Legal Ch2 – leaving your employer

• Classification of employees changes employee’s rights and duties

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

4 - Deciding whether to Incorporate

Goals -
• reduce liability exposure
• Minimize taxes
• Ensure business capable of being financed
• Conducted efficiently

Forms of Business Entity - see 4.1, p 67

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

• Limited liability company

• Sole proprietership

Chapter 5
Incorporation - much is boiler plate but should understand critical terms
• Where to incorporate
o Generally state where activities take place or DE
 o DE favorable corporate law, only 1 director, file quickly amendments,
specialized, experienced court
o If not primary place of business - then maybe higher taxes
o California specific restrictions - may only buy back shares or pay
dividends to extent that meets certain RE tests, cumulative voting
rights, elect board yearly, right of common shareholders to vote as
separate class in the event of a proposed merger
• Certificate of incorporation - - file with secretary of state with filing fee
o Name of corporation
o Purpose
o Authorized capital of corporation
o Name and address of agent resident in the state for legal purposes
o Provisions for indemnification
o Person signing is incorporator
• Bylaws - operating rules
• Mechanics of Incorporation -
o Action by incorporator -
• Splitting the Pie - chart by Shannon

6 - Forming and Working with the Board

Reasons to have board
o Legal ones
o Variety of skills
o Keep eye on big picture
o Add perspective
o Internal sparring partner
o Long term planning
Size of board - small enough to be accountable and act as deliberate
body, large enough to carry out necessary responsibilities (5-9)
,; outsiders should outnumber insiders

Frequency and Duration of Meetings - options include - monthly, only to

discuss important matters, quarterly; between 3-5 hours
Type of representation Desired -
o Combination of functional skills to keep business running bring next
level of growth, and mix of personalities
o Needed Skills - assess own weaknesses and add complementary
skills
• Age gender cultural background
• Outsiders and insiders
o Personality mix and board structure -
• Able to function as group, respect
• Practical experiences and business savvy
Responsibilities -
o Duty of loyalty and good faith - best interests of company
• Includes executive compensation issues - is in best interest of
company
 • Remain arms length -
o Duty of care and oversight -
o Limitations on liability and indemnification -

Business Judgment Rule - requires the plaintiff prove the directors were
grossly negligent or acted in bad faith before liability will attach

Compensation of Board Members - tangible and intangible

o Intangible - ideas, learning, personal fulfillment
o Tangible - pay for meeting attendance, , equity, salary

Types of information that directors need

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

Make Effective use of board - strategic planning - big picture questions….

7 - Raising Money and Securities Regulation

Sources of Funds -
• Friends and Family
o Relatively cheap and quick source of seed capital
o Preferred when management wants to maintain control and manage
without investor input
o Do not have expertise or other strategic value
o Unable to invest significant amounts (temporary)
o Risk of harming relationships
• Angel Investors - private sales of debt or equity securities
o Relatively quick
o Preferred when mgmt wants to maintain control
o More money than friends
o Generally require no more than right to veto, although may organize
into board of angel investors… and want more power
o Generally preferred stock
o Also do not bring much expertise or talent
• Venture Capital - money from professional investors for investment in new
or developing business
o Resources to provide multiple rounds
 o Can assist in forming business plans, etc
o Most insist on sharing control of company (seats on board, veto
power, management positions, info, registration rights,)
o Negotiate more heavily on prices, etc
o Exit vehicle - way to get money back without liquidating the
company
• Placement agents - distributes a document describing company and the
offering to suitable persons and assists in sale of private securities
o Commissions 7 -15%
o Do your homework - check references, how make contacts with
potential investors
o Tail provision - gives placement agent right to be paid for a financing
occurring after services complete within a certain timeframe
• Self-financing ad credit - generate capital by carefully managing
company's internal funds (bootstrapping)
o Favorable credit terms, obtain payment on goods before paying out
o No loss of control
o Generally not sufficient funds
• Strategic alliances/Joint Ventures (collaborative agreement with an
established company that has complementary needs or objectives
o Minority investment, separate joint venture, fund research, useful
when one company has technology other may want
o Less costly financing that venture capital
o Benefit from technical/business expertise
o Requires cooperation and agreement
o Each party liable for other's wrongdoing
o Antitrust and conflict of interest concerns

Pitching to investors
• Business plan - include all material info and risks
o Describe the company - detailed, history and goals
o Describe the product and market - stage of dev, patent prospects,
obstacles
o Describe the strengths and weaknesses of the management team
o Identify the risks
o Describe the competition
o Avoid unsupported statements
o Prepare a back up file
o Further requirements - describe securities being offered and intended
use
• Private placement memorandum - offering document that meets
requirements of federal and state securities laws
o Discloses benefits and risks of investment
o Not often required except by placement agencies
o But useful for avoiding swearing contest later in court
• Issues related to investment securities
o Most investors want preferred stock, sometimes want warrants
(options to purchase stock), or right of first refusal
 o Most require extensive representations and warranties and many
conditional on certain corporate changes
o Investors have greater bargaining power than entrepreneurs
o Identify acceptable level of dilution of stock (entrepreneur should)
o Term sheet - spells out terms of agreement; allows the parties to
agree before lawyers proceed

Equity Finanacing -
• Classes of stock -
o Common stock - if all stock has same rights - its common stock(#
votes/share; rights to vote, dividends
o Preferred stock- additional rights with the stock
o Convertible preferred stock - preferred stock that may be converted
into common stock at a specified exchange ratio
o Warrant - right for a given period of time to purchase a stated
amount of stock at a stated price (generally fair market value); like
option but sold to investors; sometimes called 'equity sweetener'
o Employee compensation plans - generally stock option plan

• Rights of Holders of preferred stock

o Liquidation preference - any assets remaining after payment of all
debts are distributed first to preferred stock holders
• Participating preferred stock - entitles holder to receive their
share of liquidating preferences plus any accrued dividends then
to share remaining sale proceeds pro rata with common
shareholders
o Dividend preference -
• Sometimes cumulative - amounts not paid one year and paid in
addition to next year's
o Redemption rights - redemption - corporation buys back shares from
stockholder
• Investor redemption rights - (put rights) - permit the investor to
require the corporation to redeem his/her shares for cash at a
specified price (provided corporation is not prohibited by law
from doing so)
• Company redemption rights - permit the corporation at its
option to redeem shares for a specified price either after a given
period of time or upon occurrence of certain events; may have
the effect of forcing investor to convert shares to common stock
to avoid redemption; therefore a company can eliminate
liquidation and dividend preferences on preferred stock
o Conversion rights - preferred stockholders can convert preferred
stock into common stock at any given time, generally automatically
converts with IPO, can also be forced by vote of majority
• Pay to play provisions - cause an investor's preferred stock to
convert to common or to a new series (price based antidilution
protection)
• Antidilution provisions - adjust conversion prices at which
convertible preferred stock can be converted to common stock
in the event of certain company actions
 • Structural antidilution provisions - company undergoes
structural change (stock splits/dividends)
• Percentage dilution - protection assures preferred holder that
can convert to common at same percentage of total as before
dilution
• Price based antidilution provision - triggered if corporate issues
additional common or preferred shares at price less than
conversion price (per share price paid by investor)
 Full ratchet method - conversion price is adjusted
downward to the issuance price of dilutive financing
 Weighted average method - reduces conversion price in
proportion to the amount of dilution
o Voting rights - equal to those of common stockholders and vote as
separate class on major events (amending charter), elect certain
members to the board without common shareholders input
o Charter amendment - rights must be set forth in detail in certificate
of incorporation; or if not then in certificate of determination

• Stock Purchase Agreement and related agreements

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

Federal Securities Registration and Exemptions

• Securities act of 1933 - designed to give investors proper info, must
register with SEC, provide prospectus
 o b/c IPO expensive sale of securities by entrepreneur designed to be
exempt from regulations
o Pooling investors money or buying collectively managed assets =
sale of securities under SEC regulation - point = be careful
o May be exempt if private offering, limited offering, offering to
qualified investors or offering in single state
o Failure to comply and investors can rescind and get money back
o State securities laws - blue sky laws
• Exemptions -
o Private offerings - securities are offered only to limited number of
selected qualified investors who can understand and bear risk of
investment; must prove that all those offered to had ability to bear
risk via extensive questionnaire
o Regulation d Safe harbor exemptions for offerings to public of up to
$1M and private placements -
• Accredited investors - national bank; private business
development company; corporation, etc not formed for purpose
of acquiring the offered securities with total assets not >$5m;
director or general partner of issuer, natural person w income
>200,000 for last 2 years or joint of >300,000 with reasonable
expectation of reaching same level in current year; person
whose net worth >$1M; trust with assets >$5M not formed with
purpose of acquiring securities offered; or entity in which all
equity owners are accredited investors
• Integration offerings - in calculating 12month amount of capital
raised and # accredited investors, SEC may combine sales
within limited period of time - most likely occurs when offerings
are part of single plan of financing, made about same time,
involve same consideration or type of securities and are made
for same purpose
 Rule 502 - provides an integration safe harbor for
regulation D offerings of 6months before or after sale
 Rule 701 - offerings to employees and others not integrated
• Rules 504 - exempts offerings of up to $1M within 12 month
period, no limit on number of purchasers and general solicitation
is permitted (used for friends, family, angels)
 Not available to blank check companies - those that have
no specific business except to locate and acquire other
ones
 No prescribed info disclosure requirement
 Must file form D within 15 days of first sale
 Careful to avoid integration problems
• Rule 505 - exempts up to $5M and limits # unaccredited to 35,
general solicitations and advertising not permitted (no cold
calling must have substantial prior relationship)
• Rule 506 - exempts offerings of any amount to not more than 35
unaccredited investors provided that investor is 'sophisticated',
requires certain info to purchaser
o Interstate offerings - exempts securities offered and sold if everyone
lives in same state - doing business and living in
 o Regulation A - a privately held company may offer and sell up to $5M
in 12 months, $1.5M of which may be sold by selling security
holders; must file disclosure document; a testing the waters provision
permits issuers to solicit indications of interest before filing disclosure
docs - no sales may be made during this period, once regulation A
offering statement is made all testing the waters must cease, not
exempted from blue sky laws
o Rule 701 - offerings to employees, consultants and advisors - are
exempt pursuant to written compensatory benefit plan or written
contract relating to compensation of such peoples, less than $1M and
15% of total assets of issuer and outstanding securities of the class
being offered and sold; must provide with copy of plan but no other
disclosure doc is required
• Blue Sky laws - state securities laws must comply where business is
headquartered and where offerees live
o If posted on web then deemed made in all 50 states - exempt if
specifically says not in this state or no sales are made to residents of
certain state
o Uniform securities act emphasizes disclosure as means to protect
investors, some states authorize securities administrator to deny sale
if find business plan and issuance unfair, commissioner can also deny
- called merit review

8 - Contracts and Leases -

Contract - legally enforceable promise or set of promises
Choice of law - written contract include choice of law provision which
specifies state's law to govern the contract; in the absence of such - will
use where strongest contract law is
• Elements of Contract - written, oral, implied, statue of frauds requires
some to be in writing
o Implied contract - not explicitly articulated and held to exist based on
certain circumstances or on conduct of parties
o Requirements of contract -
• Agreement between parties formed by an offer and acceptance
- must be meeting of the minds,
 To keep offer open for extended period = option contract
 Counter offer - offers new terms; extinguishes original offer
• Must be supported by something of value (consideration)
• Both parties have capacity to enter (not minor or mentally
incompetent)
 Authority (necessary)
• Contract must have legal purpose
o Offer - statement by person indicating a willingness to enter into a
bargain on terms stated
o Acceptance - offeree indicates willingness to accept
 o Consideration - anything of value exchanged
o Illusory promises - do not result in contract - occurs when one party
fails to provide anything of value
o Requirements contract - buyer's agreement to purchase all of
specified commodity it needs from particular seller
o Output contract - seller's agreement to sell all of its output to
particular buyer
o Unilateral contract - promise exchanged for performance of certain
act
• Oral Agreements and Statute of Frauds -
o Statute of Frauds - must be in writing to be enforceable
• Cannot be performed in one year
• Involve transfer of real property (land, leases and those options)
• Someone who agrees to assume another's debt
• Prenups
• Contracts for sale of goods >$500
o Advantages of putting in writing -
• Oral agreements difficult to enforce
• Prevents misunderstandings, more reliable
• Integration or merger clause - statement in contract that states
that it supersedes all previous discussions, etc designed to
finalize all disagreements
• Nonreliance clause - both parties confirm that they have not
relied on any promises made during negotiations other than
written ones
• Preparing Written Contracts
o Drafting language - clear specific language, balance time and
expense, very literal, set forth all aspects of relationship
o Form
• Customized long form agreements - purchase and sale of assets
require very intense contract
• Letter of agreement - format to organize simple agreement, list
all important info and get acceptance
• Standard form contracts - (many forms including leases or
promissory notes); enhances understanding between parties,
many terms still remain negotiable, people have duty to read
contract
• Attachments - additional terms are too extensive to note in
margin, drafter should name attachment in main document
• Addenda - provide ways to modify the agreement
• Electronic contracts
o Uniform electronic transactions act -
• A record or signature may not be denied enforceability solely b/c
electronic
• Contract may not be denied solely b/c electronic
• Electronic record satisfies law that requires to be in writing
• Electronic signature satisfies law that requires a signature
o e-sign act - reiterates uniform electronic transactions act, governs
only interstate and foreign commerce, preempts all state laws
 inconsistent with it
o Exclusions - must be voluntary (if not have computer not required
to),
• UETA - Wills, codicils, trusts; family law contracts, certain
provisions of uniform commercial code,
• E-sign also excludes: court documents, cancellation of utility
services or health/life insurance; notices of recall or regarding
credit agreements, docs concerning hazardous materials
trasportation
• General terms to consider -
o Identification - names and addresses of parties
o Signatures
o Intent to enter into - statement summarizing parties intent to enter
into contract
• Date -
o Terms of agreement -
• Representation/warranties
• Conditions
• Logistical considerations
• Payment terms
• Notice and opportunity to cure -
• Timing issues
o Duration and notice of termination - contracts lacking specific
duration may be construed later as terminable at -will by either
party, at will contract should be written so neither party has absolute
right of termination
o When performance must be completed - state special deadlines
explicitly
o Renewability of the contract - may be automatically renewable,
unless one party gives intent not to renew, or may be dependant on
• Allocating risk - what events would relieve one or more parties
of obligations under contract (natural disasters, unanticipated
government actions
 Commercial impracticability - belief that event was
unforeseen and unforeseeable and that party asserting
impracticability must not have expressly or implicitly
assumed the risk of occurrence
• Arbitration and mediation - avoid costs and time of court, maybe
put clause in contract to go to mediation/arbitration first
• Choice of law and forum - contract should specify whether
disputes are to be adjudicated and which jurisdiction's laws
should be used
• Attorney's fees - if contract not specify then each pay for own
• Checklist for contract analysis
o Is void b/c illegal or violates public policy?
o Is entered into freely? - unlawful explicit or veiled threats make
unenforceable
o Is unconscionable - onerous terms, lack of bargaining power
 o Has performance become impossible or commercially impracticable -
if so nonperformance excused unless event making it so was
foreseeable
o Is clearly worded and structured to prevent ambiguity? If so may be
voided if both interpretations are reasonable and both parties knew
both or neither interpretation when contracted
o Was there a mistake of fact that renders contract voidable? Parties
make mistake about facts - has material effect on one or both
parties, either party allocated the risks of mistake to self, whether
mistake of fact made promptly
o Did a party make mistake of judgment? - erroneous assessment
about value of come aspect - not grounds for undoing contract
o Was there a breach by one party that resulted in damages to other
party?
o Did the party claiming injury mitigate its damages?
• Effect of bankruptcy -
o Automatic stay - creditors are barred from taking any legal action to
enforce contract or collect money; neither foreclose nor stop
performing obligations without court's permission (bankruptcy clause
is not enforceable)
o Debtor may also choose which contracts to maintain and which to
reject
• Remedies -
o Monetary damages -
• Expectation damages - compensate for amount it lost as result
of breach of contract
• Reliance damages - compensates for expenditures made in
reliance on a contract
• Restitution - puts both parties back in same position as before
contract
• Mitigation - nonbreaching party required to attempt to mitigate
circumstances
• Consequential damages - damages plaintiff entitled to as
compensation for additional foreseeable losses
• liquidated damages - agreed on ahead of time, specifies a set
figure that the breaching party will pay the injured party in
event of breach, must be reasonable -
o Nonmonetary remedies -
• Specific performance - order defendant to do what promised
 Used if item is unique, contract involved real property or
difficult to calculate monetary damages
• Injunctions - court orders to do something or refrain from doing
something
• Rescission - when enforcing contract is unfair, court may rescind
contract and order restitution
• Promissory Estoppel - gives limited relief to person who has reasonably
relied, to his detriment, on promises of another
 o Most likely when made in course of negotiations which break down
before meeting of minds, not supported by consideration or not
evidenced by a writing required by statute of frauds
o May recover only if -
• Must be a promise
• Reliance on promise genuine and justifiable
• Actions taken in reliance must be reasonably foreseeable to
person making promise
• Grave injustice must result if no relief given
• Quantum Meruit - can be used to recover the value of products or services
provided the absence of a contract in a situation in which the
products/services were clearly needed but party receiving benefit could
not agree to purchase them (for example, unconscious patient)
• Leases - contract between landlord and tenant; must include rental
charge and restrictions on subleasing space
• Contracts for purchase of real property - consult property lawyer - highly
technical; be wary of rules for cleanup of hazardous waste
• Loan agreements - watch out for these parts: and what happens to
collateral if default
o Logistical details of receiving loan - how receive and in installments?
o Conditions precedent - conditions must be met by borrower?
o Covenants - promises made by buyer to lender which if breached
result in default and termination
o Repayment terms

