Contractors, advisers, and employees (collectively, “Service Providers”) who receive property that is non-transferrable or subject to a substantial risk of forfeiture must generally defer their income recognition until those conditions no longer apply. However, due to the potential appreciation in the property (for example, in value of start-up equity) the ordinary income ultimately recognized could be significantly greater than the initial value. The Service Provider may be able to significantly reduce their taxes, and the employer may create a significant compensation incentive, if the Service Providers make the election under Internal Revenue Code Section 83(b) to recognize the income currently, notwithstanding the forfeiture risks. Timing of this election is critical as it must be made within 30 days after the property is transferred to the Service Provider.

Under Internal Revenue Code 83(a), Service Providers who receive property (including equity interests) for their services that are non-transferrable or subject to a substantial risk of forfeiture are required to pay, at the date the interests vest, income tax on the excess of the fair market value of the property over the amount paid for the property. If the fair market value of the property increases between the grant and vesting of the interests, Service Providers will pay an income tax on the greater value, and possibly at a higher marginal rate too. A Section 83(b) election may be the perfect tool for Service Providers to convert immediate ordinary income into deferred long term capital gains.

The downside of the election is that the income is recognized even though the risk of forfeiture still exists. If the risk materializes and the property goes down in value, or becomes worthless, there is no deduction to the Service Provider. They are stuck with paying income tax on property that is potentially worthless.

These risk/reward tradeoffs highlight the advantage of using this election for compensating employees of start-up ventures, typically with equity subject to vesting. In this case, the current value of the equity is limited, so there is little or no income to report (and pay tax on) currently. If the equity goes down in value, or is forfeited, the employee has not wasted tax payments. However, if the equity increases in value, as the parties hope, then the employee will be able to report this value at the more favorable capital gains rates instead of ordinary rates. The Section 83(b) election can make a start-up equity grant a much more effective inducement to attract new employees, by putting more money into the pocket of the employee.

But remember, taking advantage of the Section 83(b) elections requires a filing by the Service Provider within 30 days after the grant of property. The law does not want to allow the Service Provider to see which way the value is moving. The election, and the commitment to property must be made up front.

Service Providers should contact an attorney or other tax professional when deciding whether or not to make a Section 83(b) election. Additionally, issuers and companies should contact Cole Schotz P.C. before granting equity or other compensation.

Delaware General Corporate Law § 226 (the “Custodian Statute”) bestows the Delaware Court of Chancery with the power to appoint a custodian for solvent companies and receivers for insolvent companies in certain circumstances. See 8 Del. C. § 226. Specifically, a custodian may be appointed where, inter alia, a company’s “stockholders are so divided that they have failed to elect successors to directors whose terms have expired”, and where the business is suffering or threatened with “irreparable injury because the directors are so divided respecting the management of affairs that the required vote for action by the board of directors cannot be obtained and the stockholders are unable to terminate this division.” 8 Del. C. § 226(a)(1), (2). Although a custodian appointed under § 226 shall “continue the business of the corporation and not . . . liquidate its affairs and distribute its assets,” the Chancery Court has wide discretion in how it addresses a deadlock, and may even authorize a custodian to sell a company. See id. The scope of the Chancery Court’s broad discretionary authority to address deadlocks under § 226 was addressed in a recent decision of the Delaware Supreme Court. See Shawe v. Elting, No. 423, 2016, 2017 WL 563963, at *1 (Del. Feb. 13, 2017). Some read that decision as expanding the power of the courts to order the sale of a solvent company’s stock over the objection of the company’s shareholders.

In response to the decision, legislation has been proposed that would restrict the Chancery Court’s ability to dissolve or sell a solvent company by requiring that “alternative remedies prove insufficient after three years”, or the “necessary parties stipulate to such a sale.” Proposed Delaware Senate Bill No. 53.  The purpose of the proposed legislation is to “ensure the continued fair and equitable treatment of corporations in Delaware” by addressing “deficien[cies] in providing fair and equitable remedies in specific regards to deadlock situations.”  Id.  The Delaware Corporate Law Section plans to oppose the bill. The full text of the case, Shawe v. Elting, can be accessed here.

