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Legal Alert

July/August 2004

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In this issue . . .

• Navigating the rules of online advertising
• IRS warns businesses against abusive ESOPs
• The wide, wide world of warranties
• Catch up on copyright law
• Buying A Location For Your Business

Navigating the rules of online advertising

The number of businesses advertising online has grown exponentially in the past five years. So has the opportunity for deceptive advertising.

As consumer reliance on the Internet becomes even more pervasive, the Federal Trade Commission (FTC) will likely act more aggressively to ensure that goods and services promoted online are described accurately. In fact, in its quest to enforce consumer-protection laws, the FTC has already brought law-enforcement actions to stop fraud and deception online. If you advertise online, knowing the rules can help you avoid costly penalties.

Review the law

Online advertising is subject to the same consumer protections that apply to advertising in other media. That includes the FTC Act — which bars “unfair or deceptive acts or practices” — and FTC rules and FTC-published guides not limited to a particular medium.

Generally, the basic principles of advertising law apply to online advertising:

1. Ads must be truthful and not misleading. (Ads are considered deceptive if they’re likely to mislead consumers and to affect consumers’ behavior or decisions about a product or service.)
2. Advertisers must be able to substantiate their claims. (If consumers could make multiple reasonable interpretations of a claim, advertisers must substantiate each interpretation.)
3. Ads may not be unfair. (Ads are considered unfair if injuries they cause or are likely to cause are substantial, not outweighed by other benefits and not reasonably avoidable.)

The FTC has also adopted rules that refer to “written,” “writing,” “printed” or “direct mail” to cover online ads. Rules that apply to written ads or printed materials apply equally to visual text on the Internet. Sellers using e-mail to comply with notice requirements (such as notifying consumers about delivery delays) must ensure that consumers understand they will receive these notices by e-mail and must provide them in a form that consumers can retain.

Further, direct mail includes e-mail. So when a seller sends an e-mail that invites a consumer to call the sender to make a purchase, that call and any later sale must comply with rules related to telemarketing sales.

Disclose carefully

Disclosures and disclaimers must be “clear and conspicuous.” Suppose an online ad makes express or implied claims likely to mislead consumers without specified qualifying information. Then the seller must disclose that information clearly and conspicuously. Whether a disclosure satisfies the clear-and-conspicuous criterion hinges on its performance — that is, how consumers actually perceive and understand it within the entire ad’s context. (See “Is it clear and conspicuous?” above.)

In the online context, advertisers must assume a reasonable customer’s perspective when making the clear-and-conspicuous determination. They also must assume that consumers don’t read entire Web sites and must draw consumers’ attention to their disclosures.

The FTC has noted several factors relevant to whether an online disclosure meets the clear-and-conspicuous test:

• The placement in the ad and its proximity to the relevant claim,
• The disclosure’s prominence,
• Whether other items in the ad distract viewers’ attention from the disclosure,
• Whether the ad runs so long as to require repeating the disclosure,
• Whether disclosures in audio messages are presented in adequate volume and cadence,
• Whether visual disclosures appear for a sufficient duration, and
• Whether the target audience can understand the disclosure’s language.

Online advertisers should bear in mind that different types of Internet browsers may display Web pages in different formats. A disclosure that rates as clear and conspicuous on Microsoft Explorer, for example, may not come out as clear and conspicuous when viewed via Netscape.

Avoid costly noncompliance

Sellers who fail to comply with applicable advertising laws and rules could face enforcement actions or civil lawsuits. Potential penalties include cease-and-desist orders, fines as high as $11,000 per violation of cease-and-desist orders, injunctions and consumer refunds. Complying with the rules can help you avoid the penalties.

Is it clear and conspicuous?

The Federal Trade Commission has offered specific advice on how advertisers can make their disclosures and disclaimers clear and conspicuous, elaborating on the factors that affect a determination.

According to “Dot Com Disclosures: Information about Online Advertising,” here are the rules:

Place and proximity. Place disclosures near the triggering claims — on the same screen, if possible. Use text or visual cues to encourage consumers to scroll down when necessary to find a disclosure.

