When Are Out-of-State Entities Doing Business in California?

What if a corporation or a limited liability company (LLC) is formed in another state, like Delaware or Nevada, but does business in California? The out-of-state business entity (a “foreign” business entity) must register with the state, file tax returns, and (most important to the state) pay taxes to California.

Sometimes it is obvious when a foreign corporation or foreign LLC is doing business. California’s tax law defines “doing business” in the state as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” So, for instance, operating a business that is physically located in California is obviously doing business here.

But the definition doesn’t stop there. California, being hungry for tax revenue, has enacted a statute that specifies other activities that will result in the foreign entity being deemed to be doing business in California even if it’s not operating a business here.

Since January 1, 2011, based on California Revenue and Taxation Code § 23101(b), a taxpayer has been deemed to be doing business in California for a taxable year if any of the following conditions were satisfied:

  • The taxpayer’s sales in California exceed the lesser of $500,000 or 25% of the taxpayer’s total sales in the taxable year.
  • The real property and tangible personal property of the taxpayer in this state exceed the lesser of $50,000 or 25% of the taxpayer’s total real property and tangible personal property combined.
  • The amount the taxpayer paid in California for compensation in a taxable year exceeds the lesser of $50,000 or 25% of the total compensation paid by the taxpayer.

But the foregoing threshold dollar amounts are not carved in stone, so to speak. The Franchise Tax Board (FTB) is required to revise the dollar amounts annually based on increases in the California Consumer Price Index.

The FTB has spoken, and so for 2020 the threshold dollar amounts are:

  • Sales: $610,395
  • Property : $61,040
  • Payroll :  $61,040

Remember, even though the foreign business entity’s activity is below the dollar amounts, it could still be deemed doing business here if it exceeds the percentage amounts.

What if a corporation or LLC is organized in California but only does business in one or more other state? That business entity, by virtue of being formed in California, is automatically doing business in California and must pay taxes in California (in addition to any taxes payable in other jurisdictions).  So you could say that California gets you coming or going.

If you need help registering your entity with the state of California, feel free to call me or use the contact form to send an email.

 

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Bulk Sales Law: A Possible Trap for the Unwary Buyer of a Business

Buyers of businesses should be aware that California, like some other states, has a “bulk sales” law. Its official name is Uniform Commercial Code—Bulk Sales. The bulk sales act is designed to protect the creditors of a business by giving them notice of a “bulk sale” (sometimes called a bulk transfer).

What Is a Bulk Sale (and Who Cares Anyway)?

In general, a bulk sale is a sale to a buyer of all or most of the assets of the business outside the ordinary course of business. The object of the act is to reduce the prospect that the owner of a business will sell all or most of the assets of a business and then disappear with the money, leaving the creditors unpaid. In most cases, when a transaction is a bulk sale, creditors have to be given notice of the transaction. In some cases, the bulk sales law requires the purchase price to be put into an escrow so that the seller’s creditors can submit claims into the escrow and be paid.

The general rule is that a purchaser of assets or a buyer of a business is not liable for a seller’s obligations unless the buyer agrees to assume those obligations, but there are a number of laws that create successor liability, also known as transferee liability, for the purchaser of a business. The bulk sales law is one of them. Even though it creates no liability for the seller of a business, the seller of a business should consult with counsel to avoid an expected snag in the closing of the transaction. Of course, it is of more concern for the buyer.

If the transaction is subject to the bulk sales law and the buyer doesn’t make sure that the transaction complies with the law, the buyer may be liable to the seller’s creditors to pay the seller’s debts to the extent of the consideration the buyer paid the seller (or if the assets were sold for a value below their value, to the extent of the value of the assets acquired). Of course, a buyer who gets stuck paying the seller’s debts when that is not part of the deal is entitled to be reimbursed by the seller, but if the seller’s creditors haven’t been paid by the seller, the likelihood is high that the seller is a deadbeat. Thus, in most cases, the buyer will want to make sure that that the purchase of a business subject to the bulk sales law complies with that law.

California’s bulk sales act is contained in Division 6 of the California Commercial Code, which is based on the Uniform Commercial Code drafted by the National Conference of Commissioners on Uniform State Laws (sometimes referred to as the U.S. Uniform Law Commission). Because the Uniform Commercial Code is adopted in all 50 states (though only partly in Louisiana), almost every state had a bulk sales law. The operation of the law would vary from state to state, but the existence of the law was fairly universal. Most of the states have now repealed their bulk sales laws for the simple reason that the bulk sales law doesn’t do much to protect creditors. There is talk of proposals for California to repeal its bulk sales act, but for now, the law is in full force and effect.

Sales Subject to the Bulk Sales Law

First, California’s bulk sales act applies only to certain sellers. In California, the bulk sales act applies only to a seller whose principal business is the sale of inventory from stock, including those who manufacture what they sell, or that of a restaurant owner. Thus, a service business is not subject to the bulk sales act.

