Congress and the President brought a little bit of holiday cheer to unemployed Americans struggling to pay for health insurance.  As predicted by this blog in February, President Obama signed the Department of Defense Appropriations Act of 2010 yesterday which extends the federal COBRA health coverage subsidy for involuntarily terminated employees an additional 6 months.  Readers will recall that the COBRA subsidy allows laid off employees to continue their employer’s group health insurance provided they pay 35% of the monthly premium instead of the 102% that many employees had to pay in the past.

Now, employees involuntarily terminated from their employment will have the COBRA subsidy available to them for up to 15 months.  For example, if an individual was  laid off on July 15, 2009 with their health coverage ending on July 31^st, this individual is eligible for a COBRA subsidy from the period of August 2009 through October 31, 2010.

Under the new legislation, employees who experience a “qualifying event” up through February 28, 2010 will be eligible for the 15 month COBRA subsidy.  Further, the new legislation requires employers to notify former employees who were eligible for the COBRA subsidy on or after October 31, 2009, that they may continue to pay for their health insurance at subsidized rates for up to 15 months,  and that they may reinstate their COBRA coverage if they had stopped paying their COBRA premiums after their subsidy expired.

Putting aside the cost, the COBRA subsidy has been an unqualified success.  According to Hewitt & Associates,  only 19% of eligible employees made use of their COBRA rights before the ARRA.  Now, that figure rests at 38%.   Finally, we expect the Department of Labor and the IRS to have model notices ready for employers before the end of the year.

The Wall Street Journal reports that Exxon-Mobil’s recent $31 billion purchase of natural gas exploration firm XTO Energy confirms a recovery of merger and acquisition activity over the past 2 months. It reports that November and December had the most M&A activity since the summer of 2008, with values 4 times greater than a year ago. Also leading this charge were Warren Buffet’s largest ever $26 billion investment in the railroad industry, and the $4.6 billion merger of Stanley Works and Black & Decker. November alone saw the announcement of 41 U.S. deals worth a combined total of approximately $47.5 billion, benefiting mostly large Wall Street banks and boutique financial firms. Sources within the chemical industry also expect a 2010 rally in the number of deals.

Many experts believe these increases in M&A activity signal good news for the health of the broader economy in 2010. Indeed, the recent surge seems to be the result of increased access to capital markets, the stagnation of which has been cited repeatedly as the cause of the continued lagging of a broader recovery. Accompanying these positive indicators are the apparent stabilizing of economies world-wide, financing becoming more available in the broader spectrum, and the narrowing of the gap in price expectations between buyers and sellers. Consistently, a large regional bank representative recently said at a lunch meeting that their bankers have been directed to increase lending dramatically in 2010 as underwriters loosen standards for loan approval.

Until recently, any positive indicators of recovery always have seemed to accompany at least as many negative ones. As 2009 ends, however, the negative indicators appear to be waning strongly in favor of the positive. Also, while many experts claim, perhaps too definitively, that this recession is over, others hinge their disagreement mostly on lagging unemployment data. Yet unemployment typically is the last area to improve after a recession as companies tend to wait until they clearly are understaffed before resuming hiring. Moreover, early 2010 should provide great opportunities for companies to contact their previously obstinate bankers again to seek (or refinance) lines of credit and other financing.

Much is being made of the “US Pay Czar,” Kenneth Feinberg’s, effort to limit executive compensation at firms that have not re-paid TARP funds.  Feinberg plans to force 175 corporate executives to cut their salaries by 90%.

A Wall Street Journal article suggests that Feinberg won’t stop at limiting salaries:

“Mr. Feinberg will also demand a series of corporate governance changes at the firms, including splitting the chairman and CEO positions, requiring boards of directors to create “risk” committees and eliminate staggered board elections, which critics charge inhibit change.”

Feinberg’s pay restrictions will be ineffective in achieving their desired goals.  Many executives who face a 90% pay cut will simply leave their firms.  But further federal intervention into corporate governance is troubling.  Corporate law has been a long been the domain of States.  So any federalization of permissible takeover defenses represents a huge shift in the power toward Washington and away from more local government. 

More importantly, staggered board elections operate as a takeover defense to prevent hostile bidders from acquiring control of the company.  The legality of the anti-takeover measures (such as the staggered board) evolved out of several high-profile Delaware Chancery Court cases in the 1980’s.  Like them or not, anti-takeover defenses yield substantial benefits to shareholders. Indeed, having a staggered board allows managers to negotiate harder and extract a higher price for the shareholder. 

