Articles Posted in Contracts

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California is falling into line with Congress’ attempt to put an end to the gag clause associated with a number of consumer contracts. Whether you are a consumer or a producer, you know the importance of reviews. Many people turn to quality review sites to better understand what they should expect for certain products or services. As a result, many businesses are including gag clauses in their consumer contracts to avoid potentially negative reviews. In September, California became the first state to outlaw such clauses. The reasoning was that this type of approach is unfair and keeps consumers unaware of the true quality of certain products.

A Need for Change

The reality is that many companies will do whatever it takes to avoid negative reviews about them. In their consumer contract they have been able to include language that not only forbids consumers from speaking out negatively, but also fines them for doing so. This creates a kind of hostage situation where the company controls the situation and will revoke the fine if the individual removes the negative comment. Creating an atmosphere where consumers cannot be truthful about their experience hinders the ability for the marketplace to adequately serve everybody involved. Likewise, the marketplace can no longer operate at a truly competitive rate if nobody is truthful about their experience. Essentially, consumers will hear only good news and all companies are considered to be on the same plane.

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As businesses move online the way they create contracts with consumers continues to change. This ever evolving area of business law impacts not only the way businesses interact with your customers but also the way they resolve any disputes with them should they arise. This makes it extremely important for business owners and those who draft their online contracts to understand the most recent rulings regarding online contract formation. One recent California decision affects the nature of arbitration provisions in online contracts.

Savetsky v. Pre-Paid Legal Services, Inc.

This recent court decision is called Savetsky v. Pre-Paid Legal Services, Inc. The underlying lawsuit is a class action case alleging that Pre-Paid Legal Services, which did business as LegalShield, charged recurring payments for pre-paid legal services without making proper disclosures and without the the customers’ consent. LegalShield filed a motion to compel arbitration, which the court has now denied. This motion and the court’s decision regarding the motion is what is important about the case for our purposes.

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In the Internet Age, purported electronic signatures are becoming more and more common. They are the standard in certain areas of business law, like when one electronically “signs” a contract to engage in e-commerce. Real estate law, however, has always been more paper driven. While other areas have traditionally allowed for alternative contract forms like oral contracts, matters of real estate have traditionally required a paper contract. Recently, a California court decided a rare case dealing with the validity of an electronic signature.

California Court Decides Validity of Purported Electronic Signature

In this recent decision, J.B.B Investment Partners, LTD v. R. Thomas Fair, the First District Court of Appeals interpreted a portion of California’s version of the Uniform Electronic Transactions Act (UETA). The purpose of this law is to establish that electronic signatures and records are the equivalent of paper records and manually signed signatures for commerce purposes. In the case, a trial court had determined that Fair’s printed name at the end of an e-mail where he had agreed to settlement terms in a prior email from J.B.B. counted as an electronic signature under the UETA and under contract law. The appellate court disagreed and held that Fair’s printed name in the email was not a sufficient electronic signature to make the settlement agreement binding.

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Businesses frequently enter into contracts, whether it is with employees, other businesses, or customers. It is easy to think that the power to contract gives a business the ability to set whatever terms it prefers for an interaction, so long as the other party agrees. However, state law puts some limits on the power of contracting. It is important to consult with an experienced business law attorney before adding new language to the contracts you use to be sure the terms will be enforceable down the road. One example of the laws you need to be aware of when drafting contracts has to do with non-disparagement clauses.

You Cannot Use Non-Disparagement Clauses in Consumer Contracts.

A non-disparagement clause can be extremely appealing to a small business owner. In this day and age, where potential customers rely heavily on online reviewing services, like Yelp, when making decisions about who to do business with, an unfair and unflattering review can sink a small business. To counter this problem, some businesses began including clauses in their contracts with consumers prohibiting the consumer from making negative statements about the company. However, California has now banned these clauses.

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It is becoming increasingly more difficult for startups to survive. According to one report, long-term survival rates for startup companies have been plummeting over the past 20 years: Between 1994 and 2010, survival rates have declined from a nearly 100 percent survival rate in 1994 to just 25 percent in 2010. Separate studies performed by the U.S. Bureau of Labor Statistics and the Ewing Marion Kauffman Foundation — a nonprofit that promotes U.S. entrepreneurship — found that of all companies, only about 60 percent of startups survive to age three and approximately 35 percent survive to age ten.

So, why do some startups fail and how can you ensure a successful startup. Harvard Business School Professor Noam Wasserman has written a book called, “The Founder’s Dilemma: Anticipating and Avoiding the Pitfalls That Can Sink a Startup.” In the book, he has identified some reasons why startups fail. One of the major reasons startups fail is that they are co-founded by individuals who have a prior social relationship, not a prior professional relationship. According to Wasserman, such teams end up in disaster. Another major reason startups fail is that the founding teams divide the equity within a month of founding when uncertainty is at its highest.