Second, the seller must be located in California. If a seller has more than one place of business and some of them are not in California, the seller is deemed located in California if its chief executive office is in California. Thus, if a corporation or LLC has formed under Nevada or Delaware law but has its chief executive office (or its sole place of business) in California, a sale by it is subject to California’s bulk sales act.

Third, the sale must be of more than half (in value) of the seller’s inventory and equipment. So a sale of, say, one-third of a seller’s inventory would not be a bulk sale, even if the other criteria for a bulk sale are met.

Fourth, the sale must be not in the ordinary course of the seller’s business. Naturally, this is the case when the seller sells his business to a buyer; such a sale is not in the ordinary course. On the other hand, a retail shop is not conducting a bulk sale when it sells its goods to its customers in the ordinary course of business (no matter how much it sells at any one time).

In addition to the traditional negotiated sale of a business, the bulk sales law can apply to a sale by auction or a series of sales conducted by a liquidator on the seller’s behalf, but the focus of this blog post is on the acquisition of a business, either as a going concern or in liquidation.

By the way, the bulk sales law is not the only law that can make a buyer liable for the seller’s debts (even though the buyer has expressly disclaimed assuming any of the seller’s debts). See the links at the end of this post.

Bulk Sales Notice

To comply with the act, there are two steps that are essential.

First, the buyer has to prepare a notice of bulk sale that provides:

  1. A statement that a bulk sale is about to be made.
  2. The buyer’s name and business address.
  3. The seller’s name and business address.
  4. A list of any other business names and addresses used by the seller during the three prior years (the buyer is to obtain this list from the seller).
  5. A general description of the assets and their location.
  6. The place of the bulk sale.
  7. The anticipated date of the bulk sale.
  8. A statement whether the bulk sale is subject to the escrow requirements of the bulk sales law, and if so,
    (a)   the name and address of the person with whom claims must be filed and
    (b)   the last date for filing claims (one business day before the anticipated date of the bulk sale set forth in the notice).

Whether a bulk sale is subject to the escrow requirements of the bulk sales will be discussed later in this blog post.

Second, at least 12 business days before the sale takes place, the buyer must (1) record the notice of bulk sale in the county recorder’s office, (2) publish the notice in a local newspaper of general circulation, and (3) deliver the notice of bulk sale to the county tax collector. A “business day” is any day other than a Saturday, Sunday, or state holiday.

Delay Resulting from Notice Requirement

The notice requirement results in a two and one-half week period between giving the required notice and closing the transaction. In some cases, the notice period has no effect on the transaction because the time that the parties have scheduled between signing the contract and closing the transaction is longer than 12 days, and the giving of notice does not delay closing.

Often, however, the parties are negotiating the contract while the buyer is doing his due diligence, and they want to sign the contract and to close the transaction simultaneously with the signing. In that case, the notice period introduces an unwanted delay in closing the sale. In a number of cases, the parties are motivated to move as quickly as possible and any delay is unwelcome.

For example, in a distress sale, the seller may be selling because he has an obligation to make a payment by a certain date, and he intends to use the sales proceeds to satisfy that obligation. Or the seller may have an option to extend the term of his lease, but the seller does not want to exercise the option before closing because the seller does not want to commit to the additional term if there is no sale of the business. The buyer, of course, does not want to buy the business unless the buyer can extend the term. If the date parties must act by is before the twelve-day notice period expires, the notice requirement of the bulk sales law can present a serious problem.

Escrow Requirements of a Bulk Sale

In a bulk sale subject to the bulk sales law, there is no escrow requirement if the price is more than $2,000,000. There is also no escrow requirement if the price will be paid by consideration other than cash (or a promise to pay cash in the future). So, if the price will be paid by the buyer’s giving stock in the buyer exchange for the seller’s assets, there is no escrow requirement.

If the price is $2,000,000 or less and will be paid in cash or by a promise to pay cash in the future, whether or not set forth in a note (or a combination of the two methods of payment), then there is an escrow requirement.

Technically, the bulk sales act does not require an escrow, but because the purchase and sale of a business are often handled through an escrow, I refer only to the obligations imposed on the escrow agent. If there is no escrow, say because the bulk sale is not the purchase of a business, then the duties that would be imposed on an escrow agent are imposed on the buyer, and references to the duties of the escrow agent are references to the duties of the buyer.

If there is an escrow, the buyer must deposit the full amount of the purchase price into escrow. If part of the purchase price is to be paid by a promissory note, then the note is deposited into escrow along with the cash portion. Thus, while the entire purchase price is to be deposited into the escrow, only a portion (or none) may be cash.

When a proper claim is timely submitted by a creditor into the escrow, the escrow agent must pay the claim from the cash in the escrow. A proper claim is one that is due and payable before the date of the bulk sale. A timely submittal is one that is made in writing and is received on or before the date for filing claims set forth in the bulk sales notice.

If the seller disputes the claim (either on the ground that it is not due and payable or that the amount is not correct), the escrow holder must withhold from any distribution to the seller 125% of the first $7,500 of the claim ($9,375 on a $7,500 claim) plus an amount equal to the balance of the claim. Thus, if the claim is for $5,000, the escrow agent must withhold $6,250 (125% of $5,000). If the claim is for $10,000, the escrow agent must withhold $11,875 ($9,375 + $2,500). The balance of the purchase price can be disbursed to the seller.

