October 23, 2014

Mechanics' Liens: Part 5. Personal Liability Notices

shutterstock_206177620.jpgWe've been examining the role of mechanics' liens in construction contacts, including the way that reallocate credit risk among contractors and the owner of a construction project. The Indiana Mechanics' Lien Statute includes another remedy for subcontractors who do not get paid, entirely apart from a mechanic's lien against the real property where the construction takes place. The statute does not give a name to the remedy, but it's often called a personal liability notice or PLN.

To see how it works, let's go back to the hypothetical example of our last article. Assume you are a subcontractor with a $15,000 claim against the general contractor, a claim the GC disputes. Now let's assume that the deadline for filing a sworn statement and notice of intention to hold a mechanic's lien has already slipped by. Are you out of luck?

Not necessarily. First, remember from our earlier articles that the failure to acquire a mechanic's lien does not affect your breach of contract claim against the GC. All it does is provide collateral to secure that claim, so you still have the right to sue the GC for breach of contract. But that's not all. The PLN gives you a second way to transfer the GC's credit risk to the owner

Who may send a Personal Liability Notice?

The remedy of a PLN is available to subcontractors, lessors leasing construction or other equipment or tools, journeymen, and laborers. That's most, but not all, of the people who would also be entitled to a lien. (Note: Are suppliers of materials entitled to a PLN? That's an interesting question but one that we're not going to answer now. We might take it up someday in another article, but not this time.)

What should the notice say?

To assert a claim of personal liability against the owner, you must send a written notice to the owner that includes:

  • The name and mailing address of the owner of the property as shown on the records of the county auditor or assessor

  • The location of the property, preferably a legal description but at least the street address.

  • The amount of the claim

  • The name of the person who owes you money (in our hypothetical example, the general contractor)

  • A statement that the named person is indebted to you or owes you money

  • A statement that you are holding the owner of the property liable to you for payment of that amount

  • A description of the services that you provided for which you are owed payment

(Technically, not all of these items may be strictly required, but a good notice should include them.)

Then what?

Once the owner receives the notice, the owner is directly liable to you, but only to the extent that the owner owes money to the general contractor, including money that may be currently owed and money that may be owed in the future. In other words, if, at the time the owner receives your notice the owner owes the general contractor $2,000 on an invoice that the owner has already received and the contractor later submits invoices to the owner for another $10,000, the owner will be liable to you for $12,000 of the $15,000 you are owed. If the owner has already paid the general contractor in full for the entire project, the owner has no liability to you.

What if the general contractor has been fully paid for the project that I worked on but holds another contract with the same owner for another project on the same property?

In that case, the owner still has no liability to you. In essence, the PLN gives you a claim to money that the owner has yet to pay to the general contractor under the contract that covered the work you performed, but not to money that the owner may owe the general contractor for other reasons.

How long do I have to send the PLN?

There is no strict deadline equivalent to the one that applies to mechanics' liens. You can send a PLN at any time; however, your claim against the owner is only for the amount that the owner still owes the general contractor. Once the owner has fully paid the general contractor, the owner has no liability to you.

Interestingly, the statute also allows you to send a PLN to the owner even before you do the work. In that case, of course, your notice must include the total amount that you will be owed for all the work you're contracted to perform and a description of that work. Doing so may not make you very popular with either the general contractor or the owner because it creates additional concerns for both of them, but you have the right to do so and, once you do, the owner is liable to you even after the general contractor is fully paid.

Okay, I sent the PLN. Now what?

Most likely, you will enter into discussions with the owner. If you, the GC, and the owner reach an agreement on the amount you are actually owed, a common practice is for the owner to issue a two-party check, payable to you and the GC, in the amount that you are owed, then the GC will endorse the check over to you. If you can't reach an agreement, you can sue both the GC and the owner, making sure you file the lawsuit before the statute of limitations for breach of contract expires.

Continue reading "Mechanics' Liens: Part 5. Personal Liability Notices" »

October 18, 2014

Mechanics' Liens: Part 4. Enforcing a Lien

iStock_000017631785_ExtraSmall.jpgSo far we've looked at the basics of subcontracting and allocation of credit risk, how a mechanic's lien changes things by reallocating credit risk, and how a contractor, subcontractor, supplier, or worker goes about acquiring a mechanic's lien. Now let's assume you are a subcontractor with a claim against the general contractor, or GC, for $15,000. The GC has withheld that amount from your fees, accusing you of not finishing your work on schedule. The general contractor says it incurred $15,000 in additional labor charges because its workers had to wait around with nothing else to do until your work was completed. You blame the general contractor for the delay and additional expense, and you have recorded a sworn statement and notice of intention to hold a mechanic's lien in the amount of $15,000. A copy of it has been sent to the owner.

Now what happens?

At this point, there are several possibilities.

  • What you hope will happen is that either the owner or the GC will pay you - you hope it will be the entire amount but more likely it will be a negotiated compromise amount - in exchange for your signed release, which will then be filed with the county recorder. If the owner pays you, it will probably turn into a dispute between the GC and the owner, but you will not be involved (except as a witness).

  • If the owner believes there is a flaw in the lien, for example that it was recorded too late, the owner can challenge the lien in court, asking the court to remove it. If the owner is successful, it does not mean that you lose your claim. You will still have a breach of contract claim against the GC, but, if you win that case, your ability to collect will turn on the ability of the GC to pay. (Remember that earlier discussion of credit risk? The lien reallocates the GC's credit risk to the owner because the owner's property serves as collateral to secure your claim. Without the lien, the GC's credit risk falls back on you.) By the way, recording a lien that is invalid can make you liable to the owner for a tort known as slander of title.

  • The owner can post a bond to serve as substitute collateral and ask the court to order that the lien be released. That removes the owner from the middle of your dispute with the GC. If you sue the GC for breach of contract and win, and if the GC does not pay you the amount of the judgment, you can collect from the surety who underwrote the bond. (In essence, the GC's credit risk is again reallocated to the surety who charges a fee to assume that risk.) This process is often called "bonding off" a lien.

  • The owner and GC can wait to see if you sue to enforce the lien. If you do not sue within one year, the lien expires. If that happens, you will still have your claim against the GC because the statute of limitations on your breach of contract claim is either six or ten years. (See our earlier blog for a discussion of the uncertainty in the exact amount of time you have to sue the GC.)

  • The owner can send you a letterdemanding that you sue to enforce the lien within 30 days. If you do not, you lose the lien. It's sort of a put-up-or-shut-up provision in the mechanic's lien statute that gives the owner a way to speed things along.

  • You can sue to foreclose on the lien. However, to do that successfully, you will have to prove that the GC actually owes you the $15,000, which means you will have to litigate your breach of contract claim against the GC. Although there are a few different procedural paths to get there, the lawsuit will involve you, the GC, and the owner. If you lose on the breach of contract claim against the GC, the court will order the lien to be removed. If you win on the breach of contract claim against the GC, and the GC pays you the amount of the judgment, the lien will be removed. If the GC does not pay you the amount of the judgment, the owner can pay you, and the lien will be removed. If you win against the GC and neither the GC nor the owner pays you, you can force a sale of the owner's property, with the amount of the judgment being paid to you out of the proceeds of the sale and the balance paid to the owner.

