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The Pros and Cons of S Corporation Election 

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Elliot Weiss


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 

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Nicole Haff


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 Visual Arts, 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 Foundation case, 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 

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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 

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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

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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

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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.

Know Your Collateral When Perfecting Security Interests 

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Elliot Weiss and Liza Kirillova


Creditors routinely take security interests in collateral as a hedge against a borrower’s failure to satisfy outstanding debt obligations. For creditors, the importance of perfecting these security interests cannot be understated. The reason: perfecting a security interest (essentially, putting the world on notice of a creditor’s superior rights in identified property) gives the secured creditor a priority claim on specified collateral as compared to another party’s unsecured claims on a debtor’s assets.  

This begs the question: how does a creditor go about perfecting its security interest in personal property? The answer: it depends upon the collateral at issue, but in all cases, the Uniform Commercial Code (UCC) governs the method of perfection. 

Certificated and Uncertificated Securities 

Shares (or comparable equity interests) in a corporation, business trust, or similar entity are defined as a “security” for purposes of Article 8 of the UCC and “investment property” under Article 9. Where a share is represented by a physical certificate, it is characterized as a certificated security. 

A security interest in a certificated security—or any uncertificated security, for that matter—can be perfected by the proper filing of a UCC-1 financing statement. Alternatively, a secured party can perfect an interest in a certificated security by control of the certificate. To do so in the case of a stock certificate, for example, the secured party (or the secured party’s intermediary) must obtain actual possession —or take delivery—of it, along with an executed stock power indorsed to the secured party (or in blank), which allows the secured party to transfer the certificate in the event the collateral is foreclosed upon.  

Of course, in our digital age, ownership in an equity interest is not always evidenced by a physical certificate. Rather, electronic certificates may be entered in a company ledger. This is an example of an uncertificated security, in which ownership is evidenced by account statements issued by the company, the company’s transfer agent, or a broker-dealer. 

Not unlike a certificated security, a security interest in uncertificated securities can be perfected two ways: (1) by properly filing a UCC-1 financing statement or (2) by control. As for control of an uncertificated security, it is obtained by either re-registering the investment property in the name of the secured party or by the execution of a control agreement with the issuer of the uncertificated security.  

Limited Liability Companies and Limited Partnerships  

Equity interests in limited liability companies and limited partnerships are treated as either “general intangibles” or “investment property” under Article 9 of the UCC.  

In order for a secured party to treat an interest in an LLC or LP as a “security” and “investment property” under the UCC and be able to perfect its security interests accordingly, the issuer must take additional steps to effectively opt-in to Article 8. Of note, an Article 8 opt-in provision can generally be found in the issuer’s governing document (generally, the operating, LLC or LP agreement) or on the face of the certificate of a certificated LLC or LP interest, and to be effective, the opt-in provision must expressly provide that the LLC or LP interest at issue is being treated as a “security” pursuant to the UCC.  

In the absence of an effective Article 8 opt-in provision, an LLC or LP interest will be characterized as a “general intangible” (whether or not the equity interest is certificated), and the only method of perfecting a security interest in a “general intangible” is to properly file a UCC-1 financing statement. Parenthetically, the priority rule of first to file a UCC-1 financing statement will apply in the event of multiple security interests in the LLC or LP interest in question. 

So that an LLC or LP interest is treated as a “security” and not a “general intangible” for purposes of perfecting the interest, a secured party may want to request the issuer to opt in to Article 8 and further require a provision to be added to the governing documents that prohibit the issuer from later opting out. 

The Takeaway  

It bears repeating: the UCC grants priority to a perfected secured creditor over other creditors, including those who hold unperfected security interests. As such, perfecting security interests should always be top of mind for creditors, whether by (1) by properly filing a UCC-1 financing statement or (2) by control, depending, of course,  upon the type of collateral.  

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. 