Corporate governance is not likely to improve with the elimination of staggered boards.  Activist shareholders will be better equipped to challenge management - but there is no guaranty that these activist shareholders will yield more stable financial institutions.  Indeed, some acquirers may ratchet up leverage and use the company to take riskier bets in the marketplace than the old management.  As the same time, shareholders (and a nation of 401k holders) will suffer as their shares have a lower total value to potential acquirers.

The Illinois Home Repair and Remodeling Act (815 ILCS 513/1 et seq.) (view it on the web here) declared that “the business of home repair and remodeling is a matter affecting public interest” and found that “improved communications and accurate representations between persons engaged in the business of making home repairs or remodeling and their consumers will increase consumer confidence, reduce the likelihood of disputes, and promote fair and honest practices in that business in this State.”  815 ILCS 513/5.

Courts have taken the Act very seriously, strictly enforcing its edicts that a contractor 1) must have a written contract for any remodeling or repair work over $1,000; 2) must provide specific notice of certain provisions if they are present in a contract; and, 3) must provide a consumer with a brochure detailing the consumer’s rights.  As I have previously written in a CC&M Briefing to clients (CC&M Briefing, Fall, 2008, available here), in their effort to enforce the policy set forth in the Act, courts have denied sizable claims by contractors based on their failure to comply with it.

Courts in Illinois’ Third and Fourth Appellate Districts have denied contractors’ claims for roughly $11,000 and $14,000 due to failure to obtain written contracts (Central Illinois Electrical Services, LLC v. Slepian, 358 Ill. App. 3d 545 (3d Dist. 2005; Smith v. Bogard, 377 Ill. App. 3d 842 (4th Dist. 2007)).  Most importantly, those courts determined that the contractors were not only precluded from bringing contract actions, but were also precluded from making claims in quantum meruit (a theory allowing a party to seek the fair value of work and materials actually provided to and accepted by the consumer in order to preserve substantial fairness).  Thus, under these analyses, a contractor would have no recourse to obtain payment for work, no matter how satisfactory, if the contractor did not fully comply with the Act.

The Illinois Court of Appeals for the First District has recently disagreed with its sister courts.  In an interesting case (K. Miller Construction Company, Inc. v. McGinnis, No. 1-08-2514, 1st Dist., August 10, 2009, available here), the Court determined that fundamental fairness did not allow it to restrict a contractor so completely, even in the absence of a written contract for work.

In K. Miller, the contracting company’s sole owner and the homeowners were friends who reached an oral agreement for remodeling work, but never reduced the agreement to writing.  The homeowners initially agreed to pay $187,000 for the work, but later expanded the scope of the project to a price of slightly more than $500,000.  The project was completed in accordance with the expanded plans, and the parties conducted a “walk-through” of the property.  The homeowners allegedly accepted and approved the work after agreeing to a small ($300) credit to address some minor flood damage.  The homeowners made some further payments to the contractor, but refused to pay more than a total of $177,580.33.

The Court quickly dispensed with any question of a contract claim or claim for foreclosure of a mechanic’s lien, acknowledging that the Act strictly precluded such actions in the absence of a written contract.  However, the Court more carefully considered the contractor’s claim in quantum meruit and determined, at least under the facts of this case, the claim should be allowed.

The Court carefully considered the effect of the Home Repair and Remodeling Act and the cases that had previously construed it.  After a lengthy discussion of the history of quantum meruit actions and their main purpose, i.e., providing a fair payment to a party for work that it has done.  The Court determined that allowing the claim to go forward in this case would be most equitable, allowing the homeowners to contest the fair value of the work they received but allowing the contractor to attempt to prove its entitlement to payment for the work it had done.

