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Managers of LLCs Can Be Individually Liable for Unpaid Wages

Posted on Jun 14th, 2013

 

The Massachusetts Supreme Judicial Court recently held that managers of LLCs can be held liable individually for unpaid wages under the Massachusetts Wage Act. Specifically, a “manager who ‘controls, directs, and participates to a substantial degree in formulating and determining’ the financial policy of a business entity may be a ‘person having employees in his service’ under G.L. c. 149, § 148, and thus may be subject to liability for violations of the Wage Act,” [citations omitted].

The issue before the court was whether the legislative intent was to include managers of LLCs in the group of possible violators of the Massachusetts Wage Act, and the court found that it did. The court found a clear legislative intent to hold all individuals who contribute to a business’ fiscal and employment policies responsible for how employees are treated.

What does this mean for day to day business? LLCs of all sizes now have one more thing to consider when taking out director and officer and employee practices liability insurance. Since these kinds of policies are crucial to risk management for any business and this case signals a new kind of risk, this case should be on your radar.

If you have any questions about this topic, please feel free to email us.


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.


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 Supreme Judicial Court decision summarizes Massachusetts Law on Statute of Limitations on Promissory Notes and Successor Liability

Posted on Apr 17th, 2013

If you look at promissory note in your form file, odds are that the signature line indicates that the note was signed “under seal.” Aside from custom, there are several reasons why this somewhat archaic language was included. The most important reason, at least in Massachusetts, was that the language elevated the note from a plain contract to a sealed instrument. This extended the statute of limitations relating to the Note from six years to twenty.

In 1998, in connection with the revision of Article 3 of the UCC, Massachusetts adopted G. L. C. 106, § 3-118, which provided for a uniform six year statute of limitations for all negotiable instruments. In its recent decision in Premier Capital, LLC v. KMZ, LLC, the Massachusetts Supreme Judicial Court held that Section 3-118 governs all negotiable instruments, sealed and unsealed. However, to the extent that a cause of action predates this adoption of law, the Court held that the law in effect prior to 1998 will apply. As there are probably few instruments still lying around that predate this adoption, odds are that we may start see the “under seal” language slowly disappear from these types of documents.

The other significant aspect of this decision is the Court’s concise restatement of Massachusetts law on successor liability. (The issue in the case was whether a promissory note could be enforced against KMZ, an entity that the plaintiff claimed to be a successor in interest to Max Zeller Furs, Inc., the party that signed the original note.)

First, in order to be deemed a “successor corporation”, there must be a transfer to that entity of “all or substantially” of another corporation.

If the first test is met, then to impose liability on the successor corporation, one of the following factors must also be met:

  • the successor assumes the predecessor’s liability expressly or impliedly
  • the transaction is a “de facto merger”
  • the succession is merely a continuation of the predecessor, or
  • the transaction is really just a fraudulent attempt by the predecessor to avoid liability.

Here, the Court affirmed the ruling in favor of the defendants, holding that there were no undisputed facts proving that Zeller transferred “all, or substantially all” of its assets to KMZ. While Premier argued that Zeller transferred its good will to KMZ, it could not show any actual agreement memorializing that transfer. The court also held that engaging in the same business and having the same stockholders, without meeting the transfer test, was not enough.

The take away from this case is that successor liability can only be established with a clear showing of facts within the established guidelines of the case law. Courts are not likely to find successor liability for purposes of summary judgment without undisputed proof of transfer of liability.

If you have any questions about this topic, please feel free to email us.


SEC Approves Crowdfunding Venture Capital Model

Posted on Apr 9th, 2013

On March 28th, FundersClub became the first online venture capital business to be approved by the SEC. The online investment platform received a no-action letter from the SEC essentially giving the company a thumbs up, legally speaking. This is significant across the board as players throughout the venture capital industry and companies searching for funds seek out creative fundraising sources to help bootstrap and fill a capital gap for smaller investments.

