Sunday, December 23, 2012

FTC’s Report on Privacy Concerns in Kids Apps

On December 10, 2012, the Federal Trade Commission (the “FTC”) issued its second annual report examining the disclosures and information collection practices in kids’ apps. The FTC Staff aimed to determine whether the parents were able to make informed decisions about whether or not to download an app for their kids based on the privacy collection practices used by the app. The short answer is that for the most part, presently parents cannot make such informed decisions. The FTC Staff examined 400 kids’ apps from the Apple and Google Play app stores. The results were alarming. In particular, the survey found that:
  • Only 20% of the apps reviewed disclosed any information about the apps’ privacy practices;
  • Almost 60% of the apps transmitted ID number from the user’s device back to the developers, or more commonly, an advertising network, an analytics company or another party (and 14 of those apps also transmitted geolocation and/or phone number);
  • A small number of third parties receive information from many apps, which means that they can potentially develop children’s profiles based on their behavior in different apps;
  • 58% of apps contained interactive features, such as links to social media or advertising, without first disclosing it to the parents (58% of the apps contained advertising within the app, but only 15% disclosed it to the parents prior to the download; 22% of the apps contained links to social media, but only 9% disclosed this fact prior to the download; 17% of the apps provided ability for kids to purchase virtual goods for $0.99 to $29.99). 
COPPA’s purpose is to safeguard personally identifiable information of children under the age of 13. According to the Act, if apps developers collect, use and/or disclose personal information of children under the age of 13, they must (1) disclose a privacy policy; (2) provide notice to parents about their information collection practices and, with some exceptions, get verifiable parental consent before collecting personal information from children; (3) give parents the choice to consent to the collection and use of a child’s personal information; (4) not condition a child’s participation in the app on the disclosure of more personal information than is reasonably necessary for the activity; and (5) maintain the confidentiality, security and integrity of the personal information collected from children.

The survey makes it clear that the FTC should significantly step up its enforcement efforts against those apps developers that fail to comply with COPPA. In fact, the survey announced that the FTC is launching multiple investigations to determine whether certain apps developers have violated COPPA or engaged in unfair or deceptive trade practices in violation of the FTC Act. Further, the survey shows that COPPA and the current regulations related to COPPA need to be amended soon. The currently proposed amendments seek to expand the definition of personally identifiable information that may be collected from children only upon disclosure and parental consent. The proposed definition includes photos, voice recordings, unique mobile device serial numbers, as well as the geolocation of the mobile device, - information that was not considered as personally identifiable or not considered at all back in 1998, when COPPA was adopted.

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.

Thursday, December 20, 2012

LLCs: do you always need to add the word “LLC” to your company name?


When filing the articles of organization for a limited liability company, the company owners are required to add to the company’s name words such as “LLC”, “L.L.C.” or a “Limited Liability Company”. Often, for marketing purposes, these words are omitted when the company name appears in advertisements, on the business cards or on the website.

Omitting the word “LLC” or its equivalent from a limited liability company’s name may have unintended consequences for the company’s members and managers. If it is not clear that there is a company with limited liability, courts may find that the members have entered into a transaction in individual capacity, and not on behalf of their company. This may result in personal liability for the members and/or managers.

It is advisable to keep the word “LLC” at the end of a limited liability company’s name even on business cards, in advertising or on the website because the word “LLC” indicates the existence of a corporate entity that provides limited liability protection to its members. Additionally, when entering into contracts, members or managers need to sign on behalf of the company as agents for the company and not as individuals.

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.

Monday, December 17, 2012

What is Attorney-Client Privilege and How Does It Apply to Start-Ups?

Attorney-client privilege applies to communications between clients and their attorneys and is believed to be the oldest protection of confidential information in the Anglo-Saxon law. The purpose of this privilege is to encourage the client to talk frankly with his or her attorney, so that the attorney can offer the best legal advice. But, as typical in the law, there are limitations and exceptions. Let’s consider when communications between attorneys and their start-up clients are confidential and when they are not.

During the company formation process, it is important to be clear from the outset who the client is: the individual founder(s) or the company that is being formed. Attorney-client privilege can apply when the client is a company. In such cases, the corporate attorney-client privilege protects the corporation, not its individual owners/employees. Communication between the attorney and the employees, officers or directors of the company is protected so long as such communication (i) was made at the direction of the corporate officials, (ii) the matters discussed were within the employee’s duties and were not available from the upper level employees, (iii) the purpose of the inquiry was to obtain legal advice, and (iv) the communication was intended to be kept confidential. Since corporate attorney-client privilege does not protect the individuals, employees should be careful in communicating with the company counsel if disclosure of certain information may expose them to personal liability.

So, when hiring a lawyer to form a company, make sure that the engagement letter is between the attorney and the company, not the individual founders. Also, it is helpful to add a paragraph to the engagement letter listing the individual employees who are authorized to communicate with the attorney and give him / her instructions.

Representing the company and an individual founder at the same time may present a conflict of interest, especially if the board of directors of the company later decides to fire the founder. It is advisable for each of the founders to hire their own attorney when negotiating the ownership structure and the operating or the shareholders agreement. Since this can get very expensive, typically founders hire one attorney who serves as the company lawyer during the formation process.

Note that attorney-client privilege only applies to legal and not to business or other type of advice. So, when the attorney is acting primarily as a member of the board of directors of the company or as a human resources manager rather than as an attorney, the privilege does not apply. The privilege protects the communication, not the underlying factual information. Also, there is no protection for any communication made in furtherance of a crime or an illegal act. Finally, the attorney-client privilege may be waived if the communications are shared with other parties (for example, when the founder copies others on the email to the corporate counsel or invites others who are not employees, officers or directors to participate at a meeting with the company’s counsel).

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.

Monday, December 10, 2012

Leaving Your Current Employer to Start Your Own Company

Earlier this year, I presented a seminar at the Small Business Expo in New York on the top ten mistakes commonly made by start-up founders. Mistake #3 on my list was not paying enough attention to the issues that arise when an entrepreneur starts working on a start-up while still being employed somewhere else. Since these issues continue to come up in my practice frequently, I decided to summarize them in this blog post.

In short, in the absence of an agreement with your employer that contains restrictive covenants (such as non-compete, non-solicit, invention assignment, confidentiality), much depends on two factors: (1) whether the entrepreneur intends to start a competing or a non-competing venture and (2) the entrepreneur’s position with the company. Key employees (such as managers, company officers, directors, group leaders) owe fiduciary duty to the company and its stockholders (see my earlier posts about fiduciary duties: duty of care and duty of loyalty). The duty of loyalty prevents them from taking the company’s opportunities, competing with the company, and soliciting its employees. They have to always act in the best interests of the company and cannot deliberately harm it. So, starting a competing business while still in the company’s employment is out of question. It is likely that skilled employees (such as software engineers or other kind of specialists) owe similar duties. On the other hand, the unskilled employees’ duties to the company are limited to the time when they are actually working. Their off-hours activities are not restricted unless of course their activities are detrimental to the company.

