Month: April 2014

Top Ten Pitfalls In Negotiating And Drafting Business Contracts – Part I (Letters Of Intent)

This is the first of a ten-part series that may show you how the simplest-looking parts of a business deal can come back to haunt you. Stay with it and read about how to avoid getting into trouble, instead of how to get out of trouble.  I have published an abbreviated version of this series in the January 2014 issue of Nevada Business magazine.  Here is the link, but I warn you – it is so abbreviated that it only has seven pitfalls, and there is much more to be said than what you will see in that article!

1) Letters Of Intent – More Harm Than Good?

Before we even get to a contract, let’s look at where a pitfall lies – the innocent-looking letter of intent.

You’re excited about your deal, and you don’t want the other party to walk away before you can draw up a contract.  So you decide to take a baby step first – put the main deal points into a letter of intent, label it “non-binding,” get both sides to sign off so you can start work on a real contract.  If you change your mind, or something better comes along, you can just walk away because you didn’t sign a contract and the letter of intent is non-binding, right?

Not so fast.   

True, letters of intent normally do not obligate you to enter into a contract later on.  But be careful about friendly phrases like, “we are just agreeing to talk about doing a deal on these basic terms.…” It can mean more than you want it to mean. 

A court may interpret your statement as meaning “agreeing to talk in good faith…” even if you didn’t say it.  And if both parties agreed to talk in good faith about doing a deal on the basic terms that you listed, you may be unable to walk away or ask for better deal terms later in the negotiations, the way you thought you could.  True, you don’t have a contract for the deal yet, but you might already be stuck in a binding contract to conduct good faith negotiations intended to lead to the deal, even if you no longer want it.

There are ways to avoid this.  A truly non-binding document can be carefully drafted that way.  But if it were so simple, there would not be so many cases that have held a party to be in breach of a letter of intent, with resulting liability, because it mistakenly thought the phrase “non-binding letter of intent” meant what it said.

Capital-Raising: Every Silver Lining Has A Cloud

On September 23, 2013, the world changed.

For longer than most of us have been alive, if you wanted to raise capital – which usually means offering securities – the basic rule was simple, but frustrating:   If you wanted to advertise your offering, you had to register with the SEC, which was very expensive and time-consuming.  If you wanted to avoid SEC registration, you could not advertise your offering or conduct any other “general solicitation” (broadly defined).  And that, of course, begged the question of how can you find investors if you can’t advertise or go out soliciting them.

The Jumpstart Our Business Startups Act (JOBS Act) mandated the repeal of that restriction on so-called “private placements” or nonpublic offerings, which are exempt from SEC registration.  On September 23, 2013, that repeal took effect through amendments to SEC Regulation D.  Companies can now advertise and conduct general solicitations to raise capital without registering with the SEC.  In other words, now you can actually go out looking for  buyers, and the crowdfunding floodgates have opened!

But of course, it’s never all that simple.

If you want to operate in this new world, you can advertise to anyone BUT you can only sell to “accredited investors,” as defined by the SEC.  The full definition of “accredited investor” is longer than this whole article, but the principal part of the definition is:  (1) a person who had annual income of at least $200,000 in each of the last two years, or $300,000 if you include a spouse’s income, and who reasonably expects to reach that income level in the current year; or (2) a person whose net worth exceeds $1 million, excluding his or her primary residence.

Even before the new rules, “accredited investor” was an important concept, and many companies limited their offerings to accredited investors to avoid the special disclosure rules that applied to sales to non-accredited investors.  But back then, companies just needed to reasonably believe that an investor was accredited.  It became routine to use a check-the-box instruction on the subscription agreement for investors to claim accredited status, and companies tended to rely on that checked box to show their reasonable belief, without asking investors for confidential financial or tax information to prove their status.

