Starting a business has become an increasingly complex proposition as regulatory and compliance matters continue to mount for new business owners. There are a variety of considerations for business founders from the outset, including liability protection, tax implications, effective governance, and even possible exit strategies. The structuring decisions you make at the beginning of a new venture could have a real impact on your long-term success.
A little planning can go a long way
Starting a new company is an exciting time in the life of an entrepreneur. A modest amount of planning at the outset can save considerable cost and aggravation later, as a properly structured business entity has advantages over the long-term.
There are a number of issues for founders to consider when forming the business entity. Two of the most important are tax considerations and liability protection. Partnerships and corporations have considerable differences in the way they are taxed and the proper structure for a given venture will depend largely on business goals and the particular ownership circumstances. Additionally, shielding owners from personal liability should be a priority for business owners. There are a number of ways to achieve this goal and business owners must be careful to structure the business properly in order to assure an effective limitation of liability. For both tax and liability issues, it is important to seek professional guidance.
Depending upon the nature of the business, there are a wide range of other issues for the entrepreneur to consider. These range from the somewhat mundane, such as obtaining an employer identification number from the IRS and setting up bank accounts, to the potentially critical, such as an effective strategy for protecting intellectual property rights. If not properly addressed, all of these issues have the potential to become serious headaches for business owners.
At some point during the business growth cycle, most companies also reach a juncture where hiring employees is a consideration. This decision comes with another layer of planning and compliance requirements. Along with employees come obligations for tax withholding, state and federal unemployment insurance premiums, and workers compensation. In addition to complying with requirements of regulatory authorities, the proprietor should also consider internal employee matters such as benefits packages and employee policies memorialized in a formal employee handbook. As with most substantive issues faced by the small business owner, employee matters can be handled in a variety of ways depending on the particular circumstance.
The bottom line for all entrepreneurs starting a business is that a small amount of planning can pay significant dividends down the road. Often it is much more difficult and expensive for a company to remedy structure and compliance issues after a business is fully operational. By spending a modest amount of time and resources at the outset, companies can be optimally positioned to succeed over the long term. We provide clients with practical legal advice, and our goal is to put our clients in the best possible position to excel in the business world.
Corporation or Limited Liability Company?
Whether to form a limited liability company (“LLC”) or a corporation is a question often pondered by new business owners. Corporations and LLCs are not the only form of business structure, and in some cases, including professional services or investment fund vehicles, partnerships—particularly limited liability partnerships—may be ideal. LLCs, corporations, and partnership are all formed pursuant to state law. Within the corporate family, there are C-Corporations (commonly called a “C-Corp” because of the applicable section of the tax code) and S-Corporations (“S-Corps”). Contrary to popular belief, an “S-Corp” is not a distinct legal entity from a C-Corp but rather is a distinct status made through a tax election filing with the IRS.
Tax 101: A Pass-Through and a Blocker
Despite the nomenclature, we are talking tax here, not football. The most important thing to understand about tax basics for business entities is that some entities have pass-through treatment and some do not. Pass-through treatments means that the income of the entity passes through to the individual owners and is paid at their individual rates, rather than another rate at the entity level. A blocker, on the other hand, pays tax at the entity level at an entity-level rate. Important note: as we will see below, while a C-Corp pays tax at the corporate level, individuals still must pay taxes when money flows through to them in the form of salaries or dividends. This is the double-tax feature of C-Corps.
Why a C-Corp?
Most large, publicly traded companies are C-Corps, whereas many start-ups and small businesses tend to be LLCs or S-Corps. There are certain distinct advantages to C-Corps for many more established entities that are not necessarily applicable to smaller, less established companies. For one, institutional investors have a strong preference for C-Corps. Many people think that’s because C-Corp legal rights are more predictable. While there may be some truth to that, in fact, the main reason why some institutional investors prefer C-Corps is because they are NOT pass-through entities. Large, institutional investors often have tax-exempt entities, such as pensions, as their limited partner investors. Without going down a tax rabbit hole, that means these institutional investors typically need to invest in a “blocker entity” that does not have pass-through tax status (meaning a C-Corp). Otherwise, institutional investors’ limited partners could be subject to what is known as UBTI (unrelated taxable business income), which can create major problems. So, indeed if a company has designs on raising institutional funding or going public someday, a C-Corp holding company may indeed be the right choice. In fact, virtually every major corporate family has a C-Corp at the top of the organizational chart with numerous other subsidiaries and affiliates that are often pass-through entities. After the 2017 Tax Act changes, C-Corporations are now taxed at a flat 21% rate (down from 35%). Salaries or dividends are taxed separately at the individual’s personal income tax rate or 20% for qualified dividends, respectively, when distributed to individual owners.
What About LLC or S-Corp?
From the tax perspective, there are a lot of similarities between an LLC taxed as a partnership (the most common tax scenario for an LLC) and an S-Corp. Both are treated as pass-through entities, meaning that the profits and losses pass through the business to the owners of the entity, and there is no federal income tax paid at the entity level. While the primary tax structure of the LLC and the S-Corp is similar, depending on the timing of the decision and the status of the underlying business, the practical tax effect for owners can be different depending on whether an entity is a corporation or an LLC.
There are various other characteristics of the LLC and the S-Corp that have significantly different ramifications for the business owner. For instance, there are ownership and governance restrictions on an S-Corp, including a maximum of 100 shareholders and no separate classes of stock, that limit some of the flexibility in structuring economics and allocating profits, losses, deductions, and credits that can be achieved with an LLC. Unlike S-Corps where profits and losses are allocated to shareholders based on pro rata ownership regardless of the parties’ preferences, an LLC allows flexible allocations that can be drafted into the LLC operating agreement, provided the arrangement has substantial economic effects (another tax concept beyond the scope of this article).
At the same time, there are advantages that the S-Corp structure can have over the LLC. Within certain parameters, the S-Corp may provide owners with payroll tax savings not available to owners of the LLC. Additionally, the corporate structure of the S-Corp can be simpler in certain circumstances, such as when an owner dies or leaves the company.
After changes resulting from the 2017 Tax Cuts and Jobs Act, pass-through entities are entitled to a 20% income deduction for qualified business income (QBI) from a trade or business (but excluding a wide array of service businesses). The deduction is still available for excluded businesses for income up to $157,500 for an individual or $315,000 for a married couple. The deduction is allowable for the lesser of 20% of taxable income plus qualified REIT dividends and publicly traded partnership income or 20% of taxable income minus net capital gains.
The bottom line for business owners is that there is not a simple answer to the corporation versus LLC question. The decision will be fact driven depending upon the particular circumstances of the owners and the business. As with other issues pertaining to a start-up company, the particulars of the business structure are something that legal counsel should be retained to analyze so that the company will be in the best possible position to succeed long-term.
One of our firm’s specialties is fighting powerful entities that are generally able to bully normal people into submission, particularly government entities.
Victims of a wrongful determination or course of conduct by the state or a city, county, town, village, or its agents may have legal options at their disposal. Article 78 of New York’s Civil Practice Laws and Rules (CPLR) provides recourse to challenge a decision by a government entity–and even some non-government entities like condominium boards–and compel a different result.
What is Subject to Challenge
Article 78 allows citizens to challenge a wide variety of determinations, including but not limited to: denials, suspensions or revocations of licenses (such as a liquor license, pistol license or driver’s license); termination from a fire department, police department or other agency; disqualification from a civil service application process (such as a police department application process or correction officer application process); school suspensions; land use and property issues: denials of zoning permits or special land use permits; determinations about residential and commercial land use; determinations about landmark or historic designations; denials of Freedom of Information (FOIL) requests; and denials of applications to amend birth certificates or other legal documents.
Who is Subject to Challenge
The list of agencies or bodies that can be challenged is extensive, and state and local agencies often make bad decisions for a variety of reasons, including ignorance, intentional disregard of an agency’s rules or procedures, bias, lack of a diligent, fair or thorough review process, and arbitrariness.
Just because an agency supposedly has the necessary expertise to reach the correct decision does not mean that it will. State and local agencies wield enormous power, and their decisions can lead to lasting–and sometimes unfortunate–consequences, such as financial ruin, denial or loss of a coveted job, or denial or loss of a basic right or privilege.
