THE MAGAZINE OF THE LOS ANGELES COUNTY BAR ASSOCIATION

FEBRUARY 2018— PART 1 OF 2 / $5

EARN MCLE CREDIT PLUS TAX BENEFITS PATENT FOR START-UPS EXHAUSTION page 25 page 30

Class Certification post Tobacco II page 12 On Direct: JohnH.Haney page 8 Space to GROW

Los Angeles lawyers David W. Wensley (right) and Amir Sadr review the current regulatory framework governing medical and recreational cannabis in California and analyze how its operation may affect the state’s real estate page 20

FEATURES 20 Space to Grow BY DAVID W. WENSLEY AND AMIR SADR The laws, regulations, and policies governing cannabis operations in California are still evolving and subject to the unpredictable impulses of federal, state, and local officials

25 Start-Up Opportunities BY MEGAN LISA JONES New federal legislation expands opportunities for a variety of businesses to benefit from tax code exemptions Plus: Earn MCLE credit. MCLE Test No. 275 appears on page 27.

30 Exhausting the Possibilities BY RYAN SWANK A recent U.S. Supreme Court case sustains increasing adherence to the doctrine of patent exhaustion that has been developing for a century

Los Angeles Lawyer DEPARTME NTS the magazine of the Los Angeles County 8 On Direct 15 Practice Tips Bar Association John H. Haney Parental liability for copyright February 2018 INTERVIEW BY DEBORAH KELLY infringement by a minor child BY RENA E. KREITENBERG AND Volume 40, No. 11 10 Barristers Tips KAYLEE KREITENBERG How Ginger and Fred settled the battle COVER PHOTO: TOM KELLER between two "Empires" 36 Closing Argument BY ZACHARY T. ELSEA Championing the cause of civic learning in public schools 12 Practice Tips BY THE HONORABLE KEVIN S. ROSENBERG AND The determinants of class certification THE HONORABLE HALIM DHANIDINA after In re Tobacco II BY MICHAEL MALLOW, AMY LALLY, AND LOS ANGELES LAWYER (ISSN 0162-2900) is published SHAWN COLLINS monthly, except for a combined issue in July/August, by the Los Angeles County Bar Association, 1055 West 7th Street, Suite 2700, Los Angeles, CA 90017 (213) 896-6503. Period - icals postage paid at Los Angeles, CA and additional mailing offices. Annual subscription price of $14 included in the Association membership dues. Nonmember subscriptions: $38 annually; single copy price: $5 plus handling. Address changes must be submitted six weeks in advance of next issue date. POSTMASTER: Address Service Requested. Send address changes to Los Angeles Lawyer, P. O. Box 55020, Los Angeles CA 90055. 02.18 VISIT US ON THE INTERNET AT WWW.LACBA.ORG/LALAWYER E-MAIL CAN BE SENT TO [email protected]

EDITORIAL BOARD Chair JOHN C. KEITH Articles Coordinator SANDRA MENDELL Assistant Articles Coordinator TYNA ORREN Secretary RENA KREITENBERG Immediate Past Chair TED M. HANDEL

JERROLD ABELES (PAST CHAIR) GL Howard and Company CPAS, LLP SCOTT BOYER CHAD C. COOMBS (PAST CHAIR) THOMAS J. DALY GORDON K. ENG EFFECTIVE DONNA FORD (PAST CHAIR) SUPPORT FOR STUART R. FRAENKEL MICHAEL A. GEIBELSON (PAST CHAIR) WHITE COLLAR SHARON GLANCZ GABRIEL G. GREEN ISSUES STEVEN HECHT (PAST CHAIR) DENNIS F. HERNANDEZ JUSTIN KARCZAG 562.431.9844 • www.glhowardandcompanycpas.com MARY E. KELLY (PAST CHAIR) KATHERINE KINSEY JENNIFER W. LELAND CAROLINE SONG LLOYD PAUL S. MARKS (PAST CHAIR) COMM’R ELIZABETH MUNISOGLU CARMELA PAGAY GREGG A. RAPOPORT JACQUELINE M. REAL-SALAS (PAST CHAIR) LACEY STRACHAN YHEZEL ARMANDO VARGAS THOMAS H. VIDAL

STAFF Editor-in-Chief SUSAN PETTIT Senior Editor JOHN LOWE Art Director LES SECHLER Director of Design and Production PATRICE HUGHES Advertising Director LINDA BEKAS Senior Manager MELISSA ALGAZE Administrative Coordinator MATTY JALLOW BABY

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4 Los Angeles Lawyer February 2018 LOS ANGELES LAWYER IS THE OFFICIAL PUBLICATION OF THE LOS ANGELES COUNTY BAR ASSOCIATION 1055 West 7th Street, Suite 2700, Los Angeles CA 90017-2553 Telephone 213.627.2727 / www.lacba.org

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KRISTIN ADRIAN HON. SHERI A. BLUEBOND SUSAN J. BOOTH RONALD F. BROT TANYA FORSHEIT JENNIFER W. LELAND MATTHEW W. MCMURTREY F. FAYE NIA BRADLEY S. PAULEY ANGELA REDDOCK DIANA K. RODGERS MARC L. SALLUS MICHAEL R. SOHIGIAN EDWIN C. SUMMERS III KENDRA THOMAS KEVIN L. VICK WILLIAM L. WINSLOW FELIX WOO AFFILIATED BAR ASSOCIATIONS BEVERLY HILLS BAR ASSOCIATION CENTURY CITY BAR ASSOCIATION Confidence At The Courthouse. CONSUMER ATTORNEYS ASSOCIATION OF LOS ANGELES CULVER MARINA BAR ASSOCIATION Business litigation is increasingly complex. That is why we believe valuation GLENDALE BAR ASSOCIATION issues must be addressed with the same meticulous care IRANIAN AMERICAN LAWYERS ASSOCIATION as legal issues. Analysis must be clear. Opinions must be ITALIAN AMERICAN LAWYERS ASSOCIATION JAPANESE AMERICAN BAR ASSOCIATION defensible. Expert testimony must be thorough and JOHN M. LANGSTON BAR ASSOCIATION articulate. HML has extensive trial experience and can THE LGBT BAR ASSOCIATION OF LOS ANGELES provide legal counsel with a powerful resource for expert MEXICAN AMERICAN BAR ASSOCIATION testimony and litigation support. PASADENA BAR ASSOCIATION SAN FERNANDO VALLEY BAR ASSOCIATION For More Information Call 213-617-7775 SANTA MONICA BAR ASSOCIATION SOUTH BAY BAR ASSOCIATION Or visit us on the web at www.hmlinc.com SOUTHEAST DISTRICT BAR ASSOCIATION • • • SOUTHERN CALIFORNIA CHINESE LAWYERS ASSOCIATION BUSINESS VALUATION LOSS OF GOODWILL ECONOMIC DAMAGES LOST PROFITS WOMEN LAWYERS ASSOCIATION OF LOS ANGELES

Los Angeles Lawyer February 2018 5 o all of you who just reported your MCLE compli- ance, I say: I hope you learned something useless. I T don’t mean that sarcastically. I genuinely hope you learned something of no apparent application to your practice at all. I know I did, and it was worth it.

This year I spent a few hours learning wine law from some CEB programs. I don’t practice wine law. I don’t plan to practice wine law. I don’t even really want to practice wine law. But despite (or perhaps because of) that, I enjoyed those CEB programs more than any others. As attorneys, so much of our learning is driven by practical necessity. Being a litigator, I learned how to draft pleadings, motions, and discovery not out of idle curiosity but because I had to. I research legal issues as they arise and show their relevance to a matter. This type of learning has its own rewards. As we develop our practice skills, there is a pride and often enjoyment in mastering the tools of our trade. We are lucky that law is a profession that allows us to continue learning, even over decades, and most of us would not be attorneys unless we had both a skill and a thirst for learning new things. But the second of those qualities—the thirst—applies not only to overtly practical learning but also to a kind whose purpose is less clear. We should nourish that thirst, and quench it at every opportunity. For most of us, it is an innate quality that helped us persevere through years of schooling, the bar exam, and the difficult— often frightening—early years of practice, when so much felt beyond our knowledge, our skills, and our control. View it this way and it is not hard to see a practical purpose for ostensibly “useless” learning. The love of learning is like a muscle. It must be exercised, but unless you mix up your exercise routine, you risk getting bored and having your commitment flag. I was a bit bored that day I watched my first wine law program. Afterwards, I felt more reinvigorated than if I had whiled away an hour on the Internet. (For me, the Internet is a conundrum in that it enables me to consume so much information and to retain so little. At dinner, my wife may ask if I read anything interesting that day, and though I spent an hour or more online, I feel hard pressed to say anything. Perhaps because the Internet is always there—at our desks, on our phones—and tends to broadcast in bite-sized bits, browsing is more a distraction, too passive and diffuse to constitute actual learning. It is far different to affirmatively commit to something that promises to teach us something, however “useless.” Finally, here is another practical purpose for useless learning. Clients, judges, juries, coworkers, opposing counsel—they are all just people. While some are lawyers like ourselves, everyone is different. The more we know about the world and the human experience, the better we can relate to these different constituencies, and the better we are at what we do. So, let’s go out there and learn something useless today. n

John Keith is the 2017-18 chair of the Los Angeles Lawyer Editorial Board. He practices business litigation with the law firm of Fenigstein & Kaufman in Century City.

6 Los Angeles Lawyer February 2018 on direct INTERVIEW BY DEBORAH KELLY

John H. Haney Director, California Indian Law Association

chief. My mother is an attorney practic- Do you speak Muscogee Creek, a lan- ing Indian law. My brother works for the guage of the Seminoles? I tried; I wish San Manuel Band of Mission Indians. there were a Rosetta Stone for it.

Is saying “Indian” inappropriate? Indian, Do Seminoles have pow-wows? We do. Native American, and American Indi- They are based around a circle, with the ans…those are all interchangeable to me. traditional dancers in the middle, cele- brating culture and celebrating life. Your practice includes tribal law and fed- eral Indian law. How do they differ? With In 1976, the United States awarded a land tribal law, you are looking at a tribe as a claims settlement to the Seminole tribes government creating law. Federal Indian valued at $16 million for approximately 24 law governs the relationship between the million acres of lands seized by the U.S. federal government and tribes. government in Florida in 1823. Was that a good deal? Nothing can redress the The term “Seminole” derived from the atrocities of Indian removal policies. Spanish word cimarrones meaning run- aways or free people. Is that pejorative? I Negotiations lasted more than a decade. like the term “free people.” It sums us Why? Maximizing recovery or relief is JOHN H. HANEY is an associate attorney at up well. Native American tribes have en- reasonable. There were disputes as to the Holland & Knight LLP where he is a member dured over centuries, withstanding ad- allocations of funds between the Semi- of the Labor, Employment, and Benefits Group, versity. nole Nation of Oklahoma and the Flori- as well as the Native American Law Group. Mr. da Seminoles. Haney has represented employers in a variety The Seminole Nation of Oklahoma is a of matters but is specifically interested in the federally recognized Native American The Seminole Nation of Oklahoma covers intersections between state and federal labor tribe. What does the process entail? 633 square miles. What does that in- and employment law, tribal law, and federal There are over 500 federally recognized clude? Within boundaries—established Indian law. A graduate of the UCLA School of tribes. There are various complex tests by treaty—are tribal trust lands, fee sim- Law, he served as president of the UCLA Native for petitioning for the federal acknowl- ple lands owned by the tribe, individual American Law Students Association and also edgement. restricted allotments, and fee simple as a student clerk for the Hualapai and Hopi lands owned by non-Indians. Tribal Appellate Courts. He currently serves on Why all the lawsuits about tribal member- Does the Seminole Nation have a clan sys- the board of directors of the California Indian ship? Tribes can set their own blood tem? Law Association. Mr. Haney is a member of the quantum levels for membership. That’s Yes. Members within each clan are Seminole Nation of Oklahoma. just a matter of sovereignty. considered to be close kin. I am of the Sweet Potato clan. Why are there so many complaints about the Bureau of Indian Affairs? I think they In the 1900s, the Seminole were still arise from administrative sluggishness. mostly full bloods because intermarriage What is the perfect day? Spending time The bureau is empowered as a liaison with whites was discouraged. Is that the with my wife, running, and playing between the federal government and same today? It’s not discouraged today. guitar. tribes. It also executes the federal gov- Will the blood lines “run out”? No, it goes Do you play guitar in a band? No, but I sat ernment’s trust responsibilities to the again to blood quantum. At some point, in for LACBA’s Big Band of Barristers. tribes. obviously the blood quantum levels can You are one of nearly 19,000 members of What would you say is the biggest differ- get lower, so there’s this idea not to legis- the Seminole Nation of Oklahoma. What ence in the Seminole religious ceremonies late a tribe out of existence. does that mean to you? and Judeo-Christian religious ones? It My culture What are the greatest challenges facing means everything to me. comes down to the Creator. Historically, there is no Bible, but it’s very spiritual the Indian community? Preserving culture Is your family involved in Native American about loving the earth and protecting the and resisting threats to tribal sovereignty. culture? My father served a term as a earth for future generations. You went to Columbia as an undergradu-

8 Los Angeles Lawyer February 2018 ate and UCLA School of Law. Why did you want to become a lawyer? To help people.

You are a director in the California Indian Law Association. What are the organiza- tion’s goals? To serve as the representa- tive of the Indian law profession in Cali- fornia, to educate the public, and to support Indian law practitioners and law students.

How many Native American attorneys are there? It’s a very small world.

Recently, Los Angeles replaced Columbus Day with Indigenous Peoples Day. What are your thoughts on that? Love it.

What was your best job? This one.

What was your worst job? Car washer

What characteristic do you most admire in your mother?As an attorney, her bril- liance. As a mom, her caring.

Who is on your music play list? My three favorite musicians are all jazz guitarists: Grant Green, Joe Pass, and Pat Martino.

What scared you the most about your first case? On my first day at the job, I was assigned to draft and file an answer on that same day. I was terrified of handling the case myself.

What is your favorite vacation spot? Idyll- wild, California, to get away from the world.

What is your hidden talent? I make Na- tive American flutes. My grandpa was a flute maker. He added Native-designed beadwork to enhance the flute visually. I consider flute-making his gift to me.

What is your favorite sport? Running, maybe 15 hours per week. I’ve done two half-marathons.

Which television show do you record? Game of Thrones.

Which person in history would you like to take out for a beer? My namesake: Thlocklo Tustenuggee, which translates as “Great Warrior.” We often are given Indian names shortly after birth.

What are the three most deplorable condi- tions in the world? War crimes, poverty within Indian country, and violence against women.