When linking to disclosures, make the link obvious and place it near the relevant information. Label it appropriately to convey the linked information’s importance, nature and relevance. Use consistent link styles to ensure consumers realize when a link is available. Take consumers directly to the disclosure on the linked page. Assess the link’s effectiveness by monitoring click-through rates and adjust accordingly.

Display disclosures to consumers before they make a purchase, with the caveat that placement limited to the order page may not always prove effective.

For banner ads, incorporate disclosures in the ad. Or disclose them clearly and conspicuously on the page linked to the ad.

Prominence. Display disclosuresprominently to make them noticeable. Evaluate each disclosure’s size, color and graphic treatment relative to other parts of the page.

Distractions. Scrutinize the entire ad to see that other elements (such as text, graphics and links) don’t distract consumers’ attention from the disclosure.

Repeated disclosures. Repeat disclosures as necessary on long Web pages or when claims are repeated.

Audio and visual disclosures. With audio claims, use audio disclosures of sufficient volume and cadence for consumers to hear and understand. Display visual disclosures for a duration sufficient for consumers to notice, read and understand.

Understandable language. Use clear language and syntax.

IRS warns businesses against abusive ESOPs

As part of its crackdown on abusive tax shelters, the IRS has turned its attention to strategies involving employee retirement plans. A new section on the IRS Web site (www.irs.gov ) gives important information about abusive retirement plans — including so-called “listed transactions” involving plans. The IRS also recently posted a revenue ruling addressing S corporations and their employee stock ownership plans (ESOPs).

Tax benefits

In Revenue Ruling 2004-4, the IRS examined three types of situations, all involving:

• Parent-company S corporations owned by ESOPs,
• Qualified S corporation subsidiaries, and
• Stock options in those subsidiaries.

The subsidiaries’ profits remained in the businesses instead of flowing to the ESOP-owned parent companies.

Federal law allows ESOPs to own S corporations but only if their rank-and-file employees receive meaningful stakes in the S corporations. A business formed as an S corporation may find an ESOP attractive because its profits generally won’t be taxed until the ESOP makes distributions to employees when they leave the company.

The business can thus reinvest its profits tax-deferred for their participating employees’ ultimate benefit. But, in the scenarios considered in Rev. Rul. 2004-4, the essential result in each case was that most of these profits were moved away from the ESOPs, so that the rank-and-file employees didn’t benefit from the complicated structures.

The IRS concluded that the ownership structures were designed to allow one or more persons or entities to enjoy the tax benefits associated with an ESOP’s ownership of an S corporation. The IRS barred use of a subsidiary’s stock options to drain value out of an ESOP for the benefit of its S corporation’s former owners or key employees. Code Section 4979A imposes a 50% excise tax, payable by the S corporation, on the value of the stock underlying the options if rank-and-file ESOP participants are deprived of business profits in this way.

Tax avoidance

The IRS defines a listed transaction as a transaction that’s the same as — or substantially similar to — one the IRS has determined to be a tax-avoidance transaction as identified by IRS notice or other published guidance.

In the revenue ruling, the IRS identifies as “listed” any transactions in which:

1. At least 50% of an S corporation’s outstanding shares are employer securities held in an ESOP,
2. The S corporation’s profits generated by a specific person’s business activities are accumulated and held for his or her benefit in a qualified subsidiary or similar entity, such as a limited-liability company,
3. The profits aren’t paid to the person as compensation within 2.5 months after the end of the year in which earned, and
4. The person has rights to acquire the subsidiary’s or similar entity’s stock shares (or similar interests) representing 50% or more of the fair market value of the stock of that subsidiary or similar entity.

The Web site provides for more information on listed transactions.

Report and disclose

Taxpayers must report listed transactions on Form 8886, Reportable Transaction Disclosure Statement, when they file their tax returns. Parties involved in listed transactions also may have to disclose them as required by IRS rules, register them with the IRS and maintain lists of investors. Evaluating your ESOP now may help you avoid trouble with the IRS later.