FundersClub resists the term “crowdsourcing,” but it does share some crowdsourcing traits. The platform allows investors who are accredited by the company to select companies for investment from a broad range of choices. The companies themselves are early-stage startups with business plans researched by FundersClub. In other words, the platform vets, curates and connects high quality investors and companies in need of funding, and does so while appearing as a single entity.

The issue of legality arose because FundersClub is not a registered broker-dealer. FundersClub simply responded that it was merely moving offline venture capital advising work into the online space. The SEC agreed with them, at least for now.

Also of significance here is the success of FundersClub despite the traditional need for relationships and networking in the venture capital arena. When it comes to doling out large sums of money, vetting matters. Investors have historically been reluctant or unwilling to make investments without personal interactions and referrals.

The victory of FundersClub highlights the ways that the VC landscape is shifting. Few investors today have the ability to maintain a truly diverse portfolio using personal connections. As outsourcing becomes more common investors feel more comfortable trusting vetting and other homework to specialists like FundersClub, and early-stage companies benefit from the exposure they get from the arrangement.

At this point FundersClub looks like it is here to stay. The National Venture Capital Association has accepted FundersClub this year as its first online member, and as of this writing FundersClub has helped its startups raise approximately $26 million. Whether other companies will jump onto the bandwagon and copy the FundersClub model remains to be seen, but we would expect this model to quickly grow and adapt as the market develops.

If you have any questions about this topic, please feel free to email us.


FTC’s Strict New Guidelines for Digital Advertising

Posted on Mar 30th, 2013

On March 12, 2013 the Federal Trade Commission (FTC) released new guidelines covering digital advertising. They are stricter for advertisers and call for digital marketers to review their current practices for compliance.

The original guidelines from 2000 merely demanded that disclosures be in close “proximity” to ads whereas the new guidelines must be “as close as possible,” clear and conspicuous, and hyperlinked only when their meaning is easily understood by consumers. These changes are largely the result of mobile and social media advertising.

The impact is important for digital marketers to understand. The FTC explains in the guidelines that tweets with the hashtag “#Sponsored” are probably acceptable as this is would be easily understood by consumers to be an ad. However, the FTC distinguishes the example tweet “#spon” and says it is probably not acceptable and possibly deceptive.

The FTC also addressed the problems presented by digital advertising on mobile devices. The new guidelines point out that many platforms may not be appropriate for digital advertising based on their incapability of the kinds of conspicuous disclosures now mandated by the FTC. For example, the FTC advises against the use of Flash media now for digital advertising.

The new guidelines specifically address disclosures within social media and mobile platforms. The FTC makes clear that “space-constrained” platforms (like Twitter, for example) are not exempt from the disclosure rules. In fact, the FTC recommends that advertisers actually make their disclosures within the ads despite the lack of space. If they are linked, they must be linked conspicuously. The Guidelines also advise that ads be mobile-optimized, to avoid the problem of ads with clear and conspicuous disclosures on a regular-sized screen becoming ambiguous on a mobile screen or requiring scrolling. Pop ups are also discouraged, since so many people use blockers or simply disregard them completely.

The takeaway here is that digital advertisers need to ensure their compliance with the new guidelines. Mobile optimization and better social media advertising are good business anyway, but the FTC will be making sure that marketers toe the line.

If you have any questions about this topic, please feel free to email us.


ZIP Codes Constitute “Personal Identification Information” According to Recent Massachusetts Supreme Judicial Court Holding

Posted on Mar 27th, 2013

Overview

On March 11, 2013, the Massachusetts Supreme Judicial Court (SJC) followed courts in California* and many other jurisdictions, holding that ZIP Codes constitute personal identification information (PII). While this cases arises in the context of point of sale data collection by off-line brick and mortar retailer, the implications for this are significant for offline and online companies engaged in any collection of data from their customers and end users.

Case Summary

This case arises from the common practice by retailers of collecting customers’ zip codes at the time of purchases. Mass. General Laws Section 105(a) prohibits any business from recording or demanding that a credit card holder write “personal identification information, not required by the credit card issuer, on the credit card transaction form.” The PII contemplated in the section includes address and telephone number as they are explicitly listed but it also states that those are not the only PII it refers to. Any violation of Section 105(a) is considered to be “an unfair and deceptive trade practice” which means it is also in violation of Massachusetts General Laws, chapter 93A, section 2. 93A allows a plaintiff to claim treble damages and attorney’s fees, which can significantly up the ante in the event of potential violation.

