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Having represented both buyers and sellers in mergers and acquisition transactions in Silicon Valley for more years than I care to admit, I have been through a number of closings. Some M&A closings that I have been involved in were smooth affairs, accomplished through an exchange of a single phone call with a confirming email, while others have stretched into all night marathons. Although it is often difficult to know whether your deal will allow you to finish at a reasonable time, there are a number of actions you can take to make sure your closing is as smooth and stress free as possible.

Obtain Third Party Consents:

The most important task for both the seller and acquirer is to plan ahead. Everything you will need, to accomplish the closing, will take longer than you think. One item which often delays a closing is getting the necessary consents to the transaction required from third parties. Certain third parties, often parties to major relationships that the acquired company, post-closing, requires for its operations, have rights under their contracts to consent to any change in control. Many of these contracts create significant value for the acquired company and their continued existence are often a key incentive for the buyer proceeding with the deal. It is best to identify these material agreements early on and plan a strategy for securing the necessary consents. Other areas where third party consents might be required are when a party, often a strategic investor, has a right of first refusal that is triggered by the transaction.

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A few years ago, I met with a new client here in San Jose about forming a corporation for his real estate management business. He wanted to use his name as the name of the corporation, e.g. John Smith, Inc., and he had no problems with using his name as the Agent for Service of Process, and having his home address as the business address on public record. Imagine my surprise when I went to the Secretary of State’s database to confirm that the name was available and found that the exact name was taken by the same client at the same address. The corporation had been formed back in 1989 and had been suspended for decades.

I discussed it with the client and discovered that he had spoken with another lawyer about forming a corporation many years ago, and although he thought it was just an informational meeting, the attorney actually formed the corporation and the client didn’t even know about it. If my client wanted to use the name of the suspended corporation, he would first have to revive it, in which case, he would have had to pay tens of thousands of dollars in back franchise taxes and interest. I counseled the client to walk away from the suspended corporation and simply start a new one under a different name. In this case, that was okay because he took no assets from the corporation and therefore could not be held personally liable for the corporation’s taxes. However, shareholders should not walk away from a corporation without carefully considering whether the same conclusion would apply to their situation, and whether they are willing to endure the annoying tax notices to the corporation in the meanwhile.

The landmark case in this area is the Appeal of Howard Zubkoff and Michael Potash, Assumers and/or Transferees of Ralite Lamp Corporation (April 30, 1990, 90-SBE-004). In that case, the Board of Equalization stated that the only way shareholders are liable for the corporation’s franchise taxes would be if the Franchise Tax Board proves that all of the following conditions were met:

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Those of us involved in real estate loans, debt financing, and problem loans or loan workouts have sometimes wondered whether a deed of trust can be valid if no trustee is identified. I am often asked this question and, surprisingly, the issue was never been directly addressed by California courts until the end of 2012! In a decision handed down a few months ago, a California Court of Appeals ruled that the omission of a named trustee on a deed of trust at the time it is executed and recorded does not preclude enforcement of the deed of trust through a foreclosure sale of the secured property.

The facts of the case are straightforward. A real estate loan was made and secured by a deed of trust on the property being purchased. The lender designated Mortgage Electronic Registration Systems, Inc., or MERS, as the beneficiary and simply omitted naming a trustee. Later, the borrowers defaulted on the loan and MERS then recorded a substitution of trustee naming ReconTrust Company, N.A. (ReconTrust) as trustee, and assigned its beneficial interest under the deed of trust to a loan servicer who further assigned the beneficiary’s rights to Arch Bay Holdings, LLC – Series 2010B (Arch Bay). As newly appointed trustee, ReconTrust filed the required notice of default and notice of sale, and eventually conducted a trustee’s sale at which Arch Bay purchased the property. After the sale, the borrowers filed a lawsuit asserting, among other things, that the failure to designate a trustee in the original deed of trust was a fatal flaw and precluded any trustee’s sale under the power of sale in the deed of trust. See, Shuster v. BAC Home Loans Servicing, LP, et al. 211 Cal.App.4th 505 (2012).

The court first noted that this issue had never been addressed in prior California rulings. After wading through some technical arguments, the court ruled in favor of the lender or creditor and against the borrower, stating that the essential validity of the deed of trust is not affected because a trustee is omitted in the original deed of trust, as long as a trustee is named prior to a foreclosure. The court reasoned that the very limited powers granted to a trustee under a deed of trust – to convey the property at an out of court sale – are insufficient incidents of ownership or control to make the actual naming of a trustee critical to the validity of the document.

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Last November, I was working closely with one of our clients and their real estate lender to purchase a large property in the San Francisco Bay Area. I formed two California limited liability companies for the transaction. One LLC was the investment entity that was going to own the property, and the other was the management entity that was going to hold the sponsor interests in the deal. Both entities had to be properly and fully formed so that we could obtain good standing certificates from the Secretary of State and be in position to issue legal opinions for the lender. During the due diligence period, our client discovered something about the property that was not what had been represented to them by the seller of the property. As a result of this information, the purchase fell through.

