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Did you know that selling stock in exchange for an unsecured promissory note may be unlawful, void or voidable?  In an area like Silicon Valley where stock may be worth a fortune from the second a company is born, companies might think to be creative in order to sell stock to a party that’s unable or unwilling to pay large sums for it immediately. One might think that a safe course is to sell the stock for a promissory note to pay for the stock later, such as when it’s worth more than the sum of the note.

However, a somewhat obscure law in California, which is echoed in other states, makes it unlawful for a corporation to sell or issue stock in exchange for a promissory note (a debt) that is not secured by property other than the stock itself.  Section 409 of the California Corporations Code makes it unlawful for a California corporation to sell or issue stock for a promissory note that is not “adequately secured by collateral other than the shares acquired.”  Thus, a company cannot sell or issue stock for a promissory note, even if the note is secured by the stock itself.  So what consideration in a sale of stock is valid?  The answer is money, services already rendered, valuable property received or a promissory note that is secured by property other than the stock itself.

Delaware corporations, which are not subject to this provision of California law, are nevertheless subject to a similar statute under Delaware law.  Section 152 of Delaware’s General Corporation Law provides that “[t]he board of directors [of a corporation] may authorize capital stock to be issued for consideration consisting of cash, any tangible or intangible property or any benefit to the corporation, or any combination thereof.”  While this statute is less clear on the issue than the California law, Delaware case law arguably supports a construction of the Delaware statute the same as the California law, and Section 152 itself implies the corporation must receive some actual benefit in exchange for the issuance of stock.  Interestingly enough, the Delaware Constitution (Article IX, Section 3) used to expressly prohibit the issuance of stock “except for money paid, labor done or personal property, or real estate or leases thereof actually acquired by such corporation.”  However, this provision was repealed in 2004, leaving the issue somewhat more ambiguous under current Delaware law.  One would have to check the legislative history to understand why that section was repealed, but in any case the statutory provision remains, along with at least one case which cites both as a basis to consider the stock sale invalid.  See Prizm Group, Inc. v. Anderson, 2010 Del. Ch. LEXIS 105, 2010 WL 1850792 (Del. Ch. May 10, 2010).

The legal implications of these statutes are potentially not good for anyone involved in the leveraged sale of stock – neither the company, its management nor the putative purchaser.  Taking the last case first, the sale to the buyer is likely void or voidable as against the buyer, which means the corporation may rescind (cancel) the sale of stock arguably at any time the issue is raised, at least until proper consideration is received by the corporation, such as all money due on the debt that is at issue.  (Note that the sale is probably not voidable by the buyer as against the corporation, and the note is almost certainly enforceable by the corporation against the debtor, the above notwithstanding.)  As respects the company, an invalid sale of stock might expose the company to liability from other shareholders who might argue that their equity in the corporation has been unfairly diluted by a sale of stock without real value received in return.  And officers or directors who approved the sale might also be exposed to action by the corporation and/or by other shareholders on a similar theory of liability, as might arise in the context of a shareholder derivative action (a lawsuit brought by one or more shareholders in the name of the corporation against officers and/or directors for mismanagement that harmed the corporation or its shareholders).

Turning to limited liability companies, it is much less clear and, at least for now, doubtful that the limitation on consideration for the sale of equity applies to LLC’s. The statutes cited do not apply to LLC’s – they are quite specific to corporations only. With that said, in principle, one could make the same policy argument in the context of LLC’s – that the sale of equity in exchange for an unsecured note does not provide actual value to the company and thus frustrates existing equity holders and creditors.  However, the statutory and case law for LLC’s on this is thus far non-existent based on research done to date, so currently there is no known legal basis to support this policy rationale as applied to LLC’s, or other types of business associations for that matter.

However, corporations, their managers and purchasers would be wise to heed the law in California, Delaware and other states that generally bar an unsecured debt obligation as consideration for the sale of stock.  Transactions violating these laws will be void or voidable, and the participants in such stock sales may be subjecting themselves to inadvisable risks and liabilities.  So, as the saying goes, buyer beware.