9 - Ecommerce and Sales of Goods/Services

• Sales of Goods Under Article 2 of the UCC
o Goods - all things which are movable at the time of identification (by
marking or setting aside) to the contract for sale
o When sale involves goods and services, it may not be governable
under UCC
o Contract formation - requires offer, acceptance and consideration -
but more liberal than contract (most times terms are not explicitly
stated but filled in based on situation
• Supply contract - details who the parties are and general terms
of relationship, if something new or innovative, entrepreneur
should ensure that right of exclusivity is protected
• Approval clause - specifies not valid contract unless and until
approved by home office (waiting on credit approval)
• Allows for entering into contracts without payment of
consideration
• Merchant - has knowledge or skill in selling - not casual seller
o Battle of the forms - contract can exist even if parties exchange
confirmation forms in disagreement with each other, then what terms
govern sale?
 • If one party not merchant - then additional terms do not count
unless approved of by all parties
• If all parties are merchants - additions are automatically part of
contract unless: any party expressly objects within reasonable
time, materially alter original offer, original offer contains clause
expressly limiting acceptance to the terms of offer
• Knock out rule - conflicting terms knock each other out and UCC
gap filler is substituted
o Statue of frauds - provides that contracts for sale of goods >$500 are
unenforceable unless at least partially in writing
• Elements that must be in writing - statement recognizing
agreement exists, signature of party against whom enforcement
is sought, and indication of quantity of goods being sold
• If between merchants then contract can still be enforces against
party who has not signed, if other party sent written
confirmation that 1st party not respond to within 10 days
• Electronic Contracts -
o Esign and uniform electronic transactions act - see ch 8 - almost any
mark counts as signature, including click thru or typed name
o UETA says in order to avoid denial of signature party transacting
business must - confirm its assent to the terms by other means or to
revoke consent if it claims there was a mistake
• UNCITRAL - UN Commission on International Trade Law promulgated
Model law on Electronic Signatures
o Agreement on e-signature related issues including how signature
requirement met, conduct of signatory, requirements for service
providers that certify e-signatures
o Adopting by China, Mexico, Thailand and Vietnam and general
assembly (CUECIC)
• Addresses where e-contract created, where parties located, how
party expresses consent, what happens on dispute, what time
contract formed, whether displays of goods on web are offers or
just invitations
UCC Article 2 Warranties -
• Express warranty - explicit guarantee by the seller that goods will have
certain qualities;
o Seller must make statement relating to goods, provide sample or
model or description of goods
o And buyer must have relied on seller's statements in making
purchase decision
o Puffing - expressing opinion about quality of goods (this is a top
notch car - puffing) - line hard to draw
• Implied warrant of merchantability - guarantees that goods are
reasonably fit for the general purpose for which they are sold and that
they are properly packaged and labeled; applies to all goods in normal
course of business - do they do what reasonable person would expect?
o Goods must pass without objection in the trade under the contract
description
o Be fit for the ordinary purpose for which such goods are used
o Be within variations permitted by agreement
 o Be adequately contained, packaged and labeled
o Be of even kind, quality and quantity within each unit and all units
involved
o Conform to promises or affirmations of fact on packages
• Implied warranty of fitness for a particular purpose - guarantees that fit
for purpose recommended by seller
o Buyer had that particular purpose for goods
o Seller knew or had reason to know of that purpose
o Buyer relied on seller's expertise
o Seller knew or had reason to know of buyer's reliance -( can disprove
by buyer's knowledge = to seller's, buyer relied on skill of persons
hired by buyer, buyer supplied detailed specs or designs that seller
was to follow)
• Limiting liability and disclaimers - seller need not make express
warranties, seller may disclaim any warranties of quality if follows special
rules (say 'as is' or 'with all faults' - makes plain there is no implied
warranty); refrain from professing expertise, limits remedies to repair or
replacement
• Magnuson-Moss Warranty Act - protects consumers against deception in
warranties; if seller engaged in interstate or foreign commerce makes an
express warranty to buyer, then seller may not disclaim the warranties of
merchantability and fitness for a particular purpose
o Full warranty - give consumer right to free repair within reasonable
time period or after reasonable number of attempts to fix must offer
refund; warrantor must not impose any time limit on warranty's
duration, warrantor may not exclude or limit damages for breach of
warranty unless exclusions conspicuous
o All other warranties - limited
• International Sale of goods and the convention on contracts for the
international sale of goods (CISG)
o UCC only within US, CISG governs outside, signed by many of world's
largest economies
o CISG - sets out provisions to govern international sales contracts;
does not apply to goods/services bought for personal or household
use unless seller knew was for that use
o CISG automatically applies between parties from 2 signing nations
o No statute of frauds - so oral arguments allowed
o Perfect tender - delivery on goods that are exactly in accordance with
the contract on the exact date specified - CISG limits party's right to
insist on perfect tender; UCC entitles buyer to insist on perfect
tender
• Strict Liability for Defective Products - product liability extends to anyone
in the distribution chain, injured party does not need to show negligence
or otherwise at fault just needs to show
o Defendant in distribution chain of defective product and Defect
caused an injury
o Can also sue for negligence if show defendant failed to use
reasonable care - receive punitive damages
o Not applicable to services
• Defective product -
o Must show defective when left hands of defendant and defect made
product unreasonably dangerous
o Regulations - failure to comply with regulations often sufficient to
prove defective (also means defendant negligent per se), compliance
often not conclusive defense
o Manufacturing defect - flaw in the product that occurs during a
production such as a failure to meet design specs; not like others on
assembly line
o Design defect - occurs when inadequate design or choice of
materials makes dangerous to users; or if product not safe for
intended or foreseeable use (Pinto case)
o Failure to warn - product must carry adequate warnings of the risks
involved in normal use; in absence of these warnings - then defective
due to failure to warn; warning will not shield a manufacturer from
liability for a defectively manufactured or designed product
• Who may be liable -
o Manufacturers - will be held strictly liable for its defective products
regardless of how remote it is from the final user of the product; only
requirements are that the manufacturer be in the business of selling
injury causing product and that product defective when left
manufacturer
o Wholesaler - strictly liable for defects in the products they sell
o Retailers - also generally held strictly liable - although not in some
states
o Sellers of used goods - usually not held strictly liable b/c not in
original distribution chain, custom in used gods is that there are no
warranties or expectations relating to the quality of the products;
seller is strictly liable for any defective repairs or replacements
o Component part manufacturer - not liable if the specs for entire
product are questioned
o Successor liability - corporation purchasing or acquiring assets of
another is liable for its debts if there is:
• Consolidation or merger of two corporations
• Or an express or implied agreement to assume such obligations
• Even if structured as sale of assets may still be successor
liability if purchasing corporation is continuation of selling
corporation or transaction entered into to escape liability
• Defenses -
o Comparative fault - damages may be reduced by the degree to which
plaintiff's own negligence contributed to the injury
o Assumption of risk - person voluntarily and unreasonably assumes
the risk of a known danger, manufacturer is not liable for any
resulting injury - that's why there are so many damn warning labels
o Obviousness of the risk - if the use of a product carries obvious risk,
manufacturer not held liable for injuries that result from ignoring the
risk
o Misuse of the product - seller assumes will be used in normal
manner; not liable for abnormal use
 o State of the art defense - based on manufacturer's compliance with
the best available technology; shields the manufacturer from liability
if no safer product design is generally recognized as being possible
o Preemption - federal law preempts claims based on state law product
liability
• Consumer Product Safety Commission - charged by congress with
protecting the public against unreasonable risks of injury associated with
consumer products and assisting consumers in evaluating the
comparative safety of such products
o Before implementing safety standards - CPSC must find that
voluntary standards inadequate (concern that producers motivated
by short term profits and unable to self regulate)
o Any interested person may petition the CPSC to adopt a standard
and may resort to judicial remedies
o Can ban sale, manufacture, etc if not free of unreasonable risk of
personal injury
• National Highway Traffic Safety Admin - power to establish motor vehicle
safety standards
• Food and Drug Admin - food, drug, medical devices, cosmetics
• Dept of agriculture - regulates slaughtering or processing and the labeling
of meat, poultry and egg products
• FTC - has primary responsibility for regulating packaging and labeling of
all commodities
• FCC - broadcasting and telecom
• Consumer Privacy - under what circumstances can collect email,
addresses, names, etc; use of cookies
o Legislation -
• Children's online privacy act - prohibits from children under age
13 without first receiving parental consent
• Gramm-Leach -Bliley Financial Services Modernization Act -
requires financial services firms to notify consumers in writing
regarding what info is being collected, how it is being used and
with whom it is being shared, must give opportunity to opt out
of having info shared
• Fair Credit Reporting Act - ensures companies keep accurate
credit rating info and use info fairly
• Health Insurance Portability and Accountability Act - require
health care providers and others with personal medical info to
implement appropriate policies and procedures to ensure info
kept private
• Controlling the Assault of Non-solicited Pornography and
Marketing - prohibits spammers from disguising their identities
by using false return addresses and using misleading subject
lines
 Certain types of spyware violate the electronic
communications privacy act, the computer fraud and abuse
act which prohibits any unfair or deceptive trade practices
• California's consumer protection against computer spyware act
prohibits the installation of software that
 Takes control of a computer
  Modifies a consumer's interaction with the internet
 Collects personally identifiable information
 Prevents without authorization a user's effort to block or
disable such software
 Removes, disables, or renders inoperative security or anti-
spy software
• Identity theft - illegal practice of gaining access to other
people's credit information and then using if to the thief's
advantage is a federal crime
• FTC and FCC regulations
o FTC - company publishes a privacy policy then must abide by it;
failure to do so is prosecuted by the FTC; failure to protect sensitive
consumer info can itself be an unfair practice even if the promise to
keep data secure
o FCC - established do not call list; companies may not make
unsolicited phone calls to consumers who put names on that registry
unless they have done business with the consumer in the recent past
• European Privacy Directive - requires member states to safeguard the
privacy of personal data by giving notice to individuals regarding how
their info will be used; offering a choice when disclosing info to a third
party; maintaining security of personal information; ensuring data are
reliable, accurate, and current; giving individuals access to examine,
correct, delete information about them
• Self-Regulation - to forestall governmental regulations, companies started
to institutionalize their privacy policies by appointing privacy officers,
adopting online and offline privacy policies, conducting privacy risk
assessments to evaluate how personal information is used and collecting,
establishing formal complaint resolution program for consumers, training
employees, conducting privacy audits, creating formal privacy
assessment process for new products and services
• Advertising -
o Common law - provides 2 remedies for a consumer who has been
misled by false advertising - consumer may sue for breach of
contract (proving existence of contract difficult); sue for tort of deceit
• Deceit requires proof of several elements - knowledge that
misrepresentation is false; misrepresentation must be one of
fact/not opinion
o Statutory law -
• Lanham Act - protects consumers from false advertising; forbids
use of any false 'description or representation' in connection
with any goods or services; provides claim for any competitor
who might be injured by false claims; ensure truthfulness in
advertising
• National advertising Division of the Council Better Business
Bureau - handles disputes privately and cheaper
o Regulatory Law - The FTC - unfair or deceptive acts or trade practices
are illegal
• Deceptive pricing - any practice that tends to mislead or deceive
consumers about the price they paying for a good or service;
bait and switch advertising- refuses to show an advertised item,
 fails to have reasonable quantity, fails to promise to deliver
within reasonable time or discourages employees from selling
item
• Quality claims - not make quality claims without having some
basis for it; obvious exaggeration and vague generalities
considered puffing
• False testimonials and mock ups - when person endorsing
product does not actually use it; deceptive for endorser to
falsely imply that he has superior knowledge or experience in
product; also illegal to say actual demonstration when it is a
mock up
• Unfair competition -designed to prevent unlawful, false, deceptive, unfair
and unauthorized business practices
o Passing off - attempting to fool customers into believing that one's
goods are actually those of competitor
o Dilution - using another's trade name or trademark to promote
noncompeting goods and thereby potentially confusing customers
o Disparagement - untrue claims about a competitor that would tend
to damage its business
o False advertising - untrue, unsupported or deceptive claims are made
in advertising
o Right of publicity - exclusive right to exploit commercially one's name
or likeness
• Remedies - court order to stop the activity; sometimes carry criminal
charges