Fortunately, despite all of the other costs expended on pursuing this property, the client had not yet paid the $800 franchise taxes for each of the two LLCs we formed. In California, if an LLC meets certain requirements it may cancel its Articles of Organization within 12 months of the filing by filing a Short Form Certificate of Cancellation with the Secretary of State, and avoid paying the first year’s franchise taxes. These requirements include:

– The California LLC has no debts or other liabilities (other than tax liability);
– The assets, if any, have been distributed to the persons entitled to them;
– The final tax return has been or will be filed with the Franchise Tax Board;
– The California LLC has not conducted any business since filing the Articles of Organization;
– A majority of managers or members, of if there are no managers or members, then the person who signed the Articles of Organization, voted to dissolve the LLC and

– If the LLC has received any payments from investors for LLC interests, those payments have been returned to the investors.

Source: Spidell’s California Taxletter, Vol 34.11, Nov. 1, 2012.

Because our client met all of these requirements, we were able to cancel the LLCs without paying the $1600 ($800 x 2) in California franchise taxes. If, on the other hand, the client had already paid the taxes, we would not have been entitled to a refund. With this in mind, sometimes when forming an LLC it may be better to wait until the last minute before the franchise taxes are due before paying them to make sure the business is going forward, as long as you either pay them before late fees would be imposed, or you are willing to incur late fees in the event your LLC does not qualify for the short form cancellation.

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Although 2013 is well under way, taxpayers in San Jose may not be aware of changes to California laws that may affect them. Some of these changes include:

Proposition 30

With all the talk about federal income taxes going up this year, do not forget about the Proposition 30 retroactive increase in California taxes, effective as of January 1, 2012. For taxpayers with taxable income over $250,000, the California maximum rate is now 12.3%. On top of this, there is a 1% mental health surcharge for taxpayers with taxable income over $1,000,000. Together, these taxes give California the highest maximum state tax rate. If you fall under these tax brackets, you may not have paid enough taxes throughout the year, through either withholding or estimated tax payments, to avoid being under-withheld. However, there will be no penalty for the under-withholding so long as you pay the tax due in full by April 15, 2013. The ability to get out of penalties expires on April 15th. An extension to file doesn’t extend the payment deadline or the penalty exclusion. A late payment penalty of 5% plus 0.5% per month will be due if the full 2012 liability is not paid in full by April 15th.

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The pace of merger and acquisition activity in Silicon Valley continues unabated, and the satisfaction of conditions to make sure both parties conclude a deal with all loose ends tied up becomes critical to a final closing. In my last blog, I discussed certain standard closing conditions contained in merger and acquisition documentation, particularly the requirement of stockholder approval and the use and impact of dissenters’ rights. In this blog, I will cover some of the other commonly used conditions in acquisitions of privately held companies.

Being a technology transfer lawyer, many of my clients’ deals focus on the need to retain key employees after the company is sold. For that reason, a key closing condition included in most acquisition agreements requires that certain employees with the acquired company agree to continue working with the company for a period of time after the closing. Often this obligation is structured by requiring the employees to sign employment agreements or consulting agreements with the buyer. Managing this process can be tricky, because employees will want to agree to terms they find preferable (e.g., receiving additional options and higher salary) and some key employees may be reticent to work with a buyer they do not know. In addition, negotiations occur between the key employee and an acquirer before a deal is closed, which is sometimes an awkward process.

Covenants Not to Compete

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An investor bought an apartment building in San Jose and the broker wanted to send flowers for the occasion. A large bouquet was delivered to the buyer’s office with a note that read, “Rest in Peace.”

The buyer was irritated and called the florist to complain. After he had told the florist of the obvious mistake and that he was not pleased, the florist said: “Sir, I’m really sorry for the mistake, but what I’m more concerned about is . . . there is a funeral taking place today, and they have flowers with a note saying, “Congratulations on Your New Apartment!”This amusing joke is a good way of reminding us that both real estate and business deals continue to be closed in the Bay Area. As a banking, real estate and business lawyer representing parties to these transactions, I am very aware, and I expect most readers are as well, that financing continues to be a critical part of making a successful deal. During the robust period prior to 2008, one way parties garnered additional leverage in structuring real estate transactions was to utilize so-called mezzanine financing, in which the collateral securing a junior layer of debt consisted of the ownership interests in the borrower rather than the real estate. When the borrower was a limited liability company, this junior loan collateral could be secured through a pledge of the membership interests the owners held in the borrowing LLC.

The concept of using mezzanine debt to enhance leverage has not gone away. However, recent cases looking at transactions structured several years ago have curtailed the latitude of mezzanine lenders (“Mezz Lender”) and improved the position of the senior secured lender (“Mortgage Lender”) in the event problems arise after loan closings. If you are a Mortgage Lender holding real estate collateral, this may make it more attractive for you to enter into a transaction involving mezzanine financing. If you are a Mezz Lender or a borrower seeking to obtain and use mezzanine financing, obstacles now exist that were not there – or at least not believed to exist – before the markets collapsed in 2008.

