Selected Developments in Business Law — Counseling California Corporations

Courtesy of CEB, we are bringing you selected legal developments in areas of California business law that are covered by CEB’s publications.  This month’s feature is from the May 2023 update to Counseling California Corporations.  References are to the book’s section numbers. 

Counseling California Corporations

May 2023 Update

Exchange Act Rule 10b5–1(c) (17 CFR §240.10b5–1(c)) creates an affirmative defense from insider trading liability for purchases and sales in accordance with preplanned trading plans complying with Rule 10b5–1(c). The rule provides a defense for corporate insiders and companies to buy and sell company stock as long as the trading plan was adopted in good faith, before the company or the insiders became aware of any material nonpublic information. The rule was amended in 2023 to update the conditions that must be met for the affirmative defense to apply. See §3.24A.

In July 2022, the California Department of Fair Employment and Housing changed its name to the Civil Rights Department to more accurately reflect the Department’s powers and duties, which include enforcement of laws prohibiting hate violence, human trafficking, discrimination in business establishments, and discrimination in government-funded programs and activities, among others. See §3.51.

The Corporate Transparency Act (CTA) (Pub L 116–283, 134 Stat 4604) became law as of January 1, 2021, as part of the Anti-Money Laundering Act of 2020 (Pub L 116–283, Div F at §§6001–6511, 134 Stat 3388). It is codified in its entirety at 31 USC §5336. The CTA provides that it will become effective when implementing regulations are finalized by the Secretary of the Treasury. 31 USC §5336(b)(5). The first set of final regulations was issued on September 30, 2022, and is codified in 31 CFR Part 1010. See 87 Fed Reg 59498. Two more sets of regulations are in the works. Under 31 CFR §1010.380(a), “reporting companies” (as defined in 31 USC §5336(a)(11) and 31 CFR §1010.380(c)) created before January 1, 2024 will have until January 1, 2025 to submit the required reports to the Financial Crimes Enforcement Network (FinCEN) of the U.S. Department of the Treasury, while entities formed on or after January 1, 2024 must submit reports within 30 calendar days of the time they are formed or registered. Any change in ownership of the entity or in other information reported must be reported within 30 calendar days after the change. 31 USC §5336(b)(1); 31 CFR §1010.380(a). See §3A.1.

FinCEN expects that the definition of reporting companies will include (unless otherwise exempt) limited liability partnerships, limited liability limited partnerships, business trusts, and most limited partnerships in addition to corporations and LLCs. See FinCEN fact sheet dated September 29, 2022, available at https://www.fincen.gov/beneficial-ownership-information-reporting-rule-fact-sheet. See §3A.2.

The new CTA regulations detail the information required to be reported and include several helpful definitions of key terms, such as “substantial control” and “company applicant.” See §3A.3.

In September 2022, Deputy Attorney General Lisa Monaco stated that the U.S. Department of Justice will encourage companies to implement executive compensation models that reward good compliance governance and require companies to claw back compensation from executives found to have participated in, or contributed to, corporate criminal offenses. At the same time, Monaco called for an increased emphasis on timely document production and disclosures by cooperating companies, to enable prosecutors to promptly initiate related proceedings against implicated individuals. See https://www.justice.gov/opa/speech/deputy-attorney-general-lisa-o-monaco-delivers-remarks-corporate-criminal-enforcement. See §4.5.

On October 28, 2021, Deputy U.S. Attorney General Lisa Monaco announced revised corporate enforcement policies, stating that prosecutors now must consider all prior corporate conduct—not only similar conduct—in deciding whether to charge a corporation, thus signaling a tougher stance on corporate enforcement. See https://www.justice.gov/opa/speech/deputy-attorney-general-lisa-o-monaco-gives-keynote-address-abas-36th-national-institute. See §4.20.

On August 26, 2022, the SEC adopted two amendments to the rules governing its whistleblower program. The first rule allows the Commission to pay whistleblowers for their information and assistance in connection with non-SEC actions in some circumstances. The second rule affirms the Commission’s authority to consider the dollar amount of a potential award for the purpose of increasing an award but not to lower an award. See https://www.sec.gov/news/press-release/2022-151. See §4.40.

Discussing scienter, the court in In re VeriFone Holdings, Inc. Sec. Litig. (9th Cir 2012) 704 F3d 694, 701, stated that “[f]acts showing mere recklessness or a motive to commit fraud and opportunity to do so provide some reasonable inference of intent, but are not sufficient to establish a strong inference of deliberate recklessness.” See §6.44.

Proposition 22, approved by California voters in November 2020, and codified at Lab C §§7448–7467, excepts so-called app-based drivers from treatment as employees under the test for independent contractor status set forth in Dynamex Operations W. v Superior Court (2018) 4 C5th 903, 964. Proposition 22’s constitutionality was challenged, and Alameda County Superior Court Judge Frank Roesch ruled that Proposition 22 was unconstitutional and unenforceable. See Castellanos v State (Alameda Super Ct, Sept. 13, 2021, No. RG21088725), available at https://www.documentcloud.org/documents/21046832-castellanos-order. The defendants have appealed that decision. See Castellanos v State (Oct. 12, 2021, A163655). See §9.18.

Labor Code §2776 includes a retroactive business-to-business exception to the ABC test. Under that exception, Dynamex does not apply to a bona fide business-to-business contracting relationship if an individual acting as a sole proprietor, or a business entity formed as a partnership, limited liability company, limited liability partnership, or corporation (a “business service provider”) contracts to provide services to another such business. See Bowerman v Field Asset Servs., Inc. (9th Cir 2022) 39 F4th 652. See §9.18.

