficult nowadays to find someone who has never written and posted on the internet, whether as a blog, or a tweet, or a comment, or even a review on So, this lawsuit is about those who monetize this stream of content. Essentially, TheHuffingtonPost has engaged in crowdsourcing content to drive its marketing revenues. Doesn’t Facebook do that too? What about multiple online journals and newspapers (NY Entrepreneur Report blogs, The Crains, etc). There is a quid pro quo: authors get visibility in exchange for contributing free content and channeling internet traffic to the website where they posted. Everybody is happy until the website sells for $315 million. Then, it is hard not to think: what about me? Do I see any of the money for being a loyal and popular contributor?

Apart from the unjust enrichment and deceptive business practices, one cannot help but think about the legal classification of the bloggers: bloggers appear to be unpaid volunteers, volunteering for a for-profit business, TheHuffington I have addressed this very same question before, when I discussed the class action lawsuit against AOL that was settled in December 2009. That class action lawsuit was brought by thousands of former AOL volunteers (community leaders who during the 1990s spent approximately 2-4 hours per week hosting chat rooms, reviewing bulletin board postings, etc). The volunteers later claimed that they were employees and should have been paid at least minimum wages by AOL. Based on the Supreme Court decisions and DOL interpretations, volunteers don’t have to be paid only if they perform services of the kind typically associated with volunteer work (such as help to minister to the comfort of the sick, elderly, indigent, infirm, or handicapped, and retarded or disadvantaged youth). Not the case here.

Perhaps, what should have done was to enter into individual agreements with each of the bloggers, outlining the terms of the services and consideration provided, and obtaining the appropriate licenses to use the bloggers’ content on their website. If bloggers feel that the “compensation” offered by the website was adequate (“visibility, promotion and distribution” of their content), then they are free to enter into such agreements. After all, it is a free economy. However, I would suggest that should provide adequate disclosure as to the use of the content. This would be only fair to the bloggers. In this age of proliferation of the online media and marketing, online traffic, Google analytics, social media networks and everybody writing about everything, basic legal concepts still remain the same, and freedom to contract as well as the requirement of being offered adequate consideration remain unchanged.

Saturday, April 2, 2011

Accidentally "Public" - Private Companies: Watch Out for the 500 Shareholder Rule

There has been a trend for domestic companies to remain private longer instead of rushing to an IPO (good recent example is Facebook). It is not surprising, given the high costs associated with legal and accounting compliance. Also, there is now a way to obtain financing and provide liquidity in the secondary market without being public. For example, this can be done through companies like SecondMarket, which provide a trading platform for resales of stock and other financial instruments issued by private companies.

There is a concern, however, that companies may accidentally become “public” by triggering the 500 shareholder rule. This may happen if, for example, shareholders grant or sell some of their shares to others, thus increasing the total number of shareholders. It may be difficult for a company to control, unless it imposes stringent buy-sell restrictions in its shareholders agreement.

The 500 shareholder rule comes from Section 12(g) of the Securities Exchange Act of 1934 that requires a company with a class of equity securities held by 500 or more holders of record and assets in excess of $10 million to register such securities with the Securities and Exchange Commission. Securities held in the name of a corporation, partnership or a trust are considered to be held by one person, except when the corporation’s purpose is primarily to circumvent this rule. If a company “triggers” the application of this rule, it becomes subject to the periodic reporting requirements of Section 15(d) of the 1934 Act (this means that it has to file annual, quarterly and periodic reports with the SEC). The count happens only once a year, at the end of each fiscal year.

Stock options are considered a separate class of equity securities separate from the class of securities into which such options are exercisable, so a company that has 500 or more of stock option holders is also subject to registration. There is an exemption for compensatory stock options (those granted to employees, directors, consultants, advisors of the company and their permitted transferees). Such options have very strict transfer restrictions. Option holders are not permitted to pledge, hypothecate such options or transfer them except to a family member by gift, to an executor upon death or disability, back to the company, or in a change of control transaction if options are no longer outstanding. The company must provide current risk and financial information to such option holders every six months.

In conclusion, private companies should be watchful of the number of their shareholders and keep in mind that option holders also count as a separate class. Imposing buy-sell restrictions on equity may be a way of controlling the number of shareholders in a company, but at an expense of lower price for such shares, as restrictions on transfer may be viewed negatively by the potential investors. Also, please remember that nothing in this blog constitutes legal advice. One should always consult with a securities lawyer before issuing any equity to investors.