On or before the second business day after the disbursement of the purchase price to the seller, the escrow agent must send a notice to the claimant that the amount withheld will be paid to the seller unless the claimant files for and obtains a writ of attachment within 25 days of the mailing of the notice. After 25 days, an amount that is not subject to a writ of attachment must be disbursed to the seller.

Creditor Claims in Excess of Cash

What happens if the cash in the escrow is not sufficient to pay all claims?  Things get more complicated.

If the cash in the escrow is not sufficient to pay all claims, the distribution of the purchase price and the conveyance of title must be delayed for at last 25 days and no more than 30 days from the mailing of the notice to claimants.  The escrow agent must send out a notice to each claimant, stating:

  1. The total consideration deposited or agreed to be deposited in the escrow.
  2. The name of each claimant who filed a claim against the escrow and the amount of each claim.
  3. The amount proposed to be paid to each claimant,
  4. The new date scheduled for the passing of the legal title.
  5. The date on or before which distribution will be made to claimants (no more than five days after the new date specified for the passing of legal title).

The statute provides a distribution scheme that sets forth the priorities of various types of creditors. Thus, some types of creditors may get paid in full, and others may share pro-rata share of the balance remaining (or receive nothing at all).

Noncompliance with the Act

Many times, however, parties proceed with a transaction that falls within the act but knowingly doesn’t comply with it. Often, a buyer can do that, either with complete safety from any claim under the act or with relative safety.

Transactions That Are Exempt

First, the California version of the bulk sales act contains two express exemptions. It does not apply to a sale of assets having a value of more than $5,000,000 on the date of the bulk sale agreement or to a sale of assets having a value, net of liens and security interests, of less than $10,000.

What if the value falls within those two amounts? Quite often, the Purchase and Sale of business is structured in a way that the transaction does not fall within the act even if the value falls within those two amounts.

Transactions Not Subject to Act

The act does not apply to the sale of an interest in a business entity, even if the entire interest is owned by one person and the entire interest is being sold. Thus, the act does not apply to the purchase and sale of stock in a corporation, even if there is only one shareholder and all the stock is being sold. Likewise, it does not apply to the sale of a membership interest in a limited liability company (LLC) or a partnership interest.

For this reason, the bulk sales act typically does not apply to a buy-sell transaction between partners in a partnership or co-owners of a corporation or LLC. In those cases, the remaining owner is not buying the assets from the business but is instead of purchasing the partnership interest or stock or LLC membership interest.

This also does not apply to a merger of a corporation or LLC into another entity, even though the result is that all the assets of the party who would be considered the seller are transferred to the party who would be considered the buyer.

Intentional Noncompliance

Finally, many purchasers of a business intentionally don’t comply with the act, though the purchaser will ordinarily protect himself otherwise against the claims of creditors. Here are two typical scenarios applicable to the acquisition of a business subject to the act.

In one scenario, the asset purchase agreement provides that the purchaser is not assuming any liabilities, and the seller promises to pay the existing liabilities. (Of course, the whole point of the bulk sales act is that when a transfer falls within the act, third-party creditors have rights against the buyer independently of any agreement to assume liabilities. So an agreement that the purchaser takes the assets free and clear of any liabilities does not limit the creditors until the statute of limitations for claims by creditors expires).

Another typical scenario is that the seller represents and warrants to the purchaser what the liabilities are, the purchaser expressly assumes those liabilities, and the seller promises to pay any liabilities not expressly assumed by the purchaser. In this scenario, the purchaser is already liable to the third-party creditors who have been disclosed so the bulk sales add no exposure as to those creditors.

In either scenario, the purchaser is exposed to risk. What if the seller doesn’t pay the creditors whose claims the purchaser has not agreed to assume?  If the act applies and if there is no exemption, then the purchaser is on the hook to creditors.

But in these types of transactions, the purchaser typically owes the seller a portion of the purchase price, either in the form of a post-closing escrow or express hold-back of the purchase price for a specified period (which in either case can protect the purchaser against hidden claims) or in the form of deferred payment of the purchase price (typically a promissory note). It is standard for a purchaser to retain the express right to offset against the deferred payment of the purchase price any claims that the purchaser has against the seller, including a claim that the seller misrepresented liabilities or failed to pay liabilities that the purchaser did not assume. Thus, through a combination of due diligence and careful structuring of the transaction, a purchaser can avoid complying with the bulk sales act with a relative, and sometimes absolute, impunity.

Conclusion

To avoid inadvertently becoming liable to the creditors of a seller, a purchaser should be advised by a California lawyer experienced in the acquisition of a business. One of the most valuable services a lawyer can provide a client in a business purchase is helping to structure the transaction.  The prospective acquirer of business would do well to consult with counsel before making any kind of offer, including a proposed letter of intent.