Further, employees (regardless of their position with the company) cannot misappropriate the company’s trade secrets and disclose or use the company’s confidential information during and after the employment. This applies even when there is no confidentiality agreement in place. According to the Uniform Trade Secrets Act, a trade secret is information that has economic value, is not easily ascertainable (means that the information cannot be obtained legally, for example, by searching for it online) and is subject to reasonable efforts to maintain its secrecy.

Finally, even when there is no written invention assignment agreement with the employer, according to the copyright law, all copyrightable material created by an employee for the employer within the scope of employment is deemed to be “work made for hire” and is owned by the employer. So, it is likely that an employee who is writing software code for his new competing venture during regular work hours on the company’s computer at the company’s office does not own the intellectual property rights to it. Some states have limited the application of invention assignments. For example, California’s law limits the employer’s claim on the inventions made during the employee’s own time, not using company equipment and if the invention does not relate to the business of the company and does not result from work for the company.

In addition to these duties and restrictions, employers often ask the employees to sign confidentiality and invention assignment agreements. Typical restrictive covenants found in such agreements are a covenant not to compete and a covenant not to solicit the company’s employees and customers. There may also be a no-moonlighting clause (no outside activities) and a covenant prohibiting any disparaging statements about the company and its customers. Again, several states, such as California, limit the validity of such restrictive covenants.

In conclusion, my general advice for the entrepreneurs who have started working on their new venture while still being employed elsewhere is to (1) review all signed agreements with their present employer; (2) not compete with the employer, (3) not use the employer’s confidential information; (4) avoid working on the new venture during business hours, on the employer’s premises and using employer’s equipment; and (5) if possible (and this depends on the particular circumstances), disclose the new venture to the employer and negotiate the applicability of restrictive covenants, if any. Who knows, the employer may become the new venture’s first investor.

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.

Sunday, December 9, 2012

Examining Duty of Care of Corporate Directors

In addition to the duty of loyalty that corporate directors owe to the corporation and its shareholders, the directors also owe the duty of care.  As I mentioned in my earlier post, the duties of loyalty and care are the so called “fiduciary duties”.  Judges will respect the decisions of the directors (even if they turned out to be wrong) if the directors acted on an informed basis, in good faith and in the best interests of the corporation. This is called the "business judgment rule". Pursuant to it, courts will not question the directors’ decisions unless they have breached their fiduciary duties: a duty of loyalty or a duty of care.

Duty of care can be summarized as requiring the directors to make informed decisions and consider carefully all of the available information before arriving at a decision. This seems like an obvious thing to do, but you would be surprised to learn how often this requirement is disregarded. In particular, directors should:
  • Obtain all relevant information 
  • Have sufficient time to consider such information 
  • Hire experts if necessary (accountants, lawyers, financial experts) 
  • Understand the terms of the proposed transactions, understand the corporation’s finances and closely monitor the performance of executive officers 
  • Institute and supervise a set of policies that would ensure the corporation’s compliance with applicable laws and regulations. 
Typically, directors will not be found liable if they simply failed to follow the best practices. Courts will find a breach of fiduciary duty of care only in cases where directors engage in gross negligence or act with reckless disregard for the shareholders’ interests.

For example, in Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), the court found that the directors breached their duty of care because (1) they did not know prior to the board meeting that there was a pending merger and that the deadline was the next day, (2) they approved the merger in a 2-hour meeting without even reviewing the merger agreement or questioning the purchase price, (3) they relied on the CEO’s oral report without questioning the CEO’s role in bringing the merger about and did not know that he had suggested the purchase price to the buyer. In another case, In re Abbott Labs Derivative Shareholders Litigation, the court found that the directors breached their duty of care because the FDA repeatedly over a period of six years served safety violations notices to the corporation, the directors knew about this, and took no steps to ensure that the corporation changed its practices.

Directors are not the only persons with fiduciary duties. Executive officers also owe fiduciary duties to the corporation and its shareholders. Additionally, controlling shareholders owe the duty of loyalty to the minority shareholders. The activities (such as a vote) by the controlling shareholders will be respected by the Delaware courts as long as their activities had a rational business aim and the controlling shareholders were not involved in “self-dealing”.

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.

Saturday, December 1, 2012

Which Instruments are Included in a Commodity Pool?


It is challenging times now for those investment managers who have recently launched hedge funds. It is due to the change in regulations by the Commodities Futures Trading Commission (CFTC) enacted in February of 2012.  Operators of potential commodity pools are required to determine whether they operate a "commodity pool", and if yes, then they must register with the CFTC by December 31, 2012 or rely on an exemption from registration.  It is not an easy task to determine whether the hedge fund is a commodity pool.  In particular, potential commodity pool operators should check to see whether any of the agreements they have entered into are swaps.  All Title VII instruments that are swaps will, effective December 31, 2012, be included into the definition of a commodity pool along with other instruments, such as futures contracts, security futures products, commodity options, and many others.  Previously, many funds relied on Rule 4.13(a)(4) exemption from registration.  This exemption is no longer available and the transition period expires on December 31, 2012.  Now, unless investment managers qualify for other exemptions, they only have one month to register as CPOs with the CFTC.

For a closer analysis of what is a "commodity pool", I'd like to refer to an excellent blog post by Doug Cornelius.  The full version is found here.

"In looking closer at the statutory definition of “commodity pool” it seems that single swap should not turn a private fund into a commodity pool.

