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Author Archives: Kathleen A. Kelley

  1. Shareholder/Member Disagreements: How to Kick out Your Business Partner

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    One of the most frequent phone calls I get as a corporate attorney is a variation on the following question:

    “My business partner is dreadful and I should never have gone into business with him.  How can I get rid of him so I can just run the business?!”

    My first question is, “Do you have a good Shareholder Agreement or Operating Agreement (or Buy-Sell Agreement) that might give us some contract remedies?”  Usually, my second questions is, “When can you come in to talk about statutory fixes?”

    All corporations should have a Shareholder Agreement and all and limited liability companies (or LLCs) should have an Operating Agreement.  Either of those documents is likely to have a section on transfers or “Buy-Sell” provisions.  These documents are contracts among the owners (shareholders or members) and sometimes the company (the corporation or the LLC), where the parties agree on some ground rules for the management and ownership of the company.  For example, the owners can agree that no one can sell that ownership without first getting approval from the other shareholders or offering it to them first.  Some of these issues are easy, and some are not.

    I always recommend that a Shareholder Agreement or Operating Agreement (I’ll use the term Shareholder Agreement going forward, but it is true for both types of agreements) contain a provision where a shareholder can be removed as a shareholder – an Expulsion Provision.  Usually I make the Expulsion Provision very difficult to achieve – for example, you need to have committed a “Serious Act” and then if all the other shareholders agree, the “bad actor shareholder” will be required to sell its ownership back to the Company.  “Serious Act” is usually defined as material harm to the Company, embezzlement, conviction of a felony, or serious drug or alcohol use that affects the Company.  This way, if something very serious occurs, the Company can rid itself of the bad actor and move forward.  Alternatively, a Company could make the provision less strict.  If you have shareholders that are expected to work for the Company, you could make the provision require a certain level of performance, certain number of working hours, or some other metric.  In this case, if the shareholder does not meet the expectation, he or she could be expelled without going to court.

    While Companies should have a Shareholder Agreement in place, many Companies never realized they needed another Agreement, delayed entering into an Agreement or have a defective agreement that doesn’t reflect their needs.  In that case, the only remedy when an owner commits a back act, is to look to the Corporate or LLC Acts.

    For LLCs, Section 1040.1 of the Virginia LLC Act allows for judicial dissociation (or removal) of a Member if that Member “engaged in wrongful conduct that adversely and materially affected the business of the limited liability company, … or the member engaged in conduct relating to the business of the limited liability company which makes it not reasonably practicable to carry on the business with the member.”

    This judicial remedy, would require another member or the LLC itself to file a petition with the local circuit court asking for the judicial remedy to dissociate the member.  The member or the LLC would need to put on evidence that the Member’s conduct rose to the level described above.  Not something you want to do publicly, but it is a remedy if you have no other options – likely to arise only if such individual’s specific bad actions implicates the business going forward.  For example, if your business is to operate a security company and your partner was just convicted of taking your client’s secure assets.

    Contrasting with Corporations, there is no effective way to judicially remove another shareholder for such shareholder’s bad actions.  If the shareholder serves as a director or officer, there are ways to bring actions against just the individual on a breach of fiduciary duty, but just being a bad actor does not equal a breach of fiduciary duties.

    If you have a serious enough situation that you are not able to work with someone anymore because of the bad action, the only remedy is to petition the court for a judicial dissolution of the entire Corporation.  You choose that you would rather end the business, than continue with the bad actor.  In a dissolution, the Corporation’s assets would be sold and the proceeds, less any liabilities, would be distributed to the Shareholders, pro rata.  In the request for dissolution, a shareholder would need to establish that “the directors or those in control of the corporation have acted, are acting, or will act in a manner that is illegal, oppressive, or fraudulent…”  Note that the provision only applies to directors’ actions, not those of a mere shareholder, however, for a close corporation, it is likely the directors are shareholders themselves.

    There are many ways to protect yourself when you go into business with someone else, but the reality is that you need to plan for these situations in the beginning.  Without proper planning, you may need to file a lawsuit and dissolve the business just to pull yourself out of a bad situation.

  2. Management of an LLC – Members and Managers and Boards, Oh My!

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    Limited liability companies are entities created by state statutes that have their rights and responsibilities governed by a contract—typically called an Operating Agreement—among the owners.  This gives the owners/member of the LLC, great flexibility in creating the entity, but also allows for important provisions to be forgotten or not provided for properly.  Including specific provisions on Management is a must for an Operating Agreement where the LLC could be managed by its Members, a Manager or a Board.  Without strong management description, the Company could be subject to the state’s default statute and run into difficult fiduciary duty issues.