For information on possible buyer liability for the seller’s liability to the Board of Equalization (for sales taxes) (whether or not the bulk sales act applies), see https://richardburtlaw.com/boe-tax-clearances/

For information on possible buyer liability to the Employment Development Department (for the seller’s state payroll tax obligations) (whether or not the bulk sales act applies), see https://richardburtlaw.com/edd-tax-clearances/

For information on possible buyer liability for the seller’s liability to the Franchise Tax Board (whether or not the bulk sales act applies), see https://richardburtlaw.com/franchise-tax-board-tax-clearance-certificates/

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Out-of-State LLC Owning Property in California

Experienced San Jose, CA Foreign LLC Lawyer Ready To Assist You

Many California residents are members of LLCs formed under the law of other states (often referred to as “foreign LLCs”). California, being hungry for tax revenue, often tries to tax the LLC on the ground that it is doing business in California. Obviously, if a Delaware LLC owns rental property in California and is generating rental income from the property, it would be considered to be doing business in California.

But what if the resident forms an out-of-state LLC simply to hold raw land or a personal residence for the owner (either a principal residence or vacation home)? Ownership alone is not a business activity, and assuming there is no rental of the property, it might seem that the LLC is not doing business in California. But things are not always what they seem when it comes to tax law in California.

Under California Revenue and Taxation Code § 23101(b)(3), if a foreign (out-of-state) LLC’s real property and tangible personal property in California exceeds $51,186, the foreign LLC is statutorily deemed to be doing business in California. Given that most California real property is worth more than $51,186, any foreign LLC that owns real property in California is likely to be doing business in California, which will require it to register with the Secretary of State, file tax returns with the Franchise Tax Board, and pay tax to California.

By the way, in case you are wondering why an odd number like $51,186 was chosen, the answer is that the original figure was $50,000, and the FTB is authorized to increase the original figure by an inflation factor, which it has done.

If you need assistance with the arbitration, buy-sell agreements, or outside general counsel, contact Attorney Richard Burt. Serving San Jose, CA, and all of the San Francisco Bay areas, Mr. Burt can be reached at (408) 286-7333 or by filling out the online contact form.

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Fraud Alert — Beware of “Barrister Richard Burt” (it’s not me)

I was contacted by someone who had been asked to pay $5,000 for legal services. The person asking for the money was supposedly Barrister Richard Burt. This impostor showed my office address (right down to the suite number) as his purported address on his email to the intended victim of his fraud. And he provided the intended victim with a copy of a fake I.D. card with my name. The I.D. card had no indication of who supposedly issued it, but it did have my photo (filched from my website)!

So beware. If you have a doubt whether you are dealing with the real Richard Burt, a lawyer in San Jose, call me at my office (408) 286-7333.

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Breach of warranty in the sale of goods and the statute of limitations

Cardinal Health 301, Inc. v. Tyco Electronics Corp. (2008) 169 Cal. App. 4th 116.

Holdings Noted

The four-year statute of limitations bars warranty claims unless the warranty explicitly extends to future performance of the goods and discovery of the breach must await such future performance.   A warranty that the goods will have a “mechanical life of 50,000 cycles” does not come within the future-performance exception because the warranty is not for a specific and defined period of time.   In addition, the exception does not apply where it is possible for the purchaser to test the goods and determine non-compliance with the warranty.

Repair efforts by the seller can toll the statute of limitations, but the seller’s assisting the buyer in investigating the cause of failure of goods is not a repair effort.

A breach of contract claim based solely on a breach of warranty is governed by the four-year statute of limitations set forth in §2725.

A buyer’s failure to notify the seller of a breach of warranty within a reasonable time after the buyer discovers or should have discovered a breach bars the buyer from any remedy.   Not giving any notice during the lengthy time before filing suit is such a failure and bars recovery.

A buyer and seller must be in privity of contract for the buyer to have an implied warranty claim against the seller, but “direct dealings” between the buyer and the seller’s supplier can suffice for a claim by the buyer against the seller’s supplier.

A company that takes over another company’s manufacturing operations and continues to supply a product may be held to have made a warranty of fitness for purpose based on the original company’s actions in the absence of a disclaimer.

The Short Story

In 1998, Cardinal, a healthcare products company, began to develop an automated medication dispensing machine for hospital use.   To make this system work, Cardinal needed a special electrical connection for a container that would be repeatedly removed from and put back into the machine.   Because Cardinal did not have experience in designing or manufacturing electrical connectors, Cardinal contacted T&B, which had substantial expertise in this field.   T&B presented Cardinal with a proposed design drawing for a connector based on Cardinal’s stated requirements.

T&B entered into a contract with Cardinal to sell one million connectors to Cardinal at $1.17 each.   T&B agreed that the connectors would be “free of defects in material and workmanship.”  The written requirements included: “mechanical life 50,000 cycles” and specified gold plating in the contact area.   Cardinal expected to hire a contract manufacturer to build the product that would use the connectors.   T&B expressly agreed to “honor [the $1.17 price] for the . . . authorized contract manufacturer” chosen by Cardinal.   T&B delivered 85,000 connectors directly to Cardinal.   After Cardinal selected Remec (a contract manufacturer) to assemble the product that required the connectors, Cardinal then “canceled” its agreement with T&B and entered into a new agreement with Remec, the contract manufacturer, for the supply of the completed product.   The contract manufacturer then entered into a separate agreement with T&B for the supply of the remaining approximately 900,000 connectors.