Title 7 of the US Code Section 1(a)
(10) Commodity pool
(A) In general
The term ‘‘commodity pool’’ means any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any—
(i) commodity for future delivery, security futures product, or swap;
(ii) agreement, contract, or transaction described in section 2(c)(2)(C)(i) of this title or section 2(c)(2)(D)(i) of this title;
(iii) commodity option authorized under section 6c of this title; or
(iv) leverage transaction authorized under section 23 of this title.
From the statutory definition, the fund needs to operated for the purpose of trading in commodity interests.
One argument is that the fund is an end user and therefore not organized for the “purpose of trading in commodity interests.” Under the new end user exception to the swap clearing requirement, the key test is whether the entity is “using the swap to hedge or mitigate commercial risk.”
What is a swap used to hedge or mitigate commercial risk?
(c) Hedging or mitigating commercial risk.
For purposes of section 2(h)(7)(A)(ii) of the Act and paragraph (b)(1)(iii)(B) of this section, a swap is used to hedge or mitigate commercial risk if:
(1) Such swap:
(i) Is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise from:
(A) The potential change in the value of assets that a person owns, produces, manufactures, processes, or merchandises or reasonably anticipates owning, producing, manufacturing, processing, or merchandising in the ordinary course of business of the enterprise;
(B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise;
(C) The potential change in the value of services that a person provides, purchases, or reasonably anticipates providing or purchasing in the ordinary course of business of the enterprise;
(D) The potential change in the value of assets, services, inputs, products, or commodities that a person owns, produces, manufactures, processes, merchandises, leases, or sells, or reasonably anticipates owning, producing, manufacturing, processing, merchandising, leasing, or selling in the ordinary course of business of the enterprise;
(E) Any potential change in value related to any of the foregoing arising from interest, currency, or foreign exchange rate movements associated with such assets, liabilities, services, inputs, products, or commodities; or
(F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities; or
(ii) Qualifies as bona fide hedging for purposes of an exemption from position limits under the Act; or
(iii) Qualifies for hedging treatment under:
(A) Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133); or
(B) Governmental Accounting Standards Board Statement Accounting and Financial Reporting for Derivative Instruments; and
(2) Such swap is:
(i) Not used for a purpose that is in the nature of speculation, investing, or trading; and
(ii) Not used to hedge or mitigate the risk of another swap or security-based swap position, unless that other position itself is used to hedge or mitigate commercial risk as defined by this rule or Sec. 240.3a67-4 of this title.
I think most private equity funds and real estate private equity funds would be using interest rate derivatives to hedge or mitigate commercial risk.
The tough part of this argument is that a “financial entity” is not an end user.
2(h)(7)(C)(i)‘‘financial entity’’ means—
(I) a swap dealer;
(II) a security-based swap dealer;
(III) a major swap participant;
(IV) a major security-based swap participant;
(V) a commodity pool;
(VI) a private fund as defined in section 80b–2(a) of title 15;
(VII) an employee benefit plan as defined in paragraphs (3) and (32) of section 1002 of title 29;
(VIII) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 1843(k) of title 12.
In case you have forgotten about the definition of private fund under Dodd-Frank:
The term “private fund” means an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a–3), but for section 3(c)(1) or 3(c)(7) of that Act.
The end user exemption excludes private funds. That seems bad and is going to kick all of the newly registered private equity and real estate private equity funds out of the end-user exemption.
On top of that, there is a de minimis exemption from registration under the terms of Rule 4.13(a)(3). Under these requirements, either:
  • Initial margin and premiums for commodity interest transactions must be less than 5% of the liquidation value of the fund; or
  • Aggregate net notional value of commodity interest transactions must be less than 100% of the liquidation value of the fund.
That still leaves me stuck with trying to figure out when an entity becomes a commodity pool. The regulations provide no further guidance. One case that addresses the definition is Lopez v. Dean Witter Reynolds 805 F.2d 880 1986. Unfortunately for my purposes it focuses on whether separate accounts are aggregated enough to be a pool.
In CFTC v. Heritage Capital Advisory Services, Ltd. (Comm. FUT. L. REP. (CCH) 21,627, 26,377 (N.D. Ill. 1982).) the ruled that a fund investing in Treasuries and hedging the risk was a commodity pool. The defendants had solicited and pooled public funds with the stated intention of investing approximately 97% of the proceeds in United States Treasury bills, and using the remainder to hedge the account by trading futures contracts on Treasury bills. The ruling concluded that “[t]he risk to the funds of the defendants’ investors far exceeded the 3% discount which was supposedly to be committed to the futures markets” because of the possibility of a rapid decrease in the applicable market or of the pool being required to take delivery of costly Treasury bills pursuant to a future contract.
That does not provide much help for private equity funds and real estate private equity funds."

Wednesday, November 28, 2012

Guest Post: When and How to Revise Your Anti-Harassment Policy


Below is a guest post from Steven Burrell, an HR expert.  I believe some of our readers will find this information useful:   

If an employee files a harassment lawsuit, it can spell doom for a small business just starting out that doesn't have much money. And even for larger companies, it means taking time and resources away from other parts of the business in order to deal with the problem.

But what is workplace harassment, exactly? Contrary to popular belief, someone doesn't have to be specifically targeted or discriminated against to sue. Any actions, behavior, conduct, or statements made about or to a person or group that creates a work environment deemed "uncomfortable" can be considered harassment. Oftentimes when a claim of workplace harassment is put forward, it is done so in conjunction with one claiming a "hostile work environment."

With such a wide umbrella covering the things that could potentially be considered harassment, most businesses today include a policy about harassment in their handbook and outline what is considered unacceptable behavior in a broad and all-encompassing manner. Many even include training for new employees on the rules and put out educational material to help them better understand the policy and the repercussions.

But even if you have a policy, that doesn't mean that you can sit on your laurels. Here are several reasons you might want to revise your current policy.

The law has changed. Many companies model their policies after local and national laws on workplace harassment, but if you have had your policy in place for a long time, it's quite possible that updates to the law have made it obsolete. It is of vital importance that you always stay up-to-date on any alterations to the law, because one small omission could end up being the thing that takes a huge bite out of your company coffers.

You've had an incident. No company wants to have to deal with a situation where one of their employees feels uncomfortable at work, but sometimes it happens. If you are in the middle of dealing with an incident of harassment or recently went through one - whether or not it turned into a lawsuit - it's probably a good time to look at your existing policy and see if there is anything that you can clarify or strengthen. This way, you're not only protecting yourself, but your employees from having to go through a similar situation.

To go above and beyond. One of the best ways to avoid a lawsuit is to make sure that your policy on harassment not only meets the requirements of the law, but exceeds them. In fact, it can be quite valuable to even state in the text of the policy that the company holds its employees to a higher standard than the current laws, and that conduct and comments don't have to violate the law in order to violate company policies. This way, it can be easier for you to handle things in-house when an employee says they feel harassed without it escalating into a full-blown legal claim.

For example, some lawyers use the mere evidence that you disciplined an employee or had them go through counseling to prove that there was harassment that violates the law, but if your policies go beyond what the law requires, this can be difficult to prove.

If and when you do decide to make a change to your current harassment policy, don't just go into it blindly and start altering the wording. Consult with a lawyer who has expertise in this area. You need legal professionals crafting the language in the statement so that it's airtight - both for clever attorneys who try to come in and parse your words in order to help their client sue the company, and for employees looking for a way to argue that they didn't know their behavior was wrong.

About the Author:
Steven Burrell has been writing about business solutions and human resources for many years. Click here to read more about how employee assessment testing can benefit your business.

This blog is for general informational purposes and represents only the views of Steven Burrell, the author of the post.  It is not a legal advice.  

Monday, November 26, 2012

Duty of Loyalty of Corporate Directors


Directors of a corporation, whether it is a Delaware or a New York corporation or a corporation formed in another state, have certain duties towards their corporation and its stockholders. These duties are called fiduciary duties and they comprise of a duty of care and a duty of loyalty. Several courts also include the duty of good faith and fair dealing, while others treat it as a subset of the duty of loyalty.