Do Not Wait, However
The statute of limitations for bringing an Article 78 proceeding is only four months, and the clock begins ticking immediately, which means if you have a potential claim, it is important to act expeditiously.
We represent entities and individuals subject to federal or state investigations, prosecutions, or enforcement matters, including before the U.S. Securities and Exchange Commission (SEC) and other regulatory bodies. Our lawyers collectively have handled a whole variety of these types of cases, including cryptocurrency-related enforcement actions before the SEC, unregistered investment adviser enforcement matters, and insider trading investigations.
Any government investigation or action, whether civil or criminal, is a serious matter, and requires experienced counsel early in the process with a well-defined strategy. Targets of government investigations very often compromise their positions by attempting to deal with an investigation without counsel. Sometimes subjects of an investigation fail to appreciate that they are the target. Sometimes they wrongly assume that by speaking freely without counsel, they will not appear to be hiding anything. The bottom line is this: if you or your business is the subject of any sort of government investigation or inquiry, attempting to deal with it on your own might be the worst decision you could ever make.
For starters, when subjects speak to government investigators without legal guidance they often unwittingly say things that are incriminating because they do not understand the law. Second, as we have seen time and again, subjects sometimes make statements or omit details that can later be construed or depicted as false or misleading, which can end up constituting the very crime for which a subject is ultimately prosecuted. Retain experienced counsel as early in the process as possible before you start a dialogue with government officials or investigators.
We are very different than your typical lawyer
Unlike most firms, our lawyers have extensive business and finance experience, so our role goes beyond just serving as a legal counselor. We have done the deals, but we have also crunched the numbers and built spreadsheets, so we can show you things other lawyers won’t. We can help you maintain your cap table, show you the effects of dilution on your ownership, and explain to you how venture capitalists value their positions using Black Scholes option pricing theory.
Financing 101
Many successful start-up and growing companies face the proposition of raising capital for company expansion. This financing can come in many stages from the less formal “friends and family” fundraising to the structured world of venture capital funding. In every one of these stages of capital raising, companies and owners have numerous issues to navigate, including structuring questions, company valuation, tax considerations, and complex state and federal securities law regimes. As entrepreneurs, our attorneys understand both the excitement and anxiety that are a part of growing businesses.
While these financing issues can present an intimidating undertaking for entrepreneurs, it is extremely important that they be handled appropriately by experience counsel. Neglecting to address the relevant legal issues at the outset can result in significant hurdles for later stages of financing and development. Comprehensive planning of financing rounds pays real dividends in the long run and can have extremely adverse implications for companies and entrepreneurs if not handled skillfully in the early stages. We counsel both companies in various phases of financial development and capital raising, as well as investors looking to protect their investment and maximize the chances of success.
Share Issuance
Many entrepreneurs do not realize that share issuance, even at the beginning stages of the company, is a taxable event. Usually, although not always, shares are deemed of little value in the beginning stages of a company, so there is no tax owed. However, depending on how and when shares are issued, severely adverse tax consequences can result. Even in the early stages of a company, it is generally advisable for founders to execute an intellectual property (IP) assignment to the company in exchange for shares. In addition to the fact that the company should own the IP associated with a business idea rather than the individuals, an IP assignment can lessen tax liability since it exchanging a property right for shares rather than shares for services.
For both founders and new hires as a company grows, investors generally want to see shares vest over time, which provides an incentive for management to stay with the company over time and avoid “dead equity,” which is equity that has already been issued and vested without continued services being rendered. Generally shares are issued to entrepreneurs either through restricted stock (including restricted stock units RSU) or options.
Stock Options
There are complicated rules governing issuance of stock options, which should be formalized through a company stock option plan, including how many stock options can be granted annually depending on whether a stock option is qualified a stock option (a/k/a statutory or incentive stock options exclusively for employees that carry preferential tax treatment) or non-qualified stock option (for non-employees with non-preferential tax treatment). There are different tax rules that govern the exercise of qualified versus non-qualified options. Generally, issuance and vesting of option agreements is a non-taxable event as long as the strike price of the stock option is equal to the fair market value of the underlying security. If the strike price is less than fair market value such that the holder of the option receives an immediate economic benefit, then the grant is taxable.
Depending on the type of stock option, exercise of an option and sale of the underlying security can have significant tax consequences. When a qualified stock option is exercised, even if the underlying security has appreciated and is worth more than the exercise price (presumably it would be), the exercise is not taxable for ordinary income tax purposes, although may be subject to the alternative minimum tax. The exercise is not subject to employment tax withholding. For non-qualified stock options, however, the value of the exercise (underlying security fair market value minus strike price) is taxable as ordinary income and subject to employment tax withholding. For non-qualified stock options, the spread on the value of the underlying stock and the strike price is deductible by the company, since that difference is a theoretical loss to the company for not issuing the shares at fair market value, whereas the spread is not deductible in the case of qualified stock options.
For qualified stock options, only $100,000 of the security underlying the option can be exercised in any calendar year in for shareholders who own more than 10% of the shares, options strike prices must be at least 110% of fair market value at grant and may not be exercisable for at least 5 years. For non-qualified stock options, these limitations do not exist. For qualified stock options to qualify for long-term capital gain, the underlying stock must be held for at least one year and the option grant must have occurred at least two years ago.
Restricted Stock, 83(b) Elections, and 409A Valuations
When restricted stock vests, however, that is a taxable event in the year of vesting, even if the shares cannot be sold. Particularly if the venture is successful and the shares appreciated significantly over the course of the vesting schedule, this can leave entrepreneurs with a punishing tax liability. The way to deal with this conundrum is through an 83(b) election, which must be made shortly after share issuance. With an 83(b) election, the recipient of the restricted stock must pay tax on the fair market value of the stock at the time of the issuance. This also results in a tax liability for the recipient, but it is generally much lower than the tax that would be due when the stock vests if the venture is successful. However, 83(b) payments are risky in that there are no refunds from the IRS if the stock ends up being worth less than the valuation upon which tax is paid.
The tax liability for an 83(b) election is based on the valuation at the time of issuance. For publicly traded stock, assessing valuation is easy. For private stock without liquid market, valuation is much more difficult. An equity fundraising round generally establishes a valuation and at least theoretical fair market value. Without a benchmark, however, parties can either make their own assessment about valuation, which is very vulnerable to challenge by tax authorities in the event of an audit, or engage professionals to value the company and render a 409A opinion, which is less subject to challenge than a company’s self-interested assessment.
Securities Issuance
The 1933 Securities Act provides that all securities must either be registered (which involves a lengthy and expensive process with the SEC) or be issued pursuant to an exemption. The vast majority of companies, including start-ups, issue securities pursuant to a private placement exemption that is based on Section 4(2) of the 1933 Act, as well as subsequent case law and regulations. The most common private placement exemption is Section 506 of Regulation D pursuant to the 1933 Act. Section 506 allows issuers to issue securities to an unlimited number of accredited investors and up to 35 non-accredited investors (we strongly advise companies only to issue securities to accredited investors in private offerings). There are various restrictions to be mindful of when issuing securities, including what representations to make to investors and rules involving advertising and solicitation in connection with an offering. Generally, private placements restrict an issuer’s ability to generally solicit, although Section 506(c) permits solicitation and advertising if all of the investors are accredited and the issuer takes reasonable steps to verify their accredited status. It is extremely important to conduct these activities under the guidance of experienced counsel.
Civil litigation encompasses a wide range of legally contested disputes, ranging from commercial litigation to tort actions between two or more entities or individuals. Money is usually at the heart of these disputes, although the direct subject of the dispute can sometimes involve real property, intellectual property, or the enforcement or exercise of a legal right. The broad spectrum of litigants involved in civil litigation ranges from multinational corporations to individuals. We handle a wide variety of these matters, particularly in light of our dual emphasis on litigation and corporate matters. Naturally, business disputes often involve intricate corporate and business issues that need proper analysis and perspective in preparation for successful litigation. With attorneys from corporate and litigation backgrounds, we handle all aspects of our clients’ business and personal disputes, regardless of whether our client is a plaintiff, a defendant or both. Civil litigation matters fall into a wide spectrum of areas:
Breach of Contract
A contract is a legally enforceable agreement creating obligations between two or more parties. A breach consists of a violation of some obligation under that contract, whether it be omitting to perform an act that is required or engaging in some act that is prohibited. Fundamentally, breach of contract is the cornerstone of most commercial litigation, since almost any business agreement creates a contract. Some common subjects of breach of contract disputes include real estate transactions, sale of a company or firm, promissory notes, agreements to provide goods or services, employment agreements, partnership agreements, and non-compete agreements.