In May 2000, Cardinal began selling the machines to hospitals for $65,000 each.   At about the same time, Tyco purchased the electrical connector division of T&B (just the division, not the entire company).   Cardinal learned of this fact when a Tyco employee formerly employed by T&B informed a Cardinal employee responsible for the product that the acquisition had occurred and that “nothing changes until we tell you further.”  Cardinal’s relationship with Tyco was the same as its relationship with T&B before the acquisition.   T&B continued to exist, manufacturing and selling other electrical products.

Shortly after the acquisition, Tyco entered into an agreement with the contract manufacturer for the sale of the connectors, who purchased the connectors directly from Tyco, and then incorporated them in the product and delivered the product to Cardinal.   Tyco adopted all of the specifications and design drawings that had been negotiated between Cardinal and T&B.   Tyco manufactured the connectors in the same manner as had T&B, used the custom-made tools T&B had created for the manufacturing process and charged the same price.

Within the year, hospitals began notifying Cardinal they were experiencing problems with the machines.   After an extended investigation, and based on the report of an expert, Cardinal concluded the problems were the result of intermittent electrical connections caused by insufficient gold plating on the bottom portions of the pins, making them prone to internal corrosion and electrical connection failures.   Cardinal sent a copy of the expert’s report to Tyco.   Tyco never indicated any disagreement with the report’s findings.

Cardinal decided to replace the connectors and contracted with a different company for the manufacture of a connector with a new design to use as a replacement connector.   Cardinal decided that it would not replace all of the Tyco/T&B connectors with this new connector.   Instead, it decided it would replace only those connectors on products that had a “failure” rate of one percent or higher.

In November 2004, Cardinal filed an action against Tyco, T&B, and the contract manufacturer to recover its costs for replacing the connectors.

T&B’s Statute of Limitations Defense

T&B contended the lawsuit was barred by the four-year limitations period of California Uniform Commercial Code section 2725.   The court of appeal agreed.

The last time the T&B connectors were delivered to Cardinal had been in July or August 2000, and Cardinal did not file the action against T&B until more than four years later, in November 2004.

Future Performance Exception

Under Commercial Code §2725, the general limitations rule for a breach of warranty cause of action is four years from the date the goods are delivered (regardless of the date the buyer discovers the breach), unless the “warranty explicitly extends to the future performance of the goods and discovery of the breach must await the time of such performance .   .   .   .” (§2725, subd. (2).)  If the exception applies, the accrual date is the time the breach “is or should have been discovered.”

Cardinal argued that specification in the 1998 agreement that the connectors have a “mechanical life” of 50,000 cycles was a warranty extending to “future performance” and thus the exception applied.   The court rejected this argument, noting that the scope of the “future performance” exception has been the subject of numerous, and sometimes conflicting, decisions throughout the country.   But the majority (and California) view is that the exception must be narrowly construed and that it applies only when the seller has expressly agreed to warrant its product for a specific and defined period of time.

The promise about the mechanical life of the connectors does not specify a date or time in the future, nor did the 50,000-cycle warranty pertain to a time period that could be determined by reference to an external source.   Because a “mechanical cycle” means the number of times a particular connection is opened, both the beginning and end of the 50,000-cycle period were entirely within Cardinal’s control.   Both could occur within months of delivery, or—as Cardinal’s counsel asserted during a closing argument—may not occur for 7 years or 10 years or 25 years.   Cardinal’s engineer characterized the 50,000-cycle requirement as a durability requirement, rather than a warranty defining a specific time period.   This evidence and argument reflected the vague and indefinite time period of the warranty.

Cardinal argued that T&B’s 50,000-cycle warranty extended to future performance because the 50,000 cycles could not be performed at the time of delivery.   However, the courts have rejected the argument that a warranty necessarily extends to future performance merely because it contains promises regarding the manner in which the goods will perform after the tender of delivery.   The same argument applies to nearly all warranties.

Considering the nature of this transaction and the fact that Cardinal and T&B were sophisticated commercial businesses, the court said that the parties knew how to draft plain language in an agreement to “explicitly” state duration of the warranty to ensure the limitations period would extend beyond the four-year period if the breach was not discovered during that time.   The court “necessarily” assumed that by failing to do so the parties did not intend to extend the limitations period.   Given the lack of any specific basis to determine when the 50,000 cycles would occur, this warranty did not fall within the “future performance” exception.