To learn more about the author of this article, visit www.ihwlaw.com.

Did you know that your company or the one that you represent may not have the right to enter into contracts, sue or defend itself against a lawsuit in California?  Well-settled law, ignored by many businesses and even lawyers to some degree, can disqualify a company from entering into contracts or litigating in California if it fails to establish and maintain a qualified status with the Secretary of State (“SOS”) and the Franchise Tax Board (“FTB”), the state taxing authority.

In Silicon Valley and elsewhere throughout the state, a large percentage of start-ups decide to form their company – be it a corporation or an LLC – in a state other than California, such as Delaware.  However, if these foreign companies plan to have a presence or otherwise do business in California, state law requires these companies to register for qualification with the California Secretary of State, pay an annual franchise tax and potentially pay state income taxes the same as an entity that is formed in California.  If foreign companies fail to comply with these requirements, they forfeit all “corporate powers, rights and privileges” in California, which include not only the right to maintain a lawsuit in the state, but also the power to enter into valid contracts with other persons or entities.  See Cal. Corps. Code §§ 2105, 2203 and Cal. Rev. and Tax. Code § 23304.1; and see Neogard Corp. v. Malott & Peterson-Grundy, 106 Cal.App.3d 213, 219-220 (1980) (corporation transacting business in California without qualifying to do so risks a number of sanctions, both civil and criminal, including the right to maintain lawsuit).  Contracts formed while a company’s status is invalid (i.e., unqualified or suspended) are voidable at the option of the other party; this means that the contract remains in effect but the other party may cancel it.  White Dragon Prods. v. Performance Guars., 196 Cal. App. 3d 163, 168-169 (1987) (contract entered into when party was not qualified with state is voidable and remains so even after party qualifies in California).

While a foreign company does have the right to defend itself against a lawsuit in California, service of the lawsuit may potentially be accomplished by serving the Secretary of State instead of the company directly, see e.g. Cal. Corps. Code § 17708.07 (limited liability companies only), so the company may lose before it knows it has been sued.  And, in any event, every unqualified foreign entity is deemed to have submitted to California jurisdiction, which may prevent the entity from claiming lack of jurisdiction even after they qualify with the state.

Further, if your company was formed in California, the loss of rights and powers is even more severe than for a company formed in another state.  The lost “corporate powers, rights and privileges” include not only the voidability of contracts formed during suspension and the right to maintain a lawsuit in the state but also the right to defend against one, too.  Damato v. Slevin, 214 Cal. App. 3d 668, 673 (1989).   For example, if a California entity is suspended for failure to pay taxes due to the FTB or failure to file a Statement of Information (for a prolonged period), the corporation may be entirely “disabled from participating in litigation activities” during the suspension.  See Tabarrejo v. Superior Court, 232 Cal. App. 4th 849, 863 (2014), review denied (Apr. 1, 2015).

Little known to most people, including even lawyers, is that it is a misdemeanor (you read that right– a crime) for any person to attempt to exercise “the powers, rights, and privileges of a corporation that has been suspended pursuant to [Cal. Rev. & Tax. Code] Section 23301 or who transacts or attempts to transact … business in this state on behalf of a foreign corporation.”  Cal. Rev. & Tax. Code s. 19719.  Further, an attorney who knowingly represents a suspended corporation and conceals this fact from the court may be subject to sanctions. See Palm Valley Homeowners Ass’n, Inc. v. Design MTC, 85 Cal.App.4th 553, 563 (2000). Fortunately for insurers and their lawyers, the criminal statute does not apply “to any insurer, or to counsel retained by an insurer on behalf of the suspended corporation, who provides a defense for a suspended corporation in a civil action based upon a claim for personal injury, property damage, or economic losses against the suspended corporation,” and the statute does not “create or limit any obligation upon an insurer to defend a suspended corporation.”

What to do if your company is suspended?  A suspended company may regain its rights by undergoing a process known as revivor, and the steps to accomplish this are outlined on the websites of the SOS and FTB.  Any competent business lawyer or accountant should be able to assist you.  After a company is revived by the State, it regains the power to enter into valid contracts and to maintain and defend against lawsuits.  Damato, 214 Cal.App.3d at 674.  But any contract made during the suspension remains voidable by the other party.