The wide, wide world of warranties

  Warranties often prove just as important to sellers as to consumers. Properly drafted and managed, warranties can effectively:

• Define the parties’ rights and obligations,
• Serve as marketing tools by encouraging consumer confidence,
• Make comparisons easier, and
• Facilitate prompt and satisfactory resolution of problems.

Let’s take a look at warranties.

Comparing express vs. implied

Express warranties are sellers’ statements made about a product or an agreement to remedy defects in a product. These warranties are rooted in express language between the parties and may be written or oral — including claims in ads or product literature and salespersons’ statements. But a salesperson’s mere opinion or recommendation of a product doesn’t constitute an express warranty. Only a promise or statement of fact creates a warranty.

Implied warranties are created by law and apply automatically to contracts. An implied warranty of merchantability guarantees that a product will perform as intended — that is, a vacuum cleaner will vacuum. An implied warranty of fitness for a particular purpose also is based in state statutes but protects more narrowly. It arises when consumers clearly state the specific purpose they intend to use a product for. And these warranties rely on the seller’s representation that the product can indeed fulfill that purpose. For example, an implied warranty of fitness for a vacuum cleaner would arise when a consumer tells the salesperson that he or she intends to use it to vacuum liquids, and the salesperson represents that the vacuum can accomplish that purpose.

The applicable state statute determines impliedwarranties’ duration and determines whether a merchant may sell products “as is” — thereby disclaiming the warranties.

Displaying disclaimers

Businesses frequently insert disclaimers in consumer contracts. To be effective, a business must prominently display and specifically refer to the disclaimed warranties. State statutes usually describe the particular language to use.

Businesses must recognize that disclaimers of implied warranties could negatively affect express warranties. A court may deem a disclaimer included in the same agreement that grants an express warranty as an unfair business practice. This is based on the theory that a consumer actually receives less warranty protection than if an agreement included no express warranty and no disclaimer. But prominently displaying a disclaimer and an express warranty in the same part of an agreement may circumvent this issue.

Drafting the written warranty

According to the Federal Trade Commission, a written warranty must include such information as:

• Product parts or types of problems covered,
• Coverage period,
• Actions the business will take to correct problems,
• How customers can obtain warranty service,
• How state law may affect some warranty provisions,
• Any limitations or conditions, and
• A title indicating whether the warranty is “full” or “limited” for products sold for more than $10.

A full warranty covers both labor and materials. Federal statutes require full warranties to provide that a business:

• Will provide warranty service to anyone owning the product during the warranty period,
• Will provide free warranty service — including such costs as returning the product or removing or reinstalling the product,
• Will let the consumer choose replacement or a full refund if the business can’t repair the product after a reasonable number of attempts,
• Will provide warranty service without requiring the consumer to return a warranty registration card, and
• Won’t limit implied warranties’ duration.

The FTC advises businesses to avoid including promotional statements and other extraneous material that might confuse consumers. A business that must include this material should separate it from the warranty.

Limiting remedies

Businesses can reduce their potential liability by limiting consumers’ rights. They can agree to allow consumers to receive only repair or replacement of their products, at the seller’s discretion. And they can disclaim incidental and consequential damages. For example, by disclaiming incidental and consequential damages, a consumer can’t hold a washing-machine manufacturer liable for damages to a home caused by a malfunctioning machine. This disclaimer limits the maker’s responsibility to damage to the machine itself.

When a manufacturer grants an express warranty but a seller doesn’t, the sales agreement typically limits the consumer’s right to make claims against the manufacturer. The agreement may state that the seller grants no express warranty and disclaim the seller’s liability for implied warranties as well as incidental and consequential damages.

Untangling the web

A wide variety of federal and state laws govern both express and implied warranties. An attorney can help ensure compliance with all applicable rules and craft warranties to minimize liability exposure.

Catch up on copyright law

The U.S. Constitution empowered Congress to “promote the progress of science and useful arts by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries.” Congress, through the Copyright Act of 1976, as amended, has been continually updating copyright laws. Let’s review some of those laws so that your company can avoid infringement claims.

