My heart inevitably sinks when a client asks the ever popular question “What form of legal entity would be best for my for-profit enterprise?” The entrepreneur’s excitement is contagious but answering is never easy. There are so many variables that determine where a start-up might end up no matter how researched the assumptions and projections might be. And yet, a choice has to be made.
For the growing number of social entrepreneurs, it has become even more nuanced. There are three new legal forms emerging to satisfy the “Impact Investment Revolution” in our midst (the Flexible Purpose Corporation, the Benefit Corporation and the Low-Profit Limited Liability Company or L3C), and Illinois is considering the creation of a fourth, the Benefit L3C. While each is designed to accommodate ventures that pursue social and environmental benefits attractive to impact investors, social entrepreneurs should consider a variety of factors before using the traditional LLC or corporation.
Summarizing the similarities and differences of each of the new legal forms is no straightforward task. Each state that has adopted one or more of the alternative new forms has slightly different requirements and there is no real case law to date analyzing how state specific legislation is to be interpreted since these legal forms are so new.
In general, the Flexible Purpose Corporation permits the founders of a for profit corporation to establish a blend of business and charitable or social objectives that are not profit maximization or asset growth oriented. The board and management of the Flexible Purpose Corporation are then charged to act with those blended objectives in mind and to report to the shareholders on its success or failure in achieving them.
The Benefit Corporation differs slightly in that it is a for profit entity that is required to advance a general public benefit in addition to any other purposes adopted as a business corporation. The Benefit Corporation may also have as a purpose the creation of one or more specific public benefits. The directors have an affirmative duty to consider the effects of their decisions on all of the corporation’s constituencies (shareholders, customers, suppliers, the environment, the community) and an annual benefit report prepared by an independent third party describing efforts to create the public benefit during the preceding year must be filed with the Department of State and distributed to shareholders.
In contrast, an L3C is usually formed to create a presumption of eligibility for program related investments (PRIs) from one or more foundations or to lock in a charitable mission when the founders have a set of investors who will support that mission. See my earlier post “Private Foundations and New Regulations Regarding Program-Related Investments”. The L3C is, by definition, a low-profit limited liability company which significantly furthers the accomplishment of one or more charitable or educational purposes within the meaning of Section 170(c)(2)(B) of the IRS Code of 1986, as amended. No significant purpose of the L3C can be the production of income, the appreciation of property or one or more political or legislative agendum within the meaning of Section 170(c)(2)(D) of the IRS Code of 1986, as amended.
The L3C therefore goes further than the Flexible Purpose Corporation or the Benefit Corporation in that both of those are set up to be money-making enterprises that also have social or charitable mission(s). The L3C can operate a business but producing income or maximizing appreciation of assets cannot be a significant purpose of the venture and if it becomes clear after formation that income or appreciation is the focus, the L3C will immediately cease to exist as a low-profit LLC although it will continue to exist as a limited liability company.
Note that “B Corporations” are not a corporate form but rather a certification mark available to all three of the above forms and even traditional for profit corporations. The certification or brand can be obtained from the nonprofit organization called B Lab and requires achieving a specific score after the B Lab evaluation of a variety of factors including the entity’s treatment of its employees and successful evaluation of socially responsible goals. See http://www.bcorporation.net for more information on B corporations.
With the above in mind, reverting to the age old “Who”, “What”, “Where”, “When” and “Why” analysis is probably the best way to analyze the alternatives. Throwing in a “How” or two will help even more.
Looking at the “who”, entrepreneurs, investors and consumers each have characteristics that may make one choice unavailable or at least inappropriate. For example, if the founding principals consist of one or more non-profit corporations rather than individuals, a Benefit Corporation may be desired although such an entity would be unable to elect pass through “S” status which may prompt a closer examination of the L3C model. If attracting foundation PRIs is a large part of the business plan, that too might suggest that the L3C is the proper vehicle. In contrast, if the initial or anticipated future investors articulate the desire to consistently build profits along with a material positive impact on society or the environment, the L3C requirement for “low-profit” expectations will be violated and the L3C status possibly challenged. The Benefit Corporation would be a better choice for such investors especially where enough time has simply not elapsed for anyone to determine how low the “low profit” requirement really is.