The Tyler case was filed after the similar Pineda decision from California (see below) and was based on a complainant’s argument that she provided her ZIP Code to defendant Michael’s over the course of a year believing she had to in order to make her purchases. The plaintiff also alleged that Michael’s employees recorded her ZIP code information in an electronic transaction form and that Michaels was then able to get her address and phone number from commercial databases using her name and ZIP Code to send her unwanted, unsolicited marketing materials. The plaintiffs asserted that this was tantamount to writing PII on a credit card transaction form. Ergo, according to Massachusetts law, the practice should be considered a deceptive or unfair trade practice. Michaels moved to dismiss.

The district court agreed that ZIP codes are PII and that Section 105(a) may apply to the Michaels electronic credit card transaction forms. However, the district court dismissed because it found that, absent identity theft, there was no cognizable injury stated by the plaintiffs under chapter 93A of the General Laws. Thus, the district posed the following three questions to the SJC to answer under Massachusetts law:

(1) Do ZIP Codes constitute personal identification information (PII); (2) Absent identity fraud, can a violation of the Massachusetts General Laws, chapter 93, section 105(a) give rise to an action concerning PII; and (3) Third, does the phrase “credit card transaction form” covers both electronic and paper transaction forms equally. These three questions originated within a class action lawsuit citing violation of Section 105(a) on the part of Michaels who had allegedly asked for and stored customers’ credit cards’ ZIP codes.

The Court first clarified that “based on the text, title and caption, and legislative history of § 105,” the purpose of the statute was not in fact to protect against identity theft; rather, this section’s purpose is to protect consumer privacy with regard to credit card transactions. Because ZIP codes could allow other PII about consumers to be discovered using public databases (PII like addresses and phone numbers) the court reasoned that ZIP codes must also be PII. The court further observed that Section 105(a) is not specifically limited to identity theft and thus refused to limit it in this way. Finally, the statute explicitly states that it applies to “all credit card transactions”, so the court found that electronic credit card transaction forms would be included within its purview.

Impact of Tyler

It is possible that, as with the older Pineda case, the Tyler case might lead to additional class action lawsuits. In any event, given the Massachusetts SJC’s strong stand on consumer rights in Tyler, businesspeople and retailers (local or national) doing business in the Commonwealth of Massachusetts should re-evaluate their own practices to make certain they are in compliance with Section 105(a). This practice should also be taking place in the other states that have similar laws on the books.

It is possible, within the confines of Tyler, that collecting this kind of information for internal use only, and not for marketing or to sell or make a profit on the information, might not give rise to enough of an actual “harm” to support a cause of action. Any plaintiff still must prove an actual injury to some extent. Still, the decision makes collecting information beyond what is required by credit card issuers risky.

* (For a related case see the California Supreme Court decision Pineda v. Williams-Sonoma Stores which also holds that ZIP codes are personal identification information according to California’s Song-Beverly Credit Card Act, Civil Code section 1747.08. In excess of 15 states, Massachusetts and California among them, have laws that regulate the type of customer personal identification information that retailers may legally collect and store.)

If you have any questions about this topic, please feel free to email us.


Some Thoughts on Convertible Notes vs. Straight Equity

Posted on Mar 15th, 2013

In today’s early stage fundraising market, most seed investments come in several flavors: common stock, convertible notes (or “converts” as they are sometimes called) and a simple preferred stock investment. There are a lot of interesting posts on this topic on Quora and elsewhere so we thought that we would provide our take.

