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Selected Developments In Business Law Courtesy of CEB — Financing and Protecting California Businesses

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 February 2019 update to Financing and Protecting California Businesses.  References are to the book’s section numbers.  See CEB’s BLS Landing Page for special discounts for Business Law Section members.  The most significant legal developments since the last update include developments in such important topic areas as start-up financing, going public, securities law, lending transactions, insurance, cybersecurity, and tax law.

Start-up Financing; Private Placements

Simple Agreements for Future Equity (SAFEs) are a recent development in start-up financing, pioneered by Y Combinator, a Silicon Valley venture capital firm specializing in seed financing. See SAFEs are intended as an alternative to convertible debt (see §4.25), but are not debt instruments. Under a SAFE, an investor makes a cash investment in a start-up but does not receive stock in the company until the occurrence of an event specified in the agreement. The amount of stock that the investor will be entitled to receive is not fixed at the time the SAFE is executed, but rather is subject to a negotiated valuation cap specified in the SAFE. Typically, the SAFE terminates automatically and the investor receives preferred stock when the company offers preferred stock to other investors in a so-called priced round. Other events that will terminate the SAFE and trigger issuance of stock to the investor typically include change-of-control transactions, IPOs, or dissolution of the company. Because SAFEs are not debt instruments, they are not senior to the founders’ equity and no interest accrues on them. See §§4.25A, 17.3.

In SEC v Schooler (9th Cir, Sept. 26, 2018, No. 16-55167) 2018 US App Lexis 27449, the Ninth Circuit ruled that a series of offerings of general partnership interests made over a period of more than 30 years were integrated, even though they were not made at the same time; the offerings therefore failed to qualify for a Securities Act exemption. See §6.11.

In July 2018, the SEC adopted an amendment to Rule 701 increasing the dollar threshold that triggers the disclosure requirement from $5 million to $10 million. See Securities Act Release No. 33–10520 (July 18, 2018). See §6.26.

Issuers filing a notice on Form D with the commissioner in lieu of a Notice of Transaction may file by mail or electronically either through the California Department of Business Oversight’s DOCQNET (Document Quality Network) at or through the North American Securities Administrators Association, Inc. (NASAA) online electronic filing depository (EFD) (see §6.43). Cal Comm’r Corps Release No. 120-C (rev May 18, 2018); 10 Cal Code Regs §260.102.14(a)(2). See §§6.35, 19.74.

Fries v Northern Oil & Gas, Inc. (SD NY 2018) 285 F Supp 3d 706 is a good example of a court’s unwillingness to impose Rule 10b–5 liability for omissions of material facts that are not necessary to make the statements made, in the light of the circumstances under which they were made, not misleading. See §6A.2.

Smaller Reporting Companies

Paragraph (d) of Item 303 (17 CFR §229.303)(d)) provides that a smaller reporting company, as defined by §229.10(f)(1), may provide the information required in paragraph (a)(3)(iv) of Item 303 for the last 2 most recent fiscal years of the registrant if it provides financial information on net sales and revenues and on income from continuing operations for only 2 years. A smaller reporting company is not required to provide the information required by paragraph (a)(5) of Item 303. See §§6A.28, 6A.30.

Regulation S-K, Items 301–302 (17 CFR §§229.301–229.302) guide the drafter to include designated financial information for each of the last 5 fiscal years (or for the life of the company and its predecessors, if less) and, if applicable, any additional fiscal years necessary to assure that the information is not misleading. However, if the company qualifies as a smaller reporting company, as defined in 17 CFR §229.10(f)(1), the company is not required to provide the information required by this item. A smaller reporting company is defined in Item 10(f)(1) of Regulation S-K (17 CFR §229.10(f)(1)) to mean an issuer that is not an investment company, an asset-backed issuer (as defined in 17 CFR §229.1101), or a majority-owned subsidiary of a parent that is not a smaller reporting company and that

  • Had a public float of less than $75 million as of the last business day of its most recently completed second fiscal quarter, computed by multiplying the aggregate worldwide number of shares of its voting and nonvoting common equity held by nonaffiliates by the price at which the common equity was last sold, or the average of the bid and asked prices of common equity, in the principal market for the common equity; or
  • In the case of an initial registration statement under the Securities Act or Exchange Act for shares of its common equity, had a public float of less than $75 million as of a date within 30 days of the date of the filing of the registration statement, computed by multiplying the aggregate worldwide number of such shares held by nonaffiliates before the registration plus, in the case of a Securities Act registration statement, the number of such shares included in the registration statement by the estimated public offering price of the shares; or
  • In the case of an issuer whose public float as calculated under paragraph (i) or (ii) of this definition was zero, had annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available. 17 CFR §229.10(f)(1).