Who are your two favorite U.S. presi- dents? Not Andrew Jackson.

What is the one word you would like on your tombstone? Tustenuggee.

Los Angeles Lawyer February 2018 9 barristers tips BY ZACHARY T. ELSEA

How Ginger and Fred Settled the Battle Between Two “Empires”

THE NINTH CIRCUIT COURT OF APPEAL recently weighed in on a Though the court did not discuss it, the requirement that a dispute between two empires: one real, the other fictional. In junior use refer to or comment on a senior use is not without Twentieth Century Fox Television v. Empire Distribution, Fox precedent in intellectual property law. Under the fair use doctrine sought a declaratory judgment that its television show Empire in copyright law, for example, a parody of an original work can and related marketing and merchandising did not violate the be a privileged fair use, but the parody incorporating the original trademarks of Empire Distribution, Inc.1 Debuting in 2015, work must comment on that work in some way.4 If a work bor- Empire chronicles the saga of a New York City-based record rows from an original work to comment on something else label, Empire Enterprises. Empire Distribution is a San Fran cis - entirely, then it is unprotected satire. co-based hip hop, rap, and R&B music label founded in 2010. Nonetheless, the court rejected Empire Distribution’s proposed The court held that Fox’s use of the “Empire” mark is protected rule and held that for purposes of First Amendment protections by the First Amendment and therefore immune from suit for under the Rogers test, it is irrelevant what the use of a mark in a trademark infringement. The ruling is notable for two reasons. work’s title refers to, so long as it is artistically relevant to the First, the court formally extended the First Amendment’s protections underlying work. The court was right to reject Empire Distribution’s for expressive works to advertising and merchandising materials proposed requirement: adopting such a rule would be antithetical bearing the work’s name, including the sale of consumer goods. to the Lanham Act’s goal of preventing consumer confusion.5 Second, the court declined to adopt a requirement that an expressive When a trademark uses an English word to identify a particular work incorporating a mark actually refer to the original trade- product or service, the mark can be wielded to prevent competitors marked work or entity. With respect to the court’s first holding, from using the same mark to confuse consumers, but the trademark Empire Distribution argued that advertising and merchandising does not operate as a monopoly on the underlying generic word efforts were not protected expression and thus subject to Lanham or concept. For example, Apple, Inc. can fiercely defend its mark Act trademark infringement claims. The First Amendment protects in the technology arena, but it cannot enjoin the sale of apples in expressive works from Lanham Act claims. Under the Rogers the produce aisle. The rule proposed by Empire Distribution flips test,2 “the Lanham Act should not be applied to expressive works this logic on its head: an expressive work could freely refer to the ‘unless the [use of the trademark or other identifying material] specific trademarked good or service, but the work would be has no artistic relevance to the underlying work whatsoever.’”3 barred from evoking the mark’s common or generic meaning. Empire Distribution conceded the Empire television show is For example, a movie released with the title Amazon would be an expressive work but argued that Fox’s merchandising—e.g., entitled to greater First Amendment protections if were a fictional Empire T-shirts, champagne glasses—are not and are not entitled story about the Internet commerce company rather than a tale to the First Amendment protections laid out in Rogers v. Grimaldi. set in the Amazon rainforest. But that result would promote, The court noted that those “promotional efforts technically fall rather than prevent, consumer confusion: consumers almost cer- outside the title or body of an expressive work” but reasoned tainly would be more likely to believe that Amazon, the e-commerce that the First Amendment protections afforded to a work’s title company, had a hand in sponsoring or producing a film about would be severely undermined if the work could never be adver- itself than in creating a film set in the South American rainforest tised or marketed by that name. Thus, the court formally extended that has nothing to do with the Seattle-based company. Rogers to protect advertising and marketing of expressive works, Thus, as result of the court’s holding in Empire Distribution, including use of the work’s title in consumer merchandise. it is clear that the First Amendment protects merchandise adver- The court also held that an expressive work’s use of a mark tising an expressive work from Lanham Act claims to the same need not refer to the same referent as the protected trademark. extent it protects the work itself. It is also clear that there is no Empire Distribution argued that inherent in the Rogers test was requirement that the expressive work refer to the same referent a requirement that the junior work—here, Empire—refer to the as the mark to qualify as a protected use. n senior work, viz. Empire Distribution. That was the case in Rogers. Ginger Rogers sued the producers of the Federico Fellini 1 Twentieth Century Fox Television v. Empire Distribution, Inc., No. 16-55577 film Ginger and Fred for using her and her late acting and dance (9th Cir. Nov. 16, 2017) (publication pending). partner’s names. The title indeed referred to Ginger Rogers and 2 See Rogers v. Grimaldi, 875 F. 2d 994, 999 (2d Cir. 1989). 3 Fred Astaire, but it was relevant to the film, which told the Brown v. Elec. Arts, Inc., 724 F. 3d 1235, 1242 (9th Cir. 2013) (modification in original). fictional story of two Italian cabaret dancers who became known 4 Campbell v. Acuff Rose Music, Inc., 510 U.S. 569, 580, (1994). in Italy as “Ginger and Fred.” By contrast, Empire did not refer 5 See Park ‘N Fly, Inc. v. Dollar Park & Fly, Inc., 469 U.S. 189, 190, (1985). to Empire Distribution but rather the show’s setting in the Empire State and the fictional music and entertainment business empire Zachary T. Elsea is an attorney at Kinsella Weitzman Iser Kump & Aldisert at the heart of the show. LLP and a member of the LACBA Barristers Executive Committee.

10 Los Angeles Lawyer February 2018

practice tips BY MICHAEL MALLOW, AMY LALLY, AND SHAWN COLLINS

The Determinants of Class Certification After In re Tobacco II

CLASS ACTIONS ARE A POWERFUL TOOL for consumer plaintiffs who believe they were harmed by a defendant’s false advertising, since they enable the aggregation of large numbers of claims that, if prosecuted separately, might be too small to justify the costs of litigating.1 Indeed, a court’s denial of class certification is commonly viewed as the death knell of the litigation.2 In California as else- where, there are various prerequisites to obtain certification of a class action. These include that there be “a well-defined community of interest” among the class members, which, in turn, “‘embodies three factors: (1) predominant common questions and law or fact [i.e., commonality]; (2) class representatives with claims or defenses typical of the class [i.e., typicality]; and (3) class repre- sentatives who can adequately represent the class [i.e., adequacy].’”3 When proscuted as a class action, a claim under the “fraudulent business practice” prong of California’s Unfair Competition Law (UCL) is a powerful tool for consumers to attack false advertising.4 To state such a claim, “it is necessary only to show that members of the public are likely to be deceived,” and the claim traditionally “has been understood to be distinct from common law fraud,” which requires a showing of deception.5 While a false advertising ruling was not so broad as many thought, and opinions issued in class action under the UCL is potentially a very powerful tool, the the wake of Tobacco II show that state and federal courts in UCL was far more threatening to business than it is today. Prior California have been careful to limit the case’s application. to the 2004 passage by California voters of Proposition 64, “the Much of the confusion that has occurred in the wake of Tobacco UCL authorized any person acting for the general public to sue II can be attributed to “standing” and “commonality” being con- for relief from unfair competition” without regard to the require- flated, even though they remain separate and distinct requirements ments governing class actions, and “[s]tanding to bring such an for the maintenance of a class action. While Tobacco II may action did not depend on a showing of injury or damage.”6 In have tilted the playing field in favor of plaintiffs with regard to other words, just about anyone could bring a claim against any the issue of standing, defendants can still defeat class certification business about almost anything without ever interacting in any on the issue of commonality if the plaintiff cannot prove that way with the business. After Proposition 64 passed, “a private class members were necessarily exposed to the advertisement that person has standing to sue only if he or she has suffered injury in forms the basis of the UCL fraud claim. fact,” and representative UCL actions must comply with the In Tobacco II, a group of plaintiffs comprised of smokers in requirements governing all class actions.7 California filed a class action against several tobacco companies.9 The complaint alleged a cause of action under the UCL based In re Tobacco II on a claim that the plaintiffs had become smokers after being In 2009, in In re Tobacco II,8 a UCL case that had been pending exposed to the companies’ false advertising and deceptive mar- in the trial court when Proposition 64 passed, the California keting activities within the state of California.10 After Proposition Supreme Court held that the trial court improperly decertified a 64 passed in November 2004, the tobacco companies filed a class of California smokers based on the change in the law and motion to decertify the class action claims under the UCL, arguing that the trial court should presume that absent class members that “each class member was now required to show an injury in relied on some type of misrepresentation by the tobacco company fact…as a result of the alleged unfair competition.”11 The trial defendants concerning the risks of cigarettes. Since then, plaintiffs’ court granted the motion, and the California Supreme Court counsel have relied on Tobacco II to argue that their clients may subsequently granted review. proceed on a on class-wide basis founded upon only the named On review, the California Supreme Court addressed two specific plaintiffs’ individual experiences with the advertising at issue, questions: 1) Who in a UCL class action must comply with without regard to whether absent class members suffered actual Proposition 64’s standing requirements, the class representatives injury caused by a defendant’s allegedly fraudulent business practice. The decision has been hailed by plaintiffs’ lawyers and derided by Michael Mallow and Amy Lally are partners in the Los Angeles and Century defense counsel as opening the door to unfettered California false City offices, respectively, of Sidley Austin LLP. Shawn Collins is an associate

RICK EWING advertising class actions. However, the California Supreme Court’s in the firm’s Orange County office.

12 Los Angeles Lawyer February 2018 or all unnamed class members, in order for consistently denied such motions if they there is no evidence that a majority of the class to proceed? and 2) What is the seek to expand Tobacco II and Keegan Listerine consumers viewed any of those causation requirement for purposes of estab- beyond their unique facts.19 commercials.”28 lishing standing under the UCL?12 The court For a defendant seeking to limit the In Mazza v. American Honda Motor answered these two questions by ruling that impact of Tobacco II and Keegan on a Co., Inc., the Ninth Circuit reversed the 1) only the class representatives, and not court’s decision on class certification, prop- certification of a nationwide class of con- absent class members, must meet standing erly framing the inquiry as a question of sumers who purchased or leased cars equip - requirements of actual injury and causation, commonality (exposure) and not a question ped with a Collision Mitigation Brak ing 2) only the class representatives must estab- of standing (reliance) will be key. A number System (CMBS) during a three-year period, lish actual reliance in accordance with fraud- of courts now have held that class certifi- holding that “[i]n the absence of the kind ulent inducement principles in order for the cation in a UCL case is inappropriate when of massive advertising campaign at issue in class action to proceed, and 3) the class plaintiffs cannot show that members of the Tobacco II, the relevant class must be de - representatives do not independently have class were exposed to the same misrepre- fined in such a way as to include only mem- to show reliance on particular advertise- sentations or any omissions.20 bers who were exposed to advertising that ments or marketing materials with unreal- In Cohen v. DIRECTV Inc.,21 the plain- is alleged to be materially misleading.”29 istic specificity.13 In short, Tobacco II held tiff alleged that DIRECTV advertised its The plaintiffs had alleged that certain adver- that class certification cannot be defeated high-definition satellite service “without the tisements misrepresented the characteristics solely for lack of standing by absent class intent to provide the customers” with the of the CMBS and omitted material infor- members. advertised levels of resolution, and also that mation on its limitations.30 In reversing class While the California Supreme Court the defendant “switched its HDTV channels certification, the court in Mazza noted that expressly limited its ruling in Tobacco II to a lower resolution, reducing the quality “Honda’s product bro chures and TV com- to the issue of standing, plaintiffs cite to of the television images it transmits to sub- mercials that were alleged to have been mis- language in the opinion for the notion that scribers.”22 The Cohen court affirmed the leading and deceptive fell short of the ‘exten- courts may presume reliance on some type denial of class certification because the class sive and long-term [fraudulent] advertising of false or misleading representations when would include subscribers: 1) who never campaign’ at issue in Tobacco II [], and there is evidence of “an extensive and long- saw DIRECTV advertisements of any kind [that the] difference is meaningful.”31 “For term advertising campaign.”14 In Tobacco before purchasing HD services, 2) who only everyone in the class to have been exposed II, the court presumed all class members saw or relied upon DIRECTV advertise- to the [alleged] omissions…it is necessary relied on some type of misrepresentation ments that contained no mention whatso- for everyone in the class to have viewed the based on the decades-long campaign of the ever of technical terms regarding resolution, allegedly misleading advertising.”32 The tobacco industry to conceal the health risks or 3) who purchased DIRECTV HD pri- court ultimately held that “the limited scope of its product while minimizing the growing marily based on word-of-mouth or because of [Honda’s] advertising [made] it unrea- consensus regarding the link between cig- they saw DIRECTV’s HD in a store or at a sonable to assume that all class members arette smoking and lung cancer.15 friend or family member’s home.23 The court viewed it.”33 The court in Keegan v. American Honda ex plained: “[W]e do not understand the UCL Theory of Common Exposure Motor Company, Inc.16 made a similar pre- to authorize an award for injunctive relief sumption, on different facts. There, the and/or restitution on behalf of a consumer For a defendant opposing certification of plaintiffs moved for class certification on who was never exposed in any way to an a UCL false advertising class action, pre- claims that the automobiles they purchased allegedly wrongful business practice.”24 senting evidence that disrupts the theory had defective rear suspensions, and they Similarly, in McAdams v. Monier, Inc.,25 of common exposure is critical. While the cited to Tobacco II as support for their arg - the court reversed a denial of class certifi- plaintiff certainly has the burden of estab- ument that plaintiffs are permitted to prove cation and remanded the matter to the trial lishing uniform exposure, defense counsel a UCL violation with “general evidence that court to determine whether the class rep- should, if at all possible, not merely rely Defendants’ conduct was ‘likely to deceive’ resentative could demonstrate standing on arguing that representative plaintiffs members of the public.”17 The court in under the Tobacco II standard but offered cannot establish uniform exposure. Affirm - Keegan held that plaintiffs satisfied the com- the following proviso: “The members of ative evidence should be developed to drive monality requirement for class certification these classes, prior to purchasing…had to the point home. Evidence of nonuniform because “all class members re ceived the have been exposed to a statement along exposure might include: various product same information from defendants regarding the lines that the roof tile would last 50 labels for an offending product that do not the purported defect—which is to say, no years, or would have permanent color, or contain alleged misrepresentations, adver- information concerning the possibility of would be maintenance free.”26 The day tising circulation data showing limited pub- premature and excessive tire wear.”18 after the McAdams decision, another court lication of advertisements, Internet data While many might have predicted that of appeal issued its decision in Pfizer Inc. establishing that website views are far less Tobacco II and Keegan were the beginning v. Superior Court, reversing the trial court’s than product sales, deposition testimony of a new trend, they remain the only two certification of a class consisting of “all and declarations to the effect that purchas- cases in which all class members were pre- persons who purchased Listerine, in Cal - ing customers were not exposed to offend- sumed to have been exposed to some type ifornia, from June 2004 through January ing representations, and expert witness of false representation (or in Keegan, the 7, 2005.”27 The court in Pfizer found that testimony on the limited reach of an ad- absence of representations about the defect), 19 of the 34 Listerine mouthwash bottles vertising campaign. This type of evidence and there is no language in either of these did not include a label with the alleged creates significant roadblocks to named cases that suggests they apply beyond their misrepresentation, and that, although Pfizer representatives establishing that a putative unique facts. Of course, that has not pre- ran four different television commercials class was uniformly exposed to false or vented plaintiffs from relying on them to with the alleged misrepresentations, “the misleading representations. seek class certification, but courts have commercials did not run continuously and Following Tobacco II, to establish stand-