Jurisdiction, choice of forum and choice of law in ecommerce disputes

• Resolving online disputes in an offline court -
o Issues include
• Which country (state) has authority to require defendant to
make a decision about a dispute at location (what is the forum
or situs)
• What law will govern the dispute
• When will court recognize and enforce a judgment in foreign
jurisdiction
o US approach to jurisdiction - cannot require out of state defendant to
submit to its jurisdiction unless defendant has either agreed to do or
has sufficient minimum contacts with the state such that the
maintenance of the suit does not offend traditional notions of fair
play and substantial justice
• Nonresident defendant must either - have done something or
consummated some transaction in the forum in which it is being
sued or have purposefully availed itself of the privilege of
conducting activities in the forum
• When doing business over internet - US courts have held that us
courts have no personal jurisdiction over non resident
jurisdiction
o In search of global rules - European commission's regulation on
jurisdiction and enforcement of judgments in civil and commercial
matters - gives consumers right to sue a foreign defendant in the
 consumer's home country if the defendant pursues commercial or
professional activities in member states - or consumers have right to
bring a lawsuit relating to contracts executed via the internet in their
home country
o Many jurisdiction permit parties to use private contract law to
establish their own set of rules regarding jurisdiction, choice of forum
and choice of law, except in cases involving consumers
• What to do - company should include in its contracts explicit provisions
addressing jurisdiction, choice of forum and applicable law
o Firm should assume that if it regularly sells products in a state or
country then it will be subject to that jurisdiction's laws and can be
required to litigate in that jurisdiction all claims
o Keep in mind that any presence in a jurisdiction other than passive
website, may be enough to make subject to jurisdiction.

Legal Ch10 – Marshaling Human Resources

 Federal Labor Laws

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

 does not apply to independent contractors

 damages include back pay, front pay and compensatory
damages
 3 types of discrimination
• Disparate treatment – intentional discrimination
(denying employment or a benefit/privilege) must
prove
o Member of the protected group
o Was denied position or benefit
o Employer must prove nondiscriminatory grounds
• Disparate Impact – not necessarily intentional
o Employer has hiring criteria that
disproportionately affected a certain protected
group
o Employer must prove that the criteria was
essential to the job function
• Harassment, includes hostile work environment;
employee must prove
o Was subjected to sexual conduct
o Conduct was sufficiently sever or pervasive,
altering conditions of employment or abusive
environment
o Employer is liable for a supervisor’s actions
even if the employer had no reason to be aware
of the situation, if the supervisor took adverse
 employment action against the victim
(demotion, etc.)
o If no adverse action was taken, employer must
prove
 Employer exercised reasonable care to
prevent and promptly correct behavior
 Employee unreasonably failed to take
advantage of preventive or corrective
opportunities provided by employer
• employer may legally hire a person based on religion,
sex or national origin only IF it is a Bona Fide
Occupational Qualification (does not include
stereotypes)
Seniority and Merit Systems

 employer can legally apply different compensation in a bona

fide seniority or merit system (purposeful discrimination)
 Age Discrimination in Employment Act (ADEA)
 Applies to all companies in interstate commerce with at least
20 empl.
 Covers workers 40+, applicants and current employees
 Excludes independent contractors
 Employer can require a terminated employee to waive claims
in return for extra severance benefits. Waiver must:
• Be understandable
• Specifically refer to the employee ADEA rights
• Not require employee to waive rights to future actions
• Offer consideration
• Advise employee to consult with attorney
• Offer employee 21 days to consider (45 days if more
than one employee is discharged at the same time)
• Provide employee with 7 days after signing to revoke
• If more than one employee is Discharged at the time,
waiver must contain separate list of ages and job titles
of all employees a)being retained and b) being let go
 Americans with Disabilities Act (ADA)
 Covers employers with 15+ employees working at least 20
calendar weeks in a year
 Employer required to provide reasonable accommodations to
disabled employees, unless doing so would cause undue
hardship to employer
 Remedies include back pay, reinstatement and
reimbursement of legal fees
 Disability mental or physical impairment that substantially
limits one or more major life activity (walking, seeing,
hearing, procreating…)
 If it can be corrected with drugs, it doesn’t count
  Employer can deny employment if the condition imposes a
direct threat to health and safety of the employee (or others)
 Family and Medical Leave Act (FMLA)
 Applies to employers with 50+ full time employees
 up to 12 weeks unpaid leave per year in connection with
adoption, birth, care of an immediate family member, serious
health condition
 employee must have worked for the company for at least 1
year, 1,250 hours to qualify
 employer must continue to provide health care and must
restore employee to same (or equivalent level) position upon
return
 employee cannot contract out of FMLA rights
 Fair Labor Standards Act (FLSA)
 Covers ALL employers in interstate commerce
 regulates min. wage, overtime pay and use of child labor
 Some types of employees are exempt from min. wage and
overtime (salespeople, professional, executive, and admin.
And highly skilled computer professionals)
 does not cover independent contractors
 Worker’s Compensation
 Can be provided in three ways (based on state laws)
• Self-insure by the company
• Purchase through state fund
• Purchase through private insurer
 Occupational Safety and Health Act (OSHA)
 Applies to all employers in interstate commerce, except
federal and state employees
 designed to reduce workplace hazards and improve safety
 National Labor Relations Act (NLRA)
 Covers all enterprises with a substantial effect on commerce
 gives employees the right (and protection) to organize unions
 protects employers by limiting union solicitation, prohibiting
employee from disclosing his salary
 protection extends to employees, not supervisors or
independent contractors
 Equal Employment Opportunity Commission (EEOC)
 Federal administrative agene to enforce Title Vii and other
antidiscrimination statues
 Person with a grievance must first exhaust procedures of the
EEOC before filing law suit
 EEOC investigates and if reasonable cause exists, attempts
to resolve the issue out of court first
 Immigration Reform and Control Act of 1986 (IRCA)
 Illegal for employer with 4+ employees to discriminate based
on national origin or citizenship status
  An employee can legally be told that a job offer is contingent on
passing a job-related medical exam if all candidates go through the
same exam

Classifying as Employees or Independent contractors?

 Independent contractors are less expensive

 No workers comp insurance
 No unemployment comp
 No job benefits (health insurance, retirement savings plan)
 Incorrect classification of workers can bring federal and state penalties
 Worker status can affect employer’s right to copyrightable works or
patentable inventions for independent contractors:
 Written contract must specify a “work for hire” or assignment of the
copyright
 Must agree upon the desired work product, but worker controls the
manner of achieving the outcome
 Contractors offer services to the public at large, not just one
business
 Determining whether an employment relationship existed, courts
asses
 Nature and degree of control/supervision of the employer
 Are the services in question an integral part of the
employer’s business?
 Did the employer provide training
 Amt of worker’s investment in facilities and equipment
 Kind of occupation
 Worker’s opportunities for profit or loss
 Method of calculating payment for work
 Skill, initiative and judgment required for the independent
enterprise to succeed
 Permanence and duration of the work relationship
 Was annual or sick leave given?
 Did the worker accumulate retirement benefits or medical
benefits?
 Did the employer pay SS taxes?
 What was the intention of the parties – was there a written
agreement?
 Courts tend to lean in favor of the worker
 Steps to establish nonemployee status
 Written contract spelling out
• intent
• duties
• conditions of the service
• responsibilities of contractor
• services to be performed
 • time frame for completion
• give contractor right to hire assistants at his own
expense
 contractor carries his own liability and workers comp
insurance and pays his own taxes
 make it clear contractor can offer services to other
companies
 Temporary workers are hired (typically) through a personnel agency
 Agency and company are both liable for violations of most
employment laws
 If possible, client company should have agency agree to indemnify
the employer on employment-related liabilities
 Employee privacy
 Employers should have a written policy to bolster the right to
examine employee e-mail
 Policy should state that computer, etc. is company property and
employee has no reasonable expectation of privacy on the system
 Employment at Will (employee or employer may terminate the
relationship at any time for any reason)
 Employer can discharge for no reason but not for a bad reason
 May states have adopted whistle blower statues
 Employment at will exception includes court interpretations of
implied contract to limit employer’s right o discharge without good
cause
 Employee is long-term empl.
 Employee has received raises, bonuses and promotions
 Employee was assured that employment would continue
based on doing a good job
 Employee was assured he was doing a good job
 Company stated that it did not terminate employees without
good cause
 Employee had never been formally warned
 Implied Covenant of Good Faith – termination of long-term
employee without good cause in order to deprive him of
commissions is a breach of contract
 Employment contract should be in writing and clarify terms
 Duties
 Compensation benefits
 Stock options and grants
 Duration and termination of employment
 Right to work in the U.S. (verification)
 Proprietary information (NDA) and assignment of inventions
 Noncompetition and nonsolicitation provisions
 Integration clause (document is complete and overrides any prior or
oral agreements/provisions
 Mandatory arbitration agreements
 Saves the company money in legal fees
  Outcome more predictable than a jury ruling
 Will be enforced as long as it does not require employee to forego
statutory rights
 Can be condition of employment (not considered duress)
 Employers hiring foreign nationals must comply with U.S.
antidiscrimination laws and U.S. immigration laws and procedures
 Equity compensation can take many, many forms, but typically stock
option
 Stock options
 Terms include number of shares, tax advantaged incentive or not,
exercise price, maximum duration of the option, permissible forms
of payment, contractual restrictions on purchase or transfer of
shares
 Types include incentive stock options and nonqualified stock options
(difference relates to tax implications)
 Maximum duration is typically 10 years, except if the optionee owns
more than 10% of the company, then it’s 5 years
 Forms of payment – cash or cash equivalent, shares of the stock
already owned, proceeds from immediate sale of stock upon
exercise, promissory note
 Vesting (unrestricted right to purchase stock)
 Cliff vesting – no vesting in the first year
 Some companies tie vesting to achievement of performance
goals
 Plan may allow individual to exercise an option immediately even if
the shares are not vested (becomes tricky with accounting)
 Other plans allow exercise only on vested shares
 Company may give itself right to require shares that an optionee
wishes to transfer when the company is not publicly traded
 Most companies provide right to first refusal in the company’s favor
 Other employee benefits
 Health coverage is bought through an insurance company, HMO or
through a broker
 Employer providing healthcare coverage must abide by health
information privacy regulations
 Section401K allows nontaxable contributions; company can take an
immediate tax deduction on employee contributions
 401K SIMPLE is available (and less expensive) to a company with
100 or less employees
 401K plans involve liability of employer to ensure that the
investment choices offered are prudent ones
 Misclassification of employees as contractors can result in
retroactive liability for benefits denied
 Employer should make sure benefits plans specifically
exclude workers classified as contractors even if a gov’t
agency later reclassifies the worker as an employee
 Employer is liable for his or her own negligence in hiring or supervising an
employee
  Select employees carefully
 Document the relationship
 Implement good practices and policies
 Terminate with care

