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Michigan
Business Law
The
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CONTENTS
Volume 30
Issue 2
Summer 2010
Section Matters
From the Desk of the Chairperson
Officers and Council Members
Committees and Directorships
1
3
4
Columns
Did You Know? G. Ann Baker
Tax Matters
Paul L.B. McKenney
Technology Corner: Supreme Court Clarifies Privacy in the Workplace
Michael S. Khoury and Michelle L. Coakley
6
9
11
Articles
What Does That Operating Agreement Mean?
Donald H. Baker, Jr.
Treatment of Single Member LLCs Under SBT and MBT after
the Kmart and Alliance Decisions
Donald A. DeLong
Property and Transfer Tax Considerations for Business Entitites
Mark E. Mueller
Using Retirement Plan Assets to Fund a Start-up Company
Adam Zuwerink
Protecting Competitive Business Interests Through Non-Compete Clauses
Ryan S. Bewersdorf and Nicholas J. Ellis
Social Networking: Your Business Clients and Their Employees Are Doing It
…Are You Advising Your Clients on How to Manage the Legal Risks?
P. Haans Mulder and Nicholas R. Dekker
Secondary Liability and “Selling Away” in Securities Cases
Raymond W. Henney and Andrew J. Lievense
The History and Future of Michigan Debtor Exemptions
Thomas R. Morris
ICE Steps Up Its Aggressive Employer Audit Campaign
James G. Aldrich
13
20
27
34
40
44
49
57
63
Case Digests
68
Index of Articles
ICLE Resources for Business Lawyers
70
77
Published by THE BUSINESS LAW SECTION, State Bar of Michigan
The editorial staff of the Michigan Business Law Journal welcomes suggested topics of general interest to the Section members, which may be the subject of future
articles. Proposed topics may be submitted through the Publications Director, D.
Richard McDonald, The Michigan Business Law Journal, 39577 Woodward Ave.,
Ste. 300, Bloomfield Hills, Michigan 48304, (248) 203-0859, drmcdonald@dykema.
com, or through Daniel D. Kopka, Senior Publications Attorney, the Institute of
Continuing Legal Education, 1020 Greene Street, Ann Arbor, Michigan, 481091444, (734) 936-3432, [email protected].
MISSION STATEMENT
The mission of the Business Law Section is to foster the highest quality of
professionalism and practice in business law and enhance the legislative
and regulatory environment for conducting business in Michigan.
To fulfill this mission, the Section (a) provides a forum to facilitate service
and commitment and to promote ethical conduct and collegiality within
the practice; (b) expands the resources of business lawyers by providing
educational, networking, and mentoring opportunities; and (c) reviews and
promotes improvements to business legislation and regulations.
The Michigan Business Law Journal (ISSN 0899-9651), is published three times per year by the
Business Law Section, State Bar of Michigan, 306 Townsend St., Lansing, Michigan.
Volume XXII, Issue 1, and subsequent issues of the Journal are also available online by accessing
http://www.michbar.org/business/bizlawjournal.cfm
Postmaster: Send address changes to Membership Services Department, State Bar of Michigan,
306 Townsend Street, Lansing, Michigan 48933-2012.
From the Desk of the Chairperson
By Tania E. (Dee Dee) Fuller
You know the old saying, time flies
when you are having a good time.
With me, that statement is true in so
many ways! My term as the Business
Law Section chair is winding down,
and this is my last Michigan Business
Law Journal chairperson article. The
last year really has been a lot of fun
for me and, in that time, I think we have accomplished
quite a bit. In this final article, I would like to summarize where we stand on many of our initiatives from last
September, and I would also like to update you on some
Business Law Section plans and some upcoming Section
activities.
After many months of work, the Strategic Plan Committee submitted the proposed 2010 Strategic Plan and
Directives to the Business Law Council in April. The
Committee received feedback from Council members
that resulted in some final tweaks to the document,
and the final version was submitted to the Council in
mid-May. Finally, the 2010 Strategic Plan and Directives
was approved at the May Business Law Section Council
meeting. The final document can be found on the Business Law Section Web page by clicking on Strategic Plan
under Council Information. Alternatively, you can get
to the Business Law Section Strategic Plan and Directives (June 2010 Update) by typing the following URL
address into your browser: http://www.michbar.org/
business/pdfs/Strategic_Plan.pdf.
I would like to extend a sincere thank you to all of
the Section members who served on this important
Committee. Admittedly, the document required a lot of
time and energy, but it was a worthwhile endeavor. I
am pleased with the final product and hope you will be
too.
As the Strategic Plan Committee worked through the
results of our Business Law Section survey and crafted
the provisions of the Strategic Plan, it became evident
that the most valuable services the Section offers to
its members are through the various substantive law
committees. Section members not only appreciate but
also require information from our Section committees
regarding law changes and caselaw updates. They are
also seeking practice tips and educational sessions. As a
result, we have established more formalized committee
responsibilities in the Strategic Plan, with hopes that the
committee members will come to expect a continuum of
information from each of the Section’s substantive law
committees. Each committee is now expected to hold
one or more educational seminars each year. Those seminars may be in the form of webinars that can be viewed
online at the member’s convenience, or they may be full
day or partial day seminars. Committees are also expected to hold at least one regular committee meeting
each year. Hopefully, as our committees become more
active, more of the Section members will glean greater
value from the Section.
The Michigan Business Law Journal may be the most
valuable product the Section produces, so we expect to
continue to provide this high quality publication. We
are also expecting to include some advertisements in the
Journal to help defray its costs. Member feedback has
told us, however, that some prefer to have the Journal
in paper form while others would prefer to receive it
digitally. Until we have the technology to segregate and
provide the Journal to each member only in the method
they prefer, we now provide it to everyone in both mediums. We are working with the State Bar to find a way
to obtain e-mail address information for those Business
Law Section members seeking their journal only via email, but until that information is available, we will send
it to all Section members in paper form and provide it on
the Section Web site digitally.
The Strategic Plan touches on virtually every aspect
of the Business Law Section’s services and products,
and I urge you to become familiar with it.
Over time we have learned that the lawyers in our
Business Law Section have very diverse practice areas.
Some Section members, normally from the very large
firms, practice in very specific areas only, such as bankruptcy, banking, or mergers and acquisitions. These
lawyers have a tremendous amount of technical expertise in those specialized areas. Other lawyers in our
Section have much more varied practices, representing
a variety of clients on a variety of matters every day.
Normally these are lawyers from smaller firms. With
that said, there are times when all of us come across issues that are outside of our comfort zone. It’s at times
like these when we would like to ask a question and get
some feedback from another lawyer. The Business Law
Section wants to provide a resource for its members to
help when they have a practice question. As a result, the
Section is establishing a LinkedIn page for members to
post practice questions, and hopefully others will provide thoughtful responses and assistance. Please look
for this page in future months.
Over the last ten years or so, I have held various positions and been active in the Business Law Council. Over
that period, Section members have approached me asking how they can get more involved in the Section. Unfortunately, I never really had a good answer. Finally,
we are putting together a process that will enable Business Law Section members to get involved in the Section
electronically. In a future E-Newsletter, you will notice
a format change with a link that members can click on
to get involved. We are hoping that through this new
system, members can select areas of interest, join committees, and generally…get involved in the Section. I am
aware that we will need to work through some bugs as
we get this membership involvement technology work-
1
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THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
ing the way we want, but I am delighted that we are moving in that direction.
The Section is involved in so many interesting and exciting projects these days. If you are interested in learning
more, please join me at the Business Law Section Annual
Meeting on September 23 in Novi. Like last year, we will
hold an educational program as well as the Annual Meeting and elections. Look for more details in an upcoming
E-Newsletter. At the same meeting, we will also recognize
the 2010 Section Schulman Award winner, who I am delighted to announce is Alex DeYonker. Alex has provided
significant contributions to the Business Law Section over
the years and we are thrilled to recognize him with this
prestigious award.
Finally, I wanted to remind everyone that the Business
Law Section is again providing Business Law Boot Camp
in Grand Rapids and southeast Michigan in the 2010/2011
year. Please extend an invitation to new business lawyers
as well as lawyers who may be entering a new practice
area or just want a refresher on business law topics. The
courses are taught by some of the best business lawyers
in the state who are experts in their respective fields. I am
sure you will find these programs very interesting.
This last year really has been a lot of fun for me, and I
am so very grateful to have had an opportunity to make
my contribution to the Business Law Section.
2009-2010 Officers and Council Members
Business Law Section
Chairperson:
Vice-Chairperson:
Secretary:
Treasurer:
TANIA E. FULLER, Fuller Law & Counseling, PC
700 W. Randall St., Suite B, Coopersville, MI 49404, (616)837-0022
ROBERT T. WILSON, Butzel Long, PC
Stoneridge West, 41000 Woodward Ave., Bloomfield Hills, MI 48304, (248)258-7851
EDWIN J. LUKAS, Bodman, LLP
1901 Saint Antoine St., 6th Floor, Detroit, MI 48226, (313)393-7516
MARGUERITE DONAHUE, Seyburn Kahn Ginn Bess & Serlin, PC
2000 Town Center, Ste. 1500, Southfield, MI 48075, (248)351-3567
TERM EXPIRES 2010:
34248 MATTHEW A. CASE—600 Lafayette E, MC 1924,
Detroit, 48226
53324 DAVID C.C. EBERHARD—12900 Hall Rd., Ste. 435,
Sterling Heights, 48313
40894 JEFFREY J. VAN WINKLE—200 Ottawa St., NW, Ste. 500,
Grand Rapids, 49503
TERM EXPIRES 2011:
54086 CHRISTOPHER C. MAESO—38525 Woodward Ave.,
Ste. 2000, Bloomfield Hills, 48304
29208 JUDITH GREENSTONE MILLER—27777 Franklin Rd., Ste. 2500,
Southfield, 48034
34329 DOUGLAS L. TOERING—888 W. Big Beaver, Ste. 750,
Troy, 48084
54806 CYNTHIA L. UMPHREY—201 W. Big Beaver Rd.,
Troy, 48084
TERM EXPIRES 2012:
38733 JUDY B. CALTON—660 Woodward Ave., Ste. 2290,
Detroit, 48226
67908 JAMES L. CAREY—2630 Featherstone Rd.,
Auburn Hills, 48326
37220 D. RICHARD MCDONALD—39577 Woodward Ave., Ste. 300
Bloomfield Hills, 48304
39141 THOMAS R. MORRIS—7115 Orchard Lake Rd., Ste. 500,
West Bloomfield, 48322
EX-OFFICIO:
38729 DIANE L. AKERS—1901 St. Antoine St., 6th Fl.,
Detroit, 48226
29101 JEFFREY S. AMMON—250 Monroe NW, Ste. 800,
Grand Rapids, 49503-2250
30866 G. ANN BAKER—P.O. Box 30054, Lansing, 48909-7554
33620 HARVEY W. BERMAN—201 S. Division St.,
Ann Arbor, 48104
10814 BRUCE D. BIRGBAUER—150 W. Jefferson, Ste. 2500, Detroit,
48226-4415
10958 IRVING I. BOIGON—15211 Dartmouth St., Oak Park, 48237
11103 CONRAD A. BRADSHAW—111 Lyon Street NW, Ste. 900,
Grand Rapids, 49503
11325 JAMES C. BRUNO—150 W. Jefferson, Ste. 900,
Detroit, 48226
34209 JAMES R. CAMBRIDGE—500 Woodward Ave., Ste. 2500,
Detroit, 48226
11632 THOMAS D. CARNEY—100 Phoenix Drive,
Ann Arbor, 48108
41838 TIMOTHY R. DAMSCHRODER—201 S. Division St.,
Ann Arbor, 48104-1387
25723 ALEX J. DEYONKER—850 76th St.,
Grand Rapids, 49518
13039 LEE B. DURHAM, JR.—1021 Dawson Ct.,
Greensboro, GA 30642
31764 DAVID FOLTYN—660 Woodward Ave, Ste. 2290,
Detroit, 48226-3506
13595 RICHARD B. FOSTER, JR.—4990 Country Dr., Okemos, 48864
13795 CONNIE R. GALE—P.O. Box 327, Addison, 49220
13872 PAUL K. GASTON—2701 Gulf Shore Blvd. N, Apt. 102,
Naples, FL 34103
14590 VERNE C. HAMPTON II—500 Woodward Ave., Ste. 4000,
Detroit, 48226
37883 MARK R. HIGH—500 Woodward Ave., Ste. 4000,
Detroit, 48226-5403
31619 JUSTIN G. KLIMKO—150 W. Jefferson, Ste. 900,
Detroit, 48226-4430
34413 MICHAEL S. KHOURY—27777 Franklin Rd., Ste. 2500,
Southfield, 48034
45207 ERIC I. LARK—500 Woodward Ave., Ste. 2500,
Detroit, 48226-5499
37093 TRACY T. LARSEN—300 Ottawa Ave. NW, Ste. 500,
Grand Rapids, 49503
17009 HUGH H. MAKENS—111 Lyon St. NW, Ste. 900,
Grand Rapids, 49503
17270 CHARLES E. MCCALLUM—111 Lyon St. NW, Ste. 900,
Grand Rapids, 49503
38485 DANIEL H. MINKUS—255 S. Old Woodward Ave., 3rd Fl.,
Birmingham, 48009
32241 ALEKSANDRA A. MIZIOLEK—400 Renaissance Center,
Detroit, 48243
18009 CYRIL MOSCOW—660 Woodward Ave., Ste. 2290,
Detroit, 48226
18424 MARTIN C. OETTING—500 Woodward Ave., Ste. 3500,
Detroit, 48226
18771 RONALD R. PENTECOST—124 W. Allegan St., Ste. 1000,
Lansing, 48933
19816 DONALD F. RYMAN—313 W. Front St., Buchanan, 49107
20039 ROBERT E. W. SCHNOOR—6062 Parview Dr. SE,
Grand Rapids, 49546
20096 LAURENCE S. SCHULTZ—2600 W. Big Beaver Rd., Ste. 550,
Troy, 48084
20741 LAWRENCE K. SNIDER—190 S. LaSalle St.,
Chicago, IL 60603
31856 JOHN R. TRENTACOSTA—500 Woodward Ave., Ste. 2700,
Detroit, 48226
COMMISSIONER LIAISON:
54998 ANGELIQUE STRONG MARKS—500 Kirts Blvd., Troy, 48084
3
2009-2010 Committees and Directorships
Business Law Section
Committees
Commercial Litigation
Chairperson: Daniel N. Sharkey
Brooks Wilkins Sharkey & Turco
PLLC
401 S. Old Woodward, Ste. 460
Birmingham, MI 48009
Phone: (248) 971-1712
Fax: (248) 971-1801
E-mail: [email protected]
Corporate Laws
Chairperson: Justin G. Klimko
Butzel Long
150 W. Jefferson, Ste. 900
Detroit, MI 48226-4430
Phone: (313) 225-7037
Fax: (313) 225-7080
E-mail: [email protected]
Debtor/Creditor Rights
Co-Chairperson: Judy B. Calton
Honigman Miller Schwartz & Cohn LLP
660 Woodward Ave., Ste. 2290
Detroit, MI 48226
Phone: (313) 465-7344
Fax: (313) 465-7345
E-mail: [email protected]
Co-Chairperson:
Judith Greenstone Miller
Jaffe Raitt Heuer & Weiss PC
27777 Franklin Rd., Ste. 2500
Southfield, MI 48034-8214
Phone (248) 727-1429
Fax (248) 351-3082
E-mail: [email protected]
4
Financial Institutions
Chairperson: James H. Breay
Warner Norcross & Judd LLP
111 Lyon St. NW, Suite 900
Grand Rapids, MI 49503-2489
Phone: (616) 752-2114
Fax: (616) 752-2500
E-mail: [email protected]
In-House Counsel
Chairperson: Matthew A. Case
Blue Cross and Blue Shield of MI
600 Lafayette E., MC 1924
Detroit, MI 48226
Phone: (313) 225-9524
Fax: (313) 225-6702
E-mail: [email protected]
Law Schools
Chairperson: Edwin J. Lukas
Bodman LLP
1901 St. Antoine St., Fl. 6
Detroit, MI 48226
Phone: (313) 393-7523
Fax: (313) 393-7579
E-mail: [email protected]
Nonprofit Corporations
Co-Chairperson: Jane Forbes
Dykema
400 Renaissance Center
Detroit, MI 48243-1668
Phone: (313) 568-6792
Fax: (313) 568-6832
E-mail: [email protected]
Co-Chairperson: Agnes D. Hagerty
Trinity Health
27870 Cabot Dr.
Novi, MI 48377
Phone: (248) 489-6764
Fax: (248) 489-6775
E-mail: [email protected]
Regulation of Securities
Chairperson: Jerome M. Schwartz
Dickinson Wright, PLLC
500 Woodward Ave., Ste. 4000
Detroit, MI 48226-5403
Phone: (313) 223-3500
Fax: (313) 223-3598
E-mail: jschwartz@
dickinsonwright.com
Uniform Commercial Code
Chairperson: Patrick E. Mears
Barnes & Thornburg, LLP
300 Ottawa Ave., NW, Ste. 500
Grand Rapids, MI 49503
Phone: (616) 742-3930
Fax: (616) 742-3999
E-mail: [email protected]
Unincorporated Enterprises
Chairperson: Daniel H. Minkus
Clark Hill, PLC
151 S. Old Woodward Ave., Ste. 200
Birmingham, MI 48009
Phone (248) 988-1813
Fax (248) 642-2174
E-mail: [email protected]
Directorships
Legislative Review
Director: Eric I. Lark
Kerr, Russell and Weber, PLC
500 Woodward Ave., Ste. 2500
Detroit, MI 48226-5499
Phone: (313) 961-0200
Fax: (313) 961-0388
E-mail: [email protected]
Nominating
Director: G. Ann Baker
Bureau of Commercial Services
PO Box 30054
Lansing, MI 48909-7554
Phone: (517) 241-3838
Fax: (517) 241-6445
E-mail: [email protected]
Programs
Tania E. (Dee Dee) Fuller
Fuller Law & Counseling PC
700 W. Randall St., Ste. B
Coopersville, MI 49404
Phone: (616)837-0022
Fax: (616)588-6373
E-mail: [email protected]
Eric I. Lark
Kerr, Russell and Weber, PLC
500 Woodward Ave., Ste. 2500
Detroit, MI 48226-5499
Phone (313) 961-0200
Fax (313) 961-0388
E-mail: [email protected]
Mark W. Peters
Bodman, LLP
201 W. Big Beaver Rd., Ste. 500
Troy, MI 48084
Phone: (248) 743-6043
Fax: (248) 743-6002
E-mail: [email protected]
Edwin J. Lukas
Bodman LLP
1900 St. Antoine St. 6th Fl.,
Detroit, MI 48226
Phone (313) 393-7516
Fax (313) 393-7579
E-mail: [email protected]
Small Business Forum
Cynthia L. Umphrey
Kemp Klein Law Firm
201 W. Big Beaver Rd., Ste. 600,
Troy, MI 48084
Phone: (248)528-1111
Fax: (248)528-5129
E-mail: [email protected]
H. Roger Mali
Honigman Miller Schwartz &
Cohn, LLP
660 Woodward Ave., Ste. 2290,
Detroit, MI 48226-3506
Phone (313) 465-7536
Fax (313) 465-7537
E-mail: [email protected]
Douglas L. Toering
Grassi & Toering, PLC
888 W. Big Beaver, Ste. 750
Troy, MI 48084
Phone: (248) 269-2020
Fax: (248) 269-2025
E-mail: [email protected]
Justin Peruski
Honigman Miller Schwartz &
Cohn, LLP
660 Woodward Ave., Ste. 2290,
Detroit, MI 48226-3506
Phone (313) 465-7696
Fax (313) 465-7697
E-mail: [email protected]
Publications
Director: D. Richard McDonald
Dykema
39577 Woodward Ave., Ste. 300
Bloomfield Hills, MI 48304
Phone: (248) 203-0859
Fax: (248) 203-0763
E-mail: [email protected]
Christopher C. Maeso
Dickinson Wright PLLC
38525 Woodward Ave., Ste. 200
Bloomfield Hills, MI 48304
Phone (248) 433-7501
Fax (248) 433-7274
E-mail: cmaeso@dickinsonwright.
com
Section Development
Director: Timothy R. Damschroder
Bodman, LLP
201 S. Division St.,
Ann Arbor, MI 48104
Phone: (734) 930-0230
Fax: (734) 930-2494
E-mail: tdamschroder@
bodmanllp.com
Daniel H. Minkus
Clark Hill, PLC
255 S. Woodward Ave., 3rd Fl.
Birmingham, MI 48009-6185
Phone: (248) 642-9692
Fax: (248) 642-2174
E-mail: [email protected]
Mark R. High
Dickinson Wright, PLLC
500 Woodward Ave., Ste. 4000
Detroit, MI 48226-5403
Phone (313) 223-3500
Fax (313) 223-3598
E-mail: [email protected]
Technology
Director: Jeffrey J. Van Winkle
Clark Hill, PLC
200 Ottawa St., NW, Ste. 500
Grand Rapids, MI 49503
Phone: (616) 608-1113
Fax: (616) 608-1199
E-mail: [email protected]
5
DID YOU KNOW?
Flexibility for Entities
Providing Medical Services
By G. Ann Baker
Pending legislation will provide flexibility for using professional corporation and professional limited liability companies to own, manage, and
operate medical practices.
Public Act 139 of 1997 amended
section 4 of the Professional Service
Corporation Act to provide that physicians and surgeons licensed under
different provisions of the public
health code could be shareholders in
the same professional corporation. It
did not include physician’s assistants
who engage in the practice of medicine under the supervision of a physician and are not permitted to independently practice medicine. Physician’s
assistants, however, would like to be
able to acquire an ownership interest
in the medical practice in which they
work.
Senate Bills 26, 27, and 28 amend
the Public Health Code, Professional
Service Corporation Act, and Michigan Limited Liability Company Act
to permit a physician’s assistant to
become a shareholder in a professional corporation (“PC”) or member of a
professional limited liability company
(“PLLC”) with physicians. SB 26 adds
a new subsection to MCL 333.17048
to permit physicians to be shareholders in the same PC or members in the
same PLLC as a physician’s assistant,
and all requirements of part 170, 175,
and 180 of the Public Health Code
must be met. The amendment requires a disclosure on license renewal
form for physicians and physician’s
assistants regarding whether they are
a shareholder of a PC or member of
a PLLC.
Senate Bills 27 and 28 amend the
definition of “professional service” to
add physician’s assistant. The bills allow a physician to organize a PC or
PLLC with one or more physicians
or physician’s assistants, subject to
section 17048 of the Public Health
Code but prohibit a PC or PLLC from
having only physician’s assistants as
shareholders or members.
Senate Bills 26-28 were signed
by the Governor and became Public
6
Acts 124-126, respectively, on July 21,
2010.
The Municipal Health Facilities
Corporations Act, 1987 PA 230, authorizes certain local governmental
units to incorporate municipal health
facilities corporations and subsidiary
municipal health facilities corporations for establishing, operating, and
managing health services. The act applies to municipal hospitals and the
transfer of ownership of public hospital and other health care facilities.
Senate Bill 1115 would amend the
Municipal Health Facilities Corporations Act to permit a county to restructure a municipal health facilities
corporation or subsidiary corporation
as a nonprofit corporation. Home
rule cities are permitted under MCL
117.4n to become a member or joint
owner in an enterprise with a private
nonprofit corporation to create a separate private nonprofit corporation
to establish, operate, or maintain a
medical facility for a public purpose.1
Senate Bill 1115 would extend similar
flexibility to counties.
The bill passed the Senate and was
on second reading in the House on
May 4, 2010.
Land Sales Act; Promotional
Sales
Public Act 49 of 2010 repeals the Land
Sales Act, which regulates the disposition of lots in subdivisions located
in other states that are offered for sale
to Michigan residents. Public Act 48
of 2010 amends section 2511 of the
Occupational Code, MCL 339.2511,
to eliminate provisions pertaining
to promotional sales in Michigan of
property located outside of the state.
A real estate broker who proposes
to engage in sales of a promotional
nature of out-of-state property is no
longer required to submit a description of the property and the proposed
terms of sale to Department of Energy, Labor & Economic Growth.
Electronic Seal
Public Acts 56 and 57 allow a seal
required on certain documents to
be affixed electronically. Public Act
56 amends MCL 565.232 regarding
sealing of deeds and other written
instruments to permit the seal of a
court, public officer, or corporation to
be affixed electronically to an instrument or writing or to an electronic
document. Public Act 57 amends
MCL 8.3n to provide that in all cases
in which the seal of any court or public office is required to be affixed to
any paper the word “seal” includes
seal affixed electronically on paper or
affixed to an electronic document.
Disclosure of Beneficial
Owners of Corporations and
LLCs
The U.S. Senate Homeland Security
and Governmental Affairs Committee held a second hearing on the
Incorporation Transparency and Law
Enforcement Assistance Act, S. 569,
in November 2009.2 The bill would
require states to obtain a list of the
beneficial owners of each corporation
or limited liability company formed
in the state and to ensure the list is
updated annually.3
Written testimony of U.S. Department of Treasury, Assistant Secretary
for Terrorist Financing, includes recommendations for amendments to
S.569.4 Kevin L. Shepherd, member
of the ABA Task Force on Gatekeeper
Regulation and the Profession, testified on behalf of the ABA in support
of reasonable and necessary efforts to
combat money laundering, tax evasion, and terrorist financing activity
but opposed the proposed regulatory
approach of S.569.5 National Association of Secretaries of State opposes
S.569 and urged postponement of the
markup process.6
Low Profit Limited Liability
Companies
A limited liability company is a forprofit entity and can be formed for
any lawful purpose for which a corporation could be formed under the
Business Corporation Act. Public
Acts 566 and 567 of 2008 amended the
Michigan Limited Liability Company
Act to permit a limited liability company to be identified as a “low-profit
limited liability company.” The definition of “low-profit limited liabil-
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
ity company” in MCL 450.4102(2)(m)
imposes restrictions on the purposes
of a limited liability company designated as a low-profit limited liability
company, and the articles must state
the business purpose for which the
LLC is being formed. When a lowprofit limited liability company is
being formed, consideration must be
given to the IRS requirements regarding program related investments.
The American Bar Association,
Section on Business Law, Committee on Limited Liability Companies,
Partnerships and Unincorporated
Entities adopted a resolution regarding L3Cs at the committee’s meeting
on April 23, 2010.7 The resolution
states “RESOLVED, that at this time
the Committee formally opposes the
incorporation into existing limited
liability company acts of low profit
limited liability company (“L3C”)
amendments and respectfully urges
all state legislatures not to adopt L3C
legislation.”8
Seven states have adopted L3C
legislation. On January 13, 2010, a
report on review of L3C legislation
conducted by the Maine Secretary
of State was presented to the Maine
Joint Standing Committee on Judiciary.9 The report does not recommend
the legislature amend the Maine statute to provide for L3Cs. This report
and article by Daniel S. Kleinberger,
A Myth Deconstructed: The “Emperor’s
New Clothes” on the Low Profit Limited
Liability Company, are included in material for 2010 International Association of Commercial Administrators
Conference.10
Tax-Exempt Organizations
The January 21, 2010 IRS press release
reminded tax-exempt organizations
to make sure to file their annual information on time. The tax-exempt status of a nonprofit organization that
has not filed the required form in the
last three years will be revoked. Organizations with gross receipts of less
than $25,000 file the 990-N (e-Postcard) (http://epostcard.form990.org) but
may choose to file a full 990. To file
the 990-N, the tax-exempt organization needs the following information:
1. Employer identification number
2. Tax year
3. Legal name and mailing
address
4. Any other names the organization uses
5. Name and address of a principal
officer
6. Web site address if the organization has one
7. Confirmation that the organization’s annual gross receipts are
normally $25,000 or less
8. If applicable, a statement that
the organization has terminated
or is terminating (going out of
business
New regulations eliminated the
advanced ruling process. The IRS now
automatically classifies a new section 501( c)(3) organization as a public charity for its first five years if it
can show in its application that it can
reasonably be expected to be publicly supported. Information about the
change is available at http://www.
irs.gov/charities/charitable/article/
0,,id=184578,00.html.
7
would like the forms delivered
to [email protected] or
calling (517)241-6470.
4. Online filing for a domestic corporation, some foreign profit
corporations, and domestic and
foreign LLC annual statements
and reports is available at www.
michigan.gov/fileonline.
5. MICH-ELF applications for
filer accounts may be faxed to
(517)241-6445 during regular
business hours of 8 a.m. and
5 p.m., Monday thru Friday,
excluding holidays. Submit
documents by fax to MICHELF:
(517)241-6437. Submit documents by email to MICHELF: CDfi[email protected].
6. Expedited review of documents
for profit corporations, nonprofit corporations, limited liability
companies, and limited partnerships is available for an additional fee. Fees for expedited service
are set by Public Acts 217-220 of
2005 and are nonrefundable.
Corporation Division
Contact Information
The following contact information is
helpful for obtaining information or
submitting documents to Corporation Division, Bureau of Commercial
Services.
1. Questions
regarding
filing
requirements, status of a pending document, or questions on
the statutes administer by the
Corporation Division can be
sent to CorpsMail@michigan.
gov.
2. Request preprinted reports and
determine fees due to renew corporate existence or renew corporate certificate of authority by
sending the corporation name,
six-digit file number assigned by
Corporation Division, and how
you would like the forms delivered to corprenew@michigan.
gov or calling (517)241-6470.
3. Request preprinted annual statements and reports, certificate of
restoration, and fees required to
restore LLC to good standing by
sending the LLC name, six-digit
file number assigned by Corporation Division, and how you
NOTES
1. Home rule cities are also permitted
under MCL 117.4n to form a nonprofit corporation for “purposes that are valid public
purposes for cities.”
2. http://levin.senate.gov/newsroom/supporting/2009/PSI.stateincorporation.031109.
pdf.
3. For discussion of S.569 see J.W. Verrett,
Terrorism Finance, Business Associations, and the
“Incorporation Transparency Act”, http://lawreview.law.lsu.edu/Volumes/70/Issue3/VERRETT.pdf.
4. http://www.ustreas.gov/press/releases/
tg353.htm.
5. http://www.abanet.org/poladv/letters/
additional/2009nov5_kevinshepherds_t.pdf.
6. http://www.iaca.org/downloads/
2010Conference/BOS/7c_Talking_Points_
NASS_Opposition_S569_Apr10.pdf.
7. http://meetings.abanet.org/webupload/
commupload/RP519000/relatedresources/
ABA_LLC_Committee-L3C_Resolution_and_
explanation-2-17-10.pdf.
8. http://meetings.abanet.org/webupload/
commupload/CL580012/relatedresources/
ABA_LLC_Committee-L3C_Resolution_and_
explanation-2-17-10.pdf.
9. http://www.iaca.org/downloads/
2010Conference/BOS/6a_Resolve_2009_
chapter_97_L3C.pdf.
10. http://www.iaca.org/downloads/
2010Conference/BOS/6b_Kleinberger_Myth_
Deconstructed.pdf.
8
G. Ann Baker is Deputy Director
of Bureau of Commercial Services,
Department of Labor & Economic Growth. Ms. Baker routinely
works with the department, legislature, and State Bar of Michigan’s
Business Law Section to review
legislation. She is a past chair of
Business Law Section and is the
2008 recipient of the Stephen H.
Schulman Outstanding Business
Lawyer Award. She is also a member of the State Bar Committee
on Libraries, Legal Research and
Legal Publications.
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
TAX MATTERS
By Paul L.B. McKenney
Bush Tax Cuts Sunset This
Year, Act Now
There is an age old tax adage that for
year-end tax planning one should
defer the recognition of income and
accelerate deductions. However, once
every generation or so, there is a year
when that advice is flipped because
of radical changes in tax rates. 2010
is that year. Also, the stepped-up
income tax basis at death rules that
predated World War II are repealed
for property passing from a 2010
decedent.
No More Good Ole Tax Rate
Days
At the end of this year, the lower
Bush Administration’s individual
dividend, income, and capital gain
tax rates regarding various individual rates sunset and become history.
This table illustrates the changes on
the highest rates:
Maximum Rate
2010
Dividends
Ordinary Income
Net Capital Gain
15%
35%
15%
20112012
39.6%
39.6%
20%
2013 &
Later
43.4%
43.4%
23.8%
In addition to the maximum rates
increasing, lower brackets also rise in
2011. The expiration of the 15 percent
rate on qualifying dividends, the lowest rate since before World War II, is
the most dramatic change. On January 1, 2011, the maximum individual
rate rises to 39.6 percent because of
the sunset provisions in the tax bills
passed during the George W. Bush
administration. Under the recently
enacted health care legislation, individual “net investment income”
(i.e., dividends, interest, rents, capital
gains, and other passive income) will,
beginning in 2013, be subject to an
additional 3.8 percent Medicare levy
for married taxpayers filing jointly
with adjusted gross incomes exceeding $250,000. This will bring the effective ordinary income rate on passive
income to 43.4 percent from today’s
35 percent. Beginning in 2013, there
will also be an additional .9 percent
levy on compensation income for
those married taxpayers filing jointly
whose AGI exceeds $250.000. These
effective in 2013 surtaxes are revenue
raising provisions in the recent health
care legislation.
Planning Implications
If one has income that can be taken
either now or in the future, then
there is a strong incentive to take
the income this year. This is particularly true as maximum dividend
rates increase from 15 percent to 39.6
percent next New Years Day. For
example, a closely held C corporation
could make an extraordinary dividend (this may involve some bank
borrowing, but many are doing it) in
2010. Would the shareholders rather
take a one-time large divided at 15
percent today rather than a series of
annual dividends at 39.6 percent (in
2011 and 2012) and at over 43 percent
in 2013 and subsequent years? A perhaps more revealing economic analysis is what it takes in gross dividend
to net $1.00 at varying tax rates:
Tax Rate
15%
39.6%
43.4%
Gross Dividend
to Net $1.00
$1.18
$1.66
$1.81
In plain English, on January 1,
2011, an additional 48 cents of gross
dividend income ($1.66 minus $1.18)
will be needed for an individual to
still net $1.00 The funding source for
many companies with good balance
sheets and cash flows is to approach
the lender now and make appropriate
liquidity arrangements.
Likewise, if an S corporation was
at one time a C corporation and has C
corporation earnings and profits, then
if the corporation earnings are not extracted this year at a 15 percent rate,
then they are locked in at tomorrow’s
far higher tax level. There is a special
election under Treas Reg 1.1368-1(f)
to have the distribution treated as
first coming from C corporation earnings and profits. Here again many are
planning for this once in a generation
opportunity at the end of 2010. Given
the lead times that may be involved,
particularly if bank lending is necessary, the time to start to explore the
issue with your clients and begin implementation is now rather than after
Thanksgiving.
Does it make sense to sell an appreciated asset today at a 15 percent
capital gains rate rather than at a 20
percent rate next year? In some cases
it will. However the 5 percent (and
8.8 percent beginning in 2013) gap
is not as glaring as that on qualified
dividends.
If there will be large income this
year because of special distributions
or other acceleration of income, this
has to be factored into alternative
minimum tax (“AMT”) planning.
Higher rates will lower the likelihood
of being in an AMT situation and, if
in AMT, will involve fewer dollars
than would have been the case in the
past. This needs to be balanced as to
whether to take accelerated deductions through this year against higher
income, or wait until next year. The
answers to these questions lie in the
numbers. It is strongly recommended
that you and your client run some
projections. This is a case where there
are very real benefits to being proactive.
