Newsletters

4416 East West Highway
Fourth Floor
Bethesda, MD 20814-4568
Phone: (301)986-9600
Fax: (301)986-1301
Toll Free: (888)986-9600
E-mail: sgro@sgrolaw.com

Legal Alert:
Current legal trends affecting you and your business

July/August 2003

In this issue . . .

• Stay out of Hot Water With a Document-Retention Policy
• Want to Sell Stock in Your Business But Keep Control? Consider an ESOP
• ADEA Update: Severance Pay, Waivers and Tender-backs

Stay out of Hot Water With A Document-Retention Policy

An attorney at Arthur Andersen’s Chicago headquarters sent a memo to its Houston office on Oct. 12, 2001, urging staffers to comply with the firm’s document-retention policy DRP). The policy specified how long employees should keep various written and electronic records and when to destroy them. DRPs usually protect businesses from liability related to destroying documents. So why did Andersen get in trouble for destroying documents even though it had a DRP? The answer can help ensure that your company destroys documents appropriately.

Learning From Andersen’s Mistakes

On its face, the Andersen lawyer’s advice seems reasonable. Every company, big and small, needs a DRP, and very company should regularly comply with it. But Andersen’s memo was problematic because it:

• Failed to direct Houston staffers to preserve all documents related to the SEC’s investigation of Andersen’s client, Enron, the now-bankrupt energy trader, and
• Aroused suspicion months later because the firm had rarely invoked its policy.

In fact, an Andersen partner who had been with the firm for 30 years testified later that he didn’t even know of the policy before October 2001. Why had Andersen chosen that particular moment to issue the memo? And why did Andersen shred thousands of documents and erase multitudes of e-mails relating to Enron’s accounting irregularities?

Prosecutors argued at trial that Andersen’s newfound enthusiasm for file purging in compliance with its policy was an implicit order to destroy documents that might have tied it to the Enron scandal. A jury convicted Andersen in June 2002 of obstruction of justice.

Andersen’s conviction and later decline points up two important lessons about document retention and destruction:

1. Every company should adopt a policy and follow it consistently and regularly, and
2. The policy should provide for the suspension of its rules if some documents otherwise scheduled for destruction might relate to a dispute, court action or investigation.

Here are some guidelines for creating and enforcing a policy for your firm.

What To Include

A DRP doesn’t have to be long and complex. It can be just a few paragraphs, though DRPs more commonly cover several pages. Basically, a good policy states:

• How long, how and where to store various kinds of documents — including paper and electronic records,
• How to dispose of records when their retention periods end,
• Under what circumstances and by whose authority to suspend the policy — such as a dispute, lawsuit, subpoena or investigation,
• Who is in charge of enforcing, monitoring and updating the policy, and
• How to organize and catalog stored records so that employees can retrieve them quickly when necessary.

Obviously, no one-size-fits-all policy exists. The specifics — such as retention periods and disposal methods — depend on your company’s nature and type and your storage capacity’s physical limits. You may have to keep some records indefinitely. For best results, work with your financial and legal advisors to nail down your policy’s details.

Remember that computer archives are discoverable and even deleted files can be retrieved.

How To Implement

When you introduce a new or revised policy to your employees, make sure you educate everyone in the company about its meaning and use. Also, appoint a few employees to conduct periodic audits to make sure you’re saving documents as long as necessary and destroying them on time. Remember that computer archives are discoverable and even deleted files can be retrieved.

Also appoint an administrator or a committee to monitor the effectiveness of your retention plan, and recommend improvements or periodic updates, especially when new regulations or standards come along.

Avoiding Liability

Most important, remember that destroying documents in the context of a lawsuit or investigation — even if according to your policy — can result in civil liability, court sanctions or, as Andersen learned, even criminal charges and company decline. If anything is worse than an incriminating document, it’s an illegally destroyed document. Moreover, destroying records is a felony punishable by up to 20 years in prison under the Sarbanes-Oxley Act of 2002, passed as a direct result of Enron and other recent debacles.

We urge you to review your current retention plan or begin drafting one. Please call us for advice on writing and implementing a plan.

