There are many reasons why businesses sell.  Certainly, the lifecycle of a successful business is often longer than the founder or controlling shareholder’s desire to continue working.  In such circumstances, a business owner may wish to extract the reward for years of sweat equity by transitioning to a new ownership group.   In other situations, a strategic combination is necessary to fuel continued growth in scope of services or customer reach.  Sometimes, an entrepreneur must simply choose between a number of different projects such that divestiture of one opportunity becomes necessary. 

Whatever the reason, preparing the business for the sale process can both enhance the value of the transaction and make for a smooth transition.  A sophisticated buyer is loath to take on uncertainties, non-ordinary course liabilities or business practices which may give rise to same.  A potential seller is wise to get their “house” in order before going to market or even considering discussions with a potential buyer. 

Financial Reporting

Financial information is a primary focus of due diligence.  Many businesses do not commission audited financial statements on an annual basis.  For many more, the annual tax return stands alone as an indication of the value of the business.  However, tax returns prepared without an eye on sale often reflect information designed to reflect a reduced tax liability as opposed to demonstrating the value of a going concern.  A business owner is wise to consider the assistance of a qualified accounting firm to prepare corporate financial information in a light more suitable for transactional purposes.  The actual filing of all applicable returns is a must.

Human Relations & Employment Practices and Policies

Human relations matters are a potential land mine.  An employee handbook summarizing policies and procedures is essential.  If benefits plans are in place, compliance with all applicable laws will be required if a deal is to be consummated.  A current employee census and proof of citizenship or immigration status will be required.  Key employees should be subject to employment agreements with assignable restrictive covenants.  An acquiror will desire protection against an exodus of management.  

Customers and Business Partnerships

Customer relationships and key business agreements should be locked down.  An analysis of such agreements in advance with special attention to assignability or change in control provisions is necessary due diligence in any sale.  Disclosure to a client or customer may make for a difficult discussion, however, a buyer will want to ensure the continuation of the business relationships prior to commitment. Indemnification obligations and intellectual property rights are certain to be addressed to the extent integral to any customer relationships.

A well-constructed house sells more readily and for greater value than a leaky one on an unstable foundation.   Further, a buyer will often require representations and warranties as to the material issues summarized above such that, even after closing, a deficiency can be costly to a seller who thought the transaction was over and the profits safely secured. monetarily impactful. A seller is wise to identify and address deficiencies in advance of sale discussions both to maximize value and make for a smooth, efficient and cost effective transaction.       

Retailers, Importers, and brands need to immediately be sure there is no cotton from Turkmenistan in their supply chains.  The U.S. Customs and Border Protection (CBP) has finally announced it will turn away or seize and withhold any shipments of cotton originating in the Central Asian nation of Turkmenistan.  Affected importers will clearly experience a significant, and probably costly, disruption of production- related procurement.   The International Labor Rights Forum (ILRF) urged the U.S. to ban Turkmen cotton two years ago but was rejected until findings of state-enforced slave labor was documented after extensive investigation.

CBP was given the authority to ban tainted products like cotton from Turkmenistan when The Trade Facilitation and Trade Enforcement Act of 2015 (TFTEA) removed the “consumptive demand” exception to the United States Tariff Act of 1930, a commonly exploited loophole to the prohibition against importing products of forced labor. Prior to the new provision, CBP used the law only 39 times since 1930 to apprehend goods tainted at some point from creation to delivery by forced labor. Since the passage of TFTEA, CBP has issued four new Withhold Release Orders (each a WRO) on specific goods from China (soda ash, calcium chloride, and caustic soda from Tangshan Sanyou Group and its subsidiaries on March 29, 2016; potassium, potassium hydroxide, and potassium nitrate from Tangshan Sunfar Silicon Industries also on March 29, 2016; Stevia and its derivatives from Inner Mongolia Hengzheng Group Baoanzhao Agricultural and Trade LLC on May 20, 2016; and peeled garlic from Hangchange Fruits & Vegetable Products Co., Ltd. on September 16, 2016). 