This case is interesting in its effect, creating a conflict between Illinois Appellate Districts that is ripe to be resolved by the Illinois Supreme Court.  However, additional facts considered by the Appellate Court may limit the applicability of the case in other Appellate Districts that have not yet ruled on the effect of the Act.  The Court took great care to note that there were significant allegations affecting the fundamental fairness questions in this case.  Most notably, the homeowner in this instance was allegedly an attorney who has practiced real estate law for nearly forty years, and the contractor was allegedly relying on a past business relationship and friendship with the homeowner when he entered this relationship without a written contract.  These additional facts seem to have had some impact on the Court’s analysis in balancing the fairness of denying any claim.  The Court specifically stated, “Such a consumer, after receiving the benefit of the contractor’s services, could use the Act, meant as a shield to protect vulnerable consumers, as a sword to deprive a contractor of the reasonable value of his services.”  The Court also stated, “Rejecting Miller’s claim would only penalize a reputable contractor, who, relying on a past business relationship and friendship with the consumer, performed remodeling work to the consumer’s satisfaction, with no involvement of predatory remodeling practices the Act sought to address.”  In other words, the Court was persuaded that a court should not be denied its equitable power to do justice between parties where one of those parties could have intentionally sought to achieve an injustice based on a technicality.

While a resolution of the conflict created by this case will be interesting, contractors and consumers are better off avoiding conflicts created by the Act.  Obtaining the advice necessary to comply with the Act when entering into a relationship will protect both the honest contractor and the honest consumer, assuring that all parties understand and agree to their rights and responsibilities under a contract and avoiding some unpleasant surprises during the project or after work is completed.  However, it will be interesting to follow the evolving case law regarding the Act, evolving law that has the potential to continue providing creative legal arguments for all parties involved in this kind of conflict.

A few years ago Harvard University disclosed that it had used anonymous proxies to purchase 52 acres of land in Boston. Boston officials exploded in outrage, but Harvard responded that the secrecy was motivated by a desire to avoid price gouging (not to mention that the lower purchase price reduced Harvard’s property tax bill). The motivations expressed by Harvard are not uncommon. Indeed many business owners take advantage of the secrecy provided by the various corporation acts and limited liability company acts for legitimate business reasons. Forming a new entity often does not require disclosure of the owners.

The relative informality of American corporate law varies significantly from most of the world. Privately held corporations and limited liability companies typically do not have to publicly disclose their owners, can issue stock with relatively few restrictions and often can be formed within 24 hours of submitting an application. Also unusual is the patchwork of corporate law across the 50 states reflecting varying public policy decisions in each of these jurisdictions. While there have been attempts to encourage states to standardize corporate and commercial laws in the last 50 years through the adoption of model statutes, the corporation acts and limited liability acts often vary markedly. Some states, like Nevada, have aggressively marketed their jurisdiction as a venue for incorporation by trumpeting the limited disclosure requirements of their corporate laws.

Entity formation abroad is significantly more regulated. In many European countries stock is not certificated but instead has to be registered with a public authority. Some countries impose a public auditing requirement on all businesses. Forming a new company can take up to a month and “expedited” filings could take as long as a week. While American lawmakers often abhor European style regulations of businesses, in a post 9/11 world Congress and American law enforcement have approvingly noted the security benefits from European Union laws requiring disclose of beneficial owners of corporations.

Congress is considering Senate Bill 569 that would require states to implement a system requiring the disclosure of each beneficial owner of new corporations and limited liability companies (including indirect owners if the owner is a corporation, LLC or other entity) at formation. The bill does not address ownership of limited partnerships and other partnership entities.

In addition, beneficial ownership must be updated by annual reporting or each time when a change occurs. If beneficial owners are not citizens or permanent residents, a formation agent must verify their name and address and obtain a copy of the government owned identification with photograph. Intentionally failing to provide or update this information could result in penalties of up to $10,000, or up to 3 years in prison, or both. The bill requires “formation agents” (which definition includes attorneys or accountants who assist in the formation of the corporation or limited liability company) to certify that they verified the identity of any beneficial owner who is not a United States citizen or permanent residence.

The potential legal liability of accountants and attorneys guarantees that this bill, if enacted into law, will increase the transaction cost and time needed to form a new entity.

The bill also creates the likelihood of a patchwork of differing laws across the states. Since the states will collect the beneficial information, each state will decide whether the ownership information should be disclosed to the public or simply transmitted to the federal government. Also, some states may simply collect information for domestic corporations while other may collect this information for foreign corporations qualifying to do business.

Overlooked in this discussion is the fact that the federal government already has beneficial ownership information for many small businesses, particularly those taxed as “pass-through” entities. Businesses have to disclose ownership information when they obtain their federal tax identification numbers. In addition, the Internal Revenue Service already receives Schedule K-1 forms reporting income allocated to owners of S-Corporations, limited liability companies and partnerships. Since the current draft of the bill does not include limited partnerships and other partnerships, proper analysis of the information already in the government’s possession should provide it with more information than the bill would provide. It is unclear whether the burdens and penalties of the proposed bill outweigh the benefits.