Chapter 11 – Operational Liabilities and

Insurance
Tort – civil wrong that injures a person, property, or certain economic
interests & business relationships. Companies are vicariously liable for torts
committed by employees acting within the scope of their employment.
Negligence – conduct that involves an unreasonable risk of causing injury to
another person or damage to another person’s property. Must show (1)
defendant owed duty to act reasonably; (2) failed to use the care a
reasonable person would have; (3) reasonably close causal connection
between breach and injury; (4) plaintiff suffered actual loss or injury
Duty – person is required to act reasonably to avoid harming other
person. Variety of contexts:
Duty of Landowner/Tenant – landowner or tenant has legal
duty to keep property reasonably safe and may be liable for
injury that occurs outside, as well as on, the premises
Duty of Employer to Third Parties – employer is liable for
any torts committed by employees acting within the scope of
their employment.
Duty of Professionals to Third Parties – professionals have
duty to clients to use reasonable care when rendering their
services. Failure to do so can result in liability for negligence
(malpractice)
Standard of Conduct – person is required to act as a reasonable
person or ordinary prudence would act under circumstances. Fact that
one complied with the law is not a defense if reasonably prudent
person would have done more than law required. However, failing to
follow law is prima facie negligence. If harm that follows is the type
that law sought to prevent, then you’re guilty of negligence without
need to prove standard of conduct.
Defenses to Negligence
Contributory Negligence – if plaintiff was also negligent, he cannot
recover any damages. Most courts have replaced this with doctrine of
comparative negligence.
Comparative Negligence – plaintiff recovers proportion of loss
attributable to defendant’s negligence
Intentional Torts – require intent to harm plaintiff, plaintiff’s property, or
certain economic interests & business relationships. Automatically liable for
intentional torts without regard to duty.
Torts that Protect Persons
Battery – harmful or offensive contact with the plaintiff’s body
or something touching it.
False Imprisonment – intentional restraint of movement,
imposed against someone’s will by physical barriers, physical
force, or threats of force.
Intentional Infliction of Emotional Distress – protects right
to peace of mind. Must show (1) defendant’s conduct was
outrageous; (2) defendant intended to cause emotional distress;
(3) defendant’s actions caused severe emotional suffering
Defamation – communication to third party of untrue
statement that injures plaintiff’s reputation. Libel is written.
Slander is spoken.
Invasion of Privacy – individuals are protected against
inappropriate invasions of privacy, including public disclosure of
private facts and intrusion. Intrusion is objectionable prying,
such as eavesdropping of unauthorized rifling of files.
Torts that Protect Interests in Property
Trespass to Land – intentional invasion of real property without
consent of owner. Only requires intent to enter property, not
intent to trespass (i.e. if you thought you were standing on a
friend’s land with his consent is still liable of trespass if it is, in
fact, owned by someone else). Refusing to move something that
at one time was permitted is also trespass.
Nuisance – non-trespassory interference with use & enjoyment
of real property (i.e. annoying odor or noise). Public nuisance
is unreasonable & substantial interference with public health,
safety, peace, comfort, convenience, or utilization of land
(normally brought by government). Private nuisance is
unreasonable and substantial interference with individual’s use
& enjoyment of his or her land.
Conversion – exercise of control over personal property, as
opposed to real property, of another. Protects one’s right to
have personal property left alone.
Trespass to Personal Property – if personal property is
interfered with but not converted
Torts that Protect Certain Economic Interests & Business
Relationships
Fraudulent Misrepresentation – also called fraud or deceit.
Protects economic interests and right to be treated fairly &
honestly. Requires proof that defendant knowingly &
intentionally misled plaintiff. Requires that plaintiff suffers injury
as a result. Fraud can also be based on defendant’s omission of
a material fact when he or she has a fiduciary duty to speak.
 Interference with Contractual Relations – protects right to
enjoy benefits of legally binding agreements. Provides remedy
when defendant intentionally induces another person to breach
a contract w/ plaintiff.
Interference with Prospective Business Advantage –
similar to previous except contract not yet signed. Must prove
defendant unjustifiably interfered with relationship plaintiff
sought to develop and caused plaintiff’s loss. Interference must
be intentional. Usually committed by competitor.
Unfair Competition – certain kinds of anti-competitive behavior if it
seems egregious & predatory to the court.
Strict Liability – liability without requirement for negligence or intent.
Imposed in product liability cases (see Chapter 9) & ultrahazardous activities
Ultrahazardous Activities – so dangerous that no amount of care
could protect others from risk of harm. Defendant is strictly liable for
injuries resulting from the activity (Ex: storing flammable liquids in
urban area, blasting, crop dusting, locating oil wells or refineries in
populated areas, etc). Court more likely to consider dangerous activity
ultrahazardous when it is inappropriate to the location. With
ultrahazardous activities, it is irrelevant that defendant observed a
high standard of care.
Toxic Torts – wrongful act that causes injury by exposure to harmful,
hazardous, or poisonous substance.
Vicarious Tort Liability & Respondeat Superior – Respondeat Superior
(“let the master answer”) establishes concept that employer is vicariously
liable for the torts of an employee acting within the scope of his or her
employment. (Ex: pizza company is liable if pizza delivery guy hits someone
while speeding to deliver a pizza, even if the manager had instructed the
employee not to speed.)
Scope of Employment – within scope if it (1) is of the nature that he
or she was employed to perform; (2) is within the time & space
limitations normally authorized by employer; (3) furthers the purpose
of the employer. Employer not vicariously liable if employee commits
tort while engaged in activity solely for his or her benefit.
Aided-in-the-Agency-Relation Doctrine – employer can be
vicariously liable for torts committed by employees acting outside the
scope of employment if the authority of the employer made it possible
for employee to commit the tort. (Ex: if supervisor fires subordinate
because subordinate rejected supervisor’s sexual advances, then
employer is liable for sexual harassment, even if employer was
unaware supervisor harassed subordinate.)
Tort Remedies
Actual Damages – aka compensatory damages, based on cost to
repair/replace item, or decrease in market value caused by tortious
conduct.
 Punitive Damages – aka exemplary damages, awarded to punish
defendant and deter others from engaging in similar conduct. Only in
cases of outrageous conduct. Generally, less than 10 times the
compensatory damages.
Equitable Relief – granted if money award cannot adequately
compensate for plaintiff’s loss. (Ex: court can order a newspaper found
liable for defamation to print a retraction)
Tort Liability of Multiple Defendants
Joint and Several Liability – multiple defendant are jointly (i.e.
collectively) and severally (i.e. individually) liable. Plaintiff may collect
entire judgment from any of multiple defendants regardless of degree
of fault. Defendant who played minor role may be required to pay all
damages (especially when that defendant is able to pay).
Contribution and Indemnification – Contribution distributes loss
among several defendants by requiring each to pay proportionate
share. Indemnification allows defendant to shift some of its individual
loss to other defendants whose relative blame is greater. Concept is
worthless is other defendants are insolvent.
Antitrust Violations – Sherman Act prohibits any and all activity that
restrains trade. Courts interpret this as any activity that “unreasonably
restrains” trade.
Contract, Combination, or Conspiracy – agreements can be (1)
horizontal, between firms that directly compete with one another; or
(2) vertical, between firms at different levels of supply chain. Courts
view horizontal agreements more harshly because they reduce
interbrand competition & result in higher consumer prices.
Per se Violations – Practices completely void of redeeming
competitive rationales are illegal per se.
Horizontal Price-Fixing – includes agreements between
competitors (1) setting min prices; (2) setting terms of sale; (3)
setting quantity/quality of goods made available for sale. Bid
rigging is one form.
Horizontal Market Division – market division whereby
competitors divide up market according to class of consumers or
geographic territory.
Group Boycotts – agreement among competitors to refuse to
deal with another competitor
Rule of Reason – if plaintiff hasn’t proved that restraint is per se
violation, then activity is evaluated under rule of reason. Determines
whether, on balance, the activity promotes or restrains competition.
Court considers structure of market, analyzes anticompetitive & pro-
competitive effects. (Ex: maximum price-fixing, vertical restraints
like exclusive licensing agreements). More likely to be upheld if
agreements of limited duration, do not foreclose major share of
market, & serve legitimate purpose.
 Monopolization – Merely having major share of market doesn’t
constitute monopoly. Must have market power (ability to raise prices
without losing market share) and have engaged in anticompetitive
acts.
Environmental Liabilities
CERCLA – Comprehensive Environmental Response, Compensation
and Liability Act – certain “responsible parties” are strictly liable for
cleanup of hazardous waste. Namely, (1) current owners or operators
of facility; (2) owners or operators at time hazardous substances
disposed of; (3) transporters of hazardous substances to a facility if
they selected the facility; (4) persons who arranged for treatment or
disposal.
Defenses – not liable if contamination caused by (1) act of
God, (2) act of war, (3) act of third party. To establish 3rd
party defense (or innocent landowner defense), owner of
contaminated property must have (1) acquired property after
disposal occurred, (2) had no actual knowledge of contamination
when it acquired the property, and (3) had no reason to know of
the contamination after conducting appropriate inquiries prior to
purchase. Courts will consider (1) specialized
knowledge/experience of landowner, (2) relationship of purchase
price to property’s value, (3) commonly known or reasonably
ascertainable information, (4) obviousness of contamination, (5)
ability to detect contamination by appropriate inspection, and
(6) level of inquiry at time of purchase.
RCRA – Resource Conservation Responsibility Act – any person who
creates hazardous waste has “cradle to grave” responsibility for its
ultimate proper disposal. Liable parties include: (1) generators of
waste, (2) persons arranging for transport, treatment or disposal, (3)
transporters of waste, & (4) persons who treat/dispose of it.
Personal Liability of Operators – individuals responsible for
operating a facility that generates hazardous waste are potentially
personally liable for violations. Responsible corporate officer doctrine
may hold officers liable for misdeeds of subordinates.
Bribery and Foreign Corrupt Practices Act (FCPA)
Bribes – FCPA prohibits any payments by U.S. company to foreign
government official or foreign political party for purpose of
improperly influencing government decisions. Statute is violated even
if bribe only offered, but never paid. Exceptions: payments to low-
ranking officials to expedite approvals, payments to foreign
businesses
Record-Keeping Provisions – all public companies must keep
records that accurately reflect disposition of company’s assets &
implement internal controls to ensure transactions are completed as
authorized by mgmt. Designed to prevent companies from setting up
slush funds to make illegitimate payments from.
Tax Fraud – Section 7201 prohibits willful attempts to evade taxes. Section
7206 forbids any false statements in a tax return. Section 7207 prohibits
willful submission of fraudulent tax returns. Section 6672 imposes civil
penalty equal to amount of corporation’s unpaid employment taxes on those
with power & responsibility for seeing that taxes withheld from various
sources are remitted in a timely manner. Bottom Line: don’t use taxes
withheld from employees’ paychecks to meet a cash crunch. Penalties can
be severe and personal.
Wire and Mail Fraud – Wire and Mail Fraud Act prohibits (1) scheme
intended to defraud or obtain money or property by fraudulent means and (2)
the use of mail or interstate phone lines to further the fraud. Supreme Court
has broadly construed “fraud” to include representations as to past, present,
or suggestions/promises of future performance.
Obstruction of Justice & Whistleblowers – O of J: any effort to impede
investigations, particularly alteration or destruction of documents.
Whistleblowers: crime to retaliate against individuals who provide truthful
information to the government about possible violations of federal law.
Computer Crime & CFAA – use of computer to steal or embezzle funds.
Computer Fraud and Abuse Act (CFAA) prohibits (1) accessing computer
without authorization, or (2) knowingly transmitting a program, information,
code, or command that results in intentionally causing damage without
authorization to use a computer (transmitting a virus, or DoS attacks).
Damage is any impairment to integrity/availability of data, program, system,
or information. Computer Piracy is theft or misuse of computer software in
violation of the licensing program.
Insurance – generally divided between first-party and third-party (or liability)
insurance
First-Party Insurance – protects policyholder in case of damage or
loss to insured or its property (i.e. fire, theft, flood.) Business
interruption insurance protects against lost revenues resulting from
event that interferes with normal conduct of business.
Liability Insurance – insures against liabilities arising out of conduct
of business (slip-and-fall cases, auto accidents, product defects).
Punitive damages are uninsurable because they are intended to punish
the wrongdoer. Director and Officer (D&O) insurance protects officers
against claims by shareholders & others for breach of fiduciary duty or
negligence.
Implied Duty of Good Faith and Fair Dealing – interests of insured
and insurer may diverge during settlement discussions. Insurer is only
liable for damages up to the policy cap. When a lawsuit is for an
amount far greater than the policy size, insurer has little incentive to
settle for an amount at the policy cap because they will pay the
maximum amount in either case. This doctrine is designed to ensure
the insurer acts in your interests.
Risk Management
 Reducing Tort Risks – implement ongoing programs of education &
monitoring to reduce likelihood of intentional torts (like defamation).
Define scope of work clearly to mitigate vicarious liability. Consult
counsel if unsure whether proposed activities might cross line into anti-
competitive practices.

14 - Intellectual property and cyberlaw

Take precautions to avoid violating others property rights

Trade secret protection - business plans, customer lists, financials, etc;

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

Copyrights - gives owner of an original piece of work of authorship the

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

Patents - exclusive right granted by fed that entitles inventor to prevent

anyone else from making, using, selling or offering to sell patented
process or product in US for a specific period of time; involves detailed
description of how to make but may request patent application to be
sealed
o Utility patent - cover machinery or a process, articles of manufacture,
new composition of materials, human made microorganisms,
improvements to any of these
o Design patents - ornamental designs
o Requirements -
• Must fall within class of patentable subject matter
• Must be useful
• Must be novel - it has not been patented or known in US; not
been previously patented in another country
o Statutory bar - will be denied if disclosed to the public more than one
year before the date that the patent application is filed
o Duration - utility - 20 years; design - 14 years, can be extended
under special circumstances
o Procedures for obtaining
• Application
• Search for prior art (earlier inventions)
• Patent examination
• Costs - major expense
• Other considerations - examiners unfamiliar with technology
and slow; frequently challenged or overturned; must obtain
written transfer of ownership rights in inventions from
employees and independent contractors
o Reduction to practice - two or more inventors compete over who first,
first one to patent wins unless not diligent in reducing the invention
to practice
• Produces working prototype
• Files application that includes description
o Patent infringement - may result in injunction, legal fees, costly,
damages
o American inventor protection act 1999 - inventors can obtain
reasonable royalties from others who make, use, sell or import the
invention during time application published and patent granted
o b/c costs and disclosure requirements, may not make sense to
pursue patents - maybe try trade secret
o Strategic aspects include -
• Bracketing - large co review patent applications, improve on one
and block use of improvement to original patent holder
• Can provide strategic competitor information

Trademarks - any word, name, symbol, etc that identifies and

distinguishes one company's products from those made or sold by others
o Establishing - seek distinctiveness (inherently distinctive or made up
are strongest form, arbitrary are words that have nothing to do with
company but are real words
 o Descriptive marks - not inherently distinctive but indicate
characteristic of product (Gold Medal), not immediately protectable
but are once acquire secondary meaning
o Perform a trademark search
o Create rights by using trademark, registering trademark, lasts for 10
years but can be renewed indefinitely, must ensure rights are not
lost - by becoming generic 'cornflakes'
o Trademark infringement - assess damages, bar from using;
• Dilution involves - using another's mark on goods or in
connection to services if use is likely to cause harm to
reputation of mark's owner (tarnishment) or lessen the
distinctiveness of the mark (blurring)
• Can effectively prove dilution even if - there is not likelihood of
confusion between two marks, subject marks do not
commercially compete with each other, famous mark owner has
not suffered economic harm
o International issues -

Domain names - anticybersquatting protection act - illegal for person to

register or use a domain name with bad faith if domain name is identical
or confusingly similar to distinctive or famous trademark
• ICANN - internet corporation for assigned names and numbers -
established arbitration process , fast and inexpensive

Trade Dress - Lanham Act - protect packaging or dressing of product; must

be distinctive and have acquired secondary meaning (or be registered);
feature must be functional

Employee Proprietary Info and Invention Agreements

• Nondisclosure and nonuse of proprietary info - p543
• Assignment of inventions - assign to the company all rights to any
invention that results from work

Table 14.2 (545)

Licensing Agreements - gives person the right to do something he would

not otherwise be permitted to do but does not transfer related property
rights
Assignment - typically used to transfer all of one's interests in an item to a
new owner
Key terms in licensing agreements
o Specification of what is to be licensed
o Scope of license - exclusive/not exclusive; limited to geography; right
to modify, sublicense or share; duration; set performance criteria?,
renewal terms
o Payments
o Representation, warranties and indemnifications -
o Covenants
Shrink wrap (by opening packaging purchaser is bound by terms) and
click wrap licenses (user must click' I accept'- then bound by terms)
 Open source software - typically distributed in source code form under
broad license rights to copy, use, distribute and modify; without warranty
or support; examine license terms

