New SEC Cybersecurity Disclosure Rules Are on the Horizon 

By Megan Penick and Jia Song

Last week, new cybersecurity rules were adopted by the Securities and Exchange Commission that directly impact public companies, including foreign private issuers (FPIs), requiring them to make certain disclosures about cybersecurity incidents, risk management, strategy and governance. Taken together, the SEC’s new rules markedly expand upon the federal agency’s current cybersecurity disclosure mandates.

Disclosure on Current Report

The final rule requires public companies to disclose material cybersecurity incidents within four business days on a Current Report on Form 8-K under a new Item 1.05 (Form 6-K for FPIs). Pursuant to Item 1.05, public companies must disclose any cybersecurity incidents they experience that are determined to be material and describe their (1) nature, scope and timing and (2) the expected impact or reasonably likely impact of the incidents upon the companies, their financial condition and results of operations.

A disclosure under Item 1.05 of Form 8-K will need to be filed within four business days after a company has determined an incident to be material in nature. As reporting on cybersecurity breaches can be difficult—because the severity or extent of a breach may not be clear until after significant internal investigation—the SEC has also adopted a rule that requires companies to amend their original Item 1.05 disclosures when and as additional information material to a given breach (or breaches, if there is more than one that is deemed related) is discovered. The SEC has indicated that in order to make cybersecurity incident disclosures clear and easy to find by investors, it was preferred that a Form 8-K disclosing the breach be amended for further disclosures, as opposed to companies simply reporting additional findings in their periodic reports on Forms 10-Q or 10-K.

Disclosure on Annual Report

In addition, the final rule compels public companies to disclose material information regarding their cybersecurity risk management, strategies and governance on their annual reports on Form 10-K (Form 20-F for FPIs)—this by adding a new Item 1C to Part I of the Form 10-K. Item 1C requires registrants to furnish the information required by Item 106 of Regulation S-K (Item 106). Item 106(b) requires registrants to describe their processes, if any, for assessing, identifying and managing material risks from cybersecurity threats, as well as the material effects or reasonably likely material effects of risks from cybersecurity threats and previous cybersecurity incidents. Board of directors’ oversight of risks from cybersecurity threats and managements’ role and expertise in assessing and managing material risks from cybersecurity threats are also mandated pursuant to Item 106(c).

Effective Timeline

The final rule will become effective 30 days after publication in the Federal Register. The Form 10-K and Form 20-F disclosures will be due beginning with annual reports for fiscal years ending on or after December 15, 2023, while the due date for the Form 8-K and Form 6-K disclosures will be the later of 90 days after the date of publication in the Federal Register or December 18, 2023. For their part, smaller reporting companies will have an additional 180 days before they must begin providing the Form 8-K disclosure. With respect to compliance with the structured data requirements, all registrants must tag disclosures required under the final rules in Inline XBRL beginning one year after initial compliance with the related disclosure requirement.

Practical Guidance

Historically, many companies have been slow to disclose hacking or other cybersecurity incidents, fearing that disclosure could expose them to further risks and hamper their ability to assess and secure their data and systems. As a result, many of these incidents have not been reported until long after they occurred. However, as more and more companies have been affected by cyber criminals and data breaches in recent years, a need for prompt and effective disclosure has been seen by many as increasingly necessary. This is particularly the case because many companies rely on third parties to handle data storage and data management, and customers and investors need to be able to assess their own risk and exposure as a result of such incidents. The SEC’s new disclosure mandate is designed to do just that.

To decide whether an event qualifies as a material incident requiring  SEC reporting is a practical issue. Companies should consult with their securities counsel to determine whether an incident is material in nature and, accordingly, whether it will need to be disclosed in a Current Report on Form 8-K. Further, companies, along with their legal counsel and financial advisors, need to value the size, nature and /or reputation or financial harms such incidents may cause, as well as other factors to determine materiality.

Of course, the public securities and cybersecurity pros at Michelman & Robinson, LLP are available to provide more detail and answer any questions you may have about the SEC’s new cybersecurity rules.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.

SCOTUS Ruling Means Shareholders Will Have to Pick Up the Slack in Direct Listings

By Megan Penick, Samuel Licker, and Sara Sarvestani

In the case of Slack Technologies, LLC v. Pirani, the Supreme Court unanimously ruled in favor of Slack, avoiding the distinction between Direct Listings and Initial Public Offerings when citing long-standing precedent concerning the application of Section 11 of the Securities Act of 1933. As a result of his failure to directly link his purchased shares to the 118 million shares registered in Slack’s registration statement, plaintiff Fiyyaz Pirani was denied legal standing in his claim that Slack’s Registration Statement had misled investors who purchased Slack shares following the Company’s June 2019 direct listing to sell its shares to the public on the New York Stock Exchange (NYSE). 

What is a Direct Listing, and how does it differ from an IPO?

Direct listings differ from traditional initial public offerings (IPOs) in that no new shares are issued and, instead, only existing, outstanding shares are sold to the public without the involvement of an underwriter. In other words, a direct listing allows a company’s current investors, promoters and employees who already hold shares in the company to directly sell such shares to the public. However, like an IPO, companies offering shares through the direct listing process must still file a Registration Statement on Form S-1 with the SEC and, as a result, anyone who purchases shares once they are being sold in the market will rely on the disclosures in that registration statement. 