As we've discussed, all the lien really does is to reallocate to the owner the risk that the GC will not pay you the amount you are properly owed. In most cases, if you win your breach of contract case against the GC, the GC will pay the judgment and the lien will be removed without the need for you to foreclose.

So what good does a mechanic's lien do? Really?

In the case of a mechanic's lien filed by a general contractor, the lien provides the GC with collateral to secure its claim against the owner. That can be very important if the owner goes into bankruptcy because the GC will be a secured creditor rather than an unsecured creditor. Of course, in most cases, if the GC wins its claim against the owner, the owner will pay and the lien will be removed. In addtion, sometimes it gives the owner an additional incentive to settle a claim by the GC because selling the property will be more difficult while the lien is in place. (Of course, if the owner really wants to sell the property, the owner can bond off the lien, albeit at the expense of having to pay for the bond.)

From a legal perspective, things aren't much different for a lien recorded by a subcontractor, but as a practical matter, the ability to record a lien gives the subcontractor more leverage in negotiating a resolution to a dispute. The lien will bring the owner into the discussion, and that may provide the GC (or higher tier subcontractor, as applicable) with additional incentive to settle your claim.

Continue reading "Mechanics' Liens: Part 4. Enforcing a Lien" »

October 17, 2014

Mechanics' Liens: Part 3. Acquiring a Lien

iStock_000016437727_ExtraSmall.jpgThis is the third in a series of articles dealing with mechanics' liens. In the first one, we discussed the basics of credit risks associated with subcontracting in an area other than construction. In the second, we examined how a mechanic's lien reallocates those credit risks for construction contracts. In this one, we explain how a contractor or subcontactor goes about acquiring a mechanic's lien. For a change of pace, we'll do it in a question-and-answer format.

Some caveats: First, mechanic's lien requirement vary significantly from state to state. Given that this is the Indiana Business Law Blog, we'll answer the questions based on Indiana law. Also note that the Indiana Mechanic's Lien Statute is filled with complicated, cumbersome, even archaic language that can be difficult for even lawyers to parse, so we'll try to give answers that are more easily understood. However, that also means we may leave out some details, making the answers a bit imprecise in some circumstances. As always, this blog is not legal advice and you should not rely on it as a substitute for legal advice.

Who can acquire a mechanic's lien?

Generally, anyone who furnishes labor, materials, or equipment (including leased equipment or tools) to the construction, repair, or removal of a building or structure, or to any other earth moving operation, is entitled to a mechanic's lien on the building or structure and the land where the construction, repair, or removal was performed. In addition, registered architects, registered engineers, and registered land surveyors are entitled to hold a mechanic's lien. The person who provides the labor, material, or equipment may do so in a contract directly with the owner of the land or under a subcontract.

How does someone go about acquiring a lien?

First things first. On some types of projects -- specifically on the original construction a single or double family dwelling, intended to be the residence of the owner of the land on which it is built, or on the repair or alteration of an owner-occupied single or double family dwelling -- there is a requirement for a "pre-lien notice." Anyone providing labor, material or equipment to such a project must notify the owner in writing that the person is providing the labor, material, or equipment and that the person has rights to a mechanic's lien, unless the person provides the labor, material, or equipment in a contract directly with the owner. (The idea is that the owner already knows about the people who hold contracts directly with the owner.) If the project is the new construction of the dwelling, the notice must be given within 60 days after the person first provides labor, material, or equipment to the project. If it is the repair of a dwelling rather than new construction, the notice is due within 30 days. If the notice isn't given, there's no right to a lien later.

Does the pre-lien notice have to be recorded in the office of the county recorder?

No. It has to be in writing and furnished to the occupying owner or the owner of record of the property, but it does not have to be recorded.

Okay, assume the person provided a pre-lien notice or that no pre-lien notice was required. Now what?

A person entitled to a lien must file, in duplicate, in the office of the county recorder a sworn statement and notice of intention to hold a lien. The sworn statement and notice of intention to hold a lien must include all of the following information:

  • the name and address of the person making the claim

  • the amount of the claim

  • the owner's name and last address as shown on the county's property tax records

  • both the street address and legal description of the property where the project is located.

The statement must be notarized and satisfy all other requirements for recording documents.

The statement and notice must be filed within either 60 days or 90 days of the last day the person making the claim furnished labor, materials, or equipment to the project. The deadline is 60 days for "Class 2" structures -- essentially single or double family dwelling units and related structures--and 90 days for all others. The lien attaches immediately when the notice is filed with the county recorder. The county recorder will then send a copy of the statement and notice to the owner.

Continue reading "Mechanics' Liens: Part 3. Acquiring a Lien" »

October 5, 2014

Mechanics' Liens: Part 2. Reallocating credit risk in construction projects

shutterstock_206177620.jpgIn part 1 of this series on mechanics' liens, we discussed a hypothetical situation with a company that hired an ad agency, with the ad agency subcontracting some work to a production company and purchasing advertising time on a television station. The production company bore the ad agency's credit risk because its contract was with the ad agency, and when the ad agency went out of business the production company faced the possibility of not being paid. In contrast, the television station did not bear the ad agency's credit risk because its contract with directly with the ad agency's client. The ad agency's client faced the possibility of having to pay for the television air time twice - once to the ad agency and a second time directly to the television station when the ad agency failed to pay for the air time on the client's behalf.

Now let's look at the credit risks associated with a construction project in which the owner of a construction project hires a general contractor to complete the entire project on a time-and-materials basis, which means that the price paid by the owner is equal to the amount the general contractor pays for the labor (i.e., the "time") and materials required to do the construction, plus a markup to cover overhead and profit. The general contractor does some of the work with its own employees and subcontracts some of the work, including the installation of the electrical wiring, to another contractor.

The electrical subcontractor completes its work and submits its invoice to the general contractor. The general contractor adds its markup to the amount of the subcontractor's invoice and submits its own invoice to the owner. The owner pays the general contractor, but before the general contractor pays the subcontractor, the general contractor goes into bankruptcy. As we saw before, the subcontractor faces the possibility of not being paid for its work; in other words, the subcontractor bears the credit risk of the general contractor. The subcontractor has no claim against the owner because there's no contractual relationship directly between the owner and the subcontractor.

Or at least that would be the case if it were not for the subcontractor's right to a mechanic's lien. The Indiana Mechanic's Lien Statute (Ind. Code 32-28-3) allows a person who provides labor or materials to the improvement of real property (in this case, the electrical subcontractor) to hold a lien on the property. Ultimately, the electrical subcontractor can foreclose on the lien, forcing the property to be sold at auction, with the proceeds of the sale being used to pay the subcontractor and any remaining proceeds going to the owner. As a practical matter, what usually happens is that the owner of the property pays the subcontractor directly, and the subcontractor releases the lien. Instead of the subcontractor not getting paid, the owner has to pay twice.

In other words, the mechanic's lien statute reallocates the credit risk of the general contractor so that it is borne by the owner of the property, not by the subcontractor. Technically, that's an oversimplification because if the property does not bring enough at auction to pay the subcontractor in full, the owner has no obligation to make up the difference, but the point remains that the mechanic's lien statute rearranges the allocation of the general contractor's credit risk, reducing the risk to subcontractors and assigning it to the owner.

In the next blog entry, we'll start an in-depth look at mechanics' liens, starting with the perspective of a subcontractor.

