Protecting Your Business from President Biden's "New Deal" for FTC to Curtail "Non-Compete Clauses"

 

                 On July 9, 2021, President Biden issued an Executive Order to coordinate all federal agencies around a national policy to promote competition, prevent and curtail abusive monopolies and monopolistic practices.  

 The Executive Order calls upon the Federal Trade Commission (FTC) to “address agreements that may unduly limit workers' ability to change jobs.”  Under Section 5(a) of the FTC Act, the FTC can regulate “unfair or deceptive trade practices in or affecting interstate commerce.”  Existing 2015 FTC policy targets “the promotion of consumer welfare.”   President Biden seeks to expand that policy to include worker mobility: “to curtail the unfair use of non-compete clauses and other clauses or agreements that may unfairly limit worker mobility.”  But “unfairness” is not defined by statute.  If a non-compete agreement is too restrictive, a worker might not find a new job with higher wages or better employment opportunities.

                For business owners and tech investors, it is time to anticipate and manage potential challenges to non-competition covenants. 

                For employees, consultants, business service providers and strategic alliance partners, new federal regulations probably cannot replace the need for smart negotiations to prevent possible abusive enforcement of a valid restrictive covenant.  

                What is a Non-Compete Clause?  A non-competition clause or “covenant” is a contractual obligation by an employee not to compete with the employer’s business during employment and for some limited period after employment.  This restricts the employee from joining a competitor until after a reasonable “cooling off” period.  But the restriction is limited in scope, duration and, if appropriate, geography.  Every situation is different, so courts analyze the benefits, burdens and reasonableness.  The non-compete clause typically includes protections for trade secrets, which can exist forever (e.g., Coca Cola’s secret formula for its soft drink).

Why Businesses Require Non-Compete Clauses.  Non-compete clauses serve valid competitive purposes.  They protect a business against:

·         Poaching of the business’s clients and employees (but not forever);

·         Unauthorized disclosure of trade secrets (both of the employer and third parties doing business with the employer) and other employer confidential information; and

·         An employee’s abuse of his or her duty of loyalty while an employee.

 What are the Public Policy Limitations on Enforcement of Non-Compete Covenants.  In New York, such clauses are permitted as a matter of long-standing public policy (“common law,” not statute) to protect an employer.  (An exception exists for the broadcast industry.)  New York common law (“public policy”) already limits non-compete covenants.  The covenant must be reasonable in scope of work (relating to the first employer’s business activities), duration and geography.  As summarized by a former New York attorney general in 2017:

A non-compete [agreement] is only allowed and enforceable to the extent it (1) is necessary to protect the employer’s legitimate interests, (2) does not impose an undue hardship on the employee, (3) does not harm the public, and (4) is reasonable in time period and geographic scope. An employer’s legitimate interest may include protecting an employer’s trade secrets and confidential information and preventing employees from taking specialized skills they gained on the job to a competitor. A non-compete’s restrictions must be no greater than necessary to protect the legitimate interests of the employer. To determine if a non-compete is enforceable, courts consider an employee’s job duties, the employer’s business interest, and the language of the agreement.

In contrast, a California statute bans non-competition covenants as a “restraint of trade” unless negotiated as part of the sale of shares or the employer’s business.  Exceptions apply to situations involving business exit transactions including the sale of the goodwill of a business, the seller’s entire ownership interest in the business entity, or all or substantially all of a business’ operating assets together with the goodwill.  Calif. Bus. & Prof. Code §§ 16600 and 16601.

 Negotiated Contractual Limitations on Non-Compete Clauses. To limit an overly broad limitation on mobility of workers and business service providers, employees, business service providers, licensors, strategic partners and others can negotiate limitations on non-compete clauses.  For example, one might negotiate an exclusion for information and know-how that is “general skill and knowledge” in an industry.  Or an employee might negotiate a separation bonus can seek some compensation, particularly where the employee to cover the post-termination period, especially where the termination was “without cause.”   For new senior executives coming on board with broad substantive and strategic knowledge, a blacklist of “competitors” and a whitelist of “non-competitors” might be identified to give comfort to both employer and executive.