Companies generally raise capital by going public. Traditionally, they do so through the IPO process, in which offerings are backed by underwriters or banks who put up their own capital and demand significant due diligence. IPO’s typically have “lockup agreements,” which prevent unregistered shares and shares owned by insiders from being sold immediately. These practices stabilize prices and boost investor confidence but are costly and time-consuming. To promote smaller private companies in going public, the SEC authorized direct listings in 2018.

What is Section 11 of the Securities Act?

Section 11 is a provision of the Securities Act that establishes civil liability for officers, directors, auditors and other experts signatory to registration statements, as well as underwriters, for material misstatements or omissions of material fact made in registration statements.  

While it’s not directly stated in Section 11 of the Securities Act, case law has historically required plaintiffs to prove they have purchased securities “traceable” to the Registration Statement in order to successfully bring a civil action under Section 11 against the issuer, underwriter, or anyone who contributed to the filing of a Registration Statement for any misrepresentations in such filing. In other words, a plaintiff must be able to “trace” their purchase of securities directly to shares registered in the allegedly misleading Registration Statement.

The Slack Case

Slack’s direct listing made available for purchase 118 million registered shares and 165 million unregistered shares, none of which were subject to lock-up provisions (as is common practice in IPOs) and thus all of which were potentially available for public purchase on the open market. Pirani, a young tech entrepreneur, purchased 30,000 Slack shares as soon as the company went public, and later bought an additional 220,000 registered and unregistered shares. While Slack filed a Registration Statement for the registered shares it intended to offer, investors like Pirani, who purchased his shares on the open market, were not able to distinguish registered shares from unregistered shares in order to trace specific shares to Slack’s Registration Statement. Pirani’s case claimed that all Slack shares available to the public should be covered by the registration statement and therefore he had standing to sue. As a result, the disclosure set forth in the Registration Statement was arguably material to any purchaser of Slack shares during that initial period because Slack had no periodic disclosure filings other than the Registration Statement for a two and half month period following its Direct Listing between June 20, 2019 until September 4, 2019.  

When Slack’s stock price dropped after the Direct Listing, in September 2019, Pirani filed a class-action lawsuit against the Slack under the Securities Act, alleging Slack had violated Section 11 of the Act by filing a fraudulent Registration Statement that contained material misrepresentations and/or omissions concerning service outages, credits for disrupted service and rival Microsoft Teams software. Slack unsuccessfully moved to dismiss on the grounds that Pirani could not fulfill Section 11’s tracing requirement. The district court held that Section 11 does not require tracing in the context of direct listings. On appeal, the Ninth Circuit affirmed, but on different reasoning, concluding that Section 11 does impose a tracing requirement applicable to direct listings, but because NYSE rules permit direct listings only if an effective Registration Statement is in place, unregistered shares qualify as “such securities” within the scope of Section 11. 

In a unanimous decision authored by Justice Gorsuch, the Supreme Court vacated the Ninth Circuit’s ruling. The Court determined that the language and structure of the Securities Act confirmed the long-standing view that Section 11 covers only securities that are registered under the Registration Statement under which the plaintiff has sued, leaving any differentiation between IPOs and Direct Listings to be clarified through Congress. As such, Pirani was denied standing since he had not shown that he had purchased shares registered under the Registration Statement and the Ninth Circuit’s ruling was vacated. Curiously, the SEC did not weigh in on the case.

Why does the SCOTUS ruling matter?

  • The Ninth Circuit’s decision threatened to substantially expand the scope of potential liability under Section 11 to unregistered shares if those shares had a “but for” connection to the challenged Registration Statement.
  • The SCOTUS ruling eliminated that risk by clarifying that Section 11 liability does not extend to unregistered shares or shares sold pursuant to any Registration Statement other than the specific filing being challenged.
  • The SCOTUS ruling reaffirms that Section 11 requires a plaintiff to plead and prove that the purchased securities are traceable to the challenged Registration Statement.

The Bottom Line

For now, the Supreme Court’s decision in Slack returns a sense of continuity to securities markets and the SEC regime. However, in the world of public offerings, the SCOTUS ruling may incentivize more companies to opt for direct listings over IPOs, given that direct listings minimize costs and delays. These companies would be well advised to heed Megan J. Penick’s, M&R partner and Public Securities Chair, advice in a recent interview with the National Law Journal about the SCOTUS decision. Put simply, Penick reminds companies that full disclosure is always the best legal advice.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.  

A Look at Qualified Small Business Company Stock: the Tax Benefits and Eligibility 

By Elliot Weiss  

Tax law can be complex and daunting, to be sure. But that should not stop investors and shareholders from taking the time to understand the tax benefits available to those selling (or exchanging) Qualified Small Business Company Stock (QSBS).  

What Constitutes a QSBS? 

QSBS is stock in a small business that may qualify for a U.S. tax benefit—codified in Section 1202 of the Internal Revenue Code—allowing sellers to avoid paying capital gains taxes on sales (or exchanges) of QSBS. In fact, for sales of QSBS issued after 2010, sellers can exclude 100% of their  gains. This benefit was created to incentivize investment in qualifying small businesses. While the availability of the QSBS tax benefit is well known in the venture capital community, the topic is less understood outside the space. 