Whether or not an issuer is a smaller reporting company is determined on an annual basis. 17 CFR §229.10(f)(2). Additional exceptions to this disclosure requirement are provided for emerging growth companies, as defined in Rule 405 of the Securities Act of 1933 or Rule 12b–2 of the Securities Exchange Act of 1934. See §6A.40.

In June 2018, the SEC revised the definition of “smaller reporting company” to include companies with a public float of greater than $75 million but less than $250 million. This amendment increased the number of companies that benefit from the scaled disclosure accommodations available to SRCs. The amendment did not, however, change the threshold to qualify as an “accelerated filer” as defined in Exchange Act Rule 12b–2 (17 CFR §240.12b–2). Consequently, a company with $75 million or more of public float that qualifies as a smaller reporting company will be subject to the requirements that apply to an “accelerated filer” as long as its public float is greater than $75 million, including the accelerated deadlines for filing periodic reports and the requirements that it provide the auditor’s attestation of management’s assessment of the effectiveness of internal controls over financial reporting required by §404(b) of the Sarbanes-Oxley Act (15 USC §7262), its Internet address and disclosure regarding the availability of its filings required by Items 101(e)(3) and (4) of Regulation S-K (17 CFR §§229.101(e)(3) and (4)), and the disclosure required by Item 1B of Form 10-K about unresolved staff comments on its periodic or current reports. On August 10, 2018, the SEC published a helpful guide for smaller reporting companies, titled A Small Entity Compliance Guide for Issuers, available at here. See §17.14.

Lending Transactions; Usury Issues

If the London Interbank Offered Rate (LIBOR), rather than the bank’s reference rate, is the index rate used by the bank, ensure there are provisions that address the phase-out of LIBOR expected to occur by 2021. The promissory note or loan agreement should address how interest will be calculated when LIBOR is no longer available and how the transition to an alternate rate will be achieved. See §8.16.

If the person nominally making the loan does not have its own money at risk because another unlicensed person has committed to buy the loan, in some circumstances the other person may be treated as the “lender” for usury and other purposes. See Consumer Fin. Protection Bureau v CashCall, Inc. (CD Cal, Aug. 31, 2016, No. CV 15-7522-JFW (RAOx)) 2016 US Dist Lexis 130584. See §8.16.

In addition to potential usury issues for a lender, the interest rate on a loan, if too high, can be unconscionable under the standard tests for unconscionability. See De La Torre, et al. v CashCall, Inc. (2018) 5 C5th 966. In that case, the California Supreme Court held that the interest rate on certain consumer loans can render loans unconscionable under Fin C §22302. A loan found to be unconscionable is a violation of the California Financing Law (Fin C §§22000–22780) and is subject to the remedies specified in the California Financing Law. In addition, a violation of the California Financing Law could trigger a claim under California’s Unfair Competition Law (Bus & P C §§17200–17210) as was claimed in CashCall. See §8.16.

Even though foreign parties to a contract may voluntarily choose California law for the resolution of their disputes and a party to the contract cannot later claim forum non conveniens, a court has the statutory authority to decline to exercise its jurisdiction in circumstances where California has no public interest in burdening its courts in an action that lacks any identifiable connection to the state. See Quanta Computer Inc. v Japan Communications Inc. (2018) 21 CA5th 438, 444. See §8.86.

For a comprehensive chart of the California usury law exemptions, see §8.89.

Insurance Issues

Because CGL policies typically do not provide coverage for professional negligence claims, they often contain exclusions for loss resulting from the rendering of or failure to render professional services. Energy Ins. Mut. Ltd. v Ace Am. Ins. Co. (2017) 14 CA5th 281, 292. See §11.14.

If an insurer has denied coverage or breached its duties, it may not be able to rely on a consent condition as a coverage defense. See, e.g., Teleflex Med. Inc. v National Union Fire Ins. Co. (9th Cir 2017) 851 F3d 976, 986 (“when a primary insurer wrongfully denies coverage, unreasonably delays processing a claim, or refuses to defend an action against the insured as required by the policy, the insured is entitled to make a reasonable settlement of the claim in good faith and then sue for reimbursement, even though the policy prohibits settlements without the consent of the insurer” (citations omitted)). See §11.21.