Breach of Fiduciary Duty
A fiduciary is one who owes to another the duties of good faith, trust, confidence and candor. Thus, a fiduciary owes a fiduciary duty to those who rightfully place a high degree of trust in the fiduciary. For example, a corporate officer owes a fiduciary duty to the shareholders of that corporation. The members of a partnership owe each other a fiduciary duty. Trustees owe a fiduciary duty to the beneficiaries of the trust. Breach of fiduciary duty is an abuse of trust and is often a cause of action that parties raise when involved in commercial disputes.
Fraud
Fraud is simply an intentional, knowing misrepresentation of the truth, or the concealment of a material fact in order to gain an advantage over another party or to cause that party to act to its detriment. Business disputes often involve fraud, since lies, deceptions, and machinations are so often the cause of those disputes. In cases of fraud, the aggrieved party may be entitled to have the contract terminated (a solution known as “rescission”) or may seek other monetary damages, including, in some cases, punitive damages.
Defamation
In many professions, the most valuable asset a person has is his or her reputation. Unfortunately, reputations can be damaged or ruined instantly by a misinformed or malicious individual or organization. A false or misleading statement about one’s business can cost goodwill, money, or both. In legal terms, this sort of reputational harm is known as defamation. The written form of defamation is known as libel. The spoken form of defamation is known as slander.
Whether defamation targeted at you is written or spoken, the harm can be long-lasting and far-reaching, particularly in the Internet age, where a nasty rumor or outrageous statement can turn into an ugly “Google tattoo” that can rear its ugly head repeatedly for relatives, friends, business associates, clients, and anyone else to see. In addition to aggressive legal action, we have the media savvy and experience to launch a proactive media campaign on behalf of clients.
Business Disputes
Certain business disputes can be brought pursuant to a statutory proceeding, as opposed to a standard action for common law causes of action. For instance, New York’s BCL (Business Corporation Law) provides certain mechanisms for seeking remedies by owners of a company, including dissolution of the company. Under Section 1104 of the BCL, holders of at least 50% of a corporation can petition for dissolution of the company in the event of an intractable deadlock. Under 1104-a, holders of 20% or more of a corporation can seek judicial dissolution on various grounds, including the controlling parties are engaged in waste, fraud, or oppressive behavior. When a petitioner seeks dissolution on 1104-a grounds, other shareholders have an absolute right for 90 days to purchase the petitioner’s share at fair value (not necessarily the same as market value) as of the day before the petition is filed. The election to purchase the petitioner’s shares is generally irrevocable and avoids dissolution. Section 702 of the Limited Liability Company Law also gives members the ability to seek judicial dissolution.
Our lawyers are experienced in private company merger and acquisition transactions of all kinds. We represent clients in the structuring, negotiating, and closing of transactions in mergers, acquisitions, assets sales, and business reorganizations. Transactions of this nature are significant events in the business life-cycle and, for many owners, are once in a lifetime transactions. We provide advice from the beginning to the end of a deal so that our clients can maintain focus on what is most important: running their businesses.
When business owners initially consider an M&A transaction it often appears like a relatively straight-forward process. However, there are structuring considerations from the outset that can have a very real impact on a company’s finances and risk profile.
After the basic business terms of a transaction are agreed upon, the process of drafting and negotiating the written deal documents present a number of potential complications. In addition to the deal structure, the closing process, representations and warranties, indemnities, and termination provisions contained in the documents are just a few of the provisions that can be very high stakes for both parties. Our attorneys diligently represent and protect the interests of our clients in these deals to avoid unnecessary risks.
Deal Structure
Business acquisition are generally structured as either entity stock sales or asset sales. There are characteristics of each structure that have a significant impact on the parties and the net results of the transaction. In an asset sale, the buyer purchases some or all of the target company’s assets while the seller maintains its ownership interest in the target company. If the target company sells all of its assets, it has little to no value after the transaction and is often dissolved. In an entity sale, the buyer purchases the seller’s ownership interest (i.e. in the case of a corporation, the seller’s stock and in the case of a limited liability company, the seller’s membership interest). Along with that ownership interest comes all of the assets and liabilities of the company.
As a very general matter, buyers will often prefer an asset sale because of advantages with both taxes and liabilities. An asset sale will typically permit buyers to take a “step up” in the tax basis of the acquired assets, and buyers generally want to allocate as much of the purchase price as possible to assets that allow for quicker depreciation after the acquisition. Additionally, in an asset sale, the liabilities that the buyer acquires are defined in the transaction documents so the buyer may be able to leave certain liabilities with the selling entity rather than acquiring all future liabilities. However, transferring certain assets may be contractually prohibited or require consents, which can complicate the process.
Similarly, as a very general matter, sellers will often prefer an entity sale for tax and liability reasons. By selling the ownership interest in the entity the seller will typically be taxed at the long-term capital gains rate, which can be significantly lower than the income tax rate that could apply to some or all of the proceeds from an asset sale. Asset sales for C corporations also present issues of double taxation for shareholders since asset sales create tax at the corporate level and then again at the individual level upon distribution of funds. In regards to liabilities, in an entity sale all company liabilities are acquired by the buyer when the ownership interest is purchased. This assures the seller that subsequent to the transaction, with certain exceptions, it will have no further exposure to liabilities related to company operations.
A third avenue utilized for certain business transactions is the statutory merger. While a statutory merger can take various forms, the general framework entails the combination of two or more legal entities that concludes with the ongoing existence of one entity while the other entity or entities cease to exist. The end result is similar to the transactions discussed above in that one company acquires the operations of another. However, the process and the considerations involved in the merger structure are significantly different. A statutory merger is defined by particular steps that are detailed in the laws of the states of domicile of the participating entities.
In all cases, whether dealing with a merger, acquisition, or reorganization of some form, there are a long list of state and federal laws that can be implicated in the transaction. These range from simple government and private party notifications to formal approval requirements. The particular applicability of each law will often depend upon the size of the companies involved and nature of the business that the company conducts. If any applicable laws or regulations are not given the proper consideration there can be serious ramifications for all parties involved in the transaction.
It is important to understand that business transactions are fact specific. The generalities of deal structure discussed in the preceding paragraphs can, and will, change considerably based upon the particulars of the transaction. Retaining experienced legal counsel to structure around those particulars is extremely important in assuring that the transaction is executed in the most efficient and advantageous manner possible.
We advise private equity clients on a range of matters from fund formation to business transactions. Fund formation, in particular, is a complex and important issue on which private equity funds must focus. Private equity funds and hedge funds are generally structured in the form of limited partnerships, which consist of a general partner, or sponsor, operated by the fund’s management team, and limited partners, who are the investors and do not participate in the management of the fund. General partners often then contract with an affiliated but distinct management company, which assumes management responsibilities.
There are a variety of considerations when forming a fund, and many of the issues are set forth in the terms of the limited partnership agreement (LPA), which specifies various economic terms, including the carried interest (typically close to 20% of profits) the hurdle rate, high-water mark, preferred return for limited partners, term for the fund, and the structure of the fund’s waterfall.
In addition to needing an LPA that both the general partner, or sponsor, executes, along with all of the limited partners, the general partner will also generally enter into a management agreement with an affiliate that is assigned day-to-day management responsibilities. The management firm will typically be paid 1-2% of the fund’s committed assets under management, and this amount sometimes scales down later in a fund’s life when capital has been more fully deployed. At the fund’s outset, limited partners in a private equity fund generally commit to funding a certain amount, and the fund’s general partner can “call” that capital as needed as investment opportunities are sourced and pursued.
Carried Interest You Say?
