Know what you’re getting into before you sign the loan papers

It’s not always easy for business owners to find financing. Most business owners will, at some point, turn to conventional bank lending to help finance their business or fund growth, like acquisitions. There are, however, many different types of financing products available in the commercial lending market. But whatever type of financing you settle on, it’s critical to know exactly what you’re risking.

“Business owners often focus more on ‘getting the loan’ than on the specific terms and covenants of the loan, which in many instances can hinder the ongoing operations of the business,” says Christian A. Farmakis, shareholder and chairman of the board at Babst Calland.

Smart Business spoke with Farmakis about the lending environment and legal risks to keep an eye on.

What are loan options for small and mid-sized business owners?

Since the Great Recession, traditional bank lending has competed with other forms of lending. For instance, business owners are increasingly turning to private equity funding and family office lending rather than traditional, asset-based lending. These options may require sacrificing significant ownership and control over the business.

Other loan types include U.S. Small Business Administration loans backed by the federal government but underwritten by banks, small business loans for real estate financing and equipment loans.

Credit unions and regional and community banks sometimes offer different and more flexible terms and do smaller loans because they service the loan in their portfolio, where a larger bank might have stricter underwriting requirements.

What legal issues could crop up in the term sheet and loan documents?

Loans can include affirmative and negative covenants, but it’s usually the negative ones that trip people up.

Most loans require you to give a personal guarantee, provide certain information on a yearly basis, keep you from spending above a particular threshold on capital expenditures without prior approval, or stop you from taking out more debt. Most financial covenants require compliance with certain ratios, such as a debt to equity ratio; if you exceed those, the lender can theoretically default the loan. A larger loan also may require annual audits or reviewed statements, which can be disruptive and costly if the company is not already having those statements done by a CPA.

Another item to consider is pre-payment penalties, which can be significant but might decline over the first few years of the loan. It’s also not uncommon for a burdensome pre-payment penalty to stall, end or defer the business owner from doing a deal until the penalty is gone.

Therefore, it’s critical to know how the loan terms might restrict your operations and burden you with requirements. Take time to truly understand what events could trigger fees or penalties.

How much room is there to negotiate these terms?

Your negotiating room depends on the financial strength of your business, your growth model and if the bank sees opportunities to cross sell other fee-based services. Healthier, stronger businesses may be able to get items minimized or eliminated, such as fees. In addition, sometimes loans require borrowers to use services like payroll, lockbox or credit card processing. You may be able to disassociate the loan from these services.

You also want to get several quotes because banks have different underwriting requirements. For instance, one lender may require less collateral than others. And while a lot of this relates to the strength of the borrower, it also connects to the bank’s focus. If a lender isn’t interested in lending to a certain industry, it might not give the best terms.

Generally, a first-time, smaller borrower’s loan terms will be standard. You can take it or leave it, so you’re left negotiating interest rate and whether there’s a pre-payment penalty. But bigger borrowers with a solid balance sheet and strong business can prioritize the most costly or burdensome items and see if better terms are possible.

Insights Legal Affairs is brought to you by Babst Calland

How to use mediation rather than litigation to resolve business disputes

Civil litigation very often is mediated, sometimes twice, so that parties in conflict can avoid fighting out a dispute in court. 

“Businesses should think long and hard about moving forward with litigation without first trying to reconcile their differences through mediation,” says David Schaefer, Esq., a principal at McCarthy, Lebit, Crystal & Liffman Co., L.P.A. and a member of the National Academy of Distinguished Neutrals. “It’s a tried-and-true process that’s inexpensive when compared to the cost of litigation. And it’s a process that can save companies both time and money.”

Smart Business spoke with Schaefer about the mediation process and how it can be used in place of litigation to resolve business disputes.

When is mediation a good choice for businesses in dispute? 

Mediation typically is undertaken after a dispute has been ongoing for some time. At the very beginning of a dispute, the ability to resolve it through mediation is lower than after it has gone on for, say, a few months — statistics on early mediation indicate the settlement rate pre-lawsuit is lower than during the lawsuit. Still, there are a good number of mediations that occur before a lawsuit is filed, and some of those pre-lawsuit mediations work out, but not often. 