To be eligible for QSBS tax treatment, companies must meet the following requirements:  

Qualified Trade or Business 

The QSBS tax exemption requires the issuer of the capital stock to be engaged in a qualified trade or business other than an excluded business type set forth in Section 1202 of the Internal Revenue Code. These excluded business types include those that perform services in the fields of healthcare, law, engineering, architecture, financial and brokerage services or any other trade or business in which the principal asset is the reputation or skill of one or more of its employees. Likewise, businesses involved in banking, insurance, financing, leasing, investing, farming and hospitality are also generally not treated as qualified trades or businesses (and thus ineligible for QSBS tax treatment). That being said, companies in the business of manufacturing, technology, research and development and software may qualify as QSBS. 

Active Business 

In addition to the general qualified trade or business requirement, a company must meet the so-called 80% Test. Pursuant to Section 1202, for a company's stock to qualify as  QSBS, “at least 80 percent (by value) of the assets” of the corporation* must be used in the “active conduct of one or more qualified trades or businesses during substantially all of the taxpayer’s holding period for such stock.” Satisfying this 80% Test is oftentimes a challenge because it requires an assessment of the ongoing nature of the corporation’s business activities. Further, there is a lack of IRS guidance regarding the 80% Test, which places the burden of proof and persuasion on the taxpayer during an audit.  

*Note that C corporations can issue QSBS. Partnerships and LLCs can as well, but only if they file an election to be taxed as a corporation. For their part, S corporations will not qualify, unless converted into a C corporation and then, only after such a conversion.  

Gross Assets 

For a company’s stock to be deemed QSBS, the aggregate gross assets of the corporation (or any predecessor entity) must not exceed $50 million. To be clear, once a company’s gross assets are north of $50 million, it can never again issue QSBS. This is the case even if gross assets dip below the $50 million threshold at a later date; however, this is a going forward restriction, meaning prior QSBS issuances made before crossing the $50 million threshold will not be precluded from the tax benefit of gain exclusion under Section 1202 just because the $50 million threshold was crossed after the prior QSBS was issued.   

Original Issuance 

QSBS eligibility requires the stock to have been acquired directly from the corporation in exchange for money, property or services performed (other than services performed as an underwriter). The original issuance requirement is satisfied where the QSBS is acquired directly from the corporation upon formation, during a subsequent offering, upon the exercise of options or warrants, upon conversion of convertible debt, upon distribution from a partnership, or when received as a gift or at death. Stock obtained from the secondary market or upon transfer of an existing stockholder will not be deemed originally issued.   

Minimum Holding Period  

To take advantage of the tax benefits set forth in Section 1202, QSBS stock must be held for at least five years prior to sale, with the holding period beginning on the date of acquisition (or the date of exercise or conversion where the original issuance stems from the exercise or conversion of convertible securities).  

The Tax Benefit: Limitations on Excludable Amounts    

What does all this mean if the above requirements are met and a shareholder is in possession of QSBS at the time of a proposed stock sale? At minimum, a noncorporate shareholder can exclude 50% of the taxable gain from the sale of QSBS held for at least five years. This 50% exclusion increases to 75% for QSBS acquired from February 18, 2009 through September 27, 2010, and then again to 100% for QSBS obtained on or after September 28, 2010. It is important to note that the total taxable gain that may be excluded based on the foregoing is subject to cumulative and annual limitations. 

These limitations provide that for each annual year the total amount of gain exclusion is limited by the greater of (i) $10 million (reduced by the dollar amount of gain exclusions taken by the taxpayer on QSBS in prior years), or (ii) an annual limitation equal to 10x the aggregate adjusted basis of the QSBS that the taxpayer sold. Since the dollar cap on excludable gain involves the “greater of” the cumulative and the annual limitations, the annual limitation may allow the taxpayer to exclude more than a total of $10 million. 

Of course, legal and tax experts can weigh in on a seller’s specific tax situation and relevant QSBS qualifications. 

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.   

Our Number One Court Sides With Jack Daniel’s in Trademark Dispute Over a Number Two Dog Toy 

By Nicole Haff

The U.S. Supreme Court issued a decision today holding that a dog toy laced with amusing, scatological-based references satirizing Jack Daniel’s iconic liquor bottle was not covered by the First Amendment’s free speech protections. 

A Bit of Background: Jack Daniel's Properties, Inc. v. VIP Products LLC 

VIP Products LLC (VIP) is the seller of a dog toy marketed as the "Bad Spaniels Silly Squeaker.” It resembles a bottle of Jack Daniel's Old No. 7 Black Label Tennessee Whiskey and sets forth alterations to the text Jack Daniel’s prints on its bottles. These modifications—mostly “bad doggie” references centered on potty humor—include a references to “Bad Spaniels” rather than “Jack Daniel’s,” “Old No. 2, on your Tennessee Carpet,” instead of “Old No. 7 Brand Tennessee Sour Mash Whiskey, and  a boast of "43% POO BY VOL.,” in lieu of a listing of alcohol by volume.  