Clarity in Delaware About a Corporate Officer’s Duty of Oversight 

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Michael Poster, Steven Weiss, Megan Penick, Liza Kirillova


When it comes to corporate officers, it has long been an open question whether the scope of their fiduciary duties is the same as those imposed upon company directors. In Delaware, those questions have now been answered by the state’s Court of Chancery, which held late last month that under Delaware law, officers and directors are on equal footing, both owing the same fiduciary duties to their companies, including a duty of oversight.

This was the determination in In re McDonald’s Corporate Stockholder Derivative Litigation, a headline-grabbing ruling that will surely reverberate through C-suites and boardrooms nationwide.

In re McDonald’s Corporate Stockholder Derivative Litigation: a Bit of Background

From 2015 until his termination with cause in 2018, David Fairhurst served as Executive Vice President and Global Chief People Officer of McDonald’s Corporation. In that capacity, Fairhurst was responsible for ensuring that McDonald’s fostered a safe and respectful workplace environment. In a derivative lawsuit filed by company shareholders, it was asserted that he failed to do so. More specifically, Fairhurst was alleged to have breached his fiduciary duties owed to McDonald’s—specifically, the duty of oversight—by fostering a corporate culture that condoned sexual harassment.

According to company shareholders, Fairhurst’s duty of oversight required him to make a good faith effort to establish a system that would generate the information necessary to manage the human resources function at McDonald’s. And with that information, he was duty-bound to report to the company’s Chief Executive Officer and board of directors known instances of sexual harassment and misconduct. Trouble was, Fairhurst allegedly chose not to do so.

In their derivative action, McDonald’s shareholders claimed Fairhurst breached his duty of oversight by consciously ignoring red flags and, in effect, disabling himself from being informed of risks or problems requiring his attention. In opposition, Fairhurst attempted to have the lawsuit dismissed, asserting that Delaware law—as set forth in in the seminal case of In re Caremark International Inc. Derivative Litigation—did not impose on officers any obligations equivalent to the duty of oversight. By way of its ruling on January 25, the Delaware Court of Chancery disagreed.

In re McDonald’s Corporate Stockholder Derivative Litigation: the Court’s Ruling

As previewed above, the court in Delaware has made clear that officers owe the same fiduciary duties as directors, and that includes a duty of oversight—a function that may be better suited to corporate officers who are responsible for managing a corporation’s day-to-day operations. Given that officers are responsible for managing and maintaining systems to detect and identify red flags and are further tasked with correcting wrongdoing in the workplace, the court concluded that a duty of oversight should attach to officers who now, under Delaware law, can be sued derivatively by shareholders.

The Scope of an Officer’s Duty of Oversight

In the wake of the ruling in In re McDonald’s Corporate Stockholder Derivative Litigation, a new question arises: What exactly is the scope of an officer’s oversight responsibilities under Delaware law? Truth is, there is no “one-size-fits-all” answer.

The parameters of an officer’s duty of oversight will be largely dependent upon facts and circumstances and, as a result, the course of conduct that must be taken to rectify a given situation will vary based on context. For example, a CEO with company-wide responsibility will likely have a broader duty of oversight as compared to a Chief Financial Officer solely responsible for a company’s finances or a Chief Legal Officer in charge of a corporation’s in-house legal department. By extension, a Chief Marketing Officer will not likely be on the hook for deficiencies in financial or legal reporting systems or related oversight. That being said, should a red flag be overtly obvious and particularly egregious, then any officer could potentially have a duty to report it even if the subject matter of the red flag falls outside his or her domain.

Whatever the case may be, officers must be vigilant, even before claims are asserted. For purposes of illustration, consider data privacy. It is clear that a data breach could have catastrophic implications to a corporation’s business. Indeed, in the wake of a hack and under Delaware law, stockholders of a company impacted by cybercriminals could now sue an officer in charge of data privacy for the breach of his or her duty of oversight—were it found or alleged that the cybersecurity officer had failed to make a good faith effort to put adequate data privacy protections in place or had otherwise ignored clear weaknesses, or red flags, in the organization’s overall data security operation. In the aftermath of the decision in In re McDonald’s Corporate Stockholder Derivative Litigation, officers should anticipate the possibility of this type of exposure (even beyond the cybersecurity realm) and act accordingly.