 Planning How to Improve your Chances of Enforcing a non-Competition Clause.  Anticipating new FTC regulations on interstate businesses, you can improve your odds of judicial enforcement of your non-competition covenants.  In addition to carefully crafting your non-compete clauses, you can:

 ·         Pay some money that is earned only during the post-termination period.  This provides special “consideration” beyond one’s normal salary. 

-        In England, they send such employees to “garden leave” to do nothing but grow a garden. 

-      In Japan, the “corner office work” serves the same function, where job duties are restricted with full pay.

·          Limit the scope to what is needed for saving your customers, your employees and your trade secrets from poaching.  

·         Protect trade secrets through internal management practices, manuals, trainings and segregation of functions, as well as clauses in employment agreements, licensing agreements, business services agreements (outsourcing), non-disclosure agreements, financings, strategic transactions, and any transaction for a change of control.

·         Protect existing and prospective client relationships and employees from being poached by delivering good customer experiences and employee satisfaction.

·         Link non-compete clauses to stock options, restricted stock units and/or deferred compensation.

·         Negotiate with your new employees (and their attorneys) to have them agree the restrictions are reasonable.

·         Require disclosure to new employers so that they can evaluate whether there is a risk of conflict and breach.

·         Consult an attorney who understands your business model and can help you build, protect and securely exit your business.

U.S. National Security Regulation of Information Technology Supply Chains and IT Infrastructure as a Service: (CFIUS-Style National Security Review for Cloud Computing, Software, Hardware, SaaS, IoT and Other Tech-Enabled Devices)

Regulation of IT Supply Chain after January 19, 2021 and after SolarWinds

On January 19, 2021, as a final act of the departing Trump administration, the Department of Commerce published an interim final rule (the “Rule”) and President Trump signed an Executive Order (the “Order”) to regulate U.S. information technology (“IT”) companies in transactions with foreign actors.  Entitled “Securing the Information and Communications Technology and Services Supply Chain,” the Rule is based on delegated authority under the International Emergency Economic Powers Act. The Order expands on an Executive Order issued May 15, 2019.   The Rule coincides with newspaper reports that some U.S. governmental agencies and other tech services companies downloaded malicious software from SolarWinds, a Texas tech services company reportedly with over 18,000 customers, that appears to have been hacked by foreign hackers.

Summary of New ITSC Regulation

As of January 19, 2021, any American business’s purchase of Information and Communications Technology and Services (“ICTS”) from “persons owned, controlled our under the jurisdiction or direction” of a “foreign adversary” is subject to a Commerce Department review for national security and critical dependency risks.  The Rule covers all ICTS Transactions where the tech or services are “designed, developed, manufactured or supplied” by such persons.  The Rule seeks to protect the American IT supply chain (“ITSC”).  No exemptions apply, regardless of your company’s size, industry or activities.  

The 2021 ITSC Rule follows the policies reflected in the 2018 amendments to laws governing virtually all foreign acquisitions of U.S. tech companies, under scrutiny for national security by the Committee on Foreign Investment in the United States (“CFIUS”).  To avoid duplication, the Rule states it does not apply to ICTS Transactions that CFIUS is actively reviewing, unless the ICTS Transaction is distinct from a CFIUS-reviewed transaction.  Like the CFIUS review process, the Commerce Department can identify a mechanism and relevant factors for the negotiation of agreements to mitigate concerns raised in connection with the Order.

The ITSC Rule

Scope of ITSC Transactions

Virtually every digital service and product is covered, regardless whether it handles a single computer, a computer network, cloud service, telecommunications switches or just individual product data.

Definition of ICTS.  The Rule defines “Information and communications technology or services or ICTS” to mean “any hardware, software, or other product or service, including cloud-computing services, primarily intended to fulfill or enable the function of information or data processing, storage, retrieval, or communication by electronic means (including electromagnetic, magnetic, and photonic), including through transmission, storage, or display.”