Protection

Authors can obtain automatic federal copyright protection for “original works of authorship,” including such broad categories as literary, dramatic, musical, artistic and some other intellectual works. To qualify, a work must be:

1. Fixed in a tangible medium of expression (the work must exist in some physical form for at least a brief period),
2. Original (the author independently created the work), and
3. A creative expression (the work represents at least some degree of the author’s creative effort).

But copyrights don’t protect the ideas or facts a creative expression is based on, or titles, names, short phrases such as slogans, and familiar symbols or designs, among other things.

Even without registering a copyright with the U.S. Copyright Office, authors can protect their intellectual property by placing copyright notices on their works. This lays the groundwork for asserting common-law copyrights. You have probably seen these notices. They may include the “circle c” or © or the word “Copyright” followed by the year, or a written claim: “This work is the copyrighted material of ________ and it may not be reproduced, distributed or published without the written expressed consent of its author.” Technically speaking, the © is reserved for copyrights registered by the U.S. Copyright Office, but the point is to notify others not to use the material.

As soon as a work is created and fixed tangibly, an author gains exclusive rights to reproduce, distribute, perform or display, create derivative works, and assign rights in the work. A copyright endures for 70 years after the author’s death for works published after 1977. Works made for hire and anonymous and pseudonymous works carry copyrights for 95 to 120 years, depending on publication dates. Anyone who desires to use the work must obtain permission.

Fair use

But under the fair-use doctrine, reporters, critics, researchers and academicians can minimally quote from a copyrighted work without permission. To determine whether a particular use is fair, the Copyright Act sets out four factors to consider:

1. The purpose and character of the use — including whether for commercial or nonprofit educational purposes,
2. The work’s nature,
3. The used portion’s amount and substantiality in relation to the work as a whole, and
4. The effect of the use on the work’s potential market.

Tread cautiously when relying on the fair-use doctrine to take advantage of another’s work — particularly for a competitive or commercial purpose. Courts won’t hesitate to punish infringers who abuse the doctrine.

Buying A Location For Your Business

Given the current interest rate environment, you may be considering whether to buy property to use as a location for your business. A business that owns its premises has the opportunity to build equity that can be leveraged to further growth and profitability.

Tax Considerations. The ownership of improved real property creates depreciation deductions for a portion of the value of the building and any improvements. There are also tax deductions for interest paid on the mortgage and for real property taxes. It may be more beneficial to form an affiliated company which would own the property and rent to the existing business. This would protect the existing business from property-related liability risks, allow it to continue to expense rent while keeping the debt from the purchase off its financial statements, and ensure longevity in the designated business location.

Long-term planning. It is essential to consider long-term business plans and goals in deciding whether to purchase a business location. Will the space be large enough to accommodate your company over five, ten or twenty years? Will the space and location appeal to a potential buyer of your business? Does the county or municipality have plans for the areas around the location? Is there development being planned that would change the nature of the location?

Landlord Issues. If the property has other tenants, you should consider whether the responsibilities of being a landlord are right for you, or whether you will want to pay a management company to manage the property for you. You should find out what services, such as utilities or common area management, the current landlord provides to the existing tenants, whether there are existing leases and if so the lengths and terms of each. For existing tenants with leases, you will probably “step into the shoes” of the current landlord. As such, you should evaluate carefully what your responsibilities will be and how long it will be until you are be able to renegotiate the terms of the lease or terminate such tenancy.

Zoning, Environmental and Regulatory Considerations. Property-owners must comply with all the applicable laws and regulations. You may need to ensure that you can conduct your kind of business in that location without violating the zoning regulations. If you plan on renovating the property, you will need to make sure that those renovations will also comply with the zoning and building codes. You should find out whether the property contains lead paint or asbestos, or other hazardous materials, and ensure that the property is not contaminated in any manner. You should also consider whether you will be required to comply with the provisions of the Americans with Disabilities Act, which can add to the costs of ownership.

Good planning always maximizes the opportunity for successful property ownership. Our real estate partner, H. Mark Rabin, is available to assist your company and its accounting advisors in planning real estate strategies. Please feel free to contact him at (301) 634-3134.