Not too long ago, technology was considered a “vertical” market filled with companies that met the needs of the “technology” industry (think Microsoft, Dell, Cisco, Intel, and IBM).  However, technological products and services have evolved to the point of serving a “horizontal” market, having become an important aspect of many different types of businesses across a wide variety of industries and sectors (think fintech, healthtech, cleantech, autotech, edtech, etc.) and, by extension, M&A transactions.

For example, deals in the media industry increasingly are focused on the digital media aspects, particularly given the decline in demand for print media.  Likewise, parties to acquisitions in the financial services industry often pay close attention to the protection of proprietary investment strategies, data protection, trade names, and customized software.  Even manufacturers and other traditionally “non-tech” companies are leaning on technology more and more in order to streamline their business processes, manage and analyze data better, and to protect themselves from cyber-attacks.

This trend towards a “horizontal” market only looks to accelerate as technology becomes more and more embedded in businesses of all stripes, as presaged by the $13.7 billion purchase of Whole Foods by Amazon.com Inc. this year.  Similarly, private equity interest in tech and tech-enabled businesses has grown in recent years, particularly for more “stable” businesses such as software companies that generate recurring revenue or that serve other businesses.

Given the growing proportion of M&A deals that are considered to be “tech” deals (even where non-technology companies are involved), middle market businesses of all kinds that are evaluating the possibility of a sale or, conversely, looking for potential targets to acquire cannot afford to overlook the importance of technology as a key asset.

High-level legal concerns often revolve around the target’s ownership or right to use key technological assets, as well as the level of protection and ability to transfer the same.  This includes making sure that all owned intellectual property of the business is properly registered with the USPTO or copyright office in the name of the appropriate entity, and that all renewals and maintenance fees have been paid.  Additionally, acquirers should check that employees and, particularly, key independent contractors of the target have assigned their rights in and to all key intellectual properties to the target.  Inbound licenses that are material to the business, as well as revenue generating outbound licenses, should be reviewed to determine assignability.  It goes without saying that it is critical to ascertain whether the target has any existing or suspected infringement claims, as well as any security interests or encumbrances affecting its key technology assets.

Further, to the extent key technologies are held within a joint venture between the target and a third party, an acquirer should consider whether its business model would allow it to “step into the shoes” of the target vis a vis the joint venture versus the extent to which the acquirer could readily extract the technological assets and/or wind-down the joint venture.

The takeaway here is when engaging in M&A transactions – whether in the middle market or otherwise – ignore technology at your peril.  Those companies (even “non-tech” ones) that can demonstrate a strong command of their technological assets should increase their attractiveness as targets as we move into the future.  Conversely, acquirers that understand their own technology “gaps,” can quickly assess the target’s key technological assets and grasp how such assets will improve the integrated business post-closing will be better positioned to focus their due diligence efforts, minimize indemnification risks, and ultimately achieve the intended synergies.

As New Yorkers enjoy their pumpkin spice lattes, the fact that a Grande (16oz) serving will cost them about 380 calories (including 2% milk and whipped cream, because why not?) is becoming common knowledge.  Calorie information has been conspicuously posted on menus at “covered establishments” in New York City for nearly a decade, but on August 28, 2017, New York City agreed to postpone enforcement of its rule requiring restaurants, convenience stores and other establishments to post calorie counts for prepared food in response to a law suit brought by the food industry and supported by the Federal government.

In 2008, New York City became the first jurisdiction in the United States to require chain restaurants to post calorie information on menus and menu boards.   Shortly thereafter in 2010, the Federal government adopted similar laws by way of the Affordable Care Act.  The Federal government’s implementation of such laws has continually been delayed over the years, but now the Food and Drug Administration (“FDA”) plans to provide additional guidance on menu labeling requirements in May 2018.  New York City did not want to wait for the Federal guidance to begin enforcement of its Rule 81.50, New York City’s nearly identical version of its federal counterpart.

New York City’s most recent version of Rule 81.50 tracks its federal counterpart and applies to “covered establishments”, which means “a food service establishment or similar retail food establishment that is part of a chain with 15 or more locations nationally doing business under the same name and offering for sale substantially the same menu items, or a food service establishment that is not party of such a chain that voluntarily registers with the United States Food and Drug Administration to be subject to the federal requirements for nutrition labeling of standard menu items pursuant to 21 CFR 101.11(d), or successor regulation”.   For any such covered establishment, “[m]enus and menu boards must provide the number of calories contained in each standard item.”

While the FDA plans to provide guidance in May 2018, New York City nonetheless wanted to move forward with its enforcement of Regulation 81.50 beginning on August 21, 2017, but on July 7, 2017, the Food Marketing Institute and the National Restaurant Association teamed with several other food-service industry groups to file suit against the City of New York for what it said was premature enforcement of nutritional disclosure guidelines for food-service establishments. The National Association of Convenience Stores and the New York Association of Convenience Stores also joined in the suit, which was filed in the U.S. District Court for the Southern District of New York.