Los Angeles Lawyer February 2018 13 ing on behalf of a class, named plaintiffs counsel with a bit of a Hob son’s choice: there are three varieties of unfair competition: practices in a UCL representative action need only define a class narrowly to encompass only which are unlawful, unfair or fraudulent.” Tobacco II, 46 Cal. 4th at 311. “A violation of the UCL’s fraud establish their own reliance on an alleged those purchasers who in fact were exposed prong is also a violation of the false advertising law false advertisement. However, as one court to a specific alleged false advertisement (and ([BUS. & PROF. CODE] §§17500 et seq.).” Tobacco II, observed, “Tobacco II does not stand for sacrifice the more lucrative possibilities of 46 Cal. 4th at 312. the proposition that a consumer who was a larger class), or define it to more broadly 5 Tobacco II, 46 Cal. 4th at 312. never exposed to an alleged false or mis- cover purchasers of a product (and risk hav- 6 Id. at 314. 7 Id. leading advertising or promotional campaign ing class certification denied). n 8 Id. at 298. 34 is entitled to restitution.” Accord ingly, 9 Id. when a UCL complaint involves a fraud 1 In re Tobacco II Cases, 46 Cal. 4th 298, 313 (2009). 10 Id. claim, courts have consistently held since 2 See, e.g., Shelley v. City of Los Angeles, 36 Cal. App. 11 Id at 306 Tobacco II that class representatives must 4th 692, 695 (1995). 12 Id. 3 Tobacco II, 46 Cal. 4th at 313 (citing Fireside Bank 13 show, at a minimum, that absent class mem- Id. at 321-29. v. Superior Ct. 40 Cal. 4th 1069, 1089 (2007)). See 14 Id. at 328 (“[W]here…a plaintiff alleges exposure bers were actually exposed to the alleged also CODE CIV. PROC. §382. to a long-term advertising campaign, the plaintiff is misrepresentations. That courts have done 4 “The UCL defines unfair competition as ‘any unlawful, not required to plead with an unrealistic degree of so has presented defendants with a roadmap unfair or fraudulent business act or practice....’ ([BUS. specificity that the plaintiff relied on particular adver- to opposing class certification, and plaintiffs’ & PROF. CODE] §17200.) Therefore, under the statute tisements or statements.”). 15 Id. 16 Keegan v. Am. Honda Motor Co., Inc., 284 F.R.D. 504 (C.D. Cal. 2012). 17 Id. at 533-34 (quoting Plascencia v. Lending 1st Mortgage, LLC, 259 F.R.D. 437, 448 (N.D. Cal. 2009)). 18 Id. 19 Cohen v. DIRECTV Inc., 178 Cal. App. 4th 966, 981 (2009) (finding Tobacco II to be irrelevant to the court’s analysis of whether or not class certification was properly denied because the issue of standing is simply not the same thing as the issue of commonality); Pfizer Inc. v. Superior Ct., 182 Cal. App. 4th 622, 625 (2010) (“[t]he circumstances herein stand in stark con- trast to those in Tobacco II, where the tobacco industry defendants allegedly violated the UCL ‘by conducting a decades-long campaign of deceptive advertising and misleading statements about the addictive nature of nicotine and the relationship between tobacco use and disease.’”); McVicar v. Goodman Global, Inc., No. 13-1223, 2015 WL 4945730 at *11 (C.D. Cal. Aug. 20, 2015) (“This case is different from cases like Tobacco II and Keegan where all class members may be presumed to have been exposed to some type of representations…[and] more like Cohen, where many members of the proposed class ‘who never saw [] adver- tisements or representations of any kind before deciding to purchase the company’s’ product would have been swept into the class definition.”). 20 Cohen, 178 Cal. App. 4th at 981 (common issues did not predominate when the class would include sub- scribers who never saw [allegedly misleading] adver- tisements and representations of any kind before decid- ing to purchase the company’s services); see also Stearns v. Ticketmaster Corp., 655 F. 3d 1013, 1020 (9th Cir. 2011) (“A presumption of reliance does not arise when class members were exposed to quite disparate infor- mation from various representatives of the defendant.”). 21 Cohen, 178 Cal. App. 4th at 966. 22 Id. at 969-70. 23 Id. at 979. 24 Id. at 980. 25 McAdams v. Monier, Inc., 182 Cal. App. 4th 174 (2010). 26 Id at 192-93. 27 Pfizer Inc. v. Superior Ct., 182 Cal. App. 4th 622, 625 (2010). 28 Id. at 632-33. 29 Mazza v. American Honda Motor Co., Inc., 666 F. 3d 581, 596 (9th Cir. 2012). 30 Id. at 585. 31 Id. at 596. 32 Id. 33 Id. 34 Pfizer Inc. v. Superior Ct., 182 Cal. App. 4th 622, 632 (2010).

14 Los Angeles Lawyer February 2018 practice tips BY RENA E. KREITENBERG AND KAYLEE KREITENBERG

Parental Liability for Copyright Infringement by a Minor Child

IT IS NO SECRET THAT MINOR CHILDREN actively download pro- found liable, but also Napster itself was found liable for con- tected material from the Internet illegally through various appli- tributory and vicarious copyright infringement.9 cations on their laptops and home computers. As a result, an The basis for imposition of copyright infringement liability issue has arisen as to whether there is a basis to impose parental under Napster is similar to the type of infringement that occurs liability for the illegal copyright infringement by their minor when a minor illegally downloads material from a home computer. children. One factor contributing to the problem of whether to But there is one major distinction—there is no exchange of the impose parental liability is the generational gap between parents material illegally downloaded as between the parent and the and their children when it comes to technology. Parents could minor child. Relying on the holding in the Napster case, the be wholly unaware that their children are engaged in illegally Supreme Court in Sony Corp. of Am. v. Universal City Studios, downloading material from the Internet, and there is no mechanism Inc. held that without constructive knowledge of the fact that in place that would notify parents of infringe- ment by their minor children. Under California state or federal law, is there a While other jurisdictions have eliminated negligent parental liability, basis to impose parental civil liability for a minor child’s illegal downloading of pro- tected works through the Internet? California has taken a broader approach. The federal Copyright Act grants the copyright holder exclusive rights to use and to authorize others to use the work in specified ways, including equipment (or a platform) was used to make unauthorized copies reproduction of the copyrighted works in copies.1 However, any of copyrighted materials, secondary liability could not be individual may reproduce copyrighted work for fair use.2 The imposed.10 It appears the rationale in the Supreme Court’s Copyright Act affords the owner of a copyright with multiple opinions in Napster and Sony would preclude secondary liability remedies against an infringer of his or her work ranging from an of a parent for the illegal downloading of material by a minor injunction to destruction of reproductions made of the work, that is done without the parent’s knowledge; nevertheless, upon statutory damages, and attorney’s fees.3 a further examination of California state law, contributory and Proof of direct copyright infringement under the Copyright vicarious liability offers a possible viable theory. Act has two elements: demonstrating ownership of the allegedly It has long been the view under California law that the mere infringed material and that the alleged infringer violated at least parent-child relationship does not automatically impose liability one of the exclusive rights granted to copyright holders.4 Applying upon the parent for a child’s tortious acts.11 Specific circumstances the Copyright Act to impose liability on a parent for a minor must exist before parental liability is triggered. Typically, a key child’s infringement would be difficult because the act does not factor is whether the parent enabled the child to cause the injury provide a basis to impute infringement. Thus, although parents through express conduct engaged in by the parent.12 may monitor their minor child’s computer use and may even have Civil Code Section 1714.1 provides that a parent is liable for actual knowledge of the infringing conduct, direct copyright a minor child’s willful misconduct and that reparations shall not infringement would undoubtedly be difficult to impose because exceed $25,000.13 The ability to control the minor is a crucial the parent does not personally engage in any infringing conduct. factor in determining liability.14 Courts have defined this control While the Copyright Act does not provide for secondary as a showing of physical custody and opportunity to exercise infringement liability, such liability emerged from common law authority is required.15 Because the statute imposes liability and is now generally accepted.5 When infringement pertains without fault, a pecuniary limit is imposed. As a result, the specifically to illegal downloading from the Internet, the Ninth statute limits compensation from a parent for injuries caused by Circuit case A&M Records, Inc. v. Napster, Inc. remains the a minor child. Section 1714.1 has expanded the scope of liability most well known. Napster was a platform in which its users to include a guardian and an individual parent (rather than were able to download MP3 files to individual computer hard jointly on both parents). drives available for other Napster users.6 Napster attempted to California has adopted Section 316 of the Restatement (Second) assert a fair use defense against the direct copyright infringement, claiming its users did not directly infringe plaintiff’s copyrights Rena E. Kreitenberg is a partner in the Los Angeles litigation firm Mesisca because the users were engaged in “fair use” of the material.7 Riley & Kreitenberg LLP where her practice focuses on real estate, business, The Ninth Circuit rejected the argument and concluded that appeals, employment, and legal malpractice. Kaylee Kreitenberg will graduate Napster’s users were direct infringers because they actually Southwestern Law School in May and take the California Bar Examination in exchanged the copyrighted songs.8 Not only were Napster users July 2018.

Los Angeles Lawyer February 2018 15 of Torts.16 The Restatement, however, firearm accessible to the minor. Under these over, it would be difficult to impose con- slightly limits the scope of liability provided circumstances, the court found that notwith- tributory liability on a parent for his or under Section 1714.1 by requiring a parent standing a lack of legal custody of the minor, her minor child’s infringement because to exercise reasonable care over a minor the father could be found liable under a there is no material contribution by the child to prevent him or her from inten- parental negligence liability theory.27 parent other than access to a computer. tionally harming others when the parent The analysis in Robertson stands in But what if the parent provides the has knowledge and the ability to control stark contrast to the earlier opinion of minor child with access to a computer the child.17 The California Supreme Court Costello v. Hart, which held a guardian with actual knowledge that the child has defines the term “knows” as knowledge need not possess extensive prior knowledge and will continue to access and illegally of dangerous habits and the ability to con- of a child’s dangerous tendencies in order download copyrighted material? This fac- trol the child as prerequisites to parental to trigger parental liability.28 In Costello, tual scenario has not been addressed by liability.18 Case law has laid down princi- a grandmother was held liable for the con- the courts. ples adopting a more expansive approach. duct of her minor grandson when he ran Contributory liability as applied to In Robertson v. Wentz, the minor child out from underneath a rack of clothing copy right infringement requires that the robbed a bookstore and subsequently shot causing the plaintiff to sustain an injury secondary infringer fail to act “knowingly” and killed the victim.19 Robertson conceded of the femur.29 Costello emphasized that or “have reason to know” of direct copy- that while no common law vicarious lia- the defendant need not have knowledge right infringement and material contribu- bility is imposed upon parents for torts of of the child’s dangerous tendencies for any tion.37 Thus, a case could be made for their children, a parent might become liable particular length of time so long as the parent al secondary liability if the parent is for an injury caused by the minor when knowledge was acquired in a timely man- aware of prior illegal downloading and does the parents’ negligence contributed or ner sufficient to take reasonable measures.30 nothing to prevent future illegal conduct. caused the injury.20 The court held that evidence of the child’s But imposition of civil parental liability While other jurisdictions have elimi- misbehavior in that case was conspicuous in the copyright infringement context poses nated negligent parental liability, California and continuous for an appreciable amount specific complications. Under Section has taken a broader approach. Under the of time in the presence of defendant and 1714.1, civil parental liability is limited Restatement, as applied in Robertson, one that the defendant had reared the boy, only to willful or intentional conduct of a who takes charge of a third party and having care and custody of him, which minor child. Most copyright infringement knows he is likely to cause harm has a supports a verdict for the plaintiff.31 by a minor is rarely willful or intentional. duty to exercise reasonable care.21 Thus, Based on the foregoing theories of com- Moreover, what is generally at issue in without a parent’s active negligence that mon law and statutory parental liability, illegal downloading by minors is a parent’s enables the child to cause harm, parental it would be difficult to impose parental constructive knowledge or knowledge that liability will not attach.22 liability for a minor child’s copyright is imputed to the parent simply as a result Robertson pointed out that the purpose infringement without the actual knowledge of the nature of a parent-child relationship. of the law is to provide a remedy to inno- of the parent of that infringement. On the Sony v. Universal addressed imposition of cent third parties injured by a minor when other hand, if a plaintiff could prove that vicarious liability based on constructive none is otherwise available under the Civil the parent was actually aware of a prior knowledge and the fact that the equipment Code.23 The Robertson court concluded incident of such illegal conduct and failed used for the infringing activity was owned that the statute intended an expansive to take preventative action to enjoin similar by the defendant, but this basis for vicar- scope for parental liability but with limited future conduct, a court then might find ious liability was adamantly rejected by damages as a compromise when a minor the parent liable. the U.S. Supreme Court.38 child causes damage through willful mis- But what about liability under a sec- In the context of copyright infringement, conduct.24 Because control of the minor ondary liability theory? The California vicarious liability has generally been applied is the crucial determining factor for impo- Supreme Court adopted the theory of con- when there is a financial incentive for the sition of negligence liability, a showing of tributory liability in 1975 by repudiating secondary infringer and a failure to prevent custody is necessary.25 the “all or nothing” rule of contributory the infringing activity.39 Thus, if a parent But the Robertson court reasoned that negligence.32 More specifically, the Supreme could be proven to have had actual knowl- an interpretation of the statute to require Court decided to utilize the “pure” form edge of their children’s infringing activity, “actual” physical control would not further of comparative negligence, which appor- a failure to prevent future infringement the objective of the imposition of such lia- tions liability in direct proportion to fault.33 and an economic incentive to avoid pay- bility and concluded the Legislature This theory was further refined a few years ment for the materials downloaded by intended mere legal custody sufficient to later by permitting apportionment of lia- their child, an argument could be made trigger parental liability.26 Thus, the court bility in accordance with a tortfeasor’s that secondary liability should be imposed rejected an interpretation of the statute to comparative fault.34 under the current case authority. require actual physical control of the child California case law has applied the gen- Currently, there are few cases that have as a prerequisite for imposition of statutory eral theory of contributory liability to copy - directly addressed parental liability for a liability. Ultimately, the Robertson court right infringement. Contributory liability minor child’s infringement. In the case of decided that although the mother had legal may be imposed when the individual has Sony v. Tenenbaum, the defendant was a custody of the minor, it was not determi- knowledge of the infringing activity and student at Goucher College who installed native of her parental liability because it induces, causes, or materially contributes the Napster peer-to-peer network on his was undisputed that the minor obtained to the infringing conduct of another.35 desktop at his family’s home in Rhode the gun from the home of his father, the However, the California Supreme Court Island.40 Once Napster was shut down, noncustodial parent. The mother had no long ago rejected the application of con- the defendant started using alternative knowledge of the availability of firearms tributory liability to a parent based solely peer-to-peer networks for the same illegal in the father’s home and did not leave the on the parent-child relationship.36 More - purpose.41 The defendant’s father knew

