Civil Code Sections relating to General Releases Modified

On February 28, 2019, the Corporations Committee of the Business Law Section of the California Lawyers Association published an e-bulletin that I authored. The text of the e-bulletin, as submitted for publication, follows.

With SB 1431 (chapter 157, statutes of 2018), the legislature tweaked two Civil Code section relating to releases.

The terms “creditor” and “debtor,” used in Civil Code sections 1541 and 1542, connote claims for money borrowed, but case law makes it clear that the claims covered by a general release are not so limited. This is generally well understood by lawyers, but, according to the sponsor of SB 1431, it is not understood by self-represented parties who expect “creditor” and “debtor” to apply only to cases where money is owed and not to their own cases that do not involve a monetary debt (such as an employment-law or family-law case).

To avoid this potential confusion, the amendment adds to the terms “creditor” and “debtor” the more general terms “releasing party” and “released party,” respectively. A red-lined version of § 1542, marked to show the changes from prior law, follows:

A general release does not extend to claims which that the creditor or releasing party does not know or suspect to exist in his or her favor at the time of executing the release, which and that, if known by him or her must, would have materially affected his or her settlement with the debtor or released party.

Corresponding amendments were made to Civil Code § 1541.

The amendment states that these changes are declaratory of existing law.

Comments

Although nothing in the statute requires a general release intending to waive § 1542 to set forth the text of § 1542, it is common practice for lawyers representing a released party who wish § 1542 to be waived to include the text of the statute in the release instrument. Therefore lawyers who follow that practice should update their forms to set forth the current version of the statute.

The statute does not by its terms authorize a waiver of § 1542. Even if the statute is not waivable, however, the expression of the intent to do so might encourage a court to find that the unknown or unsuspected claim was not something that “would have materially affected” the settlement.

The statute by its terms applies to a general release, not to a release of a specific claim or set of claims. The amendment does not change this.

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Legislature Expands Shareholder Inspection Rights

The Corporations Committee of the Business Law Section of the California Lawyers Association today published an e-bulletin, which I authored. The text follows:

The legislature amended Corporations Code § 1601, which grants shareholders the right to inspect and copy corporate records. The corporations subject to § 1601 are California corporations, foreign corporations having their principal executive office in California, and foreign corporations keeping records subject to shareholder inspection in California.

In Innes v. Diablo Controls (2016), 248 Cal.App.4th 139, a California shareholder sought to inspect and copy corporate records of a California corporation whose records were maintained in Illinois. The court of appeal held that Corporations Code § 1601 does not require that the requested records be brought into California for inspection in California.

AB 2237 (chapter 76, statutes of 2018) is partly in response to the Innes case, and it amends Corporations Code § 1601 in a number of respects.

AB 2237 provides that, if the originals of corporate records subject to shareholder inspection are normally not physically located in California, a shareholder may inspect a true and correct copy of those records at the corporation’s principal office in California.

If the corporation does not have a principal office in California, those records may be inspected at the physical location of the corporation’s registered agent for service of process in California.

If the original records have been lost or destroyed, a shareholder has the right to inspect a copy of the records.

AB 2237 also provides that a shareholder may request that a corporation produce desired documents by mail or electronically if the shareholder pays for the reasonable costs for copying or converting the requested documents to electronic format.

In Jara v. Suprema Meats, Inc. (2004) 121 Cal.App.4th 1238, the plaintiff had sent letters to the corporation numerous times asking it to send him a copy of specified records. The corporation did not respond to his requests. The court of appeal held that Corporations Code § 1601 afforded a shareholder no right other than to inspect and copy records at the company office; it did not require the corporation to copy and send records to him. And the court also held that a corporation could ignore a request for documents to be copied and sent and that a corporation had no duty to notify the shareholder that the records are open for inspection and copying at the corporation’s office.

With the change to Corporations Code § 1601, shareholders will now have the option of asking that the corporation send records subject to shareholder inspection by mail or email.

And in what may be the most significant change made by AB 2237, it now appears that corporate “records” independent of “accounting books” are subject to shareholder inspection. Thus, contract files, employment records, letters, and emails may be available for shareholder inspection, subject to the inspection being “for a purpose reasonably related to the holder’s interests as a shareholder or as the holder of a voting trust certificate.” The legislative committee analyses of the existing law describe the existing law as though this were already the case, and there is no discussion in the legislative committee analyses of an intention to change the scope of documents subject to shareholder inspection.

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Bad Corporate Practice Leads to Bad Result

I recently had a practice note published in the February 2019 eNews from the Business Law Section of the California Lawyers Association. What follows is the text that was submitted for publication.

The Delaware Court of Chancery found that a stockholder consent signed without the stockholder having been provided the exhibits referred to in the consent made the consent invalid under the Delaware General Corporation Law (“DGCL”). This case could be of interest to California practitioners because the section of the DGCL in question is functionally identical to the corresponding section of the California Corporations Code.

In Carsanaro v. Bloodhound Technologies, Inc., 65 A.3d 618 (2013), the plaintiffs were five software developers (referred to as the “Founding Team”) who all held common stock. They claimed that after the company raised its initial rounds of venture capital financing, the venture capitalists obtained control of the company’s board of directors. From that point on, the plaintiffs alleged, the venture capitalists financed the company through self-interested and highly dilutive stock issuances. The plaintiffs said they did not learn of the issuances or their consequences until the company was sold for $82.5 million. At the time of the sale, the plaintiffs discovered that the common stockholders’ overall equity ownership had been diluted to under 1%. After members of management received transaction bonuses of $15 million and the preferred stockholders received nearly $60 million in liquidation preferences, the plaintiffs were collectively left with less than $36,000.