What is involved in the mediation process? 

Typically, the process is initiated by one party’s lawyer. A conference call with attorneys on both sides follows to discuss the procedural details: when, where, who will attend, the written materials the mediator would like to receive from the parties before the mediation, and the cost. 

The parties in conflict, along with their lawyers, meet at a neutral location — usually an office — where they’re split into separate rooms. The mediator goes from one party to the other getting information that will be used to find a resolution to the dispute. 

How can the parties be sure each is negotiating in good faith?

If one side is using mediation as, say, a means of inexpensive discovery, it becomes apparent quickly — within a couple hours of the start of mediation. But that doesn’t happen very often.

There are also instances in which a party might be ‘hoop jumping.’ That’s when a party has either been ordered by a court to mediate or needs to use mediation for dispute resolution because of a contractual obligation and is undertaking the process with little or no intention of settling the case and just wants to clear the legal or contractual hurdle.

What obligation do the parties have to abide by the mediator’s determination?

Mediators don’t make a final, binding decision like a judge or an arbitrator. Mediators, instead, make an objective suggestion to resolve the dispute. In monetary disputes, he or she can provide a mediator’s number, a suggested amount to settle the case. If both sides reject that number, then there is no agreement, and the parties and their counsel will need to decide on a future course. If both accept the mediator’s suggestion, a deal is reached and mediation is a success. 

What can parties do post mediation if they’re unsatisfied with the outcome?

When an agreement is reached through mediation, there should be a short document written up during the mediation and signed by both parties that binds them to the agreement. That document is an enforceable agreement. If one side tries to back out, which is rare, the other party can file a complaint in court to enforce the mediation settlement agreement.

There are a variety of steps that can be taken if the parties fail to reach settlement at the mediation. Probably the most common is the parties go back to litigation and engage in discovery. Sometimes the mediator will follow up with the parties’ lawyers and see if a resolution can be reached over the phone. Other times, the parties will pause and reconsider the offered resolution, and possibly accept it if it’s thought to be better than undertaking litigation.

Insights Legal Affairs is brought to you by McCarthy, Lebit, Crystal & Liffman Co., L.P.A.

How to choose strong trademarks and protect them

A trademark’s value is wholly contingent on how well it conveys to the public who is behind a product or service. That’s why it’s critical for companies to ensure their trademarks are strong and protected. However, not all companies take the proper steps.

“The costliest mistake companies make when choosing a trademark is getting too far along in the process before evaluating whether or not it’s a good and useable trademark, one that’s capable of passing a clearance review with the U.S. Patent and Trademark Office (USPTO),” says Suzanne Bretz Blum, a partner at Brouse McDowell.

A second critical mistake is failing to protect a trademark once it’s created, leaving it vulnerable for use by other companies, which may diminish its value or transfer the value built up to another company.

Smart Business spoke with Blum about how companies can ensure their trademarks are strong and the mark’s value is protected.

What legal protections exist for trademarks?

Federal law provides protections for trademarks, including provisions for suing someone who is using a trademark registered to another company through the USPTO.

In addition to federal protections, most states have their own trademark registration systems. There are also common-law trademark protections that exist under states’ unfair competition laws. These protect businesses from economic injury through deceptive or wrongful business practices, including the hijacking of a long-held but unregistered mark

How do companies enforce trademark protections once they’re secured?

It’s the responsibility of companies to watch the market for infringing uses of their trademark. Larger, international companies often pay for a service that monitors usage of their marks around the world and will alert the company to any potential infringers.

Companies with products that aren’t distributed as broadly should keep an eye out where their goods are sold, as well as in local advertising, and chase infringers with cease-and-desist letters.

Another useful strategy for protecting your marks is to take advantage of programs like Amazon’s brand registry program, through which companies can alert Amazon when they see other products on the site using an existing trademark. If the complaint is valid, Amazon will intervene and block the imposter from using the mark on the site.