Definition of ICTS Transaction.  Under the Rule, “ICTS Transaction” means any acquisition, importation, transfer, installation, dealing in, or use of any information and communications technology or service, including ongoing activities, such as managed services, data transmission, software updates, repairs, or the platforming or data hosting of applications for consumer download. An ICTS Transaction includes any other transaction, the structure of which is designed or intended to evade or circumvent the application of the Executive Order.”

Broad Scope.  In its preliminary discussion of ITSC vulnerabilities, the Commerce Department clearly intended to include SaaS (software as a service), Infrastructure as a Service, Cloud data storage and computing, IoT Internet-devices embedded in consumer goods, mobile phones and their Apps, Web browsers, drones and networked surveillance cameras.  

“Foreign Adversaries.”  The list of “foreign adversaries” consists of the following foreign governments and non-government persons: the People's Republic of China, including the Hong Kong Special Administrative Region; the Republic of Cuba; the Islamic Republic of Iran; the Democratic People's Republic of Korea; the Russian Federation; and Venezuelan politician Nicolás Maduro (Maduro Regime).

Effective Date of Rule

The Rule applies to any ICTS Transaction that is initiated, pending, or completed on or after January 19, 2021.  Further, any act or service with respect to an ICTS Transaction, such as execution of any provision of a managed services contract or installation of software updates, is an ICTS Transaction on the date that the service or update is provided.

Future Compliance Impact

The ITSC Rule imposes potentially costly compliance obligations for risk identification, assessment and regulatory licensing.  The Rule serves as a boycott of technologies from “foreign adversaries” unless approved by a Commerce Department license.  There are civil and criminal penalties, but prosecution of millions of small businesses is not practical.  Assuming the Biden Administration pursues the Rule, the scope will change the landscape for everyone, including our foreign trading partners, with potential retaliation by “foreign adversaries.”

If implemented, the ITSC Rule will likely generate a hornet’s nest in the business world and international politics.  But the reported SolarWinds hacking supports the logic of greater transparency in IT supply chains.

ICT Company Burdens.  ICT providers will need to verify countries of origin and give warranties about their extended ICT supply chains.  Even absent a legal requirement, there will be an increased need to document supply chain risk management analysis in the event an ITSC transaction is investigated by the Commerce Department.  ICT services companies must now identify the nationality, origin, foreign control and sensitivity of data that flow through their digital infrastructures.   

Corporate Governance.  Corporate boards, officers, purchasing and procurement departments and strategic planners will need to identify the risks across a potentially multi-layered IT supply chain.  How much should a board spend on verification?  Is an ICTS supplier’s self-certification sufficient?  Will an independent sourcing audit become the norm?  What should be the policy, the process and the budget?

Information Governance.  New Information Governance ("IG") policies and procedures will be needed for ITSC risk management and regulatory licensing compliance.

Privacy and Cyber-Security Risk Management.  The ITSC Rule will highlight special risk management procedures, and perhaps insurance, that relate to compliance with privacy laws, such as the California Consumer Privacy Act (to be replaced in 2023 by a Consumer Privacy Rights Act) and potentially EU’s GDPR and draft Digital Services Act.

Antitrust and Competition Law.  If Google or other dominant market player were to insist that its European subsidiaries buy only from suppliers complying with the ITSC Rule, that would have the effect of exporting American ITSC risk management compliance.  Foreign local suppliers sourcing from a “foreign adversary” would be barred.  This would be a secondary boycott unless a Commerce Department license were granted.

Best Practices for Vetting: Know Your IT Service Provider.  If they don’t already do so, enterprise customers will include an ITSC Transaction questionnaire in their requests for proposals, requests for quotations and master services agreements.  ICT agreements will include warranties and rights to audit and inspect supply chain information.  Chief Information Security Officers (CISO’s) will push for more certifications by “ethical hackers” -- independent third party testers of malware – and perhaps even direct testing.