To conclude, whether your company was formed in California or elsewhere, if it wants to do business in California, it must maintain a valid status with the Secretary of State and Franchise Tax Board, or you may find that doing business in California can be perilous and costly.  In most cases, obtaining a valid status is not complicated or costly so, if your company is presently not in good standing with the State, it should act promptly to rectify this and maintain a valid status.

As evidenced by the recent hype about the new Instagram smart app icon, companies invest a lot of time and money to develop the look and feel of a smart device application (“app”) in order to promote brand recognition.  OK, so you know that your app is a valuable piece of intellectual property, but what are you doing to protect this asset?  With the market for apps projected to reach $2 trillion by 2020, it is clear that apps will be a primary source or gateway for revenue for most businesses in the 21st Century.  Yet, few companies give due consideration to how they can protect this increasingly valuable IP asset.

To protect the look and feel of your app, trademark law and the somewhat less known law of trade dress may be your answer.  In a recent case that I litigated for a plaintiff in the U.S. District Court for the Northern District of California, the Court upheld my theory that the look of its smart device app icon was a protectable trade dress feature.  The case involved competing “selfie” photo editing apps where my client alleged that the defendants were infringing not only my client’s registered trademark for the app but also the non-functional aesthetic features of the app, including the app icon, which is used to market the app in virtual store fronts like Apple’s App Store and the Google Play Store.

In the complaint, we alleged that (1) our app icon was “so distinctive and essential an element of [our] … trade dress throughout the app that the app icon is additionally, in and of itself, an entirely protectable trade dress standing on its own,” and (2) the defendants were using “a highly similar app icon….”  The defendant moved to dismiss our trade dress claim as being improperly alleged, but the Court denied the motion, finding that our allegations did satisfy the standard of providing “a complete recitation of the concrete elements of [our] alleged trade dress….”  The Court understood that we were basing our trade dress claim, at least in part, on the theory that our app icon stood “on its own” as an independently protectable trade dress feature.  See ArcSoft, Inc. v. CyberLink Corp., No. 15-cv-03707-WHO, 2016 U.S. Dist. LEXIS 28997, at *7 (N.D. Cal. Mar. 7, 2016).*

Although the courts have grappled for years with how to apply trademark law to intangible products and services like software, my research shows that this is the first reported decision by a federal court recognizing that an app icon may, in and of itself, constitute an independently protectable trade dress feature.

Traditionally, trade dress is broadly defined as the total image and appearance – “the look and the feel” – of a product or service which indicates or identifies the source of the product or service and distinguishes it from those of others.  One classic example of trade dress in a tangible form is the original contoured Coca-Cola bottle shape.  Designed in 1916 by a bottle company with the specific intent to distinguish Coca-Cola from imitating competitors, the Coke bottle is now recognized by billions of consumers as a designation of the Coke product brand.

One hundred years later as smart device apps flood the marketplace, the primary if not only aesthetic feature that distinguishes one app from another on the “shelf” of the online store is the app icon.  Businesses invest significant resources to develop the software that enable apps to run, and they also incur great expense on art and graphic design to make apps and icons aesthetically pleasing and distinctive.  Given such extensive capital expenditures, it behooves businesses to protect app trade dress no less than they would protect any other product or service subject to trademark protection.  And as my selfie editing app case proves, trademark law is expanding to accommodate the virtual goods and services of the 21st Century market.  So be smart, and dress your app smartly.

*About the Author:  Isaac Winer is a civil litigator and business lawyer at the Law Office of Isaac H. Winer in Palo Alto, California.  He also serves as Senior Counsel to Intellectual Property Law Group LLP in San Jose, California.

On May 11, 2016, President Obama signed into law the Defend Trade Secrets Act of 2016 (the “DTSA”), creating a new federal civil claim for misappropriation of trade secrets and adding measures beyond those available under state law that give trade secret owners more fire power against trade secret theft but which also create more responsibility on employers as well as more protection for workers.