What are the limitations of trademark protections?

Companies might not be able to stop others from using a trademark if it is not distinctive, or is too literal — for example, using an image of an apple to sell apples. An earlier user of a similar mark may also challenge a company’s ability to protect its trademark.

There are 45 trademark classes that categorize marks by the type of goods and services represented. Two companies that have the same mark but are in completely different trademark classes have a good chance of registering and protecting them. It becomes an issue when similar marks are used in the same marketplace and could cause confusion among consumers.

To evaluate your trademark’s strength in such a situation, consider evidence of the first use of each mark, like early advertisements, brochures or dated photos of packaged products for sale. Consumer surveys that show public awareness of the link between a company and trademark, and evidence that the company has taken steps to prevent others from using the trademark, will help establish rights where challenged.

How can companies ensure they’re on strong legal footing as they select a trademark?

It benefits companies seeking trademark protections to work with an attorney at multiple stages of the process. Experienced attorneys can conduct clearance reviews quickly and with a clear understanding of what to look for, which leads to a more reliable conclusion. They also understand what the courts are likely to say is confusing and can help companies strategize when it comes to the registration process.

Careful consideration in the early stages of developing a trademark is important. Once a company has invested in and is using a trademark, protecting the mark is critical. An experienced attorney can help ensure that companies continue to benefit from the value they’ve created in their mark.

Insights Legal Affairs is brought to you by Brouse McDowell

A closer look at New Jersey’s new law and how it affects businesses

On March 18, 2019, New Jersey Governor Phil Murphy signed into law Senate Bill 121. The law has New Jersey joining several other states in limiting the use of nondisclosures in employment contracts. The law comes, in part, from the recent #MeToo movement and is an attempt to prevent employers from silencing victims of harassment, discrimination or sexual assault.

“Although many associate this new law with sexual harassment, the law expands beyond sexual harassment and covers any contract or settlement agreements related to a claim of discrimination, retaliation or harassment by a current or former employee,” says Joseph W. Fluehr, an attorney at Semanoff Ormsby Greenberg & Torchia, LLC.

Smart Business spoke with Fluehr about the new law and how employers should proceed now that it’s been enacted.

What do businesses need to know about the law?

Importantly, the new law prohibits contracts or settlement agreements from waiving any substantive or procedural rights of an employee relating to any claim of discrimination, retaliation or harassment. Any nondisclosure provision in such agreements is now considered to be against public policy by the New Jersey legislature and, therefore, unenforceable by the employer. However, an employee may choose to enter into such an agreement and may enforce its provisions so long as the employee has not publicly disclosed sufficient details that make the employer reasonably identifiable.

Next, the law includes an anti-retaliation provision and makes anyone enforcing or attempting to enforce a provision that’s deemed to be against public policy and unenforceable liable for the employee’s reasonable attorney fees and costs. In such an instance, the employee may institute a civil action in the Superior Court of New Jersey within two years of the occurrence.

However, the law is not all-expansive, as its terms specifically carve out non-compete agreements and agreements prohibiting the disclosure of proprietary information, including trade secrets, business plans and customer information.

Finally, the law may be on shaky ground as it may face a preemption challenge as the terms also limit mandatory pre-dispute arbitration agreements. This is contrary to the Federal Arbitration Act, which favors enforcement of such agreements.

What is the law’s immediate impact?

Of immediate impact and importance is how businesses use confidentiality provisions in employment contracts and settlement agreements. Although these provisions are found to be against public policy, the specific portions of such agreements and the full effects of the law are not known due to the law’s ambiguity. Whether the law will prohibit keeping financial terms and the fact a settlement was reached from being disclosed is of great importance. Therefore, employers entering into these agreements or settlements should consult attorneys to strategize the best means of protecting themselves. Further, employers that operate in multiple states should be aware of choice-of-law provisions that choose New Jersey law to govern agreements.