Continue reading "Mechanics' Liens: Part 2. Reallocating credit risk in construction projects" »

October 2, 2014

Mechanics' Liens: Part 1. The basics of credit risk and subcontracting

shutterstock_91856543.jpgThis starts a short series of blog articles discussing mechanics' liens and their cousins, notices of personal liability, concepts that arise in the context of construction contracts and similar agreements. To understand what's special about construction contracts, you need to understand a bit about how contract law, subcontracting, and credit risk work in other settings. So let's review the basics.

Imagine your company signs an advertising agency agreement, hiring the ad agency to create a television advertising campaign for your business. The ad agency comes up with the ideas for the commercials, hires a production company to produce them, and purchases advertising time on your behalf from local television stations. The contract to produce the commercial is between the ad agency and the production company, but the contract with the television station is between the television station and your company, signed by the ad agency as your company's agent, as it is authorized to do by the ad agency agreement.

All seems to go well, and you pay the advertising agency the full amount your company owes under the agency agreement, including money that the ad agency is supposed to pay to the television stations on your behalf. Then the advertising agency goes belly-up. It closes its doors, fires all its employees, and files for bankruptcy. Among its unpaid creditors are the production company that produced your commercial and a television station that aired it. Can the production company and the television station force your company to pay them what they should have been received from the ad agency?

Under these facts, there are two different answers. The production company is a subcontractor to the ad agency. It has no claim against your company simply because it does not have a contract with your company. The only thing the production company can do is file a proof of claim in the ad agency's bankruptcy and hope to recover something.

In contrast, the television station's contract was with your company, not with the ad agency, and your company is directly responsible for the amount owed to the television station. You'll have to pay the television station (even though you've already paid the ad agency money that was supposed to go to the television station) and hope you can recover something on your company's own proof of claim in the bankruptcy based on the ad agency's breach of contract (or some other possible legal theories that we won't go into).

In producing the commercials without getting paid first, the production company took on the ad agency's credit risk, and your company does not bear it. However, by paying the ad agency the money the ad agency was supposed to go to the television station, your company took on the ad agency's credit risk, and that risk does not fall on the television station. In the next blog entry, we'll examine how mechanics' liens change that allocation of risk for construction contracts.

Continue reading "Mechanics' Liens: Part 1. The basics of credit risk and subcontracting" »

August 27, 2014

Account Stated

iStock_000007946595Small.jpgOn December 12, 2008, Layne and Anita Dellamuth bought flooring materials and installation services from Carpets Unlimited. The Dellamuths made a downpayment that left a balance of a little more than $23,000. Carpets Unlimited subcontracted the installation services to Jared Keeton, who performed that work later the same month, but apparently not to the liking of the Dellamuths because a dispute arose between them and Keeton about the quality of the installation. In addition, the Dellamuths objected to additional charges that Keeton added to the amount owed. In February 2009 Carpets Unlimited corrected the work at no additional cost to the Dellamuths.

By August 2011 the Dellamuths still had not paid Carpets Unlimited the remaining $23,000. Carpets Unlimited sent the Dellamuths a letter and invoice, demanding payment, by certified mail, which the Dellamuths signed for on August 27. Another letter and invoice, sent on June 26, 2012, was returned unclaimed. In August the same year, Carpets Unlimited sued the Dellamuths, and the trial court granted Carpets Unlimited's motion for summary judgment. The Dellamuths appealed, and today the Indiana Court of Appeals affirmed the trial court's decision.

An interesting aspect of this case is that Carpets Unlimited did not sue on the basis of breach of contract. Instead, Carpets Unlimited sued solely on the basis of a legal theory known as account stated, a theory that is more often used as an alternative basis for a lawsuit, included in a complaint primarily as a back-up theory in case the plaintiff's breach of contract fails for one reason or another, perhaps because the contract is held to be unenforceable.

An account stated is an agreement between two parties that a statement of an amount owed by one of the parties to the other is correct and an agreement, either express or implied, that the person owing the amount will pay it. Once an account stated is established, it becomes an independent, enforceable agreement; the creditor no longer has to prove the elements of the contract or other basis of the original obligation. Instead, the burden shifts to the debtor to show that the amount is not owed.

Perhaps the most important aspect of account stated - the most powerful for the creditor and the most dangerous for the debtor - is that an agreement need not be expressed but can be implied. If the creditor sends an invoice or account statement to the debtor, and the debtor fails to object within a reasonable time after receiving the invoice or statement, the debtor is deemed to have agreed that the amount set forth in the invoice or statement is correct and to have agreed to pay that amount.

In this case, the Dellamuths failed to object to the August 2011 letter and invoice and were deemed to have accepted the amount of the invoice as a correct statement of the amount they owed and to have agreed to pay that amount. Carpets Unlimited did not have to prove that a contract with the Dellamuths existed or that the materials had been delivered and the services properly performed. Instead, the burden shifted to the Dellamuths to prove that they did not owe the amount of the invoice, and they did not (and presumably could not) do so.

However, the Dellamuths argued two other points that, in other circumstances, might have worked. First, they pointed to case law holding that once a dispute has arisen about debtor's obligation, the debtor need not continue to object to future statements from the creditor. In this case, the Dellamuths argued that by complaining to Keeton about the quality of the installation and they no longer needed to object to statements from Carpets Unlimited in order to avoid an implied acceptance of those statements. The Court of Appeals rejected that argument, pointing out that Carpets Unlimited had corrected the installation and that, although the Dellamuths objected to additional amounts that Keeton added to the total obligation, Carpets Unlimited's invoice was for the $23,000 balance to which the Dellamuths had never objected.

Second, the Dellamuths claimed that the relationship between them and Carpets Unlimited could not give rise to an account stated, pointing to case law holding that prior dealings between the parties is a prerequisite to account stated, apparently arguing that there could be no account stated because they had not previously done business with Carpets Unlimited. The Court of Appeals disagreed, looking to case law from other states to clarify that the requirement for prior dealings between the parties means that there must have been prior dealings that gave rise to the debt described in the account statement. Accordingly, the Court held that the contract between the Dellamuths and Carpets Unlimited for materials and services, as well as the delivery of the materials and performance of the services, satisfied the requirement for prior dealings.

There are two sides to the moral of this story. On the debtors's side, never ignore an invoice or an account statement because you think you do not owe it. Instead of ignoring it, object - and do it in writing to make a record of the objection. On the creditor's side, account stated can be a powerful way to shore up your ability to recover amounts that are owed to you. If in doubt, send a statement or invoice - preferably by a method that includes confirmation of receipt -- and see if the debtor objects.

Continue reading "Account Stated " »

August 19, 2014

Small Businesses Not Included in Proposed Reporting Requirement for Government Contractors

iStock_000041719054Small.jpgThe Department of Labor's Office of Federal Contract Compliance Programs ("OFCCP") has issued a notice of proposed rulemaking that would require certain government contractors to submit an Equal Pay Report to the government as a supplement to the Employer Information Report (EEO-1) that is already required.

If a final rule is adopted as proposed, the Equal Pay Report will require companies to report the number of workers within each EEO-1 job category, the total W-2 wages of all workers in each job category, and the number of hours worked by all workers in each job category, all broken down by race, ethnicity, and sex. Only aggregate information will be reported; no information regarding individual wages will be required. In addition, the reports will not include any information on worker qualifications or experience that might help explain any differences among the groups within a job category.