Generally, so long as directors comply with their fiduciary duties, their decisions are protected by the business judgment rule, which assumes that directors have acted on an informed basis, in good faith and in the best interests of the corporation. When the business judgment rule applies, the courts will not second-guess the decisions made by directors and will not hold them personally liable even if the decision turned out to be the wrong one.

There are situations when the business judgment rule does not apply, and the courts analyze the Board decisions with greater scrutiny. Typically, this happens in cases of the company sale, or if the approval of a transaction was made by interested directors, or if the company adopted defensive tactics that were not proportionate to the threat posed to it.

Today, I want to focus on the duty of loyalty (remember, the business judgment rule will not protect a director who breaches the duty of loyalty). The duty of loyalty requires directors to act in good faith and in the best interests of the corporation, and put the corporation’s interests above their personal interests. This also means that directors must abstain from any conduct that would harm the corporation. The subset of duty of loyalty is the duty of good faith and fair dealing that requires that directors “act at all times with an honesty of purpose and in the best interest and welfare of the corporation.”

The duty of loyalty prohibits self-dealing and taking of corporate opportunities by directors unless the disinterested directors agree to it. Most often, the breach of duty of loyalty may occur when there is:
  • a conflict of interest (a director has an interest in the opportunity presented to the corporation); 
  • taking of a corporate opportunity (using the opportunity that should have been presented to the corporation); 
  • competing with the corporation (without disclosing it); 
  • misappropriating corporate assets (using corporate assets for non-business purposes); 
  • egregious conduct (acting in bad faith).  
Just recently, on October 1, 2012, the Delaware Court of Chancery held that a director violated his duty of loyalty to the corporation because through his actions he consciously harmed the corporation. (Shocking Technologies, Inc. v. Michael, et al., C.A. No. 7164-VCN (Del. Ch. Oct. 1, 2012)). In this case, Shocking Technologies, Inc. sued Simon Michael, its director, because Michael tried to dissuade the company’s only potential investor from investing in the company. Michael also shared confidential company information with that same investor. In particular, Michael used the company’s dire need for financing to coerce other directors into meeting the investor’s demands, while at the same time coaching the investor not to agree to invest unless it received better terms, including a board seat. Importantly, Michael disclosed to the potential investor that it was the only potential investor at that time, which negatively affected the company’s bargaining position. The Court held that Michael breached the duty of loyalty because he was not acting in the best interests of the corporation (which was to obtain short-term financing), and actually his disclosure of confidential information was to the company’s detriment. The full opinion is available here:

Directors of all companies, whether public or private, should regard the duty of loyalty very seriously. In Delaware, unlike the duty of care, liability for breaching the duty of loyalty cannot be contractually limited, and directors may not be indemnified for breaches of duty of loyalty involving bad faith. In the next blog posts, I would like to take a closer look at the duty of care as well as the question of when the corporation’s corporate veil (i.e., limited liability) can be pierced.

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.

Monday, October 15, 2012

Investing in Hedge Funds is a Risky Business

As of April 2012, the estimated size of the global hedge fund industry was $2.13 trillion. Investing in hedge funds is not open to everyone. Only accredited investors can do so. The threshold is often raised to allow only “qualified purchasers” to invest, - these individuals are not only accredited investors, but also have at least $5 million in investments in addition to the money they are investing in the hedge fund. However, even these wealthy individuals suffer from fraudulent activities that may, and do occasionally, occur inside the hedge funds.

Just recently, on October 3rd, the Securities and Exchange Commission charged two hedge fund managers and their firms with lying to investors about how they were handling investor money. In one case, the SEC alleged that the San Francisco-based fund manager and his firm stole more than half a million dollars from a retired schoolteacher who was investing her retirement savings. According to the SEC complaint, the fund manager told the teacher that the money would be invested in the stock market using the long / short equity investment strategy, but instead used it to pay unauthorized personal and business expenses, including home mortgage, office rent and staff salaries. In addition to the SEC action, the U.S. Attorney’s Office announced criminal charges against the fund manager.

In the other case, the SEC charged the Chicago-based fund managers and their firm with fraudulently taking out at least $147,000 in excessive fees and capital withdrawals from a hedge fund they managed. Investors in the fund were not aware that the manager removed various performance hurdles when calculating the management fees. Also, the managers made unauthorized capital withdrawals from the fund.

Since the beginning of 2010, the SEC has filed more than 100 cases against hedge fund managers for lying to the investors about investment strategy or performance, hiding conflict of interests, misusing investor funds and charging excessive fees. It seems that investing into hedge funds is risky not only because of the risk of investing money in the stock market or derivatives, but also because of the possibility that fund managers may defraud the fund investors.

To protect investors and help them evaluate the risks, the SEC issued an investor bulletin on October 3, 2012. In it, the SEC advises investors to really understand the funds’ investment strategy and the use of leverage, derivatives and other investment techniques. Also, investors should identify and evaluate the managers’ conflicts of interests and conduct independent research of the managers’ backgrounds. The bulletin is a helpful and practical summary of what the investors should look for when considering a hedge fund investment. Although it will not prevent the fraudulent activities that apparently go on in some of the funds, it will at least help keep some investors away making these risky investments.

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.

Friday, October 12, 2012

COPPA Enforcements are on the Rise

This blog post is “directed to” all website owners and operators whose websites may be “directed to” (the actual term used in COPPA) children under the age of 13 or who actually know that kids access their site.

COPPA is the Children’s Online Privacy Protection Act of 1998. Its purpose is to safeguard personally identifiable information of children under the age of 13. COPPA applies to operators of commercial websites or online services “directed to” children that collect, use, and/or disclose personal information from children, and to operators of commercial websites or online services that have actual knowledge that they collect, use, and/or disclose personal information from children. In particular, COPPA requires these operators to: (1) post a privacy policy on their website; (2) provide notice to parents about the site’s information collection practices and, with some exceptions, get verifiable parental consent before collecting personal information from children; (3) give parents the choice to consent to the collection and use of a child’s personal information; (4) not condition a child’s participation in an activity on the disclosure of more personal information than is reasonably necessary for the activity; and (5) maintain the confidentiality, security and integrity of the personal information collected from children.

COPPA is currently being amended. September 24, 2012 was the deadline to submit public comments to the FTC.

In the meantime, the FTC has promised to step up its enforcement of COPPA. Just recently, on October 2nd, 2012, the FTC settled with Artist Arena LLC, an operator of fan websites for Justin Bieber, Selena Gomez, Rihanna and Demi Loyato, for $1 million. The FTC charged the defendant with the violation of COPPA because it allegedly collected children’s personal information without their parents’ consent. The websites asked the users (often kids under the age of 13) to register on the websites, create online profiles, post messages and sign up for newsletters. According to COPPA, the websites should have notified the children’s parents, disclosed what information was being collected and for what purposes, and obtained verifiable parental consent before collecting any such information.

