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Recent NY Court Decision on Rescission of Stock Option Agreement

Posted on May 12th, 2013

Employee stock options are an essential component of compensation in technology companies.  Options and other equity incentives allow employers to attract and retain talented personnel who hope to profit from a successful sale of the business that they help create.  While there has been substantial attention in recent years to the manner in which options are awarded, a topic less often discussed, but equally important, is how they may be rightfully terminated by an employer following a separation.  A recent decision by a New York appellate court’s decision in Lenel Systems Intl. v. Smith illustrates what can arise if this issue is not expressly addressed in the option agreement.

In Lenel, an employer sought to terminate an employee’s stock options who had violated his noncompetition agreement after leaving Lenel’s employment.  While the stock option agreement did not have an express provision entitling the company to terminate the agreement, it did provide that the employee’s agreement not to compete was consideration for the options.  Not having the express right to terminate, the employer sought to rescind the option on equitable grounds.

The court summarized that rescission is an equitable remedy that allows a court to declare a contract void from its inception.  As a general rule, rescission of a contract is permitted where there is a breach of contract that is material and willful, or so substantial and fundamental “as to strongly tend to defeat the object of the parties in making the contract.”  The court rejected the defendant’s argument that an express forfeiture clause in the option agreement was required in order for option to be subject to rescission.  Instead, the court reasoned that the noncompetition covenant was the sole consideration for the option agreement, and when the defendant chose to compete with Lenel “in violation of the only material condition of the agreements,” he would give up his right to the stock options promised in exchange.

In is also worth noting that two of the appellate judges dissented from this decision, arguing that the consideration for the option consisted of two parts, one being the compliance with the covenant during the term of employment and the other part for the post-termination period.  The dissent reasoned that since the defendant did comply with the covenant during his six years of employment with Lenel, it cannot be said that he did not provide any consideration for the option, thereby reducing the argument in  favor of rescission.

As a lower appellate court decision, the Lenel case is more likely to lead an academic interest than to have an binding impact on the law on this issue.  However, the case illustrates that while rescission may be available as a remedy for employers, it is a difficult path to travel and that addressing termination rights in the option agreements may be advisable.

Who’s Up for Tax-Free Capital Gains?

Posted on May 11th, 2013

From the editor:  We saw many companies raising capital in 2010 and 2011 to take advantage of the tax relief under Section 1202 of the Internal Revenue Code to give investors the potential for tax-free gains if they held the stock for the required 5 years and the company met certain conditions.  While that relief went away in 2012, recent tax law enactments have brought back this tax treatment for 2012 and 2013. We would like to thank our tax colleague Travis Blais from Travis Blais & Co.  for preparing the following post on this topic:

Most of us know that the American Taxpayer Relief Act of 2012, better known as the “fiscal cliff bill,” extended lower across-the-board tax rates, including those for dividends and long-term capital gain, for all but a handful of taxpayers.  Less well known is that the ATRA extended many business tax benefits, including the possibility of tax-free capital gains for “qualified small business stock” (QSBS).

Tax-free?  Yes.  QSBS is potentially the ultimate tax bargain – QSBS acquired through the end of 2013 and held for 5 years will incur 0% capital gains tax upon eventual sale. Of note, QSBS was extended retroactively, meaning stock previously acquired in 2012 as well that acquired in 2013 may qualify.