The “what” and the “where” is a close examination of the intended business activities and cross border implications, if any. Some activities are more fundamentally socially or environmentally beneficial than others and some are clearly charitable at their core. At the same time, while you can form a legal entity anywhere that the chosen structure is permitted and file for authority to do business in any state of operation, PRIs, bonds and grant programs are often geographically specific.
“When” is a determination of the planned exit of either the founders or specific staged investors which may suggest starting out as one kind of entity and evolving over time into another kind of entity which is permitted in most states if the requisite shareholder/member consent is obtained. The transition is not intended to be as difficult as a non-profit to for profit transformation (which, in Pennsylvania, require Attorney General and Orphans’ Court participation). “Why” is really another examination of the social/environmental/charitable mission and the expectations of all principals along with the individuals or programs the principals intend to benefit with the new endeavor. And, finally, an old fashioned projection of just “how” much money is needed at different junctures of the anticipated growth cycle is key.
LawForChange at http://www.lawforchange.org features some interesting content on the variety of legal structures available on a state by state basis. There are certainly pros and cons of using each structure and I sincerely wish you well in your efforts to choose which will be best. Forget what I said at the beginning of this post and feel free to call me if I can be of any help.
Why does it seem to take so long to solve simple problems? For years litigators have had to resort to the use of the cumbersome and needlessly expensive procedures to compel the attendance of a witness in interstate litigation pending in state court. The problem arises, of course, where the testimony of a witness located in Pennsylvania is needed in connection with litigation pending in another state, or when the witness is located out of state and his testimony is needed in connection with a Pennsylvania case.
In 2007, the National Conference of Commissioners on Uniform State Laws promulgated the Interstate Depositions and Discovery Act (the “Act”) which simplified the entire process. In October 2012 the Act was adopted in Pennsylvania and became effective December 24. It is codified at 42 Pa.C.S. § 5331.
The Act requires the Prothonotary to issue a Pennsylvania subpoena, upon the submission of a foreign subpoena. The Pennsylvania subpoena must incorporate the terms used in the foreign subpoena and provide the names and contact information for all counsel of record and unrepresented parties in the foreign proceeding. Service and enforcement of the subpoena are governed by the Pennsylvania Rules of Civil Procedure.
Need to subpoena a witness in another state for a Pennsylvania case? If the witness is located in any of the thirty two states and territories that have adopted the Act, the procedure is just as simple. Issue a Pennsylvania subpoena; send it to your local counsel on the ground in the discovery state and off you go. The Act is the law in Alabama, Arizona, California, Colorado, Delaware, District of Columbia, Georgia, Hawaii, Idaho, Indiana, Iowa, Kansas, Kentucky, Maryland, Michigan, Mississippi, Montana, Nevada, New Mexico, New York, North Carolina, North Dakota, Oregon, Pennsylvania, South Carolina, South Dakota, Tennessee, U.S. Virgin Islands, Utah, Vermont, Virginia, Washington. It is on the legislative agenda in New Jersey.
That’s all there is to it! In the words of the Commission:
The Act requires minimal judicial oversight and eliminates the need for obtaining a commission or local counsel in the discovery state, letters rogatory, or the filing of a miscellaneous action during the discovery phase of litigation. Discovery authorized by the subpoena is to comply with the rules of state in which it occurs. Furthermore, motions to quash, enforce, or modify a subpoena issued pursuant to the Act shall be brought in and governed by the rules the discovery state.
The solution is so simple one wonders why it took so long to come up with it and, once the Act became available, why it took five years to enact it in Pennsylvania? Enact it we have and litigators, their clients and the Courts will benefit from its simplicity.