What happens to employment contracts or settlement agreements that have these kinds of nondisclosure provisions?

The landscape of employment agreements in New Jersey has significantly changed. However, as the terms of the law are very broad, including key terms of the law left undefined, much is left up for interpretation. Therefore, employers should take a closer look at the terms of their agreements and their continued use of such nondisclosure provisions. Enforcement of such terms and provisions will be significantly penalized if the terms are restrictive against public policy. More importantly, employers will have to consider this new law when deciding whether to enter into separation or settlement agreements in the first place. The terms of those agreements, including monetary terms, may become public.

Employers should be wary of proceeding as they did before March 18, 2019. Employment attorneys should be consulted to review employer practices and agreements to avoid potential pitfalls established by this new law.

Insights Legal Affairs is brought to you by Semanoff Ormsby Greenberg & Torchia, LLC

The good and the ugly of convertible debt financing

Convertible debt is a common investment vehicle by which early-stage companies raise capital, where an investor grants to a company a short-term, often interest-bearing loan that converts into equity of the company at a future date. The convertible debt investors agree to push the question of what the company is worth — the valuation — down the road until the company’s next priced funding round. In return, the investors receive certain advantageous terms at the time that the debt converts to equity.

Smart Business spoke with Christian A. Farmakis, shareholder and chairman of the board, and Justine M. Kasznica, shareholder, at Babst Calland, about this investment vehicle.

What are the benefits for these investors?

As with any loan, the convertible debt note accrues interest until a defined maturity date. Unlike a standard promissory note, the convertible note often includes a conversion discount, valuation cap and other terms designed to mitigate the investor’s risk.

With the conversion discount, these investors receive a discount on the price per share at which their note converts to equity at a future priced round. Although discounts vary, it’s commonly set around 20 percent. Thus, if the price per share is set at $1, an investor’s convertible debt note would convert at a price of 80 cents per share.

With a valuation cap, (a) a maximum value of the company is established, solely for the purpose of calculating conversion of debt to equity; and (b) the investor’s price per share will be capped at the agreed upon number.

How can convertible debt negatively impact the startup?

Convertible notes are intended to be short-term investments. But when a company doesn’t get to its priced round quickly — or may require more notes to generate sufficient capital to keep the company in business — the founders can run into trouble.

By the time the company gets to a priced round, the accrual of interest, conversion discounts and valuation caps can result in a disproportionate percentage of the company being owned by the convertible debt investors, leaving the founders and employees as well as future investors with little future upside. Such a scenario can scare away new investors and render a company uninvestable.

How can founders get out of this scenario?

In many cases, this situation can be remedied through a renegotiation of the notes. For example, the valuation cap can be renegotiated or waived by the existing noteholders. Also, noteholders may agree to waive interest payments to reduce the impact of the conversion and the dilution effect on the founders. Still other times, noteholders may be interested in a buyout to get some or all of their money back.

A company’s negotiation and bargaining power is greatly enhanced if it can point to new investors who have conditioned their investment on a cap table adjustment. Noteholders can often be persuaded to give up or alter their contractual rights, if such a decision will help the company get the critical investment it needs to succeed.

What can be done to avoid this problem?

Although startups are often forced to accept bad financing deals just to get enough operating capital to survive, a few best practices can help mitigate some of these issues.

  • Fully understand the impact convertible debt financing rounds will have on shareholder equity positions by working through a variety of conversion and post-financing scenarios with advisers.
  • Where possible, try to treat multiple investments as if they were a single round, with a super-majority vote of the holders needed to amend the notes, making it easier to effectuate future note amendments.
  • When possible, ask for protective provisions such as prepayment rights, voluntary conversion prior to the maturity date and time-based conversion discounts (where the discount is smaller if the company can get to a priced round sooner).
  • Take time to know and cultivate a personal relationship with investors and to communicate regularly the company’s successes and challenges, which can go a long way in gaining goodwill in the event terms need to be renegotiated.