Takeaways for Officers of Delaware Corporations

Clearly, by virtue of the court’s determination in In re McDonald’s Corporate Stockholder Derivative Litigation, officers of Delaware corporations must be mindful of their expanded fiduciary duties and, as just mentioned, vigilant. Yet there is no need for them to panic. To be subject to oversight liability, an officer must consciously (1) fail to make a good faith effort to establish information systems or (2) ignore red flags. As such, despite the imposition of a duty of oversight, the standard to prove that an officer has acted in bad faith is quite high.

Nonetheless, in light of the expansion of an officer’s fiduciary duties, executives working for Delaware corporations should be aware that they could be exposed to personal liability if a breach of oversight obligations can be established. Still, it remains unclear what might trigger an action for breach of the duty of oversight, especially if red flags fall outside the scope of an officer’s identified roles or areas of expertise. Also unanswered is whether the business judgement protection rule will extend to officers in these cases, thus shielding them from liability.

What we do know is that this area of law continues to evolve, and officers of Delaware corporations should be sure to consult with legal counsel if and when faced with a potential claim. Likewise, it would be prudent for them to review the terms of their companies’ D&O insurance policies to check if they need to be updated in light of this expanded liability exposure.

Of course, the lawyers in our Corporate & Securities Practice Group are here to answer any questions you may have about the impact of In re McDonald’s Corporate Stockholder Derivative Litigation and its aftermath.

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.

Non-Compete Agreements Under Federal Scrutiny

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Derrick Fong-Stempel


Non-Compete Agreements Under Federal Scrutiny

Contact: Derrick Fong-Stempel

Non-compete clauses as we know them may be a thing of the past if a rule proposed by the Federal Trade Commission becomes final. This is particularly significant news for employers nationwide and across industries.

Cutting to the chase, the FTC’s proposed rule would serve to ban non-compete provisions, except in limited circumstances. By way of this alert, we answer specific questions raised by the FTC’s ongoing action.

Q. What is a non-compete clause?

A. As set forth in the proposed rule, a “non-compete clause means a contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer.” Otherwise known as restrictive covenants, these provisions are routinely included in contracts in an effort to prohibit one party from entering into or starting a similar profession or trade in competition against another party.

Q. What does the FTC’s proposed rule seek to prohibit?

A. By way of its rulemaking, the FTC is working to effect a sweeping ban prohibiting employers from entering into post-employment non-compete clauses with workers. Though it would generally not apply to other types of employment restrictions, like non-disclosure agreements, the FTC has made clear in its proposed rule that “other types of employment restrictions could be subject to the rule if they are so broad in scope [as to] function as non-competes.” Two examples have been provided by the FTC:

(1) a non-disclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment with the employer, and

(2) a contractual term between an employer and a worker that requires the worker to pay the employer or a third-party entity for training costs if the worker’s employment terminates within a specified period, where the required payment is not reasonably related to the costs the employer incurred for training the worker.

Additionally, the proposed rule states that it is an unfair method of competition “for an employer to enter into or attempt to enter into a non-compete clause with a worker; maintain with the worker a non-compete clause; or represent to a worker that the worker is subject to a non-compete clause where the employer has no good faith basis to believe that the worker is subject to an enforceable non-compete agreement.”

If the proposed rule is adopted in its present form, disputes will certainly arise over whether NDAs, customer non-solicitation provisions, or other possible restrictions an employer might impose will pass muster under the FTC’s imprecise “functional test.”

Q. Does the FTC’s proposed rule look to impose any other requirements upon employers?

A. Yes. If finalized, the proposed rule would also require employers to rescind existing non-compete agreements and actively inform workers accordingly. This means employers would have to provide notice to workers that existing non-compete clauses are no longer in effect or enforceable—notice that would need to be sent individually and in writing to current and former workers and furnished within 45 days of rescinding the non-compete clauses.

Q. Are there exceptions to the FTC’s proposed rule?

A. Yes. The proposed rule contains an extremely narrow sale-of-business exception, but this only applies to sellers having at least a 25% ownership interest in the business being sold. In such a circumstance, the proposed rule would not apply to any non-compete clause that is entered into by a person selling all or substantially all of a business entity’s operating assets.