Redrawing Supply Chains and Strategic Alliances.  Geographic and national security issues will translate into modifications in supply chains, starting with digital business models and leading into all enterprise strategic alliances, global business services, outsourcing services providers and shared services centers.  Procurement and IT departments will also examine the impact across strategic sourcing, supplier management, assessment of third party risks, artificial intelligence and robotic/intelligent process automation.

M&A and Corporate Finance.  New representations and warranties will appear in die diligence and documentation for business valuation, corporate finance and M&A transactions.

Audits.  Accountants will require ITSC audits before certifying or commenting on financial statements, which could include disclaimers as to an entity’s viability due to “incomplete” ITSC disclosures.

Cyber-risks, Hacking, Cyber-Security and Privacy.  The new Rule concerns national security, digital security, privacy and extortion.  “This [potential] data exfiltration—supported by U.S. web data hosting and storage servers—threatens to allow foreign adversaries to exploit Americans' personal and proprietary information by allowing a foreign adversary to track the locations of Americans, build dossiers of sensitive personal data for blackmail, and conduct corporate espionage from inside the borders of the United States.” Cyber-insurance policies will need to be revised to impose underwriting constraints and higher premiums on non-conforming insured enterprises.

International Trade Agreements.  In light of the reported SolarWinds hacking, President Biden will need to decide how stringently to enforce the Trump administration’s ICTS Rule.  New trade agreements might create group action against the same “foreign adversaries.”  Conflicts with allies may arise as to ICT products designed or manufactured in a trade ally country by a subsidiary from a “foreign adversary.”  For example, the Chinese tech company Huawei is planning to build 5G telecom products in France, potentially for sale to other trade allies.

How to Get a Department of Commerce License.  

Assuming a company plans to update or sign up for any "foreign adversary" technologies, a license will be needed.  To afford parties greater certainty, the Commerce Department intends to publish, within 60 days after January 19, procedures to allow a party or parties to a proposed, pending, or ongoing ICTS Transaction to seek a license.  Implementation is scheduled within 120 days after January 19.  The change from President Trump to President Biden will determine how this Rule plays out in March and May 2021.

This summary is not legal advice.  These matters are subject to change.  If you have any questions or comments, please feel free to contact us. (C) 2021 W.Bierce.

     

How to Modify Your Contracts to Reallocate Risks When Quixotic Presidential Orders Strike

In last week's blog post, I reviewed how “force majeure” issues  might excuse a contractual party’s non-performance and ways in which they might be addressed to avoid this problem.  The focus was on President Trump’s executive orders and legislative changes that could act like a hurricane to destroy predictability in international business.   Perhaps they might be merely lofty and chivalrous but impulsive and impractical, as Miguel Cervantes’ 1600’s story of Don Quixote.

This blog post looks at ways in which restructuring your contract can aid buyers and sellers under state laws for sale of goods.

The sale of goods is governed by the Uniform Commercial Code (UCC) in the 50 states.  The UCC sets forth minimum “obligations of good faith, diligence, reasonableness, and care” that “may not be disclaimed by agreement.”  UCC Section 1-302(b).  Contingency planning thus needs to consider the UCC legal framework for escaping or mitigating the impact of a new presidential executive order, law or regulation.

Pre-Contract Planning.  Risk mitigation planning starts with contract design and limitation of liability under the contract.

1. Negotiated Limitation of Liability.   Be specific and state all limitations of liability, indemnifications and non-performance scenarios (such as liquidated damages).

2. “Irrevocable” Firm Offers.  Sellers should shorten the duration of any “irrevocable” or “firm” offer  and set a reasonably early date for the expiration of the offer (See UCC 2-205), given the unpredictability of the current economic climate.  In any event, the UCC limits such “firm offers” to a maximum of three months.

Contract Restructuring.  There are several UCC rules on contract revisions. If neglected, they could result in unforeseen liability and costs.

1. Commercial Impracticability.  The UCC allows parties to be excused from performance due to “commercial impracticability.”  In other words, a contingency happened that wasn't supposed to or ordinarily would rarely happen.