We have reviewed modeling of
paying a capital gain tax on appreciated assets in “now versus later”
scenarios. Models looking out five
years may be quite advantageous, depending on what is realistic and we
suggest conservative, assumptions
you make to pay the tax now, rather
than later. This also factors into Roth
IRA planning. This is the year that
a taxable conversion to a Roth IRA
could be accomplished regardless of
the income of the taxpayer. In many
cases the income recognition on a
Roth conversion, particularly with
taxpayers who were closer to retirement, make a Roth conversion unattractive. However, those who were
on the edge before, given the higher
tax rates in the future, may benefit by
making the Roth conversion in 2010,
and recognizing the resultant phantom income.
9
10
Traditionally taxpayers have done
some year-end “balancing” via selling some stocks at a loss to balance
off gains realized earlier in the year.
That exercise will be particularly important this year.
Inherited Property—Decades
of Stepped-Up Basis Law
Repealed For 2010
There is also a one-time tax trap for
inherited property. For decades the
rule was that if property was passed
from a decedent, then the beneficiaries, estate, or trust, as the case may
be, received a so-called “stepped-up
basis” equal to the fair market value
at the date of death under IRC 1014.
As part of the one-year repeal of the
estate tax in 2010, a) the IRC 1014
basis rules were also repealed, and
b) a modified carryover basis regime
applies to property passing from 2010
decedents. See IRC 1022 and 6018.
The 2010 modified carryover basis
rules apply regardless of the value of
the decedent’s estate. For example,
assume that a taxpayer who bought
a stock 30 years ago for $10 per share
dies this year and the estate sells it for
$80 per share date of death value(that
ratio of appreciation is less than the
increase in the Dow Jones Industrials Average over that time). In 2010
only, there would be but a $10 basis
for the estate and a $70 per share taxable gain. Clients who have inherited
property from those dying this year
need to factor this into their year-end
planning. Likewise, terminally ill clients’ planning is impacted, particularly on loss assets. For example, if a
terminally ill taxpayer bought stock a
few years ago at $50 per share and it
is worth but $10 today, if sold while
the taxpayer is still alive, then a $40
per share loss is recognized. That
could be netted against gain realized
by selling appreciated assets.
Action Steps
It is highly recommended that you
meet with clients who will be affected
by these changes, discuss them, and
quantify the costs of various strategies. You will likely want to include
the business owners, other clients,
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
and the respective accountants in this
exercise. You will be serving your client well to trigger this process and
present them with the opportunity
to achieve considerable savings on
income tax liabilities.
Paul L.B. McKenney
of Varnum Riddering
Schmidt & Howlett
LLP, Novi, specializes
in federal taxation. He
is chair of the Sales,
Exchanges and Basis
Committee of the Taxation Section
of the American Bar Association,
and he is a member of the Taxation Section of the State Bar of
Michigan.
TECHNOLOGY CORNER
By Michael S. Khoury and Michelle L. Coakley
Supreme Court Clarifies Privacy in the Workplace
Our common advice to clients has
long been to be specific in employment policies to make employees
aware that they have no expectation
of privacy in the workplace. However, there have been mixed signals
from the courts about the legality of
company access to personal information generated using employer technology. The United States Supreme
Court took one more step to address
certain of these issues and the scope
of constitutional rights of an employee to privacy in the recent case of City
of Ontario v Quon, decided June 17,
2010.1
In Quon, a police sergeant was issued a text messaging device by his
department. A dispute arose about
the access of the police department to
some of his personal text messages.
The department policy was very similar to most company policies, making it clear that officers (or employees
in general) had no expectation of privacy for any information generated
using the employer’s technology. Sergeant Quon sued the city of Ontario,
California claiming that the department’s access to the messages was an
illegal search that violated his Fourth
Amendment rights.
The Ninth Circuit Court of Appeals upheld the position of Sergeant
Quon, but the Supreme Court unanimously reversed that decision. In its
decision, the Supreme Court indicated that a governmental employee using government equipment who had
been warned not to expect privacy
had no legitimate expectation of privacy when a search is conducted for a
legitimate work-related purpose.
How will this apply to private employers? The Supreme Court declined
to rule on the specific application beyond a governmental employee, so
that is yet to be determined. However, it is certainly a clear signal that the
continued use of technology policies
in employee manuals is worthwhile.
What should be included in a
company policy? The following categories are fairly commonplace:
• Scope of authorized use of firm
computers, phones, and other
technologies, including internet
usage.
• A clear statement that an employee has no expectation of privacy
for any information stored on
company computers or systems,
or data transmitted through the
use of company technology.
These issues are still developing and
we may hear more from the courts.
From a drafting standpoint, explicit
policies are the employer’s best bet.
If you, as an attorney, are communicating with an individual client, should you be concerned? Your
individual client should not use the
company’s e-mail system or Internet for anything related to their own
personal legal affairs. In addition to
being accessible by the employer, you
need to question whether any privilege can be maintained if your client
understands that there is no expectation of privacy. While this issue has
had alternative interpretations, the
client’s use of personal e-mail not
accessed through the employer’s
technology is best.
Michael S. Khoury of
Jaffe Raitt Heuer &
Weiss, PC, Ann Arbor
and Southfield, practices in the areas of
information technology, electronic commerce, intellectual property, and
commercial and corporate law.
Michelle L. Coakley is
a partner in the Southfield office of Jaffe
Raitt Heuer & Weiss.
She is a member of
the Firm’s Litigation
Practice Group, specializing in commercial litigation
and employment law since 1998.
NOTES
1. No 08-1332, 2010 US LEXIS 4972
(June 17, 2010).
11
What Does That Operating
Agreement Mean? A Primer on
LLC Capital Accounting for the
Non-Specialist
By Donald H. Baker, Jr.
Introduction
With the widespread adoption of the limited
liability company as a preferred entity format for non-public entities, business practitioners are forced to grapple with provisions
in operating agreements that adopt detailed
accounting and tax treatments generally
beyond the traditional expertise of non-tax
lawyers. These accounting and tax issues are
not present in forming a standard corporation, but are thrust on the practitioner any
time even the most basic multi-member LLC
is formed. While the “standard” LLC operating agreement approaches to these matters
are at this point generally familiar (though
perhaps less well understood), they are not
simply “boilerplate.” I fear that we (and of
course our clients) are often insufficiently
aware that these provisions mandate specific
economic relationships and results among
the members, i.e., who gets what money.
It is entirely possible that use of these standard approaches can unknowingly mandate
results that are inconsistent with the client’s
business “deal.”
I should note at the outset that this is not
intended to explain comprehensively how
the “special language” in operating agreements works as relates to profits and loss allocations for tax purposes. These subjects are
well beyond what can reasonably be treated
in a brief article. Instead, my goal is to explain
and simplify, for the non-specialist, the operation of the capital accounting provisions
found in the typical operating agreement.
Although some of the related tax allocation
provisions are surveyed in a cursory way,
my focus here is economic—making sure that
the parties have a clear idea of the economic
impact that their choice of the “typical” language found in an operating agreement has
on their business arrangements with other
members, in hopes of avoiding unintended
consequences.
What is Capital Accounting and
How Does It Work?
Practitioners involved in forming limited liability companies are no doubt familiar with
language often found in operating agreements mandating that “capital accounts be
established and maintained for each member.” Normally this language comes along
with detailed rules about how such an
account is to be maintained and adjusted
over time. Taken together, these rules generally describe “capital accounting” as an
accounting method.
Capital accounting is a system of financial
accounting for general and limited partnerships, and sometimes LLCs, that keeps a record of each member’s equity financial interactions with the company on a member-bymember basis.1 Each member has a separate
equity or “capital” account that keeps track
of these interactions. The sum of all of the
members’ capital accounts equals (as a mathematical certainty) the total member equity
shown on the balance sheet of the company
(which in turn equals assets minus liabilities). Since capital accounts are maintained
on a partner-by-partner (or member-bymember) basis, it is entirely possible that the
entity may have positive members’ equity,
but some members have a positive capital
account and others have negative capital accounts. This disaggregation feature contrasts
sharply with an entity approach to equity accounting used in corporate accounting (even
in S corporations), where equity transactions
are tracked only in the aggregate, rather than
on a member-by-member basis, and is the
key characteristic of capital accounting as a
method.
Capital accounting, as a financial accounting method, is the traditional form of equity
accounting used by partnerships and limited partnerships and can be said, for these
particular entities, to form part of the body
13
14
Many
practitioners
have the
mistaken
impression
that capital
accounting is
mandatory if
an LLC is to
be taxed as a
partnership
for federal
income tax
purposes.
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
of accounting practice known as “generally
accepted accounting principles” (“GAAP”).
However, capital accounting is not mandated for limited liability company use, either
by GAAP or the Michigan Limited Liability
Company Act. Indeed, for limited liability
companies, which are something of a statutory hybrid between corporations and limited partnerships, capital accounting must be
adopted in the operating agreement if it is
to have an economic effect on the member’s
relations with one another that trumps certain statutory default provisions that would
dictate different results. Under the LLC
Act, it is clear that the members are free to
adopt many methods of economic allocation
(and, therefore, accounting for their dealings
among the members), so long as the allocation is expressed in an operating agreement.
Many practitioners have the mistaken
impression that capital accounting is mandatory if an LLC is to be taxed as a partnership
for federal income tax purposes. For reasons
which follow, this is not the case, although it
may well have an impact on whether certain
allocations of profits and losses for tax purposes will be respected by the IRS—for tax
purposes only.
Capital accounting typically works as follows:
1. The company establishes for each member a “capital account,” which is a running balance of all capital contributions
made by each member and all distributions made to the member;
2. The member’s initial capital account
balance is the initial capital contributed
to the company. For cash contributions,
the value is obvious, but for property
contributions, the members must agree
on an appropriate “book value” that
will be treated as the value of that contribution. This is entirely a matter of economic agreement between the members
and should be addressed in the operating agreement.2 The member’s capital
account is increased each year by:
i. the amount of any additional cash
contributed by the member to the
company;
ii. the net agreed value (established by
agreement among the members) for
any non-cash property contributed to
the company;
iii. any profits of the company allocated
to that particular member (addressed
below).
3. The member’s capital account is decreased
each year by:
i. any cash distributed by the company
to that member;
ii. the net agreed value (established by
agreement among of the members) of
any non-cash assets distributed to the
member;
iii. any losses of the company allocated
to that particular member.
Capital accounting is only an accounting
methodology. It does not mandate any particular economic treatment among the members/partners corresponding to the accounting results.
However, if this accounting method is
to be meaningful, the member’s capital accounts become highly relevant in tracking
their long-term economic relationship, particularly on the occurrence of key events in
the entity’s life. For purposes of economic
matters, these include rights to distributions,
allocations of profits and losses, and, particularly, how money is distributed when the
company is liquidated. Capital accounting
language therefore can typically be found
running through the entirety of the operating
agreement when discussing these important
events.
Capital Accounting in Operating
Agreements: The Tax Background,
How We Got Here, and the Typical
Three-Prong Tax Provisions
Found in Operating Agreements
As noted above, capital accounting is not
mandatory for LLCs to be taxed as partnerships for federal income tax purposes. However, it is typically adopted for this purpose.
Why?
Much of the original impetus for widespread adoption of the LLC format arose
from a desire to have a business entity that
could be treated as a partnership for federal
income tax purposes, while enjoying corporate-like limited liability.3
Since partnership taxation was the reason
for forming such entities in the first place,
operating agreement forms, understandably,
imported from the world of limited partnership agreements standard language designed to comply with IRS “safe harbors” for
respecting the parties’ agreed allocation of
profits and losses under the partnership taxation sections of the Internal Revenue Code.
Under IRS regulations for partnership taxa-
WHAT DOES THAT OPERATING AGREEMENT MEAN?
tion under IRC 704, which continue in effect
until this day, members’ allocations of profit
and losses are respected if they have “substantial economic effect.” The safe harbor
provided that “economic effect” was present
where the partnership agreement (or operating agreement) provides that, throughout the
life of the entity :
1. capital accounts are maintained for each
member, generally in keeping with the
capital accounting method outlined
above (as extensively detailed in the
Treasury Regulations);
2. on liquidation of the entity, liquidation
proceeds are distributed to the members
only in accordance with positive capital
account balances;
3. if a partner has a deficit balance in his
or her capital account following the liquidation of the partner’s interest in the
partnership, that partner is obligated to
restore the amount of such deficit balance to the partnership by the end of the
taxable year (“Negative Capital Account
Restoration”).
See Treas Reg 1.704-1(b).
Note that there are two “events” that the
regulations mandate as the operative event
for making sure that capital accounting has
meaning: (1) the liquidation of the entity, and
(2) the liquidation of a particular member’s
interest in the entity. In the first instance, only
members having positive capital account balances receive distributions, and in the second
any partner having a deficit must restore
it, whether on liquidation of the entity as a
whole or only of that partner’s interest.
Qualified Income Offsets and Limited
Liability Companies
For limited liability companies (and for limited partnerships), Negative Capital Account
Restoration presented a major problem:
members expected to enjoy limited liability,
and yet the safe harbor, if mandated, would
create a potentially unlimited obligation to
contribute capital to the company just to meet
the economic effect test, primarily so that loss
allocations would be respected. For LLCs, the
member’s intentions were that no member
ever had to restore a negative capital account
(unlike a limited partnership where the general partner would have such a responsibility
under limited partnership laws).
In response to this dilemma, the IRS regulations provided an alternative to Negative
Capital Account Restoration in the form of
the so-called “alternative economic effect
test.” Under this test, capital accounting
was likewise required, as was liquidation
in accordance with positive capital account
balances. However, the operating agreement
could substitute a so-called qualified income
offset provision for Negative Capital Account
Restoration. A qualified income offset provision mandates that partners who unexpectedly receive an adjustment, allocation, or
distribution that brings their capital account
balance negative will be allocated all income
and gain in an amount sufficient to eliminate
the deficit balance as quickly as possible.
Under the regulations, only allocations of
losses that do not drive a partner into a negative capital account situation are protected.4
Thus, if the alternative economic effect test
is adopted in such a way that the company’s
loss allocations will always be respected,
losses will be allocated only among members having positive capital accounts until all
positive capital accounts have been reduced
to zero, after which a different treatment follows.
Non-Recourse Deductions and Minimum
Gain Chargebacks
What would happen in the special case of a
limited liability company where all members
have zero capital accounts and then a loss
occurs? How was that loss to be allocated?
Such a condition could only occur where
the entity had liabilities that exceeded the
tax basis of its assets. Since no member was
responsible to repay those liabilities because
of the protection of limited liability, a loss
deduction would have no economic effect
under the traditional safe harbor or under the
alternate economic effect test. Since all capital accounts would be reduced to zero (under
my hypothetical), the second safe harbor has
been complied with but does not resolve the
issue.
So, the IRS regulations permitted the
adoption of yet a second variation to cover
“non-recourse” deduction, which is the inclusion of language in the operating agreement
called a “minimum gain chargeback” provision. The effect of a minimum gain chargeback provision is really to mandate that if a
non-recourse deduction is allocated to a particular member, positive income will later
be allocated to that member if, when, and to
the extent that the member’s “share” of minimum gain is later reduced (which can occur,
for example, when the non-recourse debt giv-
15
Under the
regulations,
only
allocations of
losses that
do not drive a
partner into
a negative
capital
account
situation are
protected.
16
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
ing rise to that deduction is paid down or the
“underwater” property is sold for an amount
sufficient to pay off the debt). Although these
provisions are hyper-technical and will not
be analyzed here, suffice it to say that such
language is typical in operating agreement
forms designed to produce tax “comfort” as
far as deductions are concerned.
To summarize, because of these historical
developments, it is typical to find in operating agreements provisions with these characteristics:
1. mandatory use of capital accounting;
2. agreeing on a percentage or other method of allocating profits and losses;
3. allocating losses only to members having positive capital account balances;
4. modifying the “normal” allocation of
profits and losses (for tax and capital
accounting purposes) by including a
qualified income offset provision;
5. modifying the “normal” allocation of
profits and losses pertaining to nonrecourse deductions (for tax and capital
accounting provisions) by including a
minimum gain chargeback provision;
and
6. providing for liquidation in accordance
with positive capital account balances
but no negative Capital Account Restoration is required.
For purposes of the rest of this article, I’ll call
this the “Typical Language.”
An Illustration: Who Gets What on
a Reversal of Fortune?
We come now to the central point of this
article—taken as a whole, these provisions,
even though developed as a tax compliance
technique, mandate specific economic results
among the members that may or may not be
in keeping with their understanding.
Let’s take a simple example. Let’s assume
that we have new clients, Jennifer and Brad,
who want to form a new limited liability
company to take advantage of their celebrity
status and start a movie studio, perhaps to
obtain the still-new Michigan Film Credit.
They agree that Jennifer, who has most of
the money, is going to contribute $1,000,000
to the LLC to build the studio and produce
movies. Brad will contribute no money, but
will operate the studio and “make rain.” In
their initial interview, they say simply that
they want a “50-50 deal” and leave it to you
to craft the deal.
What could be simpler—or, as with all
things in the movie business, is it? Jennifer
contributes the $1,000,000, Brad runs it, and
all goes well until their ugly celebrity breakup. They sell the movie studio for $400,000, a
loss of $600,000 ignoring other factors, and it
now comes time to distribute proceeds. Who
gets the money?
Option 1 – The 50-50 “deal”
Brad and Jennifer came in asking for simply
a “50-50 deal,” so, at least without more, the
proceeds are distributed as follows:
Brad gets $200,000 (1/2 of the proceeds), a
gain of $200,000.
Jennifer gets $200,000 (1/2 of the proceeds) for an $800,000 loss.
Option 2 – The Typical Language
If the operating agreement contains the Typical Language, the result differs vastly. The
Typical Language mandates:
Jennifer
contributes
the
1. When
$1,000,000, she receives a $1,000,000
capital account. Brad has an opening
capital account balance of zero.
2. When the movie studio is sold for
$400,000, there is a net $600,000 loss.
Although they would otherwise share
profits and losses on a 50-50 basis, the
presence of a restriction on allocating
losses to members in such a way as to
drive their capital negative means that
none of that loss is allocated to Brad,
who began with a zero capital account.
So, all $600,000 of the loss is allocated
for book and tax purposes to Jennifer.
Following that allocation, Jennifer has a
$400,000 capital account, Brad has zero.
3. After sale of the studio, the LLC is liquidated in accordance with positive capital accounts. Result?
Brad gets zero.
Jennifer gets $400,000 (for a $600,000
loss).
How About the Upside?
What if we change the facts so that the studio
is sold not for $400,000, but for $3,000,000?
What result then?
Option 1 Again, the Pure 50-50 Deal
Jennifer $1,500,000 (a $500,000 gain)
(a $1,500,000 gain)
Brad $1,500,000
WHAT DOES THAT OPERATING AGREEMENT MEAN?
Option 2 – Typical Language
1. Again, when Jennifer contributes the
$1,000,000, she receives a $1,000,000
capital account. Brad has an opening
capital account balance of zero.
2. When the movie studio is sold for
$3,000,000, there is a net $2,000,000 gain.
That gain, per the parties’ agreement, is
allocated 50-50. Since there is no loss
allocation that would implicate the qualified income offset or minimum gain
chargeback, it is allocated $1,000,000 to
Brad and $1,000,000 to Jennifer. Capital
accounts after this allocation are then:
Jennifer
$2,000,000
Brad
$1,000,000
3. The LLC is liquidated in accordance
with positive capital accounts, so Jennifer gets $2,000,000, and Brad gets
$1,000,000.
Interpreting the Results
A case can be made that, under either circumstance, Option 1 or Option 2 are economically
“fair” and could be agreed on by reasonable
minds who thought about it carefully. In the
Reversal of Fortune scenario, under Option 1,
from Brad’s point of view, he ends up receiving “compensation” for his participation
in the enterprise in the amount of $200,000,
and since he was 50-50, he also experienced a
$300,000 loss from his expectation to receive
the full benefit of a $500,000 contribution
made by Jennifer. On the other hand, under
Option 1, Jennifer bears the full economic
weight of an $800,000 cash loss ($200,000 of
which ends up in Brad’s pocket). Option 2,
on the hand, protects Jennifer’s investment
primarily, and Brad receives nothing.
In the upside scenario, since there is more
money floating around, Option 1 produces a
result that gives both parties 50 percent of the
proceeds without goring Jennifer’s ox. Still,
although they are sharing proceeds 50-50,
they are not sharing gain 50-50. On a net end
result basis, the gain is allocated $1,500,000 to
Brad and $500,000 to Jennifer.
The problem of course is that Brad and
Jennifer may never have thought about the
specifics of result they wanted if their venture resulted in a loss, and they experienced
a nasty celebrity breakup, or what they really
meant by 50-50. In hindsight, it is possible that
they meant simply that whatever happened
on liquidation, those proceeds would be divided 50-50, regardless of the fact that Jennifer contributed all of the funds (an Option 1
approach). Or, perhaps if asked the question
about this reversal of fortunes, they would
have dictated that Jennifer would be paid
back all of the proceeds until she received
$1 million, after which proceeds would be
distributed 50-50. Or if asked the question in
the context of an upside, perhaps they would
have meant that it was the gain that was to be
shared 50-50, not the proceeds.
Which result should obtain—Option 1 or
Option 2? The illustration simply shows that
even in the most rudimentary of LLC formation scenarios (like this one), we as practitioners have to ask the members what result
they intend. There simply is no substitute
for inquiry and discussion. Even though the
technical language used to provide a tax safe
harbor is hyper-technical, it simply cannot be
treated as boilerplate legalese, because it does,
and is intended to have, economic impact.
This is why the IRS developed the approach
in the first place. The point here is that the
Typical Language mandates the Option 2 result, under which Jennifer loses, and Brad’s
possible expectations may be frustrated.
The Right Questions to Ask?
As the Brad and Jennifer example illustrates,
uncritical use of capital accounting will mandate a particular accounting result, in this
case the result of Option 2 on liquidation of
the LLC, a result that may or may not be in
keeping with the members intentions. The
best way that I have found to avoid unintended results here is to tease out this economic
issue by asking clients a series of questions
designed to test their intentions under (at
least) the two fact patterns illustrated above.
Let me offer the following (suggested) script
as a possibility:
“Jennifer and Brad, you’ve indicated that
you want a “50-50 deal. But this means different things to different people. Let me ask
you three questions to narrow down what
you mean.”
Question 1: Jennifer, let’s say you contribute $1 million to the LLC. Six months later
the LLC proves unsuccessful. You and Brad
want to give it up. You find a buyer who is
willing to give back some but not all of your
money, and offers $500,000 to buy you both
out. Who do you intend should receive the
$500,000? Should it be divided 50-50 between
you, or does it all go to Jennifer?
Question 2: Let’s say Jennifer contributes $1 million to the LLC. Two years later,
the LLC proves very successful. You decide
17
18
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
to sell it. A buyer offers you $3 million, which
you decide to take. Who gets the $3 million?
Does it get divided 50-50, or does the first
million go to repay Jennifer and the balance
get split 50-50?
Question 3: Let’s say Jennifer contributes
$1 million. The day afterward, Brad dies. Jennifer decides to liquidate the company. Who
gets the $1 million? Does it all go back to Jennifer, or is it split 50-50 with Brad’s estate?
Obviously, these questions are designed
to test whether they want an Option 1 or Option 2 result. If they want an Option 2 result,
then it is safe to mandate capital accounting,
and you can use the Typical Language without remorse and without any special accounting adjustments in its implementation.
Question 3, in fact, serves an additional
purpose to which I find that most clients
give short shrift: Brad’s part of the “deal”
was to operate the studio, but his death
leaves this impossible. Since Brad can’t render these services, Jennifer isn’t getting the
value for which she bargained in reaching
a 50-50 deal. If services are to be part of the
economic arrangement, then capital accounting and a mandated Option 2 result simply
do not account for this economic reality, and
modifications must be made. In addition, it
allows a discussion with Brad to the effect
that if capital accounting is used and Brad
receives credit for a capital accounting for
services to be rendered, it is likely that Brad
will recognize taxable income under IRC 83
the minute that his capital account is established and credited with half of the opening
contribution.
But what if the answers direct you to an
Option 1 result? Knowing what you now
know about capital accounting and tax safe
harbors, can you still use the Typical Language and achieve the safe harbor, but end
up with an Option 1 outcome?
Having Our Cake and Eating it Too
The answer is yes. Recall that capital accounting is a financial accounting method, rather
than principally a tax accounting method.
With the tax safe harbor in mind, it is understandable that practitioners will prefer using
the Typical Language rather than accomplishing the same tax protection by a handcrafted means.
The way to achieve this result is to use
the Typical Language for capital accounting,
but to have the parties agree on a so-called
“book up” for financial accounting purposes.
A book up gives Brad “credit” within the operating agreement for his contribution of an
“asset”—goodwill—with a value of $1 million. While the good will may be illusory, it
results in recording an additional $1 million
asset and a corresponding credit of $1 million
to Brad’s book capital account. Then, you can
feel confident that if you include language
that liquidation will be made to members
having positive (book) capital accounts, it
will result in a distribution of 50 percent to
Brad and 50 percent to Jennifer, whether it is
a loss or a gain.
This is deceptively simple, as it comes
with some tax complexities. Since Brad has
contributed an asset with zero tax basis
(goodwill) but a credit of $1 million on his
book capital account, the rules of IRC 704(c)
would mandate that tax (not book) income be
allocated among Brad and Jennifer in such a
way as to reduce that book-tax difference as
rapidly as possible. The regulations specify
various permissible methods for doing so.
The 704(c) regulations are well beyond the
scope of this article, but I raise the point to
explain why practitioners must be intentional in their use of this accounting technique as
well.
Still, these tax issues aside, the book up
does achieve the result of being able to use
capital accounting and therefore complies
with the tax safe harbor under IRC 704(b),
permitting a true 50-50 deal in the Option 1
sense.
Conclusion
My principle exhortation to my fellow attorneys who are forming LLCs as business entities is simply to be intentional and critical
when adopting the Typical Language into
their standard operating agreements. Capital
accounting, without adjustment, mandates
specific economic results among the members—results that will have an impact in
making distributions, allocating profits and
losses, and particularly in allocating distribution proceeds when the LLC is liquidated.
When the clients’ intentions are discovered
using a series of questions like the kind outlined above (and there are many other good
ones that other practitioners are using as
well), you can determine whether (a) you
want to use capital accounting since the parties intend the result that it dictates, (b) you
want to use capital accounting but need a
“book up” or other modification in order for
the economic results to be correct, or (c) you
WHAT DOES THAT OPERATING AGREEMENT MEAN?
want to avoid using capital accounting at all
and are comfortable with an entity approach
to equity accounting, in which case you will
simply have to test on a yearly basis whether
the parties’ allocations of profits and losses
for tax purposes will be respected.
NOTES
1. Capital accounting does not address non-equity
transactions between members and the company, such
as, for example, member loans. In fact, use of member
debt in this way is a typical means used to avoid the
effect of normal capital accounting rules, although it
does present its own tax complexities.
2. Although the tax basis of the property contributed
may well have an impact on the allocations of deductions among the members for tax purposes, that difference has no impact on the financial accounting for the
item contributed.
3. The ancestors of limited liability company operating agreements were developed at a time before the
IRS check-the-box regulations permitted election of
any other treatment, so the main tax issue was whether
the operating agreement, on its face, complied with
IRS regulations differentiating for tax purposes between
partnerships, on the one hand, and associations taxed
as corporations under IRC 7701, on the other. While
the check-the-box regulations have done away with the
need for drafting with this issue in mind, legacy operating agreements sometimes continue to have language
directed toward it.
4. Treas Reg 1.704-1(d).
Donald H. Baker, Jr. is a
principal with the law firm
of Safford & Baker, PLLC,
of Bloomfield Hills and Ann
Arbor, with a practice concentration in representing
technology, software, new
media and other companies that seek to
commercialize and finance intellectual
properties. He has been an Associate
Adjunct Professor in the Masters of Tax
program at Walsh College, teaching partnership taxation, consolidated tax returns
and corporate reorganizations.
19
Treatment of Single Member LLCs
Under SBT and MBT after the
Kmart and Alliance Decisions
By Donald A. DeLong
Introduction
Prior to the 2009 Michigan Court of Appeals’
decisions in Kmart Michigan Prop Servs, LLC v
Department of Treasury1 and Alliance Obstetrics
& Gynecology, PLC v Department of Treasury,2
most taxpayers and practitioners believed
that a single member limited liability company’s (SMLLC) election under the federal
“check-the-box” regulations was determinative of how that SMLLC would be treated
under Michigan’s now repealed Single Business Tax Act (SBTA).3 It now appears that an
SMLLC may choose to be treated differently
under the Internal Revenue Code and the
SBTA, and possibly the Michigan Business
Tax Act (MBTA).4 This change will impact
not only choice of entity decisions, but other
tax decisions regarding the elections that
SMLLCs will make under the federal and
Michigan tax statutes.
Federal and State Tax Law
Background
20
Treatment of SMLLCs under the Check-theBox-Regulations
The tax classification of SMLLCs under the
Internal Revenue Code is determined under
the check-the-box regulations.5 For the purposes of this article, an SMLLC is an entity
organized under the Michigan Limited Liability Company Act6 (MLLCA) that has only
one member or owner. The check-the-box
regulations make clear that “…whether an
organization is an entity separate from its
owners for federal tax purposes is a matter
of federal tax law and does not depend on
whether the organization is recognized as an
entity under local law.”7 Therefore, for federal tax purposes the exact nature of how the
SMLLC is organized under Michigan law is
not determinative of how it will be treated
under the Internal Revenue Code.
A business entity that has a single owner
can choose to be classified as a corporation
or as a disregarded entity for federal tax purposes.8 If the business entity is treated as a
disregarded entity, “its activities are treated
in the same manner as a sole proprietorship,
branch, or division of the owner.”9 In other
words, the fact that an SMLLC is a separate
legal entity under Michigan law is not relevant under the Internal Revenue Code; the
activities of the SMLLC will be treated as
those of its owner, and it will not file a separate income tax return from its sole owner.
The SMLLC may elect to be treated as
a corporation under the Internal Revenue
Code, and if it does, it is treated as an association with activities separate from those of
its owner and must file separate returns from
those of its owner. If an SMLLC does not
make an election to be treated as a corporation, it will be treated as a disregarding entity
under the default rules.10
Treatment of SMLLCs Under the SBTA
Under the SBTA, a tax was imposed on
every “person” with business activity in
Michigan.11 “Person” was defined as “an
individual, firm, bank, financial institution,
limited partnership, copartnership, partnership, joint venture, association, corporation,
receiver, estate, trust, or any other group or
combination acting as a unit.”12 A limited
liability company is not enumerated in the
types of entities defined as a “person,” nor
did the statute state how an SMLLC is to
be treated under the SBTA. On November
29, 1999, the Michigan Department of Treasury (MDT) issued Revenue Administrative
Bulletin (RAB) 1999-9, which attempted to
state that SMLLCs would be classified the
same under the SBTA as under the Internal Revenue Code and the check-the-box
regulations. In RAB 1999-9, the MDT stated
that any such election or default classification under the check-the-box regulations
was effective “for all components of the SBT
return that are related to federal income tax”
and “[a] taxpayer who elects entity classification at the federal level shall file the Michigan
SBT return on the same basis and reflect the
same tax consequences.” 13 This RAB specifi-
TREATMENT OF SINGLE MEMBER LLCS UNDER SBT AND MBT
cally states that if an SMLLC is treated as a
disregarded entity “…at the federal level it
is treated as a branch, division, or sole proprietor for SBT purposes.”14 Therefore, under
this RAB, an SMLLC would be classified in
the same manner under the SBTA as under
the check-the-box regulations.
Kmart and Alliance Court of Appeals
Decisions
The Court of Appeals in Kmart held that
Kmart Michigan Property Services, LLC
(KMPS) was not required to be consistent
in its self-classification in its Michigan and
federal tax filings for any given year.15 KMPS
was a Michigan limited liability company
wholly owned by Kmart Corporation. KMPS
filed a separate single business tax return
from its sole member, Kmart Corporation,
even though KMPS was treated as a disregarded entity for federal tax purposes. The
MDT determined that it would not accept the
separate return of KMPS and, instead, would
disregard this entity and treat it as if it were a
division of Kmart Corporation.
The MDT relied on RAB 1999-9 in arguing
that KMPS was required to use the same entity classification that it had chosen for federal
tax purposes with respect to its filings under
the SBTA. The Court of Appeals found that
while RAB 1999-9 was entitled to respectful
consideration, it was not legally binding.16
Since this Revenue Administrative Bulletin
was not legally binding, the Court looked
to the language of the SBTA to determine
whether KMPS was required to file an SBT
return. The Michigan Court of Appeals determined that KMPS did fit within the definition of a “person” conducting business activity within the state of Michigan.17 According
to the SBTA, all persons conducting business
activity within the state were required to file
an SBT return. The Court concluded that
KMPS was correct in filing an SBT return
even though it did not file a separate federal
income tax return since it was a disregarded
entity under the check-the-box regulations.
The Kmart decision was released on May
12, 2009. On August 4, 2009 the Michigan
Court of Appeals revisited this issue in the
Alliance decision. The Court in Alliance came
to the same conclusion as the Court did in its
Kmart decision under a different set of facts.
In Kmart the taxpayer was a disregarded entity under the federal check-the-box regulations, whereas in Alliance the taxpayer elected to be treated as a corporation.
In Alliance, the plaintiff, Alliance Obstetrics & Gynecology, PLC was a limited liability
company with a single member. The plaintiff
had made an election under the check-thebox regulations to be treated as a corporation
for federal income tax purposes. Accordingly, the plaintiff filed a separate single business tax return and claimed a small business
credit under MCL 208.36. The MDT disallowed the small business credit because, under MCL 208.36(2)(b)(i), a corporation whose
officers earned more than $115,000 during the
tax year was not entitled to the small business credit. Since the plaintiff had elected to
be treated as a corporation for federal income
tax purposes, the MDT determined that this
was a binding classification for all purposes
under the SBTA, including the calculation of
the small business credit.18
The Michigan Court of Appeals in Alliance cited its decision in Kmart for the proposition that classifications under the federal
and state statutes were not binding on one
another.19 The Court stated that limited liability companies are not corporations under
Michigan law and that “[b]usiness entities
such as plaintiff that are neither a corporation nor a partnership should not be required
to elect a classification inconsistent with its
organization under state law.”20 The Court in
Alliance held that the plaintiff was not to be
treated as a corporation for purposes of calculating the small business tax credit under
MCL 208.36(2), and, thus, it was entitled to
take the credit.21
Response to Kmart Decision by MDT and
Michigan Legislature
On February 5, 2010, the MDT issued a
notice to taxpayers regarding the impact of
the Kmart case. The MDT stated “pursuant to
Kmart, persons that are disregarded entities
for federal tax purposes that filed as a branch,
division, or sole proprietor of their owner for
SBT purposes (‘previously disregarded entities’) must now file a separate SBT return for
all open tax periods. Previously disregarded
entities are considered non-filers for statute
of limitation purposes under MCL 205.27a.”22
The MDT stated that SMLLCs were required
to file or amend their returns for all open tax
years under rules laid out by the Kmart decision and the February 2010 Notice. All these
returns were due on or before September 30,
2010. Returns not filed on or before September 30, 2010 would have interest assessed
for any deficiencies, which interest would
21
A business
entity that
has a single
owner can
choose to be
classified as a
corporation or
a disregarded
entity for
federal tax
purposes.
