One of the trickiest issues we deal with in business control disputes relates to the impact and management of personal guaranties on the part of the individual shareholders/members. A personal guaranty can be an impediment to a transaction among the shareholders consolidating ownership, an impediment to the withdrawal of a shareholder/member, or even a trigger of default under the terms of financing agreements in place between a business and its bank. Managing the impact and expectations of business owners as to a personal guaranty should be considered in the early stages of any potential transaction.
In nearly every small business banking relationship, the bank requires personal guaranties on the part of business owners. Personal guaranties, often even the more overbearing “spousal” personal guaranties, are the norm. Of course, the purpose from the bank’s perspective is to increase the level of security against repayment. The individual terms of the personal guaranty are governed by the language of the agreements.
The net effect of a personal guaranty is to, in effect, pierce the corporate veil and render the guarantor liable for the debt to the bank (or other creditor party to the guaranty agreement). In this way, not only does the bank obtain another source from which it can recover, but also dramatically impacts its practical bargaining power. Often we see shareholder agreements including and incorporating indemnification provisions which reference those situations in which a shareholder/member has guarantied an obligation to a lender. The value of such indemnification provisions is suspect given that the bank is always going to look to the path of least resistance to recover the extent of its obligation. In a guaranty the company is the primary obligor to the creditor. It is the primary obligor’s default which leads to exposure under a personal guaranty. In that instance, the company is not likely in a position to indemnify as its assets are likely devoted to the repayment of the primary guarantied obligation.
The best and most frequent approach to a personal guaranty in a business control dispute is to secure the release of the guaranty by the bank or other creditor as part of the transaction. Certainly, if the debt is retired in a third party sale, accounts are closed and the issue is moot. Not necessarily so in an ownership consolidation transaction involving a transfer among existing owners or members, or where one or more shareholders/members leaves the business. In that case, the business may continue and banking relationships may remain unmodified. The bank is not required to release the guaranty. Even further, under certain circumstances and agreements, a transaction may constitute an event of default of the credit arrangement. Management of the personal guaranty becomes an important part of the deal.
It is obviously always better to secure a release of a guaranty contemporaneous with a transaction. If that course of action is unavailable, indemnity is the only other option. In such cases, indemnification should flow from both the company and individuals as, if the guaranty is ever an issue, it is likely the Company’s ability to pay in the first place, which gives rise to creditor’s pursuit of the guarantor.
Business partnerships are like marriages; sometimes they work great from the start and before you know it you are celebrating a 25 year anniversary with a big party with all of your clients and customers in attendance. And sometimes; not so much. For reasons unique to business relationships and the personalities involved, business partners sometimes find they can no longer function together, no longer share the same vision, and can no longer tolerate sharing the responsibilities or benefits of common ownership. We refer to the painful and expensive process of separation as “business divorce”.
As in any divorce, emotions run high. The natural instinct is to assess blame and recruit those close to the business to one “side” or the other. Such recruiting efforts implicate disclosure of sensitive, often damaging information with the idea that inflicting pain will induce a desired course of conduct. Rarely is such an ill-conceived plan rewarded with success.
The reality is that preservation of the business as an asset should be the primary concern. Often that means preserving the opportunity for the business venture to continue operations without interruption, modification or additional added pressures attendant to disharmony. Whether the business can be divided according to an acceptable plan among the shareholders, sold as a going concern, or liquidated in an orderly fashion, continued successful operations are essential to return on the shareholders’ investment.
Successful operations are a function of several factors. First and foremost, management, employees, contractors and staff must be confident in the direction of the entity. Public disclosure of disputes among ownership breeds workforce instability, discontent, mass departure and potential competition on the part of key employees with the capacity to do so.
Customer relationships must also be protected. Instability will most certainly cause a client to search for an alternative provider of the same product or service. A client will not risk their own business by not addressing the potential impacts of instability in yours.