Insights Legal Affairs is brought to you by Babst Calland

Ways to resolve business disputes without litigation

Generally, when a business dispute arises, avoiding litigation can be the only thing two parties agree on. It could be costly, and parties want to avoid it to protect not only their secrets, but also their relationships. 

“No one goes into a business transaction looking for a dispute,” says Nicholas R. Oleski, an associate at McCarthy, Lebit, Crystal & Liffman Co., LPA. “When two parties reach an impasse, lawyers can become involved to find a way around it. And, generally, lawyers will look to negotiate the issue without litigation.”

Smart Business spoke with Oleski about alternatives to litigation when working to resolve business disputes.

Why would avoiding litigation benefit the parties involved?

Costs, confidentially and certainty are reasons parties look to avoid litigation. The process is inherently uncertain. A party might enter the process believing its case is a clear winner, but a judge or jury might not see it that way. Results can’t be guaranteed, even by the best lawyers, and that opens a party up to a great deal of risk, as well as higher-than-expected costs if the process drags out.

It’s also difficult to maintain confidentiality during litigation because court is public, and much of what happens in court becomes public record. There are mechanisms to protect confidential business information, but pleadings and other documents submitted as evidence might not get sealed by the court. Businesses want to avoid litigation when trade secrets aren’t at the center of case but could be disclosed as part of a lawsuit. 

Commercial transaction documents — contracts between the buyer and seller — should provide remedies short of litigation for disputes. The process can have multiple ascending levels, starting with informal talks between executives, before heading into formal alternative dispute resolutions, such as mediation and arbitration.

What is involved in the mediation and arbitration processes? 

Mediation is a formal negotiation procedure during which two parties and their attorneys talk with a mediator — a neutral third party, usually an experienced lawyer, with a background in whatever area the dispute is about — and attempt to resolve the dispute with a nonbinding verdict. Any information exchanged in mediation is considered privileged and can’t be used in court. 

Arbitration is a more adversarial form of negotiation, held in a more formal venue in front of an arbitrator — again, usually a neutral lawyer — who will render a legally binding decision to the parties. Arbitration enforcement is backed by federal and state statutes. The party that wins in arbitration confirms the arbitration award by filing the decision in court, which then confirms the arbitrator’s award. Then the court issues a public judgment that’s fully binding. 

When is litigation the best option when resolving business disputes?

Litigation may be the best way to protect trade secret information when it’s at the center of a dispute. Courts generally will seal or otherwise protect certain sensitive documents, which means the information they contain can only be shared between the parties’ lawyers. 

Both mediation and arbitration may not be desirable if one party is going to need access to the other’s documents regarding the transaction. In this instance, litigation in court may be preferable because the discovery mechanisms are more formal. 

Also, litigation offers the losing party appellate rights through the court of appeals. That option doesn’t exist in arbitration. 

Who should the parties consult with when deciding how best to resolve a business dispute? 

Talk with the internal employees closest to the source of the dispute first to get their input, then consult with internal counsel and discuss the event with them. Outside counsel could be brought in if additional expertise is needed. 

If at all possible, try to work it out with the aggrieved party before involving outside counsel. It’s usually never a bad idea for two sides to try to negotiate with each other to resolve the dispute before involving lawyers. However, it’s important to get lawyers involved before the dispute rises to troubling levels.

Insights Legal Affairs is brought to you by McCarthy, Lebit, Crystal & Liffman Co., LPA

How to avoid common legal pitfalls when starting a business

When forming a business, there are many considerations that should be made to protect the company’s legal and financial future. However, business owners often spend their time focused on what they are good at — making products or delivering services — and fail to assess many legal issues that create future liabilities.

Smart Business spoke with Louise M. Mazur, a partner at Brouse McDowell, about steps new business owners should take to protect their company.

What do new business owners need to know when forming the entity?

Incorporated businesses need a code of regulations that governs the organization of the business. Through this, the founders can create protections that will give them a strong position if they later take on investors for the business, such as delegating voting and nonvoting shares.