    Management in a corporation is mandated by the state’s corporate statute and separates ownership from direct management.  Management flows down from the owners:

    • shareholders elect directors each year at the annual shareholder meeting,
    • those directors manage the business and affairs of the corporation and elect officers, and
    • the corporate officers then exercise and implement the business and affairs of the corporation.

    In contrast, the LLC statute looks to the terms of the Operating Agreement for management provision, and if the Operating Agreement is silent, the default is for management by the members or owners of the LLC, in proportion to their ownership percentage.  As a result, ownership is directly linked to management, without the separation inherent in a corporation.

    However, if you are reading this blog, you do not want to know what happens if you forget to include a management provision in your Operating Agreement, you want to know the various ways LLCs can be managed.

    Just like the default statutory provision, many LLCs are “Member-Managed.”  These are typically seen in a single-member LLC, but can be used in a multi-member LLC as well.  Aside from any provisions that require a supermajority consent, the wishes of the member or members owning a majority of the ownership in an LLC, will govern.  With one member, this is very simple to execute.  With two members, outside of a 50/50 ownership, this can also be very simple to execute; the majority member wins each time.  However, with a 50/50 ownership situation or multiple members with no clear majority owner (20/20/20/20/20), the mechanics of making simple management decisions can be burdensome on the business.

    More frequently, LLCs are governed by “Managers.”  Typically, one Manager is elected by majority vote of the Members and that Manager will govern the business and affairs of the LLC.  Again, if there is a majority Member, that Member would always prevail.  While Managers are frequently also Members, unless you include that requirement in the Operating Agreement, it is not necessary.

  3. Ownership Interests in an LLC – The Options are Endless!

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    Limited liability companies are entities created by state statutes that have their rights and responsibilities governed by a contract – typically called an Operating Agreement – among the owners.  This gives the owners/member of the LLC, great flexibility in creating the entity, but also allows for important provisions to be forgotten or not provided for at all.  One provision I frequently see missing or incomplete in an Operating Agreements is a comprehensive description of ownership among the members – how much each member owns, any rights and preferences that differ for a member, and a provision to make the ownership divisible into units.

    In contrast to corporations, LLCs don’t typically have shares, or units, that are issued to the owners to indicate ownership and percentage of ownership.  A corporation has a fixed pool of shares which can be issued to shareholders.  Statutes require corporations to keep a list of the shareholders and their ownership percentage and requires language on different rights and preferences of the stock to be described in a public filing.  As a result, it is easy to determine what a shareholder owns and then the percentage ownership of such shareholder.

    With LLCs, members own membership interests (sometimes called limited liability company interests) in the Company which are not naturally broken down into units of measure.  You simply own a membership interest (singular!) in the Company and part of your agreement with the other members is to describe what and how much you own.  Typically, an Operating Agreement will have a schedule that lists out the ownership percentages, but it could also be included in the text of the Agreement.

    If desired, membership interests can be expressed as “units” or “shares” rather than just an “interest.”  Members would include language in the Operating Agreement that the membership interests in the Company, including all of the Members’ rights in the Company, have been converted into “Units.”  Then, each member would own a certain number of Units and all of the Units make up all of the membership interests.  In this approach, the members could limit the total number of Units that are issued, and provide some protection against dilution.

    Additionally, providing for Units can also make the LLC appear more like a corporation in its ownership.  It is easier to prepare certificates for a set number of Units, rather than a certain percentage membership interest.

    To make LLCs even more flexible, members can own different types of membership interests or Units.  Like corporations, LLCs can have nonvoting interests, or preferred interests, or even nonvoting preferred interests.  The rights and preferences of each type of interest must be described in the Operating Agreement along with ownership in such type.  Providing for Units can make the issuance of different types of ownership interests easy to describe.  For example, the Operating Agreement can provide that the initial Members or “Founders” own the Voting Units, but allow for the issuance of a limited number of non-Voting Units to employees or management.

    Alternatively, the Operating Agreement could provide for different Units to track certain investments or property of the LLC.  For example, in an LLC that invests in real property, you might have a situation where not every member agrees that a specific investment is a good idea.  In that case, you could have Common Units that all the Members own and share in the profits, along with “Risky Strip Mall Units” that only certain Members have purchased which capital contribution was then used to purchase a “Risky Strip Mall.”  Ownership of the “Risky Units” would qualify the “Risky Unit Members” – and only those Members – to the profits generated on the risky asset the Company bought.