It is always best to learn from the mistakes of others rather than your own.  So, it is best for the websites that are likely to be visited by children to (i) have a privacy policy that discloses the information collection practices of the website and (ii) obtain verifiable parental consent before such websites collect any information from children under the age of 13.

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.

Friday, October 5, 2012

Don't Forget to Comply With Securities Laws When Raising Capital, Even if Just for a Film Project

On September 20, 2012, the California Department of Corporations filed a complaint in the Los Angeles Superior Court that alleged that a number of companies did not qualify the offer and sale of limited liability company interests, bridge loans, promissory notes and convertible debentures in at least 215 transactions worth more than $23 million. Further, the Department of Corporations claimed that the information that the investors were given contained numerous misstatements and omissions. The money raised was used for financing of entertainment projects, including motion pictures.

Although this law suit is taking place in California, the allegations lead to believe that there may be a number of federal securities law violations that are typically investigated by the Securities and Exchange Commission (SEC).

The federal Securities Act of 1933 (the “Securities Act”) requires all companies to register offerings of their securities with the SEC unless an offering complies with one of the exemptions. These exemptions from registration are typically found in Regulation D. Each state has its own securities laws (referred to as “blue sky” laws). So, when raising capital, companies need to comply with both the federal and the state securities laws.

First, let’s take a look at the definition of a “security” in the Securities Act. Apart from the obvious stocks, “security” includes many debt instruments and even certain contracts. Courts have determined, for example, that an investment contract can be a security, if a person invests his or her money in a common enterprise with an expectation of profit derived solely from the efforts of others. There is no requirement to issue formal certificates to such investors. According to this rule, membership interests in an LLC can be “securities” if the investors have passively invested their money in the LLC with an expectation of a financial return on their investment.

Similarly, a promissory note can also be a security. The question of whether a promissory note is a security turns on whether the note looks like a security and whether the selling of the note looks like a securities offering. Factors to consider include the number and sophistication of the investors/lenders, whether the note is collateralized, whether the investors/lenders are also owners of the business they are lending money to, etc. It is likely that if a company is raising money for its general operations, and the investors are investing with an expectation of return, the promissory note will be deemed to be a security. Same analysis applies to other forms of investments.

When a company is offering and selling its securities to the investors, it generally distributes a disclosure document in which it describes the offering terms, its own business, management, market, competition, financial condition, and other factors, including the risks, that can influence the investors’ decision-making. According to the federal Rule 10b-5 under the Securities Exchange Act, companies cannot intentionally include material misstatements and omissions in such disclosure documents, and they have to update all stale information to make the statements be true.

Although compliance with the federal and state securities laws may be onerous, but it is not optional. Timely compliance with the applicable securities laws and regulations is much cheaper than paying hefty fines imposed as a result of the securities law violations.

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.

Sunday, September 30, 2012

VC Investment Trends

According to an article in Crain’s NY, most of VC investments made during the second quarter of 2012 went to California companies. Out of $2.1 billion in total, only $30 million was invested in New York startups, whereas California companies received $1.45 billion. The total amount is an increase of 16% over a year ago.

$30 million in investments that went to New York was a decline of 87% as compared to the same period last year (out of that amount, one-third was invested in Adaptly). This decline can be explained by the fact that New York attracts early tech startups that do not typically receive big investments. As the attention of VCs shifts to more early stage companies, the amount of money received by New York companies will increase. Actually, the number of seed level deals in New York is on the rise: it increased by 14% over the previous quarter. Let’s hope that this trend continues and that New York-based companies will not be compelled to migrate to California just to attract VC capital.

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.

Saturday, September 29, 2012

Marketing Mobile Apps - the FTC Guidance

Recently, the Federal Trade Commission issued a report titled “Marketing Your Mobile App: Get It Right From the Start”. Importantly, the FTC explained that once developers start distributing their apps, they become advertisers, so the truth-in-advertising laws apply: anything that developers tell prospective users (on their website or in the app description page) must be truthful. There cannot be false or misleading claims or omissions of important information. If developers make an objective claim about the apps, they need to have “competent and reliable evidence” to back up their claims. For example, if an app claims to provide benefits related to health, safety or performance, there needs to be competent and reliable scientific evidence to support such claims.

The other principles include:
  • "Disclose Key Information Clearly and Conspicuously. –“If you need to disclose information to make what you say accurate, your disclosures have to be clear and conspicuous.”
  • Build Privacy Considerations in From the Start. – Incorporate privacy protections into your practices, limit the information you collect, securely store what you hold on to, and safely dispose of what you no longer need. “For any collection or sharing of information that’s not apparent, get users’ express agreement. That way your customers aren’t unwittingly disclosing information they didn’t mean to share.” 
  • Offer Choices that are Easy to Find and Easy to Use. – “Make it easy for people to find the tools you offer, design them so they’re simple to use, and follow through by honoring the choices users have made.” 
  • Honor Your Privacy Promises. – “Chances are you make assurances to users about the security standards you apply or what you do with their personal information. App developers – like all other marketers – have to live up to those promises.” 
  • Protect Kids’ Privacy. – “If your app is designed for children or if you know that you are collecting personal information from kids, you may have additional requirements under the Children’s Online Privacy Protection Act.” 
  • Collect Sensitive Information Only with Consent. – Even when you’re not dealing with kids’ information, it’s important to get users’ affirmative OK before you collect any sensitive data from them, like medical, financial, or precise geolocation information. 
  • Keep User Data Secure. – Statutes like the Graham-Leach-Bliley Act, the Fair Credit Reporting Act, and the Federal Trade Commission Act may require you to provide reasonable security for sensitive information. The FTC has free resources to help you develop a security plan appropriate for your business." 
A full copy of the Guidance is found here.

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.

Sunday, September 9, 2012

The SEC Issues Proposed Rules to Eliminate the Prohibition Against General Solicitation in Rule 506 Offerings


On August 29, 2012, the Securities and Exchange Commission (the SEC) issued proposed amendments to Rule 506 of Regulation D and Rule 144A to implement Section 201(a) of the JOBS Act.  The SEC is soliciting comments on the proposed rules.  The comment period ends on September 28th

In its release, the SEC acknowledged that it received numerous other suggestions on how to revise Rule 506, the definition of the accredited investor, and the Form D.  However, currently the SEC is only concerned with amendments required by the JOBS Act.  In particular, the SEC proposed new Rule 506(c), which would permit the use of general solicitation in Rule 506 offerings provided that (1) the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors and (2) all purchasers of securities must be accredited either because they satisfy the accredited investor definition or the issuer reasonably believes that they do, at the time of the sale of the securities. 

The new Rule’s main uncertainty comes from the requirement that the issuer must take “reasonable steps” to verify that the purchasers are accredited investors. 