Krieger case

The court distinguished Krieger v. Nickell Alexander Imports, Inc. (1991) 234 Cal.App.3d 205.   In Krieger, the warranty (for an automobile) stated the defendant would repair defects for 36 months or the first 36,000 miles, whichever occurs first—thus creating a defined three-year outer limit for the warranty period.   Moreover, there was a promise to repair the vehicle during the warranty period.   The Krieger court stated: “A promise to repair defects that occur during a future period is the very definition of express warranty of future performance ….” Here, T&B’s warranty did not include a similar promise to repair.

Possibility of Discovery of Defect

The court additionally concluded the “future performance” exception does not apply for a separate reason.   For the exception to apply, the circumstances must be such that “discovery of the breach must await” the time of the promised future performance.   Courts have interpreted this requirement to mean the discovery of the breach “must ‘necessarily await’ such future performance.”  In this case, Cardinal could have discovered the defective pins in the connectors soon after the machines were delivered and thus would know they would not work as promised.   The determinative fact, for purposes of the “must await” requirement, is that discovery is “possible prior to any specific future time.”  The undisputed circumstances, in this case, show that it was possible to test the machines and determine the defect prior to waiting for 50,000 mechanical cycles.

Tolling Argument Based on Repair Efforts

Cardinal contended the parties’ repair efforts tolled the statute of limitations.   Although a defendant’s repair efforts can toll the §2725 limitations period, here there were no facts showing T&B engaged in any repair efforts.    Although Tyco worked with Cardinal in an attempt to test the connectors and identify the problems, T&B was not involved in this activity.

Tolling during a period of repairs generally rests upon the same legal basis as does estoppel to assert the statute of limitations, i.e., reliance by the plaintiff on the words or actions of the defendant that repairs will be made.   Accordingly, repair by third parties does not involve reliance upon the defendant in any way and furnishes no basis for tolling.

Moreover, even if Cardinal could rely on Tyco’s conduct to toll the limitations period as to T&B, there was no evidence that Tyco attempted to repair the connectors.   Tyco assisted in Cardinal’s efforts to determine why some connectors were failing.   But the investigation is different from repair.   The court did agree that a limitations period is tolled while a defendant assists the plaintiff with an investigation as to the cause of the problems with the product.

Implied Warranty Claim

Cardinal’s implied warranty claim was barred for the same reason that the express warranty claim was barred.   Because an implied warranty is one that arises by operation of law rather than by an express agreement of the parties, courts have consistently held it is not a warranty that “explicitly extends to the future performance of the goods…”

Breach of Contract Claim

Cardinal argued that the rule that by the terms of  §2725, the rule that accrual of a cause of action for breach of warranty arises upon tender of the goods by the seller applies only to breach of warranty claims and that it does not apply to breach of contract claims.   The court of appeal did not agree and held that a breach of contract claim based solely on a breach of warranty is governed by the statute of limitations set forth in §2725.

Failure to Give Notice of Breach

To recover on a breach of a warranty claim, the buyer must, within a reasonable time after he or she discovers or should have discovered any breach, notify the seller of any breach or be barred from any remedy (quoting from § 2607(3)(A)).   This statutorily required notice requirement is designed to allow the seller the opportunity to repair the defective item, reduce damages, avoid defective products in the future, and negotiate settlements.   The notice also informs the seller of the need to preserve evidence and to be prepared to defend against the suit and protects against stale claims.

Cardinal conceded it did not notify T&B of the alleged breach of warranty until it filed the lawsuit.   Cardinal argued it gave T&B adequate notice of the breach, however, when it sent Tyco a copy of the expert’s failure analysis report in May 2002.

There was no evidence of any connection between T&B and Tyco in May 2002, almost two years after T&B had sold its electronics division to Tyco.   There is no authority that notice to one company constitutes notice to another separate company merely because the second company acquired a portion of the first company’s assets.   There was no reasonable basis for Cardinal, a sophisticated commercial entity, to believe that Tyco had any legal obligation or would voluntarily assume the responsibility of informing T&B of the fact that Cardinal believed T&B had breached its warranty obligations and intended to hold T&B responsible for its damages.

Vertical Privity

Tyco argued that there was no privity of contract between Cardinal and Tyco to support the sole cause of action against Tyco: breach of the implied warranty of fitness for a particular purpose.

Privity is generally not required for liability on an express warranty because it is deemed fair to impose responsibility on one who makes affirmative claims as to the merits of the product, upon which the remote consumer presumably relies.   But where the subject of the action is an implied warranty—i.e., one that is implied in law and did not originate from the manufacturer’s own statements or conduct—there is no similar justification for imposing liability on a defendant in favor of every remote purchaser.

The implied warranty of fitness for a particular purpose is a warranty implied by law when a seller has reason to know that a buyer wishes goods for a particular purpose and is relying on the seller’s skill and judgment to furnish those goods.   Vertical privity is a prerequisite in California for recovery on a theory of breach of the implied warranty of fitness unless an exception applies.   “Vertical privity” means that the buyer and seller were parties to the sales contract.   There is no privity between the original seller and a subsequent purchaser who is in no way a party to the original sale.

Although the court agreed that vertical privity is a necessary element of an implied warranty claim, it concluded the circumstances, in this case, came within the “direct dealings” exception to the privity requirement set forth in U.S. Roofing, Inc. v. Credit Alliance Corp. (1991) 228 Cal.App.3d 1431.