    It is impossible to describe in this blog all the options available for ownership in a limited liability company.  Because of their incredibly flexible nature, LLCs make the perfect entity for sophisticated business arrangements.  Remember to describe the ownership properly – who are the owners and how much do they own – and be specific about any special rights or preferences that differentiate members.  Neither the LLC statute nor a public filing (like corporations have), will provide guidance if you forget to include this information in your Operating Agreement.  Finally, if LLC ownership is divisible into Units, you need to make that clear in the Operating Agreement if that is your intention.

  4. Letter of Intent – Necessary or Not?

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    Letter of Intent, Term Sheet, Indication of Interest, and LOI are all terms for basically the same thing: a document that describes the terms of a future transaction.  Each has a different style and is more or less specific about terms, and each can be helpful to document the future transaction.

    A Letter of Intent, or “LOI”, is a classic agreement between a buyer and a seller regarding a purchase.  Typically done early in negotiating a deal, it is a basic understanding of a future transaction that will form the basis of the deal documentation.  Usually styled as a letter from the Buyer to the Seller, and signed by both parties, the LOI contains certain non-binding deal terms: purchase price (which can be a formula), method of payment (cash, note, equity in Buyer or combination thereof), timing, diligence to be conducted, and ancillary terms to the deal (future employment, non-compete or exclusivity).

    Following a signed LOI, the Buyer will proceed to a due diligence review of the Seller.  Without the understanding on the basic deal terms the LOI provides, there is no need to go through with the review, considering the cost of diligence to the Buyer and the risk to Seller for making their books and records and other confidential information available to a Buyer. The LOI gives both parties reassurances that a deal is likely.

    The deal terms listed in the LOI are usually non-binding because the parties want some flexibility in the transaction before diligence is completed.  The Buyer may find additional liability that would depress the sale price, or may realize that the financing they thought they could get from the bank is not actually available.  Aside from the deal terms, there are a handful of terms in the LOI are usually binding on the parties.  Examples of those terms are: confidentiality of the Seller’s information, exclusivity with the Buyer (if part of the agreement), and the obligation to operate the business in the ordinary course prior to the transaction date.

    Letters of Intent can be very helpful to jump start a transaction.  The parties know each is interested in working something out, and they can proceed with the additional negotiations and cost expenditures to get the terms “papered”.  There are some potential drawbacks for entering into an LOI though, mainly related to poor drafting.  Even though the terms may be non-binding, it can set back negotiations for a Seller to demand a higher purchase price or rigid future employment terms.  A poorly drafted LOI can cause the parties to lose negotiation leverage in the future, or bind them to unintended provisions.

    Used in the earliest stages of a transaction, an Indication of Interest, or IOI, is similar to a letter of intent, but is executed earlier and has even fewer deal terms.  IOIs are typically expressed as a letter solely from the Buyer and provide a very general indication of the Buyer’s intent to enter into a deal.  They may include only a vague range of purchase prices, but get the Buyer “in the door” to receive information on the Seller, including a Confidential Information Memorandum or “CIM”.  While not always used, an IOI is sometimes requested just to narrow the number of potential buyers in a deal.  Alternatively, an unsolicited Buyer may send one to an identified target.  The Board of Directors at the target may have an obligation to investigate the possibility of selling the Company to the Buyer, which could set off some auction process to find a high price for the shareholders.

    Term Sheets are very similar to LOIs in terms of timing and the specificity of deal terms, but they look very different.  Term Sheets are not done in letter form, but primarily a chart of actual deal terms.  They may include language to be used in the final agreements, and they may be signed by both parties or not.  Term sheets are seen in M&A transactions involving the purchase of an entire company and also in other types of transactions, including stock issuances and financings.

    Any document that can adequately describe the intent of the parties to enter into a transaction can be helpful to both sides to propel the negotiation of a transaction forward.  It gives the parties the ability to plan and expend resources based upon that information.  However, if these documents are prepared poorly, taking a position that does not represent intent can be detrimental to moving forward with that other party.

  5. Minority Shareholders Beware: Change in Corporate Domicile May Destroy Appraisal Rights

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    This year the Virginia Supreme Court made it clear that minority shareholders will lose their protections under Virginia’s Stock Corporation Act—including their appraisal rights—when a Virginia business changes its state of incorporation from Virginia to another state. Additionally, the Court also determined that once a Virginia business is domiciled in another state, the Step Transaction Doctrine will not apply to protect the rights of minority shareholders guaranteed by Virginia law.