Multipurpose Policy

The purpose of creating and enforcing a documentretention policy is much broader than the need to avoid obstruction-of-justice charges. Other compelling reasons to have a policy include:

• Compliance with governmental rules. The IRS, for example, sets rules for how long you must save copies of tax returns. Similarly, the Occupational Safety & Health Administration dictates how long you must retain safety and health records. Consult your tax and legal advisors to make sure you comply with all governmental rules.
• Compliance with industry or professional standards. Ask your trade or professional association for guidelines.
• Dispute resolution and litigation.  Saving documents that relate to sensitive negotiations, large transactions and major contracts, for example, can help support your position in a dispute or claim. Also, should litigation arise unexpectedly, a written policy gives you a reasonable basis for explaining why you destroyed related documents.
• Storage costs.  Storing massive amounts of paper documents and even electronic data takes up space and costs money. A written policy helps manage costs by requiring you to maintain only useful or necessary files and to destroy all others.
• Information management. In many cases, saving obsolete records, superceded documents, first drafts and outdated information can cause confusion. Often the best policy is to save only the final (or latest) version of a document.
• Confidentiality. The less of a paper trail you leave, the lower the chances that your competitors will get their hands on proprietary information.

Want to Sell Stock in Your Business But Keep Control? Consider an ESOP

In a closely held corporation, a time may come when the owner wants to sell stock in the company but still maintain control. This might occur, for example, when the owner plans to retire soon or simply seeks a way to raise capital. But an owner may be hard-pressed to find an outside investor. Selling stock to other shareholders may be an option, but in many cases the best way is to sell stock to employees through an employee stock ownership plan (ESOP).

4 Good Reasons To Offer an ESOP

ESOPs are the most commonly used form of broadbased employee ownership in the United States, according to the National Center for Employee Ownership (www.nceo.org). About 11,500 companies in all industries have ESOPs in place, though more than 25% of those are in the manufacturing sector.

An ESOP provides several benefits not only to the owner, but to the company as a whole and, of course, to the employee participants. We’ll take a look at the disadvantages, but first, here’s a summary of an

ESOP’s four main advantages:

1. Capital market. An ESOP creates a "friendly" market for a retiring owner’s shares — assuming the company has no interest in going public or being acquired.
2. Tax advantages. An ESOP offers substantial tax benefits — for example, the company’s ESOP contributions are largely tax-deductible. In some cases, an owner of at least 30% of the corporate stock can defer tax on capital gains.
3. Financing opportunities. An ESOP can borrow money to buy stock, and the company can make tax-deductible payments on the loan — providing an attractive form of debt financing.
4. Employee incentive. As an employee benefit, an ESOP can help attract and retain valuable employees. And when employees become owners, they profit from business growth, so they have an incentive to be more productive.

How the Plan Works

An ESOP is a tax-qualified employee benefit plan in which most or all of the assets are invested in the employer’s stock. Funds and securities are held in trust and allocated to inpidual accounts for the benefit of employees and their beneficiaries.

Like profit-sharing and 401(k) plans, an ESOP must include all full-time employees who meet specified requirements, often related to the number of years they’ve worked for the company. The company may allow broader participation in the plan — for example, part-timers who work at least 20 hours a week.

The company may contribute stock directly to the ESOP, but more commonly it contributes funds the ESOP can use to buy shares, or else the ESOP borrows money to buy stock. Contributions are entirely or partly tax-deductible. As mentioned earlier, using the ESOP to borrow money offers significant additional tax advantages. That is why most companies with ESOPs use this method of debt financing.

You can set up an ESOP that gives participating employees either an equity interest or a controlling interest in the company. Different companies use different formulas to determine how many shares to allocate to each employee. For example, some base the number of shares on each employee’s relative yearly pay, so that highly paid workers receive more shares than low-wage workers. Others allocate an equal number of shares to all employees. And some use a combination of criteria that doesn’t discriminate on the basis of race, gender or other criteria.

Payback Time

Most ESOPs are set up so that employees gradually vest in their accounts. By law, vesting must be at least 20% per year. Employees typically can receive pidends on the stock each year they’re with the company.

When participating employees retire, leave the company or die, they (or their estates) become direct owners of the vested shares in their accounts. The company must offer to buy back their shares at an appraised fair market value, so that employees are guaranteed a market for the stock.

Costs and Disadvantages

Setting up an ESOP is complex and expensive. And you have to spend money annually on appraisals and other professional services. Rarely is an ESOP cost-effective for a company with fewer than 20 employees, unless it expects to grow quickly.

Another disadvantage is that some former employees might not sell their stock back to the company but instead hold it, allowing them to vote as shareholders. You have to decide whether you can live with that possibility.