Court documents claim that that the local New York City rules are not identical to the impending FDA rules because they are effective immediately which would clash with the Federal government’s plan to delay compliance for one more year.  The plaintiffs asked the court to stop New York City from enforcing the regulations on the local level prior to the nation-wide rollout in May 2018 and argued that New York City’s Rule 81.50 was preempted by Federal law. The FDA filed court papers in support of the lawsuit.

New York City has now agreed to honor May 2018 as the start date due to the preemption of Regulation 81.50 by the similar provisions contained in the Affordable Care Act. As such, “covered establishments” will have more time to comply and the FDA will be able to set forth guidance as it planned in May 2018.

As the nation awaits the FDA’s guidance, food establishments in New York City should begin to think about whether or not they are a “covered establishment” and the steps they will need to take in order to avoid eventual enforcement action.

New York entrepreneurs in the virtual currency space must be careful to follow New York’s licensing requirements enacted under Financial Services Law Sections 102, 104, 201, 206, 301, 302, 309, and 408. Under the new regulations issued by the New York State Department of Financial Services, a business that engages in “Virtual Currency Business Activity” must be licensed by the New York State Department of Financial Services.  A business is engaged in Virtual Currency Business Activity if it:

  1. receives virtual currency for transmissions or transmits virtual currency;
  2. stores, holds, or maintains custody or control of virtual currency on behalf of others;
  3. buys and sells virtual currency;
  4. exchanges or converts something of value, into virtual currencies; or
  5. controls, administers, or issues a virtual currency.

However, businesses chartered under New York Banking Law and “approved by the superintendent to engage in Virtual Currency Business Activity,” as well as “merchants and consumers” that use virtual currencies for investment purposes or to buy and sell goods or services are exempt from the licensing requirement.

The license application fee to register as a business engaged in Virtual Currency Business Activity is $5,000.00 and is nonrefundable.  The application must include:

  1. the exact name of the applicant, including any doing business as name;
  2. a list of all of the applicant’s affiliates and an organization chart illustrating the relationship among the applicant and such affiliates;
  3. a list of, and detailed biographical information for, each individual applicant and each director, principal officer, principal stockholder, and principal beneficiary of the applicant;
  4. a background report prepared by an independent investigatory agency for each individual applicant, and each principal officer, principal stockholder, and principal beneficiary of the applicant, as applicable;
  5. for each individual applicant; for each principal officer, principal stockholder, and principal beneficiary of the applicant, as applicable; and for all individuals to be employed by the applicant who have access to any customer funds, whether denominated in fiat currency or virtual currency: (i) a set of completed fingerprints, or a receipt indicating the vendor (which vendor must be acceptable to the superintendent) at which, and the date when, the fingerprints were taken, for submission to the State Division of Criminal Justice Services and the Federal Bureau of Investigation; (ii) if applicable, such processing fees as prescribed by the superintendent; and (iii) two portrait-style photographs of the individuals measuring not more than two inches by two inches;
  6. an organization chart of the applicant and its management structure;
  7. a current financial statement for the applicant and each principal officer, principal stockholder, and principal beneficiary of the applicant, as applicable, and a projected balance sheet and income statement for the following year of the applicant’s operation;
  8. a description of the proposed, current, and historical business of the applicant;
  9. details of all banking arrangements;
  10. all written policies and procedures required by, or related to, the requirements of this part;
  11. an affidavit describing any pending or threatened administrative, civil, or criminal action, litigation, or proceeding before any governmental agency, court, or arbitration tribunal against the applicant or any of its directors, principal officers, principal stockholders, and principal beneficiaries, as applicable;
  12. verification from the New York State Department of Taxation and Finance that the applicant is compliant with all New York State tax obligations in a form acceptable to the superintendent;
  13. if applicable, a copy of any insurance policies maintained for the benefit of the applicant, its directors or officers, or its customers; and
  14. an explanation of the methodology used to calculate the value of virtual currency in fiat currency; and

Businesses operating in the virtual currency space, that are not exempt from these new regulations, must ensure that they comply with these new licensing requirements. Businesses interested in pursuing a New York virtual currency license should consult with legal counsel.

 

Does your operating agreement reflect your intentions?
New Jersey’s Revised Uniform Limited Liability Company Act (the “RULLCA”) became effective on March 18, 2013. As noted in a post we authored in 2014, although initially applicable only to limited liability companies formed after its effective date, the RULLCA now governs all New Jersey limited liability companies.

Similar to other limited liability company statutes in other states, the RULLCA provides a number of default provisions that apply if the members of a limited liability company (the “LLC”) have not adopted an operating agreement for the LLC or if the operating agreement is silent on a particular issue.  As a result, the rules that apply to New Jersey LLC’s and their members may not reflect the parties’ intentions as to certain topics, even if the parties had previously entered into an operating agreement drafted to conform to the New Jersey’s original Limited Liability Company Act (the “Original LLC Act”).