Restrictions against competition are frequently included in employment agreements and agreements for the sale of business assets or stock. The restriction against competition is designed to secure a time period for the employer or buyer of business assets, as the case may be, during which the employer/buyer is free from competition for a departed employee or seller so as to facilitate the transition and better protect their own business assets and customer relationships. If properly drafted and implemented, restrictions against competition are enforceable under Pennsylvania law.
The primary method of enforcement in the event of breach is a preliminary injunction in equity. In order to prevail on a petition for preliminary injunction, a petitioner must demonstrate several factors including (1) the need to prevent irreparable harm which cannot be compensated by money damages, (2) that more harm will result from the denial of the preliminary injunction than from granting same, (3) that the injunction will restore the parties to the status quo, (4) the likelihood of success on the merits, (5) that the injunction is designed to abate the offending activity, and (6) that the injunction will not negatively impact public policy. In most cases the issues of likelihood of success on the merits and irreparable harm incapable of compensation with money damages represent the contested issues.
In Bucks County, the petition for preliminary injunction must be accompanied by a verified complaint and an order for hearing. The petition is often, though not always, heard by the initial pre-trial judge assigned to the case at the time of filing. Court administration reviews all petitions for preliminary injunction and assigns the presiding judge, courtroom and date for evidence to be taken. The order for hearing is an essential aspect of the petition; without it, no hearing will be scheduled.
The petitioner in any injunction matter bears a heavy burden. Adequate evidence as to the need for enforcement of the covenant, the potential irreparable harm and right to relief must be presented. Because the entry of injunctive relief is an extraordinary remedy, the evidence must be clear and persuasive. In employment and business asset transfer cases, the language of the restriction in the applicable agreements must be constrained to those aspects of competition which are reasonably necessary for the protection of the employer/buyer. For example, a covenant which is overbroad in terms of geography, time or scope will not be enforced.
Preliminary injunctive relief may be acquired in the Bucks County Court of Common Pleas if supported by the underlying agreement and if properly perfected under the practices and procedures employed in the County.
Just when minority owners of Delaware LLCs thought that the Delaware Limited Liability Company Act (the “Act”) protected them from overreaching managers, along comes the Delaware Supreme Court to say “better get it in writing.” It appears that practitioners longing for certainty will have to wait until the Delaware legislature steps in and revises the statute.
The Delaware Supreme Court recently published an opinion in a case involving a Delaware LLC (Gatz Properties, LLC) that was the manager of another LLC (Peconic Bay, LLC). Gatz Properties is managed and controlled by William Gatz, and the Gatz family and their affiliates owned controlling equity interests in Peconic Bay. They also owned real estate that was leased to Peconic Bay, which in turn subleased the property to a national golf course operator. The golf course proved to be unprofitable because it was poorly managed, and Mr. Katz anticipated that the sublease would be terminated. He decided to acquire the sublease and Peconic Bay’s other assets for himself. Consequently, he foiled the efforts of a third party to buy the sublease rights. He then engaged a valuation expert to appraise the property but did not provide the expert with information about the prior third party offers or tell the expert that the golf course’s unattractive financials were the result of its being mismanaged. Not surprisingly, the resulting appraisal showed that Peconic Bay had no net positive value. Next, Mr. Katz hired an auctioneer with no experience in the golf course industry to sell the golf course business. After lackluster advertising for the auction, Mr. Katz was the sole bidder and acquired the property for $50,000 plus the assumption of debt. Peconic Bay’s minority members brought suit in the Delaware Court of Chancery, alleging that Mr. Katz had breached his fiduciary duties to them. The Court of Chancery held that Gatz had breached both his contractual and statutory duties to the minority members, and Gatz appealed to the Delaware Supreme Court.
The Delaware Supreme Court agreed with the Court of Chancery that the LLC agreement’s clear language prohibited self-dealing without the consent of 2/3 of the minority owners, and Mr. Gatz testified on several occasions that he understood that Gatz Properties owned fiduciary duties to the minority members. The Court also upheld the lower court’s finding that Gatz breached this duty.