A tag affixed to the Bad Spaniels item disclaims any affiliation with Jack Daniel’s. Nonetheless, Jack Daniel's Properties, Inc. (JD Properties) issued a cease and desist to VIP demanding that VIP stop selling the squeaky toy. In response, VIP filed a declaratory judgment action in federal court seeking a determination that the product did not infringe upon JD Properties’ trademark rights or dilute any of JD Properties’ trademarks or, in the alternative, that the Jack Daniel’s trade dress and bottle design were not entitled to trademark protection. In effect, VIP sought to cancel the registration for the trade dress in Jack Daniel’s No. 7 bottle. JD Properties counterclaimed, asserting infringement of trademarks and trade dress and dilution by tarnishment.  

Procedural Posture 

Before trial, VIP filed a motion for summary judgment on both claims, asserting that (1) the infringement claim filed by JD Properties failed under the Rogers test, a threshold test derived from the First Amendment to protect “expressive works,” and (2) there was no dilution because the Bad Spaniels toy was a parody of Jack Daniels and therefore it made “fair use” of its famous mark, under statutory exemptions available for dilution claims. The Court rejected both arguments, and after conducting a bench trial, the district court entered judgment against VIP.  The case was appealed.  

On appeal, the Court of Appeals for the Ninth Circuit held that the district court erred in finding trademark infringement without first requiring JD Properties to satisfy at least one of the two prongs of the Roger’s test (discussed below). The Ninth Circuit also ruled that the humorous message conveyed by the toy was protected non-commercial speech and thus not actionable. With that, it reversed the district court’s judgment holding in favor JD Properties’ dilution claim, vacated the judgment JD Properties received against VIP for its trademark infringement claims, and remanded the case back to the District Court for further proceedings. 

On remand, the district court found that Jack Daniel’s could not satisfy either prong of the Rogers test. Pursuant to this finding it granted summary judgment to VIP on infringement. The Ninth Circuit summarily affirmed and the case was then appealed to the Supreme Court. 

The Rogers Test and Its Prior Application  

While the test for trademark infringement varies slightly across circuits, trademark infringement boils down to whether the use of another’s trademark is likely to cause consumer confusion as to the source of goods or services. For more than three decades, the Rogers test, which spawns from the landmark case Rogers v. Grimaldi, has been the standard that courts throughout the country have used to determine when trademark protection should apply to artistic works. 

In Rogers, the Second Circuit held such instances were limited to when the public interest in avoiding consumer confusion outweighs the public interest in free expression. In the aftermath of Rogers, courts have used the test to make sure trademark law is not used to suppress otherwise protected speech, particularly for artistic and expressive works like movies, plays, books and songs. The Rogers test requires a party alleging trademark infringement to show that the defendant's use of the trademark either (1) is not artistically relevant to the work or (2) explicitly misleads consumers as to the source or content of the work. After this inquiry is met, likelihood of confusion is examined.  

The Jack Daniel’s Decision 

In a unanimous ruling, the U.S. Supreme Court held that when a mark is used as a source identifier, meaning as a trademark, the use does not receive special First Amendment protection and a threshold inquiry like the Rogers test should not apply, except perhaps in rare situations. Source identifiers, such as the Nike “swoosh” or the name of a brand, like Google, help consumers identify the source of goods and assist consumers in distinguishing that source from other sources. 

The Court also ruled that “this result does not change because the use of the mark has other expressive content – i.e., it conveys some message on top of source.” The justices, in unanimity, reasoned that many marks possess an expressive element and if a threshold test, like Rogers, was applied to all expressive marks, few cases would ever advance to the likelihood of confusion test. Thus, when a trademark is used as a trademark, the traditional likelihood of confusion test must be used to determine infringement claims. A plaintiff is not required to first satisfy the Rogers test before a likelihood of confusion is examined. Notably, the Court expressly declined to decide whether the Rogers test is “ever appropriate.” 

Further, the Court ruled that while goods, like the Bad Spaniels toy, may contain an expressive aspect, that “message” can be examined “in assessing confusion because consumers are not so likely to think that the maker of a mocked product is itself doing the mocking.” As such, mockery, humor and parody can still be considered but when a mark is being used as a source designator, that consideration is confined to the likelihood of confusion test, not a threshold First Amended inquiry, like Rogers. 

Regarding the dilution claims raised by JD Properties, the Court ruled that the use of a mark does not count as non-commercial, “just because it parodies, or otherwise comments on, another’s products.” The Lanham Act’s statutory exclusion from dilution liability for “[a]ny noncommerical use of a mark,” does not shield parody, criticism or commentary when an alleged diluter uses a mark as a designation of source for its own goods. 

Based on all of the foregoing, the Court vacated the judgment below and remanded the case for further proceedings consistent with its opinion. 

An Important Takeaway 

Businesses that produce parody products that use or imitate the trademarks of others should reconsider their business models in light of the Jack Daniel’s decision. While parody may be considered in conducting a likelihood of confusion test, the Rogers test is no longer available to the producers of parody goods when a mark is being used as a source identifier. In fact, it is unclear whether the Rogers test is “ever appropriate,” as the U.S. Supreme Court has declined to issue a holding on that issue. 