 

In a recent decision of the Delaware Court of Chancery, the Court struck down a corporate bylaw provision of NutriSystem, Inc., a Delaware corporation (the “Company”), ruling the provision to be inconsistent with the Delaware General Corporation Law.  See Fretcher v. Zier, No. CV 12038-VCG, 2017 WL 345142 (Del. Ch. Jan. 24, 2017).  The Company’s bylaw provision, which had recently been adopted as an amendment to the Company’s bylaws, stated that the stockholders of the Company may remove directors, but only upon the vote of “not less than 66 and two-thirds percent…of the voting power of all outstanding shares” of Company stock.  Id. at *1.  This bylaw provision is in contravention of 8 Del. C. § 141(k) under which directors may be removed by a majority vote of corporate shares.

Plaintiff, a shareholder of the Company, brought a class action suit on behalf of the shareholders of the Company against Defendants, who were comprised of the Company and the Board of Directors of the Company.  Id.  Prior to the adoption of the subject bylaw amendment, the relevant bylaw allowed Company stockholders to remove directors only for cause and upon the affirmative vote of two-thirds of all outstanding shares of Company stock (the “Removal Provision”).  Id.  On January 7, 2016, the Company filed a Form 8-K with the Securities and Exchange Commission announcing that the Board had approved an amendment to the Company’s bylaws which removed the “for cause” requirement from the Removal Provision.  Id.

The Plaintiff filed his Verified Class Action Complaint on February 24, 2016 (the “Complaint”) pleading two counts.  Id. at *2.  In Count I, the Plaintiff alleged a breach of fiduciary duty against the Defendants, contending that the directors breached the duty of loyalty by enacting an unlawful bylaw to entrench themselves in office.  Id.  In Count II, the Plaintiff sought a declaratory judgment that the Removal Provision violates Section 141(k).  Id.  The Defendants moved to dismiss the Complaint on May 27, 2016 and the Plaintiff moved for partial summary judgment on Count II on August 9, 2016.

The Defendants defense was centered on two legal issues.  First, the Defendants focused their argument on 8 Del. C. § 216, which permits corporations to adopt bylaws specifying the required vote for the transaction of the business of the corporation, subject to other voting requirements necessary to take specific actions.  Id. at *3.  The Defendants conceded that the specific provisions of Section 141(k), addressing removal of directors, supersede this general permissive language, but argued that Section 141(k) “does not dictate a contrary result” because the Section “sets the rules only for the circumstances under which stockholders may remove directors without cause, and does not address the percentage of the vote that is required to remove directors.”  Id.  Second, the Defendants argued that the majority vote portion of Section 141(k) is a permissive provision, noting that Section 141(k) provides only that a majority of stockholders may remove directors, “thereby leaving the bylaws free to require a minority, a supermajority or even unanimity as a requisite for director removal.”  Id.

The Court disposed of Defendant’s arguments using a plain language reading of the statute, ruling that “[Section 141(k)] provides that holders of a majority of stock may—not must—remove directors; that is, if they so choose, the section confers that power.”  Id. at *4.  Stated otherwise, the permissive portion of Section 141(k) is whether a director is removed — not the required vote for such removal.

The Court denied Defendant’s Motion to Dismiss and granted Plaintiff’s Motion for Summary Judgment with respect to Count II.  Count I was withdrawn.  Id.

This decision is a stark reminder that corporations should be mindful of statutory rules when drafting and adopting bylaws.  While corporate statutes serve as guidelines in some circumstances, careful attention must be given to those provisions of a state’s corporate law that are to be literally, not figuratively, construed.

Each year state, local and federal agencies award billions of dollars in contracts to private businesses and of those contracts awarded, government agencies set aside a percentage of business opportunities or contacts for certified Women Business Enterprises (WBE).  These government set-asides are for businesses certified as a WBE and sometimes require additional certification as a small business, as such term is defined under federal or state applicable laws to be a Women Owned Small Business (WOSB) and/or industry specific requirements.  In addition to government work, many large private sector companies seek to have business relationships with women owned businesses.  If a business meets certain requirements, the business could certify as a WBE and reap the benefits of lucrative private sector contract initiatives.  For this reason alone, certification solely as a WBE could greatly benefit your business.