In addition, certain employers would not be subject to the proposed rule, including banks, savings and loan institutions, federal credit unions, common carriers, air carriers and foreign air carriers, and persons and businesses subject to the Packers and Stockyards Act, 1921 (subject to certain exceptions).

Q. Does the FTC’s proposed rule apply to all workers?

A. The prohibition against the use of restrictive covenants would apply to employees, independent contractors, interns, and volunteers.

Q. If finalized, how would the FTC’s proposed rule impact existing state laws?

A. The proposed rule would supersede all contrary state laws.

Q. What are the next steps in terms of the FTC’s proposed rule becoming finalized?

A. Now that the rule has been proposed by the FTC, the public is invited to comment on it through March 10 (unless the FTC extends that deadline). Once the comment period has come to a close, the FTC can issue a new proposed rule, terminate its rulemaking, or finalize the rule as proposed.

If and when finalized, the rule would be published in the Federal Register, but would not take effect until it was sent to Congress and the Government Accountability Office for review and oversight. If approved, the proposed rule would become effective 60 days thereafter, but employers would have 180 days to comply.

Q. What should employers do during this process?

A. First, employers should understand that we are a long way from a blanket prohibition of non-compete provisions. The FTC rulemaking is in its early stages, with the public comment period just beginning. And even if the FTC rule as proposed is ultimately issued, it will surely be subject to litigation aimed at deeming such a sweeping ban on restrictive covenants unlawful. Legal challenges could result in revisions to the general scope of the rule, enumerated exceptions, and perhaps modification of the notice and rescission requirements. Michelman & Robinson, LLP will monitor any relevant litigation in real-time.

Regardless, as we await an outcome, employers wanting to impose non-compete clauses should do what they can to draft them reasonably (in terms of duration and geographic scope) and narrowly with an eye toward protecting legitimate business interests (e.g., trade secrets, confidential information, or customer goodwill).

Of course, the employment team at Michelman & Robinson, LLP will keep you apprised of significant developments related to the proposed FTC rule. In the meantime, feel free to reach out with any questions you may have about restrictive covenants and their proper use.

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.

New Employment-Related Laws In California

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With the new year have come a slew of new laws impacting employers throughout California. Here’s an overview: 

MINIMUM WAGE 

Minimum wage continues to increase in California. 

Beginning on January 1, all employees in the Golden State are required to be paid at least $15.50/hour. As of the summer of 2022, the minimum wage is even higher in certain cities, as follows:

  • Los Angeles County: $15.96/hour 
  • City of Los Angeles: $16.04/hour and $18.86/hour for hotel employees working in properties with 60 or more rooms
  • Malibu: $15.96/hour  
  • Pasadena: $16.11/hour  
  • Santa Monica: $16.96/hour and $18.17 for hotel employees  
  • West Hollywood: $17.50/hour (businesses with 50 or more employees), $17.00/hour (businesses with fewer than 50 employees) and $18.35/hour for hotel employees (starting July 2023, employees in all three categories must be paid at least $18.86)

Note that employers should remain alert for further updates as many city minimum wage increases occur mid-year. Also, other cities and industries, not referenced above, may also have their own minimum wages. 

LEAVE LAWS 

The scope of bereavement leave rights has been expanded. 

Bereavement is now a protected leave category in California. Employees are permitted to take up to five days of bereavement leave for the death of a family member. This leave may be unpaid, but employees can avail themselves to available vacation, personal leave, accrued sick leave, or compensatory time off. 

Employees may take leave to care for a “designated person.” 

Additionally, leave has been expanded so that an employee can care for “designated persons” (defined as any individual related by blood or whose association with the employee is the equivalent of a family relationship)—this under the California Family Rights Act. Employees may identify one “designated person” every 12 months.  

NON-DISCRIMINATION LAWS 

California identifies a new protection for reproductive health decision-making. 

