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What are the risks of misclassifying a person as an employee versus a contractor?

Those that have misclassified an employee as an independent contractor may be subject to adverse consequences, including:

  • having to pay unpaid minimum wage and overtime amounts, with interest, typically going back three years in California if the violation was not willful and four years if the violation was willful (and longer in certain states, such as New York, which has a six-year statute of limitations);
  • having to pay back withholding of taxes (state, federal, and FICA) with interest going back three years under California law;
  • civil penalties, including, in California, penalties for not providing itemized wage statements or affording workers prescribed meal and rest periods;
  • statutory penalties, including, in California, penalties for failure to timely pay wages when due and not providing itemized wage statements;
  • individual civil liability (rare but possible), including unanticipated tort liability to third parties and wrongful discharge liabilities; and
  • individual criminal liability (rare).

Directors and officers can be held personally liable for unpaid wages.

With respect to civil penalties, specifically, employers who violate the California Labor Code’s wage-and-hour requirements, including those that arise from misclassification of independent contractors, may face a lawsuit pursuant to the Private Attorney’s General Act (“PAGA”). The PAGA allows an aggrieved employee to collect civil penalties for each Labor Code violation. The civil penalties are assessed per violation, per employee, going back one year from the date the aggrieved employee submitted notice of the lawsuit to the employer and pertinent state agency. The aggrieved employee may represent other employees even if they experienced a different Labor Code violation the aggrieved employee never experienced or hold different job positions and/or duties than those held by the aggrieved employee. In other words, a PAGA lawsuit is akin to a class action lawsuit for civil penalties, except that it does not have to meet many of the procedural hurdles that stand in the way of aggrieved employees in a class-action lawsuit. In addition to a PAGA lawsuit, aggrieved employees can also bring class action claims to recover owed wages for a class of workers, including interest and liquidated damages.

As described above, companies often fail to appreciate the significant penalties associated with misclassification. Therefore, prior to retaining and classifying an individual as an independent contractor, we recommend contacting any member of the employment or trade secrets litigation practices at WSGR.

What is a certificate of incorporation?

TLDR: The certificate of incorporation is the constitutional document of a company and establishes many of the critical rights and attributes of a company.

The two main governing documents of a corporation are its charter (called the “certificate of incorporation” in Delaware and the “articles of incorporation” in California) and its bylaws.

The charter is the document that formally and officially commences the existence of a corporation upon its filing with Secretary of State, or other state company registrar, in the state of incorporation.

In Delaware, the certificate of incorporation must include the following information:

  • the name of the corporation;
  • a statement of business purpose;
  • the address of the corporation’s registered office in the State of Delaware and the name of the registered agent at such address for service of process;
  • the total number of shares of stock the corporation is authorized to issue and a description of the different classes of stock (if there is more than one class); and
  • for the initial filing, the name and address of the corporation’s incorporator.

In general, any changes or amendments to the certificate of incorporation must be approved by the board of directors and the stockholder of the corporation and filed with the Secretary of State. In start-up companies, the certificate of incorporation is most often amended in the context of a financing event to create additional classes of stock for new investors and to establish the rights and preferences of such stock.

Careful observance of a corporation’s charter is a key element of good corporate governance. Acting in violation of a corporation’s charter can render such actions invalid.

What are securities laws?

In the U.S., there is a complex web of federal and state laws and regulations that cover what a company must complete when it offers and sells stock, options, convertible notes, and other securities. These laws are in place to protect investors and regulate how securities can be marketed, sold, and issued by companies. Many other countries also have their own securities laws that must be followed when a company sells securities to residents of such countries.

Whenever a company offers securities in the U.S., the general rule is that the company must register the securities with the government and provide extensive disclosures about its business, unless the offering fits within specific exemptions from the registration requirement. The general registration requirement and the exemptions are set forth in rules promulgated by the U.S. Securities and Exchange Commission (SEC) and the various states.

Registration is a costly and time-consuming process involving extensive fees to financial and legal advisors and is the procedure that companies undergo when planning to “go public” or hold an initial public offering (IPO). Accordingly, until they are ready for an IPO, a vast majority of start-ups offer and sell securities through so-called “private placements,” which rely on the exemptions from registration. Relying on the exemptions for a private offering entails compliance with very specific requirements, so companies should seek advice from competent and experienced corporate and securities attorneys to ensure that their offerings fit within the exemptions.

The securities laws are actively enforced by the SEC and state regulators, and investors have the right to litigate in the event that they are misled or defrauded by a company in connection with a securities offering. Companies that are found to have broken the securities laws could be required to rescind their securities and return money to their investors or pay penalties and damages.

What do stockholders generally need to approve?

Before taking an action, a company must ensure all corporate formalities have been followed. By being aware of the corporate formalities in advance of taking such action, a company will be better able to preserve its valuable time, cash and resources, gain confidence from current and future investors, and avoid delaying or blowing up a transaction.

We recommend that companies discuss with their attorneys the specific corporate formalities that they must follow in advance of taking such actions to avoid unnecessary headaches and to ensure company-specific formalities are followed. The following list of items can serve as a reference point of actions that typically require stockholder approval:

  1. Amend the company’s certificate of incorporation or bylaws
  2. Effect a sale of all or a substantially all of the company’s assets or business
  3. Effect a merger, combination, or reorganization
  4. Establish stock option plans and amendments to stock option plans (e.g., increase the number of shares set aside for a stock option plan)
  5. Elect directors
  6. Enter into indemnification agreements with the company’s officers and directors
  7. Enter into investment documents for debt or equity financings
  8. Enter into a related party transaction

Please note that as a company matures and seeks outside investment, this list will proportionately grow. Investors often will negotiate special stockholder approval rights as a way to control the company and its actions.

What are bylaws?

TLDR: The bylaws establish many of the rules and procedures for operating a company and are typically closely-tied to the state statutes governing the operation of a company.

The two main governing documents of a corporation are its charter (called the “certificate of incorporation” in Delaware and the “articles of incorporation” in California) and its bylaws.

Unlike the charter of a corporation, which is required to be on file with the Secretary of State in the corporation’s state of incorporation, the bylaws of a corporation are generally not filed with the state. Instead, the bylaws can be adopted, amended, or repealed by the corporation’s board of directors or by vote of the corporation’s stockholders, and are kept with the corporation’s books and records. However, the bylaws must be consistent with the corporation’s charter and the corporate laws of the state in which the corporation is incorporated.

Delaware law allows for a corporation’s bylaws to contain any provision relating to the conduct of the corporation’s business, so a corporation’s bylaws could contain, among others, rules around the following topics:

  • The place, time, and frequency of meetings of the board of directors and stockholders of the corporation
  • Procedures for calling meetings of the board of directors or stockholders
  • Quorum requirements for actions taken by the board of directors or stockholders
  • The authority and responsibilities of the board of directors and officers
  • Procedures for electing directors and dealing with resignations and vacancies on the board of directors
  • The ability of the corporation to indemnify its directors and officers
  • Notice and reporting requirements
  • Procedures for maintaining corporate records
  • Voting procedures
  • Procedures and restrictions on transfers of stock

Careful observance of a corporation’s bylaws is a key element of good corporate governance. In some situations, acting in violation of a corporation’s bylaws can render such actions invalid. For example, actions taken by the board of directors at a board meeting without a quorum, as prescribed by the bylaws, are invalid.

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