The plaintiffs challenged the dilutive transactions, the allocation of $15 million in merger proceeds to management, and the fairness of the merger. The defendants moved to dismiss on a wide range of theories. With limited exceptions, the motions to dismiss were denied. This practice note focuses on one narrow aspect of the case, and for the ease of reading, a number of facts are omitted.

Stockholder Consent to Corporate Transactions

In addition to challenging the fairness of the issuance of a series E preferred stock, the plaintiff alleged that the approval of the 10-for-1 reverse stock split (as well as the amendment to the certificate of incorporation for the series E preferred stock) violated DGCL § 228. The reverse stock split required approval by a majority of the common stockholders voting separately as a class. To get a majority vote of the common stockholders, the consent of at least one member of the Founding Team was needed. In this case, the consent of Samir Abed, a Founding Team member, was obtained.

Less than four hours before filing the amendment giving effect to the reverse stock split, the company’s CFO emailed Abed a written consent for the first time. The consent approved an amendment to the certificate of incorporation to effect the reverse stock split. The amendment (and another exhibit) was supposed to be attached to the consent as an exhibit, but the CFO did not provide the attachment. Abed replied to the CFO’s email, asking to see the exhibits. Abed then recalled the CFO telling him earlier in the week that executing the written consent was essential and an urgent matter for the company. Fearing that his delay might jeopardize the financing and that could cause the company to take a harder line in its negotiations with him on the terms of his departure from the company, Abed signed and emailed back to the CFO the written consent without receiving the exhibits.

If Abed’s consent was valid, then the reverse stock split received the necessary vote. The plaintiffs argued that the written consent Abed executed failed to comply with § 228 because it did not adequately describe the actions taken. DGCL § 228 states:

Unless otherwise provided in the certificate of incorporation, any action required by this chapter to be taken at any annual or special meeting of stockholders of a corporation, or any action which may be taken at any annual or special meeting of such stockholders, may be taken without a meeting, without prior notice and without a vote, if a consent or consents in writing, setting forth the action so taken, shall be signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present…. [emphasis added]

The form of consent provided to Abed incorporated by reference exhibits to the consent, including the certificate of amendment effecting a reverse stock split. But the exhibits were not attached or otherwise provided to Abed.

The defendants argued that when stockholders are asked to vote on an amendment to the certificate of incorporation at a meeting, the notice can provide the text of the amendment “in full” or “a brief summary of the changes to be effected thereby.” 8 Del. C. § 242(b)(1). They argued that the consent summarized the actions taken.

But the court responded that the language of § 242(b)(1) is premised on action being taken at a meeting. Section 228(a) establishes a different requirement: the consent must “[set] forth the action so taken.”

The court held that when a stockholder consent specifically refers to exhibits and incorporates their terms, the plain language of § 228(a) requires that a stockholder have the exhibits in hand to execute a valid consent.

Relevance to California Corporations Code

Section 603(a) of the California General Corporation Law corresponds to DGCL § 228(a). Though there are some slight differences in wording, the two sections are functionally identical.

California Corporations Code § 603(a) provides:

Unless otherwise provided in the articles, any action that may be taken at any annual or special meeting of shareholders may be taken without a meeting and without prior notice, if a consent in writing, as specified in Section 195, setting forth the action so taken, shall be provided by the holders of outstanding shares having not less than the minimum number of votes that would be necessary to authorize or take that action at a meeting at which all shares entitled to vote thereon were present and voted. [emphasis added]

A California court could well come to the same conclusion as the Delaware court and could hold a shareholder consent invalid on the ground that the consent did not “[set] forth the action so taken” if the consent referred to exhibits but the exhibits were not attached to the consent or otherwise provided to the signatory.

Discussion

In a major corporate transaction, particularly those involving financing or a merger, it is not unusual for there to be time pressures. Often, the operative instruments, such as an amendment to the articles of incorporation or a merger agreement, will be approved by the board and the shareholders only after the finishing touches have been put on the underlying documents, which may be at the last minute. Carsanaro makes it clear that bad practices in getting board and shareholder approval can have bad consequences.

Take this hypothetical example. Drafts of operative documents are being circulated by email to various corporate decision-makers (board members or shareholders). Time is running out, and in the interest of efficiency, the corporate decision-makers sign bare consents. These consents refer to and incorporate by reference as exhibits the operative documents, but the operative documents do not yet exist in final form. Once the lawyers for the various parties agree on the final form of the operative documents, someone attaches to the pre-signed consents the operative documents as exhibits.

In light of the Carsanaro case, this procedure cannot be recommended. An argument could be made that the consents in this hypothetical example, when signed, did not “[set] forth the action so taken” and therefore are invalid. A counter-argument could be made that the consents were not effective until delivered, that whoever attached the operative documents as exhibits was authorized to do so by the persons signing the consents, and that delivery was authorized to be made only after the exhibits were properly attached to the consents. But the counter-argument raises a number of legal and factual issues. Why have these issues?