16 Los Angeles Lawyer February 2018 that his son was illegally downloading monetary damage would also be minimal. (3) to distribute copies or phonorecords of the because prior to leaving for college his son Further, unless it can be proven that the copyrighted work to the public by sale or other transfer of ownership, or by rental, lease, or showed him the songs he had downloaded. parent materially contributed to the child’s lending; Soon thereafter, the defendant’s father infringement, any monetary judgment (4) in the case of literary, musical, dramatic, instructed his son to cease illegally down- would be solely against the minor child and choreographic works, pantomimes, and loading the material and not to engage in and not likely collectible. motion pictures and other audiovisual works, such conduct in the future. The defendant Nevertheless, the more prevalent the to perform the copyrighted work publicly; and (5) in the case of literary, musical, dramatic, was also sent direct warnings by Goucher downloading and sharing of applications and choreographic works, pantomimes, and College, his family’s Internet service provider, become, the more likely it will be that pictorial, graphic, or sculptural works, includ- and even the potential plaintiffs them - minors will share with others the materials ing the individual images of a motion picture selves. The behavior of the defendant in they have downloaded, providing another or other audiovisual work, to display the copy- Tenenbaum was clearly intentional, willful, wrinkle in the analysis and an incentive righted work publicly. 2 and direct copyright infringement. But for legal proceedings by the copyright 17 U.S.C. §106. 3 Id. §§502-505. while the First Circuit imposed liability holder. Given the foregoing, it will not be 4 A&M Records, Inc. v. Napster, Inc., 239 F. 3d 1004, on the defendant, it did not impose liability long before courts are required to directly 1013 (9th Cir. 2001). on defendants’ parents.42 address parental complicity in their chil- 5 Metro-Goldwyn-Mayer Studios Inc. v. Grokster, In addition, it appears there is little dren’s illegal downloading of copyrighted Ltd., 545 U.S. 913, 914 (2005). 6 incentive for copyright owners to pursue and protected materials under some form Id. at 1011. 7 Id.; see, also, 17 U.S.C. §107. (“[T]he fair use of a copy - infringers unless the infringement is willful of secondary liability, especially as the righted work...is not an infriringement of copyright.”) conduct coupled with distribution of older generation attains a higher level of 8 A&M Records, Inc., 239 F. 3d at 1021. infringed material that has resulted in sub- sophistication with computer technology 9 Id. stantial monetary harm. When applying and the Internet. n 10 Sony Corp. of Am. v. Universal City Studios, Inc., copyright infringement to the parent of a 464 U.S. 417, 439 (1984). 11 Gissen v. Goodwill, 80 So. 2d 701, 704 (Fla. 1955) 1 Section 106 of the Copyright Act provides: minor child, the incentive to sue is mate- (citing Buelke v. Levenstadt, 190 Cal. 684, 689 (1923)). Subject to sections 107 through 118, the owner rially diminished. Not only is it difficult 12 Dillon v. Legg, 68 Cal. 2d 728, 752 (1968). of copyright under this title has the exclusive to prove a minor intentionally downloaded 13 “Any willful misconduct of a minor that results in rights to do and to authorize any of the fol- material in knowing violation of the law, injury or death to the property of another shall be lowing: imputed to the parent or guardian…the joint and several a minor likely will not distribute the down- (1) to reproduce the copyrighted work in copies liability of the parent or guardian having custody and loaded materials because it is intended for or phonorecords; control of a minor [shall] not exceed twenty-five thou- (2) to prepare derivative works based upon the child’s own use and enjoyment rather sand dollars ($25,000)….” CIV. CODE §1714.1. the copyrighted work; than to distribute for financial benefit. The 14 Robertson v. Wentz, 187 Cal. App. 3d 1281, 1293 (1986). 15 Id. 16 RESTATEMENT (SECOND) OF TORTS §316 (1965) [here- inafter RESTATEMENT]. 17 Id. 18 Hoff v. Vacaville Unified Sch. Dist., 19 Cal. 4th 925, 935 (1998) (quoting Robertson, 187 Cal. App. 3d at 1285). 19 Robertson, 187 Cal. App. 3d at 1285. 20 Id. 21 Id. at 1287. 22 Id. 23 Id. at 1293. 24 Id. 25 Id. at 1294 (quoting Costello v. Hart, 23 Cal. App. 3d 898, 901 (1972)). 26 Robertson, 187 Cal. App. 3d at 1293. 27 Id. at 1295. 28 Costello, 23 Cal. App. 3d at 900 (quoting RESTATEMENT §316). 29 Costello, 23 Cal. App. 3d at 900. 30 Id. 31 Id. 32 Li v. Yellow Cab Co., 13 Cal. 3d 804, 809 (1975). 33 Id. at 827. 34 American Motorcycle Ass’n v. Superior Ct., 20 Cal. 3d 578, 607 (1978). 35 Sony Corp. of Am. v. Universal City Studios, Inc., 464 U.S. 417, 487 (1984). 36 Dillon v. Legg, 68 Cal. 2d 728, 752 (1968). 37 A&M Records, Inc. v. Napster, Inc., 239 F. 3d 1004, 1021 (9th Cir. 2001); Metro-Goldwyn-Mayer Studios Inc. v. Grokster, Ltd., 545 U.S. 913, 927 (2005). 38 Sony, 464 U.S. at 439. 39 Grokster, 545 U.S. at 930. 40 Sony BMG Music Entm’t v. Tenenbaum, 660 F.3d 487, 492 (1st Cir. 2011). 41 Id. 42 Id. at 515.

18 Los Angeles Lawyer February 2018

by DAVID W. WENSLEY and AMIR SADR GROWSPACE TO Legalization of marijuana presents significant opportunities for property owners looking to cash in on California's budding cannabis industry

With voter approval of Proposition 64, the Adult and California is expected to garner a material share of the coun- Use of Marijuana Act (AUMA), in November try’s overall cannabis market.4 2016,1 the recreational use of cannabis by adults Legalized recreational cannabis use and operations are expected age 21 and older became legal in the state of to provide significant opportunities for a broad range of property California. Over 56 percent of voters expressed owners looking to cash in on California’s budding cannabis indus- their approval of AUMA,2 indicating that a sig- try. The unique risks and legal landscape governing real estate nificant portion of California’s population no longer stigmatizes transactions for cannabis operations also will cause an increase cannabis use, even for recreational purposes. Broad voter support in demand for legal counsel specializing in this area of law. Since may also suggest that commercial property owners view the the statutory and regulatory climate governing the cannabis indus- cannabis industry as a legitimate opportunity to secure new try at the federal, state, and local levels is rapidly evolving and tenants and increase returns on their investments. not entirely clear, the current environment raises legal and ethical As of January 1, 2018, when the state began issuing temporary issues for attorneys considering whether to represent property licenses for recreational cannabis operations, the growing consensus owners in connection with cannabis operations. Attorneys must is that the legal cannabis industry will develop exponentially. exercise caution in delving into this practice area, as the laws, The rise in consumer demand for legal cannabis has led to regulations, and policies governing cannabis operations are still increased prices for raw land and industrial buildings for grow in the developing stages and subject to the unpredictable impulses operations, industrial facilities for manufacturing and distribution, of federal, state, and local officials.5 and retail space for the sale of cannabis and cannabis-related Regulatory Framework products. Annual gross revenue projections for the nation’s legal cannabis industry are estimated to grow from approximately In 1996, voters passed Proposition 215, the Compassionate Use $6.7 billion per year in 2016 to more than $20 billion by 2021,3 Act, making California the first state to legalize the medical use

David W. Wensley and Amir Sadr are real estate transactional attorneys in the Orange County office of Cox Castle & Nicholson, LLP, where they handle virtually all aspects of real estate transactions, including commercial leasing, real property acquisitions and dispositions, joint ventures, and development

and management of real estate assets. MICHAEL CALLAWAY

20 Los Angeles Lawyer February 2018 of cannabis.6 In 2003, the California Legislature passed Senate school or youth center, the licensed premises must contain digital Bill 420, the Medical Marijuana Program Act, creating a regulatory video surveillance throughout the space and retailers may only framework for the medical use of cannabis.7 Subsequently, in sell and operate between the hours of 6:00 A.M. and 10:00 P.M. 2015, the state revamped its medicinal cannabis statutes with Pacific Standard Time.17 Also, under MAUCRSA, an applicant the passage of the Medicinal Cannabis Regulation and Safety may obtain more than one cannabis license type for a specific Act (MCRSA), which created a state licensing system and updated location, provided the licensed premises at the location are “sep- and clarified statutes governing medicinal cannabis.8 arate and distinct.”18 As of early December 2017, what qualifies With the passage of Proposition 64, state regulators faced a as separate and distinct had not been established by the three dilemma whether to continue with two separate regulatory regulatory agencies in California and will likely be determined tracks for legalized cannabis—one for medical use under MCRSA on a case-by-case basis through the licensing application process. and another for adult recreational use under AUMA—or to Com mercial property owners and cannabis applicants must con- consolidate them. In June 2017, Governor Jerry Brown signed sider the potential costs in connection with constructing demising the Medicinal and Adult-Use Cannabis Regulation and Safety walls and additional entrances to meet the “separate and distinct” Act (MAUCRSA),9 which called for merging the medical and standard. Fur thermore, under MAUCRSA, the cultivation licensing recreational laws into one unified system. Under MAUCRSA, application requires the cannabis operator to meet the “average three regulatory agencies govern legal cannabis in California: electricity greenhouse gas emissions intensity required by a local 1) the Department of Consumer Affairs, Bureau of Cannabis utility provider” under California’s existing Renewables Portfolio Control, 2) the Department of Food and Agriculture, Manu - Standard Program.19 factured Cannabis Safety Branch; and 3) the Department of Lease Provisions and Considerations Public Health, CalCannabis Cultivation Licensing. Acting as the lead regulatory agency, the Bureau of Cannabis Control is To operate a cannabis business, a prospective tenant must first tasked with issuing state licenses for dispensaries, distributors, overcome three major hurdles: 1) whether the type of cannabis testing labs, and the many anticipated microbusinesses that will operation being considered for the property is permissible by the develop to serve the industry and consumers.10 The California locality, 2) whether the property is properly zoned for the specific Department of Food and Agriculture is responsible for issuing type of operation or whether the requisite land use permits and/or state licenses to cannabis cultivators and operating a “track- approvals may be obtained, and 3) whether the prospective tenant and-trace” system to track the seed-to-sale process for cannabis qualifies for applicable state and local cannabis business licenses. in the state.11 Finally, the Department of Public Health issues License Contingency or Condition Subsequent Clause. Once state licenses to businesses that manufacture cannabis products the cannabis operator has overcome the aforementioned hurdles, such as edibles, oils, lotions, and other cannabis-containing in order to apply for a California state license the prospective products.12 Cannabis operators may apply for and obtain one tenant/operator must obtain a signed lease or alternative form or more of the various available business license types, with the of authorization from a property owner granting permission to exception of test lab operators, which are prohibited from licen- operate a cannabis business on the subject premises. However, sure for any other commercial cannabis activity.13 possession of a valid license by the state is a prerequisite for the cannabis business to operate from the subject premises in com- Local Jurisdiction Licensing pliance with applicable law.20 This condition creates a dilemma California’s cannabis laws grant local governments the authority for landowners because the landowner must enter into a signed to allow, limit, or ban the number of cannabis operations within lease with a prospective cannabis operator who is not yet, and their city or county limits.14 State agencies may only issue a tem- may never be, authorized to operate its cannabis operation. This porary or permanent license to a cannabis operation if the circumstance mandates that the lease or other agreement between applicant has a valid permit, license, or other form of authorization the landowner and cannabis operator contain a license contingency issued by their local jurisdiction.15 Therefore, ultimate control or condition subsequent provision, which provides for a unilateral over a prospective cannabis operator’s ability to conduct business (in favor of the landlord) or a mutual (in favor of both the lies with the city or county. landlord and tenant) right to terminate the lease should the The lack of uniform laws among cities and counties across cannabis operator ultimately fail to obtain the requisite state and California means property owners interested in leasing to a can- local licenses within a specified time. nabis operation must first determine if their local jurisdiction As in any commercial lease, landowners should also consider permits cannabis operations within its borders. If cannabis oper- security or collateral for the tenant’s surrender and restoration ations are locally permissible, property owners and their legal obligations of the leased premises. Many prospective cannabis counsel must carefully examine the intricacies of local require- businesses will likely require possession of the landlord’s property ments and restrictions for the property and cannabis business prior to obtaining the necessary state and local licenses to plan type in question. For example, many local jurisdictions impose construction, security, and business operations. Therefore, the greater limitations than those set forth under MAUCRSA, includ- license contingency or condition subsequent provision should ing, without limitation, requirements limiting proximity to incorporate appropriate surrender and restoration terms so the schools and government buildings, hours of operations, the landlord may recover possession of its property in an acceptable onsite use of cannabis in open areas and the total number or condition if the operator fails to obtain the applicable business concentration of cannabis operations within a city or county.16 licenses necessary to operate in compliance with state law. The A locality may also require the cannabis operator to show proof landlord should also endeavor to defer payment of any broker that it is current on local, state, and federal taxes. Finally, many commissions, tenant improvement allowances, or performance local jurisdictions require evidence of sufficient funds to operate of any other landlord obligations until all licensing requirements a cannabis business. are satisfied. Legal counsel must also consider specific restrictions under Compliance with Applicable Laws. Most boilerplate lease MAUCRSA, including, among other things, the fact that cannabis agreements require the landlord and tenant to act and comply in operations must be located at least 600 feet away from a K-12 accordance with all applicable laws. While cannabis operations