Moving on to whether Gatz breached a statutory duty under the Act, the Court noted that it was “improvident and unnecessary” for the Court of Chancery to decide that the Act imposed “default” fiduciary duties on managers where the LLC agreement is silent because, in the case at bar, the issue could be decided by interpreting the text of the LLC agreement. Additionally, no litigant asked that the lower court resolve the issue by interpreting the Act. Another concern for the Court was the lower court’s suggestion that its statutory interpretation should withstand scrutiny because practitioners rely on its rulings. The Court remarked that, as the highest court in Delaware, it was not bound to follow the lower court’s decisions. The Court rebuked the lower court for using the case at hand as a “platform to propagate [its] world views on issues not presented.” The Court concluded its reprimand by stating that because the issue of whether the Act imposes default fiduciary duties is one on which reasonable minds can differ, the matter should be left to the legislature to clarify.
Following the decision in Gatz Properties, equity holders in Delaware manager-managed LLCs would be prudent to clearly identify in the LLC agreement which fiduciary duties are intended to apply to their managers. Given the Court’s position that the issue is a matter for the legislature (not the courts) to decide, practitioners will be monitoring the activities of the legislature to see if it takes up the gauntlet.
As the calendar year comes to a close, all corporate entities, profit and nonprofit, look to their books and make end of year decisions to best avoid the pitfalls of the clear and concise (NOT!) Internal Revenue Code (the “Code”). Private foundations have a unique challenge in their efforts to avoid excise taxes which are imposed on them, as well as their managers, in accordance with Section 4944(a)(1) of the Code if it is found that such foundations made investments that jeopardize the private foundation’s exempt purposes. Such “jeopardizing investments” generally occur when foundation managers fail to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long and short term financial needs of the private foundation.
On May 21, 2012 the Service published proposed regulations that provide nine new examples of types of private foundation investments that qualify as Program Related Investments (“PRIs”). PRIs are not classified as investments which jeopardize the carrying out of exempt purposes of a private foundation because they possess the following characteristics:
a. have as the primary purpose the accomplishment of one or more charitable or educational purposes defined by Section 170(c)(2)(B) of the Code;
b. do not have as a significant purpose the production of income or the appreciation of property; and
c. do not further one or more of the purposes described in Section 170(c)(2)(D) of the Code (relating to prohibited political activities and lobbying).
To be certain both the foundation and the recipient of the PRI are on the same page (and to also prove the foundation is exercising “expenditure responsibility” to the Internal Revenue Service), a private foundation must secure a written commitment from the recipient of the PRI which specifies the purpose of the investment and contains an agreement by the organization:
a. to use all amounts received only for the purposes of the investment and to repay any amount not used for these purposes back to the foundation, provided that, for equity investments, the repayment is within the limitations concerning distributions to holders of equity;
b. to submit, at least once a year, a full and complete financial report together with a statement that it has complied with the terms of the investment;
c. to keep adequate books and records and to make them available to the private foundation; and
d. not to use any of the funds to carry on propaganda, influence legislation, influence the outcome of any public elections, carry on voter registration drives or make grants that do not comply with the requirements regarding individual grants or expenditure responsibility.
Examples of acceptable PRIs in the proposed new regulations are based on published guidance and on financial structures that had previously been approved in private letter rulings. The regulations do not modify the existing regulation but illustrate certain principles and current investment practices. Where the examples in the older regulations focused on domestic situations principally involving economically disadvantaged individuals in deteriorated urban areas, the new examples include a broader range of opportunities that might be presented to a private foundation.