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Having practiced corporate law in Silicon Valley for 15 years, I must say that there is nothing more frustrating for my clients, who are mostly closely held businesses in the San Jose area, than spending months or years training an employee only to have her leave and go on to compete with the company that trained her. In particular, I represent several staffing and consulting companies and have had to listen to their complaints of how unfair this is from the employer’s perspective. Often, I have to tell these hard working, small business owners that there is almost nothing they can do (except pursue a claim against the employee for misappropriation of trade secrets). In 2008, the California Supreme Court decided Edwards v. Arthur Andersen LLP, making it clear that employee post-employment non-compete agreements are unenforceable in California except in certain very limited circumstances, including in connection with the sale of a good business involving goodwill.

Now, a new California Court of Appeals case, Fillpoint, LLC v. Maas (August 24, 2012) further enforces California’s attitude towards fostering open competition and disfavoring restrictions on employees. In the Fillpoint case, a major shareholder and key employee signed both a three year non-compete agreement related to the sale of his stock, and a one year post-employment non-compete in his new employment agreement. The Court paid particular attention to whether the stock purchase agreement and the employment agreement should be read together as one document. The employment agreement alone would violate California’s view of post-employment non-compete agreements as against public policy. However, in connection with the sale of the business, it could be enforceable. In this case, the shareholder/employee worked for the acquired company until the three year non-compete ran out, but then terminated his employment and went to work for the competition. The company claimed that the one year non-compete covenant in the employee’s employment agreement should restrict him from such competing employment. The employment agreement non-compete provision specifically prohibited him from making sales contacts or actual sales to any customer or potential customer of the company, working for or owning any business that competes with the company, and employing or soliciting for employment any of the company’s employees or consultants.

The court found that the two agreements should be considered integrated because the covenants were executed in connection with the sale or disposition of stock in the acquired company. In particular, they noted the integration clause in the documents, which stated that if there were any conflicts between the two documents, the stock purchase agreement would control. The court went on to consider whether the non-compete and non-solicitation covenants should be void and unenforceable, and found that they were because they were overly broad. In particular, the court noted the over-broad restriction against selling to potential customers of the company.

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As a Silicon Valley corporate attorney, I work with a lot of Internet law and cyberspace law issues and am often asked by businesses to make sure their websites keep them free from trouble. Whether you are a large, multi-national corporation, a mid-size company, or a small business owner, chances are you run and operate a commercial website. One way to minimize the risk that comes from operating a commercial website is to create the conditions, sometimes called Terms of Use, that govern a visitor’s use of the site. A court decision in September, however, found that website terms could be invalid and therefore fail to provide any protection to website operators. Because the court is located in the federal district that includes California, it is a critical decision that affects California website operators.

The case, In re Zappos.com Inc., Customer Data Security Breach Litigation, 2012 WL 4466660 (D. Nev. Sept. 27, 2012) arises out of Zappos’ customer data security breach in January of this year. As is typical in a data breach situation, Zappos notified all persons whose personally identified information may have been compromised. When the inevitable lawsuit was filed, Zappos attempted to enforce an arbitration clause in the Terms of Use found on its website. A federal court in Nevada said “not so fast”.

Some background is helpful. Terms of Use are often created with little thought, and can often be changed at any time by the website operator. They typically are submitted as a “browse-wrap” agreement, which, unlike a “click-wrap” agreement, does not require the user to click on a box to confirm the user’s consent to the agreement. Browse-wrap agreements are usually referenced with an inconspicuous link at the bottom of a home page.

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As 2012 is coming to an end, corporations and individuals alike are already thinking about taxes that they will need to pay at year-end. Every meeting I have with business owners lately somehow comes around to talking about taxes and how much I expect taxes to increase next year. The passage of Assembly Bill 1492 added yet another tax to the mix – the wood and lumber tax. This tax may affect homeowners, contractors and real estate developers.

We have all heard that ordinary federal income tax rates, currently maxing out at 35%, are scheduled to increase to 39.6%. Dividends could lose their special tax treatment and be taxed at this ordinary income tax rate as well. Federal long term capital gains rates will go from 15% back up to 20%. Payroll taxes may go back up from 4.2% to 6.2%. The AMT exemption amount may go back to 2010 levels. And high income earners will have an additional 3.8% Medicare tax. But on top of all that, starting January 1, 2013, those of us in California will also have to pay an additional 1% tax on the sales price of engineered wood and lumber products. (Assembly Bill 1492 (Ch. 12-289)).

Normally I would write this off as minor, but this year my husband and I are actually right in the middle of planning a huge fencing and deck project for our new house. (Did you know there was still residential land in the Silicon Valley that has not been fenced?) So, it was quite annoying to read about how this tax is going to be instituted on lumber, decking, railings and fencing as well as particle board, plywood and other wood building products, and even non-wood but wood-like products such as plastic lumber and decking. Even more so because it is already the middle of October and I’m pretty sure our project won’t be completed until early 2013. So, if I buy all the wood before the end of the year, I save 1%… but probably end up with more than I need and the inability to return it. But, if I wait until January to buy it just in time to install it, I am going to hate paying that extra 1%.

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