    Appraisal rights give “corporate shareholders who oppose [certain] extraordinary corporate action[s]” the right “to have their shares judicially appraised and to demand that the corporation buy back their shares at the appraised value.” Black’s Law Dictionary 122 (10th ed. 2014). Under the Virginia Supreme Court’s holding in Fisher v. Tails, Inc., 289 Va. 69 (Va. 2015), once a Virginia corporation is domiciled in another state, Virginia corporate law no longer applies and the rights of minority shareholders are governed by the laws of the other state. As a result, minority shareholders can be left without recourse if the company in which they own stock incorporates in a jurisdiction like Delaware that does not offer the same minority shareholders rights that Virginia does.

    Fisher v. Tails involved minority shareholders who sought—under Virginia law—to enforce their right to an appraisal after an asset sale when their company, Tails, Inc., decided to change its corporate domicile from Virginia to Delaware. Tails’ majority shareholders had just authorized the sale of Tails to a Delaware company over the objections of the minority shareholders. This sale transaction involved four distinct steps: (1) a change of incorporation from Virginia to Delaware; (2) a merger with and into a Delaware LLC; (3) the amendment of that Delaware LLC’s operating agreement; and (4) a sale of assets. Virginia law gives minority shareholders appraisal rights in the event of a sale of assets and certain other corporate transactions. See Virginia Code § 13.0-722.2. In contrast, Delaware only makes appraisal rights available under its merger statutes. See Del. Code Ann. tit. 8, § 262(b).

    Tail’s minority shareholders argued that Virginia law on appraisal rights should apply because the 4-steps listed above were actually part of the same sale-of-assets transaction under the Step Transaction Doctrine or the equitable doctrine of “substance over form.” The Step Transaction Doctrine allows a court to treat the steps in a series of separate but closely related transactions involving the transfer of property as if they were a single transaction. See Bank of N.Y. Mellon Trust Co., N.A. v. Liberty Media Corp., 29 A.3d 225, 239-50 (Del. 2011). Similarly, the equitable doctrine of “substance over form” permits courts to look beyond the form of a transaction to its substance to achieve equitable goals. See Gatz v. Ponsoldt, 925 A.2d 1265, 1280 (Del. 2006). The minority shareholders of Tails argued that because the 4-step sale of assets transaction started out with a Virginia corporation, Virginia law should apply and the minority shareholders should get appraisal rights.

    The Virginia Supreme Court disagreed. Stating unequivocally that “Virginia statutory law settles this matter….,” the Virginia Supreme Court rejected the arguments of the minority shareholders. Fisher, 289 Va. at 73. The Court noted that Virginia’s Business Corporation Act is based on the Model Business Corporation Act. Id. at 75. But unlike the MBCA, Virginia did not include appraisal rights upon “consummation of a domestication” in its Business Corporation Act. Compare Va. Code § 13.1-730 with MBCA § 13.02(a)(6). The Court applied the statutory canon of expressio unius est exlusio alterius (“the express mention of one thing excludes all others”) to hold that “the General Assembly intended to exclude the change in corporate domicile from [Virginia’s list of triggers for appraisal rights].” Fisher, 289 Va. at 73.

    This case is potentially significant for companies doing business in Virginia. Under this precedent, majority shareholders may be able to structure transactions in such a way that they can eliminate the appraisal rights of minority shareholders by changing a corporation’s state of incorporation from Virginia to another state like Delaware that does not recognize the same appraisal rights. For this reason, minority shareholders in Virginia should carefully scrutinize any transaction involving a change in corporate domicile.­

  6. Synthetic Equity, Phantom Stock, and Stock Appreciation Rights – What are they and how are they used?

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    You’ve probably heard of Synthetic Equity, Phantom Stock, and Stock Appreciation Rights for employees, but which one is right for your Company?

    Short answer: it depends!  These types of arrangements are done through a contract among the parties and one would need to look at the specific contract to see the specific terms and conditions of the synthetic equity, phantom stock, and stock appreciation rights.  Generally though, these types of plans are given to employees to give them an approximation of equity in a Company, but not actually give them equity in the Company to disturb the management or ownership structure.  It is not real ownership, but the parties act as if the holder has real ownership in the Company.  These plans are not right for every Company, but can promote employee retention and motivation to grow the Company’s value when providing actual equity is disfavored.

    Traditionally, Companies were formed as corporations.  The founders received stock from the corporation representing ownership–Common Stock–which came with voting and cash dividend rights.  In this model, everyone has the same rights, which was shared depending on your ownership percentage.  Eventually, Companies wanted to be able to give other pieces of the Company away–perhaps stock without voting rights, or stock with extra rights to distributions.  Non-Voting Stock and Preferred Stock were created to provide alternative rights from the Common Stock.  The issuance of Non-Voting Stock gives Common Stock owners the ability to raise money or capital in the Company, but not give away any real control over the Company.  For a corporation, all types of stock must be described in the certificate of incorporation or articles of incorporation on file with the state where the Company is organized.  With this information, investors can determine what types of stock are issued by the Company, what rights each type of stock has, and how many shares of each type the Company can issue (this can be helpful to see how much an investor can be diluted by the issuance of additional stock).