A liability policy is presumed to include a duty to defend unless the carrier can introduce undisputed evidence that there is no potential for coverage. Street Surfing, LLC v Great Am. E&S Ins. Co. (2014) 752 F3d 853, 857. However, the facts known or alleged must “fairly apprise” the insurer that the suit is or could be one on a covered claim; there is no duty to defend if the potential for liability is “tenuous and farfetched.” All Green Elec., Inc. v Security Nat’l Ins. Co. (2018) 22 CA5th 407, 416 (no duty to defend; no allegations or extrinsic facts that could give rise to liability). See §11.41.

In Pulte Home Corp. v American Safety Indem. Co. (2017) 14 CA5th 1086, 1113, the court ruled that the existence of a duty to defend turns on facts known by insurer at the inception of the third party lawsuit. See §11.41.


Ransomware is a type of malicious software that infects and locks down access to a computer to deny the owner’s use until a ransom is paid. Ransomware typically infects the host computer through phishing e-mails and exploits unpatched security vulnerabilities in software. See here. In 2017, Microsoft estimated that the “Wanna Cry” ransomware variant was found in over 150 countries and infected over 300,000 computers across 100,000 businesses in multiple industries including retail, manufacturing, transportation, healthcare, and finance. See here. See §13.1.

In In re Facebook Internet Tracking Litig. (ND Cal 2017) 263 F Supp 3d 836, the court dismissed class action litigation accusing Facebook of tracking its users’ Internet activity. Plaintiffs alleged that Facebook’s cookies allowed it to identify users and correlate their identities with their browsing activity even when they were logged out of Facebook. The court held that Title II of the Electronic Communications Privacy Act of 1986 (18 USC §§2701–2712), known as the Stored Communications Act (SCA), did not apply to Facebook’s cookies because they are information in local storage on a user’s computer, rather than information that is temporarily stored “‘incident to [the] transmission’ of a communication.” 263 F Supp 3d at 845. In addition, the court held that personal computers are not “facilities” under the SCA through which an electronic communications service is provided. 263 F Supp 3d at 845. See §13.11.

The National Institute of Standards and Technology (NIST) has provided guidance on security and privacy controls for devices connected to the Internet (the so-called Internet of Things) in both the public and private sectors. It has listed technical and procedural safeguards designed to protect individuals, organizations, and systems when creating or operating “smart” devices. See Due to the lapse in government funding, and all associated online activities will be unavailable until further notice. See §13.14A.

Tax Matters

If a patent holder exercises control over a transferee corporation with the result that there is no effective transfer of all substantial rights in the patent, the requirements of IRC §1235 are not met, even if the documents describing the transfer formally assign all substantial rights. “The key inquiry remains whether, as a practical matter, the transferor shifted all substantial rights to the recipient.” Cooper v Comm’r (9th Cir 2017) 877 F3d 1086, 1092 (taxpayer did not transfer all substantial rights to patents to corporation because taxpayer retained right to retrieve ownership of patent at will). See §3.8.

Practitioners should note that as a result of the 2017 Tax Cuts and Jobs Act, research and experimental costs paid or incurred in tax years beginning in 2022 may no longer be deducted as current expenses and must instead be amortized over a 5-year period. There is an exception for research and experimental costs attributable to foreign research (within the meaning of IRC §41(d)(4)(F)), which must be amortized over a 15-year period. See §15.14.

The 2017 Tax Cuts and Jobs Act added a provision, under IRC §83(i), that allows a qualified employee to elect to defer the inclusion in income of the amount of income attributable to qualified stock transferred by the employer to the employee. Specifically, if qualified stock is transferred to a qualified employee and the employee timely makes an IRC §83(i) election with respect to the stock, then the income with respect to the stock is included in the employee’s income in the tax year that includes the earliest of the following (rather than included in income when required by IRC §83(a)):

  • The first date the qualified stock becomes transferable (including, solely for this purpose, becoming transferable to the employer);
  • The date the employee first becomes an excluded employee (defined below);
  • The first date on which any stock of the corporation that issued the qualified stock becomes readily tradable in an established securities market;
  • The date that is 5 years after the first date the employee’s rights in the stock are transferable or aren’t subject to a substantial risk of forfeiture, whichever occurs earlier; or
  • The date on which the employee revokes (at the time and in the manner that the IRS provides) the IRC §83(i) election with respect to the stock.