2. How to Wiggle out of your Contract?   What’s necessary for modification, rescission or waiver of a contract?  If you want to wiggle out, wiggle carefully!  To modify a signed contract for the sale of goods, the changes must be in writing (except “as between merchants”).  UCC 2-209. By requesting modification or rescission, the party seeking the change may be deemed to have waived any non-performance by the other party.  To avoid this risk, the request for modification or rescission should be carefully written.  If the other party has waived a clause, the waiving party may retract the waiver by reasonable notification that strict performance will henceforth be required for any term waived.  However, such a retraction of waiver is invalid if “the retraction would be unjust in view of a material change of position in reliance on the waiver.”  So, once you waive a breach (such as for force majeure), you can’t retract it if your counterparty detrimentally relied in a material manner.

3. Kicking Your Own Bad Habits.  Similarly, have you been too lenient with your supplier by putting the contract in the drawer and forgetting the performance standards and service level agreements?  it may be time to disrupt any “course of dealing” or “course of performance” (or even “usage of trade”).  Kick your “bad habits” by expressly re-affirming that strict compliance with contract terms is required (if you are the buyer) or by proposing a modification or waiver (if you are the seller).  UCC 2—208 holds the parties to an implied contractual provision where the contract for sale involves “repeated occasions for performance by either party with knowledge of the nature of the performance and opportunity for objection to it by the other, any course of performance accepted or acquiesced in without objection.” If you don’t object, you’re stuck with the practical construction of the contract by course of performance, you’re committed to it.

4. Play the Game.  Don’t forget your duty to cooperate, particularly as a buyer.  UCC 2-311 allows one party to a sale contract to treat non-cooperation by the other party relating to delivery or acceptance of the goods as either (i) an excuse for his own delay, (ii) a breach, or (iii) an opportunity to proceed in a reasonable manner.

5. How Bad Must it Be Before You Can Invalidate the Deal?  Was the contract “unconscionable” at inception?  If so, the UCC 2-302 allows a court to invalidate the entire contract or just the provisions that are unconscionable.  This rule generally applies only to the sale of consumer goods.

6. Feeling Insecure about the Contractor’s Performance?  What if President Trump’s executive orders give a buyer or seller reasonable grounds to feel insecure about the future performance of its counterparty?  The UCC resolves this by allowing a party to demand “adequate assurances” and, if it does not receive them, to suspend or cancel the contract.  Under UCC 2—609, each party has a right to adequate assurance of performance by the other.  If there is no “assurance of due performance” within a reasonable time (not more than 30 days) of a receipt of a justified demand, failure to provide adequate assurances can be treated as a repudiation of the contract.

7. Launch a Pre-emptive Strike.   Whether or not a party requests and gets “adequate assurances” of performance, a contract may be canceled if one party acts in “anticipatory repudiation” under UCC 2—610.  This could be a defensive tactic used when either party can foresee that its performance may not be up to par in accordance to their contract.  Of course, a repudiating party can retract his repudiation “with due excuse and allowance to the aggrieved party for any delay occasioned by the repudiation.” UCC 2-611.

In conclusion, when force majeure clause or “commercial impracticability” under UCC 2-615 is not available as an excuse for non-performance, principles of contract restructuring may be available. However, care should be taken to avoid inadvertent technical breach by anticipatory repudiation or inadvertent waiver.

Wiggle carefully!

Legal Escapes from Disasters: Force Majeure and other Excuses for Contractual Non-Performance under Sudden Changes in Presidential Executive Orders

What’s the difference between a hurricane and a presidential order of Donald Trump? Legally, maybe not much.

President Trump’s unexpected executive order in January 2017, which banned any nationals from 7 countries from entering the U.S. for 90 days, surprised not only the would-be terrorists but also the law-abiding business community. More disruption may be foreseeable. NAFTA could be terminated or restructured. Business visas could be curtailed. Imported goods and services could be subject to a new “border adjustment tax,” while exports would be exonerated. Other disruptions to the global supply chain are clearly foreseeable, but the parameters remain to be seen.

