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

Warranty form in San JoseThe 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.

Warranty certificate in San JoseCardinal 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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Bad Corporate Practice Leads to Bad Result

Woman having a headache as a result of bad corporate practice in San JoseI 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

Bad corporate practice in San Jose led the man to have a headacheIn 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.

Posted in Business Disputes, Contract Drafting, Corporate Law, Covenant not to compete, Non-competes | Tagged | Comments Off on Delaware Court Upholds Non-Compete against California Employee

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.

Posted in Corporate Law, Entity Law, Limited Liability Comanies (LLC's), Limited liability companies (LLC), Suspended Entity | Comments Off on Administrative Dissolution of Corporations and LLCs Adopted in California