22
The Michigan
Legislature,
recognizing
this burden
and the
inherent
unfairness
of the MDT’s
position in
its February
2010 Notice,
introduced
House Bill
5937.
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
be added to the deficiency from the time the
tax was originally due. Interest on refunds
would be calculated and added to the refund
commencing 45 days after the claim is filed.23
The MDT would assess a penalty against any
previously disregarded entities that did not
file a return by September 30, 2010.24 Moreover, the MDT stated that previously disregarded entities would be considered non-filers for statute of limitations purposes.25 This
meant that SMLLCs would have to go back
and file tax returns for all years in which
their revenues exceeded the filing threshold.
However, SMLLCs that previously filed SBT
returns that included one or more previously disregarded entities had to amend their
returns for all open years, but they could not
amend their SBT returns beyond the statute of limitations set forth in MCL 205.27a.
The February 2010 Notice was going to be a
tremendous administrative burden on both
SMLLCs and the MDT.
The Michigan Legislature, recognizing
this burden and the inherent unfairness of
the MDT’s position in its February 2010 Notice, introduced House Bill 5937. In March
2010, this bill was reported out of committee.
The committee report described the situation
as follows:
Taxpayers that relied on the Department’s policies for many years now
face the tremendous task of filing
new or amended returns for all “open
periods”. Since the Department considers previously disregarded entities to be nonfilers, returns must be
filed for all tax years for which the
entities exceed the SBT filing threshold. For some taxpayers, this lookback period will be as long as 10 or 20
years. If the affected taxpayers have
a tax liability, they will be charged
interest for the entire time the tax
was due. On the other hand, if taxpayers’ liability is reduced, refunds
will be paid only for the four years
prescribed by the Act.26
House Bill 5937 was passed by the Michigan Legislature and signed by the Governor
on March 31, 2010 as 2010 Public Act 38 (PA
38). PA 38 became effective on March 31,
2010. PA 38 amended section 207a of 1941
Public Act 122, as amended by 2003 Public
Act 23, being MCL 205.27a. In pertinent part,
PA 38 amends MCL 205.27a by adding the
following language:
(8) Notwithstanding any other provision in this act, for a taxpayer that
filed a tax return under former 1975
PA 228 [the SBTA] that included in
the tax return an entity disregarded
for federal income tax purposes
under the internal revenue code,
both of the following shall apply:
(a) The department shall not
assess the taxpayer an additional tax or reduce an overpayment
because the taxpayer included
an entity disregarded for federal
income tax purposes on its tax
return filed under former 1975
PA 228.
(b) The department shall not
require the entity disregarded
for federal income tax purposes
on the taxpayer’s tax return filed
under former 1975 PA 228 to file
a separate tax return.
(9) Notwithstanding any other provision in this act, if a taxpayer filed
a tax return under former 1975 PA
228 that included in the tax return an
entity disregarded for federal income
tax purposes under the internal revenue code, then the taxpayer shall not
claim a refund based on the entity
disregarded for federal income tax
purposes under the internal revenue
code filing a separate return as a distinct taxpayer.27
It is important to analyze what PA 38 does
and what it does not do. First, PA 38 does not
amend the SBTA to change the definition of
“person” and, in fact, does not amend the
SBTA at all. Second, PA 38 makes no mention
of the MBT and should not have any impact
on the interpretation of this tax act. Third, PA
38 does not approve nor disapprove of the
analysis or holdings of Kmart and does not
even mention the Alliance decision. PA 38
does state in its enacting section the following:
This amendatory act is curative,
shall be retroactively applied, and
is intended to correct any misinterpretation concerning the treatment
of an entity disregarded for federal
income tax purposes under the internal revenue code under former 1975
PA 228 that may have been caused
by the decision of the Michigan court
of appeals in Kmart….28
TREATMENT OF SINGLE MEMBER LLCS UNDER SBT AND MBT
If the above enacting language is read in
light of MCL 205.27a(8), it does not appear
that PA 38 is disapproving the analysis of
Kmart, but just “correcting any misinterpretation” regarding the treatment of SMLLCs
“that may have been caused” by the Kmart
decision. What PA 38 does do is reflected in
the actual language of MCL 205.27a(8). PA 38
changes the requirements for filing returns
under the SBTA that were made mandatory
by the February 2010 Notice. Under PA 38, if
the owner of an SMLLC filed a return treating the SMLLC as a disregarded entity then
(1) the MDT cannot increase or decrease that
owner’s tax liability because the owner did
not file a separate return for the SMLLC, and
(2) the owner cannot be required to file a separate return. PA 38 also states that the owner cannot file a separate SBT return for the
SMLLC if it originally filed its return treating the SMLLC as a disregarded entity. Significantly, PA 38 does not mention anything
about owners of SMLLCs that may have filed
separate returns even though they may have
elected to be treated as disregarded entities
under the federal check-the-box regulations.
Reading the language of the committee report, PA 38, and its enacting language together, it appears that PA 38 actually “repeals”
the MDT’s February 2010 Notice because it,
in essence, does away with this Notice’s SBT
filing requirements, without addressing the
analysis of Kmart.
On April 12, 2010 the MDT issued a
“new” Notice rescinding its previous February 2010 Notice.29 The April 2010 Notice says
that “2010 PA 38 reinstates the law governing disregarded entities under the SBT in effect prior to Kmart.”30 It also goes on to say
that the February 2010 Notice is rescinded
and concludes “that RAB 1999-9 and RAB
2000-5 reflect the correct interpretation of the
law regarding the treatment of disregarded
entities under the SBT.”31 It appears that the
MDT in its April 2010 Notice interprets PA
38 as doing away with the analysis of Kmart
altogether, which as pointed out above does
not appear to be the case.
The Kmart decision made two important determinations. First, that RABs, while
entitled to respect, were not binding on the
Court’s interpretation of the SBTA and by extension any Michigan tax act. Second, Kmart
interpreted “person,” as defined in the SBTA,
to mean SMLLCs and that the check-the-box
regulations did not affect that definition, thus
requiring SMLLCs to file separate returns.
23
PA 38 does away with the requirement of filing separate returns, but not the analysis of
Kmart as described above.
Impact Under the SBTA
PA 38 and the Kmart and Alliance decisions
affect SMLLCs and their treatment under the
SBTA in several ways. While Kmart’s interpretation of “person” is not changed, PA
38 does not allow SMLLCs to file separate
returns if they have elected to be treated as
disregarded entities under the check-the-box
regulations, but SMLLCs that have already
filed separate returns should not have to
amend their returns because PA 38 does not
require this, and the February 2010 Notice
has been rescinded. Those SMLLCs who did
file separate returns may be subject to audit
challenge by the MDT because of its interpretation in its April 2010 Notice.
SMLLCs that elected to be treated as corporations and that took the small business
credit under MCL 208.36 should still be able
to take the small business credit under the
analysis of the Michigan Court of Appeals
in Alliance. This means that an SMLLC that
paid in excess of $115,000 to a member is not
disqualified from taking the small business
credit because the member is not considered an officer or shareholder of the SMLLC.
SMLLCs that did not take the small business
credit on any open year returns because of
“compensation” to a member in excess of
$115,000 might consider filing an amended
return and seeking a refund.
The impact on SMLLCs under the SBTA
is admittedly limited due to its repeal effective December 31, 2007. Only SMLLCs who
have open years or who are subject to audit
will be able to rely on Kmart and Alliance.
Impact Under the MBTA
Filing a Separate Return If an Election
Is Made To Be Treated As a Disregarded
Entity Under the Check-the-Box
Regulations
The MBTA has two different types of
taxes. The MBTA imposes a modified
gross receipts tax (GRT) on taxpayers with
Michigan nexus at the rate of 0.8 percent.32
It also levies the business income tax (BIT)
on taxpayers with Michigan business activity at the rate of 4.95 percent.33 The term
“taxpayer” is defined as “a person or a unitary business group liable for a tax, interest,
or penalty under this act….”34 A person is
PA 38
and the
Kmart and
Alliance
decisions
affect SMLLCs
and their
treatment
under the
SBTA in
several ways.
24
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
defined in MCL 208.1113(3) as including a
limited liability company. As a result, except
for a unitary business group, which will be
discussed later, an SMLLC is a person subject
to the MBT, just as Kmart decided under the
SBT.
The approach that the MDT will take on
this issue can be gleaned from the Frequently
Asked Questions (FAQs) issued by the MDT
since the passage of the MBTA. Specifically,
FAQs Mi25 and Mi28 reveal that the MDT will
follow RAB 1999-9. Mi 25 asks “Does the MBT
follow the federal check-the-box regulations?”
with answers that can be summarized as follows: (1) Yes, the MBT follows the federal
regulations; (2) for single-member disregarded entities, the single member is an MBT
taxpayer and the SMLLC will be treated as a
sole proprietorship, branch, or division; and
(3) an SMLLC will only be a MBT taxpayer if
it elects to be taxed as a corporation for federal tax purposes and is not part of a unitary
group.35
FAQ Mi 28, in pertinent part, asks: “Are
single member limited liability companies…disregarded for federal tax purposes
also disregarded under the MBT?”36 The answer to this question is that the MBT generally conforms to the check-the-box regulations
and SMLLCs will be treated as sole proprietorships, branches, or divisions of the sole members. Both FAQs Mi25 and Mi28 were issued on
April 15, 2008 before the Kmart and Alliance decisions. In light of April 2010 Notice, they are not
likely to be rescinded. Therefore, SMLLCs that
are not part of a unitary business group could
argue that they can file as a corporation or a
disregarded entity regardless of how they file
under the check-the-box regulations. SMLLCs
that are not part of a unitary business group
will for the most part be SMLLCs whose sole
members are individuals or foreign entities,
not United States entities such as corporations,
partnerships or limited partnerships, or limited liability companies. These types of SMLLCs
should make an independent analysis of the
tax impact on them from a federal income tax
and MBT standpoint taking into consideration
the likelihood of challenge from the MDT if
audited.
SMLLCs whose sole members are entities must take into consideration the unitary business group rules. A unitary business group must:
file a combined return that includes
each United States person, other
than a foreign operating entity, that
is included in the unitary business
group. Each United States person
included in a unitary business group
or included in a combined return
shall be treated as a single person
and all transactions between those
persons included in the unitary business group shall be eliminated from
the business income tax base, modified gross receipts tax base, and the
apportionment formula under this
act.37
Unitary business group is defined, in pertinent part, as:
a group of United States persons,
other than a foreign operating entity,
1 of which owns or controls, directly or indirectly, more than 50% of
the ownership interest with voting
rights or ownership interests that
confer comparable rights to voting
rights of the other United States persons, and that has business activities
or operations which result in a flow
of value between or among persons
included in the unitary business
group or has business activities or
operations that are integrated with,
are dependent upon, or contribute to
each other. For purposes of this subsection, flow of value is determined
by reviewing the totality of facts and
circumstances of business activities
and operations.38
A full discussion of the unitary business
group concept is beyond the scope of this
article, but an SMLLC whose sole member
is an entity organized in the United States
will be part of a unitary business group
and will be required to include its business
activities as part of its sole member’s tax return. In short, SMLLCs with members that
are United States entities will not be able
to file separate returns under the analysis
of Kmart because of the unitary business
group rules.39
Some SMLLCs might consider organizing
their parent entities as a foreign corporation
in light of the unitary business group rules to
avoid having to file a single consolidated return. If the tax benefits are substantial, some
taxpayers may consider organizing the sole
member of the Michigan SMLLC as a foreign
entity, but only if the foreign entity is an “operating” entity.
TREATMENT OF SINGLE MEMBER LLCS UNDER SBT AND MBT
The Small Business Tax Credit
The MBT, like the SBT, has a small business
tax credit.40 A taxpayer that qualifies for the
small business tax credit effectively reduces its MBT liability (combination of GRT, BIT,
and surcharge) to 1.8 percent its adjusted business income. To qualify for the credit, a taxpayer must not exceed $20 million of gross
receipts and $1.3 million (adjusted for inflation
after 2008) of adjusted business income.41 As
under the SBT, the MBT disqualifies entities
whose owners have compensation over certain thresholds. As applied to SMLCCs, if its
sole member receives more than $180,000 as a
distributive share of the SMLLC’s adjusted
business income (minus the loss adjustment),
the SMLCC is disqualified from using this
credit. In addition, a corporation is disqualified from taking this credit if the compensation and director’s fees of a shareholder or
an officer exceed $180,000.
In Alliance, the SMLLC (i.e., the plaintiff) elected to be taxed as a corporation
under the check-the-box regulations, but
claimed the small business credit despite
its sole member receiving in excess of
$115,000 from the SMLLC. The court in Alliance pointed out that the term “corporation” was not defined in the SBTA. Since
the SMLLC in Alliance was not a corporation under Michigan law, it was not a corporation for purposes of the SBTA and the
small business credit.
The MBT, however, does define the term
“corporation” as “a taxpayer that is required
or has elected to file as a corporation under
the internal revenue code.”42 Based on this
definition, an SMLLC that elects to be treated as a corporation under the check-the-box
regulations will fall within the definition of a
corporation for the purposes of MBT, including the small business credit under the MBT.
Accordingly, an SMLLC in the same situation as the plaintiff in Alliance will not be able
to make that same argument and will be disqualified from using this credit.
Conclusion
The decisions in Kmart and Alliance have a
significant impact on SMLLCs that have open
tax years to which the SBT applies. Despite
the MDT’s April 2010 notice that PA 38 has
“repealed” the Kmart decision, it appears
that the analysis of this decision is still viable. Therefore, affected SMLLCs might consider filing returns or amended returns that
classify the SMLLCs differently than under
the check-the-box regulations. Practitioners
should consider doing an analysis of savings that might be achieved. The impact of
the Kmart and Alliance decision on the MBT’s
treatment of SMLLCs is less dramatic. Many
SMLLCs that might have considered filing
separate returns under the SBT will probably not be able to do so under the MBT as
a result of the unified business group rules.
However, SMLLCs that do not fall within the
unitary business group rules might consider
taking the position that they are not bound
by the check-the-box regulations in connection with their classification under the MBT
since it appears that the rationale of the Kmart
and Alliance decisions are still valid, notwithstanding the MDT’s position. This might
present a planning opportunity for SMLLCs.
However, any SMLLC that takes this position should only do so with the knowledge
that the MDT will probably not agree with
this analysis.
NOTES
1. 283 Mich App 647, 770 NW2d 915 (2009).
2. 285 Mich App 284, 776 NW2d 160 (2009).
3. MCL 208.1 et seq., which was repealed by 2006
PA 325 effective December 31, 2007.
4. MCL 208.1101, et seq., which became effective
January 1, 2008.
5. Treas Reg 301.7701-1 (the check-the-box regulations).
6. MCL 450.4101 et seq.
7. Treas Reg 301.7701-1(a)(1).
8. Treas Reg 301.7701-2(a).
9. Id.
10. Treas Reg 301-7701-3(b)(ii).
11. MCL 208.31(1).
12. MCL 208.6(1).
13. RAB 1999-9 at 2.
14. Id.
15. Kmart, 283 Mich App at 654.
16. Id.
17. Id.
18. Alliance, 285 Mich App at 286.
19. Id.
20. Id.
21. Id.
22. “Notice to Taxpayers Regarding Kmart Michigan Property Services LLC v. Dept of Treasury, The
Single Business Tax, RAB 1999-9, and RAB 2000-5”
(February 5, 2010) (the February 2010 Notice), which
can be found at http://www.michcpa.org/Content/Public/Documents/Direct%20File%20Links/Kmart%20No
tice%20Retroactive%20Application%20Amended%20
Returns.pdf.
23. Id.
24. Id.
25. Id.
26. “Disregarded Entity: SBT Returns H.B. 5937: Analysis As Reported From Committee” (March 25, 2010).
27. MCL 207.27a(8).
25
26
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
28. MCL 207.27a, enacting section 1.
29. “Rescinded: Notice to Taxpayers Regarding
Kmart Michigan Property Services LLC V Dep’t Of Treasury, The Single Business Tax, RAB 1999-9, and RAB
2000-5” (April 12, 2010) (hereinafter referred to as the
April 2010 Notice), which can be found at: http://www.
michigan.gov/documents/taxes/Kmart_Notice_Retroactive_Application_Amended_Returns_1_310402_7.pdf.
30. Id.
31. Id.
32. MCL 208.1203.
33. MCL 208.1201.
34. MCL 208.117(5).
35. Michigan Business Tax Frequently Asked Questions, page 82 (April 15, 2008), which can be found at
http://www.michigan.gov/documents/taxes/MBTFAQ_
208917_7.pdf.
36. Id. at page 84.
37. MCL 208.1511.
38. MCL 208.1117(6).
39. The unitary business group rules will also
require more SMLLCs to file MBT returns since the
filing threshold of $350,000 will more likely be reached
when filing as part of a unitary business group than
separately. SMLLCs, whether they elected to be treated
as corporations or disregarded entities under the checkthe-box regulations will become part of larger groups
of entities under these rules and SMLLCs that were not
subject to the SBT because of its threshold of $350,000
will now be subject to the MBT.
40. MCL 208.1417.
41. Id.
42. MCL 208.1107(3).
Donald A DeLong of the
Law Offices of Donald A.
DeLong, PC, Southfield,
Michigan practices in the
areas of general business
and
corporate
law,
representation of private
foundations and charitable
organizations, estate planning and
probate administration, and real estate
law.
Property and Transfer Tax
Considerations For Business
Entities
By Mark E. Mueller
Business attorneys are often called on to
advise in restructuring business entities,
forming new companies, transferring interests among individuals and entities, and
moving assets around. Quite often the parties
to the transactions are related and everyone is
in agreement as to what is to happen. In such
an environment, details are often neglected
and it might be tempting to be less than thorough in analyzing the transaction in all of its
aspects. Clients often assume that if no cash is
changing hands, there is little concern about
taxes. This article is a reminder to check the
property tax issues that attend even these
friendly deals. With state and local budgets
under tremendous pressure, we can expect
tax authorities to scrutinize transactions and
claimed exemptions.
State Real Estate Transfer Tax
Is the transfer taxable under the State Real
Estate Transfer Tax Act, MCL 207.521-537
(“SRETT”)? The SRETT Act imposes on the
seller or grantor a 0.75 percent transfer tax1
on (1) contracts for the sale of real property,
(2) deeds or instruments of conveyance
of real property for consideration, and (3)
contracts for the transfer or acquisition of a
controlling interest in an entity in which real
property comprises at least 90 percent of the
fair market value of the entity’s assets. MCL
207.523.
There are numerous exemptions to the
SRETT, specified in MCL 207.526. For transfers to an entity by one or more of the owners or by a related entity, the key exemptions
are:
• (p) A conveyance that meets 1 of the
following:
(i) A transfer between any
corporation and its stockholders
or creditors, between any limited
liability company and its members or
creditors, between any partnership
and its partners or creditors, or
between a trust and its beneficiaries
or creditors when the transfer
is to effectuate a dissolution of
the corporation, limited liability
company, partnership, or trust and
it is necessary to transfer the title of
real property from the entity to the
stockholders, members, partners,
beneficiaries, or creditors.
(ii) A transfer between any limited
liability company and its members
if the ownership interests in the
limited liability company are held
by the same persons and in the same
proportion as in the limited liability
company prior to the transfer.
(iii) A transfer between any
partnership and its partners if
the ownership interests in the
partnership are held by the same
persons and in the same proportion
as in the partnership prior to the
transfer.
(iv) A transfer of a controlling
interest in an entity with an interest
in real property if the transfer of
the real property would qualify for
exemption if the transfer had been
accomplished by deed to the real
property between the persons that
were parties to the transfer of the
controlling interest.
(v) A transfer in connection with the
reorganization of an entity and the
beneficial ownership is not changed.
and
• (t) A written instrument evidencing
a contract or transfer of property to
a person sufficiently related to the
transferor to be considered a single
employer with the transferor under
section 414(b) or (c) of the internal
revenue code of 1986, 26 USC 414.
The exemption under Section 6(p) will apply to a transfer from a dissolving entity to
its owners in dissolution. If property is contributed to an LLC or partnership (but not
a corporation), and the interests in the entity are unchanged as a result of the transfer,
27
28
There are
numerous
exemptions
to the
SRETT,
specified in
MCL 207.526.
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
then the transfer of the property is exempt
under Section 6(p)(ii) and (iii). For example,
if Able and Baker each contribute $50 to form
a new LLC with 50 percent membership interests each, and then Able contributes real
estate worth $50,000 and Baker simultaneously contributes $50,000 cash, it seems that
the interests have remained the same both
before and after Able’s transfer and would
therefore be exempt. It is not at all clear that
this is the intended result under the statute.
If the new LLC promptly dissolves with Able
getting the cash and Baker getting the property (which should be exempt under Section
6(p)(i) as a transfer in dissolution), then the
property has effectively been transferred
from Able to Baker for a net consideration of
$50,050 in cash without paying the SRETT.
Application of the “single employer” exemption under Section 6(t) is not readily apparent from the language of the statute and
requires a bit of further study. The reference
to IRC 414(b) or (c) directs us to the concept
of a group of entities under common control.
This can be a parent-subsidiary group (basically, an 80 percent control test), or a brother-sister group. RAB 1989-48 provides that a
brother-sister group consists of two or more
organizations conducting business if:
• the same five or fewer individuals own
a controlling interest (at least 80 percent) in each organization, and
• taking into account the ownership of
each of those persons only to the extent
that such ownership is identical with
respect to each organization, those persons are in effective control (more than
50 percent) of each organization.
The Michigan Department of Treasury uses
RAB 1989-48 (originally issued in connection with the Single Business Tax) to define
entities under common control for purposes
of the SRETT. RAB 1989-48 contains several
useful examples and is required reading for
interpretation of the Section 6(t) exemption.
Undoubtedly, some taxpayers have been
tempted to misuse the exemption set forth
in 6(a), which exempts instruments in which
the “value of the consideration for the property is less than $100.00.” If Able and Baker
form a real estate LLC, with Able contributing the real estate worth $50,000 and Baker
contributing $50,000 cash, and each receives
a 50 percent membership interest, it’s tempting to claim the $100 exemption since there’s
no cash changing hands between Able and
the new LLC. But Able’s 50 percent member-
ship interest is valuable consideration for the
transfer of his property to the LLC. The value
is “the current or fair market worth in terms
of legal monetary exchange at the time of the
transfer.”2 Able exchanged his property for a
membership interest that has value greater
than $100, and such exchanges are taxable.3
Lawyers who prepare deeds for such conveyances and claim the $100 exemption put
themselves at risk of civil and criminal penalties under MCL 205.27.4
Application of Transfer Tax to
Controlling Interest Transfers
The SRETT was imposed on transfers of
“controlling interests” by amendments to
the Act contained in Public Act 473 of 2008,
which was given a retroactive effective
date of January 1, 2007. The amendment
was an attempt by the legislature to close
a perceived loophole. In commercial real
estate transactions, it had become somewhat
common to drop the subject real estate down
into a subsidiary LLC (a transfer that would
be exempt from the SRETT), and to then
convey the LLC interests to the buyer rather
than giving a deed. This tactic avoided the
need to record a deed conveying the property
to the buyer and thereby evaded the SRETT.
The SRETT amendment added a definition
to the Act, setting an 80 percent threshold
for a “controlling interest,” and modified
the definition of “value” for purposes of
determining the tax base in a transaction
involving the transfer of a controlling
interest.
Consider a simple case. Suppose Able,
Baker, and Charlie are the three equal
members of an LLC, which in turn owns
a commercial rental property valued at
$950,000, plus cash and other holdings
valued at $50,000 for a total of $1,000,000.
The members each sell their membership
interests in the LLC to Delta, which thereby
acquires a controlling interest in the LLC
(100 percent). The new SRETT amendments
impose the transfer tax on the sellers in this
“transfer or acquisition” because the real
property owned by the LLC comprises more
than 90 percent of the fair market value of the
LLC’s assets. The tax base is the “value of the
real property or interest in the real property,
apportioned based on the percentage of the
ownership interest transferred or acquired
in the entity.”5 This yields a tax base equal
to $950,000 x 100% = $950,000, and a tax of
PROPERTY AND TRANSFER TAX CONSIDERATIONS FOR BUSINESS ENTITIES
$7,125, payable by the three sellers in the
amount of $2,375 each.
Now suppose things are a little more
complicated. Able owns a 50 percent
membership interest, Baker 35 percent, and
Charlie 15 percent. Able and Baker each sell
their membership interests in the LLC to
Delta, which thereby acquires a controlling
interest in the LLC (50%+35%=85%). In this
case, there should be a transfer tax equal
to 0.75 percent of $807,500 (85 percent of
$950,000), or $6,056.25, payable by Able and
Baker. If the tax is proportionately allocated
between them, Able would pay $3,562.50 and
Baker would pay $2,493.75.
The act does not address what happens if
Able sells his 50 percent interest to Delta, and
then Baker, in a separate transaction a few
months later, sells his 35 percent interest to
Delta. On closing with Baker, Delta might be
said to have acquired a controlling interest.
Is the tax base 35 percent of $950,000, reflecting only the transaction by which Delta “acquired” a controlling interest? Or is it 85 percent including Able’s sale too? If Able’s sale
is to be included in the tax base, is he then responsible for paying the tax even though his
sale in itself was not taxable? Is Baker’s sale
not a transfer or acquisition of a controlling
interest at all, since it is only 35 percent?
These and other questions have caused the
SRETT amendments to be roundly criticized,
not so much for the closing of a loophole,
but for an overall lack of clarity and the
impracticality of various provisions.6
County Transfer Tax
Is the transfer subject to the county Real
EstateTransfer Tax under MCL 207.501-513?
MCL 207.502 imposes on the grantor a
0.11 percent transfer tax7 on:
(a) Contracts for the sale or exchange
of real estate or any interest therein or
any combination of the foregoing or
any assignment or transfer thereof.
(b) Deeds or instruments of
conveyance of real property or any
interest therein, for a consideration.
The tax is collected by each county for transfers of property in the county. The county
tax pre-dates the SRETT and contains some,
but not all, of the same exemptions. Unlike
the SRETT and the General Property Tax Act
(discussed below), the county tax does not
have exemptions for transfers between affiliates or entities under common control.8 The
county tax does not apply to entity interest
29
transfers, but it will apply to most transfers
of real property by or to legal entities.
Property Tax Valuation Uncapping
Does the transfer cause uncapping of the
taxable value of the property under MCL
211.27a? Beginning in 1995, annual increases
in the taxable value of real property were limited to the lesser of five percent or the inflation rate.9 The limitation applies until there
is a “transfer of ownership,” whereupon the
taxable value for the calendar year after the
transfer is equal to the property’s state equalized value.10 The transfer of ownership starts
the process over, and future annual increases
in the taxable value are again limited.11 This
removal of the limitation on taxable value
following a transfer of ownership has come
to be called “uncapping.”
Uncapping is caused by a transfer of
ownership, which Section 27a(6) of the Act
defines as “the conveyance of title to or a
present interest in property, including the
beneficial use of property, the value of which
is substantially equal to the value of the fee
interest.”12 Conveyances by deed, land contract, by will, or in trust are covered, as are
changes in the beneficial interests under a
trust.13 A conveyance of more than 50 percent of the ownership interest in a corporation, partnership, LLC or other entity is also
deemed to be a transfer of ownership of the
entity’s real property under Section 27a(6)(h)
of the Act.14
Since no deed is filed for a conveyance
of entity interests, such a transfer might not
ever come to the attention of the property assessor, so the statute requires the affected entity to notify the assessor by filing a Property
Transfer Affidavit no more than 45 days after
the transfer.15
There are numerous transfers that are
expressly excluded from uncapping, set
forth in Section 27a(7), including transfers
between spouses, transfers subject to a life
estate in the grantor, foreclosures, transfers
to a trust for the benefit of the grantor or his
or her spouse, etc. The key statutory exemptions for transfers by or to business entities
are set forth in Section 27a(7), subsections (j),
(k), (l), and (m):
• (j) A transfer of real property or other
ownership interests among members
of an affiliated group. As used in this
subsection, "affiliated group" means
1 or more corporations connected by
stock ownership to a common parent
Beginning
in 1995,
annual
increases in
the taxable
value
of real
property
were limited
to the lesser
of five percent
or the
inflation rate.
30
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
The
exemption
that should
be of keen
interest
to lawyers
working
with
individual
owners of
small and
medium
business
entities will
be Section
27a(7)(l)…
corporation. Upon request by the state
tax commission, a corporation shall furnish proof within 45 days that a transfer
meets the requirements of this subdivision. A corporation that fails to comply
with a request by the state tax commission under this subdivision is subject to
a fine of $200.00.
• (k) Normal public trading of shares of
stock or other ownership interests that,
over any period of time, cumulatively
represent more than 50% of the total
ownership interest in a corporation or
other legal entity and are traded in multiple transactions involving unrelated
individuals, institutions, or other legal
entities.
• (l) A transfer of real property or other
ownership interests among corporations, partnerships, limited liability companies, limited liability partnerships, or other legal entities if the entities involved are commonly controlled.
Upon request by the state tax commission, a corporation, partnership, limited
liability company, limited liability partnership, or other legal entity shall furnish proof within 45 days that a transfer
meets the requirements of this subdivision. A corporation, partnership, limited
liability company, limited liability partnership, or other legal entity that fails to
comply with a request by the state tax
commission under this subdivision is
subject to a fine of $200.00.
• (m) A direct or indirect transfer of real
property or other ownership interests
resulting from a transaction that qualifies as a tax-free reorganization under
section 368 of the internal revenue code,
26 USC 368. Upon request by the state
tax commission, a property owner shall
furnish proof within 45 days that a
transfer meets the requirements of this
subdivision. A property owner who
fails to comply with a request by the
state tax commission under this subdivision is subject to a fine of $200.00.
Affiliated Groups (MCL 211.27a(7)(j)
The affiliated group exemption under Section 27a(7)(j) presumably refers to a group
or chain of commonly owned corporate entities that would qualify as an affiliated group
under IRC 1504, so as to be allowed to file a
consolidated federal income tax return under
IRC 1501. Transfers between corporations in
such a group will avoid uncapping for transfers between parent and subsidiary corporations or between brother-sister subsidiary
corporations of the same parent.
Public Trading (MCL 211.27a(7)(k)
The administrative impossibility of tracking
changes of ownership resulting from normal
public trading of shares in a publicly traded
entity no doubt gave rise to the “public trading” exemption set forth in Section 27a(7)(k).
This does not mean that public companies
always get a pass, however. The State Tax
Commission (“STC”) has identified six types
of transfers for public companies that may
result in uncapping:
• The merger of two or more companies;
• The acquisition of one company by
another or by an individual;
• The initial public offering (IPO) of the
stock of a company (an IPO occurs
when a company’s stock is first offered
for sale to the public);
• A secondary public offering of the stock
of a company (a secondary public offering occurs when a company whose
stock is already publicly traded issues
additional new stock for sale to the public);
• The trading of the stock of a privately
held company (a privately held company is a company whose stock is not
available for sale to the public); and
• A takeover involving a public offer
by someone to buy stock from present
stockholders in order to gain control of
a company.16
Commonly Controlled Entities (MCL
211.27a(7)(l)
The exemption that should be of keen interest
to lawyers working with individual owners
of small and medium business entities will be
Section 27a(7)(l), which concerns transfers of
real property or ownership interests among
legal entities if those entities are “commonly controlled.” As we saw with the SRETT,
the Michigan Department of Treasury relies
mostly on RAB 1989-48 to determine whether entities are commonly controlled. The bulletin describes three categories of common
control:
• a parent-subsidiary group of trades or
businesses,
• a brother-sister group of trades or businesses, or
PROPERTY AND TRANSFER TAX CONSIDERATIONS FOR BUSINESS ENTITIES
• a combined group of trades or businesses (a specific combination of a parent
subsidiary group and a brother-sister
group of trades or businesses).
The STC guidelines take some liberties here,
departing from the strict application of RAB
1989-48. First, the STC notes that in order for
entities to be commonly controlled under
RAB 1989-48, they must be engaged in a business activity. The guidelines give an example
of a husband and wife who, for estate planning reasons, convey their residence to an
LLC owned by the wife.17 The STC notes that
the “entities involved (the husband and wife
and the limited liability company)” cannot
be entities under common control according
to RAB 1989-48 because no business activity
exists in the situation.
The STC goes on to state that certain situations will constitute common control even
though the strict requirements of RAB 198948 are not met, such as:
Property (or an ownership interest) is
conveyed from one entity to another
entity and both entities are owned by
the same individual(s) with the same
percentage of ownership.
Let’s call this the Proportionate Ownership Rule. The guidelines give the following
example:
Example: Individual A and individual B own a lakefront cottage property
together as tenants in common, each
with an undivided 50 percent interest. This is the only such property
these individuals own and they use
the property solely for recreational
purposes, residing there from time
to time. For liability protection purposes, individual A and individual
B convey the property to a limited
liability company. Individual A and
individual B are the only members of
the limited liability company, each
having a 50 percent ownership interest. Even though these entities (individual A, individual B, and the limited liability company) are not entities
under common control under Michigan Revenue Administrative Bulletin 1989-48, these entities are considered to be under common control by
policy of the State Tax Commission
and this property transfer would not
be a transfer of ownership.
First, let us note that the example does not
really exemplify the Proportionate Ownership
Rule. The rule speaks of transfers between
two entities owned by the same individuals in the same proportions. The example
has two individuals transferring property
that they own 50/50 to an entity they own
50/50. “Entities” says the STC, “means corporations, partnerships, limited liability
companies, limited liability partnerships, or
any other legal entity.”18 Individuals do not
appear on the list.
For contrast, the STC then draws the same
example again, but instead of a 50/50 LLC,
the individuals convey their 50/50 owned
property to an LLC that is owned 49/51. This
makes all the difference under the Proportionate Ownership Rule, and, in such a case,
the STC says the entities are not under common control.
With these examples, the STC guidelines
appear to dispense with two requirements of
RAB 1989-48 as to who can be an “entity under common control.” First, RAB 1989-48 nowhere contemplates individuals as “entities
under common control.” Second, the STC
itself notes that RAB 1989-48 requires such
entities to be engaged in a business activity.
Neither of these requirements is imposed on
our cottage owners in the examples. Instead,
the STC creates the Proportionate Ownership
Rule seemingly out of whole cloth. Other
commentators have also questioned the Proportionate Ownership Rule.19
As the STC giveth, so the STC taketh
away. In another departure from RAB 198948, the STC dispenses with the constructive
ownership rules set forth in the Bulletin:
Michigan Revenue Administrative
Bulletin 1989-48 refers to Internal
Revenue Service regulations concerning constructive ownership (also
commonly known as ownership
attribution). It is the opinion of the
State Tax Commission that, although
Michigan Revenue Administrative Bulletin 1989-48 is to be used in
determining entities under common
control, the Internal Revenue Service
regulations concerning constructive ownership are to be disregarded. Application of the regulations
regarding constructive ownership
(ownership attribution) would result
in transfer of ownership exemptions
that were clearly not intended by the
legislature.20
Unfortunately, the STC guidelines do not
inform us as to what the supposed intent of
31
The STC
goes on to
state that
certain
situations
will constitute
common
control even
though
the strict
requirements
of
RAB 1989-48
are not met…
32
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
the legislature was. The legislature presumably knew what “commonly controlled”
meant when it included that language in
the statute. At the time, RAB 1989-48 was
already the Michigan Treasury’s published
guidance on commonly controlled entities
under Michigan tax law.