Similarly, limited liability companies need articles of organization, which enable the founders to designate themselves as the managing member and tax matter partner. These articles give them control of the day-to-day operations and oversight of the important financial decisions, legally establishing the founder’s authority so it cannot be challenged by future investors.

New businesses should also have an established buy/sell agreement that controls how ownership interests are sold to new investors, which will help avoid disputes with future investors.

There are also ongoing legal responsibilities after a business is formed. For example, a company must regularly update the existence of its business, including updates to the designation of its statutory agent. A company can be cancelled if it fails to file articles of continued existence or does not update its statutory agent. If that occurs, the founders could be, unknowingly, personally liable for the debts and obligations of the business.

How do founders shield themselves from liability?

Founders need to establish a separate mailing address for the company — even if just a P.O. Box — a separate bank account, credit card and line of credit. They should also keep their business receipts separate from personal receipts.

Those who do not establish a clear line between their personal and business identities may have significant problems. For example, if an owner makes a personal purchase on a company credit card, the IRS will classify it as income to the individual, which means the person needs to either declare it as such on his or her taxes, or reimburse the company for the purchase. Failing to do so will lead to penalties.

What should a business do to protect its operations from the start?

An employee should be asked to sign a new hire agreement that contains three components: confidentiality, noncompete, and work-for-hire provisions.

Concerning confidentiality, the employee will acknowledge that certain proprietary information is the property of the business and that the employee is legally prohibited from using the confidential information or sharing confidential information with third parties during and after employment.

Noncompete agreements are designed to restrict an employee’s ability to compete directly with the company, either by setting up a competing business or working for a competitor, within a specified geography and amount of time.

In the employer/employee relationship, the employer owns all rights to the work created by the employee. Nonetheless, the new hire agreement should include a work-for-hire provision to clearly confirm that all of the employee’s works or inventions become the sole property of the employer.

A new business should also develop terms and conditions of sale to outline the required due dates for payment and interest that accrues for late payments. Terms and conditions can also protect a business by placing limitations on liability to customers and minimizing customers’ remedies against the business. Terms and conditions should address how problems will be handled if and when they occur.

Before forming a business, founders should talk with an accountant and an attorney to ensure the company will be on strong legal footing and positioned to optimize any tax advantages. A little foresight at the start goes a long way for a new business.

Insights Legal Affairs is brought to you by Brouse McDowell

What the DOL’s new overtime regulations mean for your business

In March, the U.S. Department of Labor (DOL) issued a replacement of the controversial (and more employee-friendly) Obama-era overtime rule that was blocked by a federal judge in Texas in 2017, days before it was scheduled to take effect. The new rule brings a host of changes, including the reclassification of more than 1 million currently exempt workers as nonexempt.

Smart Business spoke with Stephen C. Goldblum, an attorney at Semanoff Ormsby Greenberg & Torchia, LLC, about what employers need to know about the new rule.

What are the new Department of Labor regulations?

The Fair Labor Standards Act (FLSA) overtime rule determines whether employees are eligible or exempt for overtime pay. Based upon their compensation and the type of work they do, exempt employees are not eligible for overtime pay for hours worked over 40 in a workweek. Nonexempt employees are eligible for overtime pay and must be paid at least time and one-half their regular pay rate for all hours worked over 40 in a workweek.

The new rule, issued in March, raises the minimum salary threshold required for non-exempt workers to qualify for the FLSA’s ‘white collar’ exemptions from $23,660 to $35,308 per year. Above the $35,308 compensation level, employees are not automatically eligible for overtime, but still must meet certain job duties (executive, administrative, professional, computer professionals and outside salespersons) to qualify. The DOL did not make any changes to the ‘duties test,’ which governs whether an employee’s duties fall within one of these classifications.

The new rule also increases the total annual compensation requirement for highly compensated workers from $100,000 to $147,414. That means an employee is exempt from overtime if:

1) The employee earns total annual compensation of $147,414 or more, which includes at least $455 per week paid on a salary basis;

2) The employee’s primary duty includes performing office or non-manual work; and

3) The employee customarily and regularly performs at least one of the duties or responsibilities of an exempt executive, administrative or professional employee.