See IRC §83(i)(1)(B)(i)–(v). See §§15.18, 15.20.

On June 21, 2018, the United States Supreme Court issued its decision in South Dakota v Wayfair, Inc. (2018) 585 US ___, 138 S Ct 2080. Under Wayfair, a retailer may have a substantial nexus with California without having a physical presence in the state. Beginning April 1, 2019, retailers located outside of California are required to register with the California Department of Tax and Fee Administration (CDTFA), collect the California use tax, and pay the tax to the CDTFA based on the amount of their sales into California, even if they do not have a physical presence in the state. The new collection requirement applies to a retailer if during the preceding or current calendar year:

  • The retailer’s sales into California exceed $100,000, or
  • The retailer made sales into California in two hundred (200) or more separate transactions.

The new collection requirement will apply to taxable sales of tangible personal property to California consumers on and after April 1, 2019, and is not retroactive. Retailers reaching either of the above sales thresholds are now required to register with the CDTFA to collect the California use tax even if they were not previously required to register. These retailers include retailers that sell tangible goods for delivery into California through the Internet, mail-order catalogs, telephone, or any other means. See §16.35.

Reporting Obligations; Going Public Transactions

Effective September 10, 2018 (per SEC Release No. 33–10513), financial statements for the earliest of the 3 years before an acquisition may be omitted if the net revenues of the acquired business in the most recent fiscal year are less than $100 million. This threshold was raised from $50 million. In recent years, the SEC has also begun to grant waivers more liberally for target company financial statements that are difficult or impossible to obtain. See §17.5.

Spotify Technology S.A. went public on April 3, 2018, through a “direct listing” of its shares on the New York Stock Exchange. A direct listing is a newly developed structure that provides certain companies with an alternative to a traditional IPO for going public. In a direct listing, a company’s outstanding shares are listed on a stock exchange without either a primary or secondary underwritten offering. Existing shareholders, such as employees and early-stage investors, become free to sell their shares immediately on the stock exchange. Because a direct listing does not require participation of an underwriter, certain features of a traditional IPO—such as lock-up agreements and price stabilization activities—are not present in a direct listing. The success of Spotify’s direct listing was due in part to the following factors: (1) Spotify was a well-capitalized company with no need to raise additional capital; (2) it had a large and diverse shareholder base that could provide sufficient supply-side liquidity on the first day of trading; (3) it had a well-recognized brand name and an easily understood business model; and (4) its founders, directors, and management were comfortable having no involvement in establishing the initial “price to public” of Spotify’s shares. A direct listing may not be appropriate for a company that does not share these characteristics. See §18.5A.

The 2018 voting guidelines of Institutional Investor Services Inc. (ISS), the influential proxy advisory company, provide that ISS will recommend a vote “against” or a “withhold from non-independent directors” when

  • Independent directors comprise 50 percent or less of the board;
  • The nonindependent director serves on the audit, compensation, or nominating committee;
  • The company lacks an audit, compensation, or nominating committee so that the full board functions as that committee; or
  • The company lacks a formal nominating committee, even if the board attests that the independent directors fulfill the functions of such a committee.

See the ISS United States Proxy Voting Guidelines at at 9. Glass, Lewis & Co. (Glass Lewis) has similar voting guidelines. See the 2018 U.S. proxy voting guidelines of Glass Lewis at here. See §18.42.

The Economic Growth, Regulatory Relief, and Consumer Protection Act (Pub L 115–174, 132 Stat 1296), which became law on May 24, 2018, directs the SEC to amend Regulation A (1) to allow reporting companies to offer securities in accordance with Regulation A and (2) to allow reporting companies utilizing Tier 2 offerings to satisfy Regulation A’s periodic reporting obligations by complying with their reporting obligations under Exchange Act §13 or §15(d). See §§19.12, 19.32.

The requirements for financial statements of businesses acquired or to be acquired are in Rule 3–05 and Art 11 of Regulation S-X (17 CFR §210.3–05). In September 2018, the SEC stated that financial statements for the earliest of the 3 years before an acquisition may be omitted if the net revenues of the acquired business in the most recent fiscal year are less than $100 million. Securities Act Release No. 33–10513 (June 28, 2018). In recent years, the SEC has also begun to grant waivers more liberally for target company financial statements that are difficult or impossible to obtain. See §20.13.

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