22 Los Angeles Lawyer February 2018 may be legal under California state and local laws, the federal against California cannabis operators despite compliance with government has not legalized cannabis use. The possession, cul- state and local laws; and the fear of potential negative stigma tivation and distribution of medical or recreational cannabis for surrounding tenants and businesses mandating additional remains illegal under the federal Controlled Sub stances Act (CSA) consideration from property owners that lease to a cannabis and cannabis remains categorized as a Schedule I drug.21 As a operator. Schedule I drug, cannabis is treated as a substance that has a To address these risks, in addition to higher rents, property “high potential for abuse” and “no currently accepted medical owners should also consider whether extraordinary security or use in treatment in the United States.”22 collateral to secure performance by the cannabis operator is war- The U.S. Department of Justice (DOJ) maintains authority to ranted. A larger security deposit, letter of credit, or personal prosecute state legal cannabis businesses under various federal guaranty of a financially creditworthy party should be considered laws, including federal drug and money laundering statutes.23 to secure the cannabis tenant’s obligations to pay rent, comply Moreover, related businesses and professionals working in or with applicable laws, and surrender and restore the premises with the cannabis industry may also be prosecuted as co-con- timely upon lease expiration or earlier termination. spirators or aiders and abettors under the federal statute.24 As Unique Use Controls. Whether through traditional agricultural discussed in the Los Angeles Lawyer article, “High Time,”25 means or industrial indoor grow operations, cannabis growers federal enforcement of cannabis laws is currently uncertain. present unique issues that property owners need to consider. For During the Obama administration, the DOJ adopt ed a set of example, indoor cannabis farming operations typically require guidelines commonly referred to as the Cole Memo on “Guidance extraordinary electricity and water use beyond that of other Re garding Marijuana Enforcement,” which set recommendations indoor industrial uses. These extra costs are typically passed on enforcement policies and practices related to cannabis opera- through to the operator in a single-tenant scenario, however in a tions.26 However, on January 4, 2018, Attorney General Jeff multitenant project the lease should address methods for measuring Sessions rescinded the Obama-era Cole Memo guidelines and and charging the cannabis operator appropriately for its potentially instead granted federal prosecutors with the authority to decide extraordinary use. how to enforce federal laws prohibiting cannabis operations in In addition, cannabis businesses remain largely cash-based states where its use has been legalized.27 due to the illegality of cannabis operations under federal law.32 Yet, pursuant to an amendment to the omnibus spending bill It may be appropriate to consider drafting lease provisions that commonly referred to as the Rohrabacher-Blumenauer Amendment recognize the significant amounts of cash that may be held on (originally the Rohrabacher-Farr Amendment), the U.S. Court the premises and necessitate unique protections or increased of Appeals for the Ninth Circuit ruled that DOJ is prohibited security at the property to mitigate potential vandalism and theft. from spending funds to prosecute individuals engaged in conduct Under MAUCRSA, alarm systems, commercial grade locks, that strictly complies with state medical marijuana laws.28 It is secure storage, and 24-hour video surveillance are required for not clear if this ruling extends to recreational use of cannabis or any area containing cannabis and cannabis products.33 Leases whether the DOJ will be granted funding to implement Attorney should be drafted to appropriately allocate the burden of such General Session’s enforcement policy. additional risks and costs as between the landlord and the Regardless, the Ninth Circuit’s ruling coupled with the cannabis operator. Attorney General’s latest position creates a quandary for property For multitenant projects and buildings, property owners and owners and cannabis operators. Property used to facilitate the their legal counsel must examine whether the intended cannabis cultivation, distribution, and manufacturing of cannabis may operation is permitted under existing private covenants, including still be subject to federal asset forfeiture laws, and there is a CC&Rs (covenants, conditions, and restrictions) and leases with risk that the federal government could seize such property.29 other tenants at the property. Many institutional quality projects Property owners can also be charged with aiding and abetting are encumbered by private restrictions or leases that may prohibit a violation of the CSA.30 Simultaneously, however, as noted, cannabis operations. In the retail arena, many national and under MAURCSA, the authorization of a property owner by regional retail operators insist on imposing restrictions on the lease, license, or other arrangement is a prerequisite to obtain a landlord against various “undesirable” uses, which may expressly license and comply with state law. This creates a significant or by implication include cannabis operations. legal issue for property owners because by signing a lease with Required Licenses and Notice. Lease agreements with cannabis a cannabis operator, a commercial landlord cannot claim igno- operators, as noted, should include an express covenant requiring rance as to the cannabis operation on their property and avail the operator to obtain and continuously maintain any and all themselves of the so-called “innocent owner defense” under necessary permits, licenses, or governmental ap provals required federal law.31 Consequently, the applicable law provision in any for use of the premises. These leases should also include a provision lease for a cannabis operation should be modified to include a requiring the cannabis operator to provide the landlord with a carve-out for the CSA and its underlying regulations. copy of all permits and impose an obligation to notify the landlord Rent, Security Deposit, and Collateral Issues. Due to the of receipt of any notice from federal, state, or local authorities extensive regulations and jurisdictional control over cannabis relating to the tenant’s cannabis operations. businesses, properties suitable and available for cannabis opera- Operations/Odor/Nuisance/Loitering. As the smell and nature tions may, due to limited supply vis à vis increasing demand, of the cannabis plant is distinct, a lease should include strict lan- command greater rents. As witnessed in a number of states where guage protecting against issues relating to nuisance, odor, and cannabis operations are legalized, property owners will likely pests in and around the premises. Landlords may wish to consider demand higher rents and greater security to offset the perceived requiring above-standard ventilation and filtration systems to risks in leasing to a cannabis operator as opposed to a more tra- prevent the odor and other forms of nuisance from impacting ditional tenant. These risks include the possibility that the cannabis adjacent tenants and businesses. In addition, the lease should business will not be able to maintain its required licenses and include language to prevent loitering by customers and the presence will be shut down by governmental authorities; the federal gov- of persons under the influence or appearing to be under the influ- ernment will no longer refrain from prosecuting federal laws ence in and around the premises.

Los Angeles Lawyer February 2018 23 Lending. Since cannabis remains illegal resentation will not be construed as aiding June 10, 2017, available at http://www.latimes.com. 5 at the federal level, a pressing challenge in the commission of an illegal act or vio- For the purposes of this article, the authors do not distinguish among cannabis, marijuana, and THC- for real property owners and investors con- lation of federal law. The engagement letter free cannabinoid products. All references herein are sidering leasing to a cannabis operator is should also include a caveat that such legal to cannabis as it may be defined and regulated by fed- the impact of a potential “illegal use” on representation is limited to advising the eral, state, and local laws. This article is not intended the property owner’s existing or contem- client as to compliance with current Cal - to provide practice tips for representing cannabis oper- plated real property financing. Most, if not ifornia law. Finally, due to the ever-evolving ations, provided, however, that many of the same legal and ethical issues may apply to representing cannabis all, real property loan agreements, deeds nature of California state and local cannabis operations. of trust, mortgages, and related security laws, as well as the uncertainty of federal 6 HEALTH & SAFETY CODE §11362.5. agreements contain provisions requiring the enforcement policies, it is recommended 7 HEALTH & SAFETY CODE §§11362.7 et seq. borrower to keep the subject property in that the engagement letter include a state- 8 HEALTH & SAFETY CODE §§11018 et seq.; BUS & compliance with all applicable laws and ment regarding the risks of the potential PROF. CODE §§26000 et seq. 9 advising that the subject property may not unenforceability of leases and other agree- S.B. 94, 2017-18 Leg. (June 27, 2017). 10 See Bureau of Cannabis Control California, http://bcc be used for illegal activities. Consequently, ments involving the cultivation, distribu- .ca.gov. most traditional lenders are presently un- tion, possession, or use of cannabis. 11 See CalCannabis: What We Do, CalCannabis willing to lend on property leased for Cultivation Licensing, Cal. Dep’t of Food & Agric., Progressing Landscape cannabis operations and such an operation http://calcannabis.cdfa.ca.gov (last viewed Dec. 21, could be a violation of the express terms Whether one favors or opposes legal can - 2017). 12 See Manufactured Cannabis Safety Branch, Cal. of the governing loan documents. Attorneys nabis, most Californians can agree that Dep’t of Public Health, https://www.cdph.ca.gov should discuss with their clients whether legal cannabis operations will have a sig- /Programs/CEH/DFDCS/Pages/MCSB.aspx (last viewed there is existing or contemplated financing nificant impact on the state’s economy and Dec. 21, 2017). for the property, and, if so, the client should its commercial real estate industry. Com - 13 See What You Need to Know, Bureau of Cannabis be advised that leasing to a cannabis oper- mercial cannabis activity in California is Control Licensing Information, Bureau of Cannabis Control, https://cannabis.ca.gov/wp-content/uploads ator may run afoul of their obligations to expected to add significant tax revenue to /sites/13/2017/03/17191_Information_Workshop_v3 their lenders and compromise their financing state and local government through licens- .pdf (last viewed Dec. 21, 2017). arrangements. ing fees and taxes. Property values in cities 14 Id. and counties permitting cannabis businesses 15 Id. Conflicting State and Federal Laws 16 have already skyrocketed in California and See, e.g., L.A. MUN. CODE. Ch. X, art. 4 (2017). 17 As of December 2017, the California State will likely continue to do so until supply See CAL. CODE REGS. tit. 16, §§5000 et seq. A youth center is defined as “any public or private facility that Bar had not published a formal opinion matches demand. Factories, warehouses, is primarily used to host recreational or social activities whether an attorney may ethically represent and self-storage facilities, among other for minors, including, but not limited to, private youth a client under California’s cannabis laws property types, have been transformed into membership organizations or clubs, social service or as to any party engaging in business cultivation sites for cannabis grow opera- teenage club facilities, video arcades, or similar amuse- with cannabis operators. However, the Los tions. Retail storefronts have been repur- ment park facilities.” HEALTH & SAFETY CODE §11353.1. 18 BUS. & PROF. CODE §26053. Angeles County Bar Association and the posed to top-quality cannabis dispensaries 19 See BUS. & PROF. CODE §8305. For more information Bar Association of San Francisco have with finishes comparable to those of other regarding California’s existing Renewables Portfolio issued formal opinions on the matter. Both more traditional major retail tenants. Real Standard Program, see Quick Links, Renewables Port- bar associations have concluded that an property owners and state agencies alike folio Standard, Cal. Energy Comm’n, http://www attorney may ethically advise a client on must continue to evaluate this progressing .energy.ca.gov/portfolio (last viewed Dec. 21, 2017). 20 See Apply for a License Here!, Bureau of Cannabis how to comply with California cannabis landscape in search of ways to legally profit Control California, http://bcc.ca.gov. laws but may not advise the client to violate from the cannabis industry. 21 21 U.S.C. §§801 et seq. federal law and must advise the client that It is important to understand that all 22 18 U.S.C. §1956. conducting business relative to cannabis commercial real estate contracts and trans- 23 18 U.S.C. §§1956, 1957; 21 U.S.C. §§841, 856. operations may violate federal law.34 actions are unique, as is the real property 24 21 U.S.C. §812 (b)(1). 25 Julia Sylva, High Time, L.A. LAWYER, Mar. 2017, Attorneys should consider all of the involved. Cannabis laws in California at at 16-17. above issues, particularly the conflict in the state and local levels are rapidly chang- 26 Memorandum from James M. Cole, U.S. Deputy federal and state laws, and be aware of ing. Effective representation of commercial Attorney General, on Guidance Regarding Marijuana the potential risks associated with repre- real property owners contemplating leasing Enforcement to all U.S. Attorneys (Aug. 29, 2013), senting a real estate client leasing property property to a cannabis-related business or available at https://www.justice.gov/iso/opa/resources to a cannabis operation. Attorneys should a cannabis operator will require an expertise /3052013829132756857467.pdf. 27 See, e.g., Sadie Gurman, Sessions terminates US incorporate specific language addressing in this area of law and the ability to stay policy that let legal pot flourish, AP NEWS, Jan. 4, these risks in any engagement letter with apprised of new developments for a quickly 2018, https://apnews.com/19f6bfec15a74733b40eaf0ff a prospective client desiring to conduct evolving and highly regulated industry. n 9162bfa. business with a cannabis operator or seek- 28 U.S. v. McIntosh 833 F. 3d 1163 (9th Cir, 2016). 29 21 U.S.C. §§853, 881; 18 U.S.C. §§983, 985. ing to operate a cannabis business. The 1 HEALTH & SAFETY CODE §§11018 et seq.; BUS. & 30 18 U.S.C. §2; 21 U.S.C. §846. engagement letter should clearly state that PROF. CODE §§26000 et seq. 31 See BUS. & PROF. CODE §§19311-19312, 26030- 2 Peter Hecht, California Voters Approve Proposition cannabis currently remains a Schedule I 26031. 64 and the Recreational Use of Marijuana, SACRAMENTO substance under the CSA and is illegal at 32 See Cannabis Banking Working Group, Cal. State BEE, Nov. 08, 2016, available at http://www.sacbeecom Treas urer, http://www.treasurer.ca.gov/cbwg (last the federal level. Second, the engagement /news/politics-government/election/california-elections viewed Dec. 21, 2017). letter should clarify that representation /article113422398.html. 33 See CAL. CODE REGS. tit. 16, §§5000 et seq. 3 North America Marijuana Sales to Top $20.2 Billion will exclude legal advice on any illegal 34 See L.A. County Bar Ass’n, Comm. on Prof. by 2021, Grew 30 Percent in 2016, BUS. WIRE, Jan. aspects related to possession, growth, dis- Responsibility & Ethics, Formal Op. 527, 9 (2015) and 3, 2017, http://www.businesswire.com. tribution, or sale of cannabis. Third, the Bar Ass’n of San Francisco Legal Ethics Comm., Formal 4 Patrick McGreevy, Legal Marijuana Could Be a $5- Op. No. 2015-1, 2-3 (June 2015). letter should include a statement that rep- Billion Boon to California’s Economy, L.A. TIMES,

24 Los Angeles Lawyer February 2018 MCLE ARTICLE AND SELF-ASSESSMENT TEST By reading this article and answering the accompanying test questions, you can earn one MCLE credit. To apply for credit, please follow the instructions on the test answer sheet on page 27.

by Megan Lisa Jones

Start-Up Opportunities

The Internal Revenue Code permits the exclusion of certain gains from qualified small business stock

business owners and sold if certain conditions are met.1 This MOST founders are aware of provision became permanent with the pas- the basic forms of corporate structure such sage of the Protecting Americans from Tax as C corporations, S corporations, limited Hikes (PATH) Act on December 18, 2015.2 liability companies, and limited or general If stock qualifies, part or all of the total partnerships. However, their related deci- gain on the sale of the stock is excluded sion-making often ignores alternatives that from federal tax depending on when the may offer similar protections but greater initial stock investment was made. advantages or that supplement these core If the stock was acquired before Febru - structures. These alternatives include qual- ary 18, 2009, the exclusion is 50 percent;3 ified small business stock, dual classes of if between February 18, 2009 and Sep - stock, and various tax incentives targeted tember 27, 2010, the exclusion is 75 per- at encouraging research and development. cent;4 and if acquired thereafter, the exclu- Under Internal Revenue Code Section sion is 100 percent.5 In application, this 1202, certain gains on stock that meets means that only 50 percent, 25 percent, the definition of qualified small business and zero percent of the respective sales stock (QSBS) are excluded from tax when proceeds will be subject to tax, with the

Megan Lisa Jones is a tax attorney who advises on business and estate planning at Clark Trevithick A.P.C. She was previously an investment banker at firms including Lazard Freres & Company. She has both a J.D. and an LL.M. in taxation.