Small Businesses Excluded

Small businesses -- those with fewer than 100 employees -- are excluded from the new reporting requirements. In addition the new reporting requirements apply only to companies that hold a contract, subcontract, or purchase order with the Federal government that, including modifications, covers a period of more than 30 days and is worth at least $50,000.

Purpose of the New Reporting Requirement

According to the Department of Labor, working women earn only 77% of the wages earned by working men, and the gap is even greater for African American women and Latinas. The new reporting requirement is intended to address that situation in two ways: First, it will provide the Department of Labor with a source of information to facilitate enforcement actions against government contractors who violate equal pay regulations. However, enforcement actions will not be based solely on the reported information. Instead, the agency will use the information in targeting and prioritizing its enforcement actions. Second, the Department of Labor will use the reports to compile and issue summary data to assist government contractors with their own internal compliance programs.

Where the Proposed Rule fits in the Rulemaking Process

The notice of proposed rulemaking, or NPRM, was published in the Federal Register on August 8, 2014. (Generally, the NPRM is the first official step in the creation of an administrative rule or regulation, but sometimes it is preceded by an advance notice of proposed rulemaking, or ANPRM.) This NPRM has a 90-day comment period, which means that Department of Labor will accept written comments from the public until November 6, 2014. The NPRM contains not only the proposed regulatory language that, if adopted, would be placed into the Code of Federal Regulations, it also includes an extensive preamble with an executive summary, a discussion of the background of the proposed rulemaking, a section-by-section discussion of the proposed rule, and an analysis of other factors, including the need for the regulation and the anticipated costs of the proposed rule.

Once the comment period closes, the agency will analyze all the comments submitted by the public and, probably, issue a final rule by publishing it in the Federal Register. The notice of the final rule will include the language of the final regulation as well as a preamble that usually includes a summary of the comments recieved from the public and the agency's response to those comments.

How to Submit Comments

If you would like to submit your own comments on the NPRM for the Equal Pay Report, you may do so by any of the following means:

  • You may submit them online at the Federal rulemaking portal, http://www.regulations.gov.
  • If your comments consist of six pages or less, you may fax them to (202) 693-1313.
  • You may mail them to Debra A. Carr, Director, Division of Policy and Program Development, Office of Federal Contract Compliance Programs, Room C-3325, 200 Constitution Avenue, N.W., Washington, D.C. 20210.

Note that the comments must be received (not merely postmarked) by November 6, 2014. You may view comments submitted by others here.

Continue reading "Small Businesses Not Included in Proposed Reporting Requirement for Government Contractors" »

August 11, 2014

LLC Veil Piercing: Required Corporate Formalities, revisited

iStock_000014425910XSmall.jpgOne of the factors for determining when the owners of an LLC (or a corporation) may be held liable for the obligations of the business is whether the required corporate formalites have been observed. A while back, we posted an article about the required corporate formalities for Indiana limited liability companies. One of them is that each Indiana LLC must maintain certain records and must make them available to members for inspection and copying. Notably, that requirement is not a default provision that can be reduced or eliminated by the operating agreement.

Last week the LLC Law Monitor blog by Doug Batey of Stoel Rives commented on a Massacusetts case, Kosanovich v. 80 Worcester Street Associates, LLC, No. 201201 CV 001748, 2014 WL 2565959 (Mass. App. Div. May 28, 2014), that imposed liability on the sole member of a Massachusetts limited liability company primarily because of the LLC's failure to maintain records. Doug described the case (correctly, in my view) as "an outlier decision on veil-piercing" for piercing the veil based on so little.

First, a quick summary of Massachusetts veil-piercing law as described in the decison by the Appellate Division of the Boston District Court. A corporate veil may be pierced only in rare circumstances and only to defeat or remedy fraud, wrong, or injustice. Massachusetts courts weigh twelve factors, but the analysis is not merely an exercise in counting factors. The twelve factors are (1) common ownership (presumably relevant when multiple entities are involved); (2) pervasive control (which is not enough, by itself, to pierce the veil); (3) confused intermingling of business assets; (4) thin capitalization; (5) nonobservance of corporate formalities; (6) absence of corporate records; (7) no payment of dividends; (8) insolvency at the time of the litigated transaction; (9) siphoning away of corporation's funds by dominant shareholder; (10) nonfunctioning of officers and directors; (11) use of the corporation for transactions of the dominant shareholders; and (12) use of the corporation in promoting fraud.

In this case, the LLC was owned and entirely controlled by one person, a construction contractor who set up a separate LLC for each of his projects. The only record the LLC produced was a copy of the articles of organization. The owner testified that some of the records might have existed at one time but that they might have been lost when his former partner left the business. There were no tax records, no checkbook, no statements from subcontractors -- none of the records that one would ordinarily expect to be created in the ordinary course of a construction contracting business. The court upheld the trial judge's decision to hold the owner liable based on only two of the twelve factors: pervasive control (which, taken alone, would be insufficient) and the absence of corporate records.

One gets the sense that the court (and almost certainly the plaintiff's lawyer) was frustrated by the absence of records because they are also the records that, if they existed, might have served as evidence of the other veil-piercing factors and of the independent prerequisites of fraud, wrong, or injustice. Nonetheless, there was no evidence of any of the ten other factors nor evidence of fraud, wrong, or injustice. Had there been proof that the owner had destroyed records, it might have justified an inference that the records destroyed would have proven enough to pierce the veil, but there was no evidence of that, either. The evidence proved was that the owner completely neglected business records, but not that he destroyed them. As Doug stated in his blog, "The court's reliance on [the owner's] inadequate record-keeping effectively placed on his shoulders the burden to prove that he was innocent of violating any of the other 12 factors."

Would the result have been the same under Indiana law? I do not believe so, or at least I do not believe that it should, based in part on a provision of the Indiana Business Flexibility Act, the statute that governs Indiana LLCs. As mentioned in the first paragraph, the statute requires Indiana LLCs to maintain certain records and to make them available to members for inspection and copying. However, Ind. Code section 23-18-4-8(e) specifies that failure to maintain those records does not constitute grounds for holding the owners personally liable for the obligations of the LLC. Even without that provision, I do not believe Indiana courts would pierce the veil of an Indiana LLC under similar circumstances, but I think that provision forecloses any possibility of the owner of an Indiana LLC (sole owner or otherwise) being held liable just because the LLC does not maintain the required records.

As Doug also pointed out, lawyers (including this one) advise their business clients to observe formalities of running a business and to maintain good records, including those required by the Indiana Business Flexibility Act, and this case, even if it is an outlier, and even if an Indiana court would not reach the same result, is an example of a business owner who paid a price for not doing so.

Continue reading "LLC Veil Piercing: Required Corporate Formalities, revisited" »

August 8, 2014

Copyright Conundrum: A monkey's selfie

iStock_000028482722Small.jpgOkay, this article in the Washington Post is just too good not to mention.

As reported in 2011 by the Guardian, British photographer David Slater spent three days in an Indonesian national park following and photographing crested black macaques, a type of monkey. At some point, he set up his camera on a tripod and left it unattended for a few minutes. When he returned, he found that the macaques had taken the camera and were taking pictures with it, apparently intrigued by the sound of the shutter. As it turns out, they took some pretty good pictures, including some of themselves. That's right - monkey selfies.