First, the basics.  Until now, only state law provided a civil claim for misappropriation of trade secrets.  And, while all but two states have adopted the model Uniform Trade Secrets Act (“UTSA”) – New York and Massachusetts being the exceptions with their own trade secret laws, aspects of many state laws still vary from state-to-state, making a truly uniform national trade secrets law unavailable until now.  The DTSA creates a new civil claim for misappropriation of trade secrets that can be asserted in federal court by any trade secret owner against anyone “if the trade secret is related to a product or service used in, or intended for use in, interstate or foreign commerce.”  DTSA, s.2(b)(1).  Under the DTSA, a trade secret is defined essentially the same as it is defined under state law: any information where (A) “the owner thereof has taken reasonable measures to keep such information secret; and (B) the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, the public.”  DTSA, s.4(a)(2) (“trade secret” has same meaning as 18 U.S.C. s. 1839).

Next, the new fire power of the DTSA.  Until now, unless a theft of trade secrets was criminal – a high bar, the only form of immediate relief an owner could obtain was a temporary restraining order (TRO) or other injunction to stop the thief from using or disseminating a trade secret, and potentially requiring a thief to turn over property containing trade secret information.  Now, under the DTSA, a trade secret owner can ask a court – without any notice to the alleged thief (an “ex parte” request) – to order law enforcement to seize property that is “necessary to prevent the propagation or dissemination of the trade secret” that is the subject of the lawsuit.  DTSA, s. 2(b)(2)(A)(i).  Notably, however, such ex parte seizures may only be granted “in extraordinary circumstances” where it appears from “specific facts” that a TRO is inadequate because the party against whom the order is sought would “evade, avoid or otherwise not comply with such an order.”  DTSA, s. 2(b)(2)(A)(ii).  Other limitations make this remedy unlikely in all but the most extreme cases, not only because of the cost of seeking it but the potential penalty of paying actual and punitive damages and attorney’s fees to a party against whom a wrongful or excessive seizure was obtained.

Finally, the underbelly of the DTSA for trade secret owners.  In addition to protecting defendants against unjustified seizures, the DTSA also prohibits injunctions that “prevent a person from entering into an employment relationship” and requires that any conditions placed on such employment “shall be based on evidence of threatened misappropriation and not merely on the information the person knows.”  DTSA, s. 2(b)(3)(A)(i)(1)(I) (emph. added).  Further, the DTSA also protects whistleblowers (e.g., workers who report illegal activities) by providing immunity for disclosing trade secrets to attorneys or government officials and by requiring that employers provide employees with notice of this immunity on pain of losing the right to punitive damages and attorney fees in a lawsuit against an employee for violation of any trade secrets laws.  To clarify, the DTSA defines “employee” to include any person who works “as a contractor or consultant for an employer.”  DTSA, s. 2(b)(4).  Put together, the provisions of the DTSA that protect workers provide a clear message to employers that the DTSA does not only exist for their benefit.

In sum, the DTSA creates a bundle of new tools for trade secret owners to defend against trade secret misappropriation and provides defendants and workers with a bundle of new rights to help ensure the new tools are not abused. Put together, the DTSA is a significant advance in trade secrets law which, if nothing else, will serve to fuel the engine of litigation on both sides of the divide between owners and individuals who create and work with trade secret information.

New court cases in California are testing the ability of established labor law to distinguish between employees and independent contractors in the new “sharing economy,” recently focusing on the status of drivers in ride-sharing companies Uber and Lyft.  Both firms, which view themselves as “technology” companies rather than transportation firms, have preferred to categorize their drivers as independent contractors in order to avoid paying driving expenses, overtime, payroll taxes, workers compensation and other costly features of the employee grade. However, a recent ruling by a Deputy Labor Commissioner in California, coupled with at least two federal class action cases currently pending in California, have thrown the debate wide-open as to whether Uber and Lyft can legitimately classify their drivers as independent contractors.