Los Angeles Lawyer February 2018 25 remaining amount being tax-free. If only State tax and the alternative minimum defeating the estate planning strategy.18 In a partial exclusion applies, the capital gain tax (AMT) for individuals still apply to adding these estate and gift tax valuation rate that applies to the nonexcluded per- gains on the sale of QSBS. California for- rules, the government effectively limited centage is 28 percent, assuming that the merly offered preferential tax treatment how company owners could allocate the taxpayer is in the 15 or 20 percent bracket for QSBS but ended the preference for tax appreciation in their stock going forward. for long-term capital gains.6 A per-issuer years following 2012.16 Although the rules under Chapter 14 limitation on eligible gain exists, which The Section 1202 federal exclusion have limited taxpayers’ ability to use dual limits the aggregate amount of eligible gain applies to both investors and company classes of stock to achieve certain estate under Section 1202 to $10 million or 10 employees, as long as the requisite condi- planning benefits, dual classes of stock times the aggregate bases during the taxable tions are met. Thus, angel investors and remain an important option for taxpayers year.7 some venture capital investors benefit from starting new businesses to consider, depend- To qualify as QSBS, the corporation the provision. However, the holder of the ing on their objectives. Today we still see must be a domestic C corporation (not an stock must be an individual and not a cor- companies using dual classes of stock to S corporation or LLC) and it must have poration. This structure is popular in the delink voting rights from economic rights been a C corporation for substantially all venture capital infrastructure in which in the corporation. Recently, multiple of the time that the shares were held.8 The LLCs and partnerships have yet to gain a classes of shares have been utilized in the corporation cannot have over $50 million foothold. Traditionally, these investors tech industry to allow company founders in assets when the stock is initially issued aimed for an initial public offering (IPO) to retain control, with Google creating or immediately thereafter.9 Furthermore, of their portfolio companies, for which a Class C shares with no voting rights19 and the stock must have been acquired at its C corporation structure was required. Even Snap selling only nonvoting shares in its original issue and not on the secondary as IPOs have been partially replaced by recent IPO.20 Other companies have been market.10 Also, during substantially all of acquisitions for a variety of reasons, many using this strategy for many years. For the time the stock was held, at least 80 companies and investors still favor the C example, with Ford’s long-standing dual percent of the corporation’s assets must corporation structure and benefits of class of stock capital structure, the family have been used in the active conduct of a Section 1202. For companies on this path, retains 40 percent of the voting rights qualified business.11 the Section 1202 option is a powerful through ownership of the company’s Class The active business definition12 excludes incentive. B shares, even though those shares repre- a number of business types from the ben- Clients should be advised to document sent only a small percentage of the com- efits of Section 1202. Investment vehicles, any potential QSBS investments carefully. pany’s total equity.21 Berkshire Hathaway banking, insurance, financing, and leasing As many small or starting companies do is well known for its two classes of shares— are not active businesses. Service businesses not always keep meticulous records, doc- Class A and Class B. Although better are excluded and are defined to include umenting a path later may not be possible. known for the difference in price between health services, law, engineering, architec- Especially important is documenting that the Class A and Class B shares, the com- ture, accounting, actuarial science, per- the company had less than $50 million in pany’s Class A shares have more voting forming arts, athletics, financial services, assets immediately after the initial purchase rights than the Class B shares and can be brokerage services, consulting, and any and that at least 80 percent of the assets converted into B shares,22 with both classes other business in which the principal asset were used in the active conduct of a qual- of common stock trading separately on of the business is the skill or reputation ifying business. Clients should also obtain the stock exchange. of one or more of its employees. Farming a stock certificate issued to them and keep Typically, this structure creates two is also excluded, as well as any business a copy of the cancelled check or other doc- classes of stock, with differing voting rights. that produces a product subject to per- umentation showing the initial investment. For the sake of this discussion, they shall centage depletion. Finally, operating a hotel be labelled A and B. An example of a com- Dual Classes of Stock or restaurant does not constitute an active mon structure would be to give the Class business. Historically, different classes of stock have A shares 10 times the voting rights of the Additionally, the stock must have been been used for a variety of purposes. For Class B shares, with the Class A shares held for five years prior to sale for Section estate planning purposes, dual classes of owned by the company founders or other 1202 to apply.13 Interestingly, should the stock were used as part of “estate freeze” select shareholders, and the Class B shares company be bought by another company strategies,17 which were designed to allow sold to the public. Additionally, liquidation before the five-year holding period has a transferor to retain voting rights and a provisions may specify a liquidation pref- passed, the shares might still qualify for nonappreciating economic interest in a erence for the Class A shares. However, the Section 1202 exclusion. If the acquirer company, while transferring to a younger only C corporations, and not S corpora- uses its own stock in exchange for the stock generation an interest in the business that tions, can have dual classes of stock that of the target company, the resulting shares will appreciate. Chapter 14 of the Internal differ with respect to rights to distributions of the acquirer could become QSBS shares Revenue Code was enacted to limit these or liquidation proceeds.23 to the extent of gain as of the date of the types of strategies. Titled “Special Valuation This structure can have multiple bene- transaction.14 Only the gain that occurs Rules,” Chapter 14 provides guidance for fits. For company founders trying to after the transaction date would be taxed valuing a variety of interests for estate and expand their start-up business, this struc- under the normal rules. Gains can also be gift tax purposes. For transfers of interests ture allows the founders to retain control rolled over from one QSBS to another under in corporations, the rules under Chapter of the corporation while being able to Section 1045. To qualify under Section 14 would require the value of the trans- obtain financing from new investors. A 1045, the QSBS must have been held for ferred interest in the company, for gift tax class of stock with little or no voting rights more than six months and the sales pro- purposes, to include the value of the non- also has the advantage of allowing a com- ceeds must be invested in another QSBS appreciating interest that the transferor pany’s management to reward and incen- within 60 days of the first sale.15 retained, resulting in a high valuation and tivize employees by compensating them

26 Los Angeles Lawyer February 2018 MCLE Test No. 275 MCLE Answer Sheet #275 START-UP OPPORTUNITIES The Los Angeles County Bar Association certifies that this activity has been approved for Minimum Continuing Legal Education credit by the State Bar of California in the amount of 1 hour. You may take tests from back Name issues online at http://www.lacba.org/mcleselftests. Law Firm/Organization

1. Qualified Small Business Stock (QSBS) is always ditures have been reduced under the new Tax Cuts Address excluded from tax, regardless of circumstances. and Jobs Act. True. True. City False. False. State/Zip E-mail 2. To qualify as QSBS, a corporation must be a C cor- 12. Research and experimentation expenditures may Phone poration; an S corporation or other flow-through entity include expenditures for activities that further develop does not qualify. and expand upon an existing, legacy product and that State Bar # True. are already certain to work. False. True. INSTRUCTIONS FOR OBTAINING MCLE CREDITS False. 1. Study the MCLE article in this issue. 3. Under Internal Revenue Code Section 1202, service 2. Answer the test questions opposite by marking businesses (e.g., law and accounting) are included in 13. Research and experimentation expenditures may the appropriate boxes below. Each question the definition of eligible businesses under QSBS include attorney’s fees and costs incurred in obtaining has only one answer. Photocopies of this requirements. a patent. answer sheet may be submitted; however, this True. True. form should not be enlarged or reduced. False. False. 3. Mail the answer sheet and the $20 testing fee ($25 for non-LACBA members) to: 4. Shares of a corporation qualify as QSBS after the 14. Internal Revenue Code Section 41, concerning Los Angeles Lawyer company is sold to another company if the acquirer research tax credits, was repealed in the Tax Cuts and MCLE Test used its own stock in exchange for the stock of the Jobs Act. P.O. Box 55020 target company. True. Los Angeles, CA 90055 True. False. Make checks payable to Los Angeles Lawyer. False. 4. Within six weeks, Los Angeles Lawyer will 15. Research tax credits are allowable when they include return your test with the correct answers, a 5. The Internal Revenue Service has limited the use in-house research expenses of a start-up if the principal rationale for the correct answers, and a of estate-freezing techniques for estate planning pur- purpose of the expenditure is to use the results of the certificate verifying the MCLE credit you earned through this self-study activity. poses. research in the active conduct of future trade or busi- True. ness. 5. For future reference, please retain the MCLE test materials returned to you. False. True. False. ANSWERS 6. The application of dual classes of stock is a new Mark your answers to the test by checking the phenomenon that started with “hot” online companies 16. Qualified research includes nontechnological appropriate boxes below. Each question has only such as Facebook. aspects of a product, e.g., market research and adver- one answer. True. tising. False. True. 1. n True n False False. 2. n True n False 7. Only C corporations may have dual classes of stock. 3. True False True. 17. Net operating losses can still be carried back under n n False. the Tax Cuts and Jobs Act. 4. n True n False True. 5. n True n False 8. Stock in the same class may have different voting, False. 6. n True n False but not preference, rights in the capital structure. 7. n True n False True. 18. The Tax Cuts and Jobs Act allows for 100 percent False. expensing of certain business assets acquired after 8. n True n False September 27, 2017. 9. n True n False 9. The use of dual classes of stock may allow man- True. 10. n True n False agement to retain voting control over a corporation False. 11. n True n False while still raising outside funds. True. 19. Under The Tax Cuts and Jobs Act, the time for cap- 12. n True n False False. italization and amortization for research conducted 13. n True n False outside the United States will be 10 years. 14. n True n False 10. Investors view dual classes of stock favorably, pre- True. 15. n True n False ferring that management retain voting control of the False. company while allowing inside investors to benefit 16. n True n False from upside potential. 20. The new corporate tax rate is 21 percent under 17. n True n False True. the Tax Cuts and Jobs Act, which encompasses only C 18. n True n False False. corporations and not S corporations. 19. n True n False True. 11. Qualifying research and experimentation expen- False. 20. n True n False

Los Angeles Lawyer February 2018 27 with company stock, without the risk of early years of trying to get a new business ditures, herein defined as “research and new investors coming in and diluting man- off the ground and turning a profit. These development costs in the experimental or agement’s control. From an estate planning provisions include incentives targeted at laboratory sense,” generally include all perspective, although the Internal Revenue encouraging development of innovative such costs incident to the development or Code now limits the estate and gift tax new products, intellectual property, and improvement of a product.29 For example, advantages to issuing dual classes of stock, other intangibles. attorneys’ fees incurred in obtaining a this structure also allows a founder to One such incentive provision applies to patent are considered research and exper- retain voting control while transferring research and experimentation expenditures imentation expenditures. The regulations economic ownership of the business to paid or incurred by a taxpayer in connection under Section 174 explain that expendi- younger generations. with the taxpayer’s trade or business. Under tures represent research and development However, for companies looking to use Section 174 of the Internal Revenue Code, costs in the experimental or laboratory this structure to raise outside funds, this taxpayers have the option of electing to sense if they are for “activities intended to discover information that would elimi- nate uncertainty concerning the develop- ment or improvement of a product.” Uncertainty is considered to exist if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. The Internal Revenue Code also offers business tax credits for certain research activities that can be used by companies incurring research and development costs.30 Designed to encourage research, the research tax credit under Section 41 is a nonrefund- able credit for a percentage of qualified research expenses. These expenses generally must be paid or incurred “in carrying on” an established trade or business of the tax- payer; however, there is an exception to this requirement that allows in-house research expenses of a start-up to qualify if the prin- cipal purpose of the expenditures is to use the results of the research in the active conduct of a future trade or business.31 The credit is available for qualifying research activities related to the develop- ment or improvement of a business com- ponent. For purposes of this discussion, type of structure might be a cause for con- treat qualifying research and experimen- the definition of “qualified research” can cern for potential new investors. Investors tation expenditures as currently deductible be distilled into a four-part test: 1) the want a degree of control when they invest expenses.25 When such expenses are taken research must be for one of the following money into an entity. Thus far, recent com- as a current deduction, there is no recapture permitted purposes: creating new, or im - panies that have used this structure have upon the subsequent sale of the resulting prove existing, functionality, performance, been the “hot” ones, which are likely to technology.26 Under the new Tax Cuts and reliability, or quality of a business com- be dictating terms. Nonetheless, this con- Jobs Act,27 effective for amounts paid or ponent; 2) it must be undertaken with the cern of investors has caused the company incurred beginning after December 31, intent of eliminating uncertainty concerning behind the Russell 3000 index not to 2021, specified research or experimental the development or improvement of the include Snap Inc. stock in that or other expenditures will be capitalized and amor- business component; 3) it must be a process closely watched indices.24 tized over a five-year period.28 The time of experimentation; and 4) the process Although the estate-planning benefits allowed for capitalization and amortization must be technological in nature, defined of dual classes of stock have been limited will be 15 years if the research is conducted as relying on principles of the physical or by Chapter 14 of the Internal Revenue outside the United States. This capitalization biological sciences, engineering, or com- Code and companies must be C corpora- and amortization requirement applies to puter science.32 tions in order to be able to issue multiple certain types of activities, including software If these conditions are met, then the classes of stock, this structure can still be development. Additionally, under this act, business generally qualifies for a research a valuable tool for a company with a clear the application of the new provision is and development credit. The regulations vision and execution plan. treated as a change in the taxpayer’s method elaborate on this oversimplification and of accounting under Internal Revenue Code provide concrete examples. Wages, sup- Start-Up Businesses Section 481, but no adjustment is made plies, and contract research and basic The Internal Revenue Code offers certain for research or experimental expenditures research payments qualify for the credit. tax benefits and incentives that can be made before January 1, 2022. These credits can be carried forward 20