Even where the consents are circulated to decision-makers only after all the operative documents are in final form, it is not unknown for attachments to be inadvertently omitted from emails. A director who has been apprised of the negotiations might not object upon receiving an email that has omitted an exhibit to a consent (or the director might not realize that an exhibit was omitted). That director might sign the consent not realizing that a legal question could arise for lack of having all the exhibits in hand prior to signing the consent.

Practice Suggestion

One way to avoid this problem would be to create a consent that has the exhibits included as part of the document containing the consent. This is possible with the Word word-processing program, but incorporating different documents into one Word document can create a number of formatting issues. A more efficient way to transmit the consent and all the exhibits as one document would be to create the consent as a document in PDF format with all the exhibits included as part of the PDF document. That way, the formatting of one constituent document will not affect the formatting of other constituent documents. More important, there will be no issue whether the corporate decision-makers had in front of them (and as part of the consent) the exhibits that are referred to in the consent and that constitute part of “the action so taken.”

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Delaware Court Upholds Non-Compete against California Employee

The following is the text of an e-bulletin that I wrote and that was published by the Corporations Committee of the Business Law Section of the California Lawyers Association.

Patrick Miles, a California resident, was first hired in 2001 by NuVasive, a Delaware corporation doing business in California. He worked in California throughout his employment with the company, ultimately becoming president and a member of the board of directors. In 2016, Miles entered into a new employment agreement with NuVasive.

On October 1, 2017, Miles resigned as a director, officer, and employee; the following day, he joined a competitor of NuVasive as its principal executive officer. Nine days later, NuVasive sued Miles in Delaware alleging, among other things, violation of the covenant not to compete in his employment agreement. Three days after that, Miles and his new employer filed a parallel action in California.

Miles’s employment agreement provided that Delaware law would govern and that any dispute would be litigated in Delaware. The California court granted NuVasive’s motion to stay that action in part and upheld the forum-selection clause requiring litigation in Delaware. Miles then filed a motion for partial summary judgment in the Delaware action on the ground that the covenant not to compete was unenforceable under California law.

Choice-of-Law Issue

The Delaware court noted that the employment agreement between the parties, absent a choice-of-law provision, would be subject to California law and that under California law all covenants not to compete in employment contracts are void. Delaware, on the other hand, enforces reasonable covenants not to compete.

The court observed that if the choice-of-law provision were enforced, the parties would have contractually circumvented California law, and NuVasive could proceed to enforce the covenant not to compete under Delaware law. If California law applied, however, the non-compete provision would be void.

The Delaware court had previously decided a similar matter in Ascension Insurance Holdings, LLC v. Underwood. In that case, the court applied the choice-of-law analysis set out in the Restatement (Second) of Conflict of Laws and concluded that California’s specific policy in favor of freedom of employment prevailed over Delaware’s generalized public policy in favor of freedom of contract. Accordingly, in Ascension, the Delaware court declined to enforce the Delaware choice-of-law provision.

After Ascension was decided, however, California amended the California Labor Code by adding § 925, which provides in pertinent part:

(a)  An employer shall not require an employee who primarily resides and works in California, as a condition of employment, to agree to a provision that would do either of the following:

(1)  Require the employee to adjudicate outside of California a claim arising in California.

(2)  Deprive the employee of the substantive protection of California law with respect to a controversy arising in California.

(b)  Any provision of a contract that violates subdivision (a) is voidable by the employee, and if a provision is rendered void at the request of the employee, the matter shall be adjudicated in California and California law shall govern the dispute.

But § 925(e) exempts contracts where the employee is represented by legal counsel:

(e)  This section shall not apply to a contract with an employee who is in fact individually represented by legal counsel in negotiating the terms of an agreement to designate either the venue or forum in which a controversy arising from the employment contract may be adjudicated or the choice of law to be applied.

The court assumed for purposes of the motion that Miles was represented by counsel in the negotiation of the choice-of-law and forum provisions of the employment agreement. The court noted that Miles’s 2016 employment agreement was entered into before the effective date of Labor Code § 925. In the court’s view, that new provision reflected the current policy of California, even though it was not retroactive to the time Mile’s signed the agreement. The court concluded that it must use the state’s policy as it exists at the time of resolution of the conflict of laws.

The Delaware court found that enactment of Labor Code § 925 resulted in California’s public interest in prohibiting covenants not to compete where the employee is represented by counsel as being weak, in contrast with Delaware’s policy in favor of freedom of contract as being strong. The court then concluded that it would apply Delaware law in ruling on the covenant not to compete.

Comments

An initial question is whether the exception to voidability in Labor Code § 925 has an effect on the enforceability of an employment agreement outside of that code section. Removing a statutory power to void an agreement does not necessarily mean the agreement is otherwise valid and enforceable.

The larger issue is whether the Delaware court made a correct assumption about California law: that the invalidity in California of an employee covenant not to compete is a “substantive protection of California law” intended to protect the employee. In reality, the invalidity in California of covenants not to compete is intended to protect the public as a whole, not just employees per se. It provides that “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Nothing in Business & Professions Code § 16600 (or in the statutory exceptions at § 16601 et seq.) refers to employees or employers as such or depends on an employment relationship; it applies regardless of the nature of the parties.

Section 16600 is found in Division 7, Part 2, Chapter 1 of the Business & Professions Code. Division 7 is titled “General Business Regulations,” Part 2 is titled “Preservation and Regulation of Competition,” and Part 1 is titled “Contracts in Restraint of Trade.”