Custom-Tailored Plan

The good news is that you have a wide range of options in setting up an ESOP, and you can tailor it to fit your needs and goals. If you decide to explore the idea of setting up an ESOP, or have questions about getting the most benefit from an existing plan, please call us.

Broad-Based Employee Ownership: Alternatives to an ESOP

An employee stock ownership plan (ESOP) is a great way to give employees ownership in a company, but it’s not necessarily the best plan for every company. Here are alternatives:

• Stock option plan. Stock options give key employees the right to buy shares at a fixed price (the grant price) when their options vest over a specific period in the future. The exercise term is commonly 10 years. If the stock price rises, the employees will exercise the option. If it falls, they’d have no reason to. Options work well for adequately capitalized fast-growth startups. You may offer options to as many or as few employees as you wish.
• Employee stock purchase plan (ESPP). This plan gives employees a chance to buy stock at a discounted price, usually through payroll deductions.
• Section 401(k) plan. This popular qualified pension plan can be used in combination with your company stock. Employees contribute pretax dollars, and employers may make matching contributions. Like an ESOP, the company must include all full-time employees who meet minimum qualifications. Unlike an ESOP, a 401(k) can persify its investments and offer participants a variety of choices, including company stock.
• KSOP. This combination of an ESOP and a 401(k) allows a company to match employee contributions with company stock.
• Phantom stock. This allows a company to reward key employees without giving up ownership. If the company then goes public or is bought out, owners of phantom stock receive a share of the proceeds.

ADEA Update: Severance Pay, Waivers and Tender-Backs

Laying off older employees usually isn’t pleasant and can place an employer at risk for agediscrimination claims. Employees who are 40 or older belong to a protected class under the Age Discrimination in Employment Act (ADEA). So in return for severance benefits, a savvy employer will require departing employees to sign separation agreements that waive any legal claims.

For employees 40 or older, the waiver can specifically bar age-discrimination lawsuits under theADEA. That means if laid-off employees waive their right to sue and take the severance money, courts should summarily dismiss any later suits they file against their employers, right?

When Waivers Don’t Work

Not necessarily. Courts typically don’t dismiss these suits alleging age discrimination if ex-employees allege, for example, that:

• They signed the waivers involuntarily or under duress,
• Their employers failed to adequately explain the waiver, or
• Their employers failed to allow employees ample time — 21 days under the ADEA — to let their lawyers review the agreement and seven days to rescind it.

Is this unfair to employers?

Eating Cake While Having It, Too

Many employers think so. They reason that exemployees who sue after promising not to should be required to return severance pay — at least until the lawsuit is concluded. Why should they eat their cake and have it, too?

Some employers tried to get around that perceived unfairness by inserting "tender-back" clauses in addition to waivers in their separation agreements. These clauses require ex-employees who file lawsuits after collecting severance pay to return it before proceeding with their suits.

Should ex-employees who sue after promising not to be required to return severance pay?

But in December 2000, the Equal Employment Opportunity Commission (EEOC), which administers the ADEA, enacted new rules that invalidate tenderback clauses. That is, the  rules allow ex-employees to keep their severance pay (have their cake) if they sue their former employers for age discrimination (eat it, too), even after signing waivers.

Note that the EEOC rules don’t apply to claims other than age-discrimination under the ADEA. In racial- or sexual-discrimination cases, the tender-back clause may still be valid.

Invalidating the Waiver Itself

These EEOC rules go farther than simply invalidating tender-back clauses in separation agreements. When it issued the rule, the EEOC commented that the inclusion of a tender-back clause might invalidate the entire waiver if the ex-employee files an agediscrimination claim. The EEOC’s reasoning is that the addition of the tender-back clause complicates the agreement so that the average employee may not understand it.

To play it safe, eliminate tender-back clauses from any waiver you present to employees 40 and older. Alternatively, you can split your separation agreement into two parts: one containing a waiver of ADEA claims, the other containing a waiver of all other claims. The latter may also include a tender-back clause, because the EEOC comments apply only to ADEA claims. If you present employees with two separate agreements, be sure you offer two severance benefits, one for signing each agreement.

Compliance Review

The ADEA isn’t the only federal statute that you must comply with when you fire or lay off employees. Others include Title VII of the Civil Rights Act and the WARN Act. To make sure you comply, ask your attorney to review your layoff procedures and your separation agreement — especially if they contain a waiver or tender-back clause or both. In addition, state laws may give rights to employees.

The ABCs of the ADEA

The 1967 Age Discrimination in Employment Act (ADEA) protects employees and applicants who are 40 and older from discrimination based on age. The act applies to all government and private employers with 20 or more employees.