Corporate Tax Free Reorganization (MCL
211.27a(7)(m)
Finally, Section 27a(7)(m) exempts transfers
of real property or ownership resulting from
transactions that qualify as a tax-free reorganization under IRC 368. Section 368 applies
only to corporate reorganizations.
Hypotheticals
Returning to our examples, if Able, Baker,
and Charlie are equal owners of ABC One,
LLC, and they own ABC Two, LLC as follows: Able (40 percent), Baker (40 percent)
and Charlie (20 percent), will a transfer by
deed of real property from ABC One to ABC
Two result in uncapping?
The transfer of the real estate by deed
is a “transfer of ownership” under Section
27a(6)(a). Is there an exemption? Since these
are LLCs and not corporations, and the interests are not publicly traded, we can look only
to Section 27a(7)(l) for an exemption as entities under common control. The test will be
whether ABC One and ABC Two can qualify
as a brother-sister group under RAB 1989-48
as discussed above. Assume the entities have
business activities. In our case, Able, Baker,
and Charlie own 100 percent of both ABC
One and ABC Two, so they satisfy the first
prong. To satisfy the second, we need to see
if as a group, they meet the minimum level
of effective control in both entities, considering their individual interests only to the extent those interests are the same in each entity. Able and Baker each own 33.3 percent
of ABC One for a total of about 67 percent.
Clearly they are in effective control of ABC
One. Looking at ABC Two, Able and Baker
each own 40 percent, but we can consider
this only to the extent that their respective
ownership is the same in both companies, i.e.
a maximum of 33.3 percent each. The sum
of these interests also exceeds 50 percent, so
Able and Baker are also in effective control
of ABC Two. Therefore, the transfer between
the entities should not result in uncapping.
Suppose the same example, except that
ABC Two is owned as follows: Able (90 percent), Baker (5 percent), and Charlie (5 per-
cent). Again, together they own 100 percent
of both companies. But considering their individual interests only to the extent they are
identical in both companies, we see that the
same “group” is not in effective control of
ABC Two. We can only count 33.3 percent of
Able’s interest in ABC Two, plus the 5 percent
for each of Baker and Charlie. This comes to
only 43.3 percent—not enough for effective
control. So in this example, the transfer results in uncapping.
For another example, assume that Able,
Baker, and Charlie are siblings and in 1990
they inherited a commercial property as
equal tenants in common. The property is
leased to their small business, an auto repair
shop. Their lawyer advises them to form an
LLC and contribute the property for liability
protection and ease of management. They
form ABC, LLC and contribute the property
by deed, taking equal membership interests
in exchange. Under the statute, this is clearly
a transfer of ownership, and no exemption
seems to apply. The property is not being
conveyed among entities under common
control. Each of the individuals is under his
own control. The Proportionate Ownership
Rule described in the STC guidelines does
not seem to apply either for the same reason:
the individuals are not entities. The only basis for claiming the exemption in this transaction appears to be the STC’s example in the
guidelines—an example that has been called
into question by the Michigan Tax Tribunal.21
This seemingly innocuous transfer into the
LLC may result in a huge increase in property taxes. Did the lawyer advise them of that?
How about the state and county transfer taxes that may also be due?
Conclusion
Before advising a client on (i) a conveyance
of real property to or from a business entity, or (ii) a transfer of entity interests where
the entity owns real property, lawyers need
to stop, think, and read the statutory provisions and exemptions for transfer taxes and
uncapping, combined with the administrative guidance and caselaw, which are far
from simple. Seemingly minor changes in
your facts can make the difference between
whether a transfer is taxable or exempt, and
the difference between good advice or bad.
PROPERTY AND TRANSFER TAX CONSIDERATIONS FOR BUSINESS ENTITIES
NOTES
1. Technically, the tax rate is $3.75 for each $500
(or any fraction thereof) of the consideration, so if
the consideration is not a multiple of $500, the tax
base is rounded up to the next $500 increment. MCL
207.525(1).
2. MCL 207.522(g).
3. Hansen Plaza, LLC v Michigan Dept of Treasury,
MTT Docket No. 263743 (2001).
4. See also State Real Estate Transfer Tax Questions
and Answers, 74 Mich. B J 196 (February 1995).
5. MCL 207.522(g).
6. For an excellent discussion of the SRETT
amendments and these criticisms, see J. Scott Timmer,
The Application of State Transfer Tax to Entity Interest
Transfers, 36 Michigan Real Property Review 84 (Summer 2009).
7. The tax rate is $0.55 for each $500 (or any fraction thereof) of the consideration, so if the consideration
is not a multiple of $500, the tax base is rounded up to
the next $500 increment. MCL 207.504.
8. Robert F. Rhoades and Nancy G. Itnyre, Property
Tax Cap and Transfer Taxes, 27 Michigan Real Property
Review 63 (Summer 2000). This article is especially
useful for its detailed table setting forth the application
of the SRETT, the General Property Tax Act, and the
County Tax to various transactions.
9. MCL 211.27a(2)(a).
10. MCL 211.27a(3).
11. MCL 211.27a(4).
12. MCL 211.27a(6).
13. Id.
14. MCL 211.27a(6)(h).
15. Id.
16. Transfer of Ownership and Taxable Value
Uncapping Guidelines, Mich. Dept. of Treasury, State
Tax Commission/Property Tax Division, March 31,
2001, http://www.michigan.gov/documents/Transfer_of_Ownership_Q&A_128474_7.pdf.
17. Such a transfer will also result in the loss of the
Principal Residence Exemption. MCL 211.7cc.
18. Transfer of Ownership and Taxable Value
Uncapping Guidelines, p. 20.
19. David E. Nykanen, The Danger of the Unintended Uncapping: Issues in Estate Planning and Financing Transactions, Michigan Real Property Review (Fall
2009). This article discusses a small claims case before
the Michigan Tax Tribunal, Lakewood Cottages, LLC v
Township of Sanilac, MTT Docket No 302715 (Jan 6,
2005), which seems to call the Proportionate Ownership
Rule, or at least the STC examples, into question.
20. Transfer of Ownership and Taxable Value
Uncapping Guidelines, Mich. Dept. of Treasury, State
Tax Commission/Property Tax Division, March 31,
2001, http://www.michigan.gov/documents/Transfer_of_Ownership_Q&A_128474_7.pdf.
21. Lakewood Cottages, LLC v Township of Sanilac,
MTT Docket No 302715 (Jan 6, 2005).
Mark E. Mueller of Driggers,
Schultz & Herbst advises
business
owners
and
investors
on
original
formation and governing
structure of new businesses,
buying or selling a business,
contractual
arrangements
between
partners, and evaluating and negotiating
deals with vendors and customers.
33
Using Retirement Plan Assets to
Fund a Start-up Company
By Adam Zuwerink
Introduction
100% of their plan accounts in the employersponsor’s stock, both of which are allowable
provisions in a qualified retirement plan.
After the plan has been properly set up,
the individual rolls over the previous 401(k)
account to the new plan tax-free and directs
the corporation to issue capital stock in exchange for the rollover funds in the plan.
The stock is held as a plan asset with a value
equal to the account proceeds received by the
corporation from the plan.
At the end of the day, the corporation
now has cash available to purchase the franchise and pay for start-up costs, and the plan
participant owns employer stock as a retirement plan investment. Because the stock is
viewed as having the same value as the cash
proceeds and is still an asset of the plan, no
distribution has been made and the presumption is that no income or excise tax is due under Internal Revenue Code (IRC) 72.
Often the plan is then amended to no
longer allow for the investment of employer
stock by plan participants, effectively grandfathering the investment already made, but
cutting off the right of future plan participants
to also become owners of the company.
While each piece of the above transaction
is technically allowed by the IRS, a number
of red flags are raised by the transaction as a
whole. The most important of these is that it
is prohibited for a participant to directly use
retirement plan funds in a business owned
by the participant, which is discussed further
below.
Roll-overs as Business Start-ups
Internal Revenue Service
Memorandum
After working for a manufacturing company
for the past 20 years, a client approaches you
who has recently been let go and is looking
forward to starting the next phase of life by
purchasing a local restaurant franchise. Your
client has a substantial 401(k) account with
the manufacturing company that could be
used as seed capital to purchase the franchise
and obtain bank financing. But your client is
younger than 59½ and is not excited about
the prospect of paying income tax on the distribution, plus a 10 percent excise tax to the
Internal Revenue Service (IRS) for the early
distribution of his 401(k) funds.1
Your client recently attended a franchising seminar at which a company gave a
presentation about using the 401(k) account
funds to purchase stock in a newly formed
operating company for the franchise business without paying income tax or the early
distribution excise tax. Your client insists that
the company has assured him such a transaction has been approved by the IRS, but you
still think it sounds too good to be true.
The purpose of this article is to highlight
the concerns and potential pitfalls of utilizing
this “roll-over as business start-up” (ROBS)
transaction.2 The first section outlines the basic steps in completing a ROBS transaction,
followed by a discussion of a memorandum
from the IRS’ Director of Employee Plans outlining the IRS’ concern with ROBS, and concluding with a discussion of how the United
States Department of Labor (DOL) may view
ROBS as a prohibited transaction subject to
additional excise taxes.
34
The first step in completing the ROBS transaction is to set up a C corporation with a
number of authorized, but unissued, shares
of stock.3 Once incorporation is complete, the
next step is to set up a tax-qualified retirement plan, with the shell C corporation as
the employer-sponsor of the plan. The plan
document must allow for plan participants to
roll-over funds from a previous employer’s
qualified plan, and for participants to invest
After becoming aware of a number of promoters pushing the ROBS transactions at
franchise seminars, Michael Julianelle, Director of Employee Plans for the IRS, issued a
memo on October 1, 20084 outlining a number of concerns the IRS had after reviewing
the plans of nine ROBS transaction promoters.
USING RETIREMENT PLAN ASSETS TO FUND A START-UP COMPANY
Nondiscrimination Requirements
A ROBS transaction is often set up so that
only the persons involved with setting up
the business are allowed to purchase the
employer’s stock, and the right to purchase
the stock is taken away before other employees are hired. One of the cardinal rules of
the IRC’s retirement plan rules is Section
401(a)(4), which states that a plan may not
discriminate in favor of highly compensated
employees, defined generally as either a 5
percent owner, or employee who had more
than $110,000 in income during 2009 or
2010.5 The regulations under IRC 401(a)(4)
state that the benefits, rights, and features
of a plan must be nondiscriminatory,6 and
the timing of plan amendments taking away
rights and benefits of participants is subject
to a facts and circumstances discrimination
test.7 The Julianelle Memo raises the concern
that a plan amendment taking away the right
to an employer stock offering could be a discriminatory practice designed to benefit only
the initial owners of the company.8
Valuation of Stock
Valuation rules are an often overlooked
aspect of modern 401(k) retirement plans
that allow for individual plan participants
to have their own investment account full
of publicly traded mutual funds and stocks
that are valued on a daily basis. But IRS rules
require that all assets in a plan be valued on
a regular basis, no less than annually.9 As
discussed further below, failure to properly
document that the employer securities were
exchanged for their fair market value is automatically a prohibited transaction subject to
excise tax.10
The Julianelle Memo calls into question
the validity of many start-up business valuations that it reviewed, often being given a
single sheet of paper simply stating the valuation of the company equals the value of the
available proceeds from the retirement plan
account.11 At the very least, a company engaging in a ROBS transaction must actually
start operations and have an expert provide a
true enterprise value for the company every
year.
Promoter Fees
ROBS transactions are being promoted by
some investment companies that receive
their fees from a portion of the stock purchase
proceeds, but the IRC prohibits a retirement
plan fiduciary from dealing with the assets
35
of a plan in the fiduciary’s own interest.12 A
plan fiduciary is defined as including anyone
who renders investment advice for a fee on a
regular basis.13 The Julianelle Memo raises the
concern that if an investment advisor takes a
portion of the stock purchase proceeds as a
fee for implementing the ROBS transaction,
and the advisor continues to provide advice
to the plan on a regular basis, that person
becomes a plan fiduciary who is in violation
of the prohibited transaction rules.14
Permanency
One of the requirements of implementing a
qualified retirement plan is that it “must be
created primarily for the purposes of providing systematic retirement benefits for
employees.”15 While the IRS has not historically challenged permanency issues when a
plan is terminated, the Julianelle Memo indicates this is a factor the IRS will review if a
plan is terminated shortly after the purpose
of the ROBS transaction is ended.16
Exclusive Benefit
The Internal Revenue Code requires that in
order for a retirement plan to be qualified as
tax exempt, no part of the plan’s assets can
be used for purposes other than the exclusive
benefit of employees or their beneficiaries.17
The Julianelle Memo states that so long as the
person rolling over the assets is a plan participant and the funds obtained in exchange
for the stock are actually used for business
start-up costs, the plan is not in violation of
the exclusive benefit rules.18 But the Julianelle
Memo does state that some of the ROBS
transactions the IRS reviewed were used to
set up a business for someone other than the
initial account owner, or the stock proceeds
were used to buy personal assets, such as a
Mercedes or RV.19 This violation would subject the retirement plan assets to immediate
income taxation as a non-qualified plan.
Plan Not Communicated to Employees
A qualified retirement plan carries a continuing administrative burden in that the terms of
the plan must be communicated to all newly
hired employees, or the plan risks losing
its qualified status and all assets becoming
immediately taxable.20 One of the communication requirements is that all participants in
a 401(k) plan must be given the opportunity
to defer a portion of their salary to the plan.21
The Julianelle Memo identified that, in some
cases, the retirement plan was simply put on
the shelf and forgotten about after the ROBS
A ROBS
transaction is
often set up
so that only
the persons
involved with
setting up
the business
are allowed
to purchase
the employer’s
stock, and
the right to
purchase
the stock is
taken away
before other
employees are
hired.
36
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
transaction was complete and the stock assets
received.22
It must be communicated clearly to the
client early on that, to pass muster under the
Julianelle Memo analysis, the ROBS transaction must be part of a retirement plan that
is intended to be a permanent benefit available to all employees while the company is
operating. It cannot simply be a vehicle to
obtain tax-free funds to start a business with
no thought of actually operating a retirement
plan.
Additional Considerations
It is very
important
that anyone
contemplating
a ROBS
transaction
be thoroughly
advised of
the on-going
tax and
administrative
costs
associated
with the plan.
In addition to the concerns outlined in the
Julianelle Memo, your client must be aware
of a number of administrative costs and
burdens of owning employer stock within a
start-up company’s retirement plan.
Tax Considerations
While a ROBS transaction may appear to be
tax advantageous through the initial avoidance of income taxation, a thorough examination of on-going tax considerations must be
considered. Taxes will be paid on the corporate and individual level because the ROBS
transaction must be completed through a C
corporation. But it must also be remembered
that the actual owner of the company is the
retirement plan and all dividends must be
paid to the plan, not the individual, thereby
negating a potential lower dividend tax rate
for corporate distributions to individual
owners.
Also, the ROBS transaction is only seeking
to delay income taxation on the retirement account funds, not avoid it. At some point, the
funds will still be subject to income taxation
when distributed from the retirement plan.
The only real potential tax avoidance is the
10 percent excise tax on early distributions.
Administrative Costs
The Julianelle Memo makes clear that the
IRS will scrutinize a ROBS transaction very
closely and make sure that every “i” is dotted
and “t” crossed in the retirement plan. This
means that on top of the administrative costs
to set up the individualized retirement plan
itself, an annual valuation of the stock must
be completed by a qualified business valuation expert, annual tax returns must be prepared and filed, someone must take the time
to administer the plan on an on-going basis,
etc. These costs can easily range from $5,000$10,000 or more in the first year or two alone,
which automatically negates the 10 percent
excise tax savings for any ROBS transaction
less than $100,000.
Sale of Employer Stock
The focus of the Julianelle Memo was the initial transaction of using plan assets to purchase the employer stock, but it fails to discuss the endgame of getting the stock back
out of the plan. As discussed below, having
the plan participant simply purchase the
stock from the plan likely runs afoul of the
DOL’s prohibited transaction regulations.
And if the stock is sold to an unrelated third
party, the plan participant will be required to
pay income tax on the entire stock purchase
price when it is distributed from the plan.
It is very important that anyone contemplating a ROBS transaction be thoroughly
advised of the on-going tax and administrative costs associated with the plan. The analysis will be different for each client, and the
benefits do not always outweigh the costs,
especially as the size of the roll-over account
decreases.
Department of Labor Restrictions
Many ROBS promoters took the Julianelle
Memo as the government sanction they were
looking for and began touting the plans as
“approved by the IRS.”23 But as ESPN college
football analyst Lee Corso likes to say, “Not
so fast, my friend.”24
Executive Order: Reorganization Plan No. 4
of 1978
The Julianelle Memo includes the cryptic paragraph: “We have also coordinated
our consideration of ROBS plans with the
Department of Labor (DOL). As will be noted
later, the transfer of enterprise stock within a
ROBS arrangement could raise ERISA Title I
prohibited transaction issues. Although our
coordination efforts are not yet finalized,
they remain ongoing.”25
Essentially, this means that even if the
ROBS transaction complies with every single procedural requirement outlined in the
Julianelle Memo, the IRS is not actually the
federal governmental department authorized with making the final determination on
whether a ROBS plan is a prohibited transaction subject to a potential 115 percent excise
tax.26
When ERISA was enacted in 1974, it contained its own fiduciary duty rules,27 but it also
added similar prohibited transaction rules to
the Internal Revenue Code. With oversight of
USING RETIREMENT PLAN ASSETS TO FUND A START-UP COMPANY
ERISA placed with the Department of Labor,
President Carter signed an executive order
in 1978 that transferred oversight and interpretation of the prohibited transaction rules
in the Internal Revenue Code from the Department of Treasury to the DOL. That order
provides:
All authority of the Secretary of
the Treasury to issue the following
described documents pursuant to
the statutes hereinafter specified is
hereby transferred to the Secretary
of Labor: (a) regulations, rulings,
opinions, and exemptions under section 4975 of the Code.28
Internal Revenue Code Section 4975
IRC 4975 imposes a 15 percent excise tax on
a “disqualified person” who engages in a
retirement plan “prohibited transaction.” An
additional 100 percent excise tax is imposed
during the taxable period after the prohibited
transaction occurs.29
For purposes of IRC 4975 and a typical ROBS transaction, the term “prohibited
transaction” means any direct or indirect: (a)
sale or exchange, or leasing, of any property
between a plan and a disqualified person; (b)
lending of money or other extension of credit
between a plan and a disqualified person; (c)
furnishing of goods, services, or facilities between a plan and a disqualified person; (d)
transfer to, or use by or for the benefit of, a
disqualified person of the income or assets of
a plan; (e) act by a disqualified person who is
a fiduciary whereby he deals with the income
or assets of a plan in his own interests or for
his own account; or (f) receipt of any consideration for his own personal account by any
disqualified person who is a fiduciary from
any party dealing with the plan in connection with a transaction involving the income
or assets of the plan.
And for purposes of IRC 4975 and a typical ROBS transaction, the term “disqualified
person” includes a person related to the retirement plan who is: (a) a fiduciary; (b) a
person providing services to the plan; (c) an
employer any of whose employees are covered by the plan; (d) an owner, direct or indirect, of 50 percent or more of a company
which is the plan sponsor employer; (e) a
member of the family of any individual described in the preceding classes; (f) an officer,
director (or an individual having powers or
responsibilities similar to those of officers or
directors), a 10 percent or more shareholder,
or a highly compensated employee of the
employer sponsor.
Based solely on the above definitions, a
ROBS transaction would appear to be a prohibited transaction because the principal in
control of the plan’s employer sponsor is directing the plan to purchase company stock
on that person’s behalf to invest in the disqualified company. In fact, ERISA Section
406(a)(1)(E) specifically provides it is a prohibited transaction for a plan to acquire employer securities or real property.30 But like
any good federal statute, there is an exception to the rule that all but negates it.
Where many ROBS promoters hang their
hat is ERISA Section 408(e), which exempts
from the prohibited transaction rules the acquisition or sale of employer securities by a
retirement plan so long as: (1) the acquisition
or sale is for adequate consideration, and (2)
no commission is charged in connection with
the transaction.31
In light of the fact that authority rests
with the Department of Labor to rule on
prohibited transactions, the taxpayer has the
burden to prove to the DOL that it falls under
an exception to the general rule that a plan
may not purchase employer securities. It becomes obvious that the Julianelle Memo does
not in fact answer the question whether a
ROBS transaction is a prohibited transaction
because the IRS does not have the authority
to make such a determination.
DOL Advisory Opinion 2006-01A
The question then becomes, how will the
Department of Labor view such a transaction? Unfortunately, we still do not have
a direct answer from the DOL. While the
Julianelle Memo was a preemptive pronouncement of how the IRS views ROBS, the
DOL will only answer the question through
an advisory opinion if someone asks them.
And as of now, no one has asked them.
What evidence we can gather from prior
advisory opinions shows it is likely the DOL
will not look kindly on ROBS transactions.
While first recognizing the fact DOL regulations acknowledge a disqualified person can
transact business with a company in which
a plan has invested, DOL Advisory Opinion
2006-01A states:
Regulation section 2509.75-2(c) and
Department opinions interpreting
it have made clear that a prohibited transaction occurs when a plan
invests in a corporation as part of
37
In light of
the fact that
authority
rests with the
Department of
Labor to rule
on prohibited
transactions,
the taxpayer
has the
burden
to prove to the
DOL that it
falls under an
exception
to the general
rule that a
plan may not
purchase
employer
securities.
38
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
an arrangement or understanding
under which it is expected that the
corporation will engage in a transaction with a party in interest (or disqualified person).32
A broad reading of this statement calls
into question the entire validity of ROBS
transactions, as the fundamental purpose of
the scheme is for a disqualified person to provide funds to the company that it controls.
Even a narrow reading of the DOL opinions
place severe restrictions on how the retirement plan funds can be used as the money
must not be used directly for a transaction involving the disqualified person. For example,
the money should be used only for payment
of a franchise fee or to purchase equipment,
and should not be used to pay a disqualified
person’s salary or make rent payments to a
company owned by a disqualified person.
Conclusion
It has been reported that as many as 30 percent of recent franchisees have chosen to
use 401(k) roll-over money to help fund the
franchise start-up,33 which means it is only
a matter of time before more concrete guidance and regulations will be provided by
the IRS and DOL. If a client approaches you
about using retirement plan monies to fund
a business start-up, alarm bells should ring
on both a legal and practical level. From a
practical perspective, the IRS and DOL rules
and regulations are set up with the intended
purpose of making sure people save for their
retirement years, and the inherent risks of
mortgaging the future to pay for the present
must be made with a full understanding of
the potential costs if the business does not
survive. From a legal perspective, your client
must be fully informed of the legal requirements outlined in the Julianelle Memo
regarding setting up and maintaining the
retirement plan and the prohibited transaction excise tax risks due to the uncertain status of the transaction scheme with the DOL.
Remember, if it sounds too good to be true, it
probably is.
NOTES
1. See Internal Revenue Code (IRC) Section 72(q).
2. The phrase “Rollovers as Business Startups” was
coined by Michael D. Julianelle, Director of Employee
Plans for the IRS, and the general consensus is that the
acronym “ROBS” was purposefully chosen because of
the IRS’ skepticism towards these transactions.
3. The entity must be a C corporation, rather than
an S corporation or limited liability company, because of
the prohibited transaction rules of IRC 4975(f)(6).
4. Julianelle, Guidelines Regarding Rollovers as Business Start-ups, IRS Employee Plans Director Memorandum, October 1, 2008, located at: http://www.irs.
gov/pub/irs-tege/rollover_guidelines.pdf (hereafter,
“Julianelle Memo”).
5. IRC 414(q)(1).
6. Treas. Reg. 1.401(a)(4)-4(e)(3).
7. Treas. Reg. 1.401(a)(4)-5.
8. Julianelle Memo, 7.
9. Rev. Rul. 80–155, 1980–1 C.B. 84.
10. See ERISA 406; ERISA 408(e).
11. Julianelle Memo 9.
12. IRC 4975(c)(1)(E).
13. IRC 4975(e)(3).
14. Julianelle Memo 10.
15. Julianelle Memo 11, citing Treas. Reg. 1.4011(b).
16. Id.
17. IRC 401(a)(2).
18. Julianelle Memo 12
19. Id.
20. Treas. Reg. 1.401-1(a)(2).
21. IRC 401(k)(2).
22. Julianelle Memo 12-13.
23. See, e.g., SDCooper Company ERSOP® Plans,
located at http://ersop.com/ersop-faq.html; DRDA,
P.C.’s White Paper on Rollovers as Business Startups,
located at http://www.borsaplan.com/DRDAWhitePaper_ROBS.pdf.
24. http://www.espnmediazone.com/bios/Talent/
Corso_Lee.htm
25. Julianelle Memo 4.
26. See IRC 4975.
27. ERISA 406, 408. For purposes of this article,
the terminology of IRC 4975 is used and the DOL
often uses the terms located in ERISA and the IRC at
the same time (e.g. “party in interest” under ERISA and
“disqualified person” under the IRC)
28. Executive Order: Reorganization Plan No. 4 of
1978, Section 102, located at http://www.dol.gov/ebsa/
regs/exec_order_no4.html.
29. The taxable period for imposition of the 100%
excise tax is defined in IRC 4975(f)(2) as beginning on
the date the prohibited transaction occurs and ending on
the earliest of the date the prohibited transaction is corrected, the date the excise tax is assessed, or the date of
mailing of notice of deficiency.
30. 29 USC 1106(a)(1)(E).
31. 29 USC 1108(e).
32. DOL Advisory Opinion No. 2006-01A (Jan.
6, 2006), located at http://www.dol.gov/ebsa/regs/aos/
ao2006-01a.html, citing 29 CFR 2509-75-2(c); DOL
Advisory Opinion No. 75-103 (Oct. 22, 1975); 1978
WL 170764 (June 13, 1978).
33. Dugas, Entrepreneurs turn to 401(k)s to fund
start-up businesses, USA Today, February 19, 2010.
USING RETIREMENT PLAN ASSETS TO FUND A START-UP COMPANY
Adam Zuwerink is an associate with Parmenter O’Toole
in Muskegon practicing in the
areas of business and real
estate transactions, with
an emphasis on employee
benefits and retirement plan
design. He is a member of the Business
and Real Estate Sections of the State Bar,
and a member of the Young Lawyers Section Executive Council.
39
Protecting Competitive Business
Interests Through Non-Compete
Clauses: What Interests Can
Legitimately Be Protected?
By Ryan S. Bewersdorf and Nicolas J. Ellis
Introduction
Today more than ever before, employment
agreements tend to contain some form of
non-competition provisions. For higher-level
executive employees, such provisions are virtually ubiquitous. These provisions are also
creeping into medical profession employment agreements. As the economy improves
and hiring increases, more employees will be
able to change jobs. As that happens, a new
wave of non-compete litigation likely will
result. Thus, employers should assess their
current non-compete agreements, and when
hiring employees, carefully draft new noncompete agreements to make sure they can
withstand judicial scrutiny in the event litigation occurs. Any employer seeking to include
a non-compete in its employment agreements
would be well advised to consider the rules
that govern enforcement of such provisions.
In Michigan, the enforceability of a non-compete agreement between an employer and
employee is governed by statute.1 In addition
to codifying the traditional rule that such
agreements must be reasonable, the statute
also requires that the agreement must protect “the reasonable competitive business
interests” of the employer. This article will
address the way courts have interpreted this
requirement, and the kind of interests that
fall within its scope.
A Brief History Of Non-Compete
Agreements Under Michigan Law
40
Michigan initially followed the general common law rule that non-compete agreements
were enforceable as long as they were reasonable.2 However, between 1905 and 1985,
non-compete agreements were prohibited
by statute as an illegal restraint of trade.3 In
1985, the Michigan Anti-Trust Reform Act
(“MARA”) repealed the statutory provision that specifically prohibited non-compete agreements.4 After this repeal, the gen-
eral antitrust provisions of the MARA were
interpreted as prohibiting only those agreements that were unreasonable restraints on
trade, essentially returning to the traditional
common law rule.5 In 1987, the legislature
amended the MARA such that it specifically
permits the use of non-compete agreements
between an employer and employee under
certain conditions.6
MARA’s Noncompetition Provision
Today, non-compete agreements between
an employer and employee are governed by
MCL 445.774a(1), codifying the 1987 amendment to the MARA. This statutory provision
provides that:
An employer may obtain from an
employee an agreement or covenant
which protects an employer’s reasonable competitive business interests and
expressly prohibits an employee
from engaging in employment or a
line of business after termination if
the agreement or covenant is reasonable as to its duration, geographical
area, and the type of employment or
line of business. To the extent any
such agreement or covenant is found
to be unreasonable in any respect,
a court may limit the agreement to
render it reasonable in light of the
circumstances in which it was made
and specifically enforce the agreement as limited (emphasis added).
The statute imposes two requirements for
a non-compete to be enforceable.7 The latter
part of the statute incorporates the traditional common law model based on determining
the reasonableness of the non-compete with
respect to its geographic scope, duration,
and the scope of employment that is covered.8 However, the first part of the statute
further restricts the enforceability of noncompete agreements to those that protect an
PROTECTING COMPETITIVE BUSINESS INTERESTS THROUGH NON-COMPETE CLAUSES
employer’s “reasonable competitive business
interests.”9
But what is a reasonable competitive business interest? While the Michigan Supreme
Court has not provided an extensive definition for this term, a fairly comprehensive picture can be drawn by analyzing other decisions made by the lower Michigan courts.
Interpretation of “Reasonable
Competitive Business Interests”
By the Courts
The best way to understand how courts have
interpreted the term “reasonable competitive
business interest” is to begin with what it
does not cover. Contrary to what many people might expect, the term does not include
merely protecting the employer from general
competition.10 Courts have consistently held
that employers do not have an interest in preventing employees from competing through
the use of general knowledge, skill, or facility
acquired by the employee through training
or experience during employment.11
To protect a reasonable competitive business interest, a non-compete agreement must
protect against the employee (or presumably
a competitor through hiring the employee)
gaining an unfair advantage in competing with
the former employer.12 The term “unfair” is
itself somewhat subjective and ambiguous.
To date, courts have either recognized, or
spoken of, three different categories where
employers have an interest in protecting
themselves from unfair competition:
• preventing employees from taking
existing customers,13
• preventing an employee from using
confidential information,14 and
• protecting an employer’s investment in
specialized training.15
Existing Customers
The courts’ unfair competition concern with
regard to taking existing customers is that
the employee has generally developed a relationship with the customer through his or her
position as an employee. Often, an employer
has invested its resources in developing, or
helping the employee develop, the relationship.16 Courts speak of this as preventing the
employee from appropriating the “goodwill”
that the employer has built.17 In St Clair Med v
Borgiel, the court addressed the enforceability
of a non-compete agreement between a physician and his former employer.18 The court
determined that the non-compete agreement
protected the employer’s reasonable competitive business interest because a physician who establishes patient contacts and
relationships as a result of the goodwill of an
employer’s medical practice is in a position to
unfairly appropriate that goodwill, and thus
unfairly compete with a former employer on
departure.19 Enforcement of the non-compete
agreement provides the employer with time
to regain the goodwill of its patients and
prevents former employees from using contacts gained during employment to gain an
unfair advantage in competition.20 Similarly,
in Radio One, Inc v Wooten, the court considered a non-compete agreement between a
radio personality and his former employer
radio station.21 The court made an analogy to
the St Clair Med case, and noted that, despite
the defendant’s pre-existing fame, the radio
station had built listener goodwill through
its efforts and expenditures to promote the
defendant, and it was entitled to a period of
time to promote a new radio personality to
try to retain its listeners and sponsors.22
Confidential Information
Courts consider confidential business information to cover a range of topics related
to the running of a business. In particular,
courts have stated that employers have an
interest in protecting such confidential information as pricing schemes, price markups,
marketing strategies, and sales strategies or
techniques.23 They also have recognized an
interest in protecting patient or customer
lists.24 However, the confidential information
in question must actually provide a competitive advantage. Between 2007 and 2008,
federal courts addressed the same identical
non-compete clause between Kelly Services,
Inc. and three different former employees.
The court upheld the clause against two
higher level employees who accepted similar positions with competitors.25 However
with regard to a lower level employee, then
performing clerical work for a competitor,
the court held that the clause did not protect
the employer’s reasonable business interests
because the information the former employee
had access to was of no use, and provided no
competitive advantage, in her new role.26
Specialized Training
The last area where courts have acknowledged a reasonable competitive business
interest on the part of employers, protecting an investment in specialized training,
remains poorly defined. Courts have con-
41
Courts have
consistently
held that
employers
do not have
an interest
in preventing
employees
from
competing
through the
use of general
knowledge,
skill,
or facility
acquired
by the
employee
through
training or
experience
during
employment.
42
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
sistently stated that preventing an employee
from competing through the use of general
training is not a reasonable competitive business interest.27 This is true even where the onthe-job training has been extensive and costly.28 They have, however, indicated that this
may not be the case where specialized training
is involved.29 Unfortunately, there have not
yet been any decisions under Michigan law
that address the difference between general
and specialized training. Thus, this factor of
the “reasonable competitive business interests” test remains unsettled.
Conclusion
When drafting a new non-compete agreement
or assessing a current one, an employer must
consider not only the reasonableness of the
restrictions it is imposing, but exactly what
interest it is seeking to protect. The interests
that are involved will usually depend on the
facts of the situation, and to some degree
will depend on the yet unknown capacity
in which the employee will seek to compete.
While courts have recognized a reasonable
competitive business interest in: (1) protecting existing customers, (2) confidential
information; and (3) specialized training, no
Michigan court has clearly addressed what
constitutes specialized training. Therefore,
focusing on the two interests of protecting
existing customers and confidential information will usually be the most straightforward
way for an employer to satisfy the reasonable competitive business interest test under
Michigan law. Employers should consider
setting out the specific competitive business
interests it is trying to protect within the noncompete agreement itself. While this is especially important where the agreement will be
applied to lower level employees for whom
an employer’s interest may not be as readily
apparent, it should also be done for upper
level employees. The potential harm resulting
from an upper level employee turning into a
competitor is often much greater than where
a lower level employee is involved. It may be
easier to show a reasonable competitive business interest where upper level employees
are concerned, but setting out these interests
ahead of time for all non-compete agreements
can save on discovery and other litigation
expenses later. Above all, in order to satisfy
the reasonable competitive business interest
test, employers should always be prepared
to show an interest beyond merely insulating
themselves from general competition.
NOTES
1. In contrast, non-compete agreements in most
other situations, such as the purchase of a business, are
governed solely by common law principles, however
similar these may be. See Bristol Window & Door, Inc v
Hoogenstyn, 250 Mich App 478, 495, 650 NW2d 670
(2002).
2. Bristol Window & Door, 250 Mich App at 489.
3. Former MCL 445.761.
4. Bristol Window & Door, 250 Mich App at 49293.
5. Compton v Joseph Lepak DDS, PC, 154 Mich App
360, 366, 397 NW2d 311 (1986).