A March 31, 2017 Executive Order establishing enhanced collection and enforcement of antidumping and countervailing duties and violations of trade and customs laws authorized the Secretary of Homeland Security, through the commissioner of CBP, to develop implementation plans and a strategy for interdiction and disposal of inadmissible goods and to develop prosecution practices to treat significant trade law violations as a high priority.

Although 2017 saw more antidumping and countervailing duty orders and intellectual property rights protection activity under TFTEA, there have been no published detentions prior to the ban of any shipments of Turkmen cotton, although CBP pledged to the U.S. Congress that more import bans under section 307 would be forthcoming.  Perhaps this is just the beginning of a long awaited CBP crack-down on forced labor imports to combat human rights abuses in global supply chains.

Goods Tainted by Forced Labor

Reprinted with permission from Business Law Today April 2018. 

The global fight against child labor and forced labor has been led for decades by the International Labor Organization (ILO). The ILO’s most recent estimate is that 25 million people around the world, including millions of children, are currently subjected to forced labor.  Under U.S. law, section 307 of the Tariff Act of 1930  prohibits the importation of merchandise mined, produced, or manufactured, wholly or in part, in any foreign country by convict, forced, or indentured labor. This law gave the U.S. Customs Service (now the U.S. Customs and Border Protection (CBP)) authority to seize commodities imported into the United States where forced labor was suspected to have been used anywhere in the supply chain.

The Tariff Act defines “forced labor” as “all work or service which is exacted from any person under the menace of any penalty for its nonperformance and for which the worker does not offer himself voluntarily.” Products of forced labor include goods that were produced by convicts and indentured laborers. The ILO defines forced or compulsory labor as service that involves coercion—either direct threats of violence or more subtle forms of compulsion under the menace of any penalty.  Goods made by child labor, defined as work that deprives children of their childhood, their potential, and their dignity and that is harmful to their physical and mental development,  are included in the forced-labor prohibition especially when combined with any form of indenture. Such tainted merchandise is subject to exclusion and/or seizure by the CBP, may lead to corporate criminal liability, and could even support prosecution of culpable employees individually.

The Trade Facilitation and Trade Enforcement Act of 2015 (TFTEA) removed the “consumptive demand” exception to the United States Tariff Act of 1930,  which was a commonly exploited loophole to the prohibition against importing products of forced labor. Prior to the new provision, CBP used the law only 39 times since 1930 to apprehend goods tainted at some point from creation to delivery by forced labor. Since the passage of TFTEA, CBP has issued four new Withhold Release Orders (each a WRO) on specific goods from China.  Although 2017 saw more antidumping and countervailing duty orders and intellectual property rights protection activity under TFTEA,  there have been no published detentions to date, although CBP has pledged to the U.S. Congress that more import bans under section 307 are forthcoming.

According to the National Center for Charitable Statistics (NCCS), more than 1.5 million nonprofit organizations are registered in the U.S.   We are proud to represent many such nonprofit organizations operating in the greater Delaware Valley.
These organizations serve the communities in which we live with steadfast passion and dedication.  The focus on community improvement, volunteerism and charity is remarkable.  We are pleased to play our small part in furtherance of their lofty goals.

Unfortunately, not everyone involved in the nonprofit industry shares the same altruistic philosophy.  Invariably, we read newspaper stories about the nonprofit treasurer who diverted funds destined for an ambulance squad or the director that diverted hundreds of thousands from youth athletics programs.  The question becomes, what is a nonprofit to do when defalcation is discovered? 

Generally, the law imposes no duty upon an individual or organization that discovers a financial defalcation to report the facts discovered to the authorities.  Only with respect to certain crimes, mostly involving abuse or child pornography, does a duty to report criminal activity arise.  Under current statutory law, no such duty exists upon the discovery of a theft or diversion of nonprofit funds.    