At least one of the pictures was posted on Wikimedia Commons. As Wikimedia has now disclosed, it received from Mr. Slater a "take-down notice" under the Digital Millenium Copyright Act (or DMCA). The take-down provisions of DMCA are intended to deal with some of the unique intellectual property issues created by the internet, including the issue of an online service provider (or "OSP," such as Wikimedia) being liable for copyright infringement when infringing material is posted on the OSP's web site. If the owner of copyrighted material (text, a photograph or other image, video or audio recording, etc.) discovers his material has been posted online, the copyright owner can send a notice to the OSP demanding that it be taken down. If the OSP complies, it will not be liable for infringement. However, the OSP is also required to notify the person who posted the material that it has been taken down, and that person has the opportunity to challenge the allegation of infringement.

In Mr. Slater's case, Wikimedia declined to take down the photograph because it does not believe that Mr. Slater owns the copyright to the photographs. Instead, Wikimedia explained to the ABA Journal that, in its view, no one owns the copyright to the photograph -- not Mr. Slater because he didn't take the photo and not the monkey because monkeys can't own copyrights. And that gives us a good opportunity to discuss how a copyright originates and who owns it.

Copyright protection under title 17 of the United States Code is afforded to "original works of authorship fixed in any tangible medium of expression, now known or later developed, from which they can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device." Examples of works of authorship include literary works; musical works (including lyrics); dramatic works; choreography; pictorial, graphic, and sculptural works; motion pictures and other videographic works; audio recordings; and architectural works. The standard for originality is low; a work is "original" if it was created independently by the author, i.e., without copying another work. In earlier years, the copyright to an original work of authorship did not exist until the work was published, but under today's statute the copyright exists as soon as the work is created. (Once the work is published, some complicated rules dealing with the nationality of the authors and the country in which it is first published kick in, but in most cases publication does not affect the copyright under U.S. law.)

In most cases, the author of a work owns the copyright except for a couple of situations in which the work is considered a "work made for hire." First, works created by their employees while acting within the scope of their employment are "works made for hire," and the copyright belongs to the employer. Second, the copyright to a few types of specially ordered or commissioned work belongs to the person who commissioned the work, and not to the author, if they agree in writing that the work is to be considered as a work made for hire. Of course, the author of a work may agree to transfer the copyright to another person, and the agreement can be made even before the work exists. In that case, the copyright is essentially transferred immediately after its creation.

So what about the monkey's selfie? Does a copyright exist, and, if so, who owns it? I'm not about to try to answer that question, but here are some possible arguments and questions to consider.

  • Certainly the photographs taken by the macaques are within the scope of what is ordinarily considered a work, and they qualify as original. In addition, they are fixed in a tangible medium of expression that satisfies the requirement for a copyright to exist. But is there an author so that they can be considered original works of authorship? It seems logical to assume that the copyright statute presumes that an author must be a human being, so perhaps there is no copyright to the pictures because they are not orginal works of authorship.
  • Why would Mr. Slater not be considered an author? It was his camera, and he created the circumstances that permitted the monkeys to take the camera and trigger the shutter. What if the pictures of the monkeys had been taken by a camera on the tripod with the shutter activated by a motion detector? If (as seems likely) that would be protected by copyright, what distinguishes it from pictures taken by the monkeys physically activating the shutter?
  • Imagine someone leaves a piece of fabric outdoors, fabric that fades in the sunlight. The fabric moves around in the wind so that sometimes it is folded over on itself, creating a pattern on the fabric as it fades. Would the person who placed the fabric outdoors would have a copyright to the pattern? If so, wouldn't Mr. Slater be in an analogous position? Or does it matter whether the person placed the fabric outdoors, intending to create a work of original authorship, or accidentally left the fabric outdoors with no intention of creating anything?
  • What about "elephant art," or paintings made by elephants holding paintbrushes with their trunks? It seems hard to distinguish those paintings from the monkey selfies, so as one goes, the other would likely go as well.
  • Wikimedia seems to admit that there's a copyright, but opines that Mr. Slater doesn't own it. I'd think that the only way a copyright can exist is if Mr. Slater is the author (because, as discussed above, I think an "author" must be human), which means he is also the copyright owner. It seems to me that Wikimedia's stronger argument is that no copyright exists because there is no author. But that's just me.

As I said, I'm not attempting to answer the question of the copyright of the monkey selfies or any of the other above questions, but it will be interesting to see how this gets resolved.

And about the picture at the top of this article? It's a ring-tailed lemur, not a monkey, but it's the best stock photo I could find, and there was no way I was going to use the actual monkey selfies because I'm not at all sure that Wikimedia is right.

[Update August 31, 2014: On August 19, the U.S. Copyright Office issued a proposed third edition of the U.S. Copyright Office Practices. Section 306 provides, "The U.S. Copyright Office will register an original work of authorship, provided that the work was created by a human being. . . . The Copyright Office will not register works created by nature, animals, or plants." It goes on to list several examples of works that will not be registered, including a "photograph taken by a monkey." So at least in the tentative position of the U.S. Copyright Office, Wikimedia got this one right -- the photograph is in the public domain.

And here's what the monkey has to say about it: A Statement from the Monkey.]

Continue reading "Copyright Conundrum: A monkey's selfie" »

July 28, 2014

LLCs and Apparent Authority II

iStock_000007115543Small.jpgLast week I posted an article about apparent authority of a member or manager of an Indiana limited liability companies to bind the LLC, usually by signing a contract on behalf of the company, including a discussion of a 2013 decision of the Indiana Court of Appeals, Cain Family Farms vs. Shrader Real Estate & Auction, addressing the common law doctrine of apparent authority and the provisions of the Indiana Business Flexibility Act that bestow apparent authority on members and managers. Under the facts presented by the record, the court held that apparent authority existed and, in particular, "Whether we consider the question of apparent authority under the common law or the
Indiana Business Flexibility Act, the outcome is the same."

As discussed in last week's Indiana Business Law Blog post, one can imagine situations in which the statute would establish apparent authority but the common law analysis would not, and vice versa. It seems clear that a member or manager has authority to bind a limited liability company if the Indiana Business Flexibility Act says so, even if the member or manager would not have apparent authority under the common law analysis. But what if it's the other way around? Will an Indiana court enforce a contract signed by a member or manager on behalf of the LLC if the member or manager would have apparent authority under the common law but not under the Indiana Business Flexibility Act? Although the Cain Family Farm decision does directly address that question, the Court of Appeals appears to treat the two bases of apparent authority as independently viable, implying that Indiana courts will recognize the apparent authority of a member or manager under the common law even if apparent authority does not exist under the Indiana Business Flexibility Act.

Since I posted the article last week, I've corresponded with my friend John Cunningham, a New Hampshire attorney, a recognized expert on LLCs, a blogger, and co-author of Drafting Limited Liability Company Operating Agreements, my go-to reference for LLC law and operating agreements. I asked John about the question, and he pointed me to the official commentary of the Revised Uniform Limited Liability Company Act, which discusses why the RULLCA leaves the issue of apparent authority of members to the common law. See RULLCA Section 301.