The bank can become concerned as well. Lending relationships are complicated. Often businesses obtain term loans or lines of credit which must be “rested” (reduced to zero) from time to time. A borrower’s options upon maturity can be limited and, notwithstanding a long and happy banking relationship, the bank may not be required to extend credit on the same terms and conditions. The bank may even take the position, under certain circumstances and certain loan agreements that the bank is insecure as a result of dissention thus forcing very difficult financial decisions.
Finally, in all likelihood, public disclosure of internal disputes results in the parties becoming entrenched in their respective positions such that a future together is impossible. Even a sale under such circumstances is likely to net less than market as a buyer is quick to assert pressure on one shareholder or the other in an effort to negotiate the best deal.
Really no good can come of a public airing or an internal dispute. Just like a married couple should not publicize their grievances on Facebook, business owners should take care to keep their disputes in house while seeking resolution through any number of mechanisms – at least until it becomes apparent that such resolution is not possible. Even then, the minimum amount of information necessary to effectuate a course of conduct should be disclosed in the least applicable public way.
Unmarried people in relationships cohabitate all the time. The stigma our parents warned us would follow really no longer applies. That being said, societal acceptance of cohabitation does not mean that co-ownership of real property by unmarried people is not fraught with peril. It is. As the number of couples deciding to delay or forego marriage rises, the number of clients we see who have elected to purchase real estate in joint names without the protection of the divorce code is also on the rise. By the time the client sees us for professional guidance, the damage is often done, the relationship has ended and the real estate becomes an instrument of torment or the method by which one party seeks to extract an emotional toll.
Before I go any further, let’s clear one thing up, I am not a divorce attorney - I am a litigator. So why, you ask, am I writing a blog to warn against the purchase of property in joint names with anyone other than a spouse? The answer gets at the very point of this blog, if you buy property without the benefits of marriage, you will not enjoy the protections afforded by the divorce code, and you will need to hire a litigator to untangle the complications which follow if the relationship goes south. .
Unmarried individuals as co-owners of real property enjoy the absolute right of “partition” under Pennsylvania law – meaning that the law will not require co-owners of real property to remain co-owners of that property. An entire section of the Pennsylvania Rules of Civil Procedure is devoted to the mechanism by which ownership is consolidated whether by agreement, division, consolidation of title or, in certain circumstances, private or public sale. At minimum, the co-owners are set to expend significant sums which can be taxed to the real property.
Partition is an equitable proceeding. The Court is empowered to appoint a Master to review, investigate and report on a number of equitable issues such as possession, respective contributions, credit for improvements and value. The Court receives the Master‘s report but is not bound to the Master’s findings and can conduct its’ own evidentiary hearing at its’ discretion. Every step of the way is an argument and evidence gathering endeavor, the impact of which is never fully in either party’s control.
The best way to avoid the potential for a partition action is to maintain title in a single name unless and until married. The parties can agree on shared expenses, application of mortgage payments and any other number of factors in a Co-Habitation Agreement. That Agreement can provide for reimbursement in the event the relationship fails, a lien against the property for contributions or even an option to purchase if the parties so choose. The point is, co-habitating parties, without the complicating factor of title, can decide in advance how to procced and avoid the costs, time and uncertainties of a partition action. The time to do so is in advance and not after a transfer of title into joint names.
In the corporate setting, it has long been the case that a shareholder can assert a claim on behalf of the corporation when management of the entity refuses to do so – a so called derivative action. Under Pennsylvania’s limited partner statute, a partner (general or limited) can now do the same. A derivative action is one brought by a partner to assert a claim on behalf of the partnership where the general partner refuses to do so.
To bring a derivative action, unless the requirement to do so is excused, the limited partner must first make a demand that the general partner take steps to assert the partnership’s right. The demand must be in “record form” and “give notice with reasonable specificity of the essential facts relied upon to support each of the claims made in the demand.” As will be seen, it is important to carefully craft the demand, since the scope of the derivative claims that can be asserted is limited to those claims identified in the demand and because making the demand also temporarily tolls the statute of limitations on such claims.