Many nonprofits are reluctant to report the defalcation.  The negative publicity which follows a public disclosure can be devastating to the credibility of an organization that is already competing for donor dollars.  Based on such pressures, for-profit organizations often choose to forego even the private exercise of confronting the accused in an effort to seek recovery preferring instead to simply take steps to ensure the same kind of breach of trust could not be repeated.  In the nonprofit world, such private decision making is in sharp contrast to fiduciary duties owed to the organization and the moral, if not legal, duties which are founded in the donor/donee relationship.   Moreover, the public nature of nonprofit tax filings may render disclosure inevitable,  such that the desired privacy cannot be maintained. 

Large nonprofits must file an Internal Revenue Service Form 990 each year.  The form summarizes the financial performance of the nonprofit.  In turn, every Form 990 that is filed is publicly available with just a few key strokes.  The Form 990 requires that the organization report to the IRS whether the organization “became aware of a significant diversion of the organization’s assets” in the current year.  Thus, the IRS requires the organization disclose defalcations which amount to a “significant diversion”. 

Despite potential negative publicity associated with disclosure of malfeasance in nonprofit administration, the inevitability of disclosure weighs in favor of a more transparent approach.  Best practices suggest that the entity’s Form 990 be reviewed by the board of directors prior to submission to the IRS, in fact,  the redesigned form asks whether the tax return was furnished  to the board for review prior to filing.  An astute donor – particularly a business savvy donor - is likely to read the 990 with a critical eye.  The worst scenario is that a director or donor becomes aware of the defalcation and subsequently questions the adequacy of management response, potentially a death knell to contributions, and the tenure of the secretive executive director. 

In addition, the nonprofit’s auditor, while not required to disclose every fraud in a footnote to the financials, would need to consider whether the theft had a financial impact on the statements.  If the dollar amount warranted it, it might have to be reported directly on the statements – either as a line item-loss from fraud or a receivable for repayment of stolen funds. 

Further, the question of the directors’ fiduciary duties to the organization in such circumstances has not yet been addressed.  Certainly, the directors of a nonprofit, having been placed in a position of trust by the organization, and bear some responsibility for effective management and control.   To date, no court has imposed liability upon the directors of a nonprofit for failing to investigate potential recovery, failing to report defalcation, or failing to seek recovery of proceeds unlawfully diverted.   While that is certainly not what the volunteer directors sign up for, we can see that case coming. 

Navigating the potential exposure requires a complete understanding of financial controls and information, reporting requirements and the composition of the board of directors.  Generally, the best advice is to conduct a complete investigation, proactively adopt whatever policies are necessary to prevent a re-occurrence, and report the bad actor to the relevant authorities.  Such actions would certainly satisfy any duty to the organization. 

In the many years I have been working as outside counsel to closely held businesses, one of the frequent pitfalls leading to costly litigation and operational conflicts is the failure of shareholders to adequately document and formalize their expectations, especially as it relates to minority shareholders.  The first question I ask when contacted by a business owner who is dealing with shareholder conflicts is “What does your shareholders’ agreement say?”  Unfortunately, too often, the answer is “What shareholders’ agreement?”   

Many small businesses are formed by a group of people who share a collective belief at the time of formation.  There are often unwritten understandings as to the division of roles within the business.  Almost universally, the expectation is that all of these founding shareholders will devote ongoing resources to the business.  Conflicts arise when those expectations diverge, when one shareholder fails to perform within the business, or even when a shareholder exits the company.   
 
When conflict does arise, mechanisms for resolution can be limited, complex and expensive.  Certainly a transfer of a non-performing shareholder’s stock seems like a simple straightforward course of action.  However,   in the absence of an agreement providing for transfer upon specified events, the business has no absolute right to remove a shareholder or force a transfer of the share ownership interest.  Even a shareholder who has ceased to be actively involved in the business continues to enjoy all of the rights attendant to the ownership of the shares: the shareholder need not come to work, need not contribute capital, need not pursue business opportunity in the name of the company.  Employment may end, but the right to enjoy distribution of profits does not, as long as share ownership persists.  As most small businesses are organized as subchapter “s” corporations, profits must be distributed in accordance with share percentage. 