Common Stock

If you are looking for a simple and inexpensive process and you are raising a small amount of money ($250,000 or less), common stock may be a good choice. The documentation can be very simple – a short subscription agreement (with an investor questionnaire), shareholder agreement, stock certificates and you may be done. Typical terms include basic information rights, rights of first refusal and co-sale (or tag along) rights and a pro-rata right to participate in the next round of financing of the Company. From the company’s standpoint, it is generally a good idea to keep these deals as simple as possible, both to keep costs down and to avoid a complicated structure that could impact future investment rounds. If the company is an S-corporation, a common stock round (assuming all investors are eligible S-corp shareholders) also helps the company to keep its S-corp status, which can create tax benefits for active investors and founder shareholders.

The downside of an early common stock round is that it can lock the company into a fixed valuation that has not been really tested by the market. If the valuation is set too high, it will be difficult for the company to issue cheap stock and options. Since this is often a key attraction in joining a company at an early stage before they raise a larger capital round, an excessively high valuation could prejudice the company in attracting key talent at this formative stage. Another downside to a fixed price is that follow-on investors may challenge the valuation that was reached and try to impose a lower valuation—a down round—later. This potentially puts the company in the awkward position of mediating between the original investors and the new money. The original investors, of course, put their money in at a higher risk and may insist on their negotiated deal. The new money may want to pay less and thereby substantially dilute the original seed investors. Unlike a preferred stock or convertible note structure, common stock usually does not offer a simple price protection (like a weighted average broad based anti-dilution adjustment).

If the common stock value is too low, it may be unfair to the founders and key employees. This issue may take awhile to germinate, but by the first or second venture round, there may be pressure from management and the new investors to try to “reshuffle the deck” to get the key players more of a stake in the Company’s long term outcome.

Convertible Notes

There a lot of variations on this deal structure. Over the last several years, the most prevalent terms include an unsecured note carrying a 24-36 month term, interest ranging from 5-10%, and a conversion price based on the next “Qualifying Financing” of the Company (usually $1-2MM of new money). The conversion price is now often subject to two outside conditions that help reduce some of the uncertainty of the valuation of the Qualified Financing by subjecting it to a cap and a discount of the price in that round. The cap can range from $1-2MM on low end (considered low) to $7-8MM on the higher end (this range is usually seen where the Company already has some traction or where the founders are known players and therefore able to command better terms). The discount ranges from zero to 30%, usually being in the realm of 10-20%. Similar to common stock terms, investors usually get basic information rights and pro-rata participation rights for the company’s next financing round.

The documentation for these deals also tends to be pretty light, and while a bit more than the common stock offering, a lot less than a preferred stock investment. Typical documents involve a subscription or purchase agreement and some form of convertible note. Deals can also include warrants, although this seems a bit less common in today’s market. Similar to a common stock round, these deals can be closed quickly and cost-efficiently.

Like the common stock deals, a downside of convertible notes for the company can arise at the time of the next round, if the new investors see the terms as being too rich and do not want the old investors converting into the same security as them, and at a lower price. This issue has caused many sophisticated investors to opt for more set terms on valuation, resulting in the recent popularity of preferred seed rounds, discussed below.

Series Seed or Series A-1 Lite Preferred Stock

Because preferred stock investments are significantly more complicated to close than the other deal formats, a number of national law firms and investor syndicates have tried to develop a simple set of deal documents to make this structure more attractive. (See Fenwick & West Series Seed Docs for example.) While we commend these authors for trying to establish an open-source library to streamline this process and reduce expenses, these documents are basically a watered down version of other more comprehensive VC form documents, such as the NVCA Model Documents, and leave a lot of details out that could be material. For a small amount of investment — $500,000 or less — it would seem hard to justify this structure. Also, if the Company is an S-corp, it will automatically blow the Company’s S-corp election, something that may be better delayed until the investment amount is substantial and merits losing the single-tax structure. The creators behind the Series Seed argue that those documents can be just as fast and cost-effective as convertible notes, with the added benefits of giving “investors more clear definition around rights, more stability and less potential squabbling in the next round.”

The bottom line is that no structure is perfect and there are tradeoffs for all of the parties involved. While there are lots of free (and freemium) resources available to help educate entrepreneurs on these issues, experienced counsel should be sought to help document any transaction and ensure that it is done properly. All of these structures are designed to be cost efficient, to reduce the inevitable temptation for clients to do it themselves, and to allow folks with little or no money to establish the right foundation for their investment that will facilitate their growth and future investment potential.