    An alternative to the corporate structure, LLCs were created to provide maximum flexibility.  LLCs are governed by an agreement among their members, members who own a “membership interest” in the LLC.  The Operating Agreement governs the management and financial aspects of the LLC, and can provide for various types of membership interests (including non-voting and those with preferred distributions).  Generally speaking, the members can organize an LLC any way they desire, they are not as limited as a corporation is.  Should someone receive an interest in an LLC without being admitted to the LLC, that person would hold an economic interest in the LLC, but not actually be a member and a party to the Operating Agreement.

    For both corporations and LLCs, a popular way to incentivize employees is to provide a stock option or restricted stock.  For a corporation, these can be fairly easy to implement, but will chip away at the equity and control the current owners ultimately hold.  Implementation can be ongoing and maintenance can be very costly.  When a corporation has a handful of employees to share in equity, these plans can be very effective, but when the numbers of employees, stock option grants, and associated vesting schedules grow, the plans can become very expensive.  For an LLC, options or restricted membership interests grants are near impossible.  More typical is for an LLC to provide “profits interests” to employees, but those plans can be extremely complicated and costly for a small business along with providing negative tax treatment for the employees receiving such interests.

    Outside of the cost and complexity of a traditional equity incentive program, Companies may be barred from providing actual ownership in the Company.  For an “S-Corp”, companies are capped at 100 equity owners.  Even a mid-sized Company may reach that cap quickly with a stock option plan.  Additionally, Women-Owned, 8(a), Service-Disabled Veteran-Owned, or other Companies participating in the Federal Government’s set aside contracting programs, must closely monitor their ownership in order to remain in compliance with the regulations.  Providing employee equity plans, even if the employees would not have voting or other rights that could interfere with the eligible individual, would shift ownership percentages.

    In order to avoid some of these issues, corporations and LLCs alike turn to synthetic equity, phantom stock, or stock appreciation rights.  Synthetic equity is a term that refers to all manner of equity that is not actually equity.  Phantom stock usually refers to a contractual arrangement whereby the Company acts as if the holder owns a certain amount of stock in the Company.  The holder can receive bonuses as a “distribution” of profits in the Company or share in the profits at the sale or change of control of the Company (in an M&A context).  The bonus amount would be tied to the equity in the Company–acting as if the holder had X% ownership in the Company.

    Stock appreciation rights are similar to phantom stock, but typically refer to the right to receive a bonus at a sale or change of control in an amount that would mirror the increase in the value of the Company’s stock from the date of the SAR grant to the sale.  Both types of synthetic equity can best vesting and would likely be forfeited should the employee leave the Company.

    Providing any type of phantom equity will incur an expense for the Company and some accounting/tax issues, but the fees should be lower than the maintenance and on-going expenses for stock options.  Additionally, in a corporate context, the phantom stock holder would not have any right to management (unless of course that was included in the contract regarding rights).  Contrary to some beliefs, even non-voting stock holders (actual equity owners) get a right to weigh in on fundamental corporate decisions.

    All of that said, Companies can obtain much of the same result with the issuance of restricted stock as a signing bonus, issuing bonuses on current profits or providing a “retention” type bonus to be paid out at a sale.  Frequently synthetic equity and even stock options or employee stock ownership plans provide complex answers to problems that can be solved simpler.  Regardless, Companies have many options when it comes to incentivizing employees.

  7. Fiduciary Duties – Part 3: Duties to the Insolvent Corporation

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    A fiduciary duty is the duty to act in another party’s interests.  Directors and Officers of a Corporation owe fiduciary duties to the Corporation itself and to the Corporation’s Stockholders.  Previous blog posts have discussed the two core fiduciary duties owed by Directors and Officers: the duty of care and the duty of loyalty; this blog post discusses how the duties change as the Corporation approaches insolvency.

    While this blog post refers to the company as a “Corporation” and the fiduciaries as “Directors” or “Officers” of the Corporation, the same principles are in effect for limited liability companies or limited partnerships.  The actors may be called Managers or Members, but share in many (if not most!) of the same obligations to act in another party’s interests.