In light of this setting and the literal terms of the statute, § 16600 prohibits all agreements in restraint of trade (except as statutorily permitted), not simply employee non-competes. Statutes prohibiting restraints of trade are not intended to protect the parties to anti-competitive agreements; they are intended to protect the public by prohibiting such agreements. Business & Professions Code § 16600 is no less a protection of the public simply because it allows one party to an anti-competitive agreement (an employee) to assert its invalidity as a matter of law. Nothing in Labor Code § 925 states that agreements specifically covered by it can override statutes such as Business & Professions Code § 16600 designed to protect the public.

It is unclear whether the Delaware court took Business & Professions Code § 16600 into consideration in reaching its final outcome, much less the public policy protection nature of it. On the face of the opinion, the court does not seem to have done so. Practitioners focusing on the scope and application of Business & Professions Code § 16600 may have to await further judicial developments to know whether the NuVasive case would have had a different result had the Delaware court considered Business & Professions Code § 16600 directly.

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Administrative Dissolution of Corporations and LLCs Adopted in California

The following is the text of an e-bulletin that I wrote and that was published by the Corporations Committee of the Business Law Section of the California Lawyers Association.

On September 22, 2018, Assembly Bill No. 2503 was signed into law (and became Chapter 679). This law creates a new form of dissolution, administrative dissolution, for California domestic corporations, as defined in Corporations Code Section 167, and California domestic limited liability companies, as described in Corporations Code Section 17701.02(g) & (k). The law provides for two types of administrative dissolution, involuntary and voluntary.

These laws are intended to address the status of corporations that have ceased operations and have no assets.  Frequently, the owners of these corporations simply “walk away” from the accruing tax, interest, and penalties due rather than incur the expenses associated with voluntarily dissolving the corporation.

Involuntary Administrative Dissolution

After December 31, 2018, a California corporation may be administratively dissolved if the corporation’s corporate powers have been suspended by the Franchise Tax Board (“FTB”) for 60 consecutive months.

Before dissolving the corporation administratively, the FTB must notify the corporation of the pending administrative dissolution by mailing a notice to the last known address of the corporation.  If the FTB does not have a valid address for the corporation, the FTB will notify the Secretary of State, which will provide 60 days’ notice of the pending administrative dissolution on its Internet website by listing the corporation’s name and the Secretary of State’s file number. The Secretary of State will provide instructions for a corporation to submit a written objection of the pending administrative dissolution to the FTB before the expiration of the 60 days.

If the FTB does not receive the corporation’s written objection to the administrative dissolution during the 60-day period, the corporation will be administratively dissolved.

If the FTB does receive the corporation’s written objection to the administrative dissolution during 60-day period, the corporation will have 90 days from the date the written objection is received by the FTB to (1) file returns, (2) pay all accrued taxes, penalties, and interest, (3) file a current Statement of Information with the Secretary of State, (4) fulfill any other requirements to be eligible, and (5) apply for a certificate of revivor. If all the foregoing conditions are satisfied, the administrative dissolution will be canceled, but if not, the corporation will be administratively dissolved. The FTB may extend the 90-day period one time.

If the corporation is dissolved administratively, the corporation’s liability for the minimum franchise tax, interest, and penalties, will be abated, as well as the penalties for not filing a statement of information, and no administrative or civil action will be taken or brought to collect those liabilities. An administrative dissolution will not, however, discharge the corporation’s liability to creditors.

An administrative dissolution also will not discharge any liability of the directors or shareholders of the corporation or its transferees. Therefore, if there was an illegal distribution by the corporation or a fraudulent transfer prior to the dissolution, the liability of the directors or shareholders of the corporation or its transferees would not be affected by the dissolution.

Like provisions apply to California limited liability companies.

Voluntary Administrative Dissolution

After December 31, 2018, certain California corporations may apply to be administratively dissolved. The benefit of applying for voluntary administrative dissolution is that eligible corporations need not pay the minimum annual franchise tax, interest, or penalties that relate to years in which the corporation did not do business.

Two types of California corporations are eligible for this treatment:

  1. A corporation that never did business in California at any time after the time of its incorporation.
  2. A corporation that did business in California but that has ceased to do business and has filed all required California income tax returns for the tax years in which it did business.

In applying for this benefit, the corporation must certify under penalty of perjury that it has ceased all business operations and that it has no remaining assets. Any abatement would be conditioned on a certificate of dissolution first being filed with the Secretary of State.

The abatement of taxes, interest, and penalties would not apply to any year prior to the cessation of doing business in California.

If the corporation that was voluntarily administratively dissolved continues to do business or has remaining assets that were not disclosed at the time of request for abatement, the taxes, interest, and penalties that were abated will cease to be abated and will be immediately due. In addition, a penalty equal to 50% of the total tax abated (plus interest) will be imposed.

Additional Points

The FTB is authorized to prescribe regulations to implement these new provisions.

Like provisions apply to California limited liability companies.

An earlier statute (Ch. 363, Stats. 2015) established similar administrative processes to dissolve domestic and foreign nonprofit public benefit, mutual benefit, religious corporations, and foreign nonprofit corporations that have qualified to transact intrastate business in California.

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Buy-Sell Agreements in the Articles of Incorporation

Under the Corporations Code, if there is a suit for involuntary dissolution, or if there is an election to dissolve voluntarily by shareholders representing only 50% of the voting power of the stock, the dissolution of the corporation and the appointment of a receiver can be avoided by purchasing the shares owned by the shareholder (or shareholders) initiating the dissolution. The purchase can be by the corporation or by other shareholders owning 50% or more of the stock.