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations. 

The Pros and Cons of S Corporation Election 

For many in business thinking about incorporating, electing S corporation status may be the way to go. The reason is simple: tax avoidance. 

By choosing to become S corporations, small and medium size businesses are able to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. In doing so, the entities themselves circumvent paying corporate and payroll taxes. 

No doubt about it, for certain domestic corporations having no more than 100 shareholders or one class of stock, S election can be quite beneficial.  

 But What Is an S Corporation? 

An S corporation is not unlike a C corporation, but for its tax status. Both business types are for-profit companies, incorporated under and governed by state corporation laws, and each offer similar liability protections. Likewise, S and C corporations must adhere to the same internal practices and formalities (e.g., maintain boards of directors, be governed by written corporate bylaws, conduct regular shareholders’ meetings, etc.). Of note, an LLC taxed as a corporation can also make an S election. To become an S corporation, a business must first be organized as a C corporation or an LLC (taxed as a corporation), at which point Form 2553 is filed with the IRS electing S corporation status.  

The big difference between an S corporation and C corporation is simply this: profits from a C corporation are taxed to the organization when earned, then taxed to the shareholders when distributed as dividends, thus creating a double tax. For its part, an S corporation is authorized to pass income directly to shareholders without being taxed at the corporate level. As such, an S corporation is known as a “pass-through entity,” (like an LLC). More specifically, an S corporation’s income, losses, deductions, and credits flow through to its shareholders, who report these items on their individual tax returns and pay all taxes (including payroll taxes). 

S corporations, which get their name from Subchapter S of the Internal Revenue Code, are only available to businesses meeting the following eligibility requirements: 

  • Must be taxed as a domestic corporation 
  • Shareholders are individuals, certain trusts, and estates (but not partnerships, corporations or non-U.S. citizens or non-U.S. residents) 
  • Can have no more than 100 shareholders 
  • Cannot be an ineligible entity (e.g., certain financial institutions, insurance companies, and domestic international sales corporations 
  • Has only one class of stock 

It is important to understand that these requirements must be maintained at all times—the failure to do so could result in a company losing its S corporation status.  

Another Benefit of S Corporation Election  

One of the great benefits of forming S corporations—and a prime reason for their popularity—is that  shareholders can be employees too.  From a tax perspective, this allows an owner of an S corporation to avoid paying payroll taxes on all business income, and instead  limit payroll taxes to shareholder-employee salaries. 

The IRS requires that any shareholder-employee of an S corporation receive reasonable compensation for services performed, which compensation is to be paid through the company’s payroll system. While this salary is subject to payroll taxes, additional distributions made to shareholder-employees beyond their reasonable compensation are not. In practice, this means that owners of S corporations can potentially reduce their overall tax liability by avoiding payroll tax on income paid to shareholder-employees by limiting salaries in favor of distributions.  

This is not without risk. The IRS scrutinizes the compensation paid to shareholder-employees of S corporations to ensure it is reasonable. If salaries are deemed unreasonably low, the IRS may reclassify distributions—at least a portion of them—as wages subject to payroll taxes. Consequently, it is important for owners of S corporations to work with experienced tax professionals to ensure that compensation is structured properly and meets the IRS’s requirements. 

S Corporation Pitfalls 

The downside of S election oftentimes presents itself where acquisitions of S corporations are contemplated. In the M&A context, a primary risk of acquiring the equity of an S corporation (beyond the general S corporation ownership restrictions) is that the transaction could result in the acquisition of a target corporation that previously failed to maintain its S corporation eligibility requirements (for example, if the target S corporation was previously owned by an ineligible holding company or was deemed to have more than one class of stock). This could serve to terminate the target’s S corporation status and the tax advantages that come along with it. In such a circumstance, the acquired entity defaults to C corporation treatment for tax purposes. 

For a buyer of equity in an S corporation, the financial implications of the company losing S election status can be monumental. To the extent the entity is retroactively taxed as a  corporation that has not filed corporate tax returns or paid corporate taxes for a period of time, these outstanding tax obligations become the buyer’s responsibility. This can be rather material, especially where the inadvertent termination event happened well in the past. 

While the buyer in such a transaction would likely have rights to recover damages by asserting indemnity claims, the time and expense of pursuing them would not be ideal and should be avoided by way of proper pre-closing due diligence, during which time buyers should consult with their tax and legal professionals for advice. This counsel could possibly include consideration of Internal Revenue Code § 338(h)(10) election, a useful tool for buyers to sidestep the ownership restrictions under the S corporation eligibility requirements by treating an acquisition as an asset sale for tax purposes, as opposed to the sale of stock. A § 338(h)(10) election also allows the buyer to increase the tax basis of the assets acquired to fair market value (known as a step-up tax basis), which can result in significant tax savings to the buyer (such as accelerating greater depreciation and reducing taxable income).   

Bear in mind, a § 338(h)(10) election does not cleanse a transaction where an inadvertent termination of S corporation status has previously occurred prior to closing. A transaction proceeding under § 338(h)(10) will lose associated tax benefits if it is discovered that the target company previously lost S corporation status. When confronted with this risk, parties can consummate a common restructuring of the S corporation on a pre-transaction basis using an F Reorganization under Internal Revenue Code § 368(a)(1)(F)—this is a type of qualifying tax-free reorganization that changes the identity or form of a corporation and provides certain tax benefits, including a step-up in tax basis of a target’s assets and tax deferral on an equity rollover. 