6. MCL 445.774(a)(1).
7. Kelly Servs v Eidnes, 530 F Supp 2d 940, 950 (ED
Mich 2008).
8. MCL 445.774(a)(1).
9. Id.
10. St Clair Med, PC v Borgiel, 270 Mich App 260,
266, 715 NW2d 914 (2006) (citing United Rentals
(North America), Inc v Keizer, 202 F Supp 2d 727, 740
(WD Mich 2002)).
11. St Clair Med, 270 Mich App at 266; Kelsy-Hayes
Co v Maleki, 765 F Supp 402, 406-07 (ED Mich 1991),
vacated pursuant to settlement 889 F Supp 1583.
12. St Clair Med, 270 Mich App at 266 (citing
Follmer, Rudzewicz & Co, PC v Kosco, 420 Mich 394,
402 n 4, 362 NW2d 676 (1984)).
13. St Clair Med, 270 Mich App at 266; Radio One,
Inc v Wooten, 452 F Supp 2d 754, 758-59 (ED Mich
2006); Edwards Publns, Inc v Kasdorf, No 281499,
2009 Mich App LEXIS 109, *10-13 (Jan 20, 2009)
see also Neocare Health Sys, Inc v Teodoro, No 255558,
2006 Mich App LEXIS 240, *6 (Jan 26, 2006) (assessing whether period of five years reasonably protected
“plaintiff’s legitimate business interest in protecting its
patient base.”).
14. Rooyakker & Sitz, PLLC v Plante & Moran,
PLLC, 276 Mich App 146,158, 742 NW2d 409 (Mich
App 2007); St Clair Med, 270 Mich App at 266-67;
Eidnes, 530 F Supp 2d at 950; Whirlpool Corp, v Burns,
457 F Supp 2d 806, 812 (WD Mich 2006).
15. St Clair Med, 270 Mich App at 266.
16. Radio One, 452 F Supp 2d at 758-59.
17. St Clair Med, 270 Mich App at 268.
18. Id. at 262-63.
19. St Clair Med, 270 Mich App at 268 (citing
Weber v Tillman, 259 Kan 457, 467-469, 913 P2d 84
(1996); Berg, Judicial Enforcement of Covenants not to
Compete Between Physicians: Protecting Doctors’ Interests
at Patients’ Expense, 45 Rutgers LR 1, 17-18 (1992)).
20. St Clair Med, 270 Mich App at 268.
21. Radio One, 452 F Supp 2d at 756.
22. Id. at 759.
23. Eidnes, 530 F Supp 2d at 950; Kelly Servs, Inc v
Noretto, 495 F Supp 2d 645, 657 (ED Mich 2007).
24. St Clair Med, 270 Mich App at 266-677; Godlan, Inc v Greg Whiteford & DCL, Inc, No 227696, 2003
Mich App LEXIS 610 (Mar 11, 2003).
25. Eidnes, 530 F Supp 2d 940; Noretto, 495 F Supp
2d 645.
26. Kelly Servs v Green 535 F Supp 2d 180, 185-86.
27. St Clair Med, 270 Mich App at 266; Kelsy-Hayes
Co, 765 F Supp at 406-07.
28. Follmer, Rudzewicz & Co, PC v Kosco, 420 Mich
394, 402 n 4, 362 NW2d 676.
29. St Clair Med, 270 Mich App at 266-67.
PROTECTING COMPETITIVE BUSINESS INTERESTS THROUGH NON-COMPETE CLAUSES
Ryan S. Bewersdorf is an
attorney in the Detroit office
of Foley & Lardner LLP. He is
a member of the firm’s Business Litigation, Bankruptcy
& Business Reorganizations,
and Intellectual Property
Litigation practice groups. Mr. Bewersdorf holds degrees from the University of
Michigan Law School (J.D., 2003) and the
University of Michigan-Dearborn (M.B.A.,
2000, and B.S.E. in mechanical engineering, 1997).
Nicolas J. Ellis is an attorney
in the Detroit office of Foley
& Lardner LLP. He is a member of the firm’s Business
Litigation practice group. Mr.
Ellis holds degrees from the
University of Michigan Law
School (J.D., 2009) and Michigan State
University (2006).
43
Social Networking: Your Business
Clients and Their Employees Are
Doing It…Are You Advising Your
Clients on How to Manage the Legal
Risks?
By P. Haans Mulder and Nicholas R. Dekker
Introduction
44
Social networking sites such as Facebook,
LinkedIn, and Twitter have experienced phenomenal growth in recent years. Between
2005 and 2008, the number of adult Internet
users who have a social networking profile
quadrupled from 8 percent to 35 percent.1
Since 2009, that number has increased to
approximately 50 percent of Americans.2 The
frequency of use has also grown dramatically.
The minutes spent on social networking sites
has increased by 210 percent over the last
year, and the average time spent increased
143 percent during that same time period.3
Of these sites, Facebook, LinkedIn, and
Twitter have seen significant growth.4 As of
February 9, 2010, Facebook had 400 million
registered users.5 The average time spent by
U.S. users on Facebook increased by 368 percent between December of 2008 and one year
later.6 Also, as of February 9, 2010, the business and professional social networking site,
LinkedIn, had 60 million users.7 One of the
more recent, but fastest growing social networking sites, Twitter, had 6 million unique
monthly visitors and 55 million monthly visits as of that same date earlier this year.8 Between 2008 and 2009, the number of users on
Twitter increased 579 percent from 2.7 million to 18.1 million.9
In addition to the rapid increase in individuals’ use of social networking sites, businesses have also become early adopters. The
percentage of small businesses that use social
networking sites doubled from 12 percent to
24 percent from 2008 to 2009.10 According to
a recent survey, 45 percent of small companies with fewer than 100 employees now use
Facebook and Twitter to promote their businesses.11 Another study found that about 9
percent mid-market companies use Twitter
to market their business and that 32 percent
indicate they plan to include social media in
their marketing mix in the next 12 months by
including a page on a site such as Facebook,
LinkedIn, or MySpace.12
Besides marketing to customers, businesses have been using social networking
sites for other purposes. Eighty percent of
companies were planning to use social network sites to find or attract candidates.13 In
addition, 45 percent of employers use social
networking sites to screen job candidates.14
What are Social Networking Web
Sites?
The term social networking invariably evokes
names like Facebook, Twitter, and LinkedIn.15
In legal scholarship, social networking sites
have been defined as web-based systems that
allow persons to perform three functions: (1)
build a public or semi-public profile within
a system, (2) construct a list of other users
with whom they share a connection, and (3)
view their list of connections and others that
are within the system.16 These sites allow for
the development of three different types of
social interactions.17 The first is the development of identity through profiles. A profile
is a description of the user and their characteristics, and the characteristics depend
on the nature of the Web sites. For example,
LinkedIn is oriented to business use, so the
characteristics include such items as current
employment, past employment history, and
recommendations. Sites that are focused on
social use (such as Facebook) include information like gender, birthday, hometowns,
and religious as well as political views. The
second criterion of social networking sites is
the development of relationships among people using these sites (which can be called connections, friends, followers, etc.). The third
and last attribute of these sites is the empha-
SOCIAL NETWORKING: YOUR BUSINESS CLIENTS AND THEIR EMPLOYEES ARE DOING IT
sis of community among the people who are
using the sites. These sites allow users to post
a variety of information, which can include
photographs, journal entries, personal interests, and other personal information.18
Why is Social Networking
Important to Businesses and How
are the Early Adopters Using It?
These sites have allowed businesses to market and communicate with their customers in
a variety of innovative ways.19 For example, a
Los Angeles-based manufacturer and retailer of clothing and gear for skiers and snowboarders developed a Facebook fan page and
its e-commerce went from $0 to $25,000 in
three months.20 The owner of a Milwaukee
restaurant indicated that its sales were up
25 percent after his first year of using social
networking sites.21 H&R Block has created
a Facebook fan page to aggregate its social
media activities and in doing so engage its
customers and offer tax advice as well as
resources.22 The online shoe retailer, Zappos,
uses Twitter for employees to communicate
with its customers about their passion for
footwear.23
In addition to the marketing and communications, a number of businesses use social
networking sites for employment or human
relations functions. Thirty-five percent of
employers decided not to offer a job based
on information that was included on a social
networking site.24 More than 50 percent of
employers attributed the decision not to extend a job offer based on provocative photos,
while 44 percent identified candidates’ references to the use of drugs and alcohol.25
A more notorious example of using social
networking sites for human relations functions includes the City of Bozeman, Montana.
It attempted to require all of its job applicants
to disclose their user name and password so
that the human relations department could
access their social networking sites for background checks.26 Due to the national media
attention, the City of Bozeman discarded this
requirement.
Employers are also monitoring employees’ use of social networking sites.27 This is
understandable considering a study found
that 74 percent of employed Americans surveyed believe it is easy to damage a company’s reputation via social networking sites.28
Some of the results of monitoring and discovering objectionable activity have become
publicly known. For example, in May 2007,
the Olive Garden discharged a supervisor after she posted photos on MySpace of herself,
her under-age daughter, and other restaurant employees hoisting empty beer bottles.29
Virgin Atlantic Airlines also discharged 17
flight attendants as a result of their Facebook
posting in which they criticized the airline’s
safety standards and insulted airline employees.30 The Philadelphia Eagles fired an employee when he posted on Facebook that his
employer was “retarded” for allowing a rival
franchise to acquire one of its star players.31
What Legal Issues May Arise in
the Workplace with the Use of
Social Networking Sites?
There are no federal or state laws that prohibit businesses and employers from using
social networking sites for various human
relations functions regarding employees and
job applicants. Further, employment law in
Michigan is premised on an employees’ “at
will status.”32 In other words, the termination
of an employee could be any reason or no reason at all, and even an arbitrary or capricious
discharge is not actionable.33 Despite the general freedom to contract in the employment
law context and the lack of specific regulation of employer’s use of social networking
sites, there are a number of statutes or common law theories that pose legal risks for
employer’s or their employee’s use of social
networking sites.
The first set of statutes relates to employment discrimination.34 More notably at the
federal level, this includes Title VII and the
Americans with Disabilities Act, which protect against discrimination related to various “status” categories. This could also implicate Michigan’s equivalent state law, the
Elliot-Larsen Civil Rights Act.35 Information
that relates to these protected class categories (such as race, gender, religion, etc.) are
found on many social networking sites and
may easily become known to employers.36
Using this information to make employment
decisions (whether that is hiring, firing, promoting, etc.) could result in liability under
these statues. Further, failing to discipline
other employees could result in a disparate
treatment claim. For example, Delta Airlines
dismissed a female flight attendant after
discovering “inappropriate” photographs
in her Delta uniform that were posted on a
blog. The flight attendant sued Delta alleging
among other claims sex discrimination because it purportedly failed to discipline male
There are
no federal or
state laws
that prohibit
businesses
and
employers
from using
social
networking
sites for
various
human
relations
functions
regarding
employees
and job
applicants.
45
46
There are a
number of
issues
that an
employer can
proactively
address
in their
employee
handbook
regarding
social media
policy.
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
employees who maintained blogs containing similar content.37 These issues could also
arise on a retaliatory basis when an employee
has complained about the workplace.
Another category of liability is for protection that extends to non-work related conduct. Certain states such as New York have
statutes that prohibit discrimination based
on legal recreational activities. Michigan does
not have this statutory protection. For this
reason, companies that are only operating in
Michigan should have much more discretion
under common law to regulate the lifestyles
and off-duty conduct of employees.38 As an
example, a Michigan court held that even if
an employer had minimal or no factual basis
for its decision to exclude employees from
employment based on their associations, it
would not be a public policy exception to
the at-will employment rule.39 Similarly, the
Sixth Circuit Court applying Michigan law
has upheld a number of decisions that atwill private sector employers can dismiss an
employee for certain types of relationships
and conduct that is not approved by the employer.40
A third area of concern relates to potential violations of the National Labor Relations Act. If an employer takes any action
to restrain an employee’s effort to organize
other employees related to a labor dispute,
this could constitute an unfair labor practice.
Due to the low cost and effectiveness of social networking sites, it is likely a medium
that unions either currently or will use to organize. Employers should be mindful of not
interfering in this process.
One of the most significant areas of concern is the right of privacy.41 There are four
commonly recognized varieties of invasion
of privacy in Michigan. The two that are pertinent to employment law and these issues
are: (1) intrusion on the employee’s seclusion or solitude into its private affairs, and
(2) public disclosure of embarrassing private
facts about the employee.42 This was also one
of the claims that was asserted and adjudicated in federal district court in New Jersey.43
The plaintiffs were employees of a restaurant
group. They created a group on MySpace
and posted comments “venting” about their
employer. The group was entirely private
and “could only be joined by invitation.” A
manager of one of the restaurant group’s locations asked one of the plaintiffs to provide
a password to access the site. The plaintiff
was never explicitly threatened with adverse
employment action, but she stated that she
gave her password to management because
she believed she would have “gotten in some
sort of trouble” if she did not. The group of
employees filed suit alleging, among other
claims, invasion of privacy. In analyzing the
claim, the court stated that privacy interests
must be balanced against an employer’s interest in managing the business. In applying these principles, the court indicated the
plaintiffs had created an invitation only Internet discussion space and that they had an
expectation that only invited users would be
entitled to read the discussion. On this basis,
the court held that there was an issue of material fact as to whether one of the employees
had voluntarily provided authorization to
access the Web site. If this case provides any
precedent for courts in other jurisdictions,
employers could be exposed to liability if
they take strong-arm action in accessing employees’ profiles on social networking sites.
The federal Computer Fraud and Abuse
Act may also be at issue for employers.44 This
statute makes it illegal to “intentionally access without authorization a facility through
which an electronic communication service is
provided” or intentionally exceed authorized
use of information.45 This type of activity can
result in both criminal and civil liability, as
seen in Pietrylo.46 In Pietrylo, the court focused
on what is “conduct authorized” under the
statute. Based on a dispute in facts, the court
concluded that summary judgment should
be denied and the lower court needed to determine whether authorization was in fact
freely given.
The last area that this could arise is defamation. Although no cases currently discuss
this theory, it could conceivably arise in a
context in which information that is ultimately incorrect is learned on a social networking site and then it becomes disseminated to
other employees and even outside the organization. To the extent this fits within the elements of defamation, it could also expose an
employer to liability.
All of these issues underscore the liability
exposure of an employer’s use of social networking sites and highlight the importance
of having a clear and consistent policy regarding its use of social networking sites.
SOCIAL NETWORKING: YOUR BUSINESS CLIENTS AND THEIR EMPLOYEES ARE DOING IT
What Considerations Should
Employers Address in Their
Employee Handbooks?
There are a number of issues that an employer can proactively address in their employee
handbook regarding social media policy.47
The first is to require employees to be clear
that their opinions are not the views of the
company and to make this evident within
the posting of information. More generally,
a policy should require that employees exercise good judgment in communications that
relate directly or indirectly to the company.
To eliminate any invasion of privacy claim,
the policy should be clear that employees
do not have any expectation of privacy in
their use of the Internet. Employees should
also be notified that conduct in violation of
the policy could result in discipline including, termination based on conduct that is
defamatory, obscene, libelous, or disloyal to
the company. Further, the policy should also
make clear that the sharing of confidential,
proprietary, or private information is prohibited and that any trademarks or service
marks cannot be used without permission
of the company. In addition, there should be
an outright prohibition on selling or promoting of product or services that compete with
the company. Finally, not to stifle the use of
social networking sites for valid purposes,
employees should be encouraged to consult
with the human relations department to deal
with any issues proactively.
Conclusion
It is undeniable that the use of social networking sites has exploded in recent years.
Businesses are adopting and seeing the value
in using these sites. This use has been extended to employment issues. While this information can be very valuable to employers
(in terms of making employment decisions),
there are a number issues that employers
should be advised on to minimize the likelihood of a claim by an applicant who has
not been hired or an employee who has been
disciplined or terminated based on information that was made available through social
networking sites.
NOTES
1. Pew Internet & American Life Project, Adults and
Social Network Websites, http://www.pewinternet.org/
Reports/2009/Adults-and-Social-Network-Websites.aspx
(January 14, 2009).
2. Study Says Almost Half of Americans Use Social
Networks, http://hothardware.com/News/Study-SaysAlmost-Half-Of-Americans-Use-Social-Networks/
(April 9, 2010). See also Social Media Becomes Part of
Mainstream Media Behavior, http://rismedia.com/201004-11/social-media-becomes-part-of-mainstream-mediabehavior/ (April 11, 2010).
3. Led by Facebook, Twitter, Global Time Spent on
Social Media Sites up 82% Year over Year, http://blog.
nielsen.com/nielsenwire/global/led-by-facebook-twitterglobal-time-spent-on-social-media-sites-up-82-year-overyear/ (January 22, 2010).
4. There are many more social networking sites.
Wikipedia maintains a list of the more notable sites at
http://en.wikipedia.org/wiki/List_of_social_networking_websites
5. How Over 400 Million People Use Facebook,
http://www.webpronews.com/topnews/2010/02/09/
how-over-400-million-people-use-facebook (February 9,
2010).
6. Led by Facebook, Twitter, Global Time Spent on
Social Media Sites up 82% Year over Year, http://blog.
nielsen.com/nielsenwire/global/led-by-facebook-twitterglobal-time-spent-on-social-media-sites-up-82-year-overyear/ (January 22, 2010).
7. http://en.wikipedia.org/wiki/LinkedIn.
8. http://en.wikipedia.org/wiki/Twitter.
9. Report: Time Spent On Social Media Sites
Increased By 82% Year Over Year, http://www.socialtimes.com/2010/02/report-time-spent-on-social-mediasites-increased-by-82-year-over-year/ (February 23,
2010).
10. More Small Businesses Using Social Media to
Attract New Customers, http://www.inc.com/news/
articles/2010/03/small-business-use-of-social-mediadoubles.html# (March 19, 2010).
11. Small Businesses Use Facebook, Twitter
for Promotion, http://www.eweek.com/prestitial.
php?type=rest&url=http%3A%2F%2Fwww.eweek.
com%2Fc%2Fa%2FWeb-Services-Web-20-andSOA%2FSmall-Businesses-Use-Facebook-Twitter-ForPromotion-634033%2F&ref=http%3A%2F%2Fwww.
google.com%2Fsearch%3Fq%3Dsmall%2Bbusinesses
%2Buse%2Bfacebook%252C%2Btwitter%2Bfor%2B
promotion%2B-%2Bweb%2Bservices%2Bweb%2B20
%2Band%2Bsoa%2Bfrom%2Beweek%26rls%3Dcom.
microsoft%3Aen-us%3AIE-SearchBox%26ie%3DUTF8%26oe%3DUTF-8%26sourceid%3Die7%26rlz%3D1
I7GGLL_en (October 20, 2009).
12. Businesses Increasingly Using Social Networking,
Study Finds, http://www.eweek.com/c/a/Midmarket/
Businesses-Increasingly-Using-Social-Networking-StudyFinds-285771/ (October 22, 2009).
13. Survey shows influx of companies using social
networks for recruiting, http://blogs.zdnet.com/feeds/
?p=1197.
14. Nearly Half of Employers Use Social Networking Sites to Screen Job Candidates, http://thehiringsite.
careerbuilder.com/2009/08/20/nearly-half-of-employers-use-social-networking-sites-to-screen-job-candidates/
(August 20, 2009).
15. An article in the Journal of Computer-Mediated
Communication includes a very insightful history of the
sites. Boyd, D.M. & Ellison, N.D., Social Network Sites:
Definition, History, and Scholarship Journal of ComputerMediated Communication, 13 CU, article II (2007). Id.
16. See Id. Another description of social networking
site is available at http://en.wikipedia.org/wiki/social_
network_service.
17. Grimmelmann, James, Saving Facebook, 94 Iowa
L Rev 1137 (2009).
47
[N]ot to
stifle the
use of social
networking
sites for valid
purposes,
employees
should be
encouraged to
consult with
the human
relations
department
to deal with
any issues
proactively.
48
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
18. Burnside, Ian, Six Clicks of Separation: The Legal
Ramifications of Employers Using Social Networking Sites
to Research Applicant, 10 Vand J Ent & Tech L 445
(2008).
19. 35+ Examples of Corporate Social Media and
Action, http://mashable.com/2008/07/23/corporatesocial-media/. See also How Small Businesses Are
Using Social Media for Real Results, http://mashable.
com/2010/03/22/.
20. How to Use Social Networking Sites to Drive Business, http://www.inc.com/guides/using-social-networking-sites.html (January 25, 2010).
21. How Small Businesses Are Using Social Media for
Real Results, http://mashable.com/2010/03/22/smallbusiness-social-media-results/ (March 22, 2010).
22. See Id.
23. See Id.
24. Sharon Nelson, John Simek & Jason Foltin, The
Legal Implications of Social Networking, 22 Regent U L
Rev 1 (2009-10).
25. See Id.
26. Klein, Jeffrey S. and Pappas, Nicholas J., Legal
Issues Arising Out of Employees’ Use of Social Network Web
Sites, 10/5/2009 NYLJ 3 (2009).
27. In fact, a company recently released a product that automates the monitoring of employees’ use
of social networking sites. Service monitors workers’
social network use, http://www.networkworld.com/
news/2010/032610-service-monitors-workers-social-network.html (March 26, 2010).
28. 2009 Deloitte LLP Ethics & Workplace Survey,
Social networking and reputational risk in the workplace, http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/us_2009_ethics_workplace_survey_220509.pdf.
29. Don Aucoin, MySpace Versus Workplace, Boston
Globe, May 29, 2007, at D1.
30. Crew Sacked Over Facebook Post, BBC News,
http://news.bbc.co.uk/2/hi/uk_news/7703129.stm
(October 31, 2008).
31. Eagles Employee Fired For Facebook Post,
New York Times, http://fifth-down.blogs.nytimes.
com/2009/03-10-eagles-employee-fired-for-facebookpost (March 10, 2009).
32. It is well established that employment contracts
for an indefinite duration are presumptively terminable
at the will of either party. Lytle v Malady, 458 Mich 153,
579 NW2d 906 (1998).
33. Lynas v Maxwell Farms, 279 Mich 684, 273 NW
315 (1937); Bracco v Michigan Tech Univ, 231 Mich App
578, 588 NW2d 467 (1998); Schipani v Ford Motor Co,
102 Mich App 606, 302 NW2d 307 (1981).
34. This could include: Title VII of the Civil Rights
Act of 1964, 42 USC 2000e et seq.; the Elliot-Larsen
Civil Rights Act, MCL 37.2101 et seq.; the Age Discrimination in Employment Act of 1967, 29 USC 621
et seq.; the Pregnancy Discrimination Act, 42 USC
2000e(k); and the Civil Rights Act of 1991, 42 USC
1981.
35. MCL 37.2101 et seq.
36. 42 USC 2000e et seq.
37. Simonetti v Delta Airline, Inc, Case No. 1:05CV-2321, Complaint filed (ND Ga September 7, 2005);
Legal Issues Arising Out of Employees’ Use of Social Network Websites (2009).
38. Employment Law in Michigan An Employer’s
Guide, ICLE (2005).
39. Prysak v RL Polk Co, 193 Mich App 1, 483
NW2d 629 (1992).
40. Flaskamp v Dearborn Pub Schs, 385 F3d 935
(6th Cir 2004) (teacher denied tenure base on outof-classroom conduct with former student; Marcum v
McWhorter, 308 F3d 635 (6th Cir 2002). (dismissal of
public sheriff because his relationship and cohabitation
with a married woman did not infringe on his right of
association and is guaranteed by the First and Fourteen
Amendments); Beecham v Henderson County, 422 F3d
372, 378 (6th Cir 2005) (deputy county clerk was property terminated since court officials could decide if it was
“unacceptably disruptive to the workplace for woman
employee in an office of one of the county’s courts to be
openly and deeply involved with a romantic relationship with man still married to a woman employed in the
other county court down the all).
41. On June 17, 2010, the U.S. Supreme Court
rejected a police officer’s claim that the city audit of his
personal text messages was an illegal search under the
Fourth Amendment. City of Ontario v Quon, __ US __,
130 S Ct 2619 (2010). While certain aspects of the legal
analysis may apply, it is difficult to ascertain what significance this decision will have to state common law invasion of privacy cases because it only addressed a violation
of the Fourth Amendment.
42. Lansing Ass’n of Sch Adm’rs v Lansing Sch Dist,
216 Mich App 79, 549 NW2d 15 (1996), affirmed in
part and reversed in part on other grounds Bradley v Saranac Bd of Educ, 455 Mich 285, 565 NW2d 650 (1997).
43. Pietrylo v Hillstone Rest Group, No 06-5754
(FSH), 2009 US Dist LEXIS 88702 (Sept 25, 2009).
44. 18 USC 2701 et seq.
45. 18 USC 2701.
46. Pietrylo v Hillstone Rest Group, No 06-5754
(FSH), 2009 US Dist LEXIS 88702 (Sept 25, 2009).
47. As mentioned previously, In addition to the legal
risks that have been addressed, it is important to note
that a study has shown that there is significant reputational risk with employees’ use of social networking sites.
2009 Deloitte LLP Ethics & Workplace Survey, Social
networking and reputational risk in the workplace,
http://www.deloitte.com/assets/Dcom-UnitedStates/
Local%20Assets/Documents/us_2009_ethics_workplace_survey_220509.pdf.
P. Haans Mulder is a shareholder with Cunningham
Dalman PC in Holland,
Michigan. His practice areas
include business law and
estate planning.
Nicholas R. Dekker is an
associate with Cunningham Dalman PC in Holland,
Michigan. His practice areas
include business and corporate law, construction law,
environmental law, probate law, real estate law, and wills and
trusts.
Secondary Liability and “Selling
Away” in Securities Cases
By Raymond W. Henney and Andrew J. Lievense
Introduction
Based on media accounts, there appears to be
an increase in the number of Ponzi schemes
and other fraudulent investments. The rise of
these nefarious ventures may be explained,
in part, by an investment public that is weary
of the volatility of traditional markets and is
susceptible to projects promising safety, stability, and reliable investment return.
Generally, for a registered securities
brokerage firm to market investments for
purchase directly from the issuer, the firm
is obligated to conduct an investigation or
due diligence of the investment opportunities.1 Consequently, perpetrators of these
ruses typically seek to avoid this scrutiny
and do not sell their projects as approved
investments through brokerage firms. These
schemes instead are sold directly by the issuer to the investor and not through a market or
an exchange. On other occasions, these counterfeit schemes appear as corporations that
sell stock on the over-the-counter markets.
These stocks normally are priced extremely
low, are thinly traded, and are not approved
for solicited sale by brokerage firms.
Nonetheless, individual securities brokers
affiliated with a brokerage firm often will introduce their clients to such fraudulent investments even though the investment is not
through the brokerage firm with whom they
are associated. On those occasions, when the
investment is solicited and/or sold without
the approval of, and not through, a securities
brokerage firm, the investment commonly is
known as being “sold away.” Various securities industry rules prohibit brokers from
“selling away” regardless of whether the broker receives any compensation for the transaction.2 Moreover, brokerage firms virtually
always have their own policies that prohibit
“selling away” activities and procedures for
preventing the activity.
Brokerage firms, however, cannot simply
rely on these rules and internal procedures
to avoid potential liability in the event their
brokers violate the rules and “sell away.”
Brokerage firms can be liable for the “selling
away” actions of their brokers under certain
theories of secondary liability. Under Michigan law, when an investment is truly “sold
away” from the brokerage firm, the firm potentially can be held liable pursuant to claims
of vicarious liability, apparent authority, negligence couched as a failure to supervise, and
“control person” liability under the Michigan
Uniform Securities Act. Moreover, liability
may arise in more uncommon circumstances.
For example, a brokerage firm can be liable
for the broker’s conduct even after the broker leaves a firm. This article discusses each
of these theories and when, under Michigan
law, a brokerage firm can be liable for such
claims.3
Vicarious Liability and Apparent
Authority
The initial question in “selling away” cases
is the scope of the securities brokerage firm’s
liability for the actions of its broker under
theories of vicarious liability and apparent
authority. The brokerage firm, obviously,
cannot be vicariously liable unless its broker
is found to be primarily liable.4 The broker
probably cannot be found primarily liable
based solely on the fact that he or she violated industry rules or the brokerage firm’s
policies prohibiting selling away activities.5
Consequently, an investor seeking to hold a
brokerage firm liable must first establish that
the broker is liable under some actionable
claim, such as misrepresentation or malfeasance.6
Further, the brokerage firm may not be
vicariously liable for the selling away activities of its broker where the firm was unaware
of the activity, and the broker acted outside
the scope of his or her association with the
brokerage firm and for the broker’s own purpose. For example, in Smith v Merrill Lynch
Pierce Fenner & Smith,7 a customer brought a
claim under a theory of respondeat superior
against a brokerage firm for the employee
stockbroker’s failure to repay a personal
loan from the customer to the stockbroker.
The Michigan Court of Appeals held that
the brokerage firm was not liable as a matter of law where the stockbroker was “acting
49
50
While
Michigan
courts have
clearly set
forth the
requirements
to show
apparent
authority,
few Michigan
courts have
applied the
requirements
in the
securities
context.
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
to accomplish a purpose of his own” because
the firm “could not be held vicariously liable
for [the stockbroker’s] independent action.”8
Additionally, courts have recognized that vicarious liability is inappropriate where the
broker’s conduct violates industry rules and
the brokerage firm’s own policies.9 Logically,
in such circumstances, the broker could not
be deemed to be acting on behalf of the brokerage firm, so the brokerage firm could not
be vicariously liable.
Claimants frequently confuse vicarious
liability with apparent authority by arguing
that vicarious liability applies because the
broker was selling a security and the brokerage firm authorized the broker to sell securities. But in typical situations, the brokerage
firm did not actually authorize the broker to
sell the investment away from the firm, instead the broker was acting beyond the scope
of his or her authority, which negates a claim
of vicarious liability.10
Moreover, just because a brokerage firm
authorizes the broker to sell securities does
not mean the broker has the apparent authority to sell all securities, such as unapproved securities. “[A]pparent authority
must be traceable to the principal and cannot
be established by the acts and conduct of the
agent.”11 Consequently, courts must analyze
the surrounding facts and circumstances of
the sale to determine if liability for apparent
authority may exist.12 Those facts and circumstances include the supervision activities of
the brokerage firm and the objective reasonableness of the investor’s belief that the sale
was through and approved by the brokerage
firm.13 Thus, courts look to more than just the
relationship between the brokerage firm and
the broker when considering claims under
an “apparent authority” theory. Courts also
look to the details of the transaction between
the claimant and the broker.14
While Michigan courts have clearly set
forth the requirements to show apparent authority, few Michigan courts have applied
the requirements in the securities context. In
one such case, Carsten v North Bridge Holdings,
Inc,15 the investor did not know the broker
had left the brokerage firm. The court found
that the broker was not acting with the apparent authority of the brokerage firm in part
because the broker had left the firm, the broker was not authorized to sell unapproved
securities, and the investor did not rely on
the brokerage firm when she signed a blank
piece of paper authorizing any unexplained
transaction.
Similarly, in Kohn v Optik, a non-Michigan
case,16 the court made it clear that “where the
irregularity on the actions of the employee
provide notice to the third party that the
employee is acting outside the scope of the
employee’s employment, the employer is not
bound by the employee’s action as no apparent authority exits.”17 In dismissing the
investor’s agency law claim, the court noted
that:
it is uncontested that Plaintiff did
not open a regular account with [the
brokerage firm], that Plaintiff did not
send her checks to the brokerage, and
that Plaintiff never received a single
receipt, statement, or other communication bearing [the brokerage
firm’s] name. Thus, the irregularity
of the transaction at issue provided
notice to Plaintiff that [the registered
representative] was acting outside
the copy of his employment.18
In Harrison I, the court delineated additional factors important in analyzing a claim
under an apparent authority theory:
Here the undisputed facts show Harrison did not open an account with
Dean Witter but, instead, transferred
money to Kenning and Carpenter for
them to place in Carpenter’s employee account at Dean Witter for subsequent investment. In so doing, Harrison expected to enhance his return
by paying the lower commission
charged Dean Witter employees,
although he was not an employee
entitled to the benefit. It is clear neither Kenning nor Carpenter had the
authority, actual or apparent, to use
the account thusly; Dean Witter’s
rules expressly forbade it, as would
ordinary prudence.19
The Harrison I court concluded that no “reasonably prudent person” could conclude that
the employees had the authority because the
investment transactions “were not regular on
their face and could not appear to be within
the ordinary course of business.”20
Thus, a claimant asserting a claim against
a brokerage firm for vicarious liability and
apparent authority based on the actions of
a broker must allege more than simply that
there was an employment relationship between the brokerage firm and the broker. The
claimant must allege facts, and come forward
SECONDARY LIABILITY AND “SELLING AWAY” IN SECURITIES CASES
with evidence, that the brokerage firm was
aware of, was involved in, or benefited from
the transactions at issue.
Failure to Supervise and Control
Person Liability
Michigan courts recognize a claim against a
brokerage firm based on the firm’s supervision, or failure to supervise, a broker. The
claim is couched either as a negligence claim
for the failure to supervise21 or as a claim for
“control person” liability under the Michigan
Uniform Securities Act.22
Michigan courts recognize a failure to supervise claim arising from a duty to supervise
based on the special relationship between an
individual (such as an investor) and another
entity or person (such as a brokerage firm).23
This duty comes from the securities regulations, such as NASD Rule 3010(a), which provides that broker dealers “shall establish and
maintain a system to supervise the activities
of each registered representative, registered
principal, and other associated person that
is reasonably designed to achieve compliance
with applicable securities laws and regulations, and with applicable NASD Rules.”24
Thus, a failure to supervise claim coincidentally embodies a similar standard for supervision as the criterion set forth in the rules of
the securities regulators.
In analyzing the duty imposed on brokerage firms, the standard is reasonable, not
perfect, supervision. As stated by one regulatory body:
The standard of ‘reasonableness’ is
determined based upon the circumstances of each case…. The burden is
on the staff to show that respondent’s
procedures and conduct were not
reasonable….It is not enough to demonstrate that an individual is less than a
model supervisor or that the supervision
could have been better.25
From the regulators’ point of view, as well
as a court’s, a reasonableness standard is
desirable for at least two reasons. First, the
reasonableness standard provides flexibility
in evaluating different circumstances and
factual situations. Second, the required level
of supervision must consider the cost to
consumers for access to the capital markets.
Supervisory costs necessarily are reflected in
brokerage firms’ commissions and fees. Perfect or near perfect supervision will require
the expenditure of such significant resources
that it will result in a significant increase in
the cost to invest.