After receipt of the demand, the general partner may choose to appoint a special litigation committee (SLC) to investigate the claims asserted in the demand and determine whether pursuing any of them is in the best interests of the partnership. The statute gives the general partner wide discretion to appoint members of the committee, so long as they are not interested in the claims and can exercise objective judgment. Indeed, other limited or general partners may be committee members.
The SLC is then charged with conducting an investigation. The scope of that investigation is limited by the claims set forth in the demand letter and is subject to the good faith requirements of the statute. Within these limitations, the investigation conducted is left to the committee.
Upon conclusion of the investigation, the SLC can make one of several recommendations authorized by the statute. These range from recommending that the claims not be brought (and if brought, discontinued) to recommending that the limited partnership itself assert them. The SLC has ultimate power over the claims as Court is bound to enforce its decision with judicial review limited to whether the members of the committee met the qualifications required under the statute and whether the committee “conducted its investigation and made its recommendation in good faith, independently and with reasonable care.”
I recently used the SLC procedure in a case involving a limited partner who owed a large sum of money to the limited partnership. The general partner authorized a claim against the limited partner to collect the balance due. The limited partner defended the case by asserting that the general partner was improperly appointed and therefore did not have authority to commence the collection action. The limited partner issued a demand for removal of the general partner under the act. I suggested that a special litigation committee be appointed. In this instance, I suggested that one committee member be a retired judge from the county in which the action was pending to defuse any argument that the SLC was not qualified or that it did not act in good faith and independently. As I represented the limited partnership, separate counsel was engaged to represent the general partner before the SLC.
In proceedings before the SLC, the limited partner’s counsel sought to expand the claims to include mismanagement and breaches of fiduciary duty alleged to have been committed by the general partner. Illustrating the importance of properly crafting the demand, the SLC refused to consider any of these expanded claims, holding that its review was limited to the issue raised in the demand – whether the general partner was validly appointed. .
Ultimately the SLC found that the general partner was validly appointed and directed that no claim be brought on this issue. As this claim had already been asserted, the limited partnership was preparing a motion to be filed with the Court to enforce the SLC’s determination when settlement negotiations, which had stalled over a year before, resumed, leading to a prompt settlement. The entire SLC process, from demand letter to decision, took four and one half months – a much quicker resolution, and at less cost, than fully litigating the issue.
The SLC procedure allows an independent review of the merits of derivative claims. If appropriate, such claims can be asserted on the partnership’s behalf or by the partnership itself. However, where such claims are found to be without merit, they can be summarily dismissed. The SLC is a powerful tool to address the merits of derivative claims on an expedited and reduced cost basis.
Many of our previous posts delve into the benefits of resolution of a commercial or shareholder dispute without litigation. Cost, uncertainty and business distraction are factors which often weigh in favor of settlement even at a price which seems unfair. But making a deal necessitates a desire to do so from both sides. As they say, it takes two to tango. If one party is simply not so inclined or the final best offer is simply unacceptable, litigation may be inevitable, and the only mechanism available to bring about resolution.
In a corporate setting, that litigation may take several forms. Choosing the right path is fact intensive and dependent on the relative positions of the parties. Of course, the terms of agreement between business owners may either provide mechanisms for resolution or limit potential alternatives. Regardless, every course of action comes with significant consequences which must be carefully considered prior to embarking on what can be both emotionally taxing and expensive.
Minority Shareholder Strategies
A minority shareholder who is not actively involved in the business has limited options. Unless a shareholders’ agreement provide a mechanism for redemption or transfer, it may be difficult for a minority shareholder to compel a purchase. That minority shareholder would be left to argue that he or she has been “frozen out” from the business, i.e. excluded from information relating to management, oppressed or treated inequitably in terms of distributions of profits so as to trigger an obligation that the company redeem their shares at “fair value”. An action for the appointment of a custodian or receiver is the minority shareholders weapon of choice in that instance. Majority and controlling shareholders are loathe to lose control of what is often their economic life blood.