Many commercial leases contain provisions granting landlords a lien on the tenant’s assets. These leases often provide that property abandoned by the tenant upon termination of the lease belongs to the landlord. These lease provisions reduce the security granted to commercial lenders because they can create conflicting priorities of liens.

Article 9 of the Uniform Commercial Code does not always address the priority of non-Article 9 liens. Worse, landlord liens are expressly excluded from the scope of Article 9. See 810 Ill. Comp. Stat. 5/9-109(d). If the debtor defaults, the secured creditor is likely to find itself in a priority fight with the landlord over the collateral.

It can get worse than a simple priority fight. In this economy it is not uncommon for businesses to abruptly close shop and abandon their property on the leased premises. As a result, the landlord is often the first party to discover the debtor’s insolvency. This gives the landlord a huge head start in the race to the courthouse door to obtain a judicial order confirming the landlord’s ownership. In some cases the secured creditor is not aware of the location of the collateral. In such a scenario, the landlord may have disposed the debtor’s property before the secured creditor became aware of the default. In addition, if the landlord does not cooperate the secured creditor may not be able to access the premises to remove the collateral without a court order.

However, the secured creditor may be able to reach an agreement with the landlord regarding the collateral. Many landlords do not have the interest or ability to hold auctions for abandoned property. So long as they obtain some redress for their damages, the landlord may permit the secured creditor to remove the collateral from the premises. Removal of the collateral also makes it easier to relet the premises.

Many of the secured creditor’s nightmares with respect to landlords can be avoided with two simple measures (1) regular inspections of the tenant’s business facilities to ensure that the collateral has not been moved; and (2) obtaining landlord waivers where the landlord recognizes the lien and permits the secured creditor to remove the collateral upon default. Most landlords understand that the health of their tenant’s business depends on their ability to secure adequate financing. As a result landlords generally are willing to waive their lien rights in exchange for a relatively nominal amount (often partial rent while the premises are accessed by the secured creditor).

One final item to note, which is overlooked with surprising frequency.  Secured creditors should not engage in self help when their collateral is under lock and key under premises owned by another party.  Article 9 security interests will not provide a defense to a charge of breaking and entering.

A previous entry dealt with a member’s obligation to keep funding an LLC. This entry briefly reviews something even dearer to the investor’s heart, getting their money back.

Since LLCs are flow-through entities for taxes, its members are liable for taxes on the portion of the LLC’s income allocated to them. At a minimum, the operating agreement should provide for quarterly tax distributions to meet this liability.

Privately held LLCs do not have a readily available market for their membership interests. Unless the LLC’s business plan is designed towards making it an attractive acquisition target, distributions are the only return on investment that a member is likely to receive in the foreseeable future. The issue of discretionary distributions is often a delicate balance between the need to fund ongoing operations, projected expenses and contingencies versus the investor’s desire for a monetary return on their investment. Ever since the Dodge brothers took Henry Ford to court (See 204 Mich. 459 (Mich. 1919)), the questions of distributions can get contentious or trigger litigation.

While management has an interest in preventing nervous members from disrupting its business plan, an operating agreement that leaves distributions at the sole discretion of management is equally problematic to members. Ideally the operating agreement will provide an appropriate percentage of the membership interest with the final decision on whether to make distributions. The decision to make discretionary distributions should be tailored to satisfy the capital needs of the LLC and its members.

As a practical matter, investors in an LLC may find that their minority stake will be insufficient to force a distribution. In such a scenario, a member should consider incorporating a “put right” in the operating agreement allowing the member to cash out after a specified period for an appropriate measure of fair market value. The timing of the put right should be structured to prevent liquidity problems for the LLC. The operating agreement’s buy-sell provisions should also include drag-along and tag-along rights to ensure that a minority member can cash out if the majority members sell their membership interest.

As with capital call requirements, investors should carefully review provisions in the operating agreement regarding distributions or other methods of receiving a return on their investment.

One of the often overlooked components of a limited liability company operating agreement is the portion dealing with capital contributions, allocations and distributions. This is not because of lack of interest, but rather because the statutory legalese can be enough to intimidate many investors and attorneys. However, ensuring this section is satisfactorily drafted is critical since it concerns the most important investment motive of the member – Money.