The DOL also proposed regular increases to the salary threshold every four years. The updates would not be automatic, but would come only after the submission of public comments.

Lastly, the new rule allows employers to include certain non-discretionary bonuses and incentive payments to comprise up to 10 percent of the new $35,308 threshold.

What is the effect of the new DOL regulations?

The DOL estimates the new rule, expected to take effect in January 2020, will result in the reclassification of more than 1 million currently exempt workers as nonexempt, and an increase in pay for others above the new threshold.

What does this mean for businesses?

Companies must determine if there are any employees who are currently exempt (ineligible for overtime) that are:

1) Making between $23,660 and $35,308 (the new minimum salary threshold) or

2) Making between $100,000 and $147,414 (highly compensated).

If there are employees in either category, they will need to be converted to non-exempt hourly employees eligible for overtime effective no later than December 31, 2019, or their salary will need to be increased to exceed the new thresholds.

A word of caution: state laws may differ from these federal regulations. For example, the Pennsylvania Minimum Wage Act does not recognize the highly compensated test or the computer professional exemption and therefore those do not apply in Pennsylvania. Therefore, a review of applicable state laws is necessary before any permanent changes are made.

Insights Legal Affairs is brought to you by Semanoff Ormsby Greenberg & Torchia, LLC

Areas of risk in 401(k) plans that expose companies to audits, litigation

Many employers offer a 401(k) retirement plan to their employees. In doing so, employers are generally aware of some of the key fiduciary responsibilities imposed upon them under federal law. However, there are other aspects of the operation and administration of 401(k) plans that can be overlooked. In doing so, employers become vulnerable to litigation and/or governmental audits.

Smart Business spoke with Patrick J. Egan, a partner in the Corporate & Securities and Labor & Employment Practices at Brouse McDowell, about the aspects of plan management companies tend to miss and the risks that creates.

What are the fiduciary duties employers tend to overlook?

In many circumstances, an employer will establish a 401(k) plan for its employees and will fail to ensure that its operation and administration satisfy the requirements imposed under the Employee Retirement Income Security Act (ERISA).

Under the provisions of ERISA, plan sponsors have a responsibility to make sure that the expenses and fees associated with their 401(k) plans are reasonable. If an employer has failed to review and benchmark plan fees for an extended period of time, it could constitute an ERISA fiduciary breach because third-party vendors are generally paid directly from the assets of the 401(k) plan. Thus, the higher the fees, the lower the account balances of the 401(k) participants. Employers should be reviewing and benchmarking the fees assessed by the plan’s service providers by issuing Requests for Proposal (RFPs) about every three years.

Employers also cannot ignore the overall performance of the investment funds offered under their 401(k) plan. If, for example, a large-cap mutual fund has underperformed over the past few years, the employer has a fiduciary duty to analyze it and determine whether it should be removed and replaced by a better-performing fund option.

Why are these aspects of 401(k) plan management under scrutiny?

A series of lawsuits filed by attorneys representing 401(k) participants has brought the issues regarding plan expenses and investment performance into the spotlight. Moreover, these issues have also become a point of emphasis for the U.S. Department of Labor (DOL) when it conducted plan audits. Therefore, employers now need to be more proactive regarding the operation of their plan to mitigate the possibility of any litigation or a DOL audit.

What steps can employers undertake to satisfy their fiduciary obligations?

Employers need significant processes and procedures in place that fully address the operations of their 401(k) plan. For example, employers should consider delegating responsibility to an investment committee that meets periodically to oversee the operations of their 401(k) plan, review the fees assessed by third-party service providers, review the performance of the plan’s investment options and replace underperforming investment options. Further, each investment committee meeting should be documented and the written minutes reviewed and approved at the next meeting.

There is an overall duty under ERISA that fiduciaries must act prudently. The DOL has noted that prudence focuses on the process for making fiduciary decisions. Therefore, having a committee meet periodically to review the 401(k) plan can satisfy these fiduciary responsibilities.