The ability to avoid dissolution by a purchase can be eliminated by a provision in the articles of incorporation. Effective January 1, 2018, the Corporations Code section 2000 was amended to allow such provision in the articles to be simply “a reference to a separate written agreement between two or more shareholders pertaining to the purchase of shares.” In other words, the provision in the articles that eliminates the ability to avoid dissolution by a purchase need not spell out the terms of a buy-sell agreement. It can simply refer to a separate buy-sell agreement that eliminates the ability to avoid dissolution by a purchase (and thus make the terms of the buy-sell agreement controlling).

The principal reason for this change was to eliminate the need to spell out in the articles the terms of a buy-sell agreement that would control in the event of a dissolution.

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Business Law Attorney Richard Burt Helps Draft New Corporate Law

A corporation is typically dissolved when the shareholders holding shares that have 50% or more of the voting power elect to dissolve. When an order for relief has been entered under Chapter 7 of the U.S. Bankruptcy Code, the board of directors can elect to dissolve the corporation. But after a corporation files for bankruptcy, the shares of the corporation are normally cancelled, and the corporation’s board of directors is replaced with a court-appointed representative who is responsible for liquidating the corporation’s assets and paying creditors.  So there are neither shareholders nor a board of directors to elect to dissolve.

The Insolvency Law Committee of the State Bar of California wanted to propose that the California legislature add a provision to the Corporations Code to allow the court-appointed representative to file a certificate of dissolution in cases where the court-approved plan did not authorize dissolution. The Insolvency Law Committee asked the Corporations Committee for help with the legislative proposal, and the Corporations Committee asked me, a senior adviser to the Corporations Committee, to join in providing that help. I was pleased to help, and I was one of the principal drafters of the amendments that were proposed to the California legislature.

With some modifications, the proposal was adopted by the legislature (Senate Bill 340). Corporations Code section 1401 is amended and a new section 1401.5 is added to the code by Chapter 267, Statutes of 2017, which takes effect January 1, 2018.

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LLC Bound by Contract Even Though Contract Was Outside Its Purpose and Signatory Was Technically Not a Manager

The following is the text of an e-bulletin that I authored on apparent authority and that was published by the Corporations Committee of the Business Law Section of the State Bar of California.

In  Western Surety Co. v. La Cumbre Office Partners, LLC  (February 2, 2017), a California Court of Appeal held that a California limited liability company was bound by an indemnity agreement that was outside its business purpose and that benefitted only an affiliate of its sole manager. The court relied on a statutory presumption in the LLC Act that contracts signed by a sole manager are conclusively deemed authorized by the limited liability company.

The court reached this conclusion even though the signature block for the person who signed as manager identified him as an individual when he was not individually the manager but was instead the managing member of an entity that was the sole manager of the LLC.

Facts

La Cumbre Office Partners, LLC (“La Cumbre”), was a California limited liability company, whose purpose was to acquire and operate, and perhaps redevelop, a medical office building at 200 N. La Cumbre Road, Santa Barbara. Its articles of organization, filed in 2006, provided that the company would be managed by one manager. The sole manager was Melchiori Investment Companies, LLC (“MIC”), which owned about 9.6% of La Cumbre.

The managing member of MIC was Mark J. Melchiori (“Melchiori”), and he owned half of MIC. Melchiori was also part owner of another LLC that owned about 17.8% of La Cumbre. Melchiori personally was not a member of La Cumbre. Melchiori was also the president of Melchiori Construction Company, Inc. (“construction company”).

La Cumbre’s operating agreement stated that MIC, its sole manager, would have full and exclusive authority to manage and control the business of the company and to perform all acts incident to the management of the company’s business.

In February 2008, to obtain surety bonds from Western Surety Company for his construction company, Melchiori signed an agreement agreeing to indemnify Western Surety. Melchiori signed on his own behalf, his construction company, and seven other parties. One of the signatories was La Cumbre.

The only business La Cumbre had ever engaged in was the ownership of its office building. La Cumbre had no reason to enter into an agreement to indemnify a surety company for a bond issued for Melchiori’s construction company for projects that had nothing to do with La Cumbre’s business. La Cumbre had no business, economic, or other connection to the construction company. Entering into the indemnity agreement was never discussed or approved by members of the company before the agreement was signed.

In 2009 and 2010, the surety company issued bonds to guarantee the performance of the construction company’s contractual obligations in several construction projects, none of which had any relation to La Cumbre’s business. The construction company defaulted, and the surety company paid claims amounting to over $6 million.

La Cumbre refused to reimburse the surety, and the surety company sued La Cumbre on the indemnity agreement.

Governing Law

The complaint in this case was filed in November 2012, more than one year before the California Revised Uniform Limited Liability Company Act became effective, and so the Beverly­Killea Act governed the matter.

Authority to Sign

The underwriter for the surety company prepared the indemnity agreement, and he directed that La Cumbre be named as a party and he directed how the signature block for it would appear. The underwriter testified that Melchiori had said he was the managing member of La Cumbre and could “bind the company” but the underwriter took no steps to verify Melchiori’s authority.

Melchiori testified to the contrary, that he had never told the surety company that he was La Cumbre’s managing member and that he had no idea why La Cumbre was named as an indemnitor.