This entry focuses on capital contributions, more specifically on capital calls. If an LLC is likely to need additional infusions of capital in the future it may make sense to provide for mandatory capital calls. However, the two issues that must be addressed are: (a) who makes the decision; and (b) what are the consequences for a failure to make the payment.

This is where the interests of management and membership often diverge. The controlling members are likely to want a quick low-hurdle method to make the capital call. Minority members may not have the financial wherewithal to keep making additional contributions. If they are dissatisfied with management or the company’s performance, they may not want to double down on a bad investment. Onerous capital call provisions can be misused by management trying to squeeze out unwanted minority members.

The consequences for a failure to make a mandatory capital call can be severe. The operating agreement could provide for the reduction or elimination of the defaulting member’s interest or voting rights, subordination of the defaulting member’s interest to that of non-defaulting members, a forced sale of the defaulting member’s interest, the lending by the other members of the amount necessary to meet the defaulting member’s commitment, etc.

As a result, investors should closely review the capital call requirements in the operating agreement to limit their legal and financial exposure.

Latching onto a footnote in a 1991 decision of the Delaware Court of Chancery referring to an expansion of directors’ fiduciary duties when a corporation is in the “zone of insolvency”, creditors started asserting breaches of fiduciary duties when directors did not accede to their claims. SeeCredit Lyonnais Bank Nederland, N.V. v. Pathe Commc’ns Corp., Civ. A No. 12150, 1991 WL 277613, at *34 n. 55 (Del. Ch. Dec. 30, 1991). Delaware courts have now rolled back these claims clarifying that Credit Lyonnais intended to shield the board and management of a Company from fiduciary claims by shareholders and that the expansion of fiduciary duties to include creditors did not create an independent cause of action by creditors. SeeProd. Res. Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004); N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del.2007).

By rolling back fiduciary claims, the Delaware courts decisions highlight the importance of properly drafted covenants in credit agreements. Many borrowers dislike the cumbersome package of affirmative, negative and financial covenants that populate the credit agreements, often with good reason. The standard covenant package in most form credit agreements shackles the operations of the borrower by blocking many business decisions without a creditor’s permission slip. However, from the creditor’s perspective it bears the downside of risky behavior by the borrower. A properly drafted covenant package measures the financial health of the borrower and promptly alerts the creditor when there is a deterioration of the borrower’s business. Even if the borrower has not yet defaulted on its payment schedule, covenant breaches get creditors a seat at the table for any reorganization prior to formal insolvency or payment defaults.

It is possible to find a somewhat happy medium between the competing interests of the borrower and creditor by carving out certain activities and expenditures from the covenants. However, the recent credit crisis has shown the downside for creditors who too often lend money with light covenant requirements to borrowers being aggressively wooed by other lenders. Many creditors (particularly banks) are in the business of lending money, not operating businesses. While it is in their interest to maintain a long term relationship with the borrower, creditors should craft a covenant package that does not leave them in the position of a firefighter who shows up after the house has burned down to cinders.

A previous entry highlighted some of the perils of stock pledges. It can get worse.

The most glaring limitation in a pledge of stock of a privately held company is the absence of a public market for the stock. This potentially saddles the creditor with stock that it cannot sell (absent a shareholder agreement with mandatory buy-sell provisions).  Additionally, if the stock pledge does not include all or a controlling amount of the company the creditor may not be able to elect directors of the company to force a sale of the company.  This could leave the creditor in the position of Don Quixote tilting at windmills.

However, even with these limitations stock pledges are still fairly common.

To begin with, they are often the most cost effective way to obtain a security interest.  Since the lien is perfected by possession of the stock certificate or blank stock powers, both parties can avoid UCC filing costs (or even worse, mortgage filing costs) and requirements.  Enforcing the lien upon default involves simply signing over the stock to the creditor’s name and enforcing rights as a shareholder to sell the stock or vote to force a sale of the company.  This may permit the creditor to act without court action, particularly when the pledge gives the creditor vote of a controlling interest in stock.

Stock pledges are often not as intrusive in the day to day operations of the business and do not preclude the ability to obtain additional financing or trigger defaults on existing financing (Note: encumbering stock can trigger a default under many standard bank documents).  In some cases, the company may have sufficient value that even the acquisition of a minority interest may have inherent values.

While stock pledges are not perfect even when properly perfected, the circumstances of the transaction may make them the appropriate form of security.  The pros and cons of doing so should be carefully considered.