Ownership of stock gives rise to all of the rights provided by statute.  Minority shareholders enjoy the right to obtain information about the performance of the company, attend and vote at shareholders’ meetings, and receive distributions of profits derived from corporate operations.  Minority shareholders can be an impediment to stock transfers, anchors against change and obstacles to capital expenditures. Such situations are a constant bone of contention among owners of small businesses. 
 
Of course, the best solution is an agreement that accurately reflects the understandings of the shareholders at the time the shares are assigned, or the company is formed.  Such agreements can provide clearly defined roles within the business, mandatory transfer upon termination of employment, death or disability, valuation mechanisms and provisions restricting transfer.  Adopting an agreement, at minimum, provides a foundation for the business relationship, and may provide a roadmap in the event of disagreement.    

In the absence of an agreement, a dispute with a minority shareholder requires careful management. The majority must take care to avoid vesting a minority shareholder with breach of fiduciary duty claims or shareholder oppression.   Compliance with corporate formalities is imperative. While there is no guaranty of continuing employment for a minority shareholder (with exceptions), distributions or profits in accordance with ownership percentages is required if the company has elected “s” corporation treatment.  Certainly, majority and employed shareholders may receive compensation for services rendered, but an artificial manipulation of corporate profits would certainly be relevant to a minority shareholder oppression claim.  

Pennsylvania Business Corporations Law provides little relief to a majority shareholder who continues to run a profitable business without the assistance of his or her minority shareholders. The statute provides no right to extract a non-performing shareholder against his/her will at any price, and provides no absolute right of liquidation. Even the nuclear option of judicial corporate liquidation requires that the complaining shareholder allege irreparable harm to the company; an allegation which may be impossible if the business is successful as a result of the majority’s efforts.

Formation of an appropriate and workable shareholders’ agreement requires legal representation; as does management of divergent goals between shareholders.  Owners of s corporations with minority shareholders would be wise to review their governing documents and take proactive steps to safeguard the future value of their shares, and avoid crippling and costly litigation. Antheil Maslow and MacMinn business attorneys are highly experienced in such matters and leverage a team of professionals in differing disciplines to navigate these complex waters.       

Earlier this year, amendments to Pennsylvania’s statutes governing partnerships and limited liability companies (often referred to as unincorporated entities or alternative entities) went into effect. I recently blogged about the “transferable interest” concept adopted by the Act. Today, in Part 2 of this series, I highlight another significant change brought about by Act 170: the clarification of the fiduciary and other duties owed in the context of an unincorporated entity. In general, there are three basic duties:

• Duty of loyalty: generally, a duty to avoid self-dealing, competing and usurping company or partnership opportunities
• Duty of care: a duty to refrain from gross negligence and recklessness
• Duty of good faith and fair dealing: a duty to deal fairly and consistently with the terms of the parties’ agreement and the purpose of the entity

In a general partnership, each partner owes the above duties to each of the other partners and to the entity.

In a limited partnership: (a) the general partner owes each of these duties to the limited partners and to the partnership; and (b) the limited partners owe only a duty of good faith and fair dealing to each other.

In a manager-managed LLC: (a) the manager owes these duties to the members and to the entity; and (b) the members owe a duty of good faith and fair dealing to each other. In a member-managed LLC, the members owe these duties to each other and the company.

Some of these duties may be modified by agreement of the parties. In their operating or partnership agreement, the parties may modify, but not eliminate, the duty of loyalty and the duty of care, as long as the modification is not “manifestly unreasonable.” This standard is not defined and is left to the courts to interpret, but in general the agreement cannot convert the relationship into a strictly arm’s length relationship. The duty of good faith and fair dealing may not be modified or removed, but the owners’ agreement can identify the standards by which this duty will be measured.