Plan Ahead Now. Every buyer or seller of goods or services across borders should be making plans to deal with potential sudden changes in U.S. law or policy. Let’s consider “force majeure” and other legal excuses for contractual non-performance under the Uniform Commercial Code ["UCC"] (applicable in all 50 states). Possible action steps include contingency planning, review and renegotiation of contracts, repricing, workforce redeployment or restructuring, hedging contracts, business interruption insurance, business continuity planning, disaster recovery procedures, diversification of risk portfolio by sourcing from backup suppliers, and internal and external audits of procedures.

What is “Force Majeure”?   “Force majeure” is a common law concept of equity that excuses non-performance by a seller. Typically, “force majeure” clauses in a contract define the types of events: natural disaster or regulatory prohibition. Less obvious is whether the “force majeure” concept gives a valid excuse not to deliver due to a sudden increase in the price of components or commodities, and, if so, whether such an excuse depends on whether the new shortages in global supply arise from speculators seeking to corner the market, hoarding by merchants to hedge against future risks, uncertainty or a other sudden increase in demand for the item in the marketplace. Even less obvious is whether a sudden new regulation qualifies as a force majeure if it merely increases the cost of doing business, adds a new tax to a type of transaction (such as a tax on imports of products or components needed for manufacturing), or imposes a new requirement for a governmental license. 

Drafting (or Reviewing) Force Majeure Clauses. It’s time to review your contracts and perhaps seek modification to your “force majeure” clauses.

1. Definition.  What is a “force majeure” event for purpose of this contract? The contract should define it by including specific examples and excluding cases that might be recurring, predictable and thus “ordinary” risks to be allocated expressly by contract. Must the event be unforeseeable, or merely overwhelming?

2. Impossibility?  or Mere Change in Costs of Delivery? Must the impact make performance impossible, or will the contract be changed if there is merely an extreme difficulty or higher cost? Where possible, the parties should allocate risks by specifying outcomes of predictable contingencies, such as (i) sudden shortages in the marketplace, (ii) changes in pricing or exchange rates, (iii) regulatory changes that affect the normal supply chains for labor and goods.

3. Required Mitigation?  What actions must the affected party take before the impact of the force majeure event can validly excuse non-performance or delay performance? At a minimum, one might ask the affected party to take reasonable measures using reasonable effort to overcome the adverse impact.

4. Option to Pay to Cure?  May the unaffected party insist on the right to pay extra to get a “cure” and thus enjoy the benefit of the bargain, albeit at a higher cost?

5. Notice and Other Conditions for Being Excused.  Must the affected party give notice of inability to perform due to a “force majeure” event? And how soon, to be “timely”? What kind of notice is needed? What are the consequences of not giving timely notice? Is the giving of notice excused when the unaffected party has actual or constructive notice (such as by reading newspapers or watching a TV journalist’s nightly critiques of Trump’s operations)?

6. Duty of Cooperation?  What level of cooperation (and effort and payment of money to overcome the force majeure’s impact) is required from the un-affected party?

7. Cancellation.  How long must the parties wait before treating the contract as cancelled?

8. Practical Risk Management Solutions.  What alternative solutions exist when both parties refuse to accept a risk?

a.  Insurance.  Either party can purchase business interruption insurance and thus quantify the allocation of risk. Insurance also can cover loss of the goods. What conditions are necessary to have such insurance coverage? When does the insured acquire an insurable interest?

b.  Disaster Preparedness.  Procurement officers normally insist on the seller’s or service provider’s having a business continuity plan and disaster recovery procedures, which would be audited under SOC II or SSAE 16 Type II audit processes.

c.  Resiliency in the Global Supply Chain.  Potentially, goods or services could be provided from centers located in geographies with different disaster profiles. A portfolio approach could be used to mitigate risks (political, technical, economic, pricing, regulatory, etc.) that are related to any one particular supplier.