In the state case, serial litigant Barbara Berwick – who has reportedly been a plaintiff many times since 1987 – filed a claim against Uber with the California Labor Commissioner alleging that she was not an independent contractor but rather an employee and was therefore entitled to expense reimbursement and unpaid wages (were she to prove any), despite the fact that Berwick had Uber pay her fees to a separate corporation.  In a 17-page ruling issued in June 2015, Deputy Labor Commissioner Ellen Kennedy concluded that Berwick was in fact an employee in light of how she worked as an Uber driver, and thus was entitled to have expenses reimbursed.  Kennedy based her decision on well-settled, albeit 20^th Century, California law which lays out a broad array of considerations to help distinguish between employees and contractors.  While the main test is whether the principal engaging the worker has “the right to control the manner and means of accomplishing the result,” numerous secondary factors assist in guiding this determination.  These include:  (i) whether there is a right to terminate at will; (ii) whether the service provider is engaged in an occupation or business distinct from that of the principal; (iii) whether the work is usually done under the direction of the principal or by a specialist without supervision; (iv) the skill required in the particular occupation; (v) whether the principal or the worker supplies the instrumentalities, tools, and the place of work for the person doing the work; (vi) the length of time for which the services are to be performed; (vii) the method of payment – whether by time or by project; (viii) whether or not the work is a part of the regular business of the principal; and (ix) whether or not the parties believe that they are creating an employer-employee relationship. While these factors are most prominently laid-out in a California supreme court case from 1989, they are based in part on decisions of the court and treatises dated almost fifty years still earlier.

Nevertheless, this is the same law being used by two federal judges in two class actions, also pending in California, in which drivers are suing Uber and Lyft based on the same contention – that they are employees, not contractors – and are therefore entitled to all of the benefits and protections of employees that are not available to contractors. Issuing very similar rulings on the same day in March 2015 (hardly a coincidence), judges Edward Chen and Vince Chhabria each concluded in their ruling that applying traditional, 20^th Century tests for employment poses significant challenges to deciding this issue for “sharing economy” companies like Uber and Lyft and that, absent legislative intervention, the question will need to be decided by juries in court cases, which “will be handed a square peg and asked to choose between two round holes.”  To be sure, potentially billions of dollars rest in the hands of these juries, and the stakes are no less in the state matter involving Uber driver Barbara Berwick, where Uber has appealed the regulatory ruling to San Francisco Superior Court.  While it will take time for these and other cases to wind through the legal system, they are forming new tectonic plates beneath the sharing economy.  In all likelihood, state legislatures and regulators will begin jumping into the foray, enacting new rules to address workers rights in this brave new world.  The rules will almost certainly continue to be defined on a state-by-state basis and, if recent developments are any indication, the scales seem to be tipping in workers’ favor.  In late June 2015, it was reported that grocery delivery service Instacart will convert its “shoppers” from independent contractors to employees.  Aside from being good for labor, a trend toward employee status may also not be so bad for the public.  While a pro-employee trend may mean higher prices as companies try to pass on at least some of the new costs to customers, the public should benefit from more reliable and safer services.  This involves complex business, law and insurance issues, which will be the topic of another article.

To learn more about the author, please visit my website at www.ihwlaw.com.

Given the frequent use of pre-litigation jury trial waivers in contracts, it may be news to some that such waivers are considered unenforceable under California law since the California supreme court’s decision in Grafton Partners L.P. v. Sup.Ct., 36 Cal. 4th 944 (2005).  Virtually all other states in the nation, save California and Georgia, permit pre-litigation jury trial waivers in contracts subject to certain conditions, such as whether the waiver was knowing and voluntary.  The same rule – conditional enforceability of pre-dispute jury trial waivers – is followed by the federal courts as well, as least for cases arising under federal law.  However, a recent decision by the Ninth Circuit holds that federal courts enforcing state law in diversity cases must follow state law regarding pre-litigation jury trial waivers. In re County of Orange, 784 F.3d 520 (9th Cir. 2015).