Carried interest is a controversial subject that has received a fair amount of attention by commentators and politicians. It refers to the portion of a general partner’s interest in a fund that is a “profits interest” and subject to capital gains taxes, which, in the case of long-term capital gains, means a lower tax rate. There are some complicated tax rules that dictate whether an interest qualifies as a profits interest. Fundamentally, however, the analysis looks at whether in a hypothetical liquidation of the fund’s assets, would the recipient of the interest receive anything at the time of grant. If the answer is yes, then the recipient of the interest is receiving something of value today, creating a taxable event. As opposed to a profits interest, an interest that would entitle the holder to value in a hypothetical liquidation is known as a capital interest. On the other hand, if the recipient is not entitled to anything in a hypothetical liquidation upon receipt, then the interest could be a profits interest, meaning there is no tax upon receipt and the interest qualifies for capital gains. In an effort to increase returns, some funds have deployed what is known as a management fee waiver, which allows the fund to waive receipt of management fees in exchange for a commensurate amount of additional carry that has a potentially lower tax rate. This practice has come under considerable IRS scrutiny, and whether a management fee waiver passed regulatory scrutiny depends on various factors, including whether the receipt of additional carry is subject to true “entrepreneurial risk” and hence provides an uncertain benefit or whether the waiver and exchange provides a clear benefit at the time of the waiver.
A Regulatory Minefield
When setting up a fund, it is important to ensure that the fund falls within certain regulatory exemptions that make the fund model viable. For instance, private funds typically want to be exempt from the Investment Company Act of 1940, which provides registration exemptions for funds with less than 100 beneficial owners (the 3(c)(1) exemption). If an investment company owns more than 10% of the voting securities of a fund, then all the owners of that entity will be considered beneficial owners for the purposes of 3(c)(1). The other exemption, 3(c)(7), exempts funds whose investors are exclusively qualified purchasers, which are ultra-high-net-worth individuals or entities.
Funds also generally want to steer clear of falling under the Employment Retirement Income and Security Act (ERISA) plan fiduciary requirements, which apply to funds whose assets under management are at least 25% ERISA assets. If a fund’s assets exceed the 25% threshold, they are subject to various additional rules and legal burdens, including becoming fiduciaries with limitations on certain investment activities and increased liability. The threshold also applies to each separate class of capital in the fund.
Private equity funds also sometimes fall within the venture capital operating company (VCOC) exemption to ERISA, which provides an exemption for funds whose assets, starting on the date of its first long-term investment and at least one day during an annual 90-day period, are at least 50% invested in operating companies with sufficient management rights in those operating companies. Management rights would include things like the ability to appoint officers or directors and to examine books and records, and the
Private equity funds and hedge funds also must carefully account for various tax issues, including certain tax issues that are unique to tax-exempt limited partners, such as foundations and endowments. In the case of tax-exempt investors, funds often must be careful not to generate unrelated business taxable income (UBTI), which arises from the operation of a business unrelated to the tax-exempt entities’ underlying purpose, the income of which flows through the partnership to the investor and is subject to income tax.
In summary, there are a whole host of issues that private equity and hedge funds must consider and we are equipped to provide that guidance and to assist with legal issues with arise with funds portfolio companies.
We handle a wide array of commercial real estate transactions including commercial acquisitions and sales, development projects, commercial leases, and joint ventures. We also handle real estate litigation matters both on the plaintiff and defense side. As in all practice areas, we strive to take a global view. Commercial real estate transactions–-especially in major metropolitan areas–-often involve the threat or prospect of litigation. We assist clients not just with closing deals but with anticipating the obstacles that can derail deals.
Intellectual property rights protect creations of the mind. There are various types of intellectual property and some common misconceptions, the first being the extent to which ideas are protected. While ideas, in and of themselves, are generally not protected (they can be to the extent reduced to a process, as explained further below in the description of patents), there are important intellectual property rights that can be absolutely critical to a business’s success. Similarly, carelessness in handling intellectual property, failing to protect one’s intellectual property, or breaching another party’s intellectual property can be perilous to a business. As always, it is important to seek experienced counsel in this area.
What is a Patent?
A patent protects inventions and grants exclusive property rights to the inventor for a limited period. Patents are issued by the United States Patent and Trademark Office and generally the term of a new patent is 20 years from the date the application is filed in the United States or, in special cases, from the date an earlier related application was filed, subject to the payment of maintenance fees. U.S. patent grants are effective only within the United States, U.S. territories, and U.S. possessions. Under certain circumstances, patent term extensions or adjustments may be available. Patents confer “the right to exclude others from making, using, offering for sale, or selling” the invention in the United States or “importing” the invention into the United States. What is granted is not the right to make, use, offer for sale, sell or import, but the right to exclude others from making, using, offering for sale, selling or importing the invention. Once a patent is issued, the patent holder must enforce the patent without aid of the USPTO.
There are three types of patents: (1) utility patents, which may be granted to anyone who invents or discovers any new and useful process, machine, article of manufacture, or composition of matter, or any new and useful improvement thereof; (2) design patents, which may be granted to anyone who invents a new, original, and ornamental design for an article of manufacture; and (3) plant patents, which may be granted to anyone who invents or discovers and asexually reproduces any distinct and new variety of plant.
What Is a Trademark or Servicemark?
A trademark is a word, name, symbol, or device that is used in trade with goods to indicate the source of the goods and to distinguish them from the goods of others. A servicemark is the same as a trademark except that it identifies and distinguishes the source of a service rather than a product. The terms “trademark” and “mark” are commonly used to refer to both trademarks and servicemarks. Trademark rights may be used to prevent others from using a confusingly similar mark. While trademarks and servicemarks cannot be used to prevent others from making the same goods or from selling the same goods or services under a clearly different mark, trademarks can be extremely valuable to a business, as they protect the brand value that businesses often establish in the marketplace. They can also be used to protect a business’s identifiable products (such as the color pink used by Owens-Corning for its brand of fiberglass insulation) its identifying characters or logos (such as the Pillsbury doughboy), or its identifying sounds (such NBC’s three-tone sound mark).
Similarly, trade dress refers to the total image and overall appearance of a product or service, or the totality of the elements, and may include features such as size, shape, color or color combinations, texture, and graphics. Items typically eligible for trade dress protection are product designs, product packaging, and the appearance and decor of a service business. For trade dress to be protectable under trademark law, the design must be non-functional, distinctive, and identify the source of the goods or services. A design is functional if it is essential to the use or purpose of the article or if it affects the cost or quality of the article. The functionality doctrine acts as safeguard against the impermissible extension of patent monopoly by invoking trademark protection. Additionally, trade dress must be distinctive to identify the source of the good or service. Trade dress can be inherently distinctive or acquire distinctiveness through secondary meaning. Examples of trade dress include the shape of the Coca-Cola bottle, the design of Apple’s iPhone, the red dripping wax of the Maker’s Mark bottle, the color brown for UPS.
Rights in a trademark are acquired and maintained only by use. However, registration may be sought before making use of the mark in commerce. Common law trademark rights will continue for as long as the trademark is used in commerce and the owner adequately polices the mark. There is no expiration period for common law trademark rights but trademark registration will only remain valid if the owner files the proper renewal documents and continues to use the marks (a trademark owner is permitted brief periods of non-use without relinquishing his trademark rights). Abandonment of a particular mark occurs when its use has been discontinued with intent not to resume such use. Intent not to resume may be inferred from circumstances. Non-use for three consecutive years is prima facie evidence of abandonment. However, the trademark owner can rebut the presumption by producing evidence of his intent to resume use “within the reasonably foreseeable future.” “Use” of a mark means the bona fide use of such mark made in the ordinary course of trade, and not made merely to reserve a right in a mark. Token and sporadic use of the mark will not be sufficient to meet the requirement of “use in commerce.”
While trademarks and servicemarks protect the owners of the marks, they also indicate the origin of goods or services and enable consumers to identify products and service-providers so they can either look for them again or avoid them. In this way, a trademark represents the quality and uniformity of the goods bearing the mark.