    The Duty of Care requires Officers and Directors of a Corporation to act in an informed basis and after careful consideration of all material facts and circumstances prior to making a business decision.  The Duty of Loyalty requires Officers and Directors to act in good faith for the benefit of the Corporation and its stockholders, and not for the Officer/Director’s own interest.  Generally, fiduciary duties are owed only to the Corporation and those duties may be enforced by the Stockholders because the Stockholders are the ultimate beneficiaries of the Corporation’s growth and increased value.  Fiduciaries duties are generally not owed to creditors, because creditors have contractual duties.  However, it was long thought that as the Corporation approaches insolvency and becomes insolvent, such duties would shift to being owed to creditors.

    Historically, Delaware’s Chancery Court implied that directors may owe fiduciary duties to creditors when a Corporation is in the “zone of insolvency” but not yet insolvent.  Credit Lyonnais Bank Nederland v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991).  However, in 2007, the Delaware Supreme Court clarified that directors’ fiduciary duties do not run to creditors while companies are in the “zone of insolvency.” (N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007)).

    • “[W]e hold that the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation’s directors.”
    • “When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.”

    Once the Corporation is insolvent however, Officers and Directors owe fiduciary duties to all of the stakeholders of the Corporation (e.g., stockholders, creditors, employees, etc.) to preserve the existing assets of the Corporation and to maximize their value.  Gheewalla, 930 A.2d 92 (Del. 2007)).

    In insolvency, the creditors resemble Stockholders and the creditors hold an interest in maximizing the value of the Corporation; the creditors take the place of the Stockholders as the residual beneficiaries of any increase in value, so the creditors are the principal constituency injured by any fiduciary breaches that diminish the Corporation’s value.

    However, that does not mean Directors and Officers of an insolvent Corporation must cease operations and liquidate assets.  Delaware courts have rejected the “deepening insolvency” theory as a cause of action.  Insolvent Corporations may still opt in favor of a particular business strategy—including additional debt—when other, less risky strategies are also available to it, so long as the decision was made in good faith and with due regard for the interests of creditors.  Directors and Officers continue to be protected by the business judgment rule and creditors of an insolvent Corporation have no greater right to challenge good faith business decisions than the Stockholders of a solvent Corporation.

    In the end, the business judgment rule is a powerful tool for Directors and Officers—and Stockholders—in a solvent, barely solvent or insolvent Corporation.  It allows Directors and Officers to make necessary business decisions, without the threat of additional liability, and it provides Stockholders with leaders who are able to make difficult decisions.  Without such leadership, all stakeholders would suffer.

  8. Business Breakups: Breaking Up Isn’t Always Hard to Do

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    All too frequently people go into business with a partner (or manager or member) without thinking through the end of that relationship.  Things go well for a few years, then something happens that changes the dynamic.  Perhaps the business starts faltering and profits are down, perhaps your partner no longer contributes as much as he or she did in the beginning.  At some point, you realize a change is necessary and you need to get out of the partnership.  Hopefully you planned for this occasion.  If not, you will need to work out an agreement with your partner or go through a judicial dissolution to “breakup” with the business.

    First, take a look at your organizational documents.  Do you have a Shareholder Agreement, an LLC Operating Agreement or a Buy-Sell Agreement that provides for a way to get out of the business?  Can you buy out your partner at a set price?  Can he or she buy you out?

    If you used an attorney to form your business, you likely have language that would answer some of these questions.  Typically, a Shareholder Agreement or an LLC Operating Agreement would provide a way for one partner to buy out the other partner in a “deadlock situation” for a set price or a price determined by a pre-defined formula.  A deadlock occurs when the Company cannot act because no agreement can be made among management.  This can easily occur in a 50/50 ownership situation when you need both parties to act, or even in a situation where a “supermajority” is required to take some particular action and the supermajority cannot be reached.

    Another typical provision in a Shareholder or LLC Agreement is “buy-sell” language.  Such provision provides that at a certain time (for example, five years after formation) or event (for example, at the death or disability of one of the owners), one partner or the Company, has the right to buy out the other partner.  Again, this type of provision will likely come with a set purchase price, a pre-determined formula, or an agreed-upon method to determine the purchase price (the Company hires an appraiser to set the price).

    Second, have you talked to your partner about breaking up?  Perhaps he or she would like to buy you out and would welcome the opportunity.  Having a valuation or appraisal done by a third party is a good way to show that the price you are offering is good.

    An attorney can help you prepare a letter of intent (LOI), which would provide a written offer containing an outline of the basic terms in the sale transaction: the purchase price, timing of the closing, and any post-closing obligations of the Seller (a non-compete).  An LOI can kick-start the purchase process and smooth over later negotiations.  While you may spend time submitting several offers in order to get to an agreement, if you can achieve resolution of the issues through this process, it can save a great deal of time and money by avoiding litigation.

