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Legal Alert

May/June 2004

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In this issue . . .

• Fiduciary duties of directors of privately held companies
• Complying with FMLA intermittent-leave requirements
• Get the most from technology outsourcing agreements
• Reasonable accommodation might require telecommuting
• Is new property in your future? If so, be sure to consider zoning laws
• Summary Of Maryland Mechanic’s Lien Law

Fiduciary duties of directors of privately held companies

The duties of directors and officers of publicly held companies have attracted increased attention because of recent highly publicized corporate scandals and regulatory responses such as the Sarbanes-Oxley Act. But a federal court opinion, Pereira v. Cogan, holds that directors and officers of privately held companies carry many of the same responsibilities and, in fact, may be subject to even greater scrutiny and liability. This is especially true if ownership is concentrated in a single shareholder or CEO.

Self-dealing

A private holding company declared bankruptcy in 1999, and the bankruptcy court appointed a trustee to oversee the company’s liquidation. The trustee sued Marshall S. Cogan — who was founder, CEO, controlling shareholder and chairman of the board — and several directors and officers. The trustee alleged they breached their fiduciary duties to the company’s creditors by engaging in self-dealing and by authorizing:

• Excessive compensation without recommendations from the compensation committee,
• Loans to Cogan, his family members and other insiders,
• Inappropriate dividend payments,
• His wife and daughter’s employment, and
• His extravagant birthday party.

The directors argued they couldn’t be held liable for expenditures the board hadn’t voted on and that board action during the time in question had been accomplished by written consent.

Rejected arguments

The court found that the directors had breached both their duty of due care and their duty of loyalty. It dismissed their argument that they couldn’t be held liable in the absence of board action because — if this argument were adopted — directors could shield themselves from liability by holding their noses, closing their eyes and avoiding all board meetings. This surely wouldn’t satisfy a director’s fiduciary duties to the corporation. The court based the breach of loyalty on the board’s failure to exercise diligence in the performance of their duties, combined with their close relationship with Cogan.

As for liability of nonboard company officers, the court held:

• They could be held liable for damages because they had discretionary authority in a relevant functional area and the ability to cause or preclude inappropriate conduct,
• The general counsel was liable for violating his insider-loan obligations by failing to inform the board about the loans’ statutory requirements, and
• The officer acting in the role of chief financial officer was liable because his review of daily cash reports put him in a position to prevent the loans by informing the board or taking other action.

The court held these persons personally liable.

The insolvency zone

Generally under corporate law in every state, directors and officers also owe a fiduciary duty to a corporation’s creditors when it is “in the vicinity of insolvency.” Here, the court found that the company was in the vicinity of insolvency for four years before it filed for bankruptcy.

The court applied two tests to determine when a company enters the insolvency zone:

1. The balance-sheet test finds insolvency when a company’s liabilities exceed its assets, and
2. The cash-flow test finds insolvency when a company can’t meet its financial obligations as they come due while maintaining a reasonable cushion for business fluctuations and uncertainties.

Companies may qualify as insolvent under one test but not the other, and the courts haven’t established a single standard.

The court concluded that Cogan and some of the directors and officers violated their fiduciary duties to the corporation and its creditors. So they were personally liable for more than $40 million of unlawful corporate expenditures.

Implications for private companies

Although privately held companies aren’t subject to Sarbanes-Oxley and its rules, they may nonetheless come under scrutiny in litigation — especially over bankruptcy. As Pereira noted, given the lack of public accountability, officers and directors of privately held companies arguably owe a greater duty to the corporation and its shareholders to keep a sharp eye on the controlling shareholder. “At the very least, they must uphold the same standard of care as required of officers and directors of public companies.” Board members can’t ignore corporate officers’ actions.

Officers and directors must vigilantly exercise their duties of due care and loyalty because abstaining from board action or lack of self-interest won’t protect them. When they suspect their company has entered the insolvency zone, they would be well-advised to consult their legal advisors — not company attorneys — to avoid individual liability.

Satisfying your fiduciary duties

As Pereira v. Cogan shows, private-company directors and officers can’t afford to take their fiduciary duties lightly. When seeking to fulfill their duties while avoiding liability, they should pay particular attention to:

Board meetings. The directors should meet regularly, even in states that allow boards to act by unanimous written consent. They should use written consent sparingly and only for noncritical decisions. Regular, in-person meetings show a heightened level of deliberation and care. Individual directors also must actively participate in meetings. As noted in Pereira, inaction won’t shield a director from liability. Finally, the board should appropriately record its meetings in minutes.