The new examples demonstrate that a PRI may accomplish a variety of charitable purposes, such as advancing science, combating environmental deterioration and promoting the arts. Several examples also demonstrate that an investment that funds activities in one or more foreign countries, including investments that alleviate the impact of a natural disaster or that fund educational programs for individuals in poverty, may further the accomplishment of charitable purposes and qualify as a PRI. One example specifically illustrates that the existence of a high potential rate of return on an investment does not, by itself, prevent the investment from qualifying as a PRI. Another illustrates that a private foundation’s acquisition of an equity position in conjunction with making a loan does not necessarily prevent the investment from qualifying as a PRI and two examples illustrate that the private foundation’s provision of credit enhancement (such as a deposit agreement or a guarantee) can qualify as a PRI.
As a result of the new examples, the Service has made it clear that the recipients of PRIs do not need to be within a charitable class if they are the instruments for furthering a charitable purpose.
Thus, an investment in a for-profit that develops new drugs may qualify as a PRI if the for-profit business agrees to use the investment to develop a vaccine distributed to impoverished individuals at an affordable cost. Similarly, the purchase of equity in a benefit corporation or L3C that engages in the collection of recyclable solid waste or a below market rate loan to allow a social welfare organization formed to promote the arts purchase a large exhibition space may each also qualify for a PRI from the right foundation.
The new regulations should provide private foundation boards and managers in the second half of 2012 with the additional assurance they needed to make PRIs not only to traditional non-profits but to for-profit, benefit corporations and L3Cs with an articulated social enterprise consistent with the foundation’s exempt activities. Rejecting traditional boundaries between nonprofit and for-profit sectors, the PRI regulations can help encourage the most creative business minds achieve ‘double bottom line’ (financial and social) and sometimes ‘triple bottom line’ (financial, social and environmental) results. By expanding the base for PRIs, we move beyond traditional conception of society as divided neatly into three sectors (business, nonprofit and government) help develop a new forth sector that encompasses elements of both business and nonprofit sectors.
Often, in the business context, agreements contain representations and warranties of the parties to the agreement. The representations and warranties can range from general items such as business forms and the payment of taxes, to more specific items, such as the accuracy and reliability of financial information. While such representations and warranties are commonplace in business agreements, their importance should not be overlooked.
Under Pennsylvania law, when performance of a duty under contract is due, any non-performance is a breach. If a breach constitutes a material failure of performance, the non-breaching party is discharged from its duties under the contract. A party who has materially breached a contract may not complain if the other party refuses to perform. In other words, a material breach of contract may excuse performance by the non-performing party.
In the context of representations and warranties contained in a business agreement, should the representations and warranties contained in the agreement prove to be false, the party to whom the representations and warranties were made may raise the falsity of the representations and warranties to excuse further performance of any contractual obligations under the agreement. Such a circumstance could spell disaster in the business context – particularly in a case where the payment of money is due at some time after closing.
Pennsylvania courts impose an element of materiality to the breach of a representation or warranty. The elements of materiality under Pennsylvania law include the extent to which an injured party will be deprived of the benefit which he reasonably expected, the extent to which the injured party may be adequately compensated for that part of the benefit of which he will be deprived, the likelihood that the party failing to perform or offer to perform will cure, and the extent to which the party failing to perform comports with the standards of good faith and fair dealing.
Accordingly, representations and warranties contained in an agreement should not be taken lightly, but should be made with any eye toward the potential ramifications in the event of breach.
Actually, this blog post is not really about binders full of women – the title is pure, unadulterated pandering. But it is about the conversation that generated that Tweet-worthy sound bite. In case your computer, smartphone, television and ears were down this week, let’s recap. At the October 16, 2012 town hall Presidential Debate, an undecided voter asked how the candidates would address pay inequality for women. President Obama answered by referencing his support of the Lilly Ledbetter Act. Governor Romney answered with a story about binders full of women searching for female candidates, and providing flexibility for female employees. An employment lawyer drooled. Please note that this is not a political discussion, but a legal one, and the analysis that follows is about whether the law would permit the approaches recommended by the candidates.