    Finally, if negotiations are not working, it may be time to consider that the Company will not survive and will need to be dissolved.  There are two ways a Company can be dissolved: by the parties agreeing to dissolve the Company, or by a judge dissolving the Company.  In this case, the differences between corporations and LLCs (or limited partnerships) can be very important.  Under the Virginia corporate statute, two-thirds of the shareholders must agree on the dissolution of a corporation.  Under the Virginia LLC status, unless the members have preempted the statute in their LLC Operating Agreement, all of the members must agree to dissolve the LLC.  As you can see, it may be a difficult task to get owners to agree to a dissolution.

    Without the necessary consent to approve a dissolution of the Company, in either the LLC or corporate context, members or shareholders may petition the court to order a judicial dissolution.  For a corporation, the statute lists out many reasons that a Court would order a dissolution: the Board is deadlocked, the directors’ actions are “illegal, oppressive, or fraudulent,” the business has been abandoned, and others.  For an LLC, a judge may order the dissolution “if it is not reasonably practicable to carry on the business in conformity with the articles of organization and any operating agreement.”

    While breaking up is never fun, in the business context, planning for your exit should be part of the formation process.  How long do you anticipate being active with the business?  What would change that would make you want to get out of the business?  How will you get out of the business?  With proper planning, breaking up with your business doesn’t need to be (too) painful or costly.  It may even give the business a fresh start.

  9. Guarantees: Understanding Your Obligations

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    A guarantee, at its most basic form, is a promise made by one party to fulfill an obligation of another party.  Guarantees are frequently seen in financing transactions: the Guarantor agrees to pay a debt the Borrower owes to the Lender should the Borrower fail to repay the debt.  In a small business context, most Banks require small business owners to guarantee a loan to their business.  In the end, the Company gets a loan and the Bank gets added security of the Owner’s personal assets.  The Owner, however, risks his or her home and personal property.

    Banks usually require a small business owner to guarantee a loan to the business because of basic corporate law.  Duly organized and capitalized corporations, limited liability companies and limited partnerships insulate their Owners from the Company’s obligations.  An Owner generally cannot be held liable for the debts of a corporate or LLC.  As such, a debt of the Company is not a personal obligation of the Company’s Owner.  However, through a guarantee, the Bank causes the Owners to risk their own assets and become liable for the Company’s obligations.  While this is standard practice for a loan at a traditional bank, there are other options for financing when an Owner balks at providing such a Personal Guarantee.

    From a small business perspective, entering into a financing arrangement that requires Personal Guarantees may be the right business decision at one point and not at another point in the lifeline of a Company.  Either way, Companies should carefully consider the pros and cons of each type of financing arrangement and negotiate a deal that works best for their current situation.

    Personal Guarantees

    When a Company obtains a loan from a Bank, the Company executes a Loan Agreement (or a Credit Agreement) and the loan is evidenced by a Promissory Note.  Additionally, the Bank usually requires a Personal Guarantee to be executed in favor of the Bank.  Under the Personal Guarantee, the Bank can take possession of the personal assets of the owners should the Company default on the loan.

    Typical language from a Guarantee provides that “the Guarantor irrevocably, absolutely and unconditionally guarantees to the Lender the full and complete performance of any and all obligations of the Borrower to the Lender.”  The obligations of the Guarantor to the Bank are not typically capped at a fixed amount, but rather cover all of the Company’s obligations to the Bank.  These obligations will increase over time as the amount of the Company’s loan or lines of credit increase over time.

    While the requirement to provide a Personal Guarantee may seem burdensome for an Owner, traditional lenders continue to require them in small business loans.  However, not all Owners want to provide a Personal Guarantee.  In that case, small businesses are turning to alternative financing arrangements, such as business credit-card loans or factoring in order to avoid the Personal Guarantee requirement.  Finally, Companies that have grown sufficiently in size and revenue, or have enough assets in order to qualify for asset-based lending, are typically exempted from Personal Guarantee requirements of a traditional bank.

    Validity Guarantees

    Another type of guarantee seen in Company financing arrangements is a Validity Guarantee.  In factoring– a type of financing where the Company sells its accounts receivables in order to obtain working capital financing– the Lender, who is typically called a Factor– provides cash to the Company in exchange for the right to collect payment on specific receivables.  In this relationship, the Factor is not looking to the Company or the Company’s Owners for payment; the payment obligations in factoring is with the account debtor.  As a result, the Factor wants certain assurances from the officers or managers of the Company on the financial health of the Company and the account receivables that are being sold.

    Validity Guarantees are not promises to repay the Factor, but are promises made by an individual involved in the operation of the Company that the reporting made to the Factor is true and accurate.  The individual executing the Validity Guarantee is not liable for the underlying financing, but is liable for losses as a result of fraud or gross negligence in the reports provided to the Factor.