Procedures and codes. A company should establish formal reporting procedures to allow board members and officers to regularly review financial and operational reports. And the board should develop conduct and ethics codes, including a formal procedure for handling internal complaints.

Audit committees. Sarbanes-Oxley requires publicly held companies to form audit committees composed of independent directors charged with reviewing financial reports and overseeing external audits. Privately held companies should follow suit.

Conflicts of interest. Directors and officers must go out of their way to avoid conflicts of interest and even the mere appearance of conflicts. They should fully disclose any personal interests they may have in company transactions and abstain from participating in any decisions regarding the transactions. Further, companies should limit or eliminate loans to directors and officers. If a company opts to allow loans, it should formulate an approval process to verify that loan terms represent an objectively acceptable business risk.

Complying with FMLA intermittent-leave requirements

The Family and Medical Leave Act (FMLA) requires some employers to grant eligible employees unpaid leave for family and medical reasons, including intermittent leave. By understanding FMLA’s rules, you, as an employer, can minimize your inconvenience and avoid violating the act.

Learn the requirements

If you employ 50 or more employees, the FMLA rules specifically require you to allow “intermittent leave,” defined as “FMLA leave taken in separate blocks of time” because of a single qualifying reason. Essentially, the act enables employees to take predictable or sporadic blocks of time as unpaid leave — in hours, days or weeks — if medically necessary for weekly physical therapy sessions or random flare-ups of conditions such as asthma, for example.

But your hands aren’t completely tied — you retain some rights. When a worker asks for intermittent leave, for example, you can request medical certification, including the projected number and dates of treatments and a projected period of recovery for each treatment. You may request recertification of intermittent leave once every 30 days to ensure the need continues. If not medically necessary, a worker can take intermittent leave only with your consent.

Further, when faced with intermittent-leave requests, you may:

• Dock the pay of employees exempt under the Fair Labor Standards Act for the leave without risking their exempt status,
• Limit leave increments to the shortest period your payroll system uses to record absences or leave — as long as it represents one hour or less, and
• Require an employee requesting leave to work with you to devise a leave schedule that minimizes operational disruptions.

Bear in mind, employees who can receive treatment during nonwork hours must do so.

Consider temporary transfers

Because intermittent leave may be disruptive, the rules also allow you to temporarily transfer employees. If intermittent leave is foreseeable based on planned medical treatment, you may require employees to temporarily transfer to available positions — with equivalent pay and benefits — for which they are qualified and that better fit the leave schedule. The temporary-position duties needn’t be equivalent to the employee’s regular duties, but you can’t transfer an employee in retaliation or to deter the taking of leave.

Alternatively, you may create a part-time position based on the number of hours the employee can work during leave — with the same hourly wage and benefits — even if you don’t typically offer all the benefits to part-time workers. But you may proportionately reduce benefits based on number of hours worked to reflect the hours actually worked during leave.

Give proper notice

Regardless of how FMLA leave is taken, you must notify employees within a reasonable period — say one or two business days after learning of the need for leave — that their leave will count against their FMLA allotment. If an employee is entitled to paid leave, you must designate in writing whether the company will consider it to be FMLA leave. You or the employee may opt to substitute accrued paid leave for FMLA leave under some circumstances.

Get the most from technology outsourcing agreements

As companies search for ways to cut costs and streamline operations, many consider outsourcing their technology operations — ranging from Web design to software development to database management. To reap the greatest benefits from these arrangements, your business must pay close attention when negotiating outsourcing agreements.

Why the agreement matters

What might happen if problems arise from your technology-outsourcing arrangement? Your usual legal recourses — such as lengthy litigation seeking damages, injunctions or performance — will likely be inadequate to timely and effectively solve the problems. Further, technology agreements often cap damages at levels far below actual damages suffered. For these reasons, your business needs to act aggressively when negotiating outsourcing agreements.

At a minimum, your contract language should detail:

• Specifications,
• Deliverables,
• Schedules with monetary penalties and incentives, and
• Particular vendor employees to work on your project.

You’ll also want to specify remedies, options and requirements that reflect your real business risks of a vendor’s failure to deliver, bearing in mind the need to keep your company running if a breach occurs.

Which provisions to watch for

Here are some of the most important areas to cover:

Exclusivity. Beware of exclusivity provisions that require you to buy additional services from the vendor or give it the right of first refusal or at least the right to bid on additional services. This can deter other vendors from bidding, limiting your options and diminishing your negotiating strength.

Gain-sharing. A gain-sharing provision gives you the right to share in cost savings that develop as efficiency increases and costs decrease.

Product ownership. If your business wants to own the vendor’s work product, make sure the contract is clear on this point.