What should companies do to correct any potential fiduciary oversight issues?

Employers should review the current structure and operation of their 401(k) plan. Reaching out to legal counsel may be prudent, as they can conduct a comprehensive review of the process and procedures currently in place and determine whether they are sufficient for purposes of ERISA. Further, legal counsel can assist the employer or investment committee in navigating the RFP process and can also conduct fiduciary training so that the investment committee members fully understand their fiduciary obligations as imposed under ERISA.

Employers need to be aware of the changing regulatory and legal environment and become more involved with their 401(k) plan in order to address increased litigation and governmental oversight.

Insights Legal Affairs is brought to you by Brouse McDowell

The corporate opportunity doctrine when your investors are competitors

Consider this scenario: A startup in the artificial intelligence (AI) space develops a unique algorithm. A larger AI firm is interested in this algorithm but isn’t sure it’ll work. The larger company doesn’t want to buy the startup, but it wants a foot in the door on the new technology and is willing to invest. The startup needs funds but is concerned about the competitive issues created by giving the larger company a board seat and waiving the corporate opportunity doctrine.

“A smaller company is under pressure — in this scenario or others like it — to waive the corporate opportunity doctrine,” says Sara M. Antol, shareholder at Babst Calland. “Before you do that, stop and think about what this will mean. You need to determine whether there’s room to compromise with tailored language that serves the purposes of both the company and the investor.”

Smart Business spoke with Antol and Christian A. Farmakis, shareholder and chairman of the board at Babst Calland, about the corporate opportunity doctrine.

What is the corporate opportunity doctrine?

The corporate opportunity doctrine is part of the duty of loyalty imposed upon corporate fiduciaries. It’s not uncommon for a business owner or entity to invest in another company. If the investment is significant, the investor may demand a board seat to help influence the policies and operations of the company. If this person finds out about an opportunity as a board member, the corporate opportunity doctrine stops that director or officer from personally benefitting from an opportunity that would belong to the corporation, if it meets a four-pronged test:

  • If the corporation is financially able to exploit the opportunity.
  • If the opportunity is within the corporation’s line of business.
  • If the corporation has an interest or expectation relating to the opportunity.
  • If by taking the opportunity, the officer or director is placed in a position adverse or in conflict with the corporation.

How did it become commonplace for this doctrine to be waived?

As private investment increased, investors saw the potential conflict created by the duty of loyalty if they acted to maximize their interests while serving on a board. In 2000, Delaware amended its general corporation law to allow companies to expressly waive that duty in their certificate of incorporation. Since then, other states have adopted similar provisions, such as Pennsylvania’s limited liability company law in 2016.

Today, it’s common for companies to waive the corporate opportunity doctrine. Form investment documents, especially with private equity, often include this language.

Why would a company invest in a competitor and how does it create conflict?

A bigger company looking for the next big thing might invest in startups within its market space. Then, it can leverage the product or technology when the opportunity matures. Frequently, these startups are searching for capital and willing to agree to investment from a larger competitor.

The conflict arises when the larger company wants a waiver of the corporate opportunity doctrine in the investment documents. This allows the larger company to operate in its market space, which is shared by both companies, without restriction. The smaller company, though, may justifiably have concerns about future competition from the larger company.

How can companies find a compromise?

The waiver language can be tailored to address the areas and issues where the two companies might most likely compete. For example, if the larger company ends up competing with the smaller company under the waiver, the investor could lose some investor rights — investor rights that you wouldn’t want a competitor to have, like a board seat, monthly financial information or information about customer opportunities. Instead, perhaps the board seat converts to observer rights and the investor is limited to only receiving annual financial information.

There’s room to negotiate and countless scenarios could be proposed, so founders need to think carefully and assess the situation before agreeing to waive the corporate opportunity doctrine. At the very least they’ll have their eyes open to the risks and know what they’re giving up by agreeing to this waiver.

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