While there are some factors that are beyond the control of startups, but may contribute to their demise, such as the economy or new government regulations, there are some things startups can do to help create a more stable company and one capable of surviving. Following are some of the factors experts say are likely to accompany a successful startup: (1) Starting the venture as part of a team and preferably with someone whom you have a prior professional relationship; (2) Drafting a business plan; (3) Starting the business on a full-time basis; (4) Starting a larger company, i.e., larger initial investment, greater number of employees, and greater size of assets; (5) Starting in a notoriously favorable industry; (6) Obtaining work experience in your targeted industry prior to starting your company; (7) Implementing and using a marketing plan; and, (8) Ensuring that financial controls are in place. These are important factors for startups to consider and implement, but what about the founders themselves.

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On September 21, 2013, California Governor Jerry Brown signed into law the California Revised Uniform Limited Liability Company Act (commonly known as the RULLCA), codified at Cal. Corp. Code §§ 17701.01-17713.13. The law is scheduled to take effect on January 1, 2014. The RULLCA will entirely replace the Beverly-Killea Limited Liability Company Act (referred to for purposes of this article as the “old law”), which has governed California limited liability companies (LLCs) since 1994. An LLC is a hybrid legal entity that has both the characteristics of a corporation and of a partnership. An LLC provides its owners — referred to as “members” — with corporate-like protection against personal liability, but it is treated as a noncorporate business organization for tax purposes.

The RULLCA will apply to all existing LLCs and LLCs formed under the laws of California after January 1, 2014, as well as to all foreign LLCs registered with the California Secretary of State as of January 1, 2014. The law revises certain rules governing the formation and operation of LLCs in the state of California. Below, we will highlight some of the significant changes promulgated by the new law.

While much of RULLCA is similar to existing law, it includes some important changes. First, while the “operating agreement” still serves as the foundational contract between LLC members, under RULLCA, the operating agreement does not need to be in writing. Additionally, unless specifically expressed in the operating agreement, an LLC will, by default, be managed by the members; if an LLC wishes to establish management by a manager or managers, it must be expressly stated in the operating agreement.

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Several months ago, we featured two articles about California’s ride-sharing startups. Ride-sharing companies, such as uberX, Lyft, and FlightCar, are in the business of providing vehicles-for-hire. Using apps and other online programs, the companies connect those in need of rides with non-professional drivers driving their own cars. Beginning in late 2010, the California Public Utilities Company (CPUC) issued cease and desist orders against all three ride-sharing companies for operating unlicensed charter party services, and the City of San Francisco followed up by suing FlightCar, alleging that it was undercutting rental car companies at the airport by acting like a rental car company, but ignoring the regulations that govern them. This past August, California became the first state to legalize ride-sharing companies when the CPUC issued a proposed set of rules that would grant state licenses to the ride-sharing companies and allow their vehicles to remain on California roads. The proposal creates a new category called the Transportation Network Companies and requires a ride-sharing company to apply for a license to operate in the state.

uberX Appeals Effort to Regulate It

Fast forward several months: This past Wednesday, attorneys for Uber Technologies, Inc., which runs uberX, filed an appeal — or an application for rehearing — challenging the CPUC’s power to regulate it, contending that uberX is a technology company, not a vehicle-for-hire services and that the CPUC does not have jurisdiction over technology companies that do not provide transportation services. uberX argues that it does not have to comply with the CPUC’s requirement to obtain a license because “it operates no vehicles and does not hold itself out or advertise itself as a transportation service provider.” Rather, it merely developed a software and mobile application service, which simply connects the transportation service provider with those persons seeking transportation. uberX does not own, lease, or charter any vehicles for the transportation of passengers and, therefore, should not be required to obtain a license to operate in the state of California.

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The issue of patent assertion entities, or patent trolls, continues to be a hot one in the startup community. The Ninth Circuit Court of Appeals defines a patent assertion entity as “a small company [that] enforces patent rights against accused infringers in an attempt to collect licensing fees, but does not manufacture products or supply services based upon the patents in question.” Several weeks ago, on August 28, we discussed a report issued by the Government Accountability Office (GAO), which raised questions about whether patent trolling is really a big problem for startups and small businesses and whether patent trolls are truly the cause of an increase in patent infringement litigation. The report seemed to conclude that other material factors were to blame for the increase in patent infringement litigation. Despite the conclusion of the GAO report, many in the startup community have declared “war” on patent trolls and now the Federal Trade Commission (FTC) has entered the fray.

