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On the Edge: How Current Legal Issues Affect Game Development and Marketing


July 10, 1997
 

This paper covers how the following issues affect game developers and publishers:

  • Online Law: (1) strategies for game owners to preserve the power to license Online multiplayer services; (2) the danger posed by the patent infringement case Interactive Gift Exchange v. Compuserve, et. al., which involves a patent that is claimed to apply to Online pay-for-download and CD-ROM pay-for-unencryption schemes.

  • Computer Game Editors: the question of whether the new versions of games created by "editors" can be sold without the permission of the publisher of the original game is no longer theoretical. The subject increasingly appears in disputes, including the ongoing case of Microstar, vs. Formgen, Inc. (involving "levels" created for 3D Realms' "Duke Nukem 3d").

  • Trademark Law: (1) a description of recent changes in Trademark Office system for classifying computer games, and related services (such as Online games, and game arcades); (2) the importance of trademark registration to protection of Internet domain names and developments in Internic domain name dispute policy; and (3) the use of game characters as trademarks

To accommodate anticipated changes in these issues, materials relating to them will be provided at the session. The materials below relate to the fourth subject of the session: the laws applicable to "virtual corporations".

THE VIRTUAL COMPANY MEETS NON-VIRTUAL LAW

Game development is collaborative work, and much of it still occurs in the windowless rooms where programmers, artists and occasionally the "biz guy" nest amidst computers, copies of Computer Game Monthly, Frisbees and an empty pizza box. But perhaps more than any other industry, all of the members of game companies -- programmers, the president, and the hired fulfillment company that boxes and mails finished CD-ROMs -- are physically diverse, often working out of their homes located in several states. The companies are real, often even incorporated, but have no receptionist, no parking lot, and no headquarters with views of the Golden Gate bridge. The Companies are, in a word, "virtual".

While the trend of detaching business enterprise from physical space dates back at least to 19th century correspondence courses, virtual companies are new. The law, evolved for centuries on the assumption that every company has a centralized physical office, is just adapting to them. The legal implications of virtuality is complicated the term "virtual company" describes three really separate phenomena:

* Telecommuting Corporations which are typically mainstream corporations whose employees "telecommute" from home by using email, telephone conferences and fax modems. This trend is driven by the possibility of saving on office costs, and by federal laws which encourage large corporations reduce the car commuting of their employees.

* Temporary Alliances (such as one among IBM, Motorola, and Apple Computer that produced the PowerPC microprocessor) are a sort of virtual corporation. Business Week defines them as "a temporary network of independent companies... linked by information technologies to share skills, costs and access to one another's markets".

* Email Corporations, which are real corporations at which the place the President works, the place orders are accepted, and the place software is written can all be in different states. These corporations survive mostly by email and other virtual communication. While they typically start with a handful of people, they increasingly keep their virtual form. Veri-Fone, for instance (a credit card-verification company) stayed mostly virtual even after growing to more than 2,500 employees by 1995.

The three sorts of virtual corporations raise only partly overlapping problems. All three involve the interesting management problem that for all the speed and informality of email, people need to see each other now and again to really feel part of the same enterprise, and to avoid misunderstandings. Alone among the three, the Temporary Alliance sort of virtual corporation raises issues of how trade secrets can be preserved among participating companies that, at least outside of their temporary collaboration, may be fierce competitors. Telecommuting Corporations raise workplace safety and privacy issues resulting from the fact that their employees work at home.

But the biggest legal uncertainties are raised by the type of virtual corporation that is the most common amongst game development companies: the Email Corporation. Unlike the other types, they combine the legal issues raised by employees who work at home with other issues raised by their typical lack of a real physical headquarters. The metaphysical question of "where does an Email Corporation really do business?" becomes very down to earth when the spooky issue of taxes is raised.

THE PROBLEM OF "DOING BUSINESS" IN A STATE

A corporation "resides" in the place where it is incorporated. Most traditional corporations incorporate where all their operations are located. When corporations instead incorporate in Delaware or other management friendly state for legal and liability reasons, they must separately obtain a "Certificate of Authority" (or equivalent document) in the one or more other states in which they "do business". Several problems arise from this:

* once a corporation is "doing business" in a state, the state can tax it on its income derived from the state, as well as impose a "franchise" tax; and

* failure to obtain a Certificate of Authority can result in substantial penalties.

1. What is doing business?

What "doing business" means varies from state-to-state. Historically, the important indicia were mostly tangible: factories, showrooms, or a warehouse at which orders were received, accepted and shipped. But revenue hungry states are increasingly finding that intangible connections are sufficient. Generally, these activities alone are NOT enough:

* Maintaining, defending, or settling an action, suit, claim, dispute, or administrative or arbitration proceeding;

* Holding meetings of its directors or stockholders or carrying on other activities which concern its internal affairs;

* Maintaining bank accounts;

* Maintaining offices or agencies for the transfer, exchange, and registration of its securities;

* Appointing and maintaining trustees or depositories with respect to its securities;

* Transacting business exclusively in interstate or foreign commerce;

* Conducting an isolated transaction not in the course of a number of similar transactions; and

* Corporate officers residing (but not principally also working) in a state.