The Pennsylvania General Assembly, with significant input from the Pennsylvania Bar Association’s Business Law Section, recently passed Act 170, which overhauls the statutes governing partnerships and limited liability companies (often referred to as unincorporated entities or alternative entities). This Act brings these statutes up to date with the uniform laws on which they are based and is now in effect for all new and all existing unincorporated entities. These comprehensive amendments provide default rules for governance and other matters that fill the gaps in the absence of an operating agreement or partnership agreement (or the absence of applicable provisions in those documents). Accordingly, it is important for owners of partnerships and LLCs to review their governing documents and be sure they have a clear understanding of how these new rules apply to them. Owners should work with counsel to draft provisions to vary these default rules if that is the desired outcome.    

One significant change brought about by the Act is the recognition that equity interests in unincorporated entities are bifurcated into governance rights (including consent, management, and information rights) and economic rights (i.e., the right to receive distributions). The amendments adopt a concept called a “transferable interest”, which is an interest in the partnership or LLC that includes only economic rights. The holder of a transferable interest has no governance rights; he or she has only the right to receive distributions from the entity (but not the right to demand or sue for distributions). The transferable interest approach honors the “pick your partner” principle, which assures owners of a business entity that they will be able to choose the co-owners of the enterprise. Under the revised statute, the only interest that can be conveyed to a non-member is a transferable interest, unless the operating agreement provides otherwise or the other owners expressly agree. Thus, a creditor foreclosing on a member’s equity interest or a person seeking to attach a spouse’s equity interest in a divorce proceeding can take only a transferable interest. This limitation on the rights of non-members affords owners important protections from assertions of control by outsiders which may not be in the best interest of the entity or its members. The exception to this rule is that a creditor foreclosing on an equity interest in a single-member LLC will take the full membership interest (governance and economic rights). The rationale for this exception is that because there is only one member, the “pick your partner” rationale does not apply to limit the rights of the lender.

Or
Avoiding Bad Press, Brand Impairment and Costly Litigation

Reprinted with permission from the February 28th edition of the The Legal Intelligencer © 2017 ALM Media Properties, LLC. All rights reserved.Further duplication without permission is prohibited

A significant amount of press surrounded the US Department of Justice (DOJ) one year trial pilot program on April 5, 2016 and  the earlier September 29, 2015 “Yates Memo”, instructing companies to self-disclose possible violations of the Foreign Corrupt Practices Act (FCPA) and fully cooperate with the DOJ.  What has not been as broadly made known is that, a few days later, the U.S. Customs and Border Protection (CBP) establish a Trade Enforcement Task Force within its Office of Trade to focus on issues related to enforcement of antidumping and countervailing duty laws and interdiction of imported products using forced labor. 

Antidumping and countervailing duties are historic tariffs imposed on foreign imports priced below fair market value to ensure a level playing field for domestic producers.  The interdiction of products using forced labor stems from The Trade Facilitation and Trade Enforcement Act of 2015(TFTEA), enacted in February 2016.  TFTEA eliminates an earlier “consumptive demand” exemption, meaning that goods made with indentured, child, or other forced labor are no longer allowed in the US just to meet US demand.  With this change, CBP will no longer be legally required to weigh demand considerations when processing information concerning forced labor.  CBP will be updating its regulations to clarify the TFTEA amendment but, since March 10, 2016, CBP started training personnel and has executed several withhold/release orders related to goods made by convict or forced labor using a Department of Labor (DOL) list of foreign-made products for which the DOL “has a reasonable basis to believe might have been mined, produced or manufactured” by forced or indentured labor. The CBP has also established within its Office of Trade a Trade Remedy Law Enforcement Division and seems intent on taking action.