President Obama had the easy path. The Lilly Ledbetter Act is now the law. Under the civil rights laws, employees have 180 days from the alleged discriminatory act to file a complaint with state or federal equal employment commissions. If the employee fails to file the claim in the time required, the employee’s claim is forever barred. Poor Ms. Ledbetter discovered, too late, that she was paid less than a male employee for the same work. The court dismissed her claim because she filed it more than 180 days after the first discriminatory paycheck. The Lilly Ledbetter Act states that the statute of limitations for an equal pay claim resets with each paycheck. It was the first statute that President Obama signed into law.
Governor Romney’s answer invites employment lawyer criticism. To be clear, this is not political criticism, but legal criticism. The answer essentially had two parts: first, his search for female candidates and second, his willingness to provide flexibility to female employers who needed to get home to make dinner. Let’s start with the search for female candidates. The civil rights laws prohibit discrimination on the basis of gender. It was not clear from Governor Romney’s answer whether or not he was referring to an affirmative action program, or whether there was a written diversity plan at issue. But, certainly, the goal of employing an underrepresented group in the office of the governor is a laudable one.
Nevertheless, an employment lawyer worries. Imagine two candidates, both with comparable education and experience, both interviewed well, and, in all respects were both qualified candidates. One is male, one is female. Could the governor decide to hire the female candidate solely because she was female? Put another way, would it be discrimination on the basis of gender for an employer to deny employment to the equally qualified male candidate solely on the basis of his gender? The legal answer is yes. An interesting defense to such a claim is that the governor had made a policy decision that his cabinet must reflect the views of qualified women. Employers should always base their decisions on qualifications for the job. Where an employer has decided that gender, for example, is part of the qualifications for the job, they must also articulate a legitimate business reason for such a qualification.
Governor Romney also talked about the need for flexibility for female employees. Tsk tsk, Governor Romney, tsk tsk. The law requires that Governor Romney provide the same level of flexibly for all of his employees, regardless of gender. The law also requires that Governor Romney avoid making employment decisions based on gender stereotypes (i.e., the woman needs to get home to make dinner). An employment lawyer loses a few hours of sleep.
Interestingly, this is the place where the candidates intersect. The law requires equal pay for equal work, and the Lilly Ledbetter Act keeps that claim alive with each new paycheck. But employees, male and female, do ask for flexible work schedules, and many employers are happy to oblige to keep good candidates. Our advice: don’t be like Governor Romney! Make sure flexibility is available to all employees, and that the pay is commensurate with the work provided.
The candidates’ discussion does highlight the challenges for employers: sometimes, an employer’s good intentions, the realities of the workplace, and the requirements of the law seem at odds with one another. Even presidential candidates struggle with these competing concerns. It is our experience that employers can work through these complex issues and strike a balance with good legal and human resources advice.
Employment agreements, especially those for key employees which include non-competition terms, must be carefully drafted. What should they include? Here are eight (what’s magic about ten?) musts:
1. Define the Restrictions. The non-compete should, first and foremost, clearly define the prohibited zone by industry segment, by geography and by time. Because these covenants are disfavored in the law (certainly by every trial court which I’ve ever asked to enforce one of these agreements) employers must leave no doubt about the restrictions and be able to tie each to an identifiable protectable interest. The covenants are not enforceable unless they are required to protect such interests, and then only to the extent the restrictions are reasonable.
2. Protectable interest? Courts will not enforce these covenants unless the employer has an interest which can only be protected by the restriction. Eliminating competition is not a protectable interest but, for example, protecting customer relationships is. Consider how the particular employee could hurt your business and tailor the restrictions to provide protection in those areas.
3. Reasonable? A covenant prohibiting competition anywhere in the country is not likely to be enforced where the employee’s relationships were confined to one state or region of the country. Such a broad restriction would likely be found to be unreasonable. Similarly, temporal restriction should be limited to the time required to give the employer’s new representative time to meet and solidify relationships with the customers.
4. Don’t forget to protect your people. A well drafted employment agreement will include provisions which prohibit the employee from inducing your employees to move to the new employer. Losing one key employee is bad enough; losing three or four may be catastrophic.