Under the new rules, check-the-box is not enough.  Companies must be proactive in getting specific information about an investor that reasonably demonstrates accreditation.  The most reliable information will probably be the hardest to get, namely tax returns, W-2 forms, or personal financial statements.  Of course, if your investor is Warren Buffett or Carl Icahn,  you can just rely on his identity to conclude that he is accredited.  But the less actual knowledge you have about a particular investor, the heavier the burden will be on you to obtain sufficient and reliable information that demonstrates the investor’s high income, high net worth, or other accredited status.  And you will need to retain adequate records that support your conclusion.  You can well imagine that some potential investors might resist.

What if you can’t get this information, or what if you get it and it shows you that your investor is not accredited?

Well, the old rules for private placements still coexist with the new rules.  Under the old rules, if you do not advertise or conduct general solicitation, then you can sell to a limited number of non-accredited investors and you will also be held to a lesser standard in ascertaining accredited status.

But not so fast….  When you advertised your offering in reliance on the new rules, or hopped on a crowdfunding platform, you lost your eligibility to rely on the old rules, which do not allow this activity.

So what all of this comes down to is that if you rush into your offering, without proper legal advice about how to structure it and about all the decisions you will have to make have going forward, you might wind up in a worst-case scenario – not qualifying under the new rules and disqualifying yourself under the old rules.  Ouch!

And, by the way, the antifraud provisions of the securities laws have not changed.  No matter how you advertise your offering, the legal consequences of failing to disclose material information, or making material misstatements or omissions, are severe.

If you plan to raise capital without experienced securities law counsel, plan again.  If you plan to launch your offering and then retain securities law counsel at a later stage, plan again.  If you plan to do anything other than proceed cautiously with expert advice right from the get-go, plan again.  If I can be of assistance to you, it sounds like a plan.

Serve Proudly, … But With An Indemnification Agreement!

If you are a director, officer or key employee of a corporation, at first glance Nevada law appears to protect you against liability for doing your job.  It says that if you are sued in connection with the performance of your duties and you successfully defend yourself, your company must indemnify you for the defense costs.

But it really is not that simple.  For example, what if:

1. your case drags on for months or years and you have to pay your lawyers in the meantime; or

2. you acted in good faith and reasonably believed that your actions were in the corporation’s best interests, but you did not get a judgment in your favor; or

3. you make a settlement payment, to make the case go away, before the trial ends (or even before it begins); or

4. you make no settlement payment and the plaintiff drops the case, but you still had to pay your lawyers; or

5.  no one is suing you, but you are subpoenaed to testify in someone else’s trial and you need a lawyer, just in case….

In these “what if” situations, Nevada law would generally allow the corporation to indemnify you or to advance your defense costs as you incur them (referred to as “hold harmless” protection) so you don’t go broke trying to defend yourself.  But waiting until you find yourself in this mess and then asking the corporation to pay your bills is not the best approach, to put it mildly.  At that stage, if your employer is not obligated to pay, it might choose not to pay.

If you are important enough to a company that it wants you at a high-level position (and it is usually the people at the top who get sued when things go wrong), then you need to negotiate and get a binding indemnification/hold harmless agreement at the earliest possible time and BEFORE you actually need to rely on it.  When it comes to these agreements, Nevada law can work to your advantage because it authorizes contractual arrangements for a wide range of indemnifiable events and advancement of defense costs.

In other words, there is much that a corporation is not required to protect you against, as shown in the numbered examples above, unless it agrees in advance to give you that protection.  Sometimes those protections are set forth in the corporation’s bylaws and they apply to all top-level personnel.  But complications can arise if the bylaws are later amended without your consent.  If you get a separate, properly-drafted indemnification contract, then you will have the peace of mind to know it cannot be changed without your consent.  In any event, whether these protections are in the bylaws or in your separate contract, your lawyer should make sure that it mandates indemnification and advancement of expenses to the maximum extent permitted under Nevada law (which is a pretty high maximum).

Once you get it, the “what ifs” above (and there are others) need not be a distraction to you.