Termination. You need to be able to terminate the agreement if the vendor fails to provide services or otherwise breaches the agreement. A termination provision also protects you if the vendor appears in danger of failing — such as from falling stock prices, employee defections, or reorganizations and mergers. Conversely, limit the reasons for vendor termination, ideally allowing it only if you fail to pay undisputed charges.

Exit plan. In case either party terminates, the agreement should establish a transition period during which the vendor continues to provide service, because you probably won’t be able to immediately secure the necessary substitute services. You can require a vendor to provide transition service through a third party if the vendor declares bankruptcy. You also may want to retain the right to hire the vendor’s employees and reacquire its equipment and software.

Escrow. When a vendor develops a custom program for you oruses its own proprietary system, have the source code deposited in an escrow account that you can access if triggering circumstances — such as bankruptcy — occur.

In the case of bankruptcy, the court-appointed trustee can reject provisions in a technology-outsourcing agreement. So try to incorporate appropriate protections — such as a guaranty from the vendor’s parent or affiliated company or a surety bond.

What to avoid

Although tempting, avoid shortcuts when negotiating agreements — doing so can prove costly. Be sure your agreement addresses all conceivable contingencies.

Reasonable accommodation might require telecommuting

The Americans with Disabilities Act (ADA) has required some employers since 1990 to provide disabled job applicants and employees with reasonable accommodations. Because of technological advances, accommodations may require employers to consider telecommuting as an option.

But as the EEOC has noted, not every disabled person will need or want to work at home, and some jobs can’t be performed there.

What is reasonable accommodation?

If you employ 15 or more employees, the ADA requires you to reasonably accommodate qualified applicants and employees with disabilities. It defines a “reasonable accommodation” as any change in the work environment or the way things are usually done that enables a disabled person to perform a job, unless the change produces undue hardship on the operation of your business.

The EEOC has specifically recognized working at home as a potential form of reasonable accommodation if:

• A disability prevents an employee from successfully performing a job on-site, and
• An employee can perform all or part of the job at home without creating significant difficulty or expense for you.

The ADA doesn’t require you to offer telecommuting programs to all employees. But it may require you to do so for a disabled employee — even in the absence of a program. If your company has a telecommuting program in place, you may need to waive its eligibility requirements to allow a disabled employee to participate. For example, you may have to forgo a prerequisite such as requiring an employee to work for a year with the company before working at home.

How should you decide?

To determine whether telecommuting constitutes a reasonable accommodation for a disabled employee, you must engage in an interactive process with that worker, beginning with his or her request for accommodation because of a medical condition. You may ask for information about the medical condition — including reasonable documentation — if you’re unsure whether the condition qualifies as a disability.

A “disability” is defined as inability to perform a major life function.

You must also determine whether a specific job can be performed at home. Factors to consider include:

• How you can supervise the employee at home,
• Whether face-to-face interaction is required to perform essential job functions or whether phone, fax and e-mail contact can ensure timely communications with co-workers, clients and others, and
• Whether the job depends on immediate access to documents and other information found only in the workplace.

The ADA doesn’t require you to eliminate any essential job duties to facilitate telecommuting. But you may need to reassign some marginal duties that can’t be performed outside the workplace and that present the only obstacle to home performance. And you may substitute another minor task to evenly distribute employee workloads.

All or nothing?

If some duties can be performed only on-site, you may need to allow an employee to work at home part time and at the workplace part time. But the ADA doesn’t require you to offer telecommuting if other effective alternatives are available. Remember, you may select any effective accommodation — even if an employee prefers an alternative.

Is new property in your future?
If so, be sure to consider zoning laws

Zoning issues can easily get lost in the many issues arising when a business thinks about buying, leasing or changing property. But zoning restrictions can derail a company’s plans, so business owners need to consider the issues sooner rather than later.

Zoning basics

Zoning laws govern the use of land and buildings in a city’s or county’s districts. Every jurisdiction develops its own system, and zoning varies by district.

The laws usually categorize use as residential, commercial, industrial, agricultural or recreational. Some might restrict buildings according to height and overall size, proximity to other buildings, and the types of facilities that must be included with some uses. They also address issues such as parking, signage, waste management, visual appearanceand noise.

Special uses

When use of an existing property violates a zoning law, the property is described as having a nonconforming use. The building itself or the activity conducted inside it may not conform. A property owner or tenant can lose the right to continue nonconforming use by abandoning the use or by amortization, where use is allowed for only a limited time.

Zoning may permit a conditional use, but only if some conditions are met, such as provision of parking spaces when a business operates in a residential zone.