In this case, the Ninth Circuit Court of Appeals addressed whether a federal court sitting in diversity (a case lacking a substantive federal question but involving parties from diverse jurisdictions) applies state or federal law to determine the validity of a pre-dispute jury trial waiver in a contract governed by California law.  While one might expect that such waivers are enforceable in any federal case because federal procedural law permits these waivers and a jury trial would seem to be a procedural issue, the Ninth Circuit reasoned that California’s rule is both procedural and substantive because it “embodies the state’s substantive interest in preserving the right to a jury trial in the strongest possible terms, an interest the California Constitution zealously guards.”  For legal enthusiasts, the decision is all the more interesting because of the issues raised under the pivotal Erie doctrine, which requires federal courts sitting in diversity to apply state law on substantive issues (such as what defines a legal claim) but confirming they may continue to apply federal law on procedural questions.

While it may be too soon to tell if the Ninth Circuit’s ruling will be adopted by other courts or lead to any shift in the use of jury trial waivers in contracts, both this case and California’s law regarding such waivers should give contracting parties and their counsel serious pause in including these waivers in contracts governed by California law.  It should also give parties who sign such waivers – but who would have preferred not to – cause to believe they will not be enforced in a case involving claims under California law (and presumably Georgia law, too).  An issue not addressed is the enforceability of pre-litigation jury trial waivers in federal cases arising under federal law with supplemental jurisdiction over state law claims arising under California or Georgia law.  Applying In re County of Orange, it seems likely a court would bifurcate trial and try the state law claims with a jury and the federal claims with a judge.  With this scenario inevitable, it should not be long before the case law develops an answer to this and related issues in this interesting nexus of substantive and procedural law.

To learn more about the author of this article, visit www.ihwlaw.com.

Since ICANN – the organization that allocates domain names — approved an initiative in 2011 to add thousands of new “generic” Top-Level Domains (gTLD), over 635 new gTLDs have been registered.  Many of these are creative efforts to expand topical diversity on the internet, but few have received as much notoriety as .sucks.

A gTLD is the portion of an internet address to the right of the dot, such as .com, .net or .org.  Under ICANN’s plan, third parties may register and administer new gTLD’s, such as .bank for banking, .law for the legal industry, and .golf for golfing, leaving it within the purview of the gTLD registrar to enable creation of domain names using the gTLD.  A partial list of some of the more recently approved gTLD’s can be found here.

The delegated registrar of .sucks, Momentus Inc., is charging $2,499 for pre-public registration of .sucks strings, which first requires a trademark to be registered with the Trademark Clearinghouse.  Beginning June 1, 2015, registrations of .sucks domain names are generally available to the public — at lower pricing — with an open registration process so that anyone can register a new .sucks domain without restriction.  (There are restrictions for registration of some gTLD’s but none for .sucks after May 31.) This enables trolls and trashers to gobble up .sucks strings bearing company names and brands alike.

The .sucks gTLD promises to ruffle the feathers of many a brand owner because trademark law, which protects the use of marks in domain names, may not apply to .sucks strings because one purpose of this gTLD is to enable public comment regarding brands.  Under existing law including the Lanham Act and its anti-cybersquatting provisions, courts have traditionally protected trademark owners from parties that register a domain utilizing a mark in a manner that is confusingly similar to, or dilutive of, the mark or which evinces a bad faith intent to profit from a mark the registrant does not own.  But registrants of .sucks URLs may be able to muster arguments that countervail these protections based on First Amendment law and the view that the .sucks string on its face is intended for brand criticism and thus ipso facto cannot cause confusion or be used in bad faith.  One need only consider the success of consumer darling Yelp in defending against manifold attacks on its platform to infer how .sucks registrants may be able to utilize the law in their favor to stop businesses from attacking web forums that are exclusively dedicated to trashing business brands.

Though many consider the purveying of .sucks domains to be little more than legalized extortion, businesses that value their names, brands and trademarks would do well to consider registering .sucks domains to prevent opportunists from trading-off valuable brand names to their detriment.  And some may even consider turning lemons into lemonade by using a .sucks domain to assist in their own customer relations program.

To learn more about the author of this article, visit www.ihwlaw.com.