Majority Shareholder Strategies
A majority shareholder desirous of consolidation of ownership faced with a minority owner not interested in selling also has limited options to compel a sale. In the absence of an agreement which provides for same, there is no provision at law relating to corporations to simply expel a shareholder. With regard to llc’s, the Pennsylvania Limited Liability Company Act provides a limited number of circumstances where the right of expulsion may apply. In either case, involuntary expulsion of a minority interest is no easy task.
The Nuclear Option
The above being said, the nuclear option available to a controlling interest is dissolution. Blow it up, resign all positions which impose fiduciary obligations at law, liquidate the assets and start something new. While the process may be incredibly disruptive to the continuity of business and the personal finances of all the parties, if the separation of the minority interest holder is imperative dissolution may be the only option. The minority may scream breach of fiduciary duty, but in the absence of an agreement among shareholders that the shareholders would not move to dissolve, the success of such a claim at law is speculative at best.
In the end, the decision of whether to engage in such explosive tactics involves a financial analysis but also other factors such as whether the long term interests of the parties require same. In some cases, such as in professional settings, potential irreparable damage to reputation may demand action regardless of the short term pain such action may cause.
Regardless of whether you are a liability insurance provider or the person being covered by a liability policy, a threshold issue to nearly every coverage dispute is whether or not the insurance provider is obligated to defend its insured in court. If an insurer is not obligated to defend its insured, the insured party is left to his or her own devices to secure and pay for legal counsel.
If an insurer is obligated to defend, but breaches its duty to do so, then it leaves itself exposed to potential liability since it did not perform its obligations under the insurance policy. Both sides of the conflict benefit from understanding the circumstances under which an insurer must defend its insured at the onset of a lawsuit.
Pennsylvania, like many states, has adopted the general rule that a liability insurer’s duty to defend is determined by comparing the allegations of the complaint to the terms and exclusions of the policy. This approach is informally known as the “Eight Corners Rule” due to the law’s emphasis on limiting the analysis to those two documents (each document has four corners – get it?).
The Eight Corners Rule requires that an insurer treat all allegations of a complaint as true, even if there is reason to believe the allegations could be groundless or false. If the allegations set forth at least one injury that is or could potentially be covered by the policy, then the insurer has an obligation to defend its insured against the lawsuit.
There are circumstances where an insurance provider can be relieved of its duty to defend. Usually, this occurs where the insurance provider reserves its rights to disclaim coverage and later discovers facts that would operate to exclude coverage. For example, an insurer may accept defense of a waste management company when it is sued and the plaintiff’s complaint alleges that he or she was injured when she tripped on a dumpster that was negligently placed in a dangerous location by the company. But what if, during litigation, it is revealed that the plaintiff actually tripped while avoiding a dumpster as it was being unloaded by the company’s trash truck? Most commercial liability policies exclude coverage from any damages arising from the use of the insured’s vehicle, including any loading or unloading of that vehicle. In that scenario, the insurance company may be legally entitled to withdraw its defense, leaving the insured party to hire, and pay for, its own defense and ultimate liability.
While an insurer’s obligations to its insureds can evolve throughout a lawsuit, understanding the Eight Corners Rule can be used by insurance companies and policyholders at the start of litigation to determine whether any genuine dispute relating to the insurer’s duty to defend exists, allowing the parties to more efficiently navigate the initial stages of a lawsuit
A corporation or limited liability company provides multiple advantages to business owners which is why business lawyers so frequently recommend their use. Among the most significant of these advantages is limited liability, a concept grounded in the fact that the entity has a separate legal existence from its owners and therefore its obligations are not those of its shareholders or members. Of course an owner may voluntarily agree to be responsible for such obligations as, for example, would be the case if he or she guarantees the entity’s bank borrowing. The shield of limited liability is not, however absolute. It can be breached rendering owners financially responsible for the entity’s obligations. In Pennsylvania, as in most states, there is a strong presumption against ignoring the distinction between the entity and its owners. However certain conduct by business owners will result in the court’s “piercing the veil” – ignoring the distinction between the corporation or limited liability company and its owners. Generally, courts will pierce the veil when those in control of the entity use that control, or use the entity’s assets, to further his, her or their own personal interests. While there is no single test to determine when the piercing of the veil is appropriate courts look to many factors.