    Typical language of a Validity Guarantee may provide that “the Principal [who is the person in charge of the day-to-day operations of the Company] covenants and agrees, for the benefit of the Lender, that the Principal will not (a) provide information material to the obligations that is inaccurate or misleading, (b) conceal any information which is required to be delivered to the Lender, (c) fail to cause any collateral to be turned over to the Lender, or (d) otherwise take any action that constitutes fraud or conversion.”  Through this language, the Factor is reassured that the information the Company is providing regarding the receivables is accurate and complete.

    Enforcement of Guarantees

    While the decision on how to obtain financing for a Company involves more elements than whether a requirement for Personal Guarantee is required or not, the decision to personally guarantee can have serious consequences for owners.  If a Personal Guarantee is in place, a small business failure frequently triggers a personal bankruptcy, even if the Owners have taken all other corporate precautions to shield themselves from personal liability for Company debts.  Business trade publications are full of stories of failed business and Owners who now find themselves on the hook for millions of dollars of bank financing or lease obligations.

    Donald Trump is a good example of this perspective.  While his businesses have filed for bankruptcy over and over, he has never filed bankruptcy personally.  Following a scare in the early 90s over his liability through some Personal Guarantee on real estate, Trump has steered clear of Personal Guarantees and, so far, has kept out of personal bankruptcy.

  10. Fiduciary Duties – Part 2: Duty of Loyalty

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    This blog post discusses the Duty of Loyalty. A previous blog post discussed the duty of care and subsequent blog posts will discuss special circumstances regarding fiduciary duties.

    While this blog post refers to the company as a “Corporation” and the fiduciaries as “Directors” or “Officers” of the Corporation, the same principles are in effect for limited liability companies or limited partnerships. The actors may be called Managers or Members, but share in many (if not most) of the same obligations to act in another party’s interests.

    Duty of Loyalty

    The Duty of Loyalty requires Officers and Directors of a Corporation to act in good faith for the benefit of the Corporation and its stockholders, and not for the Officer/Director’s own interest. It may seem obvious, but Officers and Directors may not engage in fraud, use their position with the Corporation for personal gain or advantage, or take opportunities from the Corporation.

    Violations of the duty of loyalty include:

    • A conflict of interest (where the Director has an interest in the “other party” in a transaction);
    • Usurping a corporate opportunity (where the Director uses an opportunity for his or her other company, instead of recommending the opportunity to the Corporation);
    • Personal benefit to the Director (golden parachute, promise of employment);
    • Fraud upon the Corporation; and
    • Misappropriating corporate assets (where a corporate asset – say a jet – is used for non-corporate purposes).

    Standard

    In contrast to the duty of care, there is no business judgment rule shield for Officers or Directors. Instead, once the mere existence of a personal benefit or other allegation of displaced loyalty is established, the Directors and Officers must show that their actions were entirely fair to the Corporation: a very high standard to prove.

    To balance this high standard, states have enacted statutory procedures for transactions involving a conflict. Virginia’s Stock Corporation Act provides that a conflict of interest transaction is not voidable by the Corporation solely because of the Director’s interest in the transaction if (i) the material facts of the transaction and the Director’s interest were disclosed or known to the board of Directors and the board of Directors authorized the transaction; or (ii) the material facts of the transaction were disclosed or known to the shareholders and the shareholders authorized the transaction, or (iii) the transaction was fair to the Corporation.

    How to Avoid Breaching the Duty of Loyalty

    In order to avoid breaching their duty of loyalty, Directors should always disclose any personal benefit they have in a transaction and have the transaction approved by either the non-conflicted Directors or the shareholders. If a Director has any reason to suspect they might have a conflict of interest, such Director should bring it to the attention of the board so that the board can consider appropriate actions. The conflicted Director can then abstain from voting upon the subject transaction.

    Things can get a little more complicated when there is not a majority of non-conflicted Board members. That would occur when there is only one director or two directors (with one having a conflict) of the Corporation. In that case, it may make sense to appoint an independent director to the Board in order to obtain the necessary approvals, or to request shareholder consent. The statutory provisions allowing for shareholder approval to “cure” any conflicts do not exclude conflicted shareholders from the approval process. In that case, the shareholders are considered to be wearing their “shareholder” hats and they can approve transactions that are in their best interests – not just the Corporation’s best interests.

    Officers and Directors of a corporation can avoid liability for a breach of the duty of loyalty by disclosing any possible conflict of interest to the Board and then obtaining consent of the non-conflicted Board.