KEN CORRAL especially helpful to taxpayers during the Research and experimentation expen- years and back one.33

28 Los Angeles Lawyer February 2018 Net operating losses34 (NOLs) can also become meaningful. With extensive new //www.forbes.com. 20 be utilized to save taxes on income earned changes enacted to go into effect in 2018, Maureen Farrell, In Snap IPO, New Investors to Get Zero Votes, While Founders Keep Control, WALL after the development stage of a company. many of which are intended to help businesses ST. J., January 16, 2017, available at https://www.wsj NOLs are loss amounts incurred by com- succeed, individualized tax code optimization .com/articles/in-snap-ipo-new-investors-to-get-zero- panies during their down years that can has become even more important. n votes-while-founders-keep-control-1484568034. be deducted against future and past earn- 21 Joshua Kennon, A Real Life Example of Dual Class Structures in a Public Company, The Balance, https: ings to lower taxes paid. Under the Tax 1 I.R.C. §1202(a). //www.thebalance.com (last viewed Jan. 3, 2018). Cuts and Jobs Act, these losses can be car- 2 Protecting Americans from Tax Hikes Act, Pub. L. 22 Memorandum from Warren Buffett on the Com - 114–113, 129 Stat. 2242 (2015). ried forward indefinitely, but can no longer parative Rights and Relative prices of Berkshire Class 3 I.R.C. §1202(a)(1). be carried back.35 A and Class B Stock (Feb. 2, 1999, updated July 3, 4 I.R.C. §1202(a)(3). 2003 and Jan. 20, 2010), available at http://www.berk- 5 I.R.C. §1202(a)(4). New Planning Opportunities shirehathaway.com/compab.pdf. 6 Topic Number: 409 – Capital Gains and Losses, 23 I.R.C. §1361(b)(1)(D); Treas. Reg. §1.1361-1(l)(1). The Tax Cuts and Jobs Act has created IRS, available at https://www.irs.gov/taxtopics/tc409 24 James Rufus Koren and Paresh Dave, Snap won’t .html (last viewed Jan. 3, 2018). more opportunities for corporations and give shareholders voting rights. For that, it’s being 7 I.R.C. §1202(b)(1). their business cohorts, partnerships and shunned by a major stock index, L.A. TIMES, July 28, 8 I.R.C. §1202(d)(1), (c)(2)(A). 2017, available at http://beta.latimes.com. LLCs, to use the tax code to maximize 9 I.R.C. §1202(d)(1). 25 I.R.C. §174(a)(1); Treas. Reg. §1.174-1. their financial results and options. The 21 10 I.R.C. §1202(c)(1)(B). 26 Rev. Rul. 85-186, 1985-2 C.B. 84. percent corporate rate36 is a tremendous 11 I.R.C. §1202(c)(2)(A), (e). 27 Tax Cuts and Jobs Act, Pub. L. No. 115-97 (2017). 12 I.R.C. §1202(e)(3). advantage, especially given that capital 28 Id. at §13206. 13 I.R.C. §1202(a)(1). gains and dividends are still taxed at a 29 Treas. Reg. §1.174-2(a). 14 I.R.C. §1202(h)(4). 30 I.R.C. §§38, 41. preferred rate. While the dividends-received 15 I.R.C. §1045(a). 37 31 I.R.C. §41(b)(1), (b)(4). deduction for corporations has been 16 See Qualified Small Business Stock (QSBS) Gains— 32 I.R.C. §41(d); Treas. Reg. §1.41-4. reduced, it still exists, meaning that cor- FAQs, State of California Franchise Tax Board, avail- 33 I.R.C. §39(a)(1). able at https://www.ftb.ca.gov (last viewed Jan. 3, porations with dividend income will pay 34 I.R.C. §172. 2018). an even lower effective tax rate. Double 35 Pub. L. No. 115-97, §13302(b). 17 For a discussion of current estate planning techniques taxation can be avoided at the shareholder 36 I.R.C. §11(b), as amended in the Tax Cuts and Jobs involving “freezing” the value of an asset, see Megan Act. level by holding stock in a Roth IRA or Lisa Jones, Creative Trust Options for Business Owners 37 I.R.C. §243(a), as amended in the Tax Cuts and by holding the stock until death, at which and Others Holding Substantial Assets, L.A. LAWYER, Jobs Act. point heirs get a step-up basis in the stock. Dec. 2017, at 19-20. 38 I.R.C. §199A (new), as created in the Tax Cuts and 38 18 See I.R.C. §2701. The 20 percent deduction allowed to Jobs Act. 19 Richard Moroney, Not All Shares Are Created flow-through entities—with exclusions for 39 I.R.C. §168(k), as amended in the Tax Cuts and Equal: More Multiclass Stocks To Join Google In The Jobs Act. service businesses above a certain income S&P 500, FORBES, July 16, 2014, available at https: level—may create additional planning opportunities for taxpayers considering how best to set up a new business. Seem - ingly, both corporations and flow-through EMPLOYMENT LAW REFERRALS entities can still deduct state and local Paying Highest Referral Fees (Per State Bar Rules) taxes without the cap applicable to indi- viduals, along with a broader array of expenses than can individuals. The Tax Honored to receive regular employment referrals from Cuts and Jobs Act also allows 100 percent over 100 of Californiaʼs fi nest attorneys first-year expensing of certain depreciable assets placed in service after September 39 Stephen Danz 877.789.9707 27, 2017. However, as the act is still in & Associates its foundational stage of being imple- Main offi ce located in Los Angeles and nearby offi ces in Pasadena, mented, further guidance and IRS regula- Orange County, Inland Empire & San Diego tions to define the application of some of Stephen Danz, Senior Partner 11661 San Vicente Boulevard, Suite 500, Los Angeles, CA 90049 its murkier (or taxpayer-favorable) provi- sions are expected. When starting a new business, it is crit- ical for business owners to find the right corporate and tax structure to build their business for the long term. Too often, advi- sors look only to obvious answers and ignore more complex provisions in the Internal Revenue Code that may offer business owners options better tailored to their distinct needs, as well as financial incentives to assist them in getting a business off the ground. When starting or running a business, every penny can make a difference. Time not spent on planning may also lead to excessive tax or litigation costs down the road. Subtle planning differences can magnify greatly when revenues

Los Angeles Lawyer February 2018 29 by Ryan Swank

POSSIBILITIESExhausting the After the Impression Products v. Lexmark ruling, manufacturers still may have legal avenues to enforce single-use restrictions on their products

THE U.S. Supreme Court’s unanimous decision in Impression Products, Inc. v. Lex mark International, Inc. reflected an increased adherence to the doctrine of patent exhaustion.1 Although the opinion, authored by Chief Justice John Roberts, roundly rejected Lexmark’s attempts to limit use of its patented ink cartridges after their initial sale, analysis of the opinion suggests that there may still be options going forward. Lexmark attempted, but failed, to protect its patented product after sale. Yet, there may still be ways to use a patent to legally protect a patented product downstream in the marketplace. In the present case, Lexmark made and sold patented ink cartridges in the United States and abroad for use in Lexmark printers. Some of Lexmark’s cartridges were sold subject to a single-use restriction, also referred to as a no-resale restriction, which sought to require that the purchaser return the spent cartridges to Lexmark. Impression Products collected spent Lex mark cartridges previously sold in the United States and abroad, and resold the restricted cartridges in the United States in violation of the imposed restriction. The Supreme Court ruled that the doctrine of patent exhaustion precluded a finding that the actions of Impression Products were patent infringement. Patent exhaustion is effectively a patent law parallel to the well-established property law abhorrence of anti-alienation restrictions on a seller’s disposition of an entire interest in a chattel. Patent exhaustion declares that a patentee’s rights in an individual patented article are “exhausted” once a patentee-authorized sale has occurred, thus enabling a purchaser to use the purchased individual article in any otherwise legal manner. Accordingly, the resale of a lawfully purchased patented good is free from restrictions under U.S. patent law under the patent exhaustion doctrine. Because restrictions precluded by patent exhaustion would otherwise be burdensome to purchasers, the Supreme Court’s decision in Impression Products appears to be ulti-

Ryan Swank is a senior associate in Lewis Roca Rothgerber Christie’s intellectual property practice group. He has a background in electrical engineering, is a recipient of Sandra Day O’Connor College of Law’s Law, Science & Technology Certificate, and is registered to practice before the U.S. Patent and AMANE KANEKO Trademark Office.

30 Los Angeles Lawyer February 2018 mately beneficial to consumers at the cost been overruled, served as a high point for essary in its operation, but which are no of downstream control for patentees. the rights of patentees seeking to place part of the patented invention” noting that Furthermore, the holding of Impression restrictions relating to the post-sale use of “the cost, inconvenience, and annoyance Products appears to align with the rationale their patented product (just as Lexmark to the public which the opposite conclu- for intellectual property law generally. For sought to do with its patented ink car- sion would occasion forbid it.”7 example, the U.S. Constitution authorizes tridges).3 Furthermore, the facts presented Had there never been a need to over- Congress “[t]o promote the Progress of to the Supreme Court in A.B. Dick, if turn A.B. Dick (that is, had the reasoning Science and useful Arts, by securing for adjusted for advancements in technology, of the dissent in that case prevailed), a limited Times to Authors and Inventors seem to mirror the facts presented in bright-line test likely would have resulted. the exclusive Right to their respective Impression Products. Then, Lexmark’s current patent infringe- Writings and Discoveries.” 2 Accordingly, In A.B. Dick, the patent holder, A.B. ment claims would not have had any it seems that any legal precedent that elim- Dick, sought to restrict the rights of a pur- merit. Indeed, it is hard to envision the inates a class of restrictions on devices chaser regarding the use of A.B. Dick’s form of an argument legally distinguish - embodying patented discoveries based patented product. The patented product ing A.B. Dick’s tie-in restriction regarding upon extra-statutory limitations imposed sold was a mimeograph machine, which the ink used with their patented mimeo- by the patent owner itself, as accomplished had a license restriction attached to it graph machine from Lexmark’s tie-in by the holding of Impression Products, declaring that the machine was “sold by restriction regarding the ink used with serves to ensure that the balance struck the A.B. Dick Company with the license their patented printer cartridges—in nei- by Congress is maintained. The goal is to restriction that it may be used only with ther case was the ink covered by the sub- do enough to promote innovation without the stencil, paper, ink, and other supplies ject patents claims. strangling commerce. made by A.B. Dick.”4 The Supreme Court Further muddying the waters in this Because the holding of Impression held, 4-3, that A.B. Dick’s tie-in restriction area of patent law is another Supreme Products provides a benefit to consumers was a legitimate and enforceable restriction Court case, General Talking Pictures Corp. while also providing a legal environment on the basis of the inherency doctrine. The v. Western Elec. Co.8 The Supreme Court that still promotes technology-advancing inherency doctrine states that because a may need to revisit this case to provide inventions, it seems that the Supreme Court patentee’s rights are exclusionary (e.g., further clarity regarding what restrictions achieved the correct result. However, it is “the right to exclude others from making, can be legally made in accordance with not entirely clear that the Supreme Court’s using, offering for sale, or selling the inven- patent law. In General Talking Pictures, decision completely bars companies from tion throughout the United States,” as the Supreme Court upheld field-of-use lim- contracting with their customers to retain stated in 35 USC Section 154(a)(1)), the itations as being in accordance with patent patent rights in downstream patented items. patentee has no obligation to allow the law. Field-of-use limitations allow a paten- In reviewing the decision of Impression patented item to be sold at all. The majority tee to restrict an authorized licensee from Products, a couple of issues are presented. held that, logically, this right must inher- using patented objects outside of a defined First, what actions should patent owners ently provide a lesser right to sell the field of use as specified by the patentee. consider as a result of the decision, regard- patented item subject to any otherwise Specifically, the Supreme Court held that less of whether such actions promote the lawful terms and conditions that the paten- the patentee could legally require that the progress of the useful arts? Second, what tee may choose. licensee sell patented amplifiers only in changes in the law would better serve the Chief Justice Edward Douglass White the field of home radios.9 progress of the useful arts? wrote for the dissent, explaining that what More important, for determining how Companies like Lexmark can conceiv- the majority’s holding meant “is that the to advise a client in a position similar to ably structure customer agreements, includ- patentee has the power, by contract, to that of Lexmark in light of Impression ing a no-resale restriction, in the form of extend his patent rights so as to bring Products, the Supreme Court in General a license agreement. However, because within the claims of his patent things which Talking Pictures held that the patentee establishing a license agreement with an are not embraced therein, thus virtually could also sue a noncontracting purchaser ordinary customer seems to undermine the legislating by causing the patent laws to that obtained a patented amplifier from spirit of the Supreme Court’s decision in cover subjects to which, without the exer- the licensee and that made use of the Impression Products, the Supreme Court cise of the right of contract, they could amplifier outside the field of home radios may need to go further, perhaps to overrule not reach.”5 That is, Chief Justice White if it could be demonstrated at trial that previous Supreme Court decisions that believed that a contractual agreement the purchaser was simply aware of the provide a legal distinction between cus- should not be able to provide further pro- terms of the agreement between the paten- tomers and licensees, should the right case tection under patent law. tee and licensee. The rationale of the court come before it. The rationale of the dissent was ulti- was that because the licensee knowingly mately determined to be sound legal rea- made sales that were outside the scope of Prior Supreme Court Decisions soning, as A.B. Dick was eventually over- its license and because the purchaser knew A number of Supreme Court decisions turned by Motion Picture Patents Co. v. of the patentee-imposed restrictions, the touch upon the doctrine of patent exhaus- Universal Film Mfg. Co., which held that sales were therefore a breach of the terms tion, some dating back as far as the middle particular restrictions (i.e., tie-in restrictions of the subject license. Because the terms of the nineteenth century. Some of the deci- requiring purchase of unpatented products) of the license were breached, the sale must sions have provided more extensive rights are improper and unenforceable under therefore be treated as if no license had to patentees, even when those rights con- patent law.6 Specifically, Motion Picture ever been granted by the patentee, the flicted with the underlying notions of patent Patents stated that “it is not competent patentee could therefore sue both the exhaustion. for the owner of a patent…to in effect licensee and the purchaser for infringement The 1912 Supreme Court decision of extend the scope of its patent monopoly in accordance with the patent laws (as Henry v. A.B. Dick Co., which has since by restricting the use of it to materials nec- opposed to suing based on a theory gov-