The Devil Is in the Details 

Of course, as is the case in all things tax- and law-related, navigating the pros and cons of S corporation election involves a lot of fine print. Without question, matters involving QSubs (Qualified Subchapter S Subsidiaries), the process to effectuate F reorganizations, and the like require an in-depth understanding of the Internal Revenue Code and deal structures. Suffice to say that S corporation election may be right for any number of small businesses across industries, so long as owners are aware of the associated limitations on attracting capital in an S corporation structure, plus the risks and strategies necessary to manage the acquisition of these types of entities, both from the buy- and sell-side. 

As always, the corporate professionals at Michelman & Robinson, LLP are available for guidance. 

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations. 

Fair Use Under the U.S. Supreme Court’s Microscope 

This week, the U.S. Supreme Court rendered a decision of great importance in the world of copyright law in a case titled Andy Warhol Foundation for the VisualArts, Inc. v. Goldsmith et al. Michelman & Robinson, LLP reports.  

A Bit of Background  

Lynn Goldsmith is a professional photographer of notoriety who has photographed various musicians ranging from Led Zeppelin to James Brown. This case concerns Prince. 

In 1981, while on assignment for Newsweek, Goldsmith photographed Prince. At this point in his career, Prince was not the icon we think of today, but his star was certainly rising. Goldsmith took several pictures of him during the short photo session at her studio. All the while, according to Goldsmith’s testimony, Prince was “really uncomfortable.” Ultimately, none of Goldsmith’s photographs ran in Newsweek. 

Fast forward three years to 1984. “Little Red Corvette” was released earlier in the year—“When Doves Cry” as well—and Purple Rain topped both the box office and music charts. Vanity Fair wanted to publish an article, including an illustration, on the now extremely famous Prince. Toward that end, the magazine licensed Goldsmith’s work for a $400 licensing fee “for use as an artist’s reference in connection with an article to be published.” The license was limited and further stated, “no other usage rights granted.” Unbeknownst to Goldsmith, the artist that Vanity Fair commissioned was Andy Warhol.   

Warhol made not one, but 16 illustrations based on Goldsmith’s photos. This collection was referred to as the Prince series. Ultimately, in November 1984, Vanity Fair ran the article “Purple Fame” and used a Warhol illustration of Prince, depicted in purple. Goldsmith is credited in conjunction with the image.  

Thirty-two years later, in 2016, Prince tragically died. In the aftermath of his death, Condé Nast (Vanity Fair’s parent company) wanted to distribute a commemorative issue celebrating him. To do so, Condé Nast contacted the Andy Warhol Foundation to inquire into licensing Warhol’s illustration from 1984, only to learn of the Prince series. At that point, Condé Nast decided instead to license an illustration affectionally referred to as “Orange Prince.” That drawing ran on the commemorative magazine’s cover, without any credit to Goldsmith. In fact, neither Condé Nast nor the Andy Warhol Foundation paid Goldsmith for the use of Orange Prince.     

Procedural Posture 

Litigation ensued, with the Andy Warhol Foundation filing a declaratory judgement action seeking a ruling of noninfringement, or in the alternative, fair use. Goldsmith, in turn, countersued for copyright infringement.  

The Andy Warhol Foundation prevailed before the district court on summary judgment, which ruled that the fair use doctrine applied because Warhol’s work was “transformative” as it communicated a different meaning and message from Goldsmith’s photograph. 

That decision was reversed by the U.S. Court of Appeals for the Second Circuit. On appeal, the court held, “the Prince Series retains the essential elements of its source material, and Warhol’s modifications serve chiefly to magnify some elements of that material and minimize others . . . . While the cumulative effect of those alterations may change the Goldsmith Photograph in ways that give a different impression of its subject, the Goldsmith Photograph remains the recognizable foundation upon which the Prince Series is built.” 

Enter the Supreme Court 

The Second Circuit’s determination was challenged on appeal and the case made its way to the U.S. Supreme Court, which rendered a decision on May 18. In a 7-2 decision, the majority held that the Andy Warhol Foundation’s use of Goldsmith’s photography was not fair use. Specifically, the high court held, in instances where “an original work and a secondary use share the same or highly similar purposes, and the secondary use is of a commercial nature, the first [fair use] factor is likely to weigh against fair use, absent some other justification for copying.” 

By way of background, the fair use doctrine permits the unlicensed use of copyright-protected works in certain circumstances, outlined in Section 107 in the Copyright Act. Stated differently, it is a defense to copyright infringement. Section 107 contains four factors, the first being the purpose and character of the work. While the term “transformative” is not actually used in Section 107, courts consider it when examining this factor. 

The U.S. Supreme Court rejected the Andy Warhol Foundation’s argument that its use was “transformative” and therefore fair. In doing so, the majority found that the first factor of the fair use analysis “instead focuses on whether an allegedly infringing use has a further purpose or different character, which is a matter of degree, and the degree of difference must be weighed against other considerations, like commercialism.” The court also ruled that because Orange Prince, “has no critical bearing on” Goldsmith’s photograph, any claims concerning the “fairness in borrowing” from Goldsmith’s photograph “diminishes accordingly (if it does not vanish).” 

