Business Law

Selected Developments in Business Law — 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 2020 update to Financing and Protecting California Businesses.  References are to the book’s section numbers.  The most significant legal developments since the last update include developments in such important topic areas as federal and state taxation, arbitration agreements, federal and state securities law, loan financing, intellectual property, and Internet law.

March 2020 Update

Small Business Financing Resources

The SBA, under §9 of the Small Business Act (15 USC §638), reserves a percentage of federal research and development funding for awards to small businesses and nonprofit research institutions. Participating federal agencies designate R&D topics and accept proposals from small businesses. Awards up to $1.6 million are made on a competitive basis after proposal evaluation. For further information, see https://www.sbir.gov/about/about-sttr. See §1.14.

California’s Jump Start Loan program, available through the Small Business Finance Center (SBFC), helps small businesses start, grow, and thrive. The program provides microloans, technical assistance, and financial literacy training. Small businesses or individuals starting a small business in California are eligible for loans from $500 to $10,000 on terms up to 5 years. For further information, see http://www.ibank.ca.gov/small-business-finance-center/. See §1.17.

Arbitration Agreements

In Ramos v Superior Court (2018) 28 CA5th 1042, the court found that an arbitration provision in an employment agreement was void and unenforceable as a matter of law because the employee did not have the opportunity to negotiate the provision. See §3.10A.

In Lamps Plus, Inc. v Varela (2019) ___ US ___, 139 S Ct 1407, the U.S. Supreme Court held that courts may not infer from an ambiguous agreement that the parties have consented to classwide arbitration. See §3.10A.

Bank Lending

In anticipation of the phase-out of the London Interbank Offered Rate (LIBOR), many lenders are already including fallback provisions in their loan agreements, adopting either an “amendment approach” or a “hardwired approach.” The Secured Overnight Financing Rate (SOFR) will most likely be the rate to replace LIBOR. For many loans, the ultimate fallback rate will be the prime rate or federal funds rate plus 500 basis points. See §8.16.

In East W. Bank v Altadena Lincoln Crossing, LLC (CD Cal 2019) 598 BR 633, reversing a bankruptcy court order, the federal district court for the Central District of California held that a default interest rate of 5 percent was valid and enforceable following the borrower’sfailure torepay a loan at maturity. Citing California Supreme Court precedent (Thompson v Gorner (1894) 104 C 168 and Garrett v Coast & S. Fed. Sav. & Loan Ass’n (1973) 9 C3d 731), the court concluded that the default interest provision should not be treated as a penalty under CC §1671(b), but rather as a contract to pay a higher rate of interest on the occurrence of one of the contingencies specified in the note, i.e., the failure to make payment of any sum when due. East W. Bank, 598 BR at 640. The court concluded that the default interest provision was a reasonable estimate of the harm to East West Bank that would occur on Altadena’s default because of the diminution in value of the loan as an asset of East West Bank. 598 BR at 643. See §8.18B.

The issue of whether a lender owes a tort duty of care to a borrower in connection with a mortgage loan modification is undecided under California law. In a recent decision, the court of appeals held that a lender does not owe a borrower a tort duty of care during loan modification negotiations and therefore that a lender has no common law duty to offer, consider, or approve a loan modification. See Sheen v Wells Fargo Bank, N.A. (2019) 38 CA5th 346. The court relied on the analysis and approach taken in the recent Supreme Court decision in Southern Cal. Gas Leaks Cases (2019) 7 C5th 391 (utility owed no tort duty of care to businesses that suffered purely economic losses; there were no claims for personal injury or property damage) and the Restatement of Torts. The court in Sheen also concluded that other bodies of law, such as breach of contract, negligent misrepresentation, promissory estoppel, and fraud are better suited to address contract negotiation issues. Sheen, 38 CA5th at 357. See §8.80.

Business Insurance

There has been considerable litigation over the scope of personal injury coverage. For example, in Albert v Truck Ins. Exch. (2018) 23 CA5th 367, the insured had been sued for abatement of private nuisance because he had erected a fence that partially blocked a road leading to the plaintiff’s undeveloped property. The insurer denied coverage. The insured sued, arguing that the policy’s “personal injury” coverage for “injury arising out of … wrongful entry … or invasion of the right of private occupancy” applied. 23 CA5th at 377. The court of appeal held that the insurer had a duty to defend its insured. It pointed out that “invasion of the right of private occupancy” is “a phrase ‘insurance companies have consistently refused to define,'” and one that “has ‘generated literally hundreds of lawsuits, with wildly varying results.” It then noted that it agreed with other courts that “invasion of the right of private occupancy’ is ambiguous and may include non-physical invasions of rights in real property.” 23 CA5th at 381 (citations omitted). It specifically rejected the insurer’s argument that there must be a physical invasion to trigger the personal injury coverage. 23 CA5th at 379. See §11.26B.