Also, under the Michigan Uniform Securities Act, a brokerage firm can be held liable
for the sale of unregistered securities by one
of its brokers, the sale of securities by a broker who is not properly registered, or for the
misrepresentation of its broker, if the brokerage firm is a “control person.”26 A brokerage
firm typically, but not always, is considered
a “control person” for a broker it licenses and
supervises as it typically “directly or indirectly controls” its brokers.27 The brokerage firm,
however, can avoid liability if it “sustains the
burden of proving that the controlling person
did not know, and in the exercise of reasonable care could not have known, of the existence of the conduct by reason of which the
liability is alleged to exist.”28 In the brokerage
firm context, the reasonable care or “good
faith” defense essentially concerns a brokerage firm’s “failure to supervise” a registered
representative, and thus overlapping with
the failure to supervise claim.29 Accordingly,
a brokerage firm generally is not liable for
the underlying violation if it establishes that
it maintained “a reasonable system of supervision, enforced that system with reasonable
diligence, and that the [brokerage firm] did
not directly or indirectly induce the violations by its [registered] representative.”30
Courts consider many factors to determine
whether the good faith defense bars “control
person” liability, such as: to whom and where
the investor sent checks, whether the investment procedures were typical, and whether
the investment procedures were part of the
broker’s efforts to circumvent compliance
efforts by the brokerage firm.31 Courts also
consider the rules and procedures in place to
prevent the underlying violation, the brokerage firm’s implementation of those rules, and
whether the brokerage firm had actual notice
or should have known of the underlying violation—meaning whether “red flags” were
present and investigated.32
Again, the decision in Kohn33 is instructive. In Kohn, the court ruled, as a matter of
law, that no “control person” liability existed
against the brokerage firm.34 In reaching that
conclusion, the Kohn court considered numerous factors, such as: whether the fraudulent
investments were even available through the
brokerage firm; whether the broker disclosed
his affiliation with the brokerage firm to the
investors; whether the brokerage firm authorized the broker to solicit for the investments;
51
Michigan
courts
recognize
a failure to
supervise
claim arising
from a duty
to supervise
based on
the special
relationship
between an
individual
(such as an
investor) and
another entity
or person
(such as a
brokerage
firm).
52
Beyond being
liable for
the actions
of a current
broker, some
courts have
recognized
that, under
certain
circumstances,
a brokerage
firm can be
liable for the
actions of a
former broker
even after
the broker
is no longer
associated
with the
brokerage firm.
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
where the investor sent investment checks;
whether the investor received receipts, account documents, account numbers, correspondence, confirmation slips, or monthly
statements from the brokerage firm; and
whether any documents even mentioned the
brokerage firm. The Kohn court concluded
that:
Plaintiff was not reasonably relying
on [the broker] as a [broker] of [the
brokerage firm], but was placing
her money with him for purposes
other than investment in markets to
which he had access only by reason
of his relationship with [the brokerage firm]; it is uncontested that [the
investment] was not traded on any
market to which [the broker] had
access solely because of his relationship with [the brokerage firm] and
that [the brokerage firm] did not
manage the purchase transaction.35
Thus, courts have ruled against claimants
asserting failure to supervise and control
person claims in “selling away” cases when
the broker controls the transaction and the
brokerage firm receives no benefits from the
transaction.36
It is evident from the above discussion
that whether a brokerage firm may be liable
as a “control person” and whether the “good
faith” defense applies is a fact-intensive inquiry. As a result, even in “selling away”
cases where a brokerage firm was completely mislead by its broker, it can be difficult
to convince a court to dismiss an investor’s
claim on the pleadings and some discovery
likely will be warranted.
Liability For Foreseeable Harm
After Termination
Beyond being liable for the actions of a current broker, some courts have recognized
that, under certain circumstances, a brokerage firm can be liable for the actions of a former broker even after the broker is no longer associated with the brokerage firm. For
example, imagine a situation where a brokerage firm discovers its broker is violating
the rules or is engaged in some other activity
that could potentially harm investors (such
as engaging in unreported outside business
activities or selling away) and then fails to
take steps to remedy the harm or to notify
other brokerage firms that may be looking to
hire the broker engaged in the wrongful conduct. In this circumstance, a brokerage firm
can be liable to another brokerage firm if it
stays silent even though it knows that there
is a reasonable possibility that the broker has
engaged in, and may continue to engage in,
the unlawful activity at a subsequent brokerage firm. While, no Michigan court has
addressed this issue directly, courts applying
statutes and regulations substantially similar
to those enacted in Michigan have done so,
and brokerage firms must be cautious not to
run afoul of these requirements.
The seminal case for imposing liability on
a brokerage firm for the conduct of a former
broker is Twiss v Kury.37 In Twiss, defendant
E.F. Hutton (“Hutton”) learned that its sales
representative, Kury, was involved with outside business activities in violation of securities laws and regulations. In response, Hutton requested and received Kury’s resignation. Hutton then filed with the regulators a
Form U-538 incorrectly stating that the termination was voluntary and failing to disclose
its investigation and the probable violations
committed by Kury. Kury remained in the
securities industry and, four years later, was
found to have sold interests in what turned
out to be a $2.4 million Ponzi scheme.
The plaintiffs in Twiss were all persons
who became Kury’s clients after his resignation from Hutton. The plaintiffs asserted negligence claims, alleging that Hutton breached
a duty to Kury’s then and future customers when it misrepresented the reasons for
Kury’s termination and failed to submit a
proper and accurate Form U-5 to the regulatory authorities. On appeal, the court found
that Florida law imposed a duty “to report
the fact of [Kury’s] termination to the [state
agency], to accurately state the reason for
such termination, and to specify any illegal
or unprofessional activity committed…then
known by Hutton. The rule required Hutton to make the report to the Department by
filing a form U-5.”39 Thus, Hutton was liable
to the plaintiffs even though they had never
been Hutton’s customers.
Like Florida, the NASD bylaws impose
the same duties to file and later correct Form
U-5 disclosures.40 In a Notice to Members issued in 1988, the NASD explained that one
purpose of the obligation to provide accurate information on the Form U-5 is that the
“[f]ailure to provide this information may []
subject members of the investing public to
repeated misconduct and may deprive member firms of the ability to make informed hiring decisions.”41 Subsequently, in 2004, the
SECONDARY LIABILITY AND “SELLING AWAY” IN SECURITIES CASES
NASD reinforced the importance of filing
timely and accurate Form U-5’s, and corrections when necessary, by increasing the
NASD’s enforcement options for the failure
to timely submit amendments to the U-5.42
The Twiss claim, however, is not an effort
to imply a cause of action under the Florida
securities act or the NASD/FINRA rules.
Rather, the reporting requirements of the
Florida act, as well as the NASD and FINRA
rules, inform the common law malfeasance
claim in defining the class of individuals to
whom the brokerage firm is liable for the
subsequent misconduct of its broker. For example, Twiss relied upon Palmer v Shearson
Lehman Hutton, Inc,43 where the court stated:
The violation of a duty created by
statute is recognized at common law
as satisfying the duty of care requirement in a negligence action, provided the injured party is in the class
the statute seeks to protect and the
injury suffered is the type the statute
was enacted to prevent.
….
…A statute creates a duty of care
upon one whose behavior is the subject of the statute to a person who is
in the class designed to be protected
by the statute, and that such duty
will support a finding of liability for
negligence when the injury suffered
by a person in the protected class is
that which the statute was designed
to prevent.44
Thus, the enactments and rules that require a brokerage firm to file a properly
completed Form U-5 inform the common
law malfeasance claim of the parties who
can bring a Twiss claim against the brokerage firm. Those parties are clearly investors
who are harmed by the broker’s subsequent
conduct. But other brokerage firms that hire
the broker with no knowledge of the broker’s
prior wrongful activity may be as well because one purpose of Form U-5 is to permit
subsequent employers to make informed hiring decisions.45 Thus, brokerage firms also
may be able to bring and prevail on claims
pursuant to Twiss.46 In other words, a brokerage firm can be liable to another brokerage
firm that hires the broker in question for negligence for violating its duties.
Michigan law imposes the same duties
found in the Florida act and the NASD rules.
For example, MCL 451.2408(1) states:
If an agent registered under this
act terminates employment by or
association with a broker-dealer or
issuer,…the broker-dealer, investment adviser, or federal covered
investment adviser shall promptly
file a notice of termination. If the registrant learns that the broker-dealer,
issuer, investment adviser, or federal
covered investment adviser has not
filed the notice, the registrant may
file the notice.
The prior version of the Michigan Uniform
Securities Act contained a similar provision.47
Pursuant to MCL 451.2408(1), the state administrator has adopted Form U-5, the Uniform Termination Notice for Securities Industry
Registration, as the appropriate form to satisfy the
requirements that the brokerage firm file a notice
of termination.48 Thus, a brokerage firm has a
duty to file a U-5 with the State of Michigan
on the termination of its broker’s connection
with the brokerage firm. A brokerage firm
also is under a continuing obligation to correct a U-5 to include matters that occur or
become known after the initial submission of
the form.49
Further, in another context, Michigan
courts have followed the reasoning in Palmer
that statutory obligations can inform and
identify the class of individuals who can
bring a common law malfeasance claim. For
example, in Transportation Dep’t v Christiansen,50 the defendant was driving a flatbed
truck loaded with machinery. The height of
the machinery was above the legal limit and
struck a highway overpass. The machinery was knocked off the truck and onto the
highway where it struck plaintiff’s vehicle.
The court noted that the “legal effect of [the
defendant’s] violation of the statutory duty
of care, standing alone, would be enough to
establish a prima facie case of negligence.”
The court further explained, however, that
this “presumption of negligence” could be
rebutted by applying the “statutory purpose
doctrine.” Under this doctrine, the court considered whether the statute was intended
to protect against the result of the violation,
whether the plaintiff was within the class
intended to be protected by the statute, and
whether the violation was the proximate contributing cause of the plaintiff’s injuries.51
These principles also would apply to a
brokerage firm accused of failing to complete
an accurate Form U-5. The claimant’s com-
53
In other
words, a
brokerage
firm can
be liable
to another
brokerage
firm that
hires the
broker in
question for
negligence for
violating its
duties.
54
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
mon law negligence claim would be informed
by the statutory violations, and the success
or failure of such a claim would depend, in
part, on an analysis of whether the claimant
is within the class of individuals protected by
the statute. Other courts have either followed
Twiss, reached a similar result, or endorsed
its reasoning.52
To be clear, a Twiss claim properly understood is not simply the failure to report
suspected or actual wrongdoing. Liability
also can arise from the failure to take corrective action. A Twiss claim is grounded in a
common law malfeasance claim for failure to
supervise. The malfeasance can be evinced in
two different ways, each of which may be actionable. First, the brokerage firm may have
had actual knowledge of a violation and took
no corrective action, thereby permitting the
violation to continue after the broker left the
brokerage firm. Second, the brokerage firm
may have knowingly failed to disclose the
activity on broker’s Form U-5 or otherwise
as required by the NASD/FINRA rules and
state regulation.
Consequently, the first and fundamental
element is that the brokerage firm knowingly
permitted the broker to engage in improper
conduct without taking steps to gain compliance. If the brokerage firm is guilty of such
conduct, then the brokerage firm may be liable for malfeasance. Further, while terminating a broker may be a proper remedial action
for selling away activities, termination alone
is not sufficient. The focus is on the disclosure (or lack of disclosure) of the broker’s improper conduct on his Form U-5. A brokerage firm’s failure to disclose the real reason
for the termination on the Form U-5 (instead,
giving the broker a clean bill of health), can
be the basis of liability. But it must be remembered that liability is not limited simply
to improper disclosure on the Form U-5. It
is first predicated upon the knowing failure
to take corrective action when the brokerage
firm learns of the improper conduct.
Conclusion
In most cases, brokerage firms already take
great care to prevent their brokers from selling away, and for good reason. Not only
does selling away expose brokerage firms
to possible secondary liability, but any customer funds that are invested in unapproved
investments necessarily are not invested in
approved investments, which generate commissions for the brokerage firm. Supervision
and prevention of selling away activities is
particularly challenging because the activity is necessarily done outside the brokerage
firm and typically done clandestinely. Ultimately, the incentives are clear, but no system of supervision is bullet-proof—and the
law does not require such a system, only a
reasonable one.
NOTES
1. See, e.g., NASD Notice to Members 03-71. Due
diligence obligations likely developed after the adoption
of Section 11 of the Securities Act of 1933. A brokerage
firm may not be liable under Section 11 of the Securities
Act of 1933 for misstatements or omissions of material
fact in a securities offering registration statement if it can
prove that it had “after reasonable investigation, reasonable grounds to believe and did believe” there were no
misstatements or omissions of material fact.
2. For example, Financial Industry Regulatory Agency (“FINRA”) Rule 3040 prohibits associated persons
from “participat[ing] in any manner in a private securities transaction” unless the associated person discloses to,
and obtains approval from, the licensing brokerage firm.
This Rule distinguishes participation with or without
compensation to the associated person. If the associated
person is to receive compensation, then he or she must
have prior written approval of the licensing brokerage firm. If the associated person is not to receive any
compensation, then he or she needs to provide written
disclosure of their contemplated participation to his or
her licensing brokerage firm prior to involvement in the
transaction. The purpose of prior notification is to allow
the brokerage firm to prohibit or regulate the activity.
3. Where appropriate, this article will cite federal
case law in addition to Michigan law because in many
contexts, such as the Michigan Uniform Securities Act,
Michigan law is the same as or similar to federal law.
Kirkland v EF Hutton & Co, 564 F Supp 427, 446 (ED
Mich 1983); Pukke v Hyman Lippitt, PC, No 265477,
2006 Mich App LEXIS 1801 (June 6, 2006).
4. The pre-condition for such secondary theories of
liability as vicarious liability is that there first is a finding
of primary violation. PR Diamonds, Inc v Chandler, 364
F3d 671, 696-97 (6th Cir 2004); Southland Secs v Inspire
Ins Solutions, Inc, 365 F3d 353, 383 (5th Cir 2004)
(“Control person liability is secondary only and cannot
exist in the absence of a primary violation.”); Heliotrope
Gen, Inc v Ford Motor Co, 189 F3d 971, 978 (9th Cir
1999) (secondary liability as a controlling person cannot
exist without a primary violation); SEC v First Jersey Secs,
Inc, 101 F3d 1450, 1472 (2d Cir 1996) (In order to find
secondary liability, plaintiffs must show a primary violation by the controlled person whom the controlling persons control.); Behrens v Wometco Enters, Inc, 118 FRD
534, 539 (SD Fla 1988) (“As with all secondary liability
under the securities laws, a primary violation of those
laws must first be found.”).
5. There can be no primary liability for any violation
of regulatory rules because the courts generally have held
that there is no private right of action for violations of
such rules. See, e.g., Vennittilli v Primerica, Inc, 943 F
Supp 793, 798 (ED Mich 1996) (the “Sixth Circuit has
held that there is no private cause of action for violation
of National Association of Securities Dealers rules.”)
(citing Craighead v EF Hutton & Co, 899 F2d 485, 493
(6th Cir 1990)); Lantz v Private Satellite Television, 813
F Supp 554, 556 (ED Mich 1993) (“the Sixth Circuit
has held that these rules [NYSE and NASD] do not provide a private right of action.”).
SECONDARY LIABILITY AND “SELLING AWAY” IN SECURITIES CASES
6. For examples of causes of actions against brokers
under Michigan law, see R. Henney & M. Hindelang,
Investor Claims Against Securities Brokers Under Michigan
Law, 28 Mich Bus L J 50 (Fall 2008).
7. 155 Mich App 230 (1986).
8. Id. at 236. See also Cocke v Trecorp Enters, Inc,
No 198201, 1998 Mich App LEXIS 2311, *14 (Feb 20,
1998) (“summary disposition is appropriate ‘where it
is apparent that the employee is acting to accomplish a
purpose of his own.’”).
9. Harrison v Dean Witter Reynolds, Inc, 974 F2d
873, 891 (7th Cir 1992) (Harrison I) (dismissing investor’s vicarious liability claim because “[the brokerage
firm’s] rules expressly forbade” the acts in question).
10. Grewe v Mt Clemens Gen Hosp, 404 Mich 240,
253, 273 NW2d 429 (1978).
11. Meretta v Peach, 195 Mich App 695, 698-699,
491 NW2d 278 (1992).
12. Id., at 699.
13. Sanders v Clark Oil Refining Corp, 57 Mich App
687, 691, 226 NW2d 695 (1975) (“plaintiff’s belief in
the agent’s authority ‘must be a reasonable one’”).
14. See Harrison I, 974 F2d at 881 (dismissing
investor’s vicarious liability claim because “[the brokerage firm’s] rules expressly forbade” the acts in question
and because no “reasonably prudent person [could] naturally suppose that [registered representative] possessed
the authority” for the acts in question). See also Sanders,
57 Mich App at 691-92.
15. 2006 Mich App LEXIS 230 (Jan 24, 2006)
16. 1993 US Dist LEXIS 7298 (CD Cal, Mar 30,
1993).
17. Kohn, 1993 US Dist LEXIS 7298 at *17.
18. Id.
19. 974 F2d at 884.
20. Id.
21. While there is no case in Michigan based on a
failure to supervise in the securities broker context, there
are cases in the employer/employee context generally (see
generally Millross v Plum Hollow Golf Club, 429 Mich
178, 192, 413 NW2d 17 (1987)), and other states have
applied the doctrine to brokerage firms in the securities
context. Burns v Rudolph, 2005 Ohio App LEXIS 6222
(Ohio App 9 Dist, Dec 28, 2005).
22. MCL 451.2509(7) (“The following persons are
liable jointly and severally with and to the same extent as
persons liable under subsections (2) to (6): (a) A person
that directly or indirectly controls a person liable under
subsections (2) to (6), unless the controlling person sustains the burden of proving that the controlling person
did not know, and in the exercise of reasonable care
could not have known, of the existence of the conduct
by reason of which the liability is alleged to exist”).
Significant amendments to the Michigan Uniform
Securities Act went into effect in 2009. See Public Act
551. The previous “control person” liability statutes was
MCL 451.810.
23. Mason v Royal Dequindre, Inc, 455 Mich 391,
397, 566 NW2d 199 (1997) (stating that a special
relationship gives rise to an exception to the general
rule that there is no duty to protect someone from third
parties).
24. NASD Rule 3010(a) (emphasis supplied).
25. In re William Lobb, NASD Compl. No
07960105, p 5 (4/6/00) (emphasis supplied).
26. MCL 451.2509(7).
27. Id. Compare Martin v Shearson Lehman Hutton,
Inc, 986 F2d 242, 244 (8th Cir 1993) (status as employer of broker was sufficient to establish it as control
person); Hollinger v Titan Capital Corp, 914 F2d 1564,
1573-76 (9th Cir 1990) (same) with Hauser v Farrell,
14 F3d 1338 (9th Cir 1994) (recognizing that a broker’s
conduct is not always within the brokerage firm’s con-
trol) and with Mosley v American Express Financial Advisors, Inc, 256 Mont 27, 38, 230 P3d 479 (2010) (weighing Martin, Hollinger, and Hauser and concluding that
“as a general rule a broker-dealer controls its registered
representatives, whether directly or indirectly”).
28. Id. It may be questioned whether the disagreement noted in footnote 24 regarding whether a brokerage firm is a “control person” of its brokers is really an
application of the “good faith” defense. The cases do not
always make it clear.
29. See, e.g., Hunt v Miller, 908 F2d 1210, 1214
(4th Cir 1990). The analysis for “control person” liability is similar under both federal securities laws and under
Michigan securities law. Kirkland v EF Hutton & Co,
564 F Supp 427, 446-47 (ED Mich 1983); Pukke v
Hyman Lippitt, PC, No 265477, 2006 Mich App LEXIS
1801, *13 (June 6, 2007).
30. Harrison v Dean Witter Reynolds, Inc, 79 F3d
609, 615 (7th Cir. 1996) (Harrison II) (requiring a
showing that the fraudulent activity was so obvious that
the control person must have been aware of it).
31. Harrison I, 974 F2d at 881.
32. Id. See also Mosley, 356 Mont at 39 (ruling
after trial that no “control person liability existed and
considering whether the broker acted in his role as a
representative of the brokerage firm when he sold the
investment, whether the investment had any relationship to the brokerage firm or was an authorized product,
whether the purchase of the investment required access
to a market through the firm, and whether the investment was “the kind of investment for which a customer
typically relies on a broker with access through his firm
to a stock exchange,” whether the investor received a
statement from the brokerage firm, whether the investor
ever invested money through the brokerage firm, whether the investor was told it was an authorized product,
and whether the brokerage firm had knowledge of or a
financial interest in the investment).
33. Kohn.
34. Id. at *7-8
35. Id. at *8.
36. See Harrison I; Harrison II; Kohn; Bradshaw v
Van Houten, 601 F Supp 983, 906 (D Ariz 1985).
37. 25 F3d 1551 (11th Cir 1994).
38. A form U-5 is a disclosure required of brokerage
firms on the termination or departure of a broker. The
form requires the brokerage firm to disclose (a) if the
termination was for cause and why, (b) if the brokerage
firm was aware of any wrongful conduct of the broker at
the time of the broker’s termination, or (c) if the brokerage firm was conducting an investigation of the broker at
the time of his termination.
39. Id. at 1556.
40. NASD Bylaws, Art. V, sec. 3(a) & (b) (note that
this rule remains applicable to brokerage firms after the
FINRA merger); see also Andrews v Prudential Secs, Inc,
160 F3d 304, 305-06 (6th Cir 1998).
41. NASD Notice to Members 88-67 (emphasis
supplied).
42. NASD Notice to Members 04-77.
43. 622 So2d 1085, 1090 & n. 8 (Fla App Dist 1,
1993).
44. Palmer, 622 So2d at 1090; see also Twiss, 25
F3d 1556 (examining whether plaintiffs “were within
the class of persons these provisions were designed to
protect”).
45. See NASD Notice to Members 88-67.
46. See also Prudential Securities, Inc v Am Capital
Corp, 1996 US Dist LEXIS 7196 (NDNY May 15,
1996) (holding that a brokerage firm’s claim against
another brokerage firm for having “violated its duty to
inform defendant of” factors leading to its employee’s
termination on the Form U-5, and that “it would not
55
56
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
have registered [the employee] as its representative, and
hence would not have incurred liability…,” is arbitrable).
47. MCL 451.601(b) of the previous version of
the securities act stated: “When an agent begins or terminates a connection with a broker-dealer or issuer, or
begins or terminates those activities that make him or
her an agent, the agent as well as the broker-dealer or
issuer shall immediately notify the administrator in writing on a form prescribed by the administrator.”
48. MCL 451.2605 delegates to power to issue form
to the administrator. the Department of Energy, Labor
& Economic Growth’s website contains the Form U5. Under the former securities act, § 451.601(b), the
administrator had adopted Rule 451.602.2(2), which
stated that: “A notice of agent termination shall contain
the information specified in U-5.” This Rule is still in
effect while the state agency adopts new rules implementing the updated securities act.
49. See the Instructions to the Form U-5. Also,
MCL 451.603 of the former securities act stated that “If
the information contained in any document filed with
the administrator is or becomes inaccurate or incomplete
in any material respect, the registrant shall promptly
file a correcting amendment unless notification of the
correction has been given under section 201(b).” While
this language appears to have been removed from the
updated securities act, brokerage firms are still under
an obligation to disclosure new information and file an
amended U-5.
50. 229 Mich App 417, 420 (1998).
51. Id.
52. See, e.g., Prymak v Contemporary Fin Solutions,
2007 US Dist LEXIS 87734 (D Colo Nov 29, 2007)
(recognizing a negligence claim against a securities dealer
based on its failure to fulfill its statutory duty of filing a
truthful Form U-5, but rejecting a private right of action
for a violation of the requirement); SII Investments, Inc
v Jenks, 2006 US Dist LEXIS 51753 (MD Fla July 27,
2006) (affirming arbitration award where SII failed to
make numerous required disclosures on a Form U-5
relating to its employee who later sold unregistered securities to claimant); Palmer v Shearson Lehman Hutton,
Inc, 622 So2d 1085 (Fla App Dist 1, 1993). One state
court has rejected Twiss where a state statute existed that
expressly “prohibits the recognition of an private-party
state law statutory civil tort liability.” Ugarte v Atlas Sec,
Inc, 2004 Cal App LEXIS 1721 *18 (Cal App 3 Dist,
Apr 1, 2004).
Raymond W. Henney is a
partner of Honigman Miller
Schwartz and Cohn LLP and
is Co-Chair of the firm’s Securities and Corporate Governance Litigation Group.
Andrew J. Lievense is an
associate of Honigman Miller Schwartz and Cohn LLP
and concentrates his practice in general commercial
litigation, including representing securities brokerage
firms in disputes with investors in federal
court, state court, and FINRA arbitration
proceedings.
The History and Future of Michigan
Debtor Exemptions
By Thomas R. Morris
Michigan has both a general debtor-exemptions statute and a bankruptcy-specific statute. The bankruptcy-specific exemptions,
MCL 600.5451, have been held unconstitutional. The general judgment-debtor exemptions, MCL 600.6023, have not kept pace with
inflation or with changes in property ownership.
This article examines the history of Michigan and federal bankruptcy exemption law
and examines the options for changes to
Michigan’s law.
Territorial Laws
In 1787, with the enactment of the Northwest
Ordinance, what is now Michigan became
part of the “Territory of the United States
northwest of the River Ohio.” In 1805, Michigan achieved status as a territory.
Michigan’s territorial government soon
adopted laws on debtor-creditor relations,
but the laws of Michigan’s pioneer days had
a haphazard quality. One of the first laws enacted in 1805 by the new territorial government concerned debtors imprisoned for debt.
A debtor who had been discharged from
debtor’s prison was allowed the following
exemptions with respect to future collections
by his judgment creditors:
his wearing apparel and household
furniture necessary for himself, his
wife and children, and tools necessary for his trade or occupation….1
In 1807, an exemption of just “one cow and
one sheep” was provided with respect to
judgments issued by district courts.2 The
first general exemption law was enacted in
1809, which allowed for more sheep but did
not provide a “tools of the trade” exemption
found in the law providing for a discharge
from debtor’s prison:
one cow and ten sheep, and such suitable apparel, bedding, tools, arms,
and articles of household furniture
as may be necessary for upholding
life….3
In 1810, the court system was altered.4 Exemptions related to judgments issued by justices
(whose jurisdiction replaced that of the dis-
trict courts) were stated with yet another
variation.5 Another 1809 law provided for an
exemption not referenced in contemporaneous acts on the subject. “Arms, ammunition
and accoutrements,” required under an 1809
militia law to be kept by “every free, able
bodied white male inhabitant” were exempt
under that militia statute.6 That exemption,
unlike the militia, remains in effect.
Later versions of the territorial exemption
provisions show evidence of more legislative
care, but the list of exempt property shifted
every few years. In 1821, the law concerning
executions became more detailed.7 The 1821
law was more generous, allowing, for example, for twenty sheep, provisions necessary
for one year, and a detailed variety of books.8
In 1825, the exemptions enacted in 1821 were
expanded.9 In 1827, the number of sheep was
trimmed to ten.10 A separate statute “for the
relief of insolvent debtors” was enacted on
the same date in 1827, yet it provided less
comprehensive exemptions for debtors subject to its provisions.11 In 1828, the 1825 exemptions were revived with respect to claims
that accrued prior to January 1, 1828, and different exemptions were made applicable to
claims that accrued after January 1, 1828.12
No provision was made for claims that accrued on January 1, 1828. In 1833, this temporal dichotomy ended.13
Statehood
Following statehood on January 26, 1837,
the existing exemptions were adopted in the
Revised Statutes of 1838. The quality and consistency of legislation in this field improved.
According to Justice Potter (writing in
1935), Michigan’s debtor-creditor law was
influenced by the state of the economy:
[With the Panic of 1837] ‘The
fancy values of landed property melted like snow in the April
sun…one manufactory after another
stopped, and the number of those
who could find neither bread nor
work increased by thousands and
tens of thousands.’
57
58
With the
adoption
of the
Constitution
of 1850,
exemptions
were given an
elevated legal
status
by being
constitutionally
guaranteed.
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
The panic of 1837…bore particularly
hard upon the people of Michigan….
To extricate themselves from their
situation, the Legislature in 1842
passed…the first exemption law
relating to personal property in this
State worthy of the name.14
Indeed, in 1842, personal property exemptions were again expanded, and the value
limits were increased several fold.15 But
when the numerous versions of the personal
property exemptions from the late territorial
era are considered, it is evident that the 1842
statute included little new material. Given
that much of the development of Michigan
exemption law took place in the late 1820s
and early 1830s, which were a time of national prosperity and of rapid growth in Michigan,16 the connection, perceived by Justice
Potter during the Great Depression, between
hard times and exemption laws, is vague.
In 1846, with the adoption of new Revised
Statutes, the cumbersome 1842 list of exemptions was reorganized and simplified. The
list is repeated here because it is recognizable
in our current non-bankruptcy statute.
1. All spinning-wheels, weaving-looms
with the apparatus, and stoves put
up and kept for use in any dwellinghouse;
2. A seat, pew, or slip, occupied by such
person or family, in any house or place
of public worship;
3. All cemeteries, tombs, and rights of
burial, while in use as repositories of the
dead;
4. All arms and accoutrements required by
law to be kept by any person; all wearing apparel of every person or family;
5. The library and school books of every
individual and family, not exceeding
one hundred and fifty dollars, and all
family pictures;
6. To each householder, ten sheep, with
their fleeces; and the yarn or cloth manufactured from the same; two cows,
five swine, and provisions and fuel for
comfortable subsistence of such householder or family for six months;
7. To each householder, all household
goods, furniture, and utensils, not
exceeding in value two hundred and
fifty dollars;
8. The tools, implements, materials, stock,
apparatus, team, vehicle, horses, harness, or other things, to enable any per-
son to carry on the profession, trade,
occupation, or business in which he
is wholly or principally engaged, not
exceeding in value two hundred and
fifty dollars;
9. A sufficient quantity of hay, grain, feed
and roots for properly keeping for six
months the animals in the several subdivisions of this section exempted from
execution, and any chattel mortgage,
bill of sale, or other lien created on any
part of property above described, except
such as is mentioned in the eight subdivision of this section, shall be void,
unless such mortgage, bill of sale or lien
be signed by the wife of the party making such mortgage or lien, (if he have
one).
In 1848, the first homestead exemption
was enacted. Before its enactment, a judgment debtor was afforded a one-year redemption period following an execution against a
homestead, and the property would not be
sold on execution if the rent or profits could
pay the judgment within seven years.18 The
1848 law provided for a homestead of up to
40 acres or, if located in a city or village, one
lot.19 There was no dollar-value limit to the
exemption.
With the adoption of the Constitution of
1850, exemptions were given an elevated legal status by being constitutionally guaranteed. Personal property was to be exempt in
an amount not less than $500. The 1850 Constitution modified the homestead exemption
by limiting it to $1,500 in value.20
During the remainder of the nineteenth
century, despite several financial recessions
and panics, the exemption laws received little legislative attention. An exemption for a
sewing machine was added in 1861.21 An exemption for shares in a building and loan association was added in 1887.22 Other changes
during this period of time were technical.23
The Twentieth Century
During the first eighty years of the twentieth
century, Michigan exemption law changed
in small increments. The Constitution of 1908
retained a separate article concerning exemptions.24 It kept in place the same minimum
for personal property and raised the homestead exemption to $2,500. Minor changes
to the exemption law were enacted in 1929
(raising dollar amounts)25 and 1939 (adding
disability benefits).26 Procedural changes regarding the homestead exemption were
THE HISTORY AND FUTURE OF MICHIGAN DEBTOR EXEMPTIONS
made in 1945.27 In 1961, dollar amounts were
raised, other minor changes were made, and
the list was codified at MCL 600.6023.28 The
Constitution of 196329 raised the homestead
to a minimum of $3,500 and personal property to a minimum of $750. MCL 600.6023 was
amended accordingly to raise the homestead
amount.30
The most significant twentieth century
additions to the exemption statute were enacted in the 1980s. In 1984, MCL 600.6023 was
amended to add an exemption for an IRA.31
Funds held in 401(k) and other accounts
“qualified” under the Internal Revenue Code
and were added in 1989.32 These additions
resulted from the growth in tax-favored defined-contribution retirement savings plans.
Although the exemption statute changed
in small steps over the last century, that
period of time was an era of great growth in
statutory law. Exemption law made its own
contribution to this growth: statutes separate from the general exemption statute were
added to allow exemptions for insurance policies, public-employee pensions, and welfare
and veterans’ benefits.33 A separate scheme
for exemptions is contained in the State Correctional Facility Reimbursement Act.34 Thus,
many of the twentieth century additions to
exemption law are not contained in the general exemption statute.
rated exemptions allowed by state law as of
the date of the petition.38
The long run of the 1898 Act ended in
1978 with the adoption of the current Bankruptcy Code.39 The Bankruptcy Code allows
each debtor (or married couple) a choice of
either (i) the exemptions available under
state and federal nonbankruptcy law, or (ii)
the exemptions specified in the Bankruptcy
Code.40 Each state, however, is permitted to
“opt out” of the federal exemptions and restrict its residents to exemptions allowed under state law.
Michigan has not opted out of the federal
exemptions, so Michigan residents have a
choice between the “state” and “federal” exemptions.41 Currently, the federal exemptions
are more generous for most debtors, but the
relative advantages of each set of exemptions
vary between debtors and have varied over
time with changes to each set of exemptions.
With bankruptcy exemptions now provided
for under the Bankruptcy Code, exemptions
provided in Michigan law are invoked in
fewer cases. They are nevertheless important for Michigan bankruptcy debtors who
choose the state exemptions, such as a married debtor without joint debt and with substantial assets held in tenancy by the entirety.
They also apply to debtors who are not eligible for bankruptcy relief or who choose not
to seek it.
A Brief History of Bankruptcy
Exemptions
Michigan’s Bankruptcy-Specific
Exemption Statute
The first two federal bankruptcy acts specified their own exemptions. Those exemptions were less comprehensive than the
contemporary Michigan exemptions. The
Bankruptcy Act of 1800 allowed for only “his
or her necessary wearing apparel, and the
necessary wearing apparel of the wife and
children, and necessary beds and bedding of
such bankrupt.”35 The Act of 1800 remained
in effect until December 1803. The next bankruptcy law was in effect from 1841 to 1843,
and it provided exemptions that were slightly more generous.36
The Bankruptcy Act of 1867 provided exemptions that included the types of necessities that had been exempt under the 1841 Act,
but it also allowed property to be exempt under state law.37 The 1867 Act remained in effect until 1878.
The next bankruptcy law was the Bankruptcy Act of 1898. The 1898 Act did not provide federal exemptions, but rather incorpo-
The latest change to Michigan exemptions
resulted in the adoption of the bankruptcyspecific exemptions codified in MCL 600.5451.
The process from which the bankruptcyspecific exemptions resulted was described
recently by Judge James Gregg:
In 2001, an Advisory Committee to
the Civil Law and Judiciary Subcommittee of the House Civil and Judiciary Committee of the Michigan
Legislature (“Advisory Committee”) was formed to review and, if
appropriate, provide recommendations to update the property exemption laws. The Advisory Committee
labored for two years before issuing a Report and Recommendations
to the Subcommittee (“Report and
Recommendations”). The Report
and Recommendations suggested
many changes to the general Michigan exemption statute, § 600.6023,
59
Although the
exemption
statute
changed in
small steps
over the last
century, that
period of time
was an era of
great growth
in statutory
law.
60
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
including an increase in the $3,500
Michigan homestead exemption to
$30,000 ($45,000 if the debtor or a
dependent of the debtor was over 65
or disabled). The Report and Recommendations did not recommend limitation of these new exemptions only
to bankruptcy proceedings. Report
and Recommendations of the Advisory
Committee Regarding Proposed Modifications to the Michigan Exemption Statutes, the Purpose and Policy of Michigan
Exemption Laws (August 11, 2003).