32 Los Angeles Lawyer February 2018 ACCESS TO MEMBER BENEFITS WILL END SOON! erned by contract law).10 ment, and if that company were to treat never given authority for their customers Accordingly, although the Supreme an individual customer as a licensee, the to dispose of the cartridges in a manner Court indicated in Motion Picture Patents act of allowing the patented product to causing them to be in the possession of a that patent law may not generally be used be the subject of a “sale” to another would competitor. to enforce post-sale restrictions on a pur- apparently be a violation occurring “out- Nothing in the holding of Impression chaser of a patented item, the Supreme side the scope of” that license. Products indicates that there is a legal dis- Court indicated that the opposite is true The opinion further noted that the court tinction between a licensee-user and a in General Talking Pictures when post- in General Talking Pictures “treated the licensee-manufacturer. It seems the only sale restrictions are enforced based on an sale ‘as if no license whatsoever had been significant distinction causing the Supreme agreement with a licensee. This disparate granted’ by the patentee, which meant that Court to uphold the patentee’s rights in treatment of licensees and general pur- the patentee could sue both the licensee General Talking Pictures, and to find that chasers seems to effectively weaken the and the purchaser—who knew about the no such rights existed for Lexmark, is that patent exhaustion doctrine, and therefore breach—for infringement.”13 However, the terms of the single-use restriction were may negatively affect the promotion of this is effectively what Lexmark was trying not part of license agreements, and Lex - the useful arts. to accomplish: denial of any authorization mark’s customers were therefore not li- to Impression Products to benefit from censees. Despite recognizing that Lex mark’s Licensees vs. Contracting Purchasers what would be an agreement-invalidating contractual rights should not be enforced The unavoidable conclusion that licensees acquiring of the patented product. If under the patent laws, it seems that the and contracting purchasers should be Lexmark had been able to prove that the Supreme Court is comfortable with the treated differently may have driven the terms of its buyback program were part notion of a patent-related cause of action thought process of the two-judge dissent of a limited, nonexclusive license and had (i.e., infringement) arising from a contract- for the Federal Circuit in Lexmark Inter- been able to prove that Impression Products related cause of action (i.e., breach of the national, Inc. v. Impression Products, Inc. was aware of those terms, then Lexmark terms of the license). This position does, With respect to post-sale restrictions, the would have recourse under patent law in fact, indicate that a practicing patentee dissent expressed concern that practicing without having to sue its customers for has fewer rights than a nonpracticing patentees may effectively have less control their failure to follow their agreement with patentee, just as the Federal Circuit’s dissent than nonpracticing patentees because a Lexmark. had indicated. licensee operating outside of the terms of The opinion declared that General Perspective on the Future its license would be engaging in an infring- Talking Pictures does not establish “that ing act. However, as the dissent expressed, patentees can use licenses to impose post- Lexmark’s desire to control a larger share the same cannot be said of a general pur- sale re straints on purchasers”14 but failed of the printer ink market is, from a business chaser ignoring a restriction tied to a sale. to explain why that is necessarily true. standpoint, and without regard to the The dissent stated the belief that post-sale Would the Supreme Court have reached progress of the useful arts, understandable. restrictions should be enforceable only as a different conclusion with respect to In light of the Supreme Court’s holding, a matter of state contract law, even when Lex mark had they couched the terms of it seems that companies now have only a the sale is conveyed through a nonexclusive their agreement with their customers as a few routes for maintaining a legal way to patent licensee, as contract law would still license? The opinion emphasized that Gen - enforce single-use restrictions on a pat - provide adequate remedy for the patentee. eral Talking Pictures involved a licensee ented product—either contract with their Despite mostly siding with the dissent, the that “infringed the patentee’s rights be - customers to restrict resale of a patented Supreme Court did not appear to share the cause it did not comply with the terms of product, and thereafter sue the customers more extreme position of further extending its license.”15 However, with respect to under a contract theory, or structure the the doctrine of patent exhaustion and left Lexmark, whether the consumers failed to terms of restrictions in accordance with a General Talking Pictures intact. comply with the terms of their agreement “license to use” agreement to provide a In an attempt to distinguish the facts with Lexmark was not apparently con- patent infringement cause of action against of Impression Products from those of tested, if brought up at all. That is, Lex - a company obtaining the patented product General Talking Pictures, the Supreme mark would have argued that both their despite being aware of such restrictions. Court stated that a licensee breaching the customers and Impression Products failed The theoretical license agreement could contract governing a license to make and to comply with the terms of the purchase either be a limited, nonexclusive license sell a patented device was a “fundamentally agreement, thereby infringing Lex mark’s with the consuming customers or a man- different situation” from the case imme- patent rights. ufacturing license with some third party, diately before it.11 However, the funda- The opinion also stated that the patentee who would ultimately sell the manufac- mentality of those differences may have in General Talking Pictures “could bring tured product to the customers. been the least convincing aspect of the a patent suit against the purchaser only It should be apparent that a business decision. The opinion emphasized that the because the purchaser participated in the strategy based on numerous lawsuits with facts in General Talking Pictures were dif- licensee’s infringement.”16 Does this mean individual customers is untenable. But why ferent because the “licensee ‘knowingly that the court did not accept as fact that wouldn’t a company like Lexmark attempt ma[de]…sales…outside the scope of its Impression Products was aware of the to identify future buyback agreements with license.’”12 However, it seems that Impres - terms of Lexmark’s buyback program? their customers as license agreements that sion Products knowingly obtained the The Supreme Court declared that “Gen - form a licensor-licensee relationship? The restricted ink cartridges outside the scope eral Talking Pictures, then, stands for the cost of the proposed license would be the of the agreement including the single-use modest principle that, if a patentee has market price for the patented cartridges restrictions. Accordingly, if a company not given authority for a licensee to make with some discount or benefit provided to producing a patented product were to place a sale, that sale cannot exhaust the paten- the licensee-customer as compared with a a single-use restriction in a license agree- tee’s rights.”17 However, Lexmark had customer that buys the patented product

34 Los Angeles Lawyer February 2018 free of restrictions. It doesn’t seem that affirmative measures to maintain patent product ends the patentee’s rights to how such companies would experience any sig- rights with respect to sold items. Such that product is legally used. If the results nificant added cost, and these companies patent holders may contract with a licensee- of the patent exhaustion doctrine provide would maintain a valid patent infringe- manufacturer whose sales are subject to a public good, and if that public good is ment suit against a competitor reselling use-related restrictions or may attempt to valued over that of the interests of com- the patented product (assuming that it structure each individual sale of the subject panies like Lexmark, it may be necessary could be proven that the competitor was patented articles as an extremely narrow, for the Supreme Court to eventually over- aware of the terms of the license agreement nonexclusive license binding each end user rule General Talking Pictures, just as it associated with the initial sale). to the same use-related restrictions. What overruled A.B. Dick. Alternatively, Con - Had Lexmark decided to enforce its sin- legal theory may be used by the patent gress may need to take action to clarify gle-use restrictions by granting a license to holders to successfully enforce these restric- the patent exhaustion doctrine. n a third party allowing them to manufacture tions remains less than perfectly clear. only cartridges that were to be filled by Accordingly, it seems that businesses 1 Impression Prods., Inc. v. Lexmark Int’l, Inc., 137 Lexmark or its subsidiaries, given that that identify a licensor-licensee relationship S. Ct. 1523 (U.S. 2017). 2 Impression Products was aware of such a with their customers will maintain an avenue U.S. CONST. art. I, §8, cl. 8. 3 Henry v. A.B. Dick Co., 224 U.S. 1 (U.S. 1912). restriction, the facts would mirror those of of recourse in a patent infringement action, 4 Id. at 12. General Talking Pictures. The patentee even though such recourse would potentially 5 Id. at 53. (Lexmark) contracted with a licensee (third- include action against their customer- 6 Motion Picture Patents Co. v. Universal Film Mfg. party manufacture) dictating that the licensees. This would, therefore, provide a Co., 243 U.S. 502 (U.S. 1917). 7 patented product (cartridge) be used in a level of downstream control of the patented Id. at 516. 8 General Talking Pictures Corp. v. Western Elec. Co., specific field-of-use (single-use). Had the products, something that seems to be at 304 U.S. 175 (U.S. 1938). third party licensee made a sale outside odds with the base notion of patent exhaus- 9 Id. at 182. the scope of the license to a purchaser (Im - tion. Should another company ever come 10 Id. pression Products), and the purchaser was into possession of such restricted patented 11 Impression Prods., Inc. v. Lexmark Int’l, Inc., 137 aware of the restrictions, Lex mark’s post- products, they may be shielded from liability S. Ct. 1523, 1535 (U.S. 2017). 12 Id. at 1535, citing General Talking Pictures, 304 sale restriction should have been upheld if it cannot be shown that they were aware U.S. 175 at 181-82 (emphasis in original). under the Supreme Court’s analysis. of the terms of such restrictions contained 13 Impression Prods., 137 S. Ct. at 1535. Just as software companies have imple- in the subject license agreement. 14 Id. at 1534-35. mented end-user agreements as an end run But should the patent laws be allowed 15 Id. at 1535 (emphasis in original). around copyright’s codified first sale doc- to be used in such a way? As indicated 16 Id. 17 Id. trine, we may see patent holders taking by the Supreme Court, selling a patented

Los Angeles Lawyer February 2018 35 closing argument BY THE HONORABLE KEVIN S. ROSENBERG AND THE HONORABLE HALIM DHANIDINA

Championing the Cause of Civic Learning in Public Schools

SADLY, MOST AMERICANS CANNOT name the three branches of Award. These schools have already demonstrated a commitment government. Many local officials and community leaders admit to civic education and may be especially interested in law-related not knowing the difference between the state and federal court education and interactive lessons. The California Courts public system. Closer to our judicial branch home, members of the jury website has a list of previous award-winning schools. The website pool often do not understand basic concepts of the legal system. also has outreach resources for judges, attorneys, and court staff. It is comforting and inspiring to learn that Chief Justice Tani Other opportunities for you to get involved include American G. Cantil-Sakauye shares the concerns of many in the legal pro- Bar Association’s Law Day (May 1).5 This year’s theme is Separa - fession about the low level of civics understanding in our com- tion of Powers: Framework for Freedom.6 munities. Shortly after assuming office, the chief justice found Civic learning is a large umbrella that ranges from voter edu- that civics was marginalized in California public schools to make cation to writing letters to legislators. Schools still devote limited way for greater emphasis on English and math. The state largely time to civics and will need to choose what to include in their depended on a one-semester American Government class in the lesson plans. Now is the time for judges and attorneys to reach senior year that included little, if any, instruction on state courts. out and bring education about the judicial branch into the schools. The chief justice teamed with State Superintendent of Public As you plan to fit outreach into your busy schedule, keep the Instruction Tom Torlakson to establish the Civic Learning Award, following in mind: 1) our democracy is at risk—your outreach which recognizes public elementary, middle, and high schools is a remedy; 2) doors are opening to civic education, but there is for civic education efforts and identifies models that can be repli- no guarantee that law-related education will be a part of it unless cated.1 To further show her commitment, Chief Justice Cantil- judges and attorneys make it happen; 3) this is a priority of Sakauye visits the three top award-winning schools. Chief Justice Cantil-Sakauye, so let’s help her succeed—she cannot The chief justice joined with Superintendent Torlakson to do this alone; 4) when legislators don’t understand the courts, create the California Task Force on K-12 Civic Learning. Months they don’t fund the courts, which leads to delays in case resolution; of research and stakeholder and public input shaped the task 5) when the public doesn’t understand the courts, they are hesitant force’s recommendations for elevating the status of civic learning to participate as jurors, witnesses, and litigants; 6) making people in our K-12 public schools. After six public hearings across the aware of their rights and how the legal system works promotes state and more than 600 comments, the final report—Revitalizing access to justice; 7) judges and the rule of law are under attack; K-12 Civic Learning in California: A Blueprint for Action—was this is a way to arm our citizens with the tools they need to fight released in 2014.2 The report has informed state leaders’ decisions back; 8) there are many ways to get involved; 9) it provides hope to build more civic learning into state-level education policy and and understanding to the next generation of decision makers; led to the creation of civic learning partnerships throughout the and 10) working with students is fun! state.3 Typically led by a judicial officer, an education leader, To learn more about the chief justice’s Civic Learning Initiative and a business leader, the partnerships convene other community and access resources, visit: www.courts.ca.gov/20902.htm. Also, leaders to promote civic learning in their counties. to become more involved, contact either author at hdhanidina Los Angeles County is proud to host a civic learning partner- @lacourt.org or [email protected]. n ship.4 Its activities include civic learning summits, civic learning fairs (which are like science fairs), and promoting the Civic 1 Civic Learning Awards, Cal. Courts, www.courts.ca.gov. Learning Awards program. 2 See www.cde.ca.gov/eo/in/documents/cltffinalreport.pdf. As the doors to civic learning open in the 82 school districts 3 Civics Movement Gains Ground, Cal. Courts, https://newsroom.courts.ca.gov. 4 in Los Angeles County and in the Los Angeles Unified School The authors are honored to be members of its steering committee. 5 See www.courts.ca.gov/civics-legal.htm. District, it is gratifying to be able to report that the Los Angeles 6 See Law Day 2018, ABA, www.americanbar.org. County Bar Association (LACBA) and the Los Angeles County Superior Court (LASC) have already been hard at work furthering The Honorable Kevin S. Rosenberg and the Honorable Halim Dhanidina are civic education. Both organizations already have a rich array of judges of the Los Angeles County Superior Court. Judge Rosenberg has been programs, including the Judge David S. Wesley Teen Court pro- involved in civics education for over 15 years, including participation in gram; SHADES (Stop Hate and Delinquency by Empowering LASC’s Judge Wesley Teen Court Program, Project LEAD, mock trials, and Students); Courtroom to Classroom; mock trials; Teachers various civics-oriented organizations. Throughout his career, Judge Dhanidina Courthouse Seminars; LACBA’s Dialogues on Freedom; and has supported civics education, including involvement in the development LACBA’s Appellate Court Experience. of an antigang program for a San Gabriel youth center, participation in The Constitutional Rights Foundation is a critical partner in Project LEAD, presiding over mock trials, and coordinating elementary school many of these programs, and you can get involved, too. One visits to the Deukmejian Courthouse in Long Beach. Both serve as repre- way is to follow up with schools that have won the Civic Learning sentatives for the Los Angeles County Power of Democracy initiative.

36 Los Angeles Lawyer February 2018