If you have any questions about this topic, please email us.


Delaware Court of Chancery Holds that a Reverse Triangular Merger is not a Transfer or Assignment by Operation of Law

Posted on Mar 13th, 2013

 

Last month the Delaware Chancery Court allayed the concerns of corporate transactional lawyers by ruling under Delaware law that a reverse triangular merger (RTM) does not constitute a transfer or assignment by operation of law. The decision, Meso Scale Diagnostics, v. Roche Diagnostics, C.A. No. 5589-VCP (Del. Ch. 2013), involved a restriction on assignments and transfers in a license agreement, which the Court held as a matter of law was not triggered by the RTM.

In brief, a reverse triangular merger structure involves a merger of a selling company (Target) with a subsidiary of the buyer company (Buyer), which is often a special purpose entity created just for the transaction. The transaction is referred to as a “reverse” type of merger because the acquired entity here ends up being the surviving entity in the merger and becomes a subsidiary of the Buyer. This structure is desirable because it resembles a stock acquisition in its final result, but has the added advantages of (1) requiring less than unanimous approval from the Target’s stockholders and (2) allows for more flexibility than a stock swap under the tax laws relating to what are called “tax free” reorganizations.

For years, corporate lawyers have taken the position that a RTM does not trigger anti-assignment provisions in contracts. That’s because in this structure, just like in a stock acquisition, no contracts are being assigned or transferred per se. The acquired entity remains in place and the only change is that its stockholders before the deal have been replaced with a single stockholder, which is either the Buyer or one of its subsidiaries. However, starting with a somewhat obscure 1991 California court decision involving Oracle, there has been a growing national trend of courts calling this line of reasoning into question. The Oracle court reasoned that a change of stock ownership in a target was a change of its legal form, which resulted in an impermissible transfer of intellectual property rights. Most recently, an earlier Chancery Court decision in 2011 in this same case created ambiguity under Delaware law – previously thought to be safe territory by most Delaware practitioners – by refusing to dismiss the case based on the stock acquisition cases cited by the defendants.

The recent Meso Scale holdings resolve these issues. The Chancery Court rejected the Oracle decision as persuasive authority on this issue. The Court reasoned that the California court’s holding that a RTM constitutes an assignment by operation of law conflicts with Delaware’s jurisprudence regarding stock acquisitions. This is because Delaware courts have consistently found over time that when a corporation lawfully acquires the ownership of another corporation and with it the corporation’s stock, this change of ownership does not imply any assignment of the contractual rights of the corporation whose securities the buying corporation purchased. Therefore, the Court of Chancery held that because both stock acquisitions and RTMs are changes in legal ownership, and not in the underlying interest of that entity, they should produce parallel legal results.

The lessons from this case are two-fold:

1.   For contracts governed by Delaware law, parties can continue to rely on stock acquisitions and RTMs as a structure where third party consents should not be required to a “transfer” or “assignment” type of contractual clause. For contracts governed outside Delaware, such as in California, the doubt still remains, so it may be prudent to get the third party consent for those contracts just in case.

2.   For Delaware-governed contracts, parties that want the right to consent to a RTM (or other similar transaction) should include a “change of control” provision in their contracts. While this is common in more complex agreements, such as financing agreements and real estate leases, commercial agreements such as software license agreements and customer and vendor contracts generally do not go to this level of drafting.

If you have any questions about this topic, please feel free to email us.


Drafting Tips from Recent Chancery Court Decision in Viacom “RockBand” Debacle

Posted on Jan 27th, 2013

Drafting Tips from Recent Delaware Chancery Court Decision in Viacom “RockBand” Debacle

The most recent decision in the saga between Viacom and Harmonix – the maker of “RockBand” – awards $12 million to the seller stockholders of Harmonix for amounts held in escrow to back up their indemnity to Viacom. Even though four separate claims for infringement of intellectual property were brought against Harmonix after the closing, and the Harmonix executives admitted that they were aware of the other patents that led to the claims, the Court found that the seller did not breach its representations and warranties in the merger agreement and that Viacom did not have a right to an indemnity against the escrow. As one can imagine, this case brings up some interesting drafting issues worth considering before your next M&A deal.