1. Is the entity undercapitalized?
2. Did the owners fail to adhere to requisite formalities such as holding shareholder and directors meetings and keeping appropriate records?
3. Was the entity insolvent at the relevant time?
4. In the case of a corporation were dividends paid or were corporate funds siphoned into the pockets of the controlling shareholders?
5. Was there a functional board of directors and corporate officers managing the affairs of the entity?
6. Was there substantial intermingling of the financial affairs of the entity and its owner(s)? 7. Under the circumstances, was the entity form used to perpetrate a fraud? Generally, the court will pierce the corporate veil when a review of these factors shows that the form is a sham, constituting a facade for the operations of the dominant shareholder or member making the entity effectively the “alter ego” of the individual(s).
People often ask, “What kind of lawyer are you?” After my stock (and feeble) comedic response of “a good one”, I often say I am a “commercial litigator”. I explain that our practice includes litigation of disputes which arise between businesses and business owners. Commercial litigation includes a wide range of potential issues ranging from business torts to breach of contract, both internal to a business entity, and between two or more separate entities. While there are a wide range of potential issues which must be considered, there are certain basic tenets which I always discuss with our clients before recommending litigation or taking on their representation.
First, do you have an agreement which might apply to the situation and, if so, what does that agreement say about your position? Agreements can come is various shapes and sizes, such as corporate by-laws, a formal shareholder agreement, a proposal combined with an acceptance or performance, or even a simple exchange of emails. Documentary evidence is key, as a litigator is challenged to explain why the written word should not be impactful.
Second, what is your goal? The kiss of death as to our representation is a client who says “it’s not about the money, it’s the principle”. When I was a young lawyer I had a mentor who gave sage advice when he communicated the firm’s policy that litigation was only appropriate when money was involved. He would politely say, “we don’t litigate over principle”. In many ways and in most situations that adage applies. However, in the corporate setting, sometimes the connection to money is not readily evident or direct such as with regard to disputes over corporate control or enforcing a covenant not to compete. In many situations, I caution stakeholders to take the long view and weigh the probable outcomes from a purely practical standpoint, taking care never to lose sight of their long range business goals.
Third, what is your capacity for litigation and business distraction? Litigation not only costs money in terms of attorney fees, accountant fees, experts and costs, but participation also requires commitment of a leader’s most valuable commodity; time. Business people are first and foremost concerned with business (daily operations, management and the bottom line). Litigation invariably requires substantial client involvement in developing strategy, reviewing pleadings, searching for documents, reviewing documents produced by other parties and preparation for testimony. I advise potential parties to litigation to think long and hard about the cost/benefit to the business of such an undertaking.
Fourth, what can you hope to recover or save; and what will it cost to do so? While a corollary to litigation about money, it is not the same question. The evaluation of potential cost is complex and issue dependent. In a recent case, settlement discussions in a commercial litigation setting were driven by the anticipated six figure cost to translate thousands of pages of information from Chinese characters to English. Costs of experts on any issue involving an opinion on issues ranging from the standard of care applicable to a corporate officer, to whether a machine functioned in the way represented, can rapidly accumulate. Unless there is a provision in an agreement which provides for the recovery of attorney fees or such recovery is otherwise permitted under law, those fees and costs are not recoverable.
The above is not to discourage litigation of bona fide disputes; of which we handle many. It is simply imperative that the lawyer and the client be on the same page as to expectations, risks and litigation management. These questions can assist in forming the framework of a solid attorney client relationship in a commercial litigation setting, which goes a long way toward developing realistic expectations, reducing the stress inherent in the process, and optimizing the chances of a successful outcome.