Direct Dealings Exception to Privity

In U.S. Roofing, a roofing contractor needed a crane for a roofing job and negotiated with a crane supplier for the purchase of a crane.   The supplier suggested the contractor enter into a lease agreement with a third party as a financing method to obtain tax and other financial savings.   Relying on this recommendation, the contractor entered into a lease agreement with a third-party lessor.   After experiencing problems with the crane, the contractor brought a lawsuit against the supplier, alleging breach of warranty and other claims.   The U.S. Roofing court said that there was considerable evidence of direct dealings between the supplier and the contractor for the purchase of the crane.

These parties had an oral agreement for the sale of the crane, supported by a deposit.   The supplier admitted it made at least one express warranty as to the crane.   When the contractor experienced problems with the crane, the contractor contacted the supplier for relief.   Repairs on the crane were arranged and paid for by the supplier.   Based on that, the U.S. Roofing court held that the jury could find the necessary privity.

The court of appeal in the present case ruled that this case sufficiently resembled U.S. Roofing to allow a finding of privity.   It went through a two-step process.

The Tyco Two-Step

First, the court noted that T&B and Cardinal directly negotiated the sale of the connectors and set forth their contractual arrangement in the 1998 agreement.   At the time, T&B knew that Cardinal would select a contract manufacturer to purchase the connectors from T&B and to assemble the product.   T&B accepted this arrangement by specifically agreeing to sell the connectors to the contract manufacturer (to be named) at the same price and essentially agreed that it would sell the connectors in the exact same design, materials, and size as the Cardinal/T&B agreement specified, which is in fact did.   The court had no problem finding that T&B had sufficient vertical privity with Cardinal to support an implied warranty cause of action even after the 1998 agreement was canceled and the contract manufacturer took over as the purchaser.

But Cardinal’s claim was against Tyco.   Here’s the second step.   When Tyco purchased T&B, Tyco made clear to Cardinal that nothing had changed, and “things would be business as usual.” Tyco then specifically adopted the T&B/Cardinal design for the connectors, and Tyco used the manufacturing tools Cardinal paid for as part of the T&B contract to supply the connectors under the same terms of the purchase order that had been binding on T&B.   All parties understood Tyco would manufacture the connectors, in the same manner, agreed to by T&B.   Thereafter, Tyco’s and Cardinal’s employees regularly discussed purchasing and production issues.   Tyco and Cardinal then jointly acted to investigate the cause of the connector problems.

The court said that the contract manufacturer essentially carried out the ministerial duties of issuing purchase orders to Tyco and paying for the connectors (for which Cardinal reimbursed the contract manufacturer) at the price Cardinal had negotiated in the 1998 agreement.

The court stated that where a supplier affirmatively engages in conduct directly with the purchaser that functionally places the party in the position of the direct seller, it is fair to imply a warranty that the goods will be fit for the buyer’s purposes (if all other elements of the claim have been established).    Moreover, given its close and continuing relationship with Cardinal, who was the sole purchaser of the connectors, Tyco could have protected itself by taking some affirmative action, such as by notifying Cardinal that it was not providing any form of warranty that the connectors would be fit for use in the product.   Under all the circumstances, the court found that Tyco’s actions brought itself into “privity” with Cardinal for purposes of the breach of an implied warranty claim.

Reliance on Skill and Judgment

Tyco argued that Cardinal could not have relied on Tyco’s skill and judgment because Tyco was not involved with Cardinal in any of the negotiations for the sale of the connectors.   Cardinal had jointly designed the connectors with T&B (not Tyco) before Tyco purchased T&B’s electronics division.   To establish a breach of an implied warranty of fitness for a particular purpose under §2315, the buyer must establish he or she relied on the seller’s skill or judgment to “select or furnish” suitable goods.   After Tyco purchased T&B’s electrical division and took over manufacturing the connectors according to T&B’s drawings, Cardinal then relied on the skill and judgment of Tyco to furnish connectors suitable for Cardinal’s product.   Cardinal did not stop relying on the manufacturer to “furnish suitable” connectors just because Tyco took over the production through its acquisition of T&B’s connector division.

Lessons Learned

Section 2607(3)(A) of the California Commercial Code provides that “Where a tender has been accepted … [t]he buyer must, within a reasonable time after he or she discovers or should have discovered any breach, notify the seller of breach or be barred from any remedy ….” In other words, speak up promptly or forever hold your peace! Whether or not a buyer of goods wishes to make a claim for breach of warranty, when the buyer discovers a defect, the buyer should nonetheless give the seller prompt notice of the defect.  And the notice should be in writing, of course.

When the buyer requires a performance warranty (a warranty that the goods will perform in a certain way) and a failure to perform in accordance with the specifications may not occur within four years, the buyer should negotiate for an extended period of time to report defects and a promise to cure.