Applying these standards, the U.S. Supreme Court ruled that the Andy Warhol Foundation’s use was not fair because it was commercial, and it shared the same purpose as Goldsmith’s original photograph – to illustrate stories about Prince in magazines. Further it was determined that modifications to Goldsmith’s photograph had little critical bearing on Goldsmith’s work, also weighing against a finding of fair use. 

The Takeaway 

In the wake of the U.S. Supreme Court’s decision in the Andy Warhol Foundationcase, the scope of the fair use defense to copyright infringement has been meaningfully limited. While new expression may be considered by courts conducting a fair use analysis, standing alone, this expression cannot be determinative of the first fair use factor. 

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations. 

Extending Appraisal Rights Under Delaware Law 

By Liza Kirillova and Elliot Weiss


The ability to demand appraisal rights to determine the fair value of a company’s stock is a powerful tool exerted by stockholders. For this reason, it is worth noting a recent amendment to the Delaware General Corporation Law (DGCL) Section 262—the provision that governs appraisal rights following mergers, consolidations or conversions of Delaware corporations.  

For context, shareholders can hold shares of stock directly or indirectly. A registered owner or record holder holds shares directly with a corporation, while a beneficial owner holds shares indirectly through a bank or broker-dealer. The amendment to Section 262 clarifies that a beneficial owner may also include any holder of stock in a voting trust or any nominee on behalf of the registered owner. 

That being said, the amendment—which only applies to mergers, consolidations or conversions adopted or entered into on or after August 1, 2022—goes on to specify that beneficial owners of stock in a Delaware corporation can now demand appraisals of their shares directly, thereby eliminating the prior requirement of having the record holder demand appraisals on their behalf.  

More specifically, Section 262(d)(3) permits beneficial owners to invoke appraisal rights through a written demand upon satisfaction of the following conditions: 

  1. The beneficial ownership of the stock is maintained from the date of the demand through the date of the merger, consolidation, or conversion;  
  1. The stockholder otherwise satisfies the requirements under Section 262(a), including the condition that the stockholder has neither voted in favor of the merger, conversion or consolidation nor consented to it in writing; and 
  1. The beneficial owner submits evidence of their beneficial ownership of the stock, along with other identifying information including the owner’s address and the identity of the record holder. 

The amendment to Section 262 also ensures that the expenses of a stockholder or a beneficial owner who engaged in an appraisal proceeding will be charged pro rata against the value of all the shares entitled to an appraisal award. The amendment also impacts appraisal notice requirements. Delaware corporations no longer have to include a copy of Section 262 in a notice of appraisal rights, provided that the notice includes directions for accessing the statute electronically (e.g., through the State of Delaware website). For practical purposes, companies that attach a link directly to their official websites will guarantee that stockholders are accessing the current version of Section 262 in order to fully understand the scope of their rights. 

Given that appraisal rights protect minority stockholders from receiving less than the fair value of their stock in major corporate transactions, the amendment carries certain important economic implications. For example, if a dissenting stockholder exercises appraisal rights and a court determines that the fair value of the dissenting stockholder’s shares is higher than the consideration offered in a merger transaction, the buyer is responsible for making up the difference to compensate the dissenting stockholder. Consequently, the increased availability of appraisal rights might deter some buyers from consummating merger transactions or business combinations without the approval of all stockholders of the target corporation, including those who hold stock in a voting trust or by a nominee.  

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations. 

Counterfeiters Beware: Courts Have Unidentified Bootleggers in the Crosshairs 

Counterfeiters Beware: Courts Have Unidentified Bootleggers in the Crosshairs

Written by: Nicole Haff

As summer nears, the 2023 concert touring season is fast approaching. With it comes the ability for musical and other touring acts to cash in on lucrative merchandise sales—unless counterfeiters beat them to it. Anticipating this issue, some entertainment professionals are turning to the courts now to secure what is theirs.   

Last week, a United States District Judge for the District of Washington issued a preliminary injunction and seizure order concerning the anticipated sale of unauthorized Phish merchandise in connection with the band’s upcoming 2023 tour. Phish Inc., the holder of the group’s intellectual property rights, asserts the order is necessary because “[s]ince the inception of Phish’s popularity in the 1990s, Phish’s concert tours have been plagued by individuals who sell unauthorized merchandise near, at and sometimes inside a concert venue.” The order Phish, Inc. obtained from the court sought to remedy this issue. 

The Order 

The order permits the United States Marshal, as well as other law enforcement agents, to seize and impound counterfeit Phish merchandise found within a 20-mile vicinity of upcoming Phish shows, and it extends to a period of 10 hours before each concert and six hours after. In addition, the order provides that “any bag, carton, container, vehicle, or other means of carriage” holding such bogus merchandise can be seized and impounded, providing a powerful tool against bootleggers, who often travel from one city to another, following Phish’s tour. 

What is particularly noteworthy about the order is it was issued against “John Doe” defendants, meaning defendants whose identities are unknown to the plaintiff at the time of filing.      