The owner must defend the trademark from infringers to maintain the trademark’s status as a source indicator. If too many people enter the marketplace with the same trademark, the mark will no longer identify a single source and the loss in distinctiveness will erode any trademark protection the mark once enjoyed.
Inherently distinctive marks acquire common law rights upon actual use, whereas non-inherently distinctive marks require proof of secondary meaning to receive trademark rights. Secondary meaning is established when the owner has established that, in the mind of the consuming public, the primary significance of the term is to identify the source of the product rather than the product itself. In other words, a mark has achieved secondary meaning when the consuming public perceives that the product or service emanates from a single source. Courts classify marks into five separate categories: (1) fanciful, (2) arbitrary, and (3) suggestive marks, all of which are inherently distinctive; (4) descriptive marks, which are NOT inherently distinctive and require proof of secondary meaning for trademark protection; and (5) generic marks, which are not eligible for trademark protection.
Although Trademark registration is not required to receive common law trademark protection, an unregistered trademark does not enjoy many benefits provided to registered marks, including public notice of the claim of ownership of the mark, the legal presumption of ownership of the mark and your exclusive right to use the mark nationwide on or in connection with the goods/services listed in the registration, the ability to bring an action concerning the mark in federal court, the right to seek incontestable status after five years of continuous use on the principal register, the use of the U.S. registration as a basis to obtain registration in foreign countries, the ability to record the U.S. registration with the U.S. Customs and Border Protection (CBP) Service to prevent importation of infringing foreign goods, the right to use the federal registration ® symbol, and listing in the United States Patent and Trademark Office’s online databases.
What is a Copyright?
Copyright is a form of protection provided to the authors of “original works of authorship” including literary, dramatic, musical, artistic, and certain other intellectual works, both published and unpublished. The 1976 Copyright Act generally gives the owners of copyright the exclusive right to reproduce the copyrighted work, to prepare derivative works, to distribute copies of the copyrighted work, to perform the copyrighted work publicly, or to display the copyrighted work publicly. The copyright protects the form of expression rather than the subject matter of the writing. For example, a description of a machine could be copyrighted, but the right would only prevent others from copying the description, not from writing a description of their own or from making and using the machine. Copyrights are registered by the Copyright Office of the Library of Congress. Creators of original works obtain common law copyrights as soon as they reduce a work to tangible form. However, it can be extremely important to register a copyright in the event it becomes necessary for a copyright holder to sue another party that is infringing.
Our lawyers are experienced in private company merger and acquisition transactions of all kinds. We represent clients in the structuring, negotiating, and closing of transactions in mergers, acquisitions, assets sales, and business reorganizations. Transactions of this nature are significant events in the business life-cycle and, for many owners, are once in a lifetime transactions. We provide advice from the beginning to the end of a deal so that our clients can maintain focus on what is most important: running their businesses.
When business owners initially consider an M&A transaction it often appears like a relatively straight-forward process. However, there are structuring considerations from the outset that can have a very real impact on a company’s finances and risk profile.
After the basic business terms of a transaction are agreed upon, the process of drafting and negotiating the written deal documents present a number of potential complications. In addition to the deal structure, the closing process, representations and warranties, indemnities, and termination provisions contained in the documents are just a few of the provisions that can be very high stakes for both parties. Our attorneys diligently represent and protect the interests of our clients in these deals to avoid unnecessary risks.
Deal Structure
Business acquisition are generally structured as either entity stock sales or asset sales. There are characteristics of each structure that have a significant impact on the parties and the net results of the transaction. In an asset sale, the buyer purchases some or all of the target company’s assets while the seller maintains its ownership interest in the target company. If the target company sells all of its assets, it has little to no value after the transaction and is often dissolved. In an entity sale, the buyer purchases the seller’s ownership interest (i.e. in the case of a corporation, the seller’s stock and in the case of a limited liability company, the seller’s membership interest). Along with that ownership interest comes all of the assets and liabilities of the company.
As a very general matter, buyers will often prefer an asset sale because of advantages with both taxes and liabilities. An asset sale will typically permit buyers to take a “step up” in the tax basis of the acquired assets, and buyers generally want to allocate as much of the purchase price as possible to assets that allow for quicker depreciation after the acquisition. Additionally, in an asset sale, the liabilities that the buyer acquires are defined in the transaction documents so the buyer may be able to leave certain liabilities with the selling entity rather than acquiring all future liabilities. However, transferring certain assets may be contractually prohibited or require consents, which can complicate the process.
Similarly, as a very general matter, sellers will often prefer an entity sale for tax and liability reasons. By selling the ownership interest in the entity the seller will typically be taxed at the long-term capital gains rate, which can be significantly lower than the income tax rate that could apply to some or all of the proceeds from an asset sale. Asset sales for C corporations also present issues of double taxation for shareholders since asset sales create tax at the corporate level and then again at the individual level upon distribution of funds. In regards to liabilities, in an entity sale all company liabilities are acquired by the buyer when the ownership interest is purchased. This assures the seller that subsequent to the transaction, with certain exceptions, it will have no further exposure to liabilities related to company operations.
A third avenue utilized for certain business transactions is the statutory merger. While a statutory merger can take various forms, the general framework entails the combination of two or more legal entities that concludes with the ongoing existence of one entity while the other entity or entities cease to exist. The end result is similar to the transactions discussed above in that one company acquires the operations of another. However, the process and the considerations involved in the merger structure are significantly different. A statutory merger is defined by particular steps that are detailed in the laws of the states of domicile of the participating entities.
In all cases, whether dealing with a merger, acquisition, or reorganization of some form, there are a long list of state and federal laws that can be implicated in the transaction. These range from simple government and private party notifications to formal approval requirements. The particular applicability of each law will often depend upon the size of the companies involved and nature of the business that the company conducts. If any applicable laws or regulations are not given the proper consideration there can be serious ramifications for all parties involved in the transaction.
It is important to understand that business transactions are fact specific. The generalities of deal structure discussed in the preceding paragraphs can, and will, change considerably based upon the particulars of the transaction. Retaining experienced legal counsel to structure around those particulars is extremely important in assuring that the transaction is executed in the most efficient and advantageous manner possible.
Our firm represents whistleblowers in federal False Claims Act matters, state False Claims Act matters, and pursuant to the IRS, SEC, and CFTC whistleblower programs. All of these legal regimes have qui tam provisions that incentivize private citizens to come forward with information about fraud and to benefit monetarily if there is a government recovery.
Under the federal and various states’ False Claims Acts, citizen whistleblowers can sue on the government’s behalf when they have knowledge of individuals or businesses defrauding the government. These cases are most commonly found in health care where government programs, Medicare and Medicaid, constitute a significant portion of industry expenditures, as well as other industries where private companies contract with the government, such as defense.
False Claims Act cases are filed “under seal” and remain secret to everyone except for the government in order to give officials an opportunity to investigate. Ultimately, the federal or state governments can decide to “intervene” in a case, which means they essentially take over the civil suit, or decline to intervene. In the event that there is a recovery, the whistleblower can recover 15 to 30 percent of the recovery.
In recent years, Congress has also established a whistleblower program for large scale tax fraud, securities fraud, and commodities fraud as well. Each provides whistleblowers with an opportunity to share in any government monetary recoveries. Whistleblower laws can be complex and have very specific procedural requirements in order to be eligible for an award. Individuals with credible, personal information about potential fraud should speak to an attorney with experience in these areas.
The sports and entertainment business often implicates a wide array of legal issues, including corporate, intellectual property, licensing, antitrust, and contractual. Awareness of the potential legal considerations and sensitivity to the unique business terms of the particular deal and industry, are critical in this practice area. We have experience as authors, creators, lawyers, and entrepreneurs at the highest levels of sports and entertainment.
In recent years, activist shareholders increasingly have looked to exert pressure on company boards and executives to seek changes to company policies. In most, but not all, cases these companies are publicly traded. Activist campaigns can involve social policies, including those involving environmental or political issues, governance changes to corporate practices or management structure, or economic changes. While some activist shareholders push their changes for ideological reasons, others do so presumably to extract value from the company that they believe current management is failing to maximize.