A new tenant or owner can’t assume it will be allowed to continue the same activity a previous tenant or owner engaged in. The previous rights holder may have qualified for “grandfathering” when a new zoning law went into effect or may have been granted a zoning variance that doesn’t pass along with the property rights.

Variances

Property owners can seek a variance when a zoning law creates particular problems or unnecessary hardship for them. Obtaining a variance gives owners the right to use their property in a manner barred by zoning laws. For example, an area variance affects property size, while a use variance addresses how land can be used — such as allowing a business in a residential area. To obtain a use variance, the owner may be required to demonstrate that the property doesn’t provide a reasonable return under the zoning law.

Business owners seeking variances often face strong opposition from neighbors. If a variance request is rejected, the owner can appeal the decision in court. An owner with specific damage also can challenge a zoning ordinance as unconstitutional.

No excuses

Business owners should never sign a lease or sales agreement without checking all applicable zoning laws. They won’t be excused from contractual obligations owing solely to zoning issues.

  Added security

Business owners shouldn’t overlook another way to protect themselves against the risks associated with zoning laws. Buyers can ask the title company whether it offers a “zoning endorsement.” Such an endorsement insures buyers against loss if zoning laws preclude them from using the property as they intended.

Summary Of Maryland Mechanic’s Lien Law

General. Any person who, pursuant to a contract, provides labor or materials for the construction of any building or the repair, rebuilding or improvement of an existing building to the extent of fifteen percent (15%) of its value, may perfect a lien on said property for the value of the services and materials provided. An owner may contend that the “value” of the work or materials furnished isless than the amount provided in the contract. A building also includes any unit of a non-residential building that is leased or separately sold as a unit.

An executory contract between a contractor and a subcontractor may not waive or require the subcontractor to waive his right to a mechanic’s lien. However, a prospective lien waiver by a contractor is valid and enforceable. Unless received as payment or the lien right is expressly waived, the acceptance of a promissory note, other security or extension of credit does not constitute a waiver. Payment by the owner is not a defense except where the project involves the construction of a single-family dwelling on the owner’s land for a personal residence. Where the project involves the construction of a singlefamily dwelling on the owner’s land and for the owner’s personal residence, the lien will be limited to the amount owed the contractor at the time the Notice is served.

A mechanic’s lien will not attach to the property of a bona fide purchaser for value. Depending upon the terms of the sales contract, a bona fide purchaser may include a contract purchaser even though actual settlement has not occurred.

Perfection. In order to establish a lien, a petition must be filed in the Circuit Court for the County where the land or any part of the land is located, within one hundred eighty (180) days after the work has been completed or materials furnished. A show cause hearing will be conducted within forty-five (45) days of the filing of said petition, provided proper notice is obtained. No mechanic’s lien will be established prior to proper notice and court decree. All persons entitled to a lien, except contractors with a direct contractual relationship with the owner, must provide the owner or owner’s agent a written notice of intention to claim a lien within one hundred twenty (120) days after furnishing the work or materials. The form of the notice of intent to claim a lien must comply with the requirements of Section 9-104 of the Code.

At the time of the show cause hearing, the court may either (a) grant a final lien; (b) deny the request for a lien; or, (c) establish an interlocutory lien. In the event the court refuses to establish either an interlocutory or final lien, within thirty (30) days, the claimant may file a written request for a trial. In the event an interlocutory lien is established, the court may require the claimant to file a bond as a prerequisite to the perfection of said lien. Further, in the event an interlocutory lien is established, a trial date for the establishment of a final lien will be set within six (6) months. The property owner or other interested person may request the property be released from the lien upon the posting of a bond.

Priority. A mechanic’s lien in Maryland does not have priority over liens or encumbrances recorded prior to the date that an interlocutory or final mechanic’s lien is ordered by the court.

Upon foreclosure or execution, all encumbrances and liens will be satisfied in accordance with their priority; however, where the proceeds are insufficient to satisfy all mechanic’s liens, the mechanic’s lienors will share proportionately, without regard to priority.

Enforcement. Only a final lien, not interlocutory lien, may be enforced. A final lien may be enforced by a foreclosure or enforcement of lien action instituted within one (1) year from the date on which the petition to establish the lien was first filed.

While the Mechanic’s Lien law was enacted to protect contractors, subcontractors and material men, entitlement to a lien depends entirely upon the claim falling within the statutory provisions as well as compliance with all requirements of the statute.

By Carlton T. Obecny, Esquire

The above summary is intended to provide a general overview of the various mechanic’s lien laws, however, should not be substituted for professional services.