Effective January 1, 2023, amended Govt C §12999 and amended Lab C §432.3 require most California employers to comply with new recordkeeping and reporting requirements and expanded rules for disclosing pay scale information to job applicants and existing employees. All employers with 15 or more employees (including any employment agency retained by such an employer) must include the pay range for a position in any job posting. Employers are also required to provide employees with the pay range for the position the employee currently holds, in which the employee is currently employed, upon reasonable request. Private employers having 100 or more employees must submit certain pay data annually to the state Civil Rights Department. There are potentially significant civil penalties for violations. See §9.18.

There are numerous challenges and pitfalls in using a special purpose acquisition company (SPAC). For example, investors in a SPAC that acquired Michigan-based electric vehicle maker Electric Last Mile Solutions in 2021 brought suit in Delaware alleging multiple breaches of fiduciary duties by the CEO and CFO of the company, who were able to cash in on company stock they acquired at a discount but failed to disclose before the acquisition. The company’s auditor resigned in February 2022, the SEC opened an investigation in March 2022, and the company’s stock was later delisted from NASDAQ. The company now plans to file Chapter 7 bankruptcy. See https://www.cnbc.com/2022/06/13/ev-start-up-electric-last-mile-solutions-to-declare-bankruptcy.html. See §10.4.

On October 26, 2022, the SEC adopted a new rule, Exchange Act Rule 10D-1 (17 CFR §240.10D-1), that directs national securities exchanges to adopt listing standards that require all issuers to establish and enforce policies that claw back incentive-based compensation paid to corporate executives when that compensation is based on misreported financial information of the issuer that later requires an accounting restatement. Rule 10D-1 does not require that the executive officer subject to the clawback be found at fault for the error. It mandates that the clawback policies must apply to all current and former executive officers of a company. Rule 10D-1 also applies to smaller reporting companies, emerging growth companies, and foreign private issuers (an issuer is defined as any company listed on a national securities exchange). See https://www.sec.gov/news/public-statement/gensler-clawbacks-2021-10-14. See §10.7A.

In 2022, the Committee on Foreign Investment in the United States (CFIUS) issued its first ever penalty guidelines identifying three types of violations that may trigger penalties: (1) failure to notify CFIUS of a transaction that requires a CFIUS declaration or notice; (2) failing to comply with CFIUS mitigation, which are modifications that CFIUS may require of a proposed transaction to reduce national security threats; and (3) misleading CFIUS, either actively or through omission. CFIUS noted, however, that not all violations will result in penalties; CFIUS will weigh aggravating and mitigating factors as it determines the appropriate enforcement response in each case. See https://home.treasury.gov/policy-issues/international/the-committee-on-foreign-investment-in-the-united-states-cfius/cfius-enforcement-and-penalty-guidelines. See §10.11.

On October 31, 2022, a California federal jury found that Navient Corp. lacked cause to terminate a co-founder and CEO of a fintech startup acquired in 2017. Both sides of the acquisition relied on standard contracting language that did not provide protections desired by either party. In particular, Navient had inserted unachievable goals into the employment agreement, which the company unsuccessfully argued constituted cause to terminate the executive within 3 months after closing of the transaction. See https://www.law360.com/articles/1545125/navient-fired-exec-without-cause-after-buying-co-jury-says. See §10.13.

In two recent cases, the Los Angeles Superior Court invalidated Corp C §§301.3 and 301.4. See Crest v Padilla (LA Super Ct, Apr. 1, 2022, No. 20 STCV 3751); Crest v Padilla (LA Super Ct, May 13, 2022, No. 19 STCV 27561). Both trial courts concluded that the statutes treat similarly situated individuals—qualified potential corporate board members—differently based on their membership (or lack thereof) in certain listed racial, sexual orientation, and gender identity groups. The trial courts held that the use of suspect categories was not justified by any compelling interest, and because the statutes were not narrowly tailored to serve the interests offered, the statutes therefore violate the equal protection clause of the California Constitution (Cal Const art I, §7). The California Secretary of State has announced California’s plans to appeal the decisions. See §10.16B.

NASDAQ’s board diversity rules have been challenged in federal court. See, e.g., Alliance for Fair Bd. Recruitment v SEC (5th Cir, Aug. 10, 2021, No. 21-60626); National Ctr. for Public Policy Research v Weber (ED Cal, Nov. 22, 2021, No. 2:21 CV 02168). See §10.16B.

It is not unusual for privately held companies, as well as the directors and officers who manage them, to be sued in civil cases brought by investors, service providers, or other third parties. In the early 21st century, however, there has been an increasing trend for directors and officers and their companies to be charged with and convicted of crimes. On a finding of liability in civil cases, contractual and statutory indemnification and limitation of liability protections can make the defendants whole, but those protections are typically unavailable for a criminal conviction, especially for convictions of crimes that involve moral turpitude or that cause material harm to the company itself. See §10.29B.

In Friend of Camden, Inc. v Brandt (2022) 81 CA5th 1054, the California Court of Appeal applied legislative intent to differentiate between the treatment of corporations and LLCs in voluntary and involuntary dissolutions. The court noted that under Corp C §2000, if only 50 percent of the voting power of the corporation votes to dissolve, holders of the other 50 percent have the right to avoid dissolution by buying out those voting for dissolution. This provision stands in contrast to the statutory treatment of LLCs, in which a 50 percent vote to dissolve results in no buyout rights for dissenters. The court noted, “In short, the Legislature intended to treat the dissolution of corporations differently than the dissolution of LLCs.” 81 CA5th at 1064. See §11.77.