With few changes, the new
exemptions suggested by the Report
and Recommendations were adopted by the Michigan Legislature in
2004, to be effective on January 3,
2005, as § 600.5451. However, the Legislature limited the application of the law
only to proceedings involving “[a] debtor in bankruptcy under the Bankruptcy
Code.” Applying the new statutory
exemptions only to federal bankruptcy proceedings was without
explanation in either the legislative
history or the Advisory Committee
records. [Citation omitted].42
One explanation for the adoption of the
bankruptcy-specific provision is that it represented a compromise between the proponents and opponents of liberalized exemptions. The opponents, taking into consideration the interests of creditors, collection
attorneys, and court officers, resisted change
to the general exemptions, but they were less
concerned with exemptions in bankruptcy.
The proponents may have felt that modernization of the bankruptcy exemptions was
the priority. As is further explored below, it
is also possible to question the role of nonbankruptcy exemptions in the current system of debtor-creditor law.
Defects in Michigan’s Exemption
Law
Judge Gregg, in In re Pontius (quoted above),
found MCL 600.5451 to be unconstitutional. Two other bankruptcy judges have also
reached this conclusion.43 Judge Dales, also of
the bankruptcy court for the Western District
of Michigan, more recently upheld the statute against a constitutional challenge.44 Some
other states’ bankruptcy-specific exemptions
have been upheld,45 so the constitutional
issues can be debated. Nevertheless, the existence of these issues undermines reliance on
MCL 600.5451. This presents several problems. First, any debtor who plans his or her
affairs in reliance on the bankruptcy-specific
exemptions, or who invokes them in a bankruptcy case, may be surprised, and his or her
counsel embarrassed, when the bankruptcy
court disallows the exemptions. Second, the
state exemptions are important for certain
bankruptcy debtors, in particular married
persons hoping to use the tenancy-by-theentirety exemption.
The other arguable defect in Michigan’s
exemption law is the failure of the general
(non-bankruptcy) exemptions to keep up
with inflation and with changes in property
ownership. As discussed in Pontius, the 2003
legislative advisory committee acknowledged the need to update the exemptions.
But the bankruptcy-specific statute absorbed
the impetus to improvement and left the general provision neglected. The dollar-amount
exemptions (such as $1,000 in furnishings
and a $3,500 homestead) are smaller in relative value than ever before. There is no exemption for medically-prescribed devices, or
for an automobile other than as a “tool of the
trade.” Further, there have been vast changes to the types and amounts of property required for a debtor and his or her household
to live productively and self-sufficiently.
Michigan’s non-bankruptcy homestead exemption, which was one of the first if not the
first in the nation, at $3,500, is the now the
lowest among those states with a homestead
exemption. (The median homestead exemption under state law is approximately $50,000.
Maryland, Delaware, Pennsylvania and New
Jersey have no non-bankruptcy homestead
exemption).
If the bankruptcy-specific statute is eventually upheld by the Sixth Circuit or the
United States Supreme Court, the remaining
question will be whether the non-bankruptcy
exemptions require updating. The usefulness of exemptions outside of bankruptcy
is debatable. In the nineteenth century,
bankruptcy relief was not widely available.
The federal bankruptcy statutes were in effect for only about 20 years in that century,
and the first bankruptcy act was applicable
only to merchants and traders.46 The centrality of state exemptions continued with the
first “permanent” bankruptcy law, the 1898
bankruptcy act, which relied on state exemptions.47 In 1979, when the current Bankruptcy
Code became effective, federal exemptions
became an option for the first time since
THE HISTORY AND FUTURE OF MICHIGAN DEBTOR EXEMPTIONS
1843.48 Bankruptcy relief is now widely available, although somewhat restricted following
the 2005 amendments that added the means
test.49 With the prevalence of bankruptcy as
an option for persons with unmanageable
debt and the availability to Michigan residents of the federal bankruptcy exemptions,
state-law exemptions have diminished in importance. They are nevertheless useful, for
example, to an elderly person whose only income is social security (exempt under federal
law) and who otherwise would not need to
file bankruptcy. The arguments against more
liberal non-bankruptcy exemptions include
the argument that it is not bad policy to force
a debtor seeking relief into bankruptcy since
bankruptcy is a comprehensive remedy with
both relief for debtors and protections for
creditors.
Options Available
The Business Law Section of the State Bar,
through its Debtor/Creditor Rights Committee, has addressed the constitutional and
reform issues. The following options for a
resolution of the crisis caused by the rulings
invalidating the bankruptcy-specific statute
have been identified:
1. Obtain a ruling from the court of appeals
upholding Jones/ Schafer and overruling
Pontius and Wallace and retain the current statutes basically as they are today.
Judges Gregg and Hughes may have
correctly decided the constitutional
issue, in which case, the second option
would deserve more serious consideration.
2. Merge MCL 600.5451 and 600.6023, raising the general exemptions to the levels
currently only available in bankruptcy.
This would resolve the constitutional
issue presented by the bankruptcy-specific statute. Language for such a proposal has been prepared by the Debtor/Creditors Rights Committee of the
Business Law Section of the State Bar,
but the proposal has not yet resulted in
legislation.
Conclusion
At present, to rely on the bankruptcy-specific
state exemptions is to skate on thin ice. Any
bankruptcy debtor who chooses the state
exemptions should be advised to be prepared
to rely on other exemptions if challenged.
A liberalization of the general state exemptions should be considered, but opposition
by creditor groups should be expected.
NOTES
1. An act for the relief of poor prisoners who are
committed by execution for debt, §4, Laws of the Territory of Michigan (Lansing: WS George & Co, 187184), (hereafter LTM), vol 1, p 83, 87 (Oct 4, 1805).
2. An additional act concerning district courts, §12,
LTM, vol 2, p 7, 9 (April 2, 1807).
3. An act concerning executions, §2, LTM, vol 4, p
57, 58 (Feb 18, 1809).
4. An act to abolish the courts of districts, and to
define and regulate the powers, duties and jurisdiction of
justices in matters civil and criminal, § 7, LTM, vol 4, p
98, 99 (Sept 16, 1810).
5. Id. See also An act to regulate and define the
duties and powers of Justices of the Peace and Constables, in civil cases, §30, LTM, vol 1, p 604, 620 (May
20, 1820).
6. An act concerning the Militia of the Territory of
Michigan, § 1, LTM, vol 2, p 47 (Feb 10 1809); An act
to provide for organizing and disciplining the Militia, §
1, Laws of the Territory of Michigan (Detroit: Sheldon
& Reed, 1820), (hereafter LTM 1820), p 177 (April 20,
1820).
7. An act subjecting Real Estate to the payment of
debts, and concerning Executions, LTM, vol 1, p 860
(April 5, 1821), LTM 1820 p 429.
8. Id, §20.
9. An act to amend an act entitled “An act subjecting real estate to the payment of debts, and concerning
executions”, LTM, vol 2, p 234 (March 30, 1825).
10. An act concerning Judgments and Executions, §
25, LTM, vol 2, p 487, 492 (April 12, 1827).
11. An act for the relief of insolvent debtors, §16.
LTM, vol 2, p 396, 403 (April 12, 1827).
12. An act to amend an act entitled “An act concerning Judgments and Executions”, LTM, vol 2, p 703
(July 3, 1828).
13. An act to amend an act entitled “An act concerning Judgments and Executions”, § 2, LTM, vol 3, p
1073 (April 20, 1833).
14. Kleinert v Lefkowitz, 271 Mich 79, 83, 259 NW
871, 872 (1935).
15. 1842 PA 48, repealed by Revised Statutes1846,
title 33, ch 173, § 1.
16. Finkelman, Paul and Hershock, Martin, eds,
The History of Michigan Law (Athens: Ohio U Press
2006), ch 2, p 38.
17. Revised Statutes 1846, title 22, ch 106, § 27.
18. An act subjecting Real Estate to the payment of
debts, LTM, vol 2, p 42 (Feb 4 1809); An act subjecting Real Estate to the payment of debts, and concerning
Executions, § 4, LTM, vol 1, p 860 (April 5, 1821),
LTM 1820, p 429.
19. 1848 PA 109, Compiled Laws 1871, ch 198,
§6137 .
20. Const 1850, art 16.
21. 1861 PA 143, Compiled Laws 1871, ch 198,
§6132.
22. 1887 PA 50, § 16.
23. See 1849 PA 185; 1863 PA 156; 1893 PA 43.
24. Const 1908, art 11.
25. 1929 PA 87.
26. 1939 PA 225.
27. 1945 PA 14.
28. 1961 PA 236, Ch 60, § 6023, eff Jan 1, 1963.
29. Const 1963, art 10, §3.
30. 1963 PA 40.
31. 1984 PA 83, MCL 600.6023(1)(k).
32. 1989 PA 5, MCL 600.6023(1).
33. Other exemptions are listed in section 3 of the
proposal.
61
62
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
seq.
34. 1935 PA 253; 1984 PA 282, MCL 800.401 et
35. Bankruptcy Act of 1800, § 5, 2 Stat 19
36. Bankruptcy Act of 1841, § 3, 5 Stat 440.
37. West Bankruptcy Exemption Manual, § 1.01(c);
14 Stat 517.
38. West Bankruptcy Exemption Manual, §
1.01(d); 30 Stat 544.
39. 11 USC 101 et seq., eff October 1, 1979.
40. 11 USC 522(b).
41. MCL 600.5451.
42. In re Pontius, Opinion Regarding Constitutionality of Michigan Bankruptcy Specific Exemptions, 08-04124
(Bankr WD Mich, Dec 22, 2009), at 3-4. Available at
miwb.uscourts.gov/opinions.
43. In re Wallace, 347 BR 626 (Bankr WD Mich
2006), and In re Vinson, 337 BR 147 (Bankr ED Mich
2006), rev’d 347 BR 620 (ED Mich 2006).
44. In re Dorothy Ann Jones and In re Steven M.
Schafer, Opinion and Order Regarding Constitutionality of
Exemption Statute, 09-09415 and 09-03268 (Bankr WD
Mich, April 22, 2010). Those cases are on appeal.
45. See e.g. In re Peveich, 574 F3d 248 (4th Cir.
2009).
46. Bankruptcy Act of 1800, § 1, 2 Stat 19.
47. Bankruptcy Act of 1898, § 6, 30 Stat 544.
48. 11 USC 522.
49. 11 USC 707.
This version is dated April 27, 2010. The
author may continue to update this article. A copyright is claimed, but permission
is granted to copy and disseminate the
article for educational purposes and
Thomas R. Morris is a member of the West Bloomfield
firm of Silverman & Morris,
P.L.L.C. His firm concentrates its practice in the areas
of bankruptcy, commercial
law, workouts, bankruptcy
litigation, and similar matters, and represent both debtors and creditors, as well as
landlords, financial institutions, and ordinary businesses. Mr. Morris is a member
of the Council of the Business Law Section and the Debtor/Creditor Rights Committee, but the opinions expressed herein
are his own.
given to the author.
ICE Steps Up Its Aggressive
Employer Audit Campaign: The
Use of Forfeiture Laws to Seize the
Assets of Businesses Employing
Illegal Aliens
By James G. Aldrich
Background
In a departure from the Bush-administration
emphasis on worksite raids, United States
Immigration and Customs Enforcement
(“ICE”) announced on July 1, 2009, that it
had issued Notices of Inspection (“NOI’s”) to
652 businesses nationwide requesting their
employment eligibility verification documentation.1 The action stemmed from the directions issued by Secretary Janet Napolitano, of
the United States Department of Homeland
Security (“DHS”), to immigration enforcement authorities to “apply more scrutiny to
the selection and investigation of targets as
well as the timing of raids.”2
Under its new strategy, ICE stated it
would focus its resources on the auditing
and investigation of employers suspected of
cultivating illegal workplaces by knowingly
employing illegal workers instead of reliance on workplace raids.3 These notices are
intended to alert business owners that ICE
would be inspecting their hiring records to
determine whether they are complying with
employment eligibility verification laws and
regulations. ICE stated it believes these inspections are one of the most powerful tools
the federal government has to enforce employment and immigration laws, and it has
indicated its increased focus on holding employers accountable for their hiring practices
and efforts to ensure a legal workforce.4 Immigration officials stated the notices are the
“first step in ICE’s long-term strategy to address and deter illegal employment.”5
ICE has confirmed the 652 businesses receiving NOI’s were not selected randomly,
but rather as a result of leads and information obtained through other investigative
means.6 The names of the companies were
not released. In Fiscal Year 2008, ICE issued
503 similar notices throughout the year.7
On November 19, 2009, ICE announced
the issuance of an additional 1,000 NOIs to
employers across the United States “associated with critical infrastructure.” ICE stated
that the 1,000 entities that received NOIs
were selected based on “investigative leads
and intelligence” and because of the business’ “connection to public safety and national security.”8 Although this might sound
like an effort aimed at preventing terrorism,
at least some of the notices were directed to
agricultural and other companies employing
low-skill labor.
Under federal law and regulations, employers are required to complete and retain
a Form I-9 for each individual they hire for
employment in the United States. Form I-9
requires employers to review and record the
individual’s identity and employment eligibility document(s), and to determine whether the document(s) reasonably appear to be
genuine as well as related to the individual.9
An additional method for employers to
verify employment eligibility is through the
use of the E-Verify program. This is an online
system that accesses Homeland Security and
Social Security databases and can provide
almost instant confirmation of a worker’s
ability to work in the United States. However, the USCIS has announced it intends to
begin data-mining the information it obtains
through E-Verify to identify patterns of misuse and fraudulent documentation.10
Forfeiture and Other Risks for
Business Owners and Managers
Not only has the U.S. government changed
its approach to investigating employment
eligibility compliance by U.S. employers, it
has stepped up the penalties it seeks when
it finds violations. Federal authorities have
begun taking the unusual step of seeking the
63
64
Under federal
law and
regulations,
employers
are required
to complete
and retain a
Form I-9
for each
individual
they hire for
employment
in the United
States.
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
forfeiture of an actual business (and/or its
assets) that is suspected of employing illegal
aliens.11 The French Gourmet, a San Diegoarea bakery, its president, and a manager
were charged in April 15, 2010, with conspiring to engage in a pattern or practice of hiring and continuing to employee unauthorized workers (a misdemeanor) and 14 felony
counts, including making false statements
and shielding undocumented alien employees from detection. In addition to imprisonment and fines, the government is also seeking forfeiture to the United States assets used
in or derived from the alleged illegal activities including the restaurant itself and the
property on which it sits.12
According to the indictment, the owner
and managers certified on the firm’s Employment Verification Forms (I-9) that the
documents they examined appeared to be
genuine, and to the best of the their knowledge, the employees listed on the I-9 were
eligible to work in the United States. They
then placed the workers on the company’s
payroll and paid them by check until they
received “No Match” letters from the Social
Security Administration (SSA) advising that
the Social Security numbers being used by
the employees did not match the names of
the rightful owners of those numbers. The indictment also alleges that after receiving the
“No Match” letters, the company conspired
to pay the undocumented employees in cash
until the workers produced a new set of employment documents with different Social
Security numbers.13
In May 2008, ICE agents executed a search
warrant at The French Gourmet and arrested
18 undocumented workers. The men face up
to five years in prison and a fine of $250,000
on each count.14
Other Recent Enforcement Actions
ICE has reported that in Fiscal Year 2009,
worksite investigations resulted in a total
of 410 criminal arrests, including 114 management personnel.15 In addition, it has
announced these recent enforcement actions:
Missouri Roofing Company
On February 3, 2010, the owner of a Bolivar,
Missouri, roofing company was sentenced
in federal court to forfeit more than $180,000
and pay a $36,000 fine for knowingly hiring
illegal aliens following a worksite enforcement investigation conducted by ICE. Russell D. Taylor pleaded guilty September 14,
2009, to knowingly hiring, contracting, and
sub-contracting to hire illegal aliens from
August 2006 through April 2008.
The court ordered Taylor to forfeit to the
government $185,363, which represented
the amount of proceeds obtained as a result
of the offense and to pay a fine of $36,000,
representing a $3,000 fine for each of the 12
illegal aliens who worked under company
supervision. A company supervisor also
pleaded guilty in a separate but related case
to harboring illegal aliens. Taylor was also
sentenced to serve five years of probation, to
implement an employment-compliance plan,
and to pay the $185,363 forfeiture amount
in monthly installments during the first 30
months of probation.16
Hanover, Maryland Restaurant
On February 16, 2010, the owner of a Hanover,
Maryland Chinese restaurant was arrested
and charged with transporting, employing,
and harboring illegal aliens. The criminal
complaint alleges that, between January 2009
and February 4, 2010, Yen Wan Cheng knowingly hired aliens who were not authorized
to work in the United States, transported the
aliens to their jobs, and harbored them in
residences she provided. According to the
criminal complaint, five aliens were specifically identified during the investigation as
working at the restaurant and residing in a
home Cheng owns in Columbia, Maryland.
She faces a maximum sentence of three years
in prison for employing illegal aliens and five
years in prison each for transporting illegal
aliens, harboring aliens, and harboring aliens
for financial gain.17
Reno, Nevada Electronics Firm
On March 4, 2010, the owner of a Reno electronics manufacturing company was indicted by a federal grand jury on six counts of
encouraging illegal aliens to reside in the
United States and aiding and abetting them.
According to the indictment, between March
2005 and May 2009, Hamid Ali Zaidi, owner
of Vital Systems Corporation, allegedly
encouraged six illegal aliens to work at his
company and therefore to reside in the United States, knowing that such residence was
in violation of federal law. If convicted, Zaidi
faces up to five years in prison and a $250,000
fine on each count.18
Illinois Staffing Companies
On April 26, 2010, in federal court in the
Northern District of Illinois, the president
and office manager of two Bensenville, Illi-
ICE STEPS UP AGGRESSIVE EMPLOYER AUDIT CAMPAIGN
nois staffing companies were charged with
illegally employing illegal aliens to staff their
customers’ needs. Clinton Roy Perkins, and
Christopher J. Reindl, president and office
manager, respectively, of Anna II Inc., and
Can Do It Inc., were charged with one count
of unlawfully hiring illegal aliens between
October 2006 and October 2007. In addition
to employing illegal workers, the defendants
are alleged to have paid wages in cash and
failed to deduct payroll taxes or other withholdings. Federal authorities also seek forfeiture from Perkins of $488,095, seized from
various company bank accounts, as well as
the Bensenville office.
Both defendants allegedly failed to require
the aliens that Perkins hired to provide documents establishing their immigration status
or lawful right to work in the United States.
In addition, they are alleged to have directed
low-level supervisory employees to transport
illegal workers back and forth between locations. Both also allegedly provided fake sixdigit numbers to a client, claiming they were
the last six digits of the aliens’ Social Security
numbers, knowing the workers were present
in the United States illegally and lacked valid
Social Security numbers.
They also, allegedly, repeatedly withdrew funds in the amount of $9,800 from
bank accounts to pay their employees’ wages
in cash, believing that withdrawing amounts
less than $10,000 would avoid triggering
the banks’ currency transaction reporting
requirements. If convicted, they each face a
maximum penalty of five years in prison and
a $250,000 fine.19
Illinois Construction Companies
Wedekemper’s Inc. and Wedekemper’s Construction Inc., two Illinois construction companies, pleaded guilty to charges related to
employing illegal aliens on April 23, 2010.
Wedekemper’s Inc. was fined $500 and forfeited $5,500, while Wedekemper’s Construction Inc. was fined $2,500 and forfeited
$12,500. The companies were also ordered
to pay a $50 special assessment fee for every
count charged against them and participate
in the E-Verify employment eligibility verification system for five years. The investigation
began in June 2009, through a tip to ICE that a
previously deported alien was employed by
Wedekemper’s Constructions Inc. The investigation found that several other illegal aliens
were also employed by the company. Seven
employees of Wedekemper’s Construction,
65
Inc. were arrested during the investigation,
and six were later charged with various criminal offenses related to document fraud and
re-entry after deportation.20
Maryland Painting Company
Robert T. Bontempo, owner of Annapolis
Painting Services (APS) pleaded guilty on
April 23, 2009, to employing illegal aliens and
money laundering. He admitted to knowingly hiring and employing these people,
failing to properly document them, and paying them with cash.21 He was sentenced to
six months confinement in a halfway house
as part of three years probation. As part of
his plea agreement, he forfeited five bank
accounts, ten vehicles, and seven properties
purchased with the profits from his painting
business. These assets were estimated to be
worth over $1,000,000.22
Other Penalties
Employers who fail to document the employment eligibility of their employees (or who
do it improperly) can also be liable for civil
charges and penalties.
Hiring or Continuing to Employ
Unauthorized Aliens
If DHS determines that the employer has
knowingly hired unauthorized aliens (or continued to employ aliens knowing that they are
or have become unauthorized to work in the
United States), it can issue a cease and desist
order prohibiting such activity and requiring
payment of the following civil fines:
1. First Offense: Not less than $375 and not
more than $3,200 for each unauthorized
alien for offenses after March 27, 2008
($275.00/$2,200.00 before that date);
2. Second offense: Not less than $3,200 and
not more than
$6,500 for each unauthorized alien for offenses after March
27, 2008 ($2,200.00/$5,500.00 before that
date); or
3. Subsequent Offenses: Not less than
$4,300 and not more
than
$16,000 for each unauthorized alien
for offenses after March 27, 2008
($3,300.00/$11,000.00 before that date.23
Failing to Comply with Form I-9
Requirements
An employer that fails to properly complete,
retain, and/or make available for inspection
Forms I-9 as required by law, can face civil
money penalties of not less than $110 and
Employers
who fail to
document the
employment
eligibility
of their
employees
(or who do it
improperly)
can also be
liable for civil
charges and
penalties.
66
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
not more than $1,100 for each violation.24 In
determining the amount of the penalty, DHS
will consider:
1. The size of the business of the employer
being charged;
2. The good faith of the employer;
3. The seriousness of the violation;
4. The history of previous violations of the
employer; and
5. Whether or not the individual was an
unauthorized alien.25
Civil Document Fraud
Employers found by DHS or an administrative law judge to have knowingly accepted
a fraudulent document to verify a worker’s
employment eligibility may be ordered to
cease and desist from such behavior and to
pay a civil money penalty as follows:
1. First offense: Not less than $375 and not
more than $3,200 for each fraudulent
document that is the subject of the violation.
2. Subsequent offenses: Not less than
$3,200 and not more than $6,500 for
each fraudulent document that is the
subject of the violation.26
Criminal Penalties
Persons or entities convicted of having
engaged in a pattern or practice of knowingly hiring unauthorized aliens (or continuing to employ aliens knowing that they are
or have become unauthorized to work in the
United States) after November 6, 1986, may
face fines of up to $3,000 per employee and/
or six months imprisonment.27
Harboring
In addition to using forfeiture statutes, Federal authorities have also begun bringing charges of harboring against U.S. employers. INA
274(a)(1)(A)(i)-(v); 8 USC 1324(a)(1)(A)(i)-(v)
defines the offense:
1) (A) Any person who(i) knowing that a person is an alien,
brings to or attempts to bring to the
United States in any manner whatsoever such person at a place other
than a designated port of entry or
place other than as designated by
the Commissioner, regardless of
whether such alien has received
prior official authorization to come
to, enter, or reside in the United
States and regardless of any future
official action which may be taken
with respect to such alien;
(ii) knowing or in reckless disregard
of the fact that an alien has come to,
entered, or remains in the United
States in violation of law, transports,
or moves or attempts to transport or
move such alien within the United
States by means of transportation
or otherwise, in furtherance of such
violation of law;
(iii) knowing or in reckless disregard
of the fact that an alien has come to,
entered, or remains in the United
States in violation of law, conceals,
harbors, or shields from detection, or
attempts to conceal, harbor, or shield
from detection, such alien in any
place, including any building or any
means of transportation;
(iv) encourages or induces an alien to
come to, enter, or reside in the United States, knowing or in reckless disregard of the fact that such coming
to, entry, or residence is or will be in
violation of law, shall be punished as
provided in subparagraph (B); or
(v) (I) engages in any conspiracy to
commit any of the preceding acts, or
(II) aids or abets the commission of
any of the preceding acts.
Harboring can bring a maximum of five
years in prison for each alien harbored.28 If
the employer harbors the alien for financial
gain, the maximum penalty increases to ten
years.29 The maximum fine for harboring is
$250,000 or double the gain to the employer,
whichever is greater.30
Money Laundering
Although commonly associated with drug
dealing, employers of illegal aliens can also
be criminally charged with money laundering. 8 USC 1961(1)(F) includes “any act
which is indictable under the Immigration
and Nationality Act, section 274 (relating
to bringing in and harboring certain aliens”
under its definition of racketeering. 8 USC
1956(c)(7)(A) includes, by reference to 8
USC 1961(1)(F), harboring illegal aliens as
an offense for which an employer can be
charged with money laundering.
The penalties for money laundering are
up to ten years in prison and fines of up to
$500,000 or twice the amount laundered,
whichever is greater.31
ICE STEPS UP AGGRESSIVE EMPLOYER AUDIT CAMPAIGN
Conclusion
Now more than ever, it is critical that
employers audit their own Form I-9s in
advance of receiving an NOI. When assessing charges and penalties, federal authorities
will look at the employer’s good-faith compliance with Form I-9 regulations that impose
on employers an on-going duty to determine compliance with U.S. law. Given that
enforcement efforts now include targeting
business owners and managers and the threat
of prison and significant financial sanctions,
many employers have begun taking steps to
determine whether their employment eligibility documentation complies with federal
requirements. While this includes reviewing
and correcting existing I-9s and establishing
a sound compliance policy, it is absolutely
essential that each employer understands its
responsibilities and how to fulfill them.
NOTES
1. U.S. Immigration and Customs Enforcement
(July 1, 2009), “652 Businesses Nationwide Being
Served with Audit Notices Today” (http://www.ice.gov/
pr/nr/0907/090701washington.htm).
2. Hsu, Spencer S. (March 29, 2009) “DHS Signals
Policy Changes Ahead for Immigration Raids” Washington Post (http://www.washingtonpost.com/wpdyn/content/article/2009/03/29/AR2009032901109.htm).
3. U.S. Immigration and Customs Enforcement
(July 1, 2009), “652 Businesses Nationwide Being
Served with Audit Notices Today” (http://www.ice.gov/
pr/nr/0907/090701washington.htm).
4. Id.
5. Id.
6. Id.
7. Id.
8. U.S. Immigration and Customs Enforcement (November 19, 2009), “ICE Assistant Secretary
John Morton Announces 1,000 New Workplace
Audits to Hold Employers Accountable for Their
Hiring Practices” (http://www.ice.gov/pi/nr/0911/
091119washingtondc2.htm).
9. USCIS, M-274, Handbook for Employers (Rev.
04/03/09)N, p.6.
10. 74 Fed. Reg., No. 98, pp 23957-23958 and
24022-24027 (May 22, 2009).
11. Indictment, United States v The French Gourmet,
Inc. (1), Michael Malecot (2), and Richard Kauffmann
(3), United States District Court, Southern District of
California, Case No. 10-CR-1417 (April 15, 2010).
12. Id.
13. Id.
14. U.S. Immigration and Customs Enforcement
(April 21, 2010), “San Diego Area Bakery, Its Owner
and Manager, Indicated on Federal Charges for Hiring
Undocumented Workers” (http://www.ice.gov/pi/
nr/1004/100421sandeigo.htm).
15. Id.
16. U.S. Immigration and Customs Enforcement
(February 3, 2010), “Missouri Roofing Company
Owner Sentenced for Hiring Illegal Aliens” (http://
www.ice.gov/pi/nr/1002/100203springfield.htm).
17. U.S. Immigration and Customs Enforcement
(February 17, 2010), “Howard County Restaurant
Owner Arrested Following Worksite Investigation”
(http://www.ice..gov/pi/nr/1002/100217baltimore.
htm).
18. U.S. Immigration and Customs Enforcement
(March 4, 2010) “Owner of Reno Electronics Firm
Faces Federal Charges for Employing Illegal Aliens”
(http://www.ice.gov/pi/nr/1003/100304reno.htm).
19. U.S. Immigration and Customs Enforcement
(April 24, 2010), “Managers of 2 Suburban Staffing
Companies Charged with Hiring Illegal Aliens” (http://
www.ice.gov/pi/nr/1004/100426chicago.htm).
20. U.S. Immigration and Customs Enforcement
(April 23, 2010), “2 Illinois Companies Plead Guilty,
Sentenced for Employing Illegal Aliens” (http://www.
ice.gov/pr/nr/1004/100423stlouis.htm).
21. U.S. Immigration and Customs Enforcement
(April 23, 2009), “Maryland Employer Pleads Guilty
to Hiring Illegal Aliens, Money Laundering” (http://
wwwice.gov./pr/nr/0904/090423baltimore.htp).
22. U.S. Immigration and Customs Enforcement
(September 4, 2009), “Owner of Annapolis Painting
Services Sentenced for Money Laundering and Hiring Illegal Aliens” (http://www.ice.gov/nr/pr/0909/
090904baltimore.htm).
23. 8 CFR 272a.10(b)(1)(ii)(A)-(C).
24. 8 CFR 274a.10(b)(2).
25. 8 CFR 274a.10(b)(2)(i)-(v).
26. 8 CFR 270.3(b)(1)(A) and (C).
27. INA 274A(f)(1), 8 USC 1324(f)(1), 8 CFR
274a.10(a).
28. INA 274(a)(1)(3)(ii), 8 USC 1324(5)(1)(B)(ii).
29. INA 274(a)(1)(B)(i), 8 USC 1324(a)(1)(B)(i).
30. 18 USC 3571(b)(3).
31. 18 USC 1756(a)(1)(B).
James G. Aldrich of Dickinson Wright PLLC, Bloomfield
Hills, Michigan specializes
in a full range of immigration
matters. He provides counsel to closely held and family businesses in the areas
of corporate, international, and business
planning. In addition, he researches
investment opportunities in the United
States for international clients.
67
Case Digests
Arbitration—Class Arbitration
Stolt-Nielsen SA v AnimalFeeds Int’l Corp, __ US __, 130 S
Ct 1758 (2010). Plaintiff brought a putative class action
against petitioners asserting antitrust claims for prices
that petitioners allegedly charged their customers over
a period of several years. Other parties brought similar
claims and, in a consolidated proceeding, the parties were
ordered to arbitrate their dispute pursuant to a clause in
a charter party agreement. The arbitrators ruled that the
arbitration clause allowed for class arbitration. The district
court vacated the award but the Second Circuit reversed,
concluding that there is no federal maritime rule of custom and usage against class arbitration and that applicable
state law did not establish a rule against class arbitration.
The United States Supreme Court reversed, finding that
a party may not be compelled under the Federal Arbitration Act to submit a dispute to class-action arbitration unless there is a contractual basis to conclude that the party
in fact agreed to do so. In other words, an arbitrator may
not infer solely from an agreement to arbitrate that there is
an implicit agreement that authorizes class-action arbitration. The court noted that class-action arbitration changes
the nature of the arbitration to such an extent that it cannot
be presumed that the parties agreed to do so merely by
agreeing to submit disputes to an arbitrator.
Employment Arbitration Agreement—
Determination for Court or Arbitrator
Rent-A-Center, W, Inc v Jackson, __ US __, 130 S Ct 2772
(2010). After plaintiff filed an employment-discrimination suit against his former employer, the employer filed
a motion under the Federal Arbitration Act to dismiss or
stay the proceedings in district court and to compel arbitration under a mutual agreement to arbitrate claims.
Plaintiff opposed the motion on the ground that the entire
arbitration agreement was unconscionable under state law.
The district court granted the employer’s motion, finding
that the agreement gave the arbitrator authority to decide
whether the agreement was enforceable. A divided Ninth
Circuit reversed on the question of who had the authority to decide whether the agreement is enforceable and
affirmed the conclusion that the provision in question was
not unconscionable.
The United States Supreme Court reversed, stating that
a party’s challenge to a separate contract provision does
not prevent a court from enforcing a specific agreement to
arbitrate, and arbitration provisions are severable from the
rest of the contract. Unless plaintiff challenges the provision delegating the arbitration of threshold issues specifically, it should be treated as valid and enforceable, with
any challenge to the agreement’s validity as a whole delegated to the arbitrator.
Patents—Business Methods
Bilski v Kappos, __ US __, 130 S Ct 3218 (2010). Petitioners
sought patent protection for a claimed invention explaining
to buyers and sellers of commodities how they could hedge
against the risk of price changes in the energy marker. The
patent examiner rejected the application, explaining that it
was not implemented on a specific apparatus and merely
manipulated an abstract idea. The United States Court of
Appeals for the Federal Circuit heard the case en banc and
affirmed, holding that a claimed process is patent-eligible
under 35 USC 101 if: (1) it is tied to a particular machine
or apparatus, or (2) it transforms a particular article into
a different state or thing. In re Bilski, 545 F3d 943 (2008).
The court concluded the machine-or-transformation test is
the sole test under 35 USC 101 and was therefore the test
for determining patent eligibility of a process under that
statute as well. Applying the machine-or-transformation
test, the court held that petitioners’ application was not
patent-eligible.
The United States Supreme Court affirmed but held
that the machine-or-transformation test is not the sole test
for determining whether an invention is a patent-eligible
process. The court also rejected the contention that 35 USC
101 completely excludes business methods. Although 35
USC 273 indicates that some business methods are eligible for patents, it does not suggest wide patentability for
inventions of that type. The court ruled that the hedging
concept described in the application was an unpatentable
abstract idea and that permitting such a patent would preempt this approach in all fields. Because the application in
this case could be rejected under prior precedents on the
unpatentability of abstract ideas, the court did not need to
define further what constitutes a patentable process.
Limited Liability Companies—Applicability
of De Facto Corporation Doctrine
Duray Dev, LLC v Perrin, No 287722, 2010 Mich App LEXIS
607 (Apr 13, 2010). Plaintiff real estate developer entered
into an excavation contract with an individual defendant
(Perrin) and Perrin Excavating, LLC, on September 30,
2004. On October 27, 2004, a contract that was intended
to supercede the previous contract was entered into by
plaintiff and Outlaw Excavating, LLC, only, with the latter recently formed by defendant Perrin and another person. There were two contracts because Perrin had not
formed Outlaw Excavating, LLC, when the first contract
was executed and at the time of the second contract the
parties believed that the Outlaw Excavating LLC had been
properly formed. After a breach of contract dispute arose,
it was discovered that Outlaw did not obtain status as a
“filed” LLC until November 29, 2004, and therefore it was
not a valid LLC when the parties executed the second contract. The trial court ruled in plaintiff’s favor, finding that
Perrin was in breach of the contract. In a posttrial memorandum, Perrin argued that he was not personally liable
for the damages for breach alleging that the LLC was liable
under the de facto corporation doctrine.
CASE DIGESTS
The court of appeals stated that the LLCA provides
precisely when an LLC comes into existence, as MCL
450.4202(2) provides that “[t]he existence of the limited liability company begins on the effective date of the articles
of organization as provided in [MCL 450.4104].” MCL
450.4104(2) requires that the articles be delivered to the
Bureau of Commercial Services and, after delivery, the administrator “shall endorse upon it the word ‘filed’ with his
or her official title and the date of receipt and of filing[.]”
MCL 450.4104(6) further provides that “[a] document filed
under [MCL 450.4104(2)] is effective at the time it is endorsed[.]”
Once an LLC comes into existence, limited liability applies, and a member or manager is not liable for the acts,
debts, or obligations of the company. MCL 450.4501(3).