Admittedly, insurance is an important part of any business plan.  Protecting against a catastrophic loss occasioned from outside factors renders the premium cost a reasonable and justifiable expense. But it is important to understand that commercial general liability insurance is not a substitute for performance, nor will insurance provide any benefit with regard to a myriad of potential claims which commonly arise in the ordinary course of business.  It is important to understand what protections are acquired and the scope of the coverage.

For example, commercial general liability insurance provides no coverage for any breach of contract claim.  Generally, the insurance benefit applies only to an “occurrence”; which, under Pennsylvania law is defined as an “accident”.  If your business fails to perform on a contract, or deliver on a promise, there has been no occurrence, and therefore no coverage will generally apply. 

Further, most basic commercial general liability policies provide no coverage for “your work” meaning no coverage is provided with respect to the products you manufacture or the things you build.  For example, if your business is engaged in the design and construction of a manufacturing line and that manufacturing line malfunctions causing damage only to itself, no coverage will apply.  In contrast, if the manufacturing line were to malfunction causing damage to the property where it was installed, those damages may be covered.  Similarly, if the manufacturing line were to malfunction causing a loss of product, those damages may likewise be covered.     

As with any contract, the scope of commercial general liability coverage and exclusion is defined by the terms of the policy.  Under Pennsylvania law, as the policies of insurance are drafted by the insurers and offered to policy holders without modification, the provisions of those policies are interpreted in a light most favorable to the insured.  Traditional common law precedent relating to contract interpretation are also applicable.  

Many particular risks which may be excluded from coverage under a basic commercial general liability policy may be subject to additional coverages available by endorsement.  Although tedious, review of the often complicated and lengthy provisions of the policy of insurance with the issuing agent is the only way to gain even a rudimentary understanding of coverages.  Even then, a professional review is often worth the investment.   There is simply no substitute for an understanding of the relationship between the business risks and the provisions of the commercial general liability policy and an analysis of additional risk that may be insured by endorsement to the policy.     

The Pennsylvania legislature recently enacted changes to the state sales tax code that affect computer software providers and their customers. These changes went into effect on August 1, 2016.

Under the Pennsylvania Tax Reform Code of 1971, a tax is imposed on the sale of “tangible personal property”, which is defined generally as “corporeal personal property” along with a non-exclusive list of various types of property. In 2010, the Pennsylvania Supreme Court held that the term “tangible personal property" includes canned computer software and that the licensing of such software is subject to the tax. In so holding, the Court rejected the argument made by the taxpayer (Philadelphia-based law firm Dechert LLP) that canned computer software consists of intangible intellectual property rights that are not subject to the tax. The Court noted, however, that fees paid by Dechert for software maintenance and support services did not represent the payment for the transfer of tangible personal property and were likely not taxable (though for whatever reason Dechert did not make the distinction and so it was not part of the Court’s holding).

The Pennsylvania General Assembly apparently disagreed with the Court’s categorization of maintenance and support. While the amendment in question was ostensibly intended to just capture digital downloads of property already subject to the tax (e.g., games, apps, video streaming, canned software, etc.), the language adopted by the legislature arguably broadens the scope of the tax. The definition of “tangible personal property” was modified to include video, books, apps, music, games, canned software, and other items “whether electronically or digitally delivered, streamed or accessed, whether purchased singly, by subscription or in any other manner, including maintenance, updates and support”. The highlighted language contradicts the Supreme Court’s commentary in Dechert that software maintenance and support, as services, are not subject to the tax. Nevertheless, the General Assembly has spoken and prudent software vendors should collect sales tax not only on the price of the canned software package itself, but also on digitally or electronically delivered maintenance, update and support services, at least until the interpretation of this provision is clarified by the Department or through the courts.

The Pennsylvania Department of Revenue has published a summary of this and other changes that are part of the recent amendment to the Pennsylvania tax code: http://www.revenue.pa.gov/GeneralTaxInformation/TaxLawPoliciesBulletinsNotices/Documents/State%20Tax%20Summary/2016_tax_summary.pdf