Under the California Fair Employment and Housing Act, it is now unlawful to discriminate against an individual in hiring or employment decisions based on “reproductive health decision-making,” which includes use of a particular drug or medical service. 

PAY TRANSPARENCY  

Employers will face heightened pay transparency requirements. 

As of January 1, employers are required to make additional disclosures on pay data reports and provide pay ranges on job postings. This new mandate impacts almost all employers and there will be large civil penalties for non-compliance, up to $10,000 per violation. 

Pay scale disclosure requirements mean employers must (1) include the applicable pay scale on all job postings; (2) not use salary history as a factor in employment decisions; and (3) maintain records of job title and wage rate information for the duration of an employee's employment, plus an additional three years.  

For employers with 100 or more employees, annual pay data reports must be submitted (this year by May 10) to the California Civil Rights Department setting forth the number of employees by race, ethnicity and sex, along with information on these employees’ earnings, pay rate and hours worked. 

EMPLOYEE PRIVACY  

Employee information is placed under heightened protection. 

Under the California Privacy Rights Act, certain employers now have increased obligations to ensure protection of employees’ information in the same way they have been expected to protect consumer data. The CPRA applies to employers that either (1) had annual gross revenues in excess of $25 million (as of January 1 of the calendar year); (2) annually buy, sell or share the personal information of 100,000 or more consumers or households; or (3) derive 50 percent or more of its annual revenues from selling or sharing consumers’ personal information. 

Under the CPRA, “personal information” is “information that identifies, relates to, describes, is reasonably capable of being associated with, or could reasonably be linked, directly or indirectly, with a particular consumer or household,” including professional or employment-related information. 

Key employee rights under the CPRA include (1) notice of collection of personal information; (2) the right to delete and correct personal information; (3) the right to know what information is sold and shared; (4) the right to opt out of the sale of personal information; and (5) the right to restrict uses of personal information.  

WORKPLACE SAFETY  

Prohibition of retaliation for failure to work during an emergency condition. 

As of January 1, employers cannot retaliate against employees who refuse to report for work or leave work during an “emergency condition” (which includes conditions created by natural forces or a criminal act, but not a health pandemic) if there is a reasonable belief that the workplace is unsafe. Likewise, employers are now prohibited from stopping employees from accessing their mobile devices to seek emergency services, assess safety concerns or communicate others to confirm their safety.  

NOTICE REQUIREMENTS 

Cal-WARN notice requirements expand to call centers. 

Existing notice requirements under Cal-WARN have been expanded to call center employers that intend to relocate their call center(s) or one or more operating units. The Labor Commission is authorized to enforce this law.  

COVID-19 UPDATES 

Notice requirements for outbreaks are now more limited. 

Employers are no longer required to notify a local public health agency in the event of a COVID-19 outbreak. However, employers must continue to notify employees of potential exposure. Previously, employers had to provide written notice to all employees the day of exposure. Now, employers must simply display a notice in a prominent place for 15 days.  

Supplemental paid sick leave expires.  

Employer requirements to provide COVID-19 Supplemental Paid Sick Leave expired on December 31, 2022. Employees on leave at the time of expiration may finish taking the amount of leave then available. Having said that, certain cities and counties have their own SPSL policies that may still be in effect.  

COVID-19 remains an “injury” for purposes of workers’ compensation.  

Under existing law that was set to expire in January 2023, illness or death from COVID-19 is an “injury” for purposes of workers’ compensation and there is a rebuttable presumption that such an injury has arisen in the course of employment, making it compensable. Under AB 1751, this law has been extended through January 2024.  

POTENTIAL ARBITRATION UPDATES 

California Supreme Court may walk back requirement to arbitrate representative actions. 

Since the U.S. Supreme Court’s decision in Viking River Cruises v. Moriana, representative actions brought pursuant to the California Private Attorneys General Act (PAGA) are now subject to individual arbitration. Nevertheless, in June 2022, the California Supreme Court granted review in Adolph v. Uber Technologies, which review will likely examine whether an employer may compel the arbitration of PAGA claims under California law. We will continue to monitor the Adolph case and report back when a decision has been issued.  