By way of example, and without limitation, in the absence of a contrary provision in an operating agreement the RULLCA provides that: (1) distributions made by an LLC to its members are to be made to the members in equal shares (in lieu of proportionate distributions based on capital contributions); (2) most decisions are made by a majority in number of the members of a member-managed LLC (rather than based upon the vote of members holding a majority of the interests in the profits of the LLC); (3) an assignment of a member’s “transferable interest” in an LLC is an assignment only of the member’s right to receive distributions from the LLC (with the transferring member retaining all voting rights of member, unless such transferring member is expelled by the unanimous consent of the remaining members following the assignment of a member’s entire “transferable interest” in the LLC).

These are just some examples to highlight the importance of  reviewing with counsel your existing operating agreements, particularly if prepared prior to the adoption of the RULLCA, to confirm that the operating agreement complies with current law and overrides any default provisions of the RULLCA that are contrary to the parties’ intended business arrangement. Further, the current law provides some other possible provisions which may be desirable and which were not available under the Original Act.   The same holds true for entities formed in other states. It is important to note that the default provisions of the RULLCA do, in certain cases, differ from the default provisions of limited liability company statutes in other states. For example, under the default provisions of the New York Limited Liability Company Law, distributions by an LLC are made to the members in proportion to their capital contributions, member voting is in proportion to the members’ respective interests in profits, and a member ceases to be a member or have any voting rights upon the transfer of all of his membership interest in the LLC.

Regardless of the state of formation, you should be certain that what your operating agreement says (and does not say) accurately reflects the parties’ business deal.

A recent decision of the Delaware Court of Chancery (the “Court”) places certain fiduciary constraints on a company’s ability to satisfy its obligations to its preferred equity holders. While investors often seek to acquire preferred stock in return for their investments, the Court’s decision in The Frederick HSU Living Trust v. ODN Holding Corporation (“ODN”) et al., makes it clear that actions taken by a company in connection with the payment of such preference will be subject to the fiduciary duties that a company’s board owes to its holders of common stock.

Plaintiff, a founding stockholder of ODN Holding Corporation (the “Company”), brought an action against the Company’s board of directors (the “Board”) alleging, among other things, breach of fiduciary duty in connection with the redemption of preferred shares owned by the Company’s controlling stockholder, the venture capital firm Oak Hill Capital Partners (“Oak Hill”). As consideration for Oak Hills’s investment in the Company, Oak Hill received shares of preferred stock in the Company, carrying a mandatory redemption right exercisable by Oak Hill five (5) years after the investment (See id. at 6). In the event that the Company did not have sufficient funds to redeem the preferred stock at the time of exercise, the Company agreed to make redemption payments to Oak Hill as funds became available (See id. at 6-7). Plaintiff claimed that Oak Hill caused the Company to alter its business strategy prior to the time that the redemption right was able to be exercised, prioritizing the hoarding of cash to satisfy Oak Hill’s redemption demand rather than fostering the growth and development of the Company for the benefit of the common holders (See id. at 10-14). This included selling two (2) of the Company’s primary lines of business in an effort to raise capital to fund such redemption, and failing to use funds to pursue acquisitions, as was the Company’s prior practice (See id.). As a result of the foregoing, Plaintiff brought several claims against the Company, Oak Hill, and individual members of the Board, among which was a claim for contravention of the Board’s fiduciary duty of loyalty to the holders of the Company’s common stock (See id. at 21).

With respect to the fiduciary duty claim, the Court held in favor of Plaintiff, denying Defendants’ Motion to Dismiss. The Court’s rationale centered on the premise that a company’s board of directors has a fiduciary obligation to maximize the long-term value of the company for the benefit of holders of its “undifferentiated equity” (i.e. its common stock) (See id. at 36-37). The Court distinguished the rights of preferred holders as contractual in nature, entitling them to fiduciary duty protection only to the extent their interests align with the interests of the common holders (See id. at 41 and 44). While the Court readily acknowledged the contractual obligation to redeem the preferred shares held by Oak Hill, it emphasized that the Board took actions to satisfy the redemption obligation before there was any contractual obligation to redeem. In other words, the Board took actions to maximize the value of the redemption right rather than the value of the common stock, which the Court ultimately held to be a direct breach of the Board’s fiduciary duty of loyalty to the shareholders of the Company.

The Court’s holding in this case reminds investors that, at the end of the day, a board’s primary directive is to maximize the company’s value to its common stockholders, not its preferred holders. Because the rights of the preferred are contractually founded, they must ultimately be subject to the overall interests of the “undifferentiated equity” of a company. From an investor’s perspective, the Court’s decision will likely spur efforts to structure preferred equity obligations in a way that gives the preferred holders the ability to take direct action rather than going through the board, thereby making the fiduciary duty issue a moot point. This may be preferable from a company’s perspective as well, especially in the case of board members who are appointed by holders of preferred stock.

However, in structuring the rights of preferred holders, care should be taken to ensure that the protections do not inadvertently lead to other issues. For example, affording preferred stock too many protections could cause it to fall under the definition of “disqualified preferred stock,” or a similar term contained in a company’s senior credit agreement, if applicable, which could have adverse consequences on the company and all of its equity holders.

The full text of the case, The Frederick HSU Living Trust v. ODN Holding Corporation (“ODN”) et al., can be found here.