Instead of a bright-line test, a specified list or a methodology that would provide issuers with greater certainty that they have satisfied the “reasonable steps” requirement, the SEC decided not to require issuers to follow uniform verification methods.  Instead, the SEC suggested a number of factors that issuers should take into consideration.  Whether the factors are “reasonable” becomes an objective determination based on particular facts and circumstances of each transaction.  Examples of the factors include: (1) nature of the purchaser; (2) information that the issuer has about the purchaser; and (3) nature and terms of the offering. 
With respect to the first factor (the nature of purchaser), the SEC noted that reasonable steps would be different depending on which of the eight categories of the accredited investor definition the investor satisfies.  Checking that the investor is a broker-dealer is easy (through the FINRA website), whereas checking that a natural person has over $1 million in assets may be much more difficult due to privacy concerns.  Perhaps, a way to go here is to ask for a letter from the investor’s accountant verifying the accredited status of the individual.

With respect to second factor (the information that the issuer has about the purchaser), the SEC provided examples such as Form W-2s, public company filings, and third-party information.  This factor puts a burden on the issuer to seek such information and it is unclear how much and what kind of information would be sufficient. 

Finally, with respect to third factor (the nature and terms of the offering), the SEC noted that a high minimum investment could be a relevant factor, as well as whether the issuer is soliciting investors through a generally accessible website or a social media platform as opposed to a re-screened accredited investors database maintained by a broker-dealer. 

In conclusion, the burden is on the issuer claiming the exemption that it is entitled to that exemption.  And due to the uncertainty as to the exact nature of reasonable steps the issuer must take to verify the accredited investor status of its investors, this burden may be heavy enough to deter some issuers from resorting to the new Rule 506(c) when conducting private placements. 

I look forward to reading the final rules.  

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, September 5, 2012

Important Update Regarding Section 83(b) Election

On June 25, 2012, the Internal Revenue Service issued a new Revenue Procedure 2012-29, which provides sample language that should be used to make a Section 83(b) election as well as examples of the income tax consequences of making a Section 83(b) election in various circumstances.

The new Revenue Procedure will be useful for startup founders and other restricted stock recipients who hold stock subject to vesting.  It is highly advisable to consult an accountant when making this election to ensure that it is done properly.  Remember that you only have 30 days from the moment of the stock grant to make the Section 83(b) election.  Missing the deadline can result in expensive and unintended tax consequences.

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.




Friday, August 17, 2012

The SEC is Delayed in its JOBS Act-Related Rulemaking


An important part of the JOBS Act that was adopted into law on April 8, 2012 is the revisions to Rule 506. Transactions pursuant to Rule 506 of the Regulation D are often referred to as the “Reg D private placements.” The Rule allows startups to issue unlimited amount of securities to an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors. Accredited investors’ definition includes individuals who have (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase (not including the value of the primary residence); or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year. Currently, one of the conditions of a Rule 506 offering is that there cannot be general solicitation or advertising. Compliance with the Rule is simple as long as the offering is made only to accredited investors. If, however, an offering involves investors who are not accredited, the company is required to provide more disclosure, which increases the offering's legal costs.

The JOBS Act lifted the ban on general solicitation and advertising in Rule 506 offerings so long as all investors are accredited, and asked the SEC to adopt rules relating to the verification of the investors’ accredited status. Changes to Rule 506 will not become effective until the SEC develops the rules. The SEC had 90 days from April 8th to accomplish this task. The 90-day period expired on July 7th but no rules came about.

Once effective, changes to Rule 506 will radically change the private placement process. Companies looking for funding will no longer be limited to contacting their wealthy friends, family members and people with whom they have a pre-existing relationship. Startups will be able to solicit and advertise openly, as long as all investors who end up investing in the company are accredited. Hopefully, the SEC is not delayed much longer in its rule-making that would enable more companies to raise the much-needed capital.

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.

Tuesday, August 14, 2012

Unlimited Vacation Time: Is it Here to Stay?

In an effort to retain the best talent, a new human resources policy has emerged among technology companies: unlimited vacation time. Companies like Evernote, Best Buy, the Motley Fool, Netflix, Zynga, Gilt Groupe, Chegg, TIBCO Software, Bluewolf, NerdWallet, WeddingWire, among others, have adopted this policy. Evernote even takes a step further and pays $1,000 to those employees who actually take a vacation during their time-off and produce an airline ticket as evidence. Companies are correct in believing that a well-rested employee is a happier and a more productive one. The latest theory behind the unlimited vacation policy is the Results-Only Work Environment (ROWE), where employees are judged based on their performance and not based on the number of hours they spend in the office. However, only 1% of the U.S. companies have formally adopted the ROWE, according to a research report of the Society forHuman Resource Management. So far, little or no complaints have been voiced by the companies with unlimited vacation plans regarding the abuse of vacation time by the employees. In fact, employees at these companies tend to take less rather than more vacation time.

So, why do these companies choose to adopt the ROWE? Mainly, to retain top talent, as the lack of experts (especially in the technology sector) becomes apparent. Currently, the unemployment rate for those in the technology field (4.4% in the Q1 of 2012) is about one half of that of the general population (8.3%). In 2011, McKinsey & Co. published areport on the big data market, where it predicted that “The United States alone faces a shortage of 140,000 to 190,000 people with analytical expertise and 1.5 million managers and analysts with the skills to understand and make decisions based on the analysis of big data.” According to an April survey from GigaOm, 45% of business intelligence projects fail due to a lack of data expertise on staff.

The technology sector is rapidly expanding and this expansion dictates new rules. Human resource specialists and management should stay informed of the trends and be willing to adopt quickly in order for the companies to stay competitive and be able to retain the best qualified personnel. In a world where personal time is ever more precious, unlimited vacation may be just the right incentive for top engineers, data scientists and other technology specialists to switch over to the companies that have adopted the ROWE.

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, July 11, 2012

Guest Post from Arizona: How to Avoid Personal Liability for Business Debts

I am re-posting here a blog from an Arizona-based law firm
Gunderson, Denton, and Peterson PC (http://www.gundersondenton.com). Even though the blog is written from the perspective of Arizona law, it is still good insight for the readers in other states.  The blog post can be found here: http://gundersondenton.com/business/business-owners-avoid-personal-liability-attempt-pierce-corporate-veil/.


How Business Owners can avoid Personal Liability if others attempt to Pierce the Corporate Veil

Generally, owners of corporations and limited liability companies are not personally liable for business liabilities. However, under some situations, courts allow creditors to “pierce the corporate veil,” to access a corporation or LLC owner’s personal assets. It is vital for business owners to know how, when, and why their personal assets may be vulnerable to their business liabilities. The major considerations the court looks to are whether the company is undercapitalized and if the owner is using the company as an alter ego.