The Federal Trade Commission Joins the Fray

Two weeks ago, the FTC, whose principal mission is to promote consumer protection and eliminate and prevent anti-competitive business practices, announced that it will use its subpoena power to begin a formal investigation into patent trolls, by seeking information from approximately 25 companies that buy and sell patents, and 15 other companies that manufacture devices and write software and applications. The commission unanimously approved the effort with a vote of 4-0. According to FTC chairwoman, Edith Ramirez, “[p]atents are key to innovation and competition, so it’s important for us to get a better understanding of how the companies operate.” The FTC will delve into the companies’ financial operations, including how much they earn from patent lawsuits and licensing and how the profits are disbursed to investors. The FTC hopes that the subpoenas will allow its regulators to explore the secret workings of troll operations. If the FTC uncovers illegal or questionable practices, it may choose to use its antitrust and anti-competition regulatory powers to pursue the patent assertion entities. We will have to wait and see what the investigation reveals.

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Last month, we discussed why collaboration and sharing physical office space is particularly important to startups. See “The Essentials for Startups: High Speed Internet and a Collaborative Environment,” September 10, 2013. In that article, we noted that while many businesses have been started and run successfully from anywhere in the world, startups are more likely to succeed in an environment where employees and/or founders are able to meet and interact in person. Prime examples of this success include companies such as Google, Twitter, and Groupon. But, is it really necessary and feasible for startups to maintain all of their functions in-house? California-based oDesk, the world’s largest online workplace, is betting that startups will quickly see the financial advantages and growth possibilities of outsourcing many key business functions. On Monday, the company announced the launch of a startup accelerator partnership program called oDesk Upstarts. Startup or seed accelerators are for-profit startup incubators, that essentially take classes of startups made up of small teams and support them with funding, mentoring, and training for a specified period of time in exchange for equity in the startups. Accelerators are privately funded and tend to focus on mobile/internet startups. oDesk Upstarts is a “slate of partnerships with more than 20 global startup accelerators aimed at introducing even more high-growth, early stage companies to the prospect of on-demand labor.” The partners will offer free outsourced labor with the goal being training, coaching, and mentoring.

The idea is an interesting one, but will startups outsource their labor? While investors tend to shy away from startups that outsource core business functions, outsourcing labor may be the solution to two of the biggest problems facing startups: (1) shortage of talent, and (2) limited financial resources. oDesk contends that investors should not fear outsourcing, but rather embrace it. According to the company, outsourcing labor is an excellent bridge over the early growth phase of startups, and is not “a replacement for a company building its core team[, but] a solution for reaching scalability more quickly and doing so in a flexible manner.” oDesk hopes that startups will outsource more than just accounting and HR functions. The company hopes that startups will outsource development and content creation as well. We will have to wait and see if the idea takes hold.

Immigration Reform

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Last week, we reported about an important event for startups: Title II of the Jumpstart Our Business Startups Act or JOBS Act took effect last Monday and it lifted the ban on general solicitation, allowing startups to publicly advertise that they are seeking investments. General solicitation means “to publicly advertise the opening of an investment round in a private company by utilizing mass communication.” As reported by Forbes magazine, “under Title II of the JOBS Act, entrepreneurs will be permitted to publicly advertise that they are fundraising for their businesses, something that was previously illegal for the past 80 years under Rule 506 of Regulation D and Rule 144A of the Securities Act of 1933.” As promised, this week, we will discuss several important steps startups must take to comply with the regulations of Title II if and when they choose to generally solicit their fundraising efforts.

Under Regulation D Rule 506(c), the rule allowing for general solicitation, the first thing you must do if you are a startup choosing to engage in public fundraising or general solicitation is ensure that only accredited investors are permitted to enter the funding round. This requirement differs from private fundraising, which is regulated by Regulation D Rule 506(b), and which allows you to have in your funding round up to 35 non-accredited investors with whom you have had a pre-existing relationship.

So what is an “accredited investor?” According to Regulation D Rule 506(c), an “accredited investor” is one generally having earned $200,000 for the past two years, or $300,000 if married, or having a net worth of $1 million not including a personal residence. Of course, it is not as easy as simply asking a potential investor if they meet this threshold. The JOBS Act requires startups to verify the status of investors and provide official documentation to confirm that each investor meets the “accredited investor” threshold. Because some investors may not feel comfortable providing such personal information (including tax returns, relevant bank statements, brokerage account statements, credit reports etc.) directly to startups, the SEC has allowed third-party services to undertake this necessary due diligence. This service protects a potential investor’s proprietary information and also relieves the startup of the burden of verification. A third-party service can be a registered investment advisor, a broker-dealer, an attorney, or a certified public accountant.