5. What happens if the employer sells the business? Unless the covenant can be assigned, it is lost and the employee is free to compete. Restrictive covenants are important assets of the business. Absent assignability, the value of those assets is lost if the business is sold.
6. A tolling provision? It may take some time for an employer to learn that a former employee has violated the covenant. Litigation to stop that violation takes more time. A well drafted document will include a tolling provision which stops the clock from running while the employee is in breach.
7. Protect confidential information. The employment agreement should protect confidential information and trade secrets. Employees are often privy to sensitive information which is necessary to do their job. When they leave employment, that information should stay behind. Make sure that the employment agreement provides that confidential information and trade secrets will not be “used or disclosed” after the sale. Define confidential information as broadly as possible, but keep in mind that it does not include information known to the public or easily discoverable.
8. Make violation risky. The former employee must know that if he chooses to violate, it will cost him. The tolling language, mentioned above is one way to get that point across. Another is to provide for recovery of attorney’s fees if the restrictive covenants are violated and enforcement litigation results.
There is a large body of state specific law surrounding the interpretation and enforcement of these agreements. Make sure the attorney who you engage is experienced in this area of the law.
Two guys are sitting at a bar discussing how they are going to quit their current jobs and start their own business. A lawyer sits next to them, overhears their happy ramblings and pipes in, as lawyers always do, that their mutual promise to devote 100% of their working energy to the new biz has to be reduced to writing. You know this joke, right?
Well, maybe not, and maybe it’s not such a knee slapper anyway. Under Delaware’s Limited Liability Company Act (the “Act”), a person may be admitted to a LLC as a member and may receive a LLC interest without making a contribution or being obligated to make a contribution to the LLC. If an interest in a LLC is to be issued in exchange for cash, tangible or intangible property, services rendered or a promissory note or obligation to contribute one or more of these items, however, the LLC’s operating agreement can and should, identify that obligation. The Act goes further and makes it clear that the operating agreement may provide that a member who fails to perform in accordance with, or to comply with the terms and conditions of, the operating agreement shall be subject to specified penalties or consequences, When a member fails to make any contribution that the member is obligated to make, the operating agreement can provide that such penalty or consequence take the form of reducing or eliminating the defaulting member’s proportionate interest in a LLC, subordinating the member’s interest to that of nondefaulting members, a forfeiture of that interest, or a fixing of the value of his or her interest by appraisal or by formula with a forced redemption or sale of the LLC interest at such value.
If only our clients made it easy on us by letting us write agreements with such detail! A more common scenario is the member who wants us to get rid of the 50% member, formerly a dear buddy, who walked out the door for whatever reason after a few months (or, even worse, walks in and plays on the computer all day doing nothing that needs to be done). Unfortunately, without an operating agreement that clearly identifies expectations with respect to contributions of services and remedies for breach, it is a challenge to argue the defaulting member forfeits his or her interest for failure of consideration as s/he might for failure to “pay” for the interest with cash or property.
While I continue to look out for case law in support of the idea of forfeiture in the context of LLCs, a recent Kansas case did address alternative remedies for breach of obligations with respect to contributions of cash. In Canyon Creek Development, LLC v Fox, the court struggled with the appropriate remedy available to a LLC when a member failed to satisfy a required capital call. The defaulting member, Fox, argued that he should not be held personally liable for the nonpayment of a post-formation capital contribution where the only remedy set forth in the operating agreement was a reduction of his ownership interest. Interpreting a statute that appears to be similar to the Act, the court ultimately agreed with Fox, making a distinction between the initial contributions (which could be in the form of cash or services, measured by their “net fair market value”) and later capital infusions which had to be in cash (unless the manager otherwise consented). The court concluded that the statutory default rule that a member is obligated to perform any promise to contribute cash or property or perform services, even if a member is unable to perform, supports the proposition that a member may be required, at the option of the LLC, to contribute an amount of cash equal to the agreed value of any initial, unmade, contribution. The court stated this was the law even where the LLC may have other rights against the noncontributing member under the operating agreement or other law. Turning to subsequent capital calls, however, the court found it significant that the remedy of cash damages, the most fundamental remedy for breach of contract, was conspicuously absent from the provisions of the operating agreement. Thus, the court concluded that the failure to include such a fundamental remedy as damages when a member fails to contribute additional capital after the LLC’s initial capitalization was not an oversight, but rather expressed a clear intent that damages are not recoverable from a member who failed to contribute additional capital after the venture was up and running. In the Fox case, the right to reduce the breaching member’s LLC interest was all that the LLC could do to punish the breaching member. No divorce, but better than a non-collectable judgment for a sum certain from my perspective.