Force Majeure in the Sale of Goods: "Commercial Impracticability" and Legal Prohibition.   In two scenarios, a seller of goods is excused from non-performance under UCC 2-615 (with caveats):

• “if performance as agreed has been made impracticable by the occurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was made. “ In other words, a contingency happened that wasn't supposed to happen or ordinarily would rarely happen. Or


• “by compliance in good faith with any applicable foreign or domestic governmental regulation or order whether or not it later proves to be invalid.”

Few contracts identify the “basic assumptions” that underlie the commercial reasonableness. Hence, the “commercial impracticability” defense under UCC 2-615 is so vague that it invites mediation, negotiation and settlement. Once it applies, though, the supplier must allocate resources in a fair and reasonable manner.

In this Trump era, unexpected and sudden changes in U.S. laws, regulations and policy may be the order of things to come. Service providers, supply chain managers (from CEO’s, CFO’s and CIO's all the way down to procurement officers) and e-commerce merchants need to rethink contingency planning, including redefining Force Majeure clauses.

More on this in my next blog.

“Transaction Costs”: A Nobel-Prize Worthy Analysis for Global Business

The death last week of Nobel-prize winning economist and retired University of Chicago Professor of Economics, Ronald Coase, at 102 years of age, reminds us all of the conflict between the real world and the economist’s theoretical world. His eight decades of work helped found the field now known as “law and economics” and continues to impact our understanding of today’s economy and the law. While an undergrad in college, I read Coase’s writings eons ago. His papers helped me understand the logic behind how business organizations work, and was a factor in my decision to become a transactional business attorney.

In law and pure economics, the fair market value of anything is the price that a willing buyer and a willing seller would agree upon, assuming each has equal knowledge of relevant facts, neither is under any compulsion and the transactions costs are nil. This economy would be comprised of self employed individuals continually contracting work with each other. However, in the real world, there is a price to pay for these constant negotiations or what Coase called “transaction costs”. In his 1937 paper, “The Nature of the Firm”, he posited the idea that people could more readily grow their business by organizing themselves into a firm and gain operational efficiencies by reducing these transaction costs. He further noted there may be a point of diminishing returns in this growth, some say foreshadowing the advent of outsourcing.

In 1960, his paper, “The Problem with Social Cost” dealt with the actions of business firms which have harmful effects on others. In a theoretical world, all affected parties would come together and arrive at a voluntary agreement and solution at nil cost as long as property rights were clearly defined and everyone was willing and able to bargain. In the real world, he advocated that cost benefit analyses should be done to determine the appropriate remedy and that each case should be evaluated individually. Where transactions costs are high, either no deal will occur or government regulation of protection of rights from externalities like factory pollution will be adopted to protect those who cannot protect their interests, or small claimants will sue under class action tort principles.

Today, we recognize that transaction costs are the norm in corporate, commercial, technology and service transactions. Business attorneys like me make a living as a transaction cost when clients buy and sell companies, intellectual property or other assets and when they enter into strategic relationships over an agreed time span, like financing, licensing, leasing, investing in depreciable business equipment and technologies. But I am just one mouth in an ecosystem of commission salesmen (“business developers”), consultants, intermediaries, brokers, investment bankers, accountants, appraisers, engineers, logistics providers, outsourced service providers and others whose transaction costs are embedded in the purchase price of an asset, a new venture or a strategic alliance of small companies fighting in a Big Company world.

For that, I am glad to express my appreciation for his insights.  Thanks, Ron.

SMB’s after ObamaCare: The New Sub-economy of 49’ers, Outsourcing, Automation, and Part-Timers

What should small and mid-sized businesses do to survive the Patient Protection and Affordable Care Act?   What lessons have we learned from the delayed Employer Mandate?

Thanks.  SMB’s can thank someone in the Obama Administration for raising the white flag and acknowledging the need to delay the “Employer Mandate” by a year until January 1, 2015.  (Of course, the statute does not permit any deferral of any mandates, so the delayed Employer Mandate raises constitutional issues.) 