In September 2006 Viacom bought Harmonix for a cash payment of $175 million plus an earn-out based on Harmonix’s earnings for 2007 and 2008. The deal included a $12 million 18-month escrow to indemnify Viacom for losses from breaches by Harmonix of its representations and warranties. At the time of the deal, GuitarHero had already been released, but other products such as RockBand were still in the works. Since intellectual property was likely a key asset in the transaction, there were a number of representations by Harmonix relating to its intellectual property. As discussed below, those reps were qualified in various ways, and those qualifications made the difference in this decision.

After the closing, four different sets of patent, trademark and copyright infringement claims were brought against the acquired business. While some of those claims had been raised prior to the closing and disclosed to Viacom, others were not. Viacom took on the claims, spending almost $30 million in legal fees, and then sought to set off its losses against the escrow, claiming a right under the indemnification provisions in the merger agreement. The Delaware Chancery Court disagreed.

Viacom argued that the seller stockholders had a duty to defend pending the determination of whether there was a duty to indemnify. Distinguishing a number of earlier decisions, the Court strictly construed the indemnification clause in the merger agreement to read that there was no separate no duty to defend unless there was an underlying duty to indemnify. The duty to defend arises from specific contract language and guarantees coverage independent of the outcome of the legal conflict it covers; the duty covers the cost of defending the claim regardless of the claim’s merit. However, indemnification involves the guarantee by the party to cover any judgment against the other party. Viacom wanted its legal fees independent of the outcome of the legal conflicts, but it was only indemnified against judgments in those cases (if at all). So, from a buyer’s perspective, one drafting consideration would be to clearly separate a duty to defend as one of the remedies in the agreement, potentially limiting that obligation to specific claims or litigations that may have been known or foreseen at the time of the closing.

Here, a right to indemnity arose only from breaches of representations and warranties of the merger agreement. It is important to note that had there been a separate indemnification obligation for third party claims arising from any intellectual property of Harmonix, or relating to business conduct prior to the closing, the outcome of this case may have been very different.

To determine whether there was a breach, the Court focused on two types of reps relating to the intellectual property. The first represented that the Company had sufficient rights to all intellectual property as necessary for the “current use” of its products. Because the claims for which Viacom sought indemnity related to the commercial version of RockBand, which was only in prototype stage at the time of the deal, the Court found that there was no breach.

It is worth noting that there could have been a claim here if the language specifically included the underlying intellectual property in the prototypes or other works in process, as integrated into the final work product. Also, while there was a broader representation regarding rights in “Company Developed Software”, that particular term also did not expressly include RockBand.

The other representations at issue related to potential infringement and were qualified by knowledge.While the Court agreed that management did have knowledge of the other parties’ patents, the crucial distinction here is that Viacom could not show that management had knowledge that they Harmonix’ products were infringing on those patents. That said, it is a bit surprising that there was no special indemnity for claims arising from that known third party intellectual property.

While it is easy to critique with 20/20 hindsight, the scenario represented in this decision is not uncommon and presents a good case study. Hundreds of startups each year are acquired for their talent and nascent technology, and buyers often take over product direction after the closing. Particularly with the explosion in patent troll litigation, often brought after the announcement of an acquisition (or investment) to target the buyer’s deeper pockets, the risk of infringement litigation that relates back to the pre-closing period is significant. In that situation, as here, sellers should look to limit their liability to current technology and known infringement, shifting the freedom to operate and infringement risks on the buyer. On the other hand, buyers would be well-advised to look for broader indemnification obligations with longer survival periods (and lots of exceptions and exclusions for key material reps), with an express duty to defend, for any third party infringement claims relating to the sellers’ products that existed at the time of the transaction, whether in a final production or prototype stage.

If you have any questions about this topic, please feel free to email us.