After reflecting on my correspondence with John and reading the commentary to the RULLCA, I've come to believe that the path on which the Court of Appeals appears to have placed Indiana law is a good one. Note that question of apparent authority is irrelevant if the member or manager has actual authority to bind the company, and it cannot be used by another party to avoid a contract with a limited liability company over the LLCs objection. (If nothing else, the LLC can always ratify the contract.) The question arises only when an LLC tries to avoid a contract signed by a member or manager in the absence of actual authority, and the question is, who suffers the consequences -- the LLC or the other party? Although the Indiana Business Flexibility Act creates some areas of relative certainty (which I believe is superior to the intentional silence of the RULLCA), it also denies apparent authority under some circumstances in which the other party to the contract reasonably believes, based on the conduct of the LLC, that the member or manager is acting within his or her authority.

In my personal view, it is better public policy to err on the side of enforcing contracts in those situations by maintaining the common law doctrine as a viable basis for apparent authority, independent of the statutory basis. First, the LLC is in the best position to control the actions of its members or managers, and the operating agreement can provide a remedy when one of them misbehaves. Second, the LLC is also in the best position to control its own actions and to avoid conduct that cloaks its representatives with apparent authority when they lack actual authority. Third, to fail to enforce a contract that the other party entered into in good faith, based on a reasonable belief that the member or manager had authority to bind the company (or to require prospective counterparties to consult the public record before signing a contract with a limited liability company) could cause others to be overly cautious, even leery, of doing business with LLCs.

Whether Indiana courts agree with this analysis remains to be seen.

Continue reading "LLCs and Apparent Authority II" »

July 24, 2014

LLCs and Apparent Authority

iStock_000007115543Small.jpgWhether a particular person has the authority to execute a contract on behalf of another person or entity is a standard question of agency law. If the principal has expressly or impliedly authorized an agent to execute contracts on behalf of the principal, the agent is said to have actual authority. However, a person who does not have actual authority can nonetheless bind the principal if that person has apparent authority.

Common Law Standard for Apparent Authority

The common law analysis of apparent authority is well established. An agent has apparent authority when a third person reasonably believes, based on the conduct of the principal, that the agent has authority. The reason for the belief need not be an actual statement by the prinicipal but can be (and usually is) found in the circumstances in which the prinicipal places the agent, but it is essential that the third party's belief is based on the conduct of the principal; the statements or actions of the agent cannot create apparent authority. Moreover, if the third person knows that the agent has no actual authority, apparent authority does not exist.

Apparent Authority under the Indiana Business Flexibility Act

The Indiana Business Flexibility Act (Article 23-18 of the Indiana Code) contains different rules for the authority of members and managers of limited liability companies, and the rules are slightly different for LLCs formed on or before June 30, 1999 (Section 23-18-3-1), and LLCs formed after that date (Section 23-18-3-1.1).

If the LLC's articles of organization do not provide for managers (i.e., a member-managed LLC), each member is an agent of the LLC for the purpose of the LLC's business and affairs. Accordingly, the act of any member for those purposes, including the execution of a contract, binds the LLC, subject to the following exceptions:

  1. The member does not have actual authority and the person with whom the member is dealing knows that the member does not have actual authority.

  2. The act is not apparently for the purpose of carrying on the LLC's business and affairs in the usual manner, unless the member has been granted actual authority by the operating agreement or by unanimous consent of the members.

  3. For LLCs formed after June 30, 1999, the articles of organization provide that the member does not have the authority to bind the company.

If the LLC's articles of organizations provide for managers, a member acting solely in the capacity of a member is not an agent of the LLC and does not have authority to bind the LLC, except to the extent provided by the articles of organization. Instead, each manager is an agent of the company and has authority to bind the LLC, subject to the following exceptions:

  1. The manager does not have actual authority and the person with whom the manager is dealing knows that the manager does not have actual authority.

  2. The act is not apparently for the purpose of carrying on the LLC's business and affairs in the usual manner, unless the manager has been granted actual authority by the operating agreement or by unanimous consent of the members..

  3. For LLCs formed after June 30, 1999, the articles of organization provide that the manager does not have the authority to bind the company.

Although Sections 3-1 and 3-1.1 of the Indiana Business Flexibility Act speak only of authority and agency, not of apparent authority and apparent agency, it seems clear that those sections deal with apparent authority and that actual authority of managers and members is addressed elsewhere, in Section 23-18-4-1. Indeed, the only Indiana decision to address Section 3-1.1, Cain Family Farm, L.P. vs. Schrader Real Estate & Auction Company, describes that section as a source of apparent authority and not actual authority.

Comparison of Common Law and Statutory Bases for Apparent Authority

The following table summarizes the main differences between the common law basis of apparent authority and the statutory basis.

Common law analysis of apparent authority

Apparent authority of members and managers under Indiana Business Flexibility Act

Applies to any agent of the company.

Applies only to members or managers.

Apparent authority created by conduct of the company.

Apparent authority created by the articles of organization; no other conduct necessary.

The person with whom the member or manager is dealing must have a reasonable belief that the member or manager has authority based on the company's conduct.

As long as the person with whom the member or manager is dealing does not have actual knowledge that the member or manager lacks authority, that person's subjective belief is irrelevant.

No exception for acts outside the usual course of business

No authority for acts outside the apparent usual way the company does business, unless the authority is granted by the operating agreement or by unanimous consent of the members.

When we're dealing with managers of an LLC or with members in a member-managed LLC, the statute confers authority more broadly than the common law because no other conduct on the part of the LLC is necessary. However, the statutory exceptions are also broader because the common law contains no exception for acts outside the usual way the LLC does business. In addition, the statute denies authority to members of a manager-managed LLC (except to the extent the articles of organization confer authority) but the common law analysis treats the members of a manager-managed LLC no differently than any other agent. In other words, it is possible for a manager or member to have apparent authority under the statute but not under the common law, and vice versa. What happens then?

One possibility is that the statute is now the exclusive source of apparent authority for members and managers of LLCs. That would not appear to cause any problems when the statute confers apparent authority more broadly than the common law standard, but what about situations that fall into one of the broader statutory exceptions, for example when the member of a manager-managed LLC takes an action that a third party would reasonably believe, based on the conduct of the LLC, the member was authorized to take? Does the statute abrogate the common law in that situation?

It appears that it does not. In the Cain Family Farms decision mentioned above, the Court of Appeals considered the apparent authority of a member to bind a member-managed LLC. In doing so, the Court of Appeals analyzed the member's authority under both the common law and the Indiana Business Flexibility Act. Perhaps because the Court found that apparent authority existed under both analyses, it did not expressly decide which one would control in the event of a conflict. Nonetheless, the implication seems to be that both sources of apparent authority remain viable and that the LLC will be bound by the actions of a member or manager if either the common law or the Indiana Business Flexibilty Act impute that authority to the member or manager.

Continue reading "LLCs and Apparent Authority" »

July 21, 2014

Covenant or Condition? Why does it matter?

iStock_000025338621Small.jpgI remember a story told by a business owner who had been involved in the negotiation of a very complicated contract, with both sides represented by high-priced lawyers. In one particularly brutal negotiating session, the lawyers argued at length about a particular provision, with one side saying it should be a warranty and the other side saying it should be a covenant. At long last, they reached some sort of agreement, and everyone took a break for dinner. The business owner related that, as he rode down the elevator with his lawyer, he asked, "What's the difference between a covenant and a warranty?" The answer: "Not much." And that is not too far from the truth. But it would be a very different story if the question had been, "What is the difference between a covenant and a condition?"