Undercapitalization & Alter Ego
Arizona requires corporations to be adequately capitalized at the time of formation and through the life of the corporation. No exact amount is required, but the purpose is to protect creditors and others with whom the company has liabilities. “Alter Ego” refers to when the owner treats the company as a sole proprietorship, a partnership, or a personal asset rather than as a separate business entity. Accordingly, it is important to take the following steps to avoid piercing of the corporate veil:
* Maintain adequate business capitalization from the inception of the company forward.
* Engage in the necessary formalities required for the business entity.
* Avoid commingling business and personal assets and activity.
* Make the corporation or LLC status known to your clients.
* Document all business actions.
1. Ensure adequate capitalization from the inception of the company forward.
All corporations, at the time of formation and throughout the life of the corporation, must be properly capitalized to respond to claims and liabilities arising out of the corporation. No exact amount is required. However, the general test of capitalization is at inception. Therefore, the most important time to have your company capitalized is at its inception. Business owners should then continue to keep the company adequately capitalized throughout the company life relative to current and foreseeable liabilities. Doing so will protect others from piercing the corporate veil to access owners’ personal assets.

2. Engage in necessary formalities.

Corporations have formalities that they must follow. Although LLC law is not as stringent, it is also smart for owners of an LLC to follow such formalities. The court views a company that lacks the necessary formalities as a possible indication the owner is using the company as an alter ego. If the court believes that the owner may be using the company as a sole proprietorship, partnership, then the court may treat the company like a sole proprietorship or a partnership, by allowing the corporate veil to be pierced making the owners personally liable. Owners should ensure their company takes part in the following formalities to avoid personal liability:

Corporations:

* Create, maintain, and update bylaws.
* Issue shares of stock to stock owners.
* Maintain a stock transfer ledger.
* Hold initial and annual meetings with directors and shareholders.
* Keep annual filings, fees, and taxes current with the state of incorporation.

LLCs:

* Issue membership certificates to owners.
* Keep a membership transfer ledger.
* Hold initial and annual meetings of the members and managers.
* Keep annual filings, fees, and taxes current with the state of incorporation.

3. Avoid commingling business and personal assets and activity.

Owners should set up a business savings account, business checking account, and business credit cards. They should pay for business expenses with business accounts and personal expenses with personal accounts. Owners should keep their personal assets in their name and the business assets in the name of the business. This will protect business owners against any allegations that they are using the business as an alter ego.

4. Make the corporation or LLC status known to your clients.

Business owners should make the status of the corporation or LLC known to their clients. Business cards and other labels should name the company as a corporation or an LLC. All contracts and documents should be assigned to the business and not the individual owner. Invoices should have the company’s name rather than the owner’s. This will protect against alter ego allegations claiming creditors and clients were unaware the company was a corporation or LLC.

5. Document all business actions.

Business owners should document everything. They should document when they engage in formalities, any evidence that shows they maintained separate accounts for personal and business activities, and any documents showing they maintain adequate business capital. These documents will be the evidence needed to protect the business owner’s personal assets if a creditor attempts to pierce the corporate veil.
Business owners should treat their company as a separate entity, should engage in all the necessary formalities required under corporation law, and should document everything. It is always best to seek out attorneys at the inception of the company and throughout as needed. The Arizona business attorneys at Gunderson, Denton, and Peterson PC assist clients with these and many other business legal needs.

Sunday, July 8, 2012

Selection of the Right Legal Entity for Your Business: LLC vs S Corp (a New York Perspective)

One of the most common questions I get asked by my clients is whether the new business should be formed as an LLC or an S corp. I address this question below.

If I were to summarize this blog in one sentence, then it would be this: the choice of entity is not just a legal question, also involves an analysis of accounting and tax considerations that vary according to the founders’ particular situation. So, in addition to a consultation with an attorney, it is important to schedule a consultation with your accountant. Skipping this step may result in unintended tax consequences and also in legal fees if the owners need to restructure their business entity later on.

Below is a quick summary of legal considerations pertaining to S corporations and LLCs in New York.

S corporation

Corporate structure:

  • Separate Legal Entity:  An S corporation is a separate entity with a legal personality, which means that it can sue and be sued, and it can own property.
  • Corporate Formalities:  It is important for an S corporation to maintain corporate formalities: open separate bank accounts, conduct period meetings of the board of directors, document decisions in a minute book, etc.
  • Management:  An S corporation has centralized management, vested in a board of directors elected by the shareholders. The board oversees the strategic decisions of the corporation and appoints officers who deal with the daily operations of the company. Directors, officers and majority shareholders own fiduciary duties to the shareholders of the corporation.
  • Limited Liability:  Shareholders, directors and officers typically have limited liability for debts and obligations of the corporation, as long as the “corporate veil” is not pierced (this can happen if, for example, corporate formalities are not preserved or there is commingling of funds or fraud).
  • Shareholders Agreement:  It is advisable, but not required, that shareholders enter into a shareholders agreement that outlines internal governance rules of the corporation, such as when shareholders can be admitted to the corporation or resign from it).
  • Buy-Sell:  It is also recommended that shareholders enter into buy-sell agreements.

Special considerations:

  • An S corporation is a regular business corporation that has elected special tax treatment on the federal and state level (New York City does not recognize “S” corporation status).
  • Only US citizens or residents can be shareholders of an S corporation.
  • An S corporation can have only up to 100 shareholders, and all shareholders must be individuals (another corporation or an LLC cannot be shareholders of an S corporation).
  • All shares must have the same economic rights to profits, distributions and liquidation of assets. This means that even though an S corporation can have voting and non-voting shares, it is not possible for an S corporation to issue preferred stock, since it would have different rights to distributions and a different liquidation preference than common stock.

Tax Considerations:

  • An S corporation has “pass-through” tax treatment at the federal and state level.
  • Shareholders of an S corporation who work for the business are considered to be employees and have to pay themselves a reasonable salary (it may result in tax savings as compared to self-employment tax for LLCs but has increased maintenance costs related to payroll).

Limited Liability Companies

Corporate Structure:

  • Separate Legal Entity:  Just like an S corporation, an LLC is a separate legal entity; it can sue and be sued and it can own property.
  • Corporate Formalities:  Unlike an S corporation, an LLC has to maintain only minimum corporate formalities, although it should still have a separate bank account to avoid commingling of business and personal funds of the owners.
  • Management:  In terms of management, LLC is very flexible: it can be member- or manager-managed; it can be run like a corporation, a general partnership or a limited partnership. If the owners so desire, it can have a board of directors, and can refer to its membership interests as “shares”.
  • Limited Liability:  There is limited liability protection for the members and managers of an LLC, absent commingling of funds, fraud or, in cases of single-member LLCs, if the LLC is just an alter-ego of its owner.
  • Members:  LLC can have from one to unlimited number of members, including non-US citizens or entities
  • Operating Agreement:  In New York, all LLCs must enter into an operating agreement within 90 days of formation.
  • Special Allocations:  LLCs allow special allocations of profits and losses among members: members can agree to share profits and losses in proportions different from their membership interests. For example, members can agree that 100% of the profits of an LLC be distributed to one member for the first three years, despite the fact that that member owns only 50% of the LLC and normally should have received only 50% of the profits and losses.