The ADEA covers all terms, conditions and privileges of employment — including hiring, firing, promotion, layoff, compensation, benefits, job assignments and training. The act also bars employers from retaliating against an employee or applicant for filing an agediscrimination claim, testifying in such a claim, or participating in any way in an age-discrimination investigation or litigation. Employers on the losing end of these lawsuits may be liable for lost wages and benefits, damages for pain and suffering, and reimbursements of legal expenses.

But the ADEA doesn’t protect some kinds of lawenforcement and fire-fighting personnel, air-traffic controllers, tenured university professors, executives in "high policy-making positions" who are 65 or older, and workers whose jobs legally require them to be younger than a specific age. But employers should be careful when invoking any of these exceptions.

When a claim for age discrimination is filed with the Equal Employment Opportunity Commission (EEOC), what happens? The EEOC investigates claims and seeks to resolve them by negotiating with the employer by suing the employer in federal court, by authorizing the employee to file a lawsuit or by dismissing the claim. Some state laws further regulate employees’ right to sue when the EEOC dismisses their claims.

Mechanic’s Liens under Maryland Law:
Proceeding Against an Owner When a General Contractor Files for Bankruptcy

Let’s say you complete your work as subcontractor on a commercial project and then learn that the general contractor has filed for bankruptcy. How will the bankruptcy affect your right to pursue a mechanic’s lien on the owner’s interest in the property?

Assuming that you have met all other prerequisites for a mechanic’s lien — such as proper notice and value of improvements — you can persuasively argue that the general contractor’s bankruptcy is immaterial to your right to a mechanic’s lien on the owner’s interest.

That’s how a bankruptcy court ruled in a series of opinions. In In re: RE Tull & Sons Inc., (we’ll call it Tull I), a supplier to a bankrupt plumbing subcontractor filed a lien against the property owner. Although aware of the bankruptcy proceedings, the supplier argued that it wasn’t seeking bankruptcy-estate property but rather the owner’s property.

The court first held that the debtor had an equitable interest in funds due from the owner under a construction contract, and that filing a bankruptcy petition stays "any action to perfect a new lien against those funds."

But later, in the same proceedings, Zakroff v. Artery Organization Inc. (Tull II), the court retreated from some of its reasoning in Tull I. The court held that the bankruptcy trustee "receives no special standing under the Maryland mechanic’s lien law, insofar as materialmen are concerned, when the owner and general contractor are not identical."

Addressing the owner’s specific issue, the court found that the question was "Did the defendants’ actions violate the automatic stay?" The court held that they didn’t. In other words, the materialmen didn’t interfere in the debtor’s estate by filing mechanic’s liens on the properties.

Although the Tull II court didn’t elaborate, Maryland law firmly supports the decision. First, under Maryland law, the only necessary party to a mechanic’s lien action is the property owner. So when the general contractor — not the owner — is in bankruptcy, proceeding against the bankruptcy estate is unnecessary.

Second, under the Maryland Trust Statute, money paid by an owner to a general contractor never becomes part of the general contractor’s estate but rather is simply "held in trust by the contractor" as trustee for the subcontractors who did the work or furnished materials. Even if the owner allegedly holds funds due the general contractor for the subcontractor’s work and materials, these don’t constitute part of the bankruptcy estate under the Trust Statute.

Finally, in the commercial context, the fact that the property owner had already paid the general contractor isn’t a defense that the owner can assert against a subcontractor pursuing a mechanic’s lien.

Citing other cases, here’s how the court explained the rule’s theory: [The owner gets the benefit of the materials, and he has control of the money. If he negligently and carelessly pays the money out to the contractor without taking precautions to see that it is applied to the payment of the materials which go in the building, then he must stand the loss rather than the materialman, who has no opportunity to protect himself once he has delivered the materials.]

In essence, the property owner — not the subcontractors — bears the burden of dealing with an unscrupulous or insolvent general contractor. So a mechanic’s lien that results in the property owner’s paying the subcontractor for work that it has already paid the bankrupt general contractor for doesn’t implicate the bankruptcy estate.

In sum, a general contractor’s bankruptcy filing shouldn’t affect lower-tier subcontractors’ and materialmen’s mechanic’s lien rights.

If you have any questions about this or any other issue relating to construction law, please contact your attorneys at Selzer, Gurvitch, Rabin & Obecny at 301.986.9600.