However, a person who signs a contract on behalf of a
company that is not yet in existence generally becomes
personally liable on that contract. It is well established that
a corporation can nevertheless become liable if (1) it either
ratifies or adopts that contract after it comes into existence,
(2) a court determines that a de facto corporation existed
at the time of the contract, or (3) a court orders that a corporation by estoppel prevented the opposing party from
arguing against the existence of a corporation. In this case,
Perrin signed the articles of organization for the LLC on
the same day as the second contract, October 27, 2004, and
then signed the October 27, 2004, contract on behalf of the
LLC. The Bureau did not endorse the articles of organization until November 29, 2004. Therefore, under the LLCA,
the LLC was not in existence on October 27, 2004, and it
did not adopt or ratify the second contract, thus making
Perrin personally liable for the LLC’s obligations unless a
de facto LLC existed or an LLC by estoppel applied.
The de facto corporation doctrine allows a defectively
formed association to attain the legal status of a corporation, while the corporation by estoppel doctrine prevents
a party who dealt with an association as though it were a
corporation from denying its existence. The court found
that the similarities between the Business Corporation Act
and LLCA support the conclusion that the acts should be
interpreted consistently and that the de facto corporation
doctrine applies to both corporations and LLCs. The purposes for forming a limited liability company and a corporation are similar and both acts contemplate the moment
when an LLC or corporation comes into existence. Thus, in
this case, the de facto corporation doctrine applied to the
LLC and, as a result, the LLC and not Perrin individually
was liable for the breach of the October 27, 2004, contract.
Similarly, the corporation-by-estoppel doctrine—which
is an equitable remedy where its purpose is to prevent
one who contracts with a corporation from later denying
its existence to hold the individual officers or partners liable—applies to LLCs as well as corporations. However,
the trial court did not make a clear and obvious mistake by
not applying the corporation-by-estoppel doctrine to the
LLC when the issue was not raised by the appealing party
69
and there was no precedent indicating that the trial court
should have applied the doctrine.
Single Business Tax—Contributions for
Employment Benefits
Ford Motor Co v Department of Treasury, No 283925, 2010
Mich App LEXIS 925 (May 20, 2010). The Department conducted an audit of plaintiff to determine plaintiff’s tax due
under the Single Business Tax Act (SBTA) for years 1997 to
1999 and assessed plaintiff with a tax liability of $21,726,713
above the SBTA taxes already paid by plaintiff because
the Department determined that voluntary contributions
made to an irrevocable trust created under the Voluntary
Employees’ Beneficiary Association (VEBA) amounted to
employee compensation that was taxable under the SBTA.
The court of appeals held that contributions plaintiff made
to the VEBA in the tax years in question did not constitute
compensation under the SBTA and, therefore, were not
subject to the SBTA tax.
Single Business Tax—Remanufacturing
Midwest Bus Corp v Department of Treasury, No 288686,
2010 Mich App LEXIS 790 (Mar 16, 2010). Plaintiff filed a
declaratory judgment action following an audit for single
business tax years 1999 through 2004, and the receipt of
tax due bills. Plaintiff alleged that it was in the business of
selling bus parts and remanufacturing buses and that its
remanufacturing contracts with various transit authorities
involved primarily the sale of tangible personal property—bus parts, regardless of whether plaintiff’s installation
of those parts was also included in the contracts. Plaintiff
argued that revenue from the sales at issue, which gave rise
to the disputed tax due bills, should have been sourced to
the destinations where they were shipped as sales of tangible personal property under MCL 208.52, and not sourced
to Michigan, under MCL 208.53, where the installation
services were performed. On the other hand, defendants
argued that plaintiff’s business of remanufacturing buses
did not merely involve the sale of bus parts. Instead, plaintiff remanufactured buses, which meant that the service of
actually installing the bus parts was not merely incidental to the sale of the parts but that rehabilitation was the
primary purpose of the business contracts. Thus , revenue
from the disputed sales was properly sourced to Michigan,
under MCL 208.53, where the services were performed,
and plaintiff was not entitled to any refund or other relief.
The trial court agreed with defendants and granted their
motion for summary disposition.
The court of appeals affirmed. A remanufacturing contract is predominantly for the provision of a service—a
rehabilitation service. Thus, for purposes of the sales factor under the Single Business Tax, these are sales “other
than sales of tangible personal property” and, because the
services were provided in Michigan in this case, the sales
were “in this state” under MCL 208.53.
Index of Articles
(vol 16 and succeeding issues)
Adequate assurance of performance demand, 23 No 1,
p. 10; 29 No 3, p. 14
Administrative expense claims under BACPA 2005, 26
No 3, p. 36
ADR
appeals of arbitrability, effect on lower courts, 26
No 2, p. 37
arbitration, pursuit of investors’ claims, 16 No 2, p. 5
commercial dispute resolution, new horizons, 22
No 2, p. 17
mediation 17 No 1, p. 15; 26 No 3, p. 49
“real time” conflict solutions 28 No 2, p. 31
Advertising injury clause, insurance coverage, 24 No 3,
p. 26
Agriculture
Farm Security and Rural Investment Act of 2002, 22
No 3, p. 30
succession planning for agribusinesses, 24 No 3,
p. 9
Annuity suitability requirements, 27 No 2, p. 15
Antiterrorism technology, federal SAFETY Act, 24
No 3, p. 34
Antitrust compliance program for in-house counsel, 22
No 1, p. 42
Assignments for benefit of creditors, 19 No 3, p. 32
Assumed names of LLCs, 28 No 3, p. 5
Attorney-client privilege, tax matters, 24 No 3, p. 7; 26
No 3, p. 9. See also E-mail
Automotive suppliers
disputes in automotive industry, lessons learned,
26 No 2, p. 11
extending credit in era of contractual termination for
convenience, 26 No 1, p. 49
requirements contracts, enforceability, 28 No 2, p. 18
Bankruptcy. See also preferences
after-acquired property and proceeds in bankruptcy,
28 No 1, p. 28
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 25 No 3, p. 27; 26 No 3, p. 18
composition agreements, alternatives to bankruptcy,
28 No 3, p. 43
cross-border insolvencies, 26, No 3, p. 10
default interest, 23 No 2, p. 47
dividends and other corporate distributions as avoidable transfers, 16 No 4, p. 22
foreclosure, bankruptcy forum to resolve disputes
30 No 1, p. 17
franchisors, using bankruptcy forum to resolve disputes, 16 No 4, p. 14
in-house counsel’s survival guide for troubled times,
22 No 1, p. 33
intellectual property, protecting in bankruptcy cases,
22 No 3, p. 14
landlord-tenant issues, 26 No 3, p. 32
litigation roadmap, 28 No 1, p. 34
mortgage avoidance cases, 26 No 3, p. 27
ordinary course of business, 23 No 2, p. 40; 26 No 1,
p. 57
overview of Bankruptcy Reform Act of 1994, 16 No 4,
p. 1
70
partners and partnership claims, equitable subordination, 16 No 1, p. 6
prepayment penalty provisions in Michigan, enforceability in bankruptcy and out, 16 No 4, p. 7
prepayment premiums in and out of bankruptcy,
23 No 3, p. 29
priority for creditors providing goods to debtors in
ordinary course of business, 28 No 1, p. 18
proof of claim, whether and how to file, 30 No 1, p. 10
reclamation and administrative offense claims, 26
No 3, p. 36
tax tips for bankruptcy practitioners, 27 No 2, p. 30
trust fund statutes and discharge of trustee debts,
28 No 1, p. 11
UCC 2-702, use in bankruptcy, 29 No 3, p. 9
Banks. See Financial institutions
Business claims, intersection of statute and common law,
27 No 1, p. 29
Business continuity planning, 28 No 1, p. 9
Business Court in Michigan, 25 No 3, p. 9
Business-income-loss claims, 27 No 1, p. 24
Business judgment rule
corporate scandals and business judgment rule, 25
No 3, p. 19
Disney derivative litigation, 25 No 2, p. 22
Certificated goods, frontier with UCC, 24 No 2, p. 23
Charitable Solicitations Act, proposed revisions,
26 No 1, p. 14
Charities. See Nonprofit corporations or organizations
Chiropractors and professional service corporations,
24 No 3, p. 5
Choice of entity
2003 tax act considerations, 23 No 3, p. 8
frequently asked questions, 25 No 2, p. 27
getting it right the first time, 26 No 1, p. 8
Circular 230 and tax disclaimers, 25 No 2, p. 7
Class Action Fairness Act of 2005, 25 No 3, p. 15
Click-wrap agreements under UCC, mutual assent, 26
No 2, p. 17
COBRA changes under 2009 Stimulus Act, 29 No 2, p. 31
Commercial finance lease agreements, 26 No 2, p. 21
Commercial impracticability, issues to consider, 29 No 1,
p.16
Commercial litigation. See also ADR
business court in Michigan, 25 No 3, p. 9
Class Action Fairness Act of 2005, 25 no 3, p. 15
document production, 28 No 2, p. 13
economic duress, proving in Michigan, 26 No 2,
p. 25
electronic discovery, 22 No 2, p. 25; 27 No 2, p. 9; 27
No 3, p. 37
future lost profits for new businesses, proving in postDaubert era, 26 No 2, p. 29
Competitor communications, avoiding sting of the unbridled tongue, 18 No 1, p. 18
Composition agreements, alternatives to bankruptcy, 28
No 3, p. 43
Computers. See Technology Corner.
Confidentiality agreements, preliminary injunctions of
threatened breaches, 16 No 1, p. 17
INDEX OF ARTICLES
Contracts. See also Automotive suppliers
doctrine of culpa in contrahendo and its applicability to
international transactions, 24 No 2, p.36
drafting, 28 No 2, p. 24
electronic contracting, best practices, 28 No 2, p. 11
letters of intent, best practices, 25 No 3, p. 44
liquidated damages and limitation of remedies clauses
16 No 1, p. 11
setoff rights, drafting contracts to preserve, 19 No 1,
p. 1
Corporate counsel. See In-house counsel
Corporations. See also Business judgment rule; Nonprofit
corporations; Securities
Business Corporation Act amendments, 21 No 1, p. 28;
29 No 1, pp. 5, 10
corporate governance, 28 No 3, p. 9
correcting incomplete corporate records, 29 No 3, p. 31
deadlocks in closely held corporations, planning ideas
to resolve, 22 No 1, p. 14
Delaware and Michigan incorporation, choosing
between, 22 No 1, p. 21
Delaware corporate case law update (2005), 25 No 2,
p. 49
derivatives transactions, explanation of products
involved and pertinent legal compliance considerations, 16 No 3, p. 11
dissenter’s rights: a look at a share valuation, 16 No
3, p. 20
dividends and other corporate distributions as avoidable transfers, 16 No 4, p. 22
drag-along rights under Michigan Business Corporation Act, 28 No 3, p. 20
employment policies for the Internet, why, when, and
how, 19 No 2, p. 14
foreign corporations, internal affairs doctrine, 27
No 1, p. 48
insolvency, directors’ and officers’ fiduciary duties to
creditors when company is insolvent or in vicinity of insolvency, 22 No 2, p. 12
interested directors, advising re selected problems in
sale of corporation, 16 No 3, p. 4
minority shareholder oppression suits, 25 No 2,
p. 16
opportunity doctrine in Michigan, proposed legislative reform, 28 No. 3, p. 15
professional service providers and Miller v Allstate Ins
Co, 28 No 3, p. 26
proposed amendments to Business Corporation Act
(2005), 25 No 2, p. 11
Sarbanes-Oxley Act of 2002, 22 No 3, p. 10
shareholder standing and direct versus derivative
dilemma, 18 No 1, p. 1
tax matters, 27 No 1, p. 8
technical amendments to Michigan Business Corporation Act (1993), 16 No 3, p. 1
tort liability for corporate officers, 26 No 3, p. 7
Creditors’ rights.
See also Bankruptcy; Entireties
property; Judgment lien statute
assignments for benefit of creditors, 19 No 3, p. 32
claims in nonbankruptcy litigation, 19 No 3, p. 14
cross-border secured lending transactions in United
States and Canada, representing the lender in,
16 No 4, p. 38
71
decedent’s estates, eroding creditors’ rights to collect
debts from, 19 No 3, p. 54
fiduciary duties of directors and officers to creditors
when company is insolvent or in vicinity of
insolvency, 22 No 2, p. 12
judgment lien statute, advisability of legislation, 23
No 2, pp. 11, 24
necessaries doctrine, Michigan’s road to abrogation,
19 No 3, p. 50
nonresidential real property leases, obtaining extensions of time to assume or reject, 19 No 3, p. 7
prepayment penalty provisions in Michigan, enforceability in bankruptcy and out, 16 No 4, p. 7
out-of-court workouts, 19 No 3, p. 9
personal property entireties exemption, applicability
to modern investment devices, 22 No 3, p. 24
receiverships, 19 No 3, p. 16
trust chattel mortgages, 19 No 3, p. 1.
Criminal law and matters, white collar-crime investigation and prosecution, 27 No 1, p. 37
Cross-border insolvencies, 26 No 3, p. 10
Cross-cultural negotiations, 27 No 2, p. 39
Cybercourt for online lawsuits, 21 No 1, p. 54
Cybersquatting and domain name trademark actions,
22 No 2, p. 9
Data breach notification act, 27, No 1, p. 9
Deadlocks in closely held corporations, planning idea to
resolve, 22 No 1, p. 14
Defamation claims for businesses, intersection of statute
and common law, 27 No 1, p. 29
Delaware and Michigan incorporation, choosing between
22 No 1, p. 21
Delaware corporate case law update (2005), 25 No 2,
p. 49
Derivatives transactions, explanation of products involved and pertinent legal compliance considerations, 16 No 3, p. 11
Did You Know?
acupuncture, 26 No 2, p. 7
assumed names of LLCs, 28 No 3, p. 5
Business Corporation Act 2009 amendments, 29 No 1,
p. 5
chiropractors and professional service corporations,
24 No 3, p. 5
educational corporations or institutions, 24 No 1,
p. 5; 24 No 3, p. 5
expedited filing, 25 No 3, p. 6; 26 No 1, p. 5
fee changes for authorized shares 25 No 3, p. 6;
26 No 1, p. 5
finding the proper agency, 25 No 2, p. 5
LLC Act amendments (2002), 23 No 2, p. 5
low profit LLCs, 29 No 1, p. 6; 29 No 2, p. 5
mold lien act amendments, 22 No 2, p. 5
names for business entities, 23 No 1, p. 5; 25
No 1, p. 5
nonprofit corporation amendments, 28 No 2, p. 7
professional corporations, 22 No 1, p. 5; 27 No 2,
p. 6
service of process on business entities and other
parties, 30 No 1, p. 5
special entity acts, 25 No 3, p. 5
summer resort associations, 24 No 3, p. 6
tort liability for corporate officers, 26 No 3, p. 7
72
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
uniform and model acts, 24 No 2, p. 5
viewing entity documents, 24 No 3, p. 5
Digital signatures, 19 No 2, p. 20
Disaster preparations for law firms, 21 No 1, p. 7
Discovery of electronic information in commercial litigation, 22 No 2, p. 25; 28 No 2, p. 13
Dissenter’s rights: A look at a share valuation, 16 No 3,
p. 20
Dissolution of Michigan LLC when members deadlock,
25 No 3, p. 38
Domain names, 21 No 1, p. 48; 22 No 2, p. 9
Drag-along rights under Michigan Business Corporation
Act, 28 No 3, p. 20
Economic duress, proving in Michigan, 26 No 2, p. 25
E-mail
encryption and attorney-client privilege, 19 No 2,
p. 26
monitoring of e-mail and privacy issues in private sector workplace, 22 No 2, p. 22
unencrypted Internet e-mail and attorney-client privilege, 19 No 2, p. 9
Educational corporations, 24 No 1, p. 5; 24 No 3, p. 5
Employment. See also Noncompetition agreements
Internet policies: why, when, and how, 19 No 2, p. 14
monitoring of e-mail and privacy issues in private sector workplace, 22 No 2, p. 22
sexual harassment, employer liability for harassment
of employees by third parties, 18 No 1, p. 12
Empowerment zones, business lawyer’s guide to, 17
No 1, p. 3
Entireties property
exemption for personal property, applicability to modern investment devices, 22 No 3, p. 24
federal tax liens, 22 No 2, p. 7; 23 No 2, p. 28
LLC interests, 23 No 2, p. 33
Estate tax uncertainty in 2010, 30 No 1, p. 8
Ethics, disaster preparations, 21 No 1, p. 7
Exemptions from securities registration, client interview
flow chart, 29 No 3, p. 39
Export controls and export administration, 24 No 1,p. 32
Farm Security and Rural Investment Act of 2002, 22 No 3,
p. 30
Fiduciary duties
insolvent company or in vicinity of insolvency, duties
of offices and directors to creditors, 22 No 2,
p. 12
LLC members, duties and standards of conduct, 24
No 3, p. 18
Film tax credit and secured transactions, 29 No 3, p. 21
Financial institutions
cross-border secured lending transactions in United
States and Canada, representing the lender in,
26 No 4, p. 38
federal legislation giving additional powers to banks
and bank holding companies, 20 No 1, p. 1
Gramm-Leach-Bliley’s privacy requirements, applicability to non-financial institutions, 20 No 1, p. 13
new Banking Code for new business of banking, 20
No 1, p. 9
revised UCC Article 9, impact on commercial lending,
21 No 1, p. 20
Force majeure and commercial impracticability, issues to
consider, 29 No 1, p. 16
Foreclosure, use of receiver or bankruptcy as alternative
to, 30 No 1, p. 17
Foreign corporations, internal affairs doctrine, 27 No 1,
p. 48
Foreign defendants, serving in Michigan courts, 30 No 1,
p. 49
Foreign trade zones, 24 No 3, p. 40
Franchino v Franchino, minority shareholder oppression
suits, 25 No 2, p. 16
Franchises
bankruptcy forum to resolve disputes, 16 No 4, p. 14
less-than-total breach of franchise agreement by franchisor, loss or change in format, 16 No. 1, p. 1
Petroleum Marketing Practices Act, oil franchisor–
franchisee relationship, 18 No 1, p. 6
Gaming in Michigan, primer on charitable gaming, 26
No 1, p. 21
“Go Shop” provisions in acquisition agreements, 27
No 3, p. 18
HITECH Act and HIPAA privacy and security issues, 29
No 2, p. 9
I.D. cards, security vs privacy, 27 No 3, p. 11
Immigration
E-verify program and its application to federal contractors, 29 No 1, p. 36
tax criminal prosecution, employer I-9 compliance, 28
No 3, p. 34
Independent contractors, tax issues, 28 No 2, p. 9
India, mergers and acquisitions, 28 No 2, p. 43
Information security, 23 No 2, p. 8; 23 No 3, p. 10
In-house counsel
antitrust compliance program, 22 No 1, p. 42
pension funding basics, 25 No 1, p. 17
risk management, 25 No 1, p. 10
survival guide for troubled times, 22 No 1, p. 33
Insolvency, directors’ and officers’ fiduciary duties to
creditors when company is insolvent or in vicinity
of insolvency, 22 No 2, p. 12
Installment contracts under UCC 2-612, perfect tender
rule, 23 No 1, p. 20
Insurance
business-income-loss claims, 27 No 1, p. 24
risk management for in-house counsel, 25 No 1,
p. 10
scope of advertising injury clause, 24 No 3, p. 26
Intellectual property
bankruptcy cases, 22 No 3, p. 14
domain name trademark actions, 22 No 2, p. 9
Interested directors, advising re selected problems in sale
of corporation, 16 No 3, p. 4
International transactions
applicability of doctrine of culpa in contrahendo, 24
No 2, p. 36
documentary letters of credit, 25 No 1, p. 24
foreign trade zones, 24 No 3, p. 40
Internal affairs doctrine, foreign corporations, 27 No 1,
p. 48
Internet. See also E-mail; Privacy; Technology Corner
corporate employment policies: why, when, and how,
19 No 2, p. 14
cybercourt for online lawsuits, 21 No 1, p. 54
data breach notification act, 27, No 1, p. 9
digital signatures, 19 No 2, p. 20
INDEX OF ARTICLES
domain names, 21 No 1, p. 48; 22 No 2, p. 9
jurisdiction and doing business online, 29 No 1, p. 23
proxy materials, Internet delivery, 27 No 3, p. 13
public records, using technology for, 19 No 2, p. 1
sales tax agreement, 23 No 1, p. 8
year 2000 problem, tax aspects, 19 No 2, p. 4
Investing by law firms in clients, benefits and risks, 22
No 1, p. 25
Joint enterprises, recognition by Michigan courts, 23
No 3, p. 23
Judgment lien statute
advisability of legislation, 23 No 2, pp. 11, 24
new collection tool for creditors, 24 No 3, p. 31
Judicial dissolution of Michigan LLC when members
deadlock, 25 No 3, p. 38
Landlord-tenant issues under BACPA 2005, 26 No 3,
p. 32
Law firms, benefits and risks of equity arrangements with
clients, 22 No 1, p. 25
Leases
commercial finance lease agreements, 26 No 2,
p. 21
obtaining extensions of time to assume or reject, 19
No 3, p. 7
Letters of credit in international transactions, 25 No 1,
p. 24
Letters of intent, best practices, 25 No 3, p. 44
Liens. See also Judgment lien statute
how to find notices of state and federal tax liens, 24
No 1, p. 10
mold lien act, 22 No 2, p. 5; 26 No 3, p. 44
special tools lien act, 23 No 1, p. 26; 26 No 3, p. 44
Life insurance, critical planning decisions for split-dollar
arrangements, 23 No 3, p. 41
Limited liability companies (LLCs)
2002 LLC Act amendments (PA 686), 23 No 1, p. 34;
23 No 2, p. 5
anti-assignment provisions in operating agreements,
impact of UCC 9-406 and 9-408, 24 No 1, p. 21
buy-sell provisions of operating agreements, 19 No
4, p. 60
entireties property, 23 No 2, p. 33
family property and estate planning, operating agreements for, 19 No 4, p. 49
fiduciary duties and standards of conduct of members
24 No 3, p. 18
joint venture, operating agreements for, 19 No 4, p. 34
low profit LLCs, 29 No 1, p. 6; 29 No 2, pp. 6, 27
manufacturing business, operating agreements for,
24 No 4, p. 2
minority member oppression, 27 No 1, p. 11
piercing the veil of a Michigan LLC, 23 No 3, p. 18
real property, operating agreements for holding and
managing, 19 No 4, p. 16
securities, interest in LLC as, 16 No 2, p. 19
self-employment tax for LLC members, 23 No 3,
p. 13
series LLCs, 27 No 1, p. 19
single-member LLCs vs member’s judgment creditors,
29 No 1, p. 33
Liquidated damages and limitation of remedies clauses,
16 No 1, p. 11
Litigation. See Commercial litigation
73
Lost profits for new businesses in post-Daubert era, 26
No 2, p. 29
Low profit LLCs, 29 No 1, p. 6; 29 No 2, p. 27
Malware grows up: Be very afraid, 25 No 3, p. 8
Material adverse effect clauses, Delaware court’s proseller attitude towards, 29 No 1, p. 28
Mediation instead of litigation for resolution of valuation
disputes, 17 No 1, p. 15
Mergers and acquisitions
disclosure of confidential information, 29 No 2, p. 39
India, framework and issuess, 28 No 2, p. 43
multiples as key to value or distraction, 23 No 1, p. 31
Michigan Business Tax, 28 No 1, p. 40; 29 No 1, p. 40
Minority oppression
LLCs, minority members, 27 No 1, p. 11
shareholder suits, 25 No 2, p. 16
Mold lien act, 22 No 2, p. 5, 26 No 3, p. 44
Mortgage avoidance cases in Michigan’s bankruptcy
courts, 26 No 3, p. 27
Names for business entities, 23 No 2, p. 5; 25 No 1, p. 5
Necessaries doctrine, Michigan’s road to abrogation, 19
No 3, p. 50
Negotiations, cross-cultural, 27 No 2, p. 39
Noncompetition agreements
geographical restrictions in Information Age, 19 No 2,
p. 17
preliminary injunctions of threatened breaches, 16
No 1, p. 17
Nonprofit corporations or organizations
amendments, 28 No 2, p. 7
Charitable Solicitations Act, proposed revisions, 26
No 1, p. 14
compensating executives, 24 No 2, p. 31
intermediate sanctions, slippery slope to termination,
26 No 1, p. 27
IRS Form 990 changes—nonprofit governance in a fish
bowl, 29 No 2, p. 11
lobbying expenses, businesses, associations, and nondeductibility of, 17 No 2, p. 14
low profit LLCs, 29 No 1, p. 6, 29 No 2, pp. 6, 27
proposed amendments to Michigan Nonprofit Corporation Act, 17 No 2, p. 1; 23 No 2, p. 70; 26, No 1,
p. 9
Sarbanes-Oxley Act of 2002, impact on nonprofit entities, 23 No 2, p. 62
shuffle up and deal: a primer on charitable gaming in
Michigan, 26 No, p. 21
tax exemptions, 26 No 1, p. 33
trustees, nonprofit corporations serving as, 17 No 2,
p. 9
Uniform Prudent Management of Institutional Funds
Act, 29 No 2, p. 17
volunteers and volunteer directors, protection of, 17
No 2, p. 6
Offshore outsourcing of information technology services,
24 No 1, p. ; 24 No 2, p. 9
Open source software, 25 No 2, p. 9; 29 No 2, p. 49
Optioning the long-term value of a company, effect on
shareholders, 27 No 3, p. 33
Ordinary course of business, bankruptcy, 23 No 2, p. 40;
26 No 1, p. 57
Partnerships
74
THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010
bankruptcy, equitable subordination of partners and
partnership claims, 16 No 1, p. 6
interest in partnership as security under Article 9,
19 No 1, p. 24
Pension funding basics for in-house counsel, 25 No 1,
p. 17
Perfect tender rule, installment contracts under UCC 2612, 23 No 1, p. 20
Personal property entireties exemption, applicability to
modern investment devices, 22 No 3, p. 24
Petroleum Marketing Practices Act, oil franchisor–
franchisee relationship, 18 No 1, p. 6
Piercing the veil of a Michigan LLC, 23 No 3, p. 18
Preferences
defending against preference claims, 29 No 3, p. 26
earmarking defense, gradual demise in Sixth Circuit,
30 No 1, p. 25
minimizing manufacturer’s exposure by asserting
PMSI and special tools liens, 30 No 1, p. 41
ordinary terms defense, 30 No 1, p. 34
Preliminarily enjoining threatened breaches of noncompetition and confidentiality agreements, 16
No 1, p. 17
Prepayment penalty provisions in Michigan, enforceability in bankruptcy and out, 16 No 4, p. 7
Prepayment premiums in and out of bankruptcy, 23
No 3, p. 29
Privacy
drafting privacy policies, 21 No 1, p. 59
Gramm-Leach-Bliley requirements, applicability to
non-financial institutions, 20 No 1, p. 13
monitoring of e-mail and privacy issues in private
sector workplace, 22 No 2, p. 22
securities industry, application of privacy laws to,
27 No 3, p. 25
Professional service providers and Miller v Allstate Ins
Co, 28 No 3, p. 26
Proof of claim, whether and how to file, 30 No 1, p. 10
Public debt securities, restructuring, 22 No 1, p. 36
Public records, using technology for, 19 No 2, p. 1
Receiverships, 19 No 3, p. 16; 28 No 2, p. 36; 20 No 1,
p. 17
Risk management for in-house counsel, 25 No 1, p. 10
S corporations
audit targets, 25 No 3, p. 7
losses, how to deal with, 29 No 3, p. 34
SAFETY Act and antiterrorism technology, 24 No 3, p. 34
Sarbanes-Oxley Act of 2002, 22 No 3, p. 10
nonprofit entities, 23 No 2, p. 62
public issuers in distress, 23 No 2, p. 55
relief for smaller public companies, 26 No 1, p. 42
Securities
abandoned public and private offerings, simplifying
Rule 155, 21 No 1, p. 18
arbitration, pursuit of investors’ claims, 16 No 2, p. 5
basics of securities law for start-up businesses, 24
No 2, p. 13
disclosure of confidential information, 29 No 2, p. 39
exemptions from registration, client interview flow
chart, 29 No 3, p. 39
“Go Shop” provisions in acquisition agreements,
27 No 3, p. 18
investment securities, revised UCC Article 8, 19 No 1,
p. 30
investor claims against securities brokers under Michigan law, 28 No 3, p. 50
Internet delivery of proxy materials, 27 No 3, p. 13
limited liability company interests as securities, 16
No 2, p. 19
privacy laws and regulations, application to employment relationships in securities industry, 27 No 3,
p. 25
public debt securities, restructuring, 22 No 1, p. 36
real-time disclosure, SEC, 24 No 2, p. 20
Sarbanes-Oxley Act of 2002, public issuers in distress,
23 No 2, p. 55
SEC small business initiatives, 16 No 2, p. 8
small business regulatory initiatives, progress or puffery, 16 No 2, p. 1
small corporate offering registration, 16 No 2, p. 13
Uniform Securities Act, technical compliance is
required, 17 No 1, p. 1
venture capital financing, terms of convertible preferred stock, 21 No 1, p.9
what constitutes a security, possible answers, 16 No 2,
p. 27
Self-employment tax for LLC members, 23 No 3, p. 13
Service of process
business entities and other parties, 30 No 1, p. 5
foreign defendants, 30 No 1, p. 49
Sexual harassment, employer liability for harassment of
employees by third parties, 18 No 1, p. 12
Shareholders
dissenter’s rights: a look at a share valuation, 16 No 3,
p. 20
minority shareholder oppression suits, 25 No 2, p. 16
oppression and direct/derivative distinction, 27 No 2,
p. 18
optioning the long-term value of a company, effect on
shareholders, 27 No 3, p. 33
standing and direct versus derivative dilemma, 18
No 1, p. 1
Shrink-wrap agreements under UCC, mutual assent,
26 No 2, p. 17
Single-member LLCs vs member’s judgment creditors, 29
No 1, p. 33
Small Business Administration business designations and
government contracting, 24 No 1, p. 29
Software licensing watchdogs, 25 No 1, p. 8
Special tools lien act, 23 No 1, p. 26
Split-dollar life insurance arrangements, critical planning
decisions, 23 No 3, p. 41
Subordination agreements under Michigan law, 24 No 1,
p. 17
Succession planning for agribusinesses, 24 No 3, p. 9
Summer resort associations, 24 No 3, p. 6
Taxation and tax matters
2001 Tax Act highlights, 22 No 1, p. 7
2004 Tax Acts: What you need to tell your clients, 25
No 1, p. 30
2009 tax rate increase, 28 No 3, p. 7
aggressive transactions, tax consequences, 27 No 3,
p. 9
attorney-client privilege, 24 No 3, p. 7; 26 No 3, p. 9
avoiding gift and estate tax traps, 23 No 1, p. 7
INDEX OF ARTICLES
bankruptcy, tax tips, 27 No 2, p. 30
C corporations, less taxing ideas, 27 No 1, p. 8
charitable property tax exemptions, 26 No 1, p. 33
choice of entity, 23 No 3, p. 8; 26 No 1, p. 8
Circular 230 and tax disclaimers, 25 No 2, p. 7
estate tax uncertainty in 2010, 30 No 1, p. 8
federal tax liens, 22 No 2, p. 7; 23 No 2, p. 28; 27 No 2,
p. 11
how to find notices of state and federal tax liens, 24
No 1, p. 10
immigration and tax criminal prosecution, employer I9 compliance, 28 No 3, p. 34
independent contractors, 28 No 2, p. 9
Internet sales tax agreement, 23 No 1, p. 8
IRS priorities, 24 No 1, p. 7; 24 No 2, p. 7
Michigan Business Tax, 28 No 1, p. 40; 29 No 1, p. 40
nonprofit organizations, intermediate sanctions, 26
No 1, p. 27
payroll taxes—don’t take that loan, 29 No 2, p. 7
preparer rules, 28 No 1, p. 7
S corporations, 25 No 3, p. 7; 29 No 3, p. 7
self-employment tax for LLC members, 23 No 3, p. 13
Swiss bank accounts disclosures, 29 No 1, p. 7
Tax Increase Prevention and Reconciliation Act of
2005, 26 No 2, p. 8
year 2000 problem, 19 No 2, p. 4
Technology Corner. See also Internet
business continuity planning, 28 No 1, p. 9
business in cyberspace, 24 No 3, p. 8
computer equipment, end-of-life decisions, 26 No 2,
p. 9
cybersquatting and domain name trademark actions,
22 No 2, p. 9
data breach notification act, 27, No 1, p. 9
electronic contracting, best practices, 28 No 2, p. 11
electronic discovery, 27 No 2, p. 9
HITECH Act and HIPAA privacy and security issues,
29 No 2, p. 9
I.D. cards, security vs privacy, 27 No 3, p. 11
information security, 23 No 2, p. 8; 23 No 3,p. 10;
29 No 1, p. 9
insider threats to critical infrastructures, 28 No 3, p. 8;
29 No 3, p. 8
Is It All Good? 22 No 2, p. 29
malware, 25 No 3, p. 8
offshore outsourcing of information technology services, 24 No 1, p. 8; 24 No 2, p. 9
open source software, 25 No 2, p. 9; 29 No 2, p. 59
paperless office, 22 No 2, p. 35
software licensing watchdogs, 25 No 1, p. 8
UCITA, 23 No 1, p. 8
Terrorism, federal SAFETY Act and antiterrorism technology, 24 No 3, p. 34
Third-party beneficiaries in construction litigation, 27
No 2, p. 25
Tools, special tools lien act, 23 No 1, p. 26; 26 No 3, p. 44
Trust chattel mortgages, 19 No 3, p. 1
UCITA, 23 No 1, p. 8
Uniform Commercial Code
anti-assignment provisions in LLC operating agreements, impact of UCC 9-406 and 9-408, 24 No 1,
p.21
bankruptcy, use of UCC 2-702 in, 29 No 3, p. 9
certificated goods, frontier with UCC, 24 No 2, p. 23
75
commercial lending, impact of revised Article 9, 21
No 1, p. 20
compromising obligations of co-obligors under a note,
unanswered questions under revised UCC Article 3, 16 No 4, p. 30
demand for adequate assurance of performance, 23
No 1, p. 10; 29 No 3, p. 14
federal tax lien searches, consequences of Spearing
Tool, 27 No 2, p. 11
film tax credit and secured transactions, 29 No 3, p. 21
forged facsimile signatures, allocating loss under UCC
Articles 3 and 4, 19 No 1, p. 7
full satisfaction checks under UCC 3-311, 19 No 1,
p. 16
installment contracts under UCC 2-612, perfect tender
rule, 23 No 1, p. 20
investment securities, revised Article 8, 19 No 1,
p. 30
notice requirement when supplier provides defective
goods, 23 No 1, p. 16
partnership interest as security under Article 9, 19
No 1, p. 24
sales of collateral on default under Article 9, 19 No 1,
p. 20
setoff rights, drafting contracts to preserve, 19 No 1,
p. 1
shrink-wrap and clink-wrap agreements, mutual
assent, 26 No 2, p. 17
Uniform Prudent Management of Insitutional Funds Act,
29 No 2, p. 17
Valuation disputes, mediation instead of litigation for
resolution of, 17 No 1, p. 15
Venture capital
early stage markets in Michigan, 25 No 2, p. 34
financing, terms of convertible preferred stock, 21
No 1, p. 9
White collar-crime investigation and prosecution, 27
No 1, p. 37
Year 2000 problem, tax aspects, 19 No 2, p. 4
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