Did you know that selling stock in exchange for an unsecured promissory note may be unlawful, void or voidable?  In an area like Silicon Valley where stock may be worth a fortune from the second a company is born, companies might think to be creative in order to sell stock to a party that’s unable or unwilling to pay large sums for it immediately. One might think that a safe course is to sell the stock for a promissory note to pay for the stock later, such as when it’s worth more than the sum of the note.

However, a somewhat obscure law in California, which is echoed in other states, makes it unlawful for a corporation to sell or issue stock in exchange for a promissory note (a debt) that is not secured by property other than the stock itself.  Section 409 of the California Corporations Code makes it unlawful for a California corporation to sell or issue stock for a promissory note that is not “adequately secured by collateral other than the shares acquired.”  Thus, a company cannot sell or issue stock for a promissory note, even if the note is secured by the stock itself.  So what consideration in a sale of stock is valid?  The answer is money, services already rendered, valuable property received or a promissory note that is secured by property other than the stock itself.

Delaware corporations, which are not subject to this provision of California law, are nevertheless subject to a similar statute under Delaware law.  Section 152 of Delaware’s General Corporation Law provides that “[t]he board of directors [of a corporation] may authorize capital stock to be issued for consideration consisting of cash, any tangible or intangible property or any benefit to the corporation, or any combination thereof.”  While this statute is less clear on the issue than the California law, Delaware case law arguably supports a construction of the Delaware statute the same as the California law, and Section 152 itself implies the corporation must receive some actual benefit in exchange for the issuance of stock.  Interestingly enough, the Delaware Constitution (Article IX, Section 3) used to expressly prohibit the issuance of stock “except for money paid, labor done or personal property, or real estate or leases thereof actually acquired by such corporation.”  However, this provision was repealed in 2004, leaving the issue somewhat more ambiguous under current Delaware law.  One would have to check the legislative history to understand why that section was repealed, but in any case the statutory provision remains, along with at least one case which cites both as a basis to consider the stock sale invalid.  See Prizm Group, Inc. v. Anderson, 2010 Del. Ch. LEXIS 105, 2010 WL 1850792 (Del. Ch. May 10, 2010).

The legal implications of these statutes are potentially not good for anyone involved in the leveraged sale of stock – neither the company, its management nor the putative purchaser.  Taking the last case first, the sale to the buyer is likely void or voidable as against the buyer, which means the corporation may rescind (cancel) the sale of stock arguably at any time the issue is raised, at least until proper consideration is received by the corporation, such as all money due on the debt that is at issue.  (Note that the sale is probably not voidable by the buyer as against the corporation, and the note is almost certainly enforceable by the corporation against the debtor, the above notwithstanding.)  As respects the company, an invalid sale of stock might expose the company to liability from other shareholders who might argue that their equity in the corporation has been unfairly diluted by a sale of stock without real value received in return.  And officers or directors who approved the sale might also be exposed to action by the corporation and/or by other shareholders on a similar theory of liability, as might arise in the context of a shareholder derivative action (a lawsuit brought by one or more shareholders in the name of the corporation against officers and/or directors for mismanagement that harmed the corporation or its shareholders).

Turning to limited liability companies, it is much less clear and, at least for now, doubtful that the limitation on consideration for the sale of equity applies to LLC’s. The statutes cited do not apply to LLC’s – they are quite specific to corporations only. With that said, in principle, one could make the same policy argument in the context of LLC’s – that the sale of equity in exchange for an unsecured note does not provide actual value to the company and thus frustrates existing equity holders and creditors.  However, the statutory and case law for LLC’s on this is thus far non-existent based on research done to date, so currently there is no known legal basis to support this policy rationale as applied to LLC’s, or other types of business associations for that matter.

However, corporations, their managers and purchasers would be wise to heed the law in California, Delaware and other states that generally bar an unsecured debt obligation as consideration for the sale of stock.  Transactions violating these laws will be void or voidable, and the participants in such stock sales may be subjecting themselves to inadvisable risks and liabilities.  So, as the saying goes, buyer beware.

To learn more about the author of this article, visit www.ihwlaw.com.