But these sorts activities -- among others -- generally ARE enough to invoke the requirement of a getting authority to do business:

* consignment operations (where the seller owns the goods for sale in a store pending their actual sale);

* accepting and shipping orders (which is different than passively passing along an order to a corporate location in a different state at which the order may be accepted or rejected); and

* permanent, regular, and systematic solicitation of business, especially if it involves regular in person sales calls, or a local business address.

2. Penalties for not doing business

The consequences of failing to be certified to transact business vary with the state, but in a worst case, they include:

* substantial fines;

* personal liability of the directors and officers involved; and

* disqualification of the corporation's right to sue using state courts.

These problems can even follow a corporation, so that after it is sold the successor corporation will bear them. Some states allow the disqualification of the right to sue to be cured as long as the corporation obtains a Certificate of Authority, and pays back taxes and any related fines and late fees.

3. Name Clearance

Unlike trademarks, which can be federally registered, corporate names are registered on a state-by-state basis: there is no central clearing house for them. If the inspiration to incorporate as BLUE HAZOO, INC. should strike someone in every state, then there can be 50 independent unrelated corporations with that name. All fifty can co-exist unless:

* they sell similar products to similar customers, in which case a trademark or trade name dispute could result based on customer confusion as to which company is the source of their respective products; or

* either company "does business" in a state other than the one in which it is incorporated, and needs a Certificate of Authority to do business there.

Before granting a Certificate of Authority to a foreign corporation, a state checks its name against a list containing the names of corporations incorporated there, and the names of those doing business there. If there is a conflict, the Certificate of Authority will not be granted until the foreign corporation either changes its name, or adopts an "assumed" name ("BLUE HAZOO (OF NEW YORK) INC.").

4. Sales tax

Since the mid-1980s, many states have broadened their sales tax laws to include computer software. Software vendors are generally required to collect sales taxes when the sale occurs in a state that charges sales tax, and the vendor has sufficient contacts with that state. Whether a vendor is obligated to collect taxes accordingly turns on two questions: in what state does the sale take place? and does the vendor have sufficient contacts in that state to be required to collect sales taxes from there? For virtual companies, both questions can have surprising answers.

The question of where the sale takes place has become complicated by new Internet systems for downloading software after ordering it and paying for it Online. In Texas, for instance, when software is ordered by phone and sent to the out-of-state buyer on a disk, the point of sale is where the disk is sent. But the Texas State Comptroller's Office recently ruled that software sold and downloaded from an Internet server located in Texas is sold in Texas.[*]

The separate question of whether a vendor has sufficient contacts in a state to be required to collect taxes there has different answers in different states. The Supreme Court has held that a State may not tax the economic activity of a foreign (out of state) corporation interstate commerce unless,

"the tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the state".[**]

Certainly, if a state is required to get authority to do business in a state, sufficient contacts exist. But something less may be sufficient. Some states have found a "substantial nexus" merely from regular mail and phone contacts, or from regular technician calls to install and maintain software.[***]

5. The Problem Of Limited Liability Companies

Some game development companies organize as Limited Liability Companies ("LLC"). LLCs have many of the characteristics of "S" corporations. Like an S (and other sorts) of corporations, the liability for company activity for investors in an LLC activities is limited to the amount of the investment. Also like S corporations, the income and losses of LLCs for federal income tax purposes generally receive more desirable treatment than that in ordinary corporations.[*]

Whether a game company should organize as a corporation or an LLC depends on many factors, including preferences about management, and whether the company has any non-resident alien investors. But a factor often overlooked is whether the LLC will be "doing business" in a state other than the one in which it is organized. Any corporation can do business (in the sense that term is used in this article) in another state, at least as long as it obtains the applicable authorization from the state. But for LLCs getting authorized is not always possible because a number of states don't have a procedure for LLCs to be created, and don't recognized the existence of LLCs from other states. When an LLC does business in a state that doesn't recognize LLCs, it risks exposing its owners to personal liability for the LLC's debts, contracts and tortious actions.[**]

6. Local City Or County Rules

City and country rules sometimes subject work-at-home workers special regulations, or require them to register their business. Malibu, California' Zoning Ordinance regulations,[***] for instance, provide that (absent a special permit) at home based businesses:

c. No signage shall be permitted;

d. No one other than residents of the dwelling shall be employed on-site or report to work at the site in the conduct of a home occupation.

f. ... no permanent work area, work bench, or structures shall be built within the required garage parking area.

h. The delivery of materials, goods, or products to and from the location of a home occupation shall be limited to the hours of 7:00 a.m. to 7:00 p.m., with the exception of newspaper deliveries.

PRACTICAL TIPS

Some of the practical consequences of this are that Email Companies should consider:

* Arranging for orders to be "accepted" only in the state where "virtual corporation" is incorporated

Providing for arbitration in contracts. In this way, if a conflict arises with another company with which the corporation has contracted, the corporation may be able to avoid the defense that it cannot go to a state court because it has not obtain Authority to Do Business in that state.

* Reserving or registering a company’s corporate name in states in which it may want to do business in the future to preclude other corporations from incorporating under the same name.

* Limit contacts (such as the places management decisions take place, and official business addresses) to those in which the corporation is incorporated.


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