16 Buying & Selling a Business

Business Combinations
o Immediate liquidity, fixed value
o No risks associated with changing stock market conditions that may
prevent IPO or prevent completion of it
o No lockup agreement (requires shareholders of IPO to not sell or
transfer for 6 months after IPO)
o avoid pressures associated with being a public company
o Potential limitations on return for target company's shareholders
o Upside is capped at purchase price
Types of Acquirers -
o What is their longterm vision?
o What is the allocation of control?
Forms of Business Combinations -
• Asset Purchase - acquiring company purchases some or all of the target
company's assets and assumes some/all of its liabilities
o Acquirer affected how?
• Purchase only what wants and only specific liabilities
• Never completely eliminate some risks (sometimes required to
take on risks not known at time such as all liability for previously
sold products)
• If not sell everything then completion of the asset purchase
should not require shareholder approval or dissenters' rights
o Target company affected how?
• Not as favorable as stock purchase, forced to retain specific
liabilities
• Double taxation on the gain of the sale
o Need for third party consent
• Sometimes spelled out in anti assignment provisions
• If almost all then generally requires shareholder approval
o Bulk sale laws - target company must give notice to the target
company's creditors
• Purchase of Equity - stock purchase or merger
o More favorable than sale of assets - assets and liabilities are sold
o Single taxation
o Assumes all liabilities (acquiring company)
• Stock Purchase and Sale - agreement to purchase all outstanding shares
for cash, stock or other consideration
o No third party consent - all contracts remain in same name
o All shareholders must agree to sell
• Merger - two companies combine
o Direct/forward merger - target company merges directly into acquirer
and does not survive
 o Forward triangular merger - target company merges directly into a
subsidiary of the acquirer and does not survive
o Reverse triangular merger - subsidiary of acquirer merges into target
company and target survives
o Variety
• Shields acquirer from direct exposure to the target company's
liabilities
• Optimizes tax treatment
• Reduces interference of third party
o Shareholder approval required
• Pricing Issues
o Purchase price - fixed dollar amount, post closing adjustment, earn
out
o Form of consideration -
• Cash payment at closing
• Deferred cash payments or promissory notes
• Part cash/part stock or all stock
• Shares of the acquirer's stock
o Fixed exchange ration v fixed market value formula
Effect of Business combo on preferred stock rights - consider them as
well as stock option rights
Tax Treatment -
o Taxable purchase and sale of assets
o Taxable forward merger
o Taxable purchase and sale of stock
o Taxable reverse triangular merger
o Tax free reorgs
• Statutory merger - target company disappears and generally
45% of the consideration must consist of acquirer's stock
• Stock for stock exchange - acquirer exchanges its voting stock
fo rat least 80% of the stock of target company
• Exchange of stock for assets - exchanges its stock for target's
assets and then target is liquidated
• Forward triangular merger - if 45% of consideration paid to
target is stock then tax free
• Reverse triangular merger - 80% of consideration must be tax
free
o Non tax considerations - dilutive effects, inability to finance
transaction, key contracts may be unassignable, unwillingness to
assume certain liabilities
Securities law Requirements -
o Federal securities laws -
• Rule 506 under regulation D -
• Regulation d information requirements
• Section 3a10
o State securities laws
• Blue sky laws
• Acquirer's state, target's state, states where targets
shareholder's reside or have principal places of business
 o Protection from fraud
o Restrictions from resale
• Rules 144 and 145
Accounting Treatment
All assets and liabilities must be recorded on acquirer's Balance
Any excess over fair value = goodwill
All intangibles with finite lives are amortized over useful life
Antitrust Compliance -
Shareholder Approval and Dissenter's Rights

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

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

Antitrust Violations -
• Contract, combination, conspiracy -
o Horizontal - btwn 2 competitors
o Vertical - different levels of value chain
o Maintain - interbrand competition
• Per se violations - condemns practices that are considered completely
void of redeeming competitive rationales
o Horizontal price fixing - set minimum prices, set terms of sale, set
quantity or quality
o Bid rigging -
o Horizontal market division -
o Group boycotts
• Restraints on trade subject to the rule of reason - does activity on reason
promote or restrains competition
• Monopolization - firm must have market power (generally defined as
ability to raise prices without losing market share) and have engaged in
anticompetitive acts - not merely having major market share
• Environmental liabilities -
o CERCLA - responsible parties are strictly liable for cleanup of
hazardous waste specifically current owners, owners at time of
disposal, transporters of substance to a facility if they selected it,
persons who arrange for treatment or disposal
o Defenses -
• Act of god
• Act of war
• Act of third part
 Defendant must have taken care
 Acquired property after disposal
 No knowledge of contamination
  No reason to know of contamination after conducting
appropriate inquiries
 Consider - knowledge of new owner, price to value of
property, commonly known info about property,
obviousness of contamination, ability to detect from
investigations, levels of inquiry conducted at time of
purchase
o RCRA - potentially liable parties include - generators of waste, people
who arrange for treatment or disposal, transporters of waste, persons
who treat/dispose
o Bribery - prohibited by Foreign Corrupt Practices Act - any payments
by a US company or and non-US controlled company or its agents to
a foreign government official or foreign political party for the purpose
of improperly influencing government decisions
o Record keeping provisions - every public company must keep records
that accurately reflect the disposition of the company's assets and
implement internal controls to ensure that its transactions are
completed as authorized by management

CHAPTER 2 – LEAVING YOUR EMPLOYER

• Classification of employees changes employee’s rights and duties

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

Legal Ch10 – Marshaling Human Resources

 Federal Labor Laws

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

 does not apply to independent contractors

 damages include back pay, front pay and compensatory damages
 3 types of discrimination
 Disparate treatment – intentional discrimination (denying
employment or a benefit/privilege) must prove
 Member of the protected group
 Was denied position or benefit
 Employer must prove nondiscriminatory grounds
 Disparate Impact – not necessarily intentional
 Employer has hiring criteria that disproportionately affected a
certain protected group
 Employer must prove that the criteria was essential to the
job function
 Harassment, includes hostile work environment; employee must
prove
 Was subjected to sexual conduct
  Conduct was sufficiently sever or pervasive, altering
conditions of employment or abusive environment
 Employer is liable for a supervisor’s actions even if the
employer had no reason to be aware of the situation, if the
supervisor took adverse employment action against the
victim (demotion, etc.)
 If no adverse action was taken, employer must prove
• Employer exercised reasonable care to prevent and
promptly correct behavior
• Employee unreasonably failed to take advantage of
preventive or corrective opportunities provided by
employer
 employer may legally hire a person based on religion, sex or
national origin only IF it is a Bona Fide Occupational Qualification
(does not include stereotypes)
Seniority and Merit Systems

 employer can legally apply different compensation in a bona

fide seniority or merit system (purposeful discrimination)
 Age Discrimination in Employment Act (ADEA)
 Applies to all companies in interstate commerce with at least
20 empl.
 Covers workers 40+, applicants and current employees
 Excludes independent contractors
 Employer can require a terminated employee to waive claims
in return for extra severance benefits. Waiver must:
• Be understandable
• Specifically refer to the employee ADEA rights
• Not require employee to waive rights to future actions
• Offer consideration
• Advise employee to consult with attorney
• Offer employee 21 days to consider (45 days if more
than one employee is discharged at the same time)
• Provide employee with 7 days after signing to revoke
• If more than one employee is Discharged at the time,
waiver must contain separate list of ages and job titles
of all employees a)being retained and b) being let go
 Americans with Disabilities Act (ADA)
 Covers employers with 15+ employees working at least 20
calendar weeks in a year
 Employer required to provide reasonable accommodations to
disabled employees, unless doing so would cause undue
hardship to employer
 Remedies include back pay, reinstatement and
reimbursement of legal fees
 Disability mental or physical impairment that substantially
limits one or more major life activity (walking, seeing,
hearing, procreating…)
  If it can be corrected with drugs, it doesn’t count
 Employer can deny employment if the condition imposes a
direct threat to health and safety of the employee (or others)
 Family and Medical Leave Act (FMLA)
 Applies to employers with 50+ full time employees
 up to 12 weeks unpaid leave per year in connection with
adoption, birth, care of an immediate family member, serious
health condition
 employee must have worked for the company for at least 1
year, 1,250 hours to qualify
 employer must continue to provide health care and must
restore employee to same (or equivalent level) position upon
return
 employee cannot contract out of FMLA rights
 Fair Labor Standards Act (FLSA)
 Covers ALL employers in interstate commerce
 regulates min. wage, overtime pay and use of child labor
 Some types of employees are exempt from min. wage and
overtime (salespeople, professional, executive, and admin.
And highly skilled computer professionals)
 does not cover independent contractors
 Worker’s Compensation
 Can be provided in three ways (based on state laws)
• Self-insure by the company
• Purchase through state fund
• Purchase through private insurer
 Occupational Safety and Health Act (OSHA)
 Applies to all employers in interstate commerce, except
federal and state employees
 designed to reduce workplace hazards and improve safety
 National Labor Relations Act (NLRA)
 Covers all enterprises with a substantial effect on commerce
 gives employees the right (and protection) to organize unions
 protects employers by limiting union solicitation, prohibiting
employee from disclosing his salary
 protection extends to employees, not supervisors or
independent contractors
 Equal Employment Opportunity Commission (EEOC)
 Federal administrative agene to enforce Title Vii and other
antidiscrimination statues
 Person with a grievance must first exhaust procedures of the
EEOC before filing law suit
 EEOC investigates and if reasonable cause exists, attempts
to resolve the issue out of court first
 Immigration Reform and Control Act of 1986 (IRCA)
 Illegal for employer with 4+ employees to discriminate based
on national origin or citizenship status
  An employee can legally be told that a job offer is contingent on
passing a job-related medical exam if all candidates go through the
same exam

Classifying as Employees or Independent contractors?

 Independent contractors are less expensive

 No workers comp insurance
 No unemployment comp
 No job benefits (health insurance, retirement savings plan)
 Incorrect classification of workers can bring federal and state penalties
 Worker status can affect employer’s right to copyrightable works or
patentable inventions for independent contractors:
 Written contract must specify a “work for hire” or assignment of the
copyright
 Must agree upon the desired work product, but worker controls the
manner of achieving the outcome
 Contractors offer services to the public at large, not just one
business
 Determining whether an employment relationship existed, courts
asses
 Nature and degree of control/supervision of the employer
 Are the services in question an integral part of the
employer’s business?
 Did the employer provide training
 Amt of worker’s investment in facilities and equipment
 Kind of occupation
 Worker’s opportunities for profit or loss
 Method of calculating payment for work
 Skill, initiative and judgment required for the independent
enterprise to succeed
 Permanence and duration of the work relationship
 Was annual or sick leave given?
 Did the worker accumulate retirement benefits or medical
benefits?
 Did the employer pay SS taxes?
 What was the intention of the parties – was there a written
agreement?
 Courts tend to lean in favor of the worker
 Steps to establish nonemployee status
 Written contract spelling out
• intent
• duties
• conditions of the service
• responsibilities of contractor
• services to be performed
 • time frame for completion
• give contractor right to hire assistants at his own
expense
 contractor carries his own liability and workers comp
insurance and pays his own taxes
 make it clear contractor can offer services to other
companies
 Temporary workers are hired (typically) through a personnel agency
 Agency and company are both liable for violations of most
employment laws
 If possible, client company should have agency agree to indemnify
the employer on employment-related liabilities
 Employee privacy
 Employers should have a written policy to bolster the right to
examine employee e-mail
 Policy should state that computer, etc. is company property and
employee has no reasonable expectation of privacy on the system
 Employment at Will (employee or employer may terminate the
relationship at any time for any reason)
 Employer can discharge for no reason but not for a bad reason
 May states have adopted whistle blower statues
 Employment at will exception includes court interpretations of
implied contract to limit employer’s right o discharge without good
cause
 Employee is long-term empl.
 Employee has received raises, bonuses and promotions
 Employee was assured that employment would continue
based on doing a good job
 Employee was assured he was doing a good job
 Company stated that it did not terminate employees without
good cause
 Employee had never been formally warned
 Implied Covenant of Good Faith – termination of long-term
employee without good cause in order to deprive him of
commissions is a breach of contract
 Employment contract should be in writing and clarify terms
 Duties
 Compensation benefits
 Stock options and grants
 Duration and termination of employment
 Right to work in the U.S. (verification)
 Proprietary information (NDA) and assignment of inventions
 Noncompetition and nonsolicitation provisions
 Integration clause (document is complete and overrides any prior or
oral agreements/provisions
 Mandatory arbitration agreements
 Saves the company money in legal fees
  Outcome more predictable than a jury ruling
 Will be enforced as long as it does not require employee to forego
statutory rights
 Can be condition of employment (not considered duress)
 Employers hiring foreign nationals must comply with U.S.
antidiscrimination laws and U.S. immigration laws and procedures
 Equity compensation can take many, many forms, but typically stock
option
 Stock options
 Terms include number of shares, tax advantaged incentive or not,
exercise price, maximum duration of the option, permissible forms
of payment, contractual restrictions on purchase or transfer of
shares
 Types include incentive stock options and nonqualified stock options
(difference relates to tax implications)
 Maximum duration is typically 10 years, except if the optionee owns
more than 10% of the company, then it’s 5 years
 Forms of payment – cash or cash equivalent, shares of the stock
already owned, proceeds from immediate sale of stock upon
exercise, promissory note
 Vesting (unrestricted right to purchase stock)
 Cliff vesting – no vesting in the first year
 Some companies tie vesting to achievement of performance
goals
 Plan may allow individual to exercise an option immediately even if
the shares are not vested (becomes tricky with accounting)
 Other plans allow exercise only on vested shares
 Company may give itself right to require shares that an optionee
wishes to transfer when the company is not publicly traded
 Most companies provide right to first refusal in the company’s favor
 Other employee benefits
 Health coverage is bought through an insurance company, HMO or
through a broker
 Employer providing healthcare coverage must abide by health
information privacy regulations
 Section401K allows nontaxable contributions; company can take an
immediate tax deduction on employee contributions
 401K SIMPLE is available (and less expensive) to a company with
100 or less employees
 401K plans involve liability of employer to ensure that the
investment choices offered are prudent ones
 Misclassification of employees as contractors can result in
retroactive liability for benefits denied
 Employer should make sure benefits plans specifically
exclude workers classified as contractors even if a gov’t
agency later reclassifies the worker as an employee
 Employer is liable for his or her own negligence in hiring or supervising an
employee
  Select employees carefully
 Document the relationship
 Implement good practices and policies
 Terminate with care