The importance of the distinction between a covenant and a condition was driven home by a 2010 decision from the Ninth Circuit Court of Appeals. The decision received a great deal of attention at the time, and I used it as an assignment in the law school class I was teaching on contract drafting. Even though the decision has been thoroughly discussed from every angle, it still serves as a useful reminder to lawyers not to be careless with license agreements and to pay particularly close attention when drafting conditions.

The case was MDY Industries v. Blizzard Entertainment, and it dealt with a license agreement for the popular online role-playing game, World of Warcraft, or WoW. The license agreement prohibited the licensee from using bots to simulate people playing WoW. There was no question that the licensee had violated that term of the agreement. The question was whether the provision was a covenant or a condition.

A covenant is a promise by a party to a contract to do something or not to do something. If the promise is broken, the breaching party is liable to the other party for monetary damages -- usually the amount of money required to put the non-breaching party in the same situation it would have occupied if the covenant had not been broken.

In contrast, a condition is a fact that must exist (or not exist) before another substantive provision of a contract takes effect. In the context of a license agreement, the other substantive provision is the license itself. If the conditions to a license are not satisfied, the license is void. And if the license is void, the breaching party will probably be liable for infringement of the underlying intellectual property -- in this case, the copyright to the software.

So the question before the Ninth Circuit was whether the crucial contract provision was a promise by the licensee not to use bots or a condition on the grant of the license itself. If the former, the licensee would be liable for monetary damages, which would amount to relatively little. However, if the prohibition on using bots was a condition to the license, the licensee would be liable for copyright infringement, including statutory damages that could greatly exceed the damages owed for breach of contract.

In analyzing the provision, the Ninth Circuit noted that the folowing language was under a heading, "Limitations on Your Use of the Service."

You agree that you will not . . . create or use cheats, bots, "mods," and/or hacks, or any other third-party software designed to modify the World of Warcraft experience . . .

First the court disregarded the heading, using the common rule of contract interpretation that headings are for convenience only and are not part of the actual language of the contract. Once that was done, the court noted that there was nothing else about the language to connect the prohibition on bots to the scope of the license or the effectiveness of the grant of the license. Instead, the provision was written merely as an ordinary agreement, or a promise. If the copyright owner's real intent when the license agreement was drafted was to restrict the scope of the license, it could easily have done so by designating the prohibition as a condition to the license. The resolution of the case, or at least part of the case, turned on that subtle, technical drafting issue.

So if you are ever in a contract negotiation and your lawyer is arguing with the other side that a provision should be a covenant instead of a warranty, or vice versa, you might want to take a break and, outside the negotiating room, ask your lawyer if it is really worth the time to argue about it. However, if your lawyer is arguing with the other lawyer about a covenant versus a condition, you can be fairly certain it really is worth the time.

Continue reading "Covenant or Condition? Why does it matter?" »

July 17, 2014

Anticipatory Breach and Mitigation of Damages revisited: The Indiana Supreme Court Clears the Minefield

iStock_000030882778Small.jpgLast year we wrote about a decision of the Indiana Court of Appeals, Fisher v. Heyman, that addressed the amount of damages owed to the seller of a condominium after the buyers refused to go through with the sale unless the seller corrected a minor electrical problem. See "Anticipatory Breach and Damage Mitigation: A Minefield for Real Estate Sellers?" Today the Indiana Supreme Court overruled the decision of the Court of Appeals.

The case began with a purchase agreement for a condo between Gayle Fisher, the seller, and Michael and Noel Heyman, the buyers. The purchase agreement permitted the buyers to have the condo inspected and to terminate the agreement if the inspection revealed major defects. The inspection report showed that some electical outlets and lights did not work. The Heymans informed Fisher that they would terminate the contract unless Fisher corrected the problem by a specified date. Fisher did not meet the deadline, and the Heymans refused to go through with the purchase. However, shortly after the deadline passed, Fisher had an electrician repair the problems, for which the electrician charged her $117. By then, however, the Heymans had found another property and refused to purchase Fisher's condo. Fisher put the condo back on the market, but the best offer she received was $75,000 less than the price that the Heymans had agreed to pay. In the meantime, she incurred additional expenses that raised her damages to over $90,000.

The buyers argued that they believed the electrical problem was a major defect that allowed them to back out of the deal. However, the trial court and the Court of Appeals disagreed with the buyers, holding that the demand for repairs was an anticipatory breach, a concept we discussed in our previous blog post. The Supreme Court decision changes nothing about that aspect of the Court of Appeals decision. Both the Court of Appeals and the Supreme Court held that trial court did not err by finding that the electrical problems were not a "major defect" and that the buyers breached the purchase agreement by making a demand that they were not entitled to make. The difference between the two opinions is how to analyze the seller's duty to mitigate damages.

When one party breaches a contract, the other party is entitled to damages sufficient to put the non-breaching party in the same position it would have occupied had the contract been performed. However, the non-breaching party must use reasonable efforts to mitigate the damages. This case illustrates the concept nicely. The original purchase price was $315,000. Sometime later, Fisher received, but rejected, an offer of $240,000. Ultimately, she sold the condo for $180,000. The trial court found (and the Supreme Court affirmed) that Fisher acted unreasonably when she rejected the offer of $240,000. Accordingly, the most she could recover was the difference between $315,000 and $240,000, not the difference between $315,000 and $180,000. The question, however, is whether the doctrine of mitigation of damages required Fisher to comply with the Heymans' demand to have the electrical problem fixed. If so, she would be able to recover only $117, the amount it cost her to fix the electrical problems. Last year, the Court of Appeals said yes.

Today, the Supreme Court said no, agreeing with Judge Cale Bradford of the Court of Appeals. In his dissenting opinion, Judge Bradford reasoned that the doctrine of mitigation of damages does not require the non-breaching party to accede to a demand that creates a breach. The Supreme Court agreed with that reasoning and elaborated that, just as a non-breaching party may not put itself in a better position than it would have been had the contract been performed as agreed, neither can the breaching party. Here, the buyers agreed to pay $315,000 for a condo that had minor electrical problems (if tripped ground fault interrupters and burnt out light bulbs can be considered "problems"), and the seller was not obligated to sell them a condo with no electrical problems for the same price. Result: The Heymans owed Fisher not $117, but more than $90,000.

Setting aside the legal arguments, the Supreme Court decision avoids some very practical, real-world issues that would have been posed by the Court of Appeals decision. Had that decision stood, the law in Indiana would have allowed a party to a contract to continue to make additional demands on the other side, confident that the worst thing that could happen is that it would be required to pay the incremental cost of the demand. Conversely, the party on the receiving end of those demands would be forced to choose between acceding to them or being satisfied with the incremental cost of the demand, regardless of the magnitude of its actual damages.

A simple example: Imagine a musician who agrees to perform at a concert for $20,000. The organizer of the concert has already incurred another $30,000 in expenses and sold $100,000 worth of tickets. At the last minute, the musician refuses to go on stage unless he is paid an additional $10,000. The organizer would be forced to choose between paying the additional $10,000 or suffering a loss of $80,000, while being able to recover no more than $10,000. Surely that is not how mitigation of damages is supposed to work.