Workforce Containment.   SMB’s can redefine their mission in a new microeconomy driven by enterprises having 49 or fewer “full-time” employees (the New 49’s).  These 49’s enterprises can avoid the complexity, costs and distractions by forcing more part-time employment (i.e., under 30 hours per week).   That means SMB’s will likely be training and keeping only those employees who will drive sustainable growth, and marginalize all the rest into part-time status, forcing part-timers to buy their health insurance on an exchange (yet to be established) or pay the penalty tax.

Boosting Outsourcing.  SMB’s should look for niches where a company of 49’ers could provide outsourced “back office” or “technical” support to other companies of 49’ers.   Any small business function can  be outsourced, such as payroll service providers, collection companies, technology suppliers, lease administration, insurance administration, HR administration, anything that a small business needs.   This will boost the “business services” economy.   Outsourcers might hire the involuntary part-timers, if needed, or just use more SaaS “web-enabled” tools for administration.  

Management of Projects and the Services Supply Chain.   SMB’s need to develop skills in partnering with others.  Such skills will allow strategic alliances to form.  The integration of a microeconomy of “49’er enterprises “ will involve project management training and tools so that unrelated companies can work as a team competing with larger enterprises.

Globalizing the SMB Workforce.    Under ObamaCare, SMB’s have been invited to globalize their workforces.  If the cost of “unnecessary” health insurance coverage is excessive, SMB’s can set up offshore offices, which can help both increase revenues and reduce costs.  Too bad this could come at the expense of local employment in the US.

Automation.   Automation can reduce labor.  The Affordable Care Act just made robots and software more affordable, comparatively. 

Web-Based Teams.   To cover greater territory, teams can be split into modules and assembled across the country.  Big services firms use webinars and videoconferencing.  SMB’s can survive with more geographical dispersion of staff (particularly in sales) while retaining core skills that can be deployed instantly without transportation.

Optimization by Shifting Societal Costs.  The resulting outsourcing, offshoring, part-timing, de-scaling and horizontal integration will have a societal cost.   But, until the law is changed, this is what the law encourages.  Nimble entrepreneurs will fill new niches, and savvy family businesses and new ventures will avoid hiring unless it drives core business revenue.  Everyone will be more specialized to remain small, nimble and niched.  

Visa Reform: Cutting Back on H-1B and L-1 Body Shops

Does your workforce depend upon foreign labor? If so your workforce planning may suddenly be changed.

On March 18, 2013, Senator Charles Grassley (Republican, Iowa) introduced a “50-50” visa bill to promote hiring local U.S. workers.  One section would require companies with more than 50 employees to limit their number of U.S. employees on H-1B or L-1 visas to 50% of its workforce.  This would apply to both domestic and foreign companies with American subsidiaries.  In short, 50% of the workers employed in the U.S. would need to be American citizens or green-card holders. 

Such visa legislation would attack foreign “body shops” that rotate contractors to the U.S. in support of global sourcing.  Aside from targeting India, a 50-50 quota bill would also hurt foreign businesses from Western Europe and Latin America that send technical staff in management consulting and business change management to the U.S.  It would hurt smaller foreign companies that depend on foreign staff as they grow into the US market.

Will a 50-50 quota really increase U.S. employment levels for technical workers?  I see several scenarios:

• Yes, it promotes local hiring to replace foreign contractors.  (This assumes you can find the right talent here.)

• No, it encourages U.S. companies to set up foreign “vendor management” teams to manage foreign workers in offshore service delivery centers.

• No change.  In the short run, it will reduce utilization rates and operating profits of foreign service providers.  Over time, nothing will stop globalization.  Businesses will find a way to deal with this by more video conferencing and online collaboration tools.  Affected foreign service providers will hire more U.S. sales people (as well as technical personnel) to meet this quota.

• It’s irrelevant.  Foreign countries with existing “friendship, commerce and navigation” treaties are entitled to “most favored nation” treatment.  So they will lobby to eliminate such rules, or they could threaten retaliatory visa action against U.S. expatriate employees in foreign subsidiaries. 

In my view, this measure would not survive long, and it highlights the need for a comprehensive immigration reform that invites foreign technical workers (“STEM” – science, tech, engineering and math) to become residents and citizens.   

What do you think?