Chapter 12 – Creditor’s Rights and Bankruptcy

Types of Loans
Term Loans – funds required for a specific purpose, acquisition, or
construction project. Borrowed either in a lump sum or in installments.
Paid on a specified date. Cannot be reborrowed.
Revolving Loans – or revolving line of credit. Firm borrows whatever
sums it requires, up to specified maximum. May reborrow amounts it
has repaid. Requires commitment fee as consideration because loan is
interest-free.
Secured Loans – loan backed up by collateral in which lender takes a
lien or security interest. If borrower fails to repay, lender may
foreclose on collateral and either sell it to pay off debt or keep it in
satisfaction of the debt.
Secured Transactions Under the UCC – mechanics of taking security
interest in personal property and consequences of taking such an interest are
governed by Article 9 of the Uniform Commercial code (UCC). Terminology:
• Security Interest – interest in personal property or
fixtures put up as collateral
• Debtor – person who has interest in the collateral
• Secured Party – lender, seller, or other person
• Security Agreement – agreement that creates or
provides for security interest
Scope of Article 9 – Provides unified, comprehensive scheme for all
types of secured transactions. Does not apply to security subject to a
landlord’s lien or to certain other exceptions.
Formal Requisites – Oral agreement sufficient when secured party
takes possession of collateral. Otherwise, authenticated security
agreement required. To be enforceable, value must be given in
exchange for security interest and debtor must have rights in the
collateral.
Security Agreements – identify parties & property used as collateral.
Specify debtor’s obligations and lenders remedies.
Parties – Secured party is the lender. Debtor owns collateral & is
also obligor if it owes payment or services.
 Granting Clause – agreement must be signed or otherwise
authenticated & expressly grant security interest. Standard operative
words: “The debtor hereby grants to the secured party a security
interest in…”
Description of the Collateral – need not be specific as long as it
reasonably identifies property. Frequently, secured party will take
security interest in ALL assets of debtor (blanket security interest).
Includes things like inventory, receivables, patents, trademarks, etc.
After-Acquired Property – property acquired after execution of
security agreement. Assets may be specified either in addition to, or
as replacements of, currently owned assets covered by agreement.
Proceeds – security interest in collateral gives secured party rights to
proceeds of collateral if sold, leased, etc.
Debtor’s Obligations – obligated to repay debt & interest, fees,
charges, expenses. Likely to have non-monetary obligations to
maintain prescribed standards of financial well-being (net worth, cash
flow, leverage, etc)
Cross-Collateralization – collateral for one loan used as collateral for
another loan if provided for in agreement
Remedies for Default – secured party has right to take possession of
collateral without judicial process. Party may (1) dispose of collateral
at public or private sale or (2) propose to retain collateral in full or
partial satisfaction of debt. Proceeds applied in following order: (1)
expenses of foreclosure & attorney’s fees, (2) satisfaction of
obligations secured, and (3) satisfaction of any subordinate security
interest.
Perfecting a Security Interest – to protect rights in collateral, lender must
ensure its security interest is perfected, that is, prior to (1) rights of other
secured creditors, (2)rights of certain buyers, lessees, licensees, (3) rights of
trustee in bankruptcy & other lien creditors. Perfected through one of the
means below:
By Possession – security interest in money perfected only by taking
possession. Interest in goods, documents, chattel paper perfected by
either possession or by filing a financial statement.
By Filing – file a UCC-1 Financial Statement form.
By Control – security in investment property, electronic chattel paper,
or deposit accounts perfected by control. Parties agree bank will
comply with instructions of secured party without further consent by
debtor.
Automatic Perfection – neither possession nor filing required.
Limited duration. Must be followed by possession or filing if perfection
is to survive for longer period. (Ex: Purchase-money security interest
taken by seller at time of purchase to secure payment of the purchase
price).
Types of Creditors and Their Rights – law gives certain creditors priority
over others depending on nature of contract
Secured Creditors – generally, the first secured creditor to perfect
has priority in payment over all others
Unsecured Trade Creditors – have no security interest in any
collateral but only a general claim against company
Equipment Lessors – entities finance leases and provide extended
financing for lease or purchase of equipment
Taxing Authorities – IRS & state taxing authorities have right to place
liens on property for unpaid taxes & may seize property.
Employees – claim for wages, salary, vacation, sick leave is generally
treated as unsecured claim. In bankruptcy, given priority claim for up
to $10,000 in compensation earned but unpaid in 180 days prior to
bankruptcy.
Personal Guaranties – some creditors may demand firm’s founder or
officers personally guarantee repayment of credit extended. Exposes
individual’s home & other assets to creditor’s claim.
Strategies for Responding to a Financial Crisis – specific responses
depend on nature of crisis, kinds of creditors involved, and amount & type of
claims. However, conserving cash and gaining additional time are critical.
General Considerations – Consider hiring financial consultant with
experience in refocusing business plans, analyzing financial data, &
preparing budgets to help persuade creditors that venture can work its
way out of crisis. Firm may be forced into involuntary bankruptcy (see
below). If personal guarantees have been made, lender may demand
payment. Likewise, general partners in partnership are personally
liable for firm’s debts. When company enters zone of insolvency,
officers and directors owe expanded fiduciary duties to creditors. Must
take special care to work in interests of both shareholders and
creditors.
Out-of-Court Reorganization – Firm contacts creditors to request
payment moratorium or negotiate new terms. Secured creditors may
be willing to overlook defaults on financial covenants. If company has
lost credibility with creditors, may have to use an intermediary who
facilitate workouts by organizing committee of creditors to negotiate
agreements. Committee usually requires firm to provide intermediary,
working on behalf of creditors, with a security interest in all the firm’s
assets.
Out-of-Court Liquidation – non-bankruptcy liquidation
(accomplished by company itself of with help of intermediary) may
result in higher payments to creditors. Firm winds down operations
over period of time, liquidating assets and distributing proceeds on pro
rata basis to creditors. Intermediaries can be appointed to take
possession and control of all assets, then liquidating and distributing
proceeds.
 Secured Creditors and Foreclosure – If liquidation is chosen,
secured creditors may opt to repossess its collateral and foreclose.
Alternatively, creditor may reach some form of forebearance (debt
restructure) agreement to give control of collateral to liquidator who
sells and provides distributions to creditors.
Types of Bankruptcy – voluntary bankruptcy allows company to retain
possession of assets, propose plan to restructure its debts to creditors, and
emerge in better financial shape. However, finances become open book to
creditors and approval of bankruptcy court is required for any business
decision outside ordinary course of business.
Chapter 11 Reorganization vs. Chapter 7 Liquidation – Chapter
11 reorganization offers company tools to propose restructure plan &
emerge from bankruptcy as a going concern. Chapter 7 liquidation, or
straight bankruptcy, liquidates all assets for distribution to creditors.
Voluntary vs. Involuntary Bankruptcy – 3 or more creditors with
claims aggregating $12,300 can file petition to force company into
involuntary bankruptcy, but they will face damages if unsuccessful in
convincing the court. Company can respond by (1) objecting to the
effort (in which case a court determines outcome), or (2) consenting by
filing its own Chapter 11 or 7 petition. If involuntary petition filed in
bad faith, company’s can face compensatory and punitive damages.
Fiduciary Duties of Officers of Insolvent Company – When a company
becomes insolvent, or enters zone of insolvency, fiduciary duty of directors
and officers expands beyond shareholders to include creditors. D&O must be
careful not to approve or take actions that favor shareholders at expense of
creditors.
Chapter 11 Bankruptcy Process – designed to permit company to
reorganize its business by changing terms on which debt must be paid.
Accomplished through plan of reorganization proposed by debtor company &
considered by court. Debtor generally stays in possession and control of its
assets, known as debtor-in-possession.
Costs of Bankruptcy – Negative impact on customer & vendor
confidence, stigma associated with filing for bankruptcy,
accountant/consultant fees, $100,000-$250,000 in attorney’s fees paid
up-front.
Automatic Stay – immediately upon filing, automatic stay to prevent
creditors from pursuing collection of debts (repossession, foreclosure,
termination of contracts). Subject to being lifted by court if (1) debtor
does not have equity over & above claims of secured creditors &
reorganization prospects are doubtful, or (2) if court finds that other
good cause exists.
Types of Creditor Claims in Bankruptcy – every creditor has right
to file proof of claim by the bar date. If not filed by that date, may be
barred from recovering anything in the bankruptcy. Debtor then
categorizes claim:
• Disputed – company believes claim is not valid
 • Contingent – claim will be valid only if some other event does
or does not occur
• Unliquidated – amount of the claim has not been established
Payment Priority – claims are paid in the following order:
• Secured claims
• Administrative claims (include claims of debtor’s attorneys,
accountants, & post-bankruptcy claims for business expenses,
wages for work performed post-petition, post-petition raw
materials, leases, etc.
• Claims of creditors arising between time of filing & decision to
put the company in bankruptcy
• Pre-petition claims of employees for unpaid salary & benefits up
to $10,000 per employee
• Consumer deposits for personal & household goods
• Certain pre-petition income & other taxes
• General unsecured claims (by trade creditors & creditors w/
executory contracts rejected in bankruptcy)
Executory Contracts and Leases – agreement in which both parties
to contract have continuing obligations to perform. In bankruptcy,
debtor company has right to terminate active performance obligations
in executory contracts. Rejection is treated as breach of contract &
must be approved by bankruptcy court. Other party can file claim
(treated as pre-petition unsecured claim). Debtor company may also
assume or assume & assign contract to another person regardless of
whether non-debtor approves. Before court allows company to assume
contract, it must (1) cure any defaults, (2) compensate for any
pecuniary losses (i.e. attorney’s fees) suffered by non-debtor, and (3)
provide adequate assurances of ability to perform under contract in
future.
Preference and Fraudulent Transfer Claims – creditor’s committee
may pursue recovery of preferential or fraudulent transfers made by
debtor company prior to bankruptcy.
Preferences – transfers made by debtor, when insolvent, to creditor
on account of pre-existing debt in the 90 days prior to filing of
bankruptcy petition (one year prior for payments made to debtor
company insiders). All payments may be recoverable. Certain
defenses for creditor include: payments made in ordinary course of
business, C.O.D., or other exchange.
Fraudulent Transfers – transfers made with intent to hinder, delay,
or defraud creditors. Include transfers made by debtor when
financially impaired and for which debtor did not receive reasonably
equivalent value in return. Unlike 90-day rule for preferences, reach-
back period extends to 4 years prior to bankruptcy.
 Creditor’s Committee – committee of unsecured creditors, generally
including debtor’s largest unsecured creditors (may also be appointed
for bondholders, equity security holders, etc). United States Trustee
(division of U.S. Justice Department) appoints committee usually in first
month after case is filed.
Effect of Bankruptcy on Director & Officer Litigation and
Indemnification – no stay of litigation against anyone other than debtor.
Directors and officers may be sued in bankruptcy.
Running a Business in Bankruptcy – court approval is not necessary for
transactions in the ordinary course of business. Notice to interested parties
and court approval are required prior to: (1) using, leasing, or selling property
outside ordinary course of business, (2) borrowing money on secured or
super-priority basis, (3) rejecting or assuming pre-petition contracts, (4)
entering into new contracts or settlement agreements that affect property of
the company.
Cash Collateral – when secured creditor’s collateral includes cash or
cash proceeds of other collateral, debtor company may not use the
cash collateral without adequately protecting creditor or obtaining its
permission.
Post-Petition Financing – debtor may obtain post-petition or debtor-
in-possession financing on such terms as bankruptcy court approves.
New post-petition lender receives security interest in post-petition
assets as wellas administrative claim ahead of all other administrative
claims (including attorney’s & other professionals fees)
Chapter 11 Plan of Reorganization – along with plan, debtor company
must file disclosure statement informing creditors and equity security holders
of material financial and business information used to evaluate plan of
reorganization. Statement sent to all creditors along with plan and ballot for
voting. After ballots tabulated, court holds hearing on confirmation of
reorganization plan.
Exclusivity Period – debtor has exclusive right to propose plan of
reorganization during first 120 days. Court can extend, but not beyond
18 months. If exclusivity terminated or expires, any creditor can file a
proposed plan.
Classification of Claims – plan of reorganization must classify
creditors into classes. Each secured creditor placed in own class.
General unsecured creditors & equity security holders placed into
separate classes. Subordinated debt holders placed in separate class
or grouped with unsecured. Classes designated as impaired if they will
not receive all their state-law rights. Impaired classes may vote on
reorg plan, but unimpaired cannot
Unasserted, Contingent, and Unliquidated Claims – Unasserted –
creditor has a claim & learns of bankruptcy, but fails to file proof of
claim, claim may be barred from any recovery & discharged.
Contingent & unliquidated claims may unduly delay reorganization in
 process of fixing or liquidating them. Court may estimate claim for
purposes of bankruptcy case to speed case along.
Plan Voting Requirements – at least one impaired class must vote to
accept reorganization plan. For a class to accept the plan, two-thirds
of the dollar amount of claims actually voting on the plan and a
majority of creditors voting on the plan must vote to accept. If all
impaired classes accept plan, confirmation is obtained more easily. If
one class accepts, debtor company may attempt to “cramdown” the
plan on other classes.
Cramdown Issues and the Absolute Priority Rule – Absolute
priority rule states that for unsecured creditors to be crammed down,
either they must be paid in full with interest or all junior classes
(including equity holders) must be precluded from receiving ANY
property. New Value Exception allows junior class, generally
shareholders, to retain shares if they contribute substantial new value
to debtor in form of money or property essential to funding
reorganization. Rather than rely on this exception, equity holders
normally negotiate a plan of reorganization that all classes can vote in
favor of. In this case, equity holders may retain whatever percentage
of ownership they can negotiate with the debtor.
Considerations in the Negotiation and Proposal of a Chapter 11
Plan – Generally, plan must adhere to the payment priority scheme
shown above. Interests of shareholders must be subordinated to those
of creditors. During first 120 days, when debtor has exclusive right to
propose a plan, debtor’s management and board must remember
fiduciary duty to all constituents, including creditors.
Discharge of Claims – If court approves reorganization plan and
debtor remains in business, all debts to creditors are discharged.
Creditors must accept property distributed according to reorganization
plan as full satisfaction on their claims.
Prepackaged Bankruptcy and Plans of Reorganization – often takes
months to propose reorganization plan & win approval from court. In pre-
packaged bankruptcy, Bankruptcy Code permits debtor to prepare
disclosure statement and plan, circulate statement and plan to creditors, and
complete voting on plan before filing the bankruptcy petition. In pre-
negotiated bankruptcy, debtor negotiates terms of plan prior to filing for
bankruptcy, but solicits votes only after case is filed and disclosure statement
is approved. Pre-negotiated may be cheaper because formal disclosure
statement and plan are drafted only if bankruptcy is filed. Pre-packaged is
most effective for holding companies holding large amounts of public bond or
debenture debt they seek to restructure or for companies with insignificant
disputed, contingent, or unliquidated claims and no major litigation pending.
Business Combination Through Chapter 11 Bankruptcy –
reorganization plan may set forth terms of a merger between debtor
company and another company and provide for stock of debtor company to
be sold to the acquiring company. Disadvantage to this approach is that the
acquiring company generally becomes liable for all debts of the debtor.
Payment priority scheme & cramdown rules may make it difficult to direct
that debtor’s shareholders receive proceeds of the merger. Alternative to a
stock merger is a sale of debtor’s assets free and clear of liens with proceeds
paid into the bankruptcy estate.
Loss of Control and Other Risks in Bankruptcy – (1) Debtor’s
management may lose control of company during bankruptcy because
creditors can file motion seeking appointment of independent Chapter 11
trustee to take possession of all assets (typically due to fraud or gross
mismanagement). (2) Another risk is that the court convert chapter 11
reorganization into chapter 7 liquidation. Conversion can be ordered for
cause, inability to develop a reorganization plan, unreasonable delays
prejudicial to creditors, or failure to meet court-imposed deadlines.
Bankruptcy Pros & Cons –
Advantages Disadvantages
• Automatic stay of creditor actions • Expensive
• Power to reject unfavorable • Court approval required for
executor contracts & limit decisions outside ordinary course
damages on leases of business
• Power to force restructure of debts • Potential loss of customer or
on non-consenting creditors vendor relationships
• Ability to recover preferences and • Possible loss of control through
fraudulent transfers conversion to Chapter 7 or
appointment of trustee
• Opportunity to preserve going
concern value of company • Risk that shareholder’s equity will
be wiped out in favor of creditors
Legal Ch. 17: Going Public