Even if one party acts intentionally, this does not mean that errors and omissions coverage necessarily is precluded. For example, in Liberty Surplus Ins. Corp. v Ledesma & Meyer Constr. Co. (2018) 5 C5th 216, the California Supreme Court considered whether a general liability policy covered a lawsuit alleging that an employer negligently hired, retained, and supervised an employee who sexually assaulted a student. The insurer argued that the insured’s intentional acts of hiring, supervising, and retaining were not “accidents.” 5 C5th at 231. The court disagreed. It rejected the argument that the intentional nature of the employee’s acts precluded coverage. “It is important to keep in mind that a cause of action for negligent hiring, retention, or supervision seeks to impose liability on the employer, not the employee.” 5 C5th at 223. The court pointed out that the employee’s “acts were neither expected nor intended” from the employer’s perspective, rejecting the notion that “negligent hiring cannot be an ‘accident.'” 5 C5th at 227. See §11.29.

Notwithstanding California law on the subject of an insured’s duty to reimburse the insurer for defense fees for defending causes of action that raise no potential for coverage, the American Law Institute approaches an insurer’s right to seek reimbursement from its insuredin a different manner. In its Restatement of the Law, Liability Insurance (2018), the Institute states:

Unless otherwise stated in the insurance policy or otherwise agreed to by the insured, an insurer may not seek recoupment of defense costs from the insured, even when it is subsequently determined that the insurer did not have a duty to defend or pay defense costs.

ALI, Restatement of the Law, Liability Insurance §21 at 182 (2018). The Institute notes that it is following “the emerging state-court majority rule that the insurer does not have a right of recoupment of defense costs unless this right is stated in the insurance policy or otherwise agreed to by the parties.” ALI, Restatement of the Law, Liability Insurance §21, comment a at 183 (2018). See §11.43A.

Intellectual Property

An Internet service provider could lose its safe harbor protection if it repeatedly fails to terminate known infringers in contradiction to its policies. BMG Rights Mgmt. (US) LLC v Cox Communications, Inc. (4th Cir 2018) 881 F3d 293, 301. See §12.18B.

The resale of a digital music file cannot be protected by the first sale doctrine. In Capitol Records, LLC v ReDigi Inc. (2nd Cir 2018) 910 F3d 649, cert denied (2019) ___ US ___, 139 S Ct 2760, the court found that the transfer of a music file from the initial purchaser to the reseller created a new and unauthorized phonorecord on the reseller’s server, and the transfer from the reseller to a new purchaser created yet another unauthorized phonorecord for the new purchaser. The court rejected the reseller’s argument that its platform’s method of deleting the original file cured the act of making a reproduction of the file. The same logic could easily be applied to efforts to copy other digital files such as movies or e-books. See §12.20A.

A copyright owner must first obtain the copyright registration before filing a lawsuit. Fourth Estate Pub. Benefit Corp. v Wall-Street.com, LLC (2019) ___ US ___, 139 S Ct 881. See §12.32.

In Iancu v Brunetti (2019) ___ US ___, 139 S Ct 2294, the U.S. Supreme Court held that the USPTO’s refusal to register the mark “FUCT” because it comprised immoral or scandalous matter violated the First Amendment. See §12.36.

Marks that are merely informational or widely used phrases cannot be registered as trademarks. To be registrable, the words or phrase must be used in a manner that indicates to purchasers or potential purchasers a single source or origin for the goods. In re DePorter (TTAB 2019) 129 USPQ 2d 1298. The relevant inquiry is whether the proposed trademark is an indicator of the source of goods, even if that source is unknown. 15 USC §1127. For this reason, the USPTO has refused attempts to register marks when the applicant attempted to capitalize on words or phrases that received widespread media treatment. See §12.36.

Cybersecurity

Following, are a series of steps that companies may take to help protect customer and proprietary data and to better manage cybersecurity risks.