A business can be WBE certified by a state government, the Federal Government, a third party certifier such as the Women’s Business Enterprise National Council, or, on the federal and often private sector level, by self-certification.  While the WBE certification process may vary slightly depending on the applicable government agency or private company, the requirements are generally similar.  At least 51% of the business must be owned and controlled by women and the day-to-day operations managed by women.  For certain government contract set-asides, including the Federal Government, an entity must operate in approved industries and not exceed certain size and/or revenue limitations with respect to such industry to qualify as a small business under applicable law.

Certifiers take this process seriously and require, among other things, various organizational, governance and tax documents to vet the applicant.  Certifiers are particularly concerned with the “control” requirement and endeavor to look beyond the applicant’s ownership into the realities of decision-making and management.  Careful attention is required when there is ownership through other entities or estate planning trusts.  Furthermore, certifiers typically prefer applicants to be in existence and conducting business for at least a year prior to submitting an application for WBE status.  New York, for example, strongly recommends, but does not require, that businesses operate for at least one year prior to applying for WBE certification.  As such, an entity may apply for WBE status prior to operating for one year, but may face issues in collecting the necessary documentation.

While the application process can be scrutinizing in some respects, the benefits of being certified as a WBE can be well worth the process.  As a WBE, businesses are afforded improved access to government and private sector work and set-asides.  While WBE status does not guarantee more work by virtue of the status itself, WBE status places businesses in favorable positions as they bid for contracts or business relationships with those seeking to work with WBEs.  For a business looking to grow, becoming a WBE could be the key to greater revenues and connecting with new industry contacts.

There are similar certifications available for minority-owned businesses.

In the recent decision Cain v. Merck & Co., Inc., the New Jersey Appellate Division held that shareholders of New Jersey corporations are entitled to inspect board of directors and executive committees minutes, in addition to minutes of shareholder meetings. The Appellate Division made clear, however, that shareholders must demonstrate a “proper purpose” in exercising this right and that the scope of board of directors and executive committee minutes required to be made available for shareholder review are limited to only those minutes pertinent to that proper purpose.

In Cain, the plaintiffs made a written demand, pursuant to N.J.S.A. 14A:5-28(4), for the inspection of certain books, minutes and records of the company in connection with the plaintiffs’ claim that the company had engaged in wrongful conduct and mismanagement in failing to disclose the results of a clinical drug trial for a period of twenty-one (21) months. The trial court ruled that the plaintiffs were entitled to inspect all of the board of director and executive committee minutes for that period.

Section 14A:5-28 provides that: (1) a corporation is required to “keep the books and records of account and minutes of the proceedings of its shareholders, board and executive committee”; (2) upon request, a corporation shall provide certain financial statements to a shareholder; (3) a shareholder holding at least five (5%) percent of the outstanding stock of a corporation, or who has owned his stock for at least six (6) months, has the right to inspect “for any proper purpose” a corporation’s “minutes of the proceedings of its shareholders and records of shareholders”; and (4) a court may, “upon proof by a shareholder of proper purpose . . . compel production . . . of the books and records of account, minutes, and record of shareholders” of the corporation. In construing the statute, the Appellate Division acknowledged that shareholders have a qualified common law right, not limited to simply stock transfer records, to examine corporate books and records, provided that the inspection request was made in good faith and for a proper purpose. The Appellate Division further noted that unlike the language of subsection (3) of the statute, the language of subsection (4) was not specifically limited to minutes of shareholder meetings. Accordingly, the Appellate Division held that under N.J.S.A. 14A:5-28(4), a shareholder is entitled to inspect the minutes of the board of directors and executive committees of a corporation.

Recognizing that an unfettered right to inspect board of directors and executive committee minutes could be detrimental to the best interests of the corporation and its shareholders, the Appellate Division made clear that this inspection right is not unqualified. A shareholder has the burden of proving a “proper purpose” for its inspection demand, based upon “specific and supported, credible allegations of mismanagement.” “Fishing expeditions” by shareholders based upon general or unsubstantiated claims of mismanagement are not permitted. Additionally, a court has the power to specifically circumscribe the scope of the inspection, limiting the inspection to only those documents relevant to the shareholder’s demonstrated proper purpose. In Cain, therefore, the Appellate Division limited the scope of the minutes available for plaintiffs’ inspection to only those portions of board of directors and executive committee minutes dealing with the clinical drug trial during the period the plaintiffs alleged the company wrongfully withheld the results of the trial. The plaintiffs were not entitled to inspect all corporate minutes for that period, as previously allowed by the trial court.