Why go public?
• Need capital , access to additional capital after public

• Belief the public capital markets will facilitate additional funding

at higher valuations and therefore result in less dilution to initial
investors

• Public offering is viable

• Ability to use stock for purchases and incentives

• Public visibility

• Investors can receive return on investment

Disadvantages to going public:

• Legal obligations (reporting, etc)

• Public scrutiny

• Mandatory compliance to regulatory reforms (Sarbanes-Oxley)

• Disclosure of stock ownership by officers and board of directors

and compensation plans

• Expensive legal fees

• Time consuming in a critical period

Impediments to sale of stock in an IPO:

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

• Rules against insider trading

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

• Officers and affiliates are required to report transactions of their

stock to the SEC

Reasons to sell the company vs IPO:

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

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

• Immediate liquidity for shareholders (but higher taxes)

• All disadvantages to going public

Reasons not to sell the company:

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

• If sold before IPO will not receive the premium

• Liquidation preferences of outstanding preferred stock may eat

up profits (in IPO those stocks typically convert to common
stock)

• Loss of control

Timing of an IPO is dependent on:

• If the market is receptive to IPOs at the time

• If the relevant industry is ‘hot’

• If the major institutional investors have exceeded the proportion

of their portfolios reserved for investment

• If a competitor or other company in the industry have

announced disappointing results
When IPO timing is not ideal, seek bridge financing from existing investors or
mezzanine financing from new investors until market conditions improve or
product milestones are achieved.

IPOs happen more slowly now due to increased regulatory scrutiny

Prospectus- detailed selling document which describes the company and its
business and management

Due Dilligence- a review of the company’s business and legal affairs that is
done to ensure the accuracy of the prospectus

Pre-effective- the amendments filed prior to pricing the deal before the
registration statement has been declared effective by the SEC typically revise
the registration statement and prospectus in response to SEC comments

Preliminary Prospectus-or Red Herring- Prospectus with red lettering on

cover to warn of its preliminary and incomplete status. Price and other items
are omitted because they are yet to be determined.

Road Show- a series of meeting s with potential investors arranged by the

underwriters in a number or major cities during a 2-3 week period

Pricing Committee-committee formed from the Board of Directors that

approve the managing underwriters’ advice on the number of shares and
price at which there is the appropriate demand

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

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

Board committees:

• Audit- reviews the company’s auditors and evaluates the accounting

systems and controls

o Required to be financially literate

o Subject to more stringent definition of independent

o Required to have at least one financial expert

 • Compensation- approving compensation plans and strategies

• Nominate and Corporate Governance- identify and evaluate board

candidates and oversee board committees , stockholder
communications and other governance matters

IPO Process:
1. Selecting the underwriters and designating managing underwriter and
co-managers

2. All hands meeting where the schedule is distributed.

3. Drafting the registration statement for SEC (4-6 weeks) [company

council responsible for coordinating the registration statement and
getting it through the SEC]

4. Company submits registration statement to SEC ; application to

exchange for listing

5. SEC evaluates for adequacy of the disclosure in the prospectus

6. 30 days after registration has been filed: SEC submits comment s to

filer

7. Pre-effective written

8. Preliminary Prospectus written by working group (see definition below);

draft of comfort letter

9. Prelim Prospectus filed; registration under Securities Exchange Act

1934

10.Managing underwriters organize the Road Show

11.2-3 days after Prelim Prospectus filed – Road show (SEC review must be
complete or nearly complete to go on Road Show)

12.Company gives presentation to interested buyers while on the Road

Show (2-3weeks)

13.SEC declares the Registration Statement effective; Registration under

SEC ACT 1934 effective

14.Pricing and signing of the underwriting agreement

15.Shares are generally traded the next day

 16.Closing of the purchase and sale of stocks occurs the 3 business days
later

17.Final Prospectus printed and distributed to purchasers of the stock

offering (Required by law) includes final pricing and all changes in the
IPO

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

• Investment banks provide analysts that publish ongoing reports on the

company’s progress

• It is important to evaluate the underwriter’s reputation for its work a

relevant industry (recent deal experience, pricing success, failed or
aborted offerings, commitment to the deal, staff ability and availability,
marketing strength and post IPO support levels)

• Companies in the IPO process are required to speak to the underwriting

investment team and the analysts separately (which was a restriction
set in place by the SEC to limit false information being fed to the
analysts for their reports)

• Companies in IPO status typically choose 2-4 investment banks to act

as underwriters, designating one as the lead underwriter

• Companies should seek a firm commitment where the investment bank

promises to purchase the shares and then sell them to their clients

• The managing underwriters typically purchase the shares at a 6-7%

discount and then sell them to their clients at full price

• Managing underwriters will form a syndicate to share in the risk and

help with the marketing

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

• Company chooses the managing underwriter by Beauty Contest or

other method. The underwriter with the highest valuation of the
company is not always the correct one to choose
Company Council Role:
• Advise company on corporate governance, disclosure and compliance
issues

• Coordinates the drafting of the registration statement and shepherd’s

it throughout the SEC review process

• Helps company select and coordinate with other participants such as

stock exchange reps, printer, transfer agent, bank note company

• Participates in the underwriting agreement

• Review the company’s charter documents and legal records to

determine what actions the company should take prior to going public

• Detailed review of the business, addressing any legal problems that

may emerge

• Identifying items that require disclosure in prospectus

• Conduct detailed review of corporate governance issues such as

Sarbanes-Oxley compliance and independence of Board and Board
committees

• Patent and regulatory council are generally asked to participate in

discussions with working group and review sections of the prospectus
in their area of legal expertise and give opinion

Underwriter’s Council Role:

• Participates on behalf of underwriters in drafting process and due
diligence

• Advising underwriters on legal issues that may arise

• Prepares underwriting agreement

• Devil’s advocate role at prospectus drafting sessions

• Coordinates the review of the underwriting arrangements by the

National Association of Securities Dealers (NASD) and any filings
required by the state securities authorities
Lead Underwriter or Managing Underwriter- bank designated as the
main underwriter

Comanagers-the other banks involved in the IPO

Firm Commitment Offering- the underwriter offers to purchase the shares

(usually at a 6-7% discount) and then resell them to their clients

Best Efforts Offering-investment banks are required only to use their best
efforts to sell the securities

Syndicate- a group of investment banks formed by the managing

underwriters to participate in the offering

Gross Spread- the difference between the offering price to the public and
the proceeds to the company

Beauty Contest or Bake Off- Company holds a competition where each

investment bank makes a presentation to the Board of Directors about the
bank’s strengths and a valuation of the company’s market value and
strengths and weaknesses analysis in order to be selected as the managing
underwriter

First All Hands Meeting- first meeting where all key participants are
required to attend and the schedule for the IPO timing is distributed

Form S-1- the form most used for the registration statement submitted to
the SEC

Form SB-2-SEC registration form for smaller companies requiring less

disclosure

Working Group-Selected members of the company’s management working

under the guidance of their underwriters, company council, underwriter’s
council and an independent accounting firm to prepare the prospectus

Underwriting Agreement-agreement between the company and the

managing underwriters which covers the aspects of the offering including the
gross spread (done after the SEC declares the registration statement
effective)

Comfort Letter- letter prepared by the auditors to address SEC comments

related to accounting issues. It summarizes the procedures the auditors used
to verify financial information in the prospectus and describes the scope of
the review in the prospectus
Transfer Agent-a specialized stock transfer company or a commercial bank
who issues and effects transfers of the company’s shares and coordinates
mailings to the shareholders

Bank Note Company-helps design and print the new stock certificates that
will be issued to shareholders in the public offering

Underwriter’s Book- the collection of potential investor’s nonbinding

statement of intent to purchase shares

Target Price-the price at which the underwriter (or other holder of stock)
hopes to sell the stock

Public Float-the value of the shares held by investors other than officers,
directors and 10% shareholders

Green Shoe-over-allotment option granted to underwriters to purchase

additional shares at the IPO price. Typically gives the underwriters the right
to purchase an amount of additional shares equal to 15% of the original
offering within 30 days

Registration Rights-Rights of certain current shareholders to sell shares

during an IPO

Blue Sky Laws-While the SEC directly, and through its oversight of the NASD
and the various Exchanges, is the main enforcer of the nation's securities
laws, each individual state has its own securities laws and rules which are
known as the Blue Sky Laws and must be met in each state where the
underwriter will offer their shares. Federal Law trumps Blue Sky Law

Free Writing Prospectus-a written communication that constitutes an offer

of securities but does not meet statutory requirements for a prospectus. It is
not considered part of the registration statement. Must be used after the
prelim prospectus and must be filed with the SEC along with any other
marketing documents

Recirculation-circulating the revised copy of the prospectus to all persons

who received an earlier version, must be done when there are any changes
(price, material changes, etc)

Friends and Family Shares or Directed Shares-a portion of the shares

set aside by the underwriters and sold to purchasers specifically identified by
the company. These transactions occur at the same time as the share
distribution through the syndicate. Has become less frequent in recent years
because the list becomes unmanageable. Also may raise SEC concerns that
the reported revenue from these customers are overstated and the SEC will
require disclosure. Raises concerns that the company did not adequately
disclose information to these customers

Closing-the stock certificates are delivered and the funds are received

Lockup Agreements-a condition to the offering where underwriters require

most shareholders including all the employees of the company from selling
any shares for a specified period of time generally 180 days from the IPO
effective date. Most underwriters believe that unless 90-95% of the shares
are locked up the IPO may be jeopardized

Form S-8-stock issued after the IPO pursuant to employee compensation

plans that are unrestricted and freely tradable.

Restricted stock-stock not sold in public offering that was not issued under
employee plans or for compensatory purposes must generally be resold
under compliance with Rule 144 under the 1033 Act

Rule 144-requires the securities be held for at least 1 yr after the purchase
and be sold in limited quantities through brokers or market makers. Limits
the amount that may be sold in a three month period to the greater of 1% of
the outstanding shares and the average weekly trading volume in the
preceding 4 weeks. Form 144 notice must be filed with the SEC when the
order to sell is placed

Material Information- information is considered material if its

dissemination would be likely to affect the market price of the company’s
stock or would likely be considered important by a reasonable investor who is
considering whether to trade in the company’s securities

The Prospectus:
• Box Summary

• Risk Factors

• Use of Proceeds

• Management’s Discussion and Analysis of Financial Condition and

Results of Operations (MD&A)

• Business Section

• Management Section

• Audited Financial Statements

Box Summary-the summary at the beginning of the prospectus which
summarizes the key elements of the company’s business, strategy and
financial statements

MD&A- Management’s Discussion and Analysis of Financial Condition and

Results of Operations. At least 3 most recent fiscal years and any applicable
interim periods (unless company has short history). Analysis of material
changes and reasons for changes, unusual and nonrecurring events that may
be misleading, in order to better understand financial situation of company.
Forward looking analysis including info that may not be readily evident in
financial statements

Business Section- narrative description of company (product,

manufacturing, marketing, etc), strategy and goals

Management Section- biographies of officers, directors and key employees.

Describes compensation, employee benefit plans, board committees, board
independence and other corporate governance issues

Audited Financial Statements-must conform to GAAP

FAS 123R-accounting rule effective Jan 2006 under which equity based
payments such as stock options generate a current charge to earnings based
on their fair value

Section 409A-Internal Revenue Code where equity awards will result in

adverse tax consequences if they are determined to be granted below fair
market value.

If the company has granted stock options 12-18 months prior to the IPO
significantly below the IPO price an additional charge to earnings to reflect
the issuance of ‘cheap stock’ may be required

Cheap Stock- Stock issued significantly below the IPO price before the IPO

Deemed Dividend- the built in gain achieved when cheap stock sold (to
non employees)

Liability for Misstatements in the Prospectus:

Section 11 and 12 of the 1933 Securities Act makes the officers who sign the
registration statement (CEO, CFO, Chief Accounting Officer), named directors
and underwriters civilly liable to the purchasers of shares for any untrue
statement of material fact contained in the registration statement or for
failure to mention a fact required to be disclosed or one that is necessary to
sufficiently explain the information so as to not be misleading. The auditors
are also liable for misrepresentation or omission in the financial statements
Pre-filing Publicity:
The company’s communications are most significantly restricted during the
pre-filing period [Includes verbal communication and Website
information]

During this period the company may not:

• Issue forecasts, projections or predictions about future performance

Safe Harbor- A period designated by the SEC ending 30 days prior to

the filing of a registration statement during which issuers may
communicate without risk of violating gun jumping provisions so
long as:

• Communication does not reference a securities offering

• Communication is made by or on behalf of the issuer

• The issuer takes reasonable steps to prevent further distribution of the

information during the 30 days prior to the filing of the registration
statement

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

to:

• Continue advertising consistent with past practices

• Send out customary reports to shareholders

• Make routine press announcements regarding factual business

developments

Gun Jumping Violation-conditioning the market prior to an IPO by making

offers to prospective purchasers without delivering a valid preliminary
prospectus

Any publication of information or publicity effort before a proposed public

offering that conditions the public mind or arouses public interest in the
issuer or its securities may constitute an impermissible offer to sell under fed
securities laws

The SEC may delay the public offering until the effect of the violations has
dissipated. May also result in criminal and civil actions against the issuer

Post filing Publicity:

Registration Period or Waiting Period- the period between the time the
registration statement is filed but before it is declared effective. During this
time the company and the underwriters will conduct the road show.
Disclosure of material not in the prospectus is not permitted

Quiet Period- 25 day period after the effectiveness of the registration

statement and the offering where sales of securities can begin and the final
prospectus is delivered. Company is not advertising during this time

Tombstone Advertisement- traditional advertisement in the financial press

placed by the underwriters which is governed by regulation and custom

Due Diligence:
• Due diligence review includes the company, underwriters, all legal
council

• Reviews the information about the company in the registration

statement

• Identify what needs to be disclosed in order to reduce risks

• Includes discussion with key customers, suppliers, collaborators,

licensors, etc

• Reviews environmental issues, projections, plans and strategy, etc

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

an opinion

• Underwriters are not permitted to share their research with the

analysts

• Reveal any existing agreements or relationships that should be

terminated

Due Diligence Defense-a director or underwriter may avoid liability by

establishing that he/she exercised due diligence – after undertaking
reasonable investigation they believed the statement to be accurate.