In a recent case that may not bode well for the enforcement of noncompete agreements in Pennsylvania and New Jersey, the Virginia Supreme Court reversed twenty years of Virginia precedent relating to noncompetes, agreements pursuant to which an employee agrees not to compete with an employer for a period of time after the termination of employment. Until this recently, Pennsylvania, New Jersey and Virginia had similar laws relating to noncompetes. Historically, courts in all states have not looked favorably on such agreements, and have used various tools to limit or deny enforcement of noncompetes. Prior to the court’s decision in Home Paramount Pest Control v. Shaffer, the law in Virginia was similar to Pennsylvania law: a Court could re-write overbroad noncompete agreements so that the document was consistent with the employer’s protectable interests. In Home Paramount Pest Control, the court stated that it would no longer re-write such provisions, and that it was free to refuse to enforce a noncompete that was overly restrictive.
The former employee in Home Paramount Pest Control signed a noncompete agreement that prohibited him from competing with his former employer’s fumigation business in any manner, in any geographic area where he worked for Home Paramount Pest Control for a period of two years after his termination. Prior to this case, it was well settled that if the court found the restrictions of the noncompete broad, it could rewrite the document and enforce more reasonable provisions. The court generally exercised its re-writing power to limit the geographic or temporal scope of the document, or to find that specific conduct did not violate a noncompete if the employer could not articulate a protectable interest in prohibiting the conduct, even where the clear language of the agreement prohibited the competitive conduct. Generally speaking, “protectable interest” means that the employer has provided something to the employee that it has the right to protect, such as access to trade secrets, or specialized training. If the restriction on future employment did not match a protectable interest, the court would not enforce the restriction.
In Virginia at least, this is no longer the case. The Virginia Supreme Court noted that it had “incrementally clarified” the law relating to noncompetes so dramatically over the past two decades that it was free to find the noncompete unenforceable in this case. Most interestingly, the court focused on language that lawyers generally believe is good drafting. The agreement in question contained a list of prohibited activities designed to address every conceivable kind of competition, as well as the ubiquitous “in any capacity whatsoever” catch-all for good measure. The court found that the employer could not articulate a protectable interest that would justify such a sweeping prohibition. Specifically, the court was looking for a nexus between the employee’s job duties, and the prohibitions imposed by the noncompete.
In the good old days, the court would simply have revised the agreement to remove whatever restrictions were too broad, such as the “in any capacity whatsoever” language. Or, the court may have found that there was no protectable interest in prohibiting the employee from engaging in his current employment. But the Virginia Supreme Court refused to do so, noting that incremental changes in the law required a different result. I will not bore the reader with the court’s very interesting discussion of how the doctrine of stare decisis applies to the case, except to note that the court recognized its decision as a departure from well-settled law.
While this case does not apply in Pennsylvania or New Jersey, many states have seriously limited the enforceability of noncompetes. We are making sure to discuss these issues with our clients, and draft noncompetes as narrowly as possible. We are also thinking creatively about other solutions to the problem of competition, trade secrets and specialized training, such as non-solicitation provisions. The Virginia Supreme Court has given us new reasons to draft carefully.