Activist campaigns can come in various forms. Sometimes an activist shareholder or group launches an outright hostile takeover bid for control of the company, but very often activists start by acquiring small stakes and then threaten a proxy battle. Shareholders who are activists typically attempt to build a sizeable enough stake in the company to influence its decision-making, which triggers various regulatory requirements on the part of the activist, most notably the 13D filing with the SEC within 10 days of acquiring a 5 percent beneficial ownership (excluding derivatives), or a 13G filing upon acquiring 5 to 20 percent (within 45 days of year end if less than a 10 percent holding or within 10 days after the end of the month if more than 10 percent).
Activists can engage with, or attempt to pressure, companies in a variety of ways. They might ask for meetings with management or write letters to managers or the Board, or they may take a more public posture and issue press releases. In more adversarial situations, activists might engage with regulatory bodies, write a poison pen letter to the SEC, or litigate with the company for access to books and records or for other corporate wrongdoing or neglect. Finally, activists can issue proxy contests either for new directors,officers, or policies through Securities and Exchange Act Rule 14a-8.
Companies typically want to avoid activist shareholders whoare seeking to change the way a company operates and, in some cases, may evenwant to take the over control of the company. Managers rightfully fear that these campaigns can lead to them losing their jobs. There are several things that companies can do, however, to ward-off activist investors. As usual, many of the most effective strategies are those that are implemented long before an activist becomes an imminent threat.v
Corporate Structure Strategies
Many anti-takeover strategies can be implemented through more effective drafting of corporate documents, with various provisions regarding meetings, by-law amendments, board size changes, director service requirements,and voting mechanisms designed to give incumbent managers flexibility. Change of control provisions in company contracts can also make an activist turnover more challenging.
Poison Pills
One of the most effective anti-takeover strategies to deter activist investors is a shareholder rights plan, also known as a poison pill. Poison pills essentially allow companies to issue warrants to holders of common stock (excluding the activist) when an activist investor acquires a certain threshold (typically 10 percent) in order to dilute the investor’s overall ownership and control. Large investors often oppose poison pill plans because they are seen as entrenching management and possibly bad practices. However, companies can have their corporate counsel draft these plans so they are ready and can be “pulled off the shelf” and adopted on short notice. Courts recognize the legitimacy of poison pills to ward off unsolicited takeovers. There are two primary kinds of poison pills (flip-in, which allows common shareholders to purchase additional shares at a major discount or flip-over, which allows common shareholders to purchase shares of the acquiring company in the event of a merger or similar transaction).
It is important that experienced counsel draft these plans to ensure that companies and existing management are fulfilling their fiduciary duties.
A last will and testament, commonly referred to as a “will,” governs the disposition and transfer of one’s property upon death. When an individual dies who has previously executed a will, the will goes through probate court where a judge can approve the disposition in accordance with the will’s terms or consider objections to the will from parties who may contest it (more on that process below). If an individual dies without executing a will, their estate is considered “intestate,” in which case the individual’s estate is distributed to heirs (or the state in the absence of heirs) according to operation of law.
It is highly advisable that adults who own any meaningful amount of assets—and particularly if they have children—execute a will (the person executing the will is known as the grantor or testator). While an attorney is not required in order for a will to be valid, it is highly advisable to have an attorney draft and supervise execution of a will. Additionally, attorneys with experience in estate planning can assist individuals and entities in promoting tax efficiency and protecting assets.
Executing a Will
Unlike many legal documents, properly executing a will requires careful observation of certain technicalities and formalities that can vary by state. Most states, including New York, require two witnesses (who should not be beneficiaries under the will and who can attest to the testator’s mental capacity). Additionally, a notary is required to observe the execution and notarize the document. Some states allow for electronic notarizations, although the vast majority still do not. Additionally, prior to and upon execution of the will, an attorney should ask the testator certain questions that the testator should answer in the presence of the witnesses that demonstrate the testator’s mental faculties and clear intent.
After execution, the testator should keep the original will and leave copies with certain parties, including the attorney and the executor (who are sometimes the same party), and possibly the beneficiaries. The will should be kept in a place known to the executor, attorney, or other trusted party where it can be retrieved at death for probate proceedings. The will should not be kept in a safe deposit box, because retrieval generally requires a probate court order, but a probate court order typically requires possession of the will.
Wills can also be amended through a codicil or replaced entirely. Again, these changes require careful observation of similar formalities, and testators should consult an attorney about best practices after a will is amended or replaced.
Other Estate Planning Documents
Very often testators who execute a last will and testament also execute a living will, health care proxy, and power of attorney. A living will specifies the treatment an individual would like to receive from health care professionals if incapacitated and unresponsive. For instance, a person may specify “DNR” (or Do Not Resuscitate) if they are ever on life support. A health care proxy designates a person who is authorized to make life saving or life ending decisions on a person’s part. Power of attorney designates a person with authority to act on their behalf, typically in the event of certain circumstances (known as springing power of attorney). Again, an attorney should be consulted to ensure proper observation of formalities and inclusion of any required “magic words” in these important estate planning documents.
More Complex Estate Planning
For many individuals or young families, a will and the basic accompanying estate documents will suffice. However, for larger, more mature, or more complex estates, there are other estate planning documents, structures, and strategies that can prove critical to tax efficiency, asset protection, and income utilization.
One aspect of estate planning is ensuring that certain assets remain outside of probate altogether upon death. For instance, property owned in joint tenancy with a right of survivorship means that the property ownership automatically vests in the joint tenant upon the other joint tenant’s death. However, it also means that a testator cannot dispose of property owned in joint tenancy with a right of survivorship to a third party in a will. There also may be gift tax implications for transferring property into joint tenancy. Transferring property into trust can also avoid the necessity of going through probate.
The world of trusts can be extremely complex and proper estate planning often requires both experienced attorneys and financial advisers. There are many different types of trusts, including revocable and irrevocable trusts. Typically, revocable trusts (also known as living trusts) do not effectively transfer ownership of the property outside of the estate of the grantor who created the trust, meaning the property is still included in the grantor’s estate and is not protected from creditors since the grantor maintains “incidents of ownership.” Establishing and transferring title to property to a living trust, however, can remove that property from going through probate, which can save time and money for heirs in the long-term.
On the other hand, irrevocable trusts cannot be changed and control over those assets in trust are controlled by the trustee, who must be someone other than the grantor or their spouse. This strategy is often used to remove property from a person’s estate. Irrevocable trusts sometimes take the form of irrevocable life insurance trusts (or ILITs), which hold a life insurance policy that insures the life of the grantor and for which the trust is the beneficiary. In order to fund the ILIT and pay the premiums for the life insurance policy, the grantor must contribute cash to the ILIT, which would generally be deemed a gift subject to the annual and lifetime gift tax limitations. However, use of “Crummey Letters,” which give the beneficiaries of the trust a period of generally not less than thirty days to remove the cash designated for premiums, will remove the cash contribution from being considered a gift. Additionally, there are advantages to forming the trust first and having the trust apply for an receive life insurance on the grantor’s behalf, as opposed to transferring an existing life insurance policy into the trust, in which case there is a three-year look-back period in which the life insurance proceeds will still be considered part of the grantor’s estate in the event of death. Careful planning and drafting can result in beneficiaries receiving life insurance proceeds tax free and not subject to the estate tax.
Estate Tax Basics
Everyone has heard that life’s two guarantees are death and taxes. While many people think of taxes as something they must pay while alive, without proper planning, death can also be a very tax-punitive event. Generally, a deceased’s estate is subject to federal estate tax and in some states, including New York, state estate or inheritance tax. There are other kinds of taxes as well that are designed to limit asset transfers, including gift taxes and generation skipping taxes.
With certain exceptions, when a spouse dies and is survived by another spouse, the deceased’s estate and property can transfer to the spouse tax free and with a step-up in the tax basis of the deceased’s assets. Basis refers to the tax baseline used to calculate gain or loss upon disposition. For example, if an individual purchased a machine for $100 and then depreciated $10 per year for two years, the basis would be $80. If the owner then sold the machine for $90, the gain would be $10 even though it was purchased originally for $100. Depending on whether the property was held for more or less than one year, the income would be considered long-term or short-term capital gains, respectively. The higher the basis, the less tax owed upon subsequent disposition of the asset.