  • Identify key company employees who are responsible for understanding and managing cyber risks and who would play a critical role in responding to cyber incidents that may arise.
  • Perform cybersecurity audits (threat hunts, cyber risk assessments, penetration tests, tabletop exercises, and red team/blue team events) to identify critical information technology strengths, weaknesses, vulnerabilities, and other issues.
  • Draft and adopt company policies regarding data management and protection, including cyber incident response.
  • Prepare a detailed cyber incident response plan (see §13.15), with information on reporting obligations (see §§13.1113.14) and sample forms of the notices required.
  • Identify third party experts who could assist the company in the event of a cyber incident, including outside counsel (to protect privilege) and forensic examiners to help mitigate live threats and investigate scope of data access by threat actors.
  • Conduct regular cybersecurity preparedness training for all employees—including response exercises, infrastructure tests, and risk assessments for the benefit of management and key employees.
  • Purchase cyber incident insurance from a reputable broker and underwriter that have requisite knowledge of cyber risk.
  • Install and test data recovery systems to help prevent data loss and business interruption in the event of a cyber incident.
  • Review the cybersecurity practices of any third party vendors to ensure their compliance with sound data management.
  • Implement risk management techniques and technological best practices to mitigate cyber risks.

See §13.10.

Federal and State Taxation

On July 1, 2019, the California governor signed AB 91 (Stats 2019, ch 39) into law, under which California selectively conforms to the Tax Cuts and Jobs Act (Pub L 115–97, 131 Stat 2054) changes. If California conformity is not specifically mentioned with respect to an Act change, practitioners should not assume that California conforms to an Act change. See §15.1.

Before AB 91 was enacted, California allowed corporations to make a separate California IRC §338 election, which could be different from the election for federal income tax purposes. Effective July 1, 2019, taxpayers must follow the federal election (i.e., the federal election is binding for California purposes). Similarly, if the corporation did not timely elect IRC §338 treatment for federal income tax purposes, the corporation may not make an election for California purposes. The new conformity provisions do not apply to acquisitions subject to a binding contract entered into before July 1, 2019, and that remains binding at all times after July 1, 2019. The AB 91 conformity legislation applies to IRC §338(g) elections as well as the IRC §338(h)(10) elections described in §15.30. See §15.29.

For purposes of obtaining an employer identification number, in the past, a “responsible party” included an entity. However, effective May 13, 2019, as part of its ongoing security review, the IRS limits “responsible parties” to individuals with tax identification numbers, prohibiting entities from using their own EIN in order to obtain additional EINs. See https://www.irs.gov/newsroom/irs-revises-ein-application-process-seeks-to-enhance-security. See §16.5.

On April 25, 2019, California passed AB 147 (Stats 2019, ch 5). Assembly Bill 147 amended Rev & T C §6203 effective April 1, 2019, to require retailers located outside of California (remote sellers) to register with the CDTFA and collect California use tax if, during the preceding or current calendar year, the total combined sales of tangible personal property for delivery in California by the retailer and all persons related to the retailer exceed $500,000. A person is related to a retailer if they have a relationship with the retailer described in IRC §267(b) and the related regulations. To assist remote sellers in determining the application of tax to many items and transactions, the CDTFA has published a California Tax Matrix for Remote Sellers, located on its website at https://www.cdtfa.ca.gov/formspubs/cdtfa758.pdf. See §16.35.

Assembly Bill 147 also amended Rev & T C § 7262 to require all retailers, whether located inside or outside of California, to collect district use tax on all sales made for delivery in any district that imposes a district tax if, during the preceding or current calendar year, the total combined sales of tangible personal property in California or for delivery in California by the retailer and all persons related to the retailer exceed $500,000. This new collection requirement is operative April 25, 2019 (see CDTFA Special Notice L-684, located on its website at https://www.cdtfa.ca.gov/formspubs/l684.pdf). See §16.35.

Beginning January 1, 2020, late filing penalties for statements and returns required to be filed thereafter are $270 per statement or return, up to a maximum of $3,339,000. IRS Bulletin No. 2018–49 (Dec. 3, 2018). See §16.71.

Federal Securities Law and Practice

NASDAQ Listing Rule 5101 provides NASDAQ with broad discretionary authority over the initial and continued listing of securities in NASDAQ in order to maintain the quality of and public confidence in its market, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to protect investors and the public interest. NASDAQ may use its discretion to deny initial listing, apply additional or more stringent criteria for the initial or continued listing of particular securities, or suspend or delist particular securities based on any event, condition, or circumstance that makes initial or continued listing inadvisable in NASDAQ’s opinion, even though the securities meet all enumerated criteria for initial or continued listing. NASDAQ has used its discretion to deny initial or continued listing or to apply additional and more stringent criteria in several instances. See §17.4A.