There was ample evidence to the effect that the indemnity agreement was not (and would not have been) authorized by La Cumbre.

Apparent Authority

Corporations Code § 17157(d) provides, in the case of a limited liability company whose articles of organization state that it is managed by only one manager, that “[A]ny . . . contract . . . or other instrument in writing . . . executed or entered into between any limited liability company and any other person, when signed by [a sole manager] is not invalidated as to the limited liability company by any lack of authority of the signing … manager in the absence of actual knowledge on the part of the other person that the signing … manager had no authority to execute the same.” (In the case of a limited liability company managed by more than one manager, the signature of at least two managers is sufficient to bind the company.)

The California Revised Uniform Limited Liability Company Act is to the same effect (Corporations Code § 17703.01(d)).

As La Cumbre did not claim that the surety company had actual knowledge that Melchiori lacked authority to sign the indemnity agreement on La Cumbre’s behalf, the court held that Corporations Code § 17157(d) bound La Cumbre to the agreement provided it was signed by La Cumbre’s manager, MIC.

Incorrect Designation of Manager

When Melchiori signed on behalf of La Cumbre, he signed as “Mark J. Melchiori, Managing Member.” But Melchiori, as an individual, was not La Cumbre’s manager. MIC (of which Melchiori was the managing member) was the manager of La Cumbre.

The signature block for La Cumbre on the indemnity agreement apparently read:

La Cumbre Office Partners, LLC

By: ______________________________
      Mark J. Melchiori, Managing Member

The signature block for La Cumbre should have read:

La Cumbre Office Partners, LLC
By:  Melchiori Investment Companies, LLC,
its manager

        By:______________________________
               Mark J. Melchiori, managing member,
.              Melchiori Investment Companies, LLC

The signature block that was used to sign the indemnity agreement was incorrect because Melchiori, as an individual, was not the managing member of La Cumbre, and as an individual, he had no authority to act for La Cumbre.

La Cumbre argued that, as a result of the designation of Melchiori (as an individual) as La Cumbre’s managing member, the manager that the statute designates as having the power to bind the company by virtue of apparent authority (MIC (of which Melchiori was the sole manager)) did not sign the agreement on La Cumbre’s behalf. La Cumbre argued that Melchiori, as an individual, did not benefit from the statute’s conclusive presumption of authority, only MIC would, and therefore Melchiori’s signature in his individual capacity did not, and could not, bind the company.

Incorrect Designation of Authority

A similar issue had arisen in the corporate context. In Snukal v. Flightways Manufacturing, Inc. (2000) 23 Cal.4th 754, the California Supreme Court held that Corporations Code § 313 “applies even when the other party should have, but does not have, actual knowledge of the officers’ lack of authority, that party is relieved of the burden of establishing justifiable reliance upon the authority of the executing officers.” Id. at 783.

Corporations Code § 313 provides that:

any … contract … or other instrument in writing … executed or entered into between any corporation and any other person, when signed by [two of the officers specified in the section] is not invalidated as to the corporation by any lack of authority of the signing officers in the absence of actual knowledge on the part of the other person that the signing officers had no authority to execute the same.

In Snukal, Lyle executed a lease on behalf of the corporation, Flightways. Lyle was president, chief financial officer, and secretary of Flightways, but he signed the lease showing his office only as president. For a party dealing with the corporation to take advantage of Corporations Code § 313, a contract or other written instrument must be signed by a person holding at least one corporate office in each of two separate categories of offices specified in the statute. The office of president is in one category, while the offices of chief financial officer and secretary are in another category. Thus, for Flightways to have been bound by the apparent authority of Lyle under Corporations Code § 313, both the president and the chief financial officer (or both the president and the secretary) had to have signed the lease.

The Snukal court rejected Flightways’s claim that the statute applies only when two officers holding the offices specified in the statute execute an instrument and name the corporate offices held (whether the requisite offices are held by the same person or held by two persons). The court held that Corporations Code § 313 does not contain any language requiring the signing officers to be separate individuals or requiring the signing officers to specify the office or offices they hold.

In Snukal, id. at 780, fn. 8, the court stated that “when the corporate officer’s actual authority to execute the agreement has been established or is not in doubt, the circumstance that he or she does not specify the office held does not invalidate the agreement as to the corporation,” citing Greve v. Taft Realty Co. (1929) 101 Cal.App. 343 and other cases.  The Snukal court held that Corporations Code § 313 “provides a conclusive, rather than a merely rebuttable, evidentiary presumption of authority to enter into the agreement on the part of the specified . . . officers.” Id. at 782.

Under this reasoning, La Cumbre would have been bound by the indemnity agreement if Melchiori had simply signed his name without indicating any official position. The court of appeal in this case stated that the fact that the indemnity agreement mistakenly designated Melchiori as the managing member was a distinction without a difference. MIC was a legal entity and therefore could sign the indemnity agreement only through the signature of a natural person (and Melchiori was “the only living person in the world” who could sign on MIC’s behalf). The natural person authorized to sign on MIC’s behalf was its managing member, Melchiori, and Melchiori signed the indemnity agreement.

It followed, therefore, that La Cumbre was bound even though the indemnity agreement’s signature page mistakenly identified Melchiori individually as its sole manager (instead of as the managing member of MIC, the sole manager of La Cumbre).

The failure of the surety company to exercise due diligence to assure that Melchiori was in fact La Cumbre’s managing member was irrelevant according to the court of appeal because Corporations Code § 17157(d) does not require the third party to be diligent.