After the death of a spouse, property transfers to the surviving spouse tax free and with a step-up in basis. Upon the second-to-die spouse’s death, the assets transfer to beneficiaries without a step-up in basis and subject to 40 percent federal estate tax after an exemption of over $11 million for individuals and $22 million for couples (these exemptions are currently set to sunset in 2026 back to the old exemption of approximately half the amount). That means any estate assets above the exemption amount are subject to the federal estate tax. The estate tax exemptions are lifetime exemptions, and the limits include lifetime gift tax limits as well. Lifetime exemptions are also portable, meaning a spouse can transfer to another any unused portion of lifetime exemptions—although this must be designated on an estate tax filing.
One of the critical strategies in estate planning, especially for larger estates, is to reduce the estate’s assets to minimize the amount of assets in the estate that are subject to tax upon death. Again, that can be accomplished through numerous strategies, including effective utilization of trusts, gifts (eligible for a $15,000 annual exemption to an unlimited number of individuals), and transfer of property into joint tenancy.
Our firm has handled a wide variety of matters involving schools and universities, often in situations where students have faced discipline by the school. These have included instances in which schools have disciplined students for expressing unpopular views on controversial political topics. We have also represented faculty who have been targeted by colleagues or administrations for expressing disfavored political views. And since the onset of Covid-19, we have represented students who faced discipline from schools for violating newly enacted, often arbitrary and unclear Covid-19 rules.
Our lawyers have written about these topics as well, with one op-ed featured in The Wall Street Journal. As is often the case with legal matters, retaining competent legal counsel as early as possible is important. Often times, clients come to us after they have been subject to investigations and disciplinary hearings and after their options are more limited.
It is important to recognize that schools and universities each have their own administrative procedures. While they are quasi-legal proceedings in that they are designed to ascertain facts and potentially impose punishment, the regular rules of evidence and civil procedure do not apply. Schools draft their own procedural rules—which can nonetheless be challenged in court after administrative remedies are exhausted under an arbitrary and capricious standard—including often requiring a lower preponderance of the evidence standard to prove an infraction. Unlike defendants in a real civil or criminal trial, students generally are not entitled to have legal counsel present or to confront witnesses, including in Title IX sexual assault cases.
However, just as it is important to have legal representation in a civil or criminal matter, it is important to have representation in an administrative school proceeding. Once students make statements to school officials—often under pressure by those officials—it can be harder to achieve an ideal outcome.
New Developments at the Intersection of Education Law and the First Amendment
The legal standard for public versus private education institutions is very different since public schools (whether high schools or schools of higher education) are treated as state actors subject to constitutional limitations. Nowhere does this distinction become more fundamental than in the realm of school speech, an area in which our firm has experience litigating.
While private schools can be subject to civil liability for violating contractual terms or acting arbitrarily and capriciously—this is the standard in New York State, with the vehicle for challenging a school decision an Article 78 proceeding—private schools are not bound by constitutional limits as non-state actors. There may also be other instances in which private schools could lose public funding for engaging in certain behavior, which was a signature part of the Trump Administration’s education policy. President Trump signed an executive order outlining how schools could lose funding for depriving students of “free speech” that schools promised in their policies.
Again, however, with private schools the standards governing school policy are heavily dictated by the school’s own published policies. Public schools, on the other hand, regardless of what their policies state, must always stay within the constitutional boundaries that govern any state actor. Like almost all aspects of law, however, the boundaries are often quite unclear and shift or come into greater clarity as real-life fact patterns emerge. Recently, the Supreme Court decided 8-1 its most consequential education free speech case in decades in Mahanoy Area School District v. Brandi Levy. Brandi Levy was a high school cheerleader who posted a profanity laced social media post when she failed to make the varsity cheerleading team. As a result, the school disciplined Levy even though her posts were made online but off campus.
The progenitor to the Levy case is the seminal Tinker case in which the Court held in 1969 that students do indeed have First Amendment rights in public schools. The Court
in Tinker also fashioned a test (known as the Tinker test) that allowed schools to still regulate speech and impose discipline if the speech was reasonably likely to cause disruptions. The Levy decision held that the public school indeed violated Levy’s First Amendment rights because Levy posted on social media off campus. The Court, however, suggested that schools might be able to impose some regulations if the post had been likely to cause a “substantial disruption.”
Restructuring is one of the most strategic areas of law, with a sweeping morass of legal and business decisions involved at almost every turn. Restructuring generally comes into play when a business finds itself in distress and, as a result, needs to make changes to its capital structure.
At the most basic level, since debt is senior in the capital stack to equity and the obligation to repay debt is almost always fixed and not contingent on the performance of the borrower, when companies experience distress, debt on the balance sheet can be the difference between viability and extinction. There are, however, numerous ways that businesses can deal with distress in an effort to remain a going concern, but the complexities, nuances, and stakeholders are many.
Out of Court Restructuring
When companies face distress, they will often try to restructure their capital structure outside of the bankruptcy process. Successful restructuring outside of court can be extremely difficult, however, due to game theory dilemmas that plague many multi-party negotiations. Pursuant to federal statute, changes to certain bond terms, including the principal amount owed or interest rate, cannot be imposed upon unwilling participants, which provides a strong incentive for parties to hold-out. Moreover, in the case of bond restructurings, companies will often require a very high participation threshold (like 90%) for the company to actually complete the restructuring in order ensure that the process actually alleviates the distress. Successful restructurings generally take the form of an exchange of debt instruments for new instruments with longer maturities and/or lower interest rate, an exchange of debt for equity, or some combination thereof.
While the high threshold is also designed to encourage participation in the exchange, there is a powerful temptation for any one debt holder to withhold consent, as the economic outcome will almost always be better for a holdout. Since everybody has this same incentive, it makes achieving a very high participation rate in the exchange offer very difficult. There are ways in which companies can combat this incentive to hold out, however. While certain terms like principal, interest, and maturity of non-participating bonds cannot be changed, others, like covenants, can be with the requisite percentage approval of other bondholders, which can make existing bonds less attractive for the holdouts. Second, companies can threaten to file for bankruptcy, in which case the bankruptcy court can impose terms on the bondholders, which can result in a far more uncertain and potentially less desirable outcome.
In order to facilitate an out of court restructuring, large bondholders will often form a bondholder committee to try to negotiate terms with the company to streamline the process. In the case of bank debt, companies will often have only a few large lenders or a syndicate lead with whom to negotiate. Companies can also attempt a tender offer with public bonds.
Prepackaged Bankruptcies
As part of an exchange offer, companies will often solicit consent to a plan of reorganization (“POR”) under prepackaged (“prepack”) bankruptcy filing, which is a greatly expedited bankruptcy process that adds serious credence to the threat of a bankruptcy filing against holdouts. A prepack allows debtors to solicit consent from creditors to a POR without the normal court approved disclosure statement process setting forth the valuation and business plan.
The Bankruptcy Process
If a company does file for bankruptcy, the process, particularly Chapter 11, is highly complex but also flexile. A Chapter 11 bankruptcy is one in which the company attempts to emerge from bankruptcy as a viable, going concern, whereas a Chapter 7 bankruptcy oversees the liquidation of the company and distribution of the assets to creditors. When a party files for bankruptcy, the automatic stay immediately goes into effect, which stops creditors and other counterparties from taking any further action to collect debts or amounts owed without court approval. All claims are also delineated into pre-filing and post-filing.
Upon filing for bankruptcy, the debtor has the exclusive right for the first 120 days (not counting extensions) to propose a POR, which groups claimants into classes based on their commonality of interest and then proposes what members of each class will receive.
Typically, when a company files for Chapter 11 bankruptcy it will also seek debtor in possession (“DIP”) financing, which the Bankruptcy Code grants priority over pre-petition unsecured claims in order to encourage lenders to continue financing the company. DIP financings may also prime prior secured lenders’ priority if it can be shown that the original creditor is adequately protected, which may include post-petition interest on the lender’s loan.