FAIR WORK WEEK  

Some employers may be faced with even more burdens around employee scheduling and pay. 

We await Mayor Karen Bass’s signature enacting the Fair Work Week Ordinance. If it becomes law as expected, retail businesses in Los Angeles or establishments employing 300 or more employees worldwide will face increased obligations around employee scheduling and pay. 

Pursuant to the law if enacted, (1) employers will have to provide a good faith estimate of their would-be employees’ work schedules before hiring; (2) employees can request preference for work hours and location; (3) employers must furnish written notice of an employee’s schedule at least 14 days in advance; (4) deviations from the provided schedule could result in overtime, or even double time pay; (5) employers will need to offer existing work to current employees before hiring additional workers; (6) employees cannot be required to find coverage for their shifts; (7) employees cannot be required to work two shifts with less than 10 hours between them; and (8) employers must retain records for at least three years, including work schedules, copies of written offers to employees for additional work, and other correspondence with employees regarding scheduling 

If approved, the Ordinance is to take effect in April 2023, it will not be subject to waiver, and violations will result in civil penalties up to $500 per infraction. Not only that, employees will also have a private right of action in the event of an alleged infraction. 

WEHO PAID TIME OFF 

Sick leave for West Hollywood employees. 

As has been the case since July 2022, employers in West Hollywood are required to provide full-time employees with at least 96 paid hours each year for sick leave, vacation or personal necessity, plus a minimum of 80 hours of unpaid sick time. Part-time employees must accrue paid time off in proportional increments, and once accrued, their paid time off must carry over, though it can be capped at 192 hours. Unused accrued unpaid time off must carry over as well but can be capped at 80 hours. 

HOTEL INDUSTRY SPECIFIC LAWS 

Increased requirements on hotels to prevent human trafficking. 

Hotel employers continue to be required to provide staff with at least 20 minutes of training on how to recognize human trafficking. On top of this, hotel operators are now subject to civil penalties if a supervisory employee “knew of or acted with reckless disregard of the activity constituting sex trafficking” within the hotel and failed to inform a proper authority (e.g., law enforcement or the National Human Trafficking Hotline). 

Increased protection for hotel workers in the City of Los Angeles. 

In Los Angeles, the Hotel Worker Protection Ordinance became effective last August. The law is meant to ensure hotel workers are equipped with personal security devices and supported in their ability to report criminal and threatening behavior. It also contains provisions to ensure fair compensation and deter overly burdensome work. And while the application of certain provisions is dependent upon the size of a given hotel, the Ordinance creates at least some new requirements for all hotels in Los Angeles.  

Key provisions of the law include (1) providing certain workers with a personal security device; (2) staffing a position to respond to distress calls; (3) conducting trainings around security measures; (4) providing notice to staff and guests of these safety policies; (5) limiting mandatory overtime; (6) record retention; (6) limiting the ability to implement programs not to clean or sanitize rooms daily; and (7) limiting workload for room attendants.  

West Hollywood enacted a similar law—the Hotel Worker Protection Ordinance—that also became effective in 2022. As such, hotels in that city should continue to ensure compliance with the Ordinance by (1) protecting hotel workers from violent or threatening conduct; (2) providing fair compensation depending upon workload; (3) ensuring the right of hotel worker recall and retention; and (4) providing public housing training. 

EMPLOYER ACTION ITEMS 

In light of all of the new laws referenced above, employers would be wise to do all of the following right away: 

  1. Review base salaries for all exempt employees to ensure they meet the applicable salary requirements and confirm that non-exempt employees are being paid at least the applicable minimum wage.  
  2. Update employee handbooks to reflect changes in the law.
  3. Create pay scales for all employee positions to be used in job posting or upon request by an employee.  
  4. Review city- and industry-specific laws to ensure compliance.  
  5. Work with those responsible for payroll and legal counsel to meet the May 10 deadline for California’s pay data reporting requirement, including aggregating pay data by position and protected characteristic. 

Of course, the employment team at Michelman & Robinson, LLP is always available to answer your employment-related questions.  

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.