Comment

Melchiori testified that he had never told the surety company that he was La Cumbre’s managing member and that when he signed the indemnity agreement, he did not even notice that La Cumbre was listed as an indemnitor. As noted above, La Cumbre had nothing to do with the surety bonds, and a person signing an agreement for a project might well believe that the agreement did not involve an entity that had nothing to do with the project.

While the foregoing facts were insufficient in light of Corporations Code § 17157(d) to establish that the signature of Melchiori did not bind La Cumbre, they might be sufficient to establish a defense of mistake.

If a natural person mistakenly signs a contract or other written instrument, there is no question of authority (as there could be in the case of a signature on behalf of an entity), but the fact that the person did not know that what he was signing was a contract or that he was under a misapprehension as to the subject of the contract might provide a defense on the basis of mistake. An entity is entitled to the defense of mistake as well.

But the apparent failure of Melchiori to read the signature blocks on the contract that he was signing could be fatal, however, to the defense of mistake. The opinion is silent on the defense of mistake, and it is not apparent whether the issue was litigated in the trial court.

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Ownership of Passive LLC Interest in Manager-Managed LLC Not “Doing Business” in California

The following is the text of an e-bulletin that I authored and that was published by the Corporations Committee of the Business Law Section of the State Bar of California.

In Swart Enterprises, Inc. v. Franchise Tax Board  (Jan. 12, 2017), a California court of appeal held that an out-of-state corporation whose sole connection with California was a 0.2% ownership interest in a manager-managed California limited liability company was not obligated to file a California corporate franchise tax return and pay the $800 minimum franchise tax due on that return.

–Franchise Tax

California imposes a franchise tax on every corporation that is incorporated in California, qualified to transact business in California, or actively doing business in California. The minimum liability for all corporations subject to the tax is $800 per year.

An out-of-state, or foreign, corporation is subject to the California franchise tax if it is “doing business” within California, whether or not it is incorporated, organized, qualified, or registered under California law. Rev. & Tax. Code § 23151(a). The phrase “doing business,” for purposes of the franchise tax, means “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Rev. & Tax. Code § 23101(a); Cal. Code Regs., tit. 18, § 23101 (Regulation 23101).

–Factual Background

Swart Enterprises, Inc. (“Swart”), was a small family-owned corporation that operated a 60-acre farm in Kansas, where it occasionally fed cattle for beef sales in Nebraska. Its place of business and headquarters were located in Iowa. Swart had no physical presence in California, such as real or personal property or employees; it did not sell or market products or services to California. Swart was incorporated in Iowa and was not registered with the California Secretary of State to transact interstate business.

In 2007, Swart invested $50,000 in Cypress Equipment Fund XII, LLC (“Cypress LLC”) and acquired a 0.2% membership interest, Swart’s sole connection with California. Cypress LLC was manager-managed, as opposed to member-managed. Under Cypress LLC’s articles of organization and operating agreement, the sole manager of the company was given “full, exclusive and complete authority in the management and control of the business of the Fund ….”

Swart was not involved in any way in Cypress LLC’s operations or management. In fact, members other than the manager were prohibited from taking part in the conduct or operation of the company. Members had no authority to execute an instrument on behalf of Cypress LLC or to otherwise act in any way on its behalf.

The FTB concluded Swart was doing business in California based on the facts that it held an ownership interest in Cypress LLC, and that Cypress LLC, which was doing business in California, had elected to be treated as a partnership for purposes of federal income taxes. The FTB demanded that Swart file a California corporate franchise tax return and pay the $800 minimum franchise tax due on that return. Swart paid the tax (and penalties and interest). It then contested the obligation and sued for a refund.

–Analysis

The court of appeal rejected the argument that the LLC’s election to be classified as a partnership for federal income tax purposes resulted in all members of the LLC being considered general partners for all tax purposes.

The court of appeal cited Appeals of Amman & Schmid Finanz AG (1996) 96 SBE 008 [1996 Cal. Tax LEXIS 62] for the proposition that the business activities of a partnership cannot be attributed to limited partners. In Amman & Schmid, foreign corporations that were limited partners in partnerships were held not to be doing business in California simply because the general partners were doing business in California on behalf of the partnerships.

The Attorney General attempted to distinguish a limited partnership interest from a membership interest in a manager-managed limited liability company and cited a legal ruling issued by the FTB (Cal. Franchise Tax Bd., Legal Ruling No. 2014-01 (July 22, 2014) [2014 Cal. FTB LEXIS 2]. The court of appeal disagreed with the analysis in the FTB’s ruling and noted that the ruling contradicted a position previously taken by the FTB in Technical Advice Memorandum No. 200658 (Dec. 22, 2000) (TAM) [2000 Cal. FTB TAM LEXIS 28].

The court of appeal held that a corporation that passively holds a 0.2% membership interest in a manager-managed LLC, with no right to act for or control the LLC, is not “doing business” in California and therefore is not required to file a California corporate tax return or pay the California minimum franchise tax.

–Constitutional Issue

Having disposed of the case on the basis of statutory interpretation, the court did not address the constitutional arguments made by Swart.

FTB Acquiescence

The time for the FTB to appeal has expired, and the FTB is reported to be working on guidance to release to taxpayers.

