Thousands of businesses across the United States fall within the definition of what is commonly referred to as “small business”. Many of these small business are formed by two “friends” with compatible skill sets and both possessing knowledge of a particular industry. Business owners commonly refer to their co-owners as “partners”. As the business and its’ complexity grows, deficiencies in performance or capacity on the part of one partner may be exposed. Alternatively, the absence of immediate success can cause a less patient partner to seek other opportunities and abandon the work that is necessary for the collective good. What starts as a promising partnership can quickly turn sour. Here are a few tips on moving forward:
1. Agree on material issues ahead of time. It goes without saying that a written agreement which contemplates and addresses material issues benefits everyone. Terms frequently addressed in such agreements include the relative duties of the parties, corporate officers, duties of directors and financial matters. If shareholders/partners/members are required to devote substantially all of their time to the venture, the agreement must so state. Similarly, if shareholders/partners/members can be required to contribute capital to the business, the prevailing agreement must so state. Agreed upon rights and remedies upon abandonment of functions within the business by a shareholder/partner/member can provide the road map for resolution and expedite transition.
2. Change terms of employment. An option which may be available to a shareholder/partner/member is the exercise of corporate power to change terms of employment with respect to the non-performing shareholder/partner/member. While a founding shareholder/partner/member may arguably have certain rights to continued employment, such guarantees are limited and may not preclude a change in terms when faced with non-performance or abandonment. Exercise of corporate power does not come without risk and any change in employment terms is almost always alleged as part of a minority shareholder oppression claim.
3. Offer a buy-out. Certainly the cleanest and most efficient means to end an unproductive arrangement quickly is to acquire the non-performing shareholder/partner/member’s interest in the business by the payment of money. Of course, such an agreement is not always financially available. Moreover, a voluntary transfer necessarily implicates that that non-performing shareholder/partner/member agree. Issues of valuation, income streams, indemnification and restrictions against competition can complicate any potential buy-out.
4. Sell the business. Often the solution to a disagreement on partner performance is a sale of the business with a corresponding post sale employment agreement for the performing shareholder/partner/member. Money is a powerful motivator. A sale generates money in a lump sum which can induce a shareholder/partner/member to forego the ongoing income stream that results from future operations. Certainly, control over the sale process, including the legal right to effectuate a sale by virtue of agreement or corporate control, are essential factors for evaluation.
5. Dissolve and start something new. As a matter of last resort, dissolution of the entity may be the only way to gain freedom from a non-performing shareholder/partner/member. The Business Corporations Law provides a mechanism for dissolution. Provided the requirements can be met, a shareholders/partners/member may seek judicial dissolution of the entity essentially forcing a judicial sale. An important aspect of dissolution is relief from fiduciary duties owed to the business and minority owners. Dissolution can be a complicated and expensive proposition and very disruptive to ongoing business operations but remains a viable strategy when business owners can no longer work together but also cannot agree on separation.
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.
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.
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.
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 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.
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.