[Note: In discussing the example of the last paragraph, this post originally mentioned a loss of $130,000 rather than $80,000, but that's not the way damages are calculated. The organizer's damages would be the cost of refunding the price of the tickets ($100,000) less the $20,000 that the organizer originally promised the musician. The $30,000 in expenses would have been incurred even if the concert proceeded, giving the organizer a profit of $50,000. If the musician breached, the organizer would have to refund the price of the tickets, leaving the organizer with a $30,000 loss. To put the organizer in the same position it would have occupied had the contract not been breached -- i.e., with a $50,000 profit -- the musician would owe the organizer $80,000.]

Continue reading "Anticipatory Breach and Mitigation of Damages revisited: The Indiana Supreme Court Clears the Minefield" »

July 9, 2014

Office Lease: No signature, no personal guaranty

iStock_000014240498_Small (1).jpgBJ Thompson Associates, Inc. leased an office from Jubilee Investment Corp. The lease included the following language:

Guaranty of Performance In consideration of the making of the above Lease by LANDLORD with TENANT at the request of the undersigned Guarantor, and in reliance by LANDLORD on this guaranty the Guarantor hereby guarantees as its own debt, the payment of the rent and all other sums of money to be paid by TENANT, and the performance by TENANT of all the terms, conditions, covenants, and agreements of the Lease, and the undersigned promises to pay all LANDLORD'S costs, expenses, and reasonable attorney's fees (whether for negotiations, trial, appellate or other legal services), incurred by LANDLORD in enforcing this guaranty, and LANDLORD shall not be required to first proceed against TENANT before enforcing this guaranty. In addition, the Guarantor further agrees to pay cash the present cash value of the rent and other payments stipulated in this Lease upon demand by LANDLORD following TENANT being adjudged bankrupt or insolvent, or if a receiver or trustee in bankruptcy shall be appointed, or if TENANT makes an assignment for the benefit of creditors.

Even though the above language referred to "the undersigned Guarantor," the lease had no signature block for a guarantor. It had signature blocks for only the landlord and tenant. The signature block looked like this

BJ Thompson Associates, Inc.

By: ____________________

Date: __________________

followed by the address for BJ Thompson Associates, Inc. and the word "TENANT." It was signed by BJ Thompson, the sole shareholder and president of BJ Thompson Associates, Inc.

The original term of the lease was for one year, but the tenant held over for a number of years. (In essence, the lease was automatically renewed for successive one-year terms.) Eventually, however, the tenant moved out three months into the year and stopped paying rent. The landlord sued both BJ Thompson Associates, Inc. for rent for the remaining nine months, and it also sued BJ Thompson personally on the theory that he had personally guaranteed his company's obligations under the lease. The trial court dismissed the complaint against BJ Thompson personally because he had signed the lease only on behalf of his company as tenant and not on his own behalf as guarantor. In an unpublished opinion, the Court of Appeals agreed.

A guaranty is a promise by one person to pay the obligations of another person. When landlords sign leases with small businesses, it is common for them to require the lease to be personally guaranteed by the business owners, and the same thing occurs with other types of contracts as well. A guaranty is simply a particular type of contract, and it is governed by the same rules that apply to the interpretation and enforcement of other contracts. However, a guaranty is also one of several types of contracts subject to the statute of frauds, which says that, in order for a contract to be enforced, the contract must be in writing and must be signed by the party against whom it is being enforced.

In this case, the lease included language obligating "the undersigned Guarantor," but it did not identify BJ Thompson as the guarantor, and, although BJ Thompson signed on behalf of his company, the tenant, nothing in the lease identified his as the guarantor and nothing in the signature blocks indicated that he was signing in any capacity other than as the agent of his company.

Continue reading "Office Lease: No signature, no personal guaranty" »

July 2, 2014

Streamlined Application for Tax Exempt Organizations

iStock_000018610908Small.jpgAs anticipated, the Internal Revenue Service announced a streamlined, much simpler and shorter version of Form 1023, the Application for Recognition of Tax Exempt Status.

Standard Form 1023

The standard Form 1023 is 26 pages long, not counting a 38-page instruction booklet, 3 additional pages of instructions the IRS has added to the front of the form making changes to the form and the instructions, and a 2-page checklist to make sure the entire submission package is complete and compiled in the correct order. But that's not all -- one of the most important sections of the form, Part IV, is only about a quarter-page long but it calls for the applicant to attach a detailed narrative description of the organization's activities explaining how each of them supports the organization's charitable purpose, and several other sections leave so little room to include all the necessary information that most applicants find it necessary to attach addtional pages. With all that, and with the other information that must be submitted, such as articles of incorporation and bylaws, Form 1023 submission packages can easily reach 50, 60, or 70 pages.

The IRS says that they currently have a nine-month backlog of Form 1023 applications, and it is possible that number is actually an understatement. Once received by the IRS, Form 1023 applications go through a sort of triage process. Applications that are complete and do not appear to pose significant obstacles to approval are directed into a queue to be processed more quickly than applications that will require the IRS to request significantly more information. Just this week our office received a determination letter for a Form 1023 that had been pending for more than seven months, and that application was, presumably, directed through the quicker process.

Form 1023-EZ

In contrast, Form 1023-EZ is less than three pages long, although that is a little misleading because it still requires an instruction booklet with 10 pages of instructions to explain how to complete the form, a 7-page worksheet that must be completed in order to determine if the organization is eligible to use the streamlined form, and a 3-page list of National Taxonomy of Exempt Entities (NTEE) Codes from which the applicant must select the code that best fits the organization. Nonetheless, Form 1023-EZ should be considerably less burdensome than the standard form.

After completing the worksheet, the applicant must file the form online at www.pay.gov, which requires a username and password obtained through free registration. Any applications submitted on paper are automatically deemed incomplete.


Most organizations with annual revenues less than $50,000 for the current year, each of the previous three years, and the next two projected years are eligible to submit Form 1023-EZ. However, some types of organizations must submit the standard Form 1023 regardless of revenues. Here is a partial list of organizations that are ineligible for Form 1023-EZ:

  • Those organized as limited liability companies.

  • Churches and associations or conventions of churches. (Note: Churches are not required to submit an application for recognition of tax exempt status, but if they do not, they will not have a determination letter from the IRS, which can be useful for various reasons. Those that wish to receive a determination letter will continue to submit Form 1023 rather than 1023-EZ.)Schools, colleges, and universities.

  • Hospitals, medical research organizations, and hospital organizations.

  • Health maintenance organizations (HMOs).

  • Accountable care organizations (ACOs).

  • Supporting organizations (i.e., charitable organizations that are derive their status as public charities from their supporting relationship to another charitable organization that is a public charity).

  • Credit counseling organizations.

  • Organizations that have previously had their tax exempt status revoked except organizations that have had their tax exempt status revoked for failing to file Form 990 (or 990-EZ or 990-N) for three consecutive years.

That last part is significant because many smaller organizations have lost their tax exempt status for failure to file Form 990, and Form 1023-EZ will be available to those wishing to have their tax exempt status reinstated.

Continue reading "Streamlined Application for Tax Exempt Organizations" »