Item 401(e) of Regulation S-K (17 CFR §229.401(e)) requires a brief discussion of the qualifications of director nominees. The SEC has stated that it expects this discussion would include any self-identified diversity characteristics (e.g., race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background) of an individual who has consented to the company’s disclosure of those characteristics. Securities and Exchange Commission, Compliance & Disclosure Interpretations of Regulation S-K, Question No. 133.13 (Feb. 6, 2019). See §17.11.

Progressive state legislatures are increasingly seeking to require public companies to advance social and political policies. In 2018, California adopted legislation that requires each publicly held corporation that is incorporated in California or has its principal executive offices in California to have (1) at least one female director by December 31, 2019; (2) at last two female directors by December 31, 2020 if it has five directors; and (3) at least three female directors by December 31, 2021 if it has six or more directors. See Corp C §§301.3, 2115.5. On August 6, 2019, three California taxpayers filed suit to prevent implementation and enforcement of California’s board gender diversity legislation, alleging that the law’s mandate is an unconstitutional gender-based quota and violates the California constitution. Crest v Padilla (Los Angeles County Superior Court, Case No. 19STCV27561). See §§17.26, 18.42.

Both the NYSE and NASDAQ require a company seeking listing to demonstrate a minimum aggregate market value of publicly-held shares. Before February 2018, the NYSE used the lesser of (1) an independent third-party valuation and (2) the most recent trading price for the company’s common stock in a private placement market, in determining whether the listing threshold was satisfied. In February 2018, the SEC approved an amendment to the NYSE listing rules to permit, on a case-by-case basis, issuers that cannot provide a private placement market trading price to effect a direct listing of their shares on the effectiveness of a resale registration statement under the Securities Act and without a related firm commitment underwriting. See NYSE Listed Company Manual, Rule 102.01B(E), available at https://nyse.wolterskluwer.cloud/listed-company-manual. The new rule requires that the company (1) have a recent valuation from an independent third party indicating at least $250 million in aggregate market value of publicly held shares, and (2) engage a financial advisor to be consulted by the NYSE’s designated market maker in determining the opening trading price. In February 2019, NASDAQ adopted a direct listing rule that is substantially the same as the NYSE rule. See NASDAQ Listing Rule IM–5315–1. Although the rule applies only to listing on the NASDAQ Global Select Market, NASDAQ has announced that it intends to adopt rules for direct listings on the NASDAQ Capital and Global Markets. Before the adoption of the rule, NASDAQ had listed a limited number of smaller companies without a concurrent underwritten public offering, although its rules did not explicitly contemplate these listings. In July 2019, iHeartMedia, Inc. effected a direct listing of its Class A Common Stock on the NASDAQ Global Select Market. See §18.5A.

When offering materials are distributed through a medium, such as Twitter, that limits the number of characters or amount of text that may be included, and including the required statements would cause the communication to exceed that limit, an issuer could satisfy the disclosure requirements of Rule 147A(f) (17 CFR §230.147A(f)) by including an active hyperlink to the required disclosure. The communication should prominently convey, through introductory language, that required information is provided through the hyperlink. When an electronic communication is capable of including the entirety of the required disclosure, without exceeding the limit on the number of characters or amount of text, the use of a hyperlink to the required disclosure should not be used. See §19.56.

In September 2019, the SEC extended to all issuers the “test the waters” accommodation available to EGCs. See Securities Act Rule 163B (17 CFR §230.163B). The new rule allows any issuer to engage in oral or written communications with potential investors that are, or are reasonably believed to be, qualified institutional buyers or institutional accredited investors, either before or after the filing of a registration statement, to determine whether those investors might have an interest in the offering. The rule is nonexclusive, and an issuer may rely on other Securities Act rules or exemptions when determining how, when, and what to communicate about a contemplated offering. Under the rule, (1) there are no filing or legend requirements, (2) the communications are deemed to be “offers,” and (3) issuers subject to Regulation FD will need to consider whether any information in a test-the-waters communication would trigger disclosure obligations under Regulation FD. Securities Act Release No. 33–10699 (Sept. 25, 2019). See §20.5A.

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