While some lawyers might suggest that another lesson learned is that a buyer of a business should disclaim responsibility for the seller’s prior transactions with its customers, that’s usually not practical. The better course is for the buyer of the business to negotiate representation and warranty from the seller (and corresponding indemnity clause) that will require the seller of the business to reimburse the buyer of the business for any warranty work needed to honor the seller’s warranties to the customers.

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Out-of-State Partnership Required to File in California because of Pass-Through Income

LCP VII Holdings LP was a foreign partnership with interests in entities both inside and outside of the United States, and it had California-source income from pass-through entities. It did not file tax returns in California on the basis it was not doing business in California.

After the Franchise Tax Board (FTB) sent the partnership a demand for tax return and the partnership did not timely respond, the FTB issued a notice of proposed assessment of tax, penalties, and interest. The partnership then filed tax returns for the years 2011 through 2014. Those tax returns reported California-source income of $667,798 from pass- through entities for 2011 and California-source income of more than $5 million for the years 2012 through 2014. After the partnership paid the $800 annual tax as well as the late-filing penalty with interest, it filed a claim for refund for the penalties and interest, which the FTB denied. The partnership appealed to the Office of Tax Appeals. 2019 OTA 399 (Nov. 19, 2019).

The partnership asserted that it was only a limited partner in pass-through entities, it was not registered to do business in California, and it did not operate any California trade or business. The partnership therefore claimed that the failure to timely file was due to reasonable cause in that it believed that it was not “doing business” in California within the meaning of Revenue & Taxation Code section 23101 and under the California Court of Appeals decision in Swart Enterprises, Inc. v. Franchise Tax Bd. (2017) 7 Cal.App.5th 497. (The Swart case was discussed in this blog, and the reader can click on the link at the end of this post to go to that blog post.)

While the partnership was not “doing business” in California within the meaning of Swart, the case was based upon the test for “doing business” in Revenue & Taxation Code section 23101(a). The Revenue & Taxation Code contains an alternative test in section 23101(b) (sometimes called the economic nexus test), which Swart did not address.

Sales Test

Under Revenue & Taxation Code section 23101(b)(2), if a taxpayer has sales in California for the applicable tax year that exceed the lesser of $500,000 or 25% of the taxpayer’s total sales, the taxpayer is deemed to be “doing business” in California. The $500,000 figure is adjusted annually for inflation after 2011.

As the Office of Tax Appeals found that the partnership had California-source income that exceeded the $500,000 level (as adjusted for inflation), it held that the partnership should have known that it was subject to filing in California. It said that the partnership “did not exercise ordinary business care and prudence when it failed to acquaint itself with the California tax law requirements.” The Office of Tax Appeals found the partnership did not show reasonable cause for filing its tax returns late and upheld the penalties.

In addition to the sales test, Revenue & Taxation Code section 23101(b) contains a property test and a compensation test, either of which is also sufficient to constitute doing business in California.

Property Test

If the value of the taxpayer’s real property and tangible personal property in California exceeds 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.

Compensation Test

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.

The figures above for the property test and the compensation test are as of 2011. As is the case with the sales test, the statute provides for annual adjustment of these figures for inflation. The 2019 figures are $601,967 for the sales test, $60,197 for the property test, and $60,197 for the compensation test.

Swart Case

Click here the blog post on the Swart case.

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Richard Burt Selected as a 2019 Top-Rated Lawyer

I was informed by the National Law Journal that I was selected as a 2019 Top Rated Lawyer for a special section to be published by it highlighting the West Coast’s Top Rated Lawyers. I would be impressed by my selection if it weren’t for the fact that to be listed in that special selection one has to pay!

But selection appears not to be strictly on the basis of selling an advertising listing as the National Law Journal claims that it works exclusively with AV Preeminent® firms and attorneys for this listing. As mentioned on the Peer Review Rating page of this website, I have had an AV® Peer Review Rating continuously since 1989. Martindale-Hubbell is the facilitator of this peer review rating process. Ratings reflect the confidential opinions of members of the Bar and the Judiciary. The AV® rating is the highest bestowed by Martindale-Hubbell.

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California Corporations Code Not Applied to Avoid Dissolution of Foreign Entities

When an action is brought to dissolve a California limited partnership or a California limited liability company, the California Corporations Code allows the other partners or the other members to avoid the dissolution by purchasing, for cash, the interests owned by the party seeking dissolution.

Corp C § 15908.02(b) is the provision that applies to limited partnership); Corp C § 17707.03 (c)( l) is the provision that applies to limited liability companies. These provisions are referred to here as the statutory buy-out provisions.

In Boschetti v. Pacific Bay Investments Inc. (Mar. 7, 2019), the court of appeal held that the statutory buy-out provisions of California law cannot be used to avoid dissolution of limited liability companies or of liability partnerships formed under the laws of other states, even if the owners of such entities have substantial ties to California.

There is also a statutory buy-out provision in the Corporations Code that allows other shareholders of a California corporation to avoid dissolution sought by a shareholder, but that provision was not involved in the case. There is no statutory buy­-out provision that applies to an action to dissolve a general partnership.

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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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