Statutory Amendment

As described below, the definition of “doing business” in Rev. & Tax. Code § 23101 was expanded, effective 2011, but because the franchise tax at issue in the case was imposed for Swart’s tax year ending June 30, 2010, the statutory expansion of the definition of “doing business” did not apply to Swart.

For tax years beginning in or after 2011, Rev. & Tax. Code § 23101(b) declares a taxpayer to be doing business in California if the taxpayer’s sales, property, or compensation paid exceed certain limits set forth in the statute (with the dollar amounts to be revised annually by the FTB).

If the taxpayer’s California sales for the taxable year exceed the lesser of $500,000 or 25% of the taxpayer’s total sales, the taxpayer is doing business in California. For this purpose, sales of the taxpayer include sales by an agent or independent contractor of the taxpayer.

If the taxpayer’s real property and tangible personal property in California exceed the lesser of $50,000 or 25% of the taxpayer’s total real property and tangible personal property, the taxpayer is doing business in California.

If the amount of compensation paid in California by the taxpayer exceeds the lesser of $50,000 or 25% of the total compensation paid by the taxpayer, the taxpayer is doing business in California.

It is doubtful that the expansion of the definition of “doing business” would have changed the result in Swart, but the expanded definition could ensnare out-of-state entities that are not actively engaging in any transaction in California for the purpose of financial or pecuniary gain or profit.

 

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Individualized Promissory Note Held Not To Be a Security

The following is the text of an e-bulletin that I authored and that was published by the Corporations Committee of the Business Law Section of the State Bar of California.

In People v. Black (Feb. 16, 2017), the court of appeal held that a single promissory note, negotiated one-on-one, to fund an investment in real property was not a security under the California Corporate Securities Law even though the note offered a share of profits to the lender as an alternative to fixed interest.

The promissory note at issue was written on the letterhead of “Atherton LLC, a land development company” and listed Atherton, LLC as “borrower” and Bronic Knarr as “lender.” In the note, the borrower promised to pay the lender the amount borrowed ($124,456) together with interest that would be calculated as follows:

  1. If the real property were sold by the borrower, the amount of interest would be a percentage of the profits from the sale.
  1.  If the borrower developed the real property, the lender would receive two lots chosen by the lender.

If the property were neither sold nor developed within one year, the principal, along with interest at the rate of 10%, would be due at the election of lender.

The note further stated that “Charles Black who is executing this Note has agreed that his separate property shall be bound hereby and that resort may be had to such separate property for the payment and enforcement of this Note.” The note was signed only by Black as “managing member” of Atherton, LLC.

Subsequently, the note was amended to reflect that Knarr had increased his loan and that Knarr would receive one residential acre, not two lots, if the property were developed. The maturity date of the note was extended several times.

Two other individuals separately gave money to Black for the deal. James McGuire, a real estate agent who knew Black from prior dealings, partnered with Black and invested about $160,000. David Faye gave Black $20,000 toward the deal but was unsuccessful in attempts to follow up with Black about his investment.

Trial Court Proceedings

The Santa Cruz County District Attorney filed an information charging Black with three counts of theft by false pretenses and three counts of making false statements in the offer or sale of a security. After the preliminary hearing, the magistrate found insufficient evidence of a false pretense but held Black to answer the charges of using false statements in the offer or sale of a security. Thereafter, the information was amended twice, and Black moved to dismiss on the ground that the promissory note was not a security.

The trial court concluded that the promissory note was not a security under either the risk-capital test or the Howey test.

Court of Appeal Opinion

On appeal, the People did not argue that the promissory note qualified as a security under the risk-capital test.

The court of appeal noted that Corporations Code section 25019 defines “security” to include “any note; stock; . . . bond; . . . evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; . . . investment contract….” Citing the California Supreme Court’s opinion in People v. Figueroa (1986) 41 Cal.3d 714, 734, the court of appeal noted that the definition of “security” is not applied literally. Rather, “the ‘critical question’ . . . is whether a transaction falls within the regulatory purpose of the law regardless of whether it involves an instrument which comes within the literal language of the definition [citations omitted].”

Black argued that the promissory note was not a security because it was a unique agreement that was negotiated one-on-one between the parties and was not designed to be publicly traded, citing Marine Bank v. Weaver (1982) 455 U.S. 551, which held that a unique agreement not designed for common trading might not be an “investment contract” or other type of security under federal law. The court of appeal noted that there was no prospectus or other indication that the arrangement with Knarr “could have been traded publicly” and thus the note at issue was not an instrument intended for wide distribution.

Black also argued that repayment to Knarr was not contingent on the success of the enterprise because Knarr had the right to be repaid the principal plus interest, whether or not the Idaho deal succeeded, and that the evidence was insufficient to show that Black would not have been able to fulfill that obligation. Knarr testified that he would not have invested with Black if the fixed repayment obligation not been included in the promissory note, and Black was unequivocal that he owed Knarr the money. The court noted that the fixed repayment obligation, together with the provision binding Black’s separate property, “inserted an element of redress that would be unlikely to come within ‘the ordinary concept of a security’ [citations omitted].”

Although the court of appeal rejected the notion that all one-on-one contracts are excluded as a matter of law from the definition of a security, it held that the individualized nature of the transaction is one factor that must be considered in determining whether that transaction comes within the regulatory purpose of the securities laws. Accordingly, the court of appeal held that the promissory note offered for Knarr’s investment in the real estate development scheme was not a security within the meaning of the Corporate Securities Law.

 

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