In my many years of practice as a commercial litigator dealing with conflicts between shareholders, it has become clear time and again that one of the best things business owners can do when in business with multiple shareholders or partners is to have a well-defined agreement which governs the operations of the business. Not only can that agreement memorialize the respective rights and obligations of the parties, it can also provide dispute resolution mechanisms which may serve the parties well in the event of material disagreement. Utilizing the powers granted by the Business Corporations Law and granted by the terms of an agreement governing business owners can be complex and risky but can often force an acceptable resolution when the status quo is no longer tenable.
In the case of a corporation, a shareholders agreement or by-laws will often identify the corporate office which holds supreme executive authority subject only to removal of that corporate officer by a vote of the directors. If the officer controls sufficient votes from the board, removal by a disgruntled shareholder may be impossible. The acts of the executive are subject to the business judgment rule and granted a certain amount of deference at law.
A majority shareholder who holds the top executive office is free to wield that power, consistent with the business judgment rule, in many ways - including business dealings with outside parties and, generally, with respect to employment decisions. If the disgruntled shareholder is an employee of the company, which is often the case in small business, that shareholder’s continued employment may be at the discretion of the majority. Termination of employment, if justified, is a use of corporate power which often impacts on the relative negotiating positions.
Of course, a majority shareholder who exercises corporate authority can be faced with claims that the minority has been “frozen” or “squeezed” out of the business. In such cases, it is important that the majority have “clean hands” and has avoided self-dealing, corporate waste or fraud as such allegations, if proven, could result in the appointment of a custodian or receiver and a loss of control. Certainly the majority cannot transfer the assets of the business to a new entity controlled solely by the majority. However, the existing entity can be managed in a way that maximizes benefit to the majority consistent with the exercise of business judgment. The existence of a dispute between shareholders does not in and of itself negate the discretion afforded by the business judgment rule.
AMM counsels clients through the minefield of corporate authority and with regard to available strategies to address disputes which arise between business owners.
It is not unusual for business owners such as manufacturers and their suppliers and consultants to enter into joint ownership in the pursuit of mutual business goals. Those pursuing this strategy should consider that such entanglements can lead to costly future litigation should circumstances change and interests of the parties diverge. In a recent case, a dispute arose between owners of a custom manufacturing limited liability company in which AMM’s client (and a supplier to that same LLC) possessed 33 1/3% of the issued and outstanding ownership interests. The firm’s client also owned 100% of the stock in a separate business entity which supplied materials to the jointly owned custom manufacturer.
When the owners had a falling out, an issue arose with regard to the payment of outstanding invoices generated by the supplier for materials provided to the jointly owned custom manufacturer. When a resolution could not be reached, AMM, on behalf of the supplier, commenced litigation. During the litigation, the majority member of the jointly held custom manufacturer transferred all of the inventory and other assets to a newly formed entity, owned entirely by him, without the payment of consideration, that is to say, without compensating the supplier entity. The transfer of assets left the jointly held entity with insufficient assets to meet its’ liabilities; including the liabilities to the supplier. As a matter of strategy, the controlling member of the jointly owned entity allowed default judgment in favor of the supplier and against the jointly held custom manufacturer. The newly created entity went about doing business utilizing the inventory transferred without regard to the liability to the supplier.
The transfers gave rise to new and additional claims under the recently adopted Uniform Fraudulent Conveyances Act and claims of breach of fiduciary duty; all of which had to be litigated while the newly formed company operated a separate business. Clearly, a small business owner can no longer simply set up shop as a new entity when things go bad and debt accumulates. However, the complexity of ownership structure and relationship between the various entities made judicial intervention very difficult. In the end, the newly formed entity was forced to file a general assignment for the benefit of creditors; the majority owner lost his interest in all of the respective entities and eventually filed for personal bankruptcy.
The above is just one of many “war stories” encountered in attempting to unwind jointly owned business enterprises. Business owners and potential investors should think very carefully before engaging in shared ownership. What may seem like a mutually beneficial relationship at the outset can be costly and challenging to undo if things go bad in the future.
The take away for business owners and potential investors is to think very carefully before engaging in shared ownership. What may seem like a mutually beneficial relationship at the outset can be costly and challenging to undo if things go bad in the future.