As you would expect, this kind of benefit comes with a lot of conditions.  The stock must be of a domestic C corporation, purchased at original issue for money, property other than stock, or services.  As a shareholder, a C corporation itself is not eligible for the tax-free treatment.  The tax-free gain is limited to the greater of “10x” (10 times one’s investment) or $10 million.  To be a “qualified small business,” the issuing corporation must never have had assets greater than $50 million either before or immediately after the stock purchase.  Moreover, 80% of the corporation’s assets must be used in a qualified trade or business, which excludes professional services, finance, farming, mining, or hospitality.For many investors, the most daunting requirement is that stock must be held for at least five years to qualify for the 0% rate.  In this regard, it is helpful that QSBS can be “rolled over,” that is, sold and its proceeds used to purchase different QSBS, deferring capital gains recognition and “tacking” the holding periods in hopes of crossing the five-year finish line.The obvious opportunity to acquire QSBS is upon the startup of a new business or a venture capital investment in an existing, small corporation.  But be on the lookout for less evident QSBS situations.  For instance, LLCs could be converted to corporations, particularly in anticipation of an investor financing that might require such a conversion anyway.  Investors might be holding stock rights in the form of options or convertible debt that could be exercised into stock.  Or QSBS may be available in newly formed shell corporations created to pursue a reverse acquisition.

Travis Blais

Adjunct Law Professor Blog

Posted on May 10th, 2013

After years of teaching corporate mergers and acquisitions at New England Law School, our founder and managing partner, Dimitry Herman, has become a contributing author to the well-known website called lawprofessorblog.com, under the Adjunct Law Prof Blog.  This blog in general is very interesting source of academic thinking on a variety of legal topics and it is a privilege to be able to be associated with it.  A few of his recent posts can be found here.

Recent Massachusetts Appeals Court Decision Interprets Enforceability of Online Terms and Conditions

Posted on May 9th, 2013

A recent Massachusetts appeals court decision by holds that a forum selection and limitation of liability clause is not enforceable under Massachusetts law in a browsewrap agreement.  This decision is a useful read both for lawyers drafting these documents and product developers and UI folks that create the user experience during which these legal terms are viewed and accepted.

The case involves the interpretation of Yahoo!’s Terms of Service (TOS) relating to its free email service.  The case was brought by the administrators of the estate of a Yahoo email user to get court approval for access to the account and the content of the emails.  Because the Yahoo! TOS had a forum selection clause requiring that all disputes be brought in California, the Court had the opportunity to interpret the enforceability under Massachusetts law of such clauses in online agreements.

After noting that the Court has not previously considered the enforceability of forum selection and limitation of liability clauses in online agreements, it looked to the case law on such issues in traditional paper contracts.  In those cases, courts have enforced such provisions as long as they have been reasonably communicated and accepted and if, considering all the circumstances, it is reasonable to enforce the provision at issue.  The burden on the first prong fall on the issuer of the TOS.  On the second prong (that the TOS themselves were reasonable), in the forum selection case, the burden falls on the plaintiffs, and no such burden applies in case of a limitations provision.

Applying this standard to online agreements, the Court held that Yahoo! did not meet their burden of showing the TOS were reasonably communicated and accepted.  Yahoo!’s affidavit that users were “given an opportunity to review” the TOS and Privacy Policy prior to registering” was not sufficient by itself.  The Court could not infer from that affidavit that the TOS were actually displayed on the user’s screen.  If the user was asked to follow a link to the TOS — which is a pretty typical user experience — Yahoo!’s affidavit would have to have provided the specific instructions relating to the link, how prominently displayed was the link, and any other information bearing on the reasonableness of this communication.

The Court also held that Yahoo! failed in showing that the TOS were accepted.  Past cases have enforced such provisions only in click-wrap agreements (where “terms of the agreement were displayed, at least in part, on the user’s computer screen and the user was required to signify his or her assent by clicking ‘I accept.’”), but not in browsewrap agreements (where ”website terms and conditions of use are posted on the website typically as a hyperlink at the bottom of the screen.”).

On that basis, the Court refused to extend the enforceability to browsewrap agreements and held that the record did not show “the terms of any agreement were reasonably communicated or that they were accepted.”

This case is reminder that legal attention to one’s online form agreements is a necessary part of operating a web-based business.  Especially if the offering is free (or fremium), website owners should take appropriate caution, and may want to sacrifice a little user experience and customer conversion in favor of knowing that to ensure that those online terms and conditions are actually going to be enforceable when the time comes.