Special Considerations:

  • Publication Requirement:  Within 120 days of formation, all LLCs organized in the State of New York must publish a notice of formation in two newspapers selected by county clerk of the county where the LLC was formed. This can be expensive: publication costs in New York county (Manhattan) are around $1,300.
  • Consequences of not publishing on time:
    • LLC will lose authority to do business in NY
    • It cannot sue anyone in New York courts, but can defend itself
    • Members may lose limited liability protection.
    • There is no penalty or fine for complying with this requirement late.
    • Contracts of an LLC that has not complied with the publication requirement are still enforceable.

Tax Consequences:

  • LLC enjoys a “check-the-box” taxation: it can elect to be taxed as a disregarded entity, a partnership or a corporation.
  • If no election is made, a one-member LLC will be treated as a disregarded entity at the federal level; and a multi-member LLC will be treated as a partnership. In such cases, the LLC itself does not pay taxes, but files an informational return.
  • Members who are actively involved in the business of the LLC pay a 15.3% self-employment tax on 92.35% of net earnings up to $106,800 and everything above is taxed at 2.9%.
  • LLCs are subject to New York City’s 4% UBT.
Business founders should work together with the attorneys and accountants to determine the best legal entity structure for their business. This will depend on a number of factors, including, but not limited to: the immigration status of the founders, plans to seek outside capital from professional investors, start-up costs, tax consequences, and the desirability of special allocations of profits and losses.

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.

Thursday, June 14, 2012

Why Should Your Company Not Go Public?

I keep thinking about what happened during the Facebook IPO, - the so much anticipated, talked about IPO. For those who have not heard, - here is a great timeline of the events related to the Facebook IPO: http://www.fastcompany.com/1838630/facebook-ipo-most-important-news-stories. The Facebook shares priced at $38 per share, opened at $42, and are now trading at $27.61 (as of the morning of June 14th). The SEC, FINRA, the Commonwealth of Massachusetts, and two congressional panels all announced their intention to review and investigate the IPO and the surrounding activities. Shareholder class action lawsuits are likely to follow soon.

Looking at the Facebook example, I ask this question: is it worth for a company to become public? One obvious major advantage is the ability to raise capital from the public in a relatively short time frame. Public companies may file the so called “shelf registration statement” with the SEC that would enable them to “do take downs off the shelf” (i.e., issue securities pursuant to that registration statement) relatively quickly. There is no need to write extensive disclosures since information about the company is already available to the market through the shelf registration statement and the public periodic reporting documents filed by the company. By being public, a company can now tap into both the public and the private financial markets. Additionally, becoming a public company brings visibility and prestige to the company.

But on the other hand, the cost associated with becoming and being a public company is exorbitant. Typical IPO fees (listing fees and fees paid to advisers) can easily exceed $1 million. Once public, the company becomes subject to reporting obligations under the Securities and Exchange Act of 1934, which means that it has to prepare and file annual, quarterly and current reports with the SEC. Periodic reporting has become an expansive undertaking for many companies that are struggling with high legal and accounting costs associated with being “public”: preparation of reports, attestation requirements, internal controls over financial reporting, etc.

I identify the following two main drivers of IPOs before the JOBS Act. First, the company investors (founders, angels, VCs, private equity funds) needed an exit. Second, the company had more than 500 shareholders, the previous threshold for reporting obligations.

Now, the second reason has been relaxed. As of April 5th, 2012, the 500 shareholder threshold has been raised to 2,000 persons in total or 500 persons who do not qualify as accredited investors (and not counting employees or those shareholders who purchased securities in a crowdfunding transaction).

As to the first reason, as suggested by David Feldman in his blog post, companies should consider avoiding the whole IPO process through alternative strategies (reverse mergers, SPACs, etc.). You can find his blog post here: http://www.reversemergerblog.com/2012/05/23/facebook-ipo-no-perfect-way-to-go-public/
So, it seems that the companies can wait a little longer before becoming public or become public companies by avoiding the IPO process.

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.

Tuesday, May 29, 2012

Raising Capital Outside of the United States


Much has been said and written about how start-up founders can raise initial capital to launch and grow their businesses by getting funds from their friends and family, angel investors or VCs.  I would like to bring to your attention an additional source of capital: foreign investors and U.S. citizens or residents located outside of the Unites States. 

Issuing equity or debt to foreign investors or U.S. citizens or residents located outside of the United States is a securities offering, just like issuing convertible notes or Series A preferred stock to domestic investors.  However, registration requirements of the Securities Act will not apply to such offering so long as it is conducted outside the United States.  Regulation S, which comprises five rules, reflects the territorial approach of the Securities and Exchange Commission: only the offers and sales of securities inside the United States are subject to the registration requirements of the Securities Act.   

Typically, the Securities and Exchange Commission decides on a case-by-case basis whether an offer and sale is made inside or outside of the United States.  Regulation S provides certain conditions, which, if met, help determine when the offer or sale is made outside of the United States.  There are two general rules.  First, the offer or sale has to occur in an “offshore transaction” (i.e., a transaction where offers or sales are made only to persons located outside of the United States at the time of purchase and either the buyer is outside the United States or the seller reasonably believes that the buyer is outside of the United States at the time the buy order is originated).  This means, generally speaking, that a U.S. citizen can purchase a security of a U.S. company in a Regulation S offering as long as that person is located outside of the United States at the time of the purchase.  Second, no “direct selling efforts” are made in the United States in connection with the distribution or resale of the securities (i.e., no activities that may condition the U.S. market, such as advertising to the U.S. investors).       

In addition to these two general requirements, there are certain other conditions (certifications, legends and reselling restrictions) found in Rule 903 that founders of a U.S.-based startup conducting a Regulation S offering should comply with.  Although securities sold pursuant to Regulation S are freely tradeable as long as sold offshore to someone who is not a citizen or permanent resident of the United States, buyers have to hold these securities for at least 40 days for debt offerings and one year for equity offerings before they can resell to U.S. persons. 

In conclusion, conducting a Regulation S offering is not onerous for a small company.  There is no prohibition on general solicitation or advertising so long as such activities are not directed into the United States.  There is no limit as to the number or nature of investors.  Regulation S does not require any specific disclosure information or financial statements (but there are requirements as to stock legends, buyer certifications, notices and other documentation).  However, start-up founders need to be careful: Regulation S will not apply to any scheme or plan to avoid registration under the Securities Act.   

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.