It is more difficult for officers to demonstrate that they would not be aware of
an inaccuracy or omission If they exercised due diligence.

Willful misrepresentations or omissions can result in criminal prosecution and

imprisonment

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

• Only the preliminary prospectus can be discussed and distributed. No

information outside the prospectus may be given

• Company and underwriters have liability for anything said or presented

during this time

Determination of Stock Price and Offering Size

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

• Actual price will be determined by negotiations between company and

underwriters and depends significantly on demand

• Company will need to effect a stock split of outstanding stock before

the offering to bring the expected price per share into normal range

• Due diligence in the valuation model is preformed before the

registration statement is filed and the red herring is printed

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

• Underwriters prefer to have several times the indications to purchase

than the number of shares available

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

target price

• The size of the offering depends on the company’s capital needs,

dilution to existing shareholders, the level of public float needed to
achieve an active trading market and provide liquidity for existing
shareholders, market receptivity, proposed price per share

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

• Information in redacted and then the report will be made public

• Requests for the confidential information are cleared through the SEC
prior to the effectiveness of the IPO
Each exchange has its own listing requirements

Nasdaq-GM offers real time trading information and is followed by more

analysts and shareholders than Nasdaq SmallCap Market. Nasdaq-GM is has
more strict listing requirements than Nasdaq SmallCap. NYSE has more
strict listing requirements than Nasdaq-GM

Reasons for delayed or terminated IPO:

• Temporary downturn of the stock market or IPO climate

• Need to incorporate another quarter’s info into the prospectus

• Acquisition and related disclosure issues

• Regulatory problems

• Change in company management

• Insufficient interest in company’s stock after road show

Offerings are most frequently delayed

1. Before responding to SEC comments and filing an amendment to the
registration statement

2. Before printing the prospectus

3. At or near completion of road show

If the company and its underwriters decide not to complete the IPO the
company asks the SEC to withdraw its registration statement and continues
as a private company

In the event of a terminated offering, securities laws limit the ability of the
company to complete a private financing within 6 months of the termination
unless the company follows the rules and requirements of Rule 155 under the
Securities Act of 1933

Rule 155 under the Securities Act of 1933 [Not From Book]

• No securities were sold

• Registration statement withdrawn

• Waiting period of 30 days

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

• Update disclosures in the private offering memorandum to reflect

current conditions

Trading of company stock acquired prior to the IPO is restricted under the
federal security laws. Neither common stock previously issued to employees
nor common stock is converted to common stock may be sold on the open
market unless certain conditions are satisfied.

Employee shares issued prior to the IPO under written compensatory plans
may generally be sold under Rule 701 of the 1933 Act 90 days after the IPO
by employees who are not affiliates of the company and are not otherwise
locked up.

Current and Periodic Reports:

Form 10-K- annual report that provides a continuing update of information
about the company and its management. Includes description of the
company’s business for the preceding year, risk factors, disclosure controls
and procedures, internal controls over financial reporting as mandated by
Section 404 of Sarbanes-Oxley, management and executive
compensation, audited financial statements and MD&A

Form 10-Q- quarterly report includes the summary of unaudited financial

report statements, an MD&A section, risk factors and information concerning
new developments in legal proceedings, disclosure and internal controls and
shareholder’s actions taken within the quarter

Form 8-K- current report required to be filed within 4 business days following
the event giving rise to the reporting obligation. Intended to supplement the
normal recurring filing requirements when material events occur that should
be brought to the prompt attention of the investing public including:

• Entry into or termination of material agreement

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

disposition transaction

• Bankruptcy

• Change in accountants
 • Results of operations

• Creation of or triggering events that accelerate direct financial

obligations under, off-balance sheet arrangements

• Notice of delisting

• Unregistered sale of securities

• Departure or election of principal officers or directors

• Amendments or waivers to the company’s code of ethics

• Other material disclosures

Effect of Proxy Rules:

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

Director’s Responsibilities in a Public Company:

Directors are bound by duties of loyalty and care imposed by the law of the
state where the company is incorporated. These duties are applicable to
directors of private companies as well as public companies.

Director’s liability for security claims-subject to damage claims for

securities fraud under the antifraud rules if:

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

• they knew or should have known that a proxy solicitation issued on

their behalf contained false or misleading statements or omissions

• they issued misleading press releases

• they issued misleading reports to shareholders

• they gave misleading speeches

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

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

blackout periods

Indemnification and Liability Insurance for Directors- under the laws of

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

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

Parties with fiduciary duty to the shareholders and the company:

• directors

• officers

• employees

• accountants
 • attorneys

• consultants

• Temporary insiders

o Investment bankers

o Rating agencies

Safe Harbor for Preexisting Arrangements or Blind

Trusts:
Rule 10b5-1- Rule under the 1934 Act which provides that a trade will be
deemed to be made on the basis of material nonpublic information if the
person making the trade was aware of the information at the time of the
trade unless the insider has taken specific measures under Rule 10b5-1c

Rule 10b5-1c- provides for a ‘safe harbor’ for traders who otherwise would
have been deemed as violators of insider trading. The provisions of the
safe harbor are:

• An individual can at a time when he/she has no nonpublic information

expressly authorize trades in the future by

o Entering into a binding contract to make the trades

o Instructing another to make the trades on his/her behalf

o Adopting a written plan for making trades

• The contract, instruction or plan must be specific as to the amount of

shares and the price and trading date or must include a formula or
other specific manner of determining the amount, price, and trading
date.

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

• An insider must be acting in good faith and not pursuant to a plan or

scheme to evade insider trading restrictions

• An insider may trade by blind trust-empowering another to make

trades at their discretion, someone who does not have access to the
insider information. The insider is required to implement reasonable
 policies and procedures to prevent the trader from obtaining the
insider information and to ensure that if they do that they do not act on
it

Company Liability:
Insider Trading and Securities Fraud Enforcement Act of 1988
(UTSFEA)-Provision that any controlling person who knew or recklessly
disregarded the fact that a controlled person was likely to engage in an
insider trading violation and failed to take appropriate steps to prevent such
acts before they occurred may be independently liable for a civil penalty of
up to the greater of $1million or 3x the controlled person’s profits or avoided
losses resulting from the violation.

Adopting a written policy prohibiting insider trading can reduce the

company’s exposure for controlling-person liability. In the event that an
employee does violate the law, the policy and related procedures reduce the
risk that the company itself will be liable under the ITSFEA

Window-Period Policies- prohibit persons (usually directors, officers and

principal shareholders) from trading in the company’s stock during a specific
period such as two to four weeks prior to the end of a quarter and extending
48-72 hours after the company has released its earnings statement. The
company usually retains the right to close the trading window early or not
open it at all if there is undisclosed information that would make trades by
insiders inappropriate.

Liability for Short-Swing Profits:

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

Insider Reports:
Section 16(a)-requires that each executive officer and director of a
company involved in an IPO file a Form 3

Form 3-form filed by each officer and director that details the beneficial
ownership of securities of the company. Typically filed at the same time the
public offering becomes effective. Form 3s are also required within 10 days
of the election of any new director or officer of the company
Form 4-filing of any change of beneficial ownership, including gifts and
transfers to trusts. Must be filed within 2 business days after the day in
which the change occurs

Form 5-annual filing to report transactions that were not otherwise

reportable or reported

The SEC has power to seek monetary fines from individuals for
violation of these laws up to the following limits:

• Up to $6k individual or $65k entity per violation for simple violations

such as late filing or non-filing of forms under Section 16 [A new
violation may occur for each day the filing is late or not corrected]

• Up to $65k individual or $325k entity per violation involving fraud,

deceit, manipulation, or deliberate or reckless disregard of the law

• Up to $130k individual or $650k entity per violation involving fraud or

reckless disregard AND result in or create a risk of substantial losses to
others or substantial gain to individual or entity involved

Post IPO Disclosure, Communications with Analysts

and Regulation Fair Disclosure (FD):
A company must disclose material information when:

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

• It is necessary to satisfy the company’s obligation under the listing

agreement with the exchange

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

securities

• Necessary to correct a prior statement that the company learns was

materially untrue or misleading at the time of publication

• The company is otherwise making a public disclosure and the omission

could be misleading

• Material nonpublic information has been disclosed, intentionally or

unintentionally to one or a group of shareholders or to investment
professionals such as analysts and not to the general public

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

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

Communications with Analysts, Selective Disclosure

and Regulation Fair Disclosure (FD):
No information ever given to an Analyst is off the record

Casual or ill-considered disclosure to an analyst of material inside information

can lead to shareholder’s lawsuits and SEC investigations for securities fraud
and insider trading and violation of Fair Disclosure

Selective Disclosure-the release of material information on an individual

basis without its simultaneous release to the public generally

SEC Regulation FD-Fair Disclosure- regulation designed to prevent and

regulate selective disclosure and to reinforce a company’s obligations to keep
the public informed in a fair and evenhanded manner.

• Restricts a company’s senior officers and others who regularly

communicate with analysts or investors from selective disclosure when
it is foreseeable that shareholders will trade on the basis of the
information

• If selective disclosure is unintentional the company must broadly

disseminate the information within 24hrs from the selective disclosure
of the commencement of the next day’s trading

• Usually is disseminated on the Form 8-K

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

• It knows or should have known that the information selectively

disclosed is both material and nonpublic

• It fails to properly disseminate information to the public

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

Individuals can also be held liable for selective disclosure either as direct
violators or aiders and abettors

The SEC is empowered to sue under Regulation FD

Any affected shareholder can sue under Section 10(b) of the 1934 Act is the
selective disclosure amounted to illegal tipping by an insider under Rule 10b-
5.

Liability for an Analyst’s Report:

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

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

Sole C S Corp General Limited Limited

Proprietorsh Corp Partnersh Partnersh Liability
ip ip ip Compan
y

Limited Liability No Yes Yes No Yesa Yes

Flow-through Yes No Yes Yes Yes Yes

taxation

Simplicity/low cost Yes Yes Yes No No No

Limitations on Yes No Yes No No No

eligibility

Limitations on Yes No Yes No No No

capital structure

a
: Limited liability for limited partners only; a limited partnership must have at least one general partner
with unlimited liability
Ability to take No Yes Yesb Noc No No
public

Flexible charter Yes No No Yes Yes Yes

documents

Ability to change Yes No No Yes Yes Yes

structure without
tax

Favorable employee No Yes Yes/N Noe No No

incentives od
(including stock
options)

Qualified small No Yesf No No No No

business stock
exclusion for gains
and roll-over ability

Special allocations No No No Yes Yes Yes

Tax-free in-kind Yes No No Yes Yes Yes

distributions

b
An S corporation would convert to a C corporation upon a public offering because of the restrictions on
the permissible number of S corporation shareholders
c
Although the public markets are generally available for partnership for LLC offerings, a partnership or
LLC can be incorporated without tax and then taken public.
d
Although an S corporation can issue ISO’s, the inability to have two classes of stock limits favorable
pricing of common stock offered to employees
e
Although partnership and LLC interests can be provided to employees, they are poorly understood by
most employees. Moreover, ISO’s are not available
f
Special low capital gains rate for stock of U.S. C corporations with not more than $50 million in gross
assets at the time stock is issued if the corporation is engaged in an active business and the taxpayer holds
his or her stock for at least five years
Notes from Table 5.1 Tax Treatment of Restricted Stock Awards, Non-
Qualified Stock Options, and Incentive

Please note:

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

Issuance of stock None until shares vest None, unless an 83(b)

subject to vesting unless file an 83(b) election. election was made, in which
(restricted stock) If file 83(b) election, ordinary case compensation deduction
income equal to fair market equal to spread.
value of shares at time of
issuance minus price paid by
employee (the spread)

Restricted Stock Ordinary income equal to Compensation deduction

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

Property Under Section 351, as long None

(including under as the investors (1)
Certain contribute property, not
Circumstances services; (2) receive stock in
Intellectual the corporations; and (3)
Property) is collectively control 80% or
Contributed to more of the corporation after
Newly Formed transaction, the investors
Corporation in pay no tax on the gain (i.e.,
Exchange for the fair market value of the
Stock stock and other property
received minus the cost
basis of the property
contributed), unless they
receive cash or other non-
stock property (boot).
Investors receiving boot are
taxed on the lesser of their
realized gain and the
amount of boot.
Notes from Table 5.1 Tax Treatment of Restricted Stock Awards, Non-
Qualified Stock Options, and Incentive (CONTINUED…)

Event Employee Tax Consequences Employer Tax

Consequences

Founder Contributes Ordinary income equal to the fair Compensation

Services in Exchange for market value of the stock received. deduction
Stock Issued Upon equal to fair
Incorporation market value of
stock.

Grant of Non-qualified None. None.

Stock Options (NQO’s)

Grant of Incentive Stock None. None.

Option (ISO)

Exercise of NQO Ordinary income equal to fair None.

market value of stock on date of
exercise minus option exercise
price (the spread)

Exercise of ISO None, except that the spread will be None.

included as a preference item in
calculating the individual’s alternative
minimum tax (AMT), which could
trigger AMT for the year in which ISO is
exercised. The employee will receive a
tax credit for any AMT paid, which can
be applied against taxes due in future
years.

Sales of Stock Acquired Capital gains equal to sale price None.

Upon Exercise of NQO minus fair market value on date of
exercise

Sale of Stock Acquired Capital gains equal to sale price minus None, unless a
Upon Exercise of ISO exercise price provided that the stock disqualifying
is not disposed of within two years of disposition. If
the grant date or within 12 months disqualifying
after exercise (a disqualifying disposition,
disposition, the gain (i.e. the sale price compensation
minus the exercise price) is taxed as deduction equal
follows; any gain up to the amount of to ordinary
the spread on date of exercise will be income
ordinary income and the balance of the recognized by
gain will be capital gains the employee.