Secured Versus Unsecured
Pre-filing claims against the bankrupt entity fall into the category of secured and unsecured. Within the realm of secured claims, creditors can have senior liens or subordinated liens. Secured creditors are generally entitled to receive full payment prior to unsecured creditors receiving anything based on what is known as the absolute priority rule (“APR”). In reality, as discussed more later, the APR is generally followed more stringently in Chapter 7 liquidations than Chapter 11 restructurings for a variety of reasons.
Unsecured creditors are those who do not have collateral in the bankrupt company’s assets, including lenders, vendors, contractual counterparties, and employees. Secured creditors are considered secured up to the value of the underlying collateral that secures the debt and unsecured to the extent that the value of the collateral is insufficient to secure the entire debt. If a secured creditor has collateral valued at $100 but the company’s debt obligation is $150, the creditor will hold a $100 secured position and a $50 unsecured position. Often times, unsecured creditors will seek to challenge the security interest (typically perfected through state UCC filings) of secured creditors, which can render a larger portion of the secured creditors interest unsecured and thus pari passu (in equal priority) with other unsecured creditors. When valuing the collateral, this rule also gives secured creditors an incentive to argue for a high valuation for the collateral and unsecured creditors an incentive to argue for a lower valuation. While secured creditors are not required to have a secured creditor committee, unsecured creditors will have at least one official committee of unsecured creditors, which the U.S. Trustee appoints and is typically the seven largest creditors willing to serve.
Counterparties to whom the debtor breached contracts or leases are generally unsecured creditors, and their damages become part of their unsecured claims. Many of these contracts are executory contracts, which are contracts in which performance is still owed by both parties to the contract. The Bankruptcy Code gives debtors the power to reject these contracts in bankruptcy, with the damages resulting from the breach falling into the unsecured class of claims.
Voidable Preferences and Fraudulent Conveyances
Bankruptcy proceedings often result in a plethora of challenges to previous transactions. For instance, parties will often challenge what are known as voidable preferences where payments are made to certain creditors as a preference to other creditors within the 90-day period prior to the bankruptcy filing for antecedent debts. If a preferential payment was made to an insider, courts will look back a year. Other transactions are often challenged on fraudulent conveyance grounds, which is when a debtor does not receive fair value in a transaction in which the debtor is or becomes insolvent. A whole variety of transactions, including acquisitions, spinoffs, assets sales, or debt issuances to major equity holders can be challenged on fraudulent conveyance grounds.
Valuation
Valuation is a critically important part of the bankruptcy process. Parties hire valuation experts to assist with this critical component of bankruptcy, and it certainly helps if the lawyers have a deep understanding of the finance and valuation component as well. First, parties will prepare an analysis based on the value that would likely be received in a liquidation versus the distribution of assets as a going concern. One important principle of Chapter 11 is that creditors should do at least as well as they would in a liquidation, an analysis often taken and known as the “best interests test.” The going concern valuation is one of the most contentious parts of the bankruptcy process too. While it dictates the distribution of hypothetical future assets, the ultimate valuation can result in very real future economic impact.
Because of the APR, secured creditors and those higher in the capital stack will argue for a lower valuation for the company coming out of bankruptcy because it enables them to capture more of the economics. In contrast, unsecured creditors and equity holders will argue for a higher valuation and make the case that senior creditors would receive more than full payment if a lower valuation is adopted that allocates them the lion’s share of the future economics. For example, if secured creditors are owed $100 and unsecured creditors are owed $50, a $75 valuation would mean theoretically that the secured creditors should own the entire future capital stack, however broken down between debt and equity. However, if the valuation is $125, then secured creditors should receive value of $100 while leaving $25 for the unsecured creditors. Of course, the valuation exercise is highly susceptible to different assumptions and arguments, leaving extensive room for uncertainty and negotiation between the parties.
Because valuation is highly dependent on inputs and open to debate, senior creditors will often make concessions to junior claim holders that do not conform to the APR in an effort to obtain consent to a POR. Some jurisdictions will also permit senior classes to “gift” part of the value to which they are entitled to more junior classes without mezzanine classes between the senior and junior classes receiving anything. Other jurisdictions, like the Second Circuit, do not allow this since it technically violates the APR. In genera, however, because junior creditors have no incentive to consent to a POR in which they receive no value, they are often able to extract value by threatening to oppose the POR.
Another critical issue on the valuation battleground is the discount rate used to calculate net present value, and parties often battle over whether to use a risk-free adjusted rate or a market rate that reflects the actual distress of the debtor.
Fulcrum Security
Ultimately, the valuation that the bankruptcy court accepts will dictate which security in the capital structure is the fulcrum security, which is where the value break occurs in the capital stack. For example, if a valuation of $100 is accepted and the senior secured lender has outstanding claims of $75, then senior lenders should be paid in full either through repayment or reinstatement of a loan out of bankruptcy. If the next most junior lender is unsecured with a claim of $50, then the unsecured loan will be the fulcrum. In theory, no claimholder junior to the fulcrum should receive anything (although not always the case) and the fulcrum security will likely end up with the future equity in the company out of bankruptcy. Distressed investors will often buy debt that they believe will end up as the fulcrum so that they will eventually own the equity of the company (sometimes called “loan to own”).
363 Sales
When a debtor is in bankruptcy, it will sometimes seek to raise cash by selling company assets through a 363 sale, which is a court supervised auction process. Typically, a 363 sale begins with a stalking horse bidder who enters an agreement to purchase assets from the company. Purchase agreements often have certain favorable terms for the stalking horse bidder, including break-up fees if the debtor ultimately sells to another purchaser. In some cases, the stalking horse bidder also benefits by having a more extensive period in which to diligence the assets being purchased while subsequent prospective bidders are forced to bid in a very tight time window.
Because 363 sales are overseen and approved by the bankruptcy court, buyers can take comfort in purchasing the assets unencumbered with clean title, whereas prior to bankruptcy, an asset purchaser must be mindful that a transaction could be reversed under a fraudulent conveyance theory. When courts analyze whether to approve 363 sales, they generally use a 13-factor test known as the Gulf Oil test. Some 363 sales are incredibly controversial, such as that which occurred in the Chrysler bankruptcy during the Great Financial Crisis in which junior creditors led by the United Auto Workers ended up with equity in a restructured entity with a higher recovery than more senior creditors.
Plan Approval and Emerging from Bankruptcy
Once the bankruptcy court approves, the debtor can solicit votes for its POR. Classes that are unimpaired are presumed to accept and classes that receive no recovery are presumed to reject. The debtor solicits from the impaired classes that are receiving some recovery. For a class to accept the plan, more than 50% in number of those participating in the voting process representing at least 2/3rds in amount must vote to accept. If an investor obtains securities in a class comprising at least 1/3 of the amount, it is known as a blocking position. If the requisite number of class votes are obtained, all members of the class are bound.
Before a debtor can emerge from bankruptcy, the court conducts a confirmation hearing. In order to obtain confirmation, proponents of the plan must satisfy several tests. First, proponents must satisfy the court that the plan is in the best interests of creditors, meaning they recover as much as would in a Chapter 7 liquidation fire sale. The proponent also must establish that the plan is feasible, meaning that the emerging entity’s capital structure and business plan will likely not result in it reentering bankruptcy. Valuation becomes critically important in establishing that this part of the test is met since it will dictate how much debt the emerging entity is likely able to support. Finally, each class either must consent to the plan or, if a class rejects, have the plan imposed on them in a “cramdown” pursuant to Section 1129 of the Bankruptcy Code.
For a cramdown to be imposed on a dissenting class, at least one other impaired class must approve the plan, and the plan must not unfairly discriminate against any group of creditors and must be fair and equitable. Unfair discrimination means treating different classes of same priority differently without sufficient justification. Fair and equitable means that the plan adheres to the APR, does not pay junior claimholders unless all senior claimholders are paid in full, and does not compensate a class more than full value. Because valuation is open to debate, junior creditors will often argue that senior claimholders are receiving greater value than that to which they are entitled. If secured creditors, for example, have claims of $100 and the enterprise value of the company that emerges from bankruptcy is valued at $100, then secured creditors will be entitled to the entire capital structure. If unsecured creditors successfully argue that the enterprise value really should be $125, then those junior claimholders would be entitled to $25 or else the senior claimholders would be receiving more than full value.