Other Examples in the Entertainment Industry 

Phish is not the first in the entertainment industry to successfully seek an injunction and seizure order against would-be bootleggers. The WWE successfully appealed the denial of such an order, bringing the issue to the Court of Appeals for the Fifth Circuit. The exclusive licensee of Shawn Mendes’ branded tour merchandise also obtained similar relief. 

The Takeaway for Touring Artists  

While federal courts generally disfavor granting injunctions against John Doe defendants, judges are more inclined to proceed when counterfeiters can be easily identified at an event. This can be achieved in instances like Phish where one entity holds all of the intellectual property rights. Similarly, WWE makes its own merchandise sales directly and does not license third parties to sell WWE merchandise at live events. These circumstances take the guess work out of identifying authorized versus unauthorized sellers of merchandise. 

Another factor courts seemingly favor is the ability (shown through previous instances of attempted enforcement) for counterfeiters to quickly dissipate, allowing them to escape all consequences and sell the same unauthorized merchandise on the next leg of a tour. 

Given the willingness of courts to proactively issue orders like the one in favor of Phish, rights holders should consider their options in advance to curtail the potential for damage caused by would-be counterfeiters. Toward that end, the Intellectual Property Practice Group at Michelman & Robinson, LLP is always available for guidance.     

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations. 


Conversions of Delaware Corporations

By Elliot Weiss

The level of approval needed to convert a Delaware corporation into another type of entity has recently changed—this pursuant to a 2022 amendment of Section 266 of the Delaware General Corporations Laws (DGCL).

Previously, approval of all stockholders—regardless of voting rights—was needed to authorize a conversion of a Delaware corporation. The idea was that a unanimous all stock voting requirement protected stockholders who might be negatively impacted if a company was converted into an entity having different governance and ownership rights. Section 266 in its original form also removed the need to extend appraisal rights in the context of a conversion.

The problem with the unanimous all stock requirement was that it created roadblocks for companies looking to utilize Delaware’s conversion statutes to convert into a foreign entity and, in certain cases, required domestic corporations to rely upon DGCL merger statutes to achieve redomestication—a solution that could be rather complex, costly and time consuming.

Consequently, the statute was amended last year. Under Section 266(b) as revised, any board of a Delaware corporation seeking conversion is now required to adopt a resolution approving the change. That resolution must (1) specify the type of entity that the domestic corporation is to be converted into and (2) recommend that the stockholders of the company approve the conversion. There is more. The amendment additionally mandates stockholder approval of the conversion, but not by unanimous all stock vote. Rather, a simple majority of the outstanding shares entitled to vote are needed to adopt the resolution and authorize conversion.

Significantly, the following stockholder protections apply to conversions under the amendment to Section 266(b):

1. If a corporation is converting into a partnership having one or more general partners, then in addition to the requisite stockholder approval, authorization of the proposed conversion also requires the approval of each stockholder slated to become a general partner;

2. In the event a certificate of incorporation or voting agreement dated (or effective) before August 1, 2022 restricts or places conditions upon a merger or consolidation, the same restrictions or conditions will apply to an approved conversion unless the certificate of incorporation or voting agreement expressly provides otherwise; and

3. Statutory appraisal rights of stockholders under Section 262 apply in the context of the conversion of a Delaware corporation.

The change to Section 266—from requiring unanimity to now just a simple majority of outstanding shares entitled to vote to adopt a resolution and authorize conversion—should increase the use of the DGCL conversion statutes and expedite the process and timeline by which boards can expect to complete statutory conversions while at the same time maintaining appropriate protections and safeguards for the benefit of stockholders.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.

Delaware Expands Upon a Board’s Authority to Issue Corporate Securities

By Elliot Weiss

It used to be that under Delaware law, only a corporate board of directors or one of its duly formed committees could authorize the creation and issuance of stock, options and rights to acquire stock. That all changed with last year’s amendments to the Delaware General Corporations Laws (DGCL).

By way of an amendment to Section 157(c) of the DGCL, boards of Delaware corporations can now delegate to officers the power and authority to allocate options and rights to purchase stock. A revision to Section 152(b) of the DGCL took this a step further—boards of Delaware corporations are now able to authorize officers to issue capital stock as well.

There are caveats to a board’s delegation of authority pursuant to these amendments. Specifically, directors must still fix:

1. The maximum number of shares of stock, rights or options to be issued and the number of underlying shares issuable upon exercise;

2. A time period during which these shares of stock, rights to purchase stock or options may be issued; and

3. A minimum amount of consideration (if any) for these shares of stock, rights to purchase stock or options and for the shares issuable upon exercise.

Of note, resolutions adopted by boards of Delaware corporations delegating these powers to officers may be dependent upon a number of outside factors, including the volume weighted average price (VWAP) for a public company issuer’s stock price. These factors must be incorporated into the adopted resolution.

As a practical matter, the amendments to Sections 157 and 152 may, among other things, streamline the hiring process of Delaware corporations with respect to the negotiation of compensation packages for prospective employees, assuming, of course, that the board in question has taken appropriate steps to duly authorize the delegation of corporate activities to its officers.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.