Author Archives: James B. Kinsel

1. Written Demands by Shareholders Prior To Filing Derivative Actions Must Meet Certain Requirements, a Recent Case Explained

   July 1, 2013 8:43 am Leave a Comment

   Virginia Code § 13.1-672.1(B)(1) contains a written demand requirement before a shareholder is able to file a derivative action on behalf of a corporation.  Under Virginia law, a shareholder has no standing to maintain a derivative suit unless he first makes a written demand that the corporation bring suit in its own right.

   In a recent case, the defendants, who are shareholders of a closely-held Virginia corporation along with the Plaintiff, claimed that Plaintiff did not meet the written demand requirement.  In the written opinion, the court laid out the specific requirements of a demand.

   In this case, the corporation was in the business of developing and managing restaurants.  In January 2008, Plaintiff claimed the defendants refused to provide him with any information concerning the corporation and essentially kept him out of the loop regarding the corporation.  Plaintiff also alleged that the defendants independently without his involvement opened another restaurant.

   Plaintiff hired an attorney to send a letter to defendants, demanding access to the company’s financial records, to which a shareholder is permitted access.  When no response was received, he sent a follow-up letter giving the defendants notice pursuant to Virginia Code § 13.1-774 that Plaintiff, as a shareholder owning more than 5% of the corporation, was entitled to the corporation’s financial records.

   This case presented a question of first impression: what components must a document have before it can be deemed to satisfy Virginia’s written demand requirement?

   The court recognized that the form of the demand is not specified in the statute except to require that it be in writing.  However, after analyzing several North Carolina cases, which evaluated a statue almost identical to the Virginia statute, the court determined certain overarching principals:

   First, the purpose of the statutory demand requirement is to put the corporation on notice of a shareholder’s objection to an alleged wrong to give the corporation an opportunity to fix it.  Second, a plaintiff cannot bring a derivative action seeking redress of wrongs not addressed in his written demand.  Third, a written demand need not discuss any specific legal theory nor every salient fact ultimately asserted in a plaintiff’s complaint, so long as the contents of the written demand are sufficiently clear and particular to put the corporation reasonably on notice as to the substance of the plaintiff’s objections and allow the corporation to address them. See Op at 5.

   The Court will thus consider (I) whether the document at issue identifies an alleged wrong, (2) whether the document demands action on the part of the corporation or its officers to redress the

   alleged wrong, (3) whether the demands in the document are clear and particular enough to have put the corporation reasonably on notice as to the substance of the alleged wrong and allow the

   corporation to assess its rights and obligations with regard to the alleged wrong, and (4) whether the alleged wrong and the claims asserted in the plaintiffs complaint are sufficiently connected.  Op. at 6.

   In the instant case, plaintiff’s two letters provided several alleged wrongs, including failure to provide plaintiff with Schedule K-1’s and federal income tax returns, failure to file tax returns, and breach of fiduciary duty associated with failure to allow plaintiff access to the corporation’s financial records without court intervention.  Plaintiff did not merely inquire about these failures; he clearly and particularly demanded that they be redressed.  The court found this sufficient to put the corporation on notice about the substance the alleged wrongs and give the corporation the opportunity to remedy the situation.

   Thus, the court held that plaintiff’s letters constituted “written demands” within the meaning of Virginia Code § 13. 1-672. I (B)(1), and any wrong addressed therein may properly form the basis of a derivative action.

   Plaintiff’s complaint, however, also included a claim that defendant usurped corporate opportunities by opening the additional restaurant.  The written demands failed to include mention of usurpation of corporate opportunities.  Therefore, the court found that Plaintiff did not sufficiently demand redress of this claim and so he was not permitted to seek redress of any alleged usurpation.

   As a result of this case, shareholders wishing to bring derivative suits must ensure that their written demands prior to bringing the derivative action:

   (1) identify an alleged wrong,

   (2) demand action on the part of the corporation or its officers to redress the alleged wrong,

   (3) clearly put the corporation on notice as to the substance of the alleged wrong and allow the corporation to assess its rights and obligations with regard to the alleged wrong, and

   (4) ensure that the alleged wrong and the claims asserted in the plaintiffs complaint are sufficiently connected.

2. A Virginia Court Discusses That the Existence Of Discretion Implicates An Implied Duty Of Good Faith And Fair Dealing In Contacts

   July 1, 2013 8:42 am Leave a Comment

   Virginia courts consistently recognize an implied duty of good faith and fair dealing in common law contracts.  In a recent case in the U.S. District Court for the Eastern District of Virginia, the court held that plaintiffs had sufficiently pleaded a breach of the implied duty of good faith and fair dealing by alleging that defendant bank acted in bad faith and against usual and prudent business and banking practices.

   This recent case identifies not only how important it is for businesses to carefully draft contract language, but it also adds an extra layer of caution in determining whether and how to exercise discretion in applying what may appear to be contractual rights.  If a party to a contract is given a right to do something, but this right is not dependent upon the occurrence of a definite fact, then that party has discretion on the question of whether or not he is allowed to exercise that right, which implicates the implied duty of good faith and fair dealing.  If this happens, the party must take extra caution.  He must be careful not to breach the implied duty of good faith and fair dealing by acting unfairly.

   In this case, Plaintiffs owed defendant bank a debt of approximately $9 million.  The bank agreed to receive a $3 million payment settlement amount from plaintiffs in lieu of the total debt owed.  After deciding on this number, the parties executed a debt settlement agreement. During the negotiation of the agreement, one of the plaintiffs, John P. Right, gave the bank financial statements. These statements did not include property held in tenancy-by-the-entirety with his wife, because Mr. Right thought that the statements were only supposed to include property held in his individual name.

   After the signing of the agreement, Mr. Right provided another financial statement which this time included the jointly-owned property, as required by the signed agreement.  The bank took notice of this additional property.

   A provision in the agreement allowed the bank to terminate the agreement and obtain its rights and remedies under the agreement if it was found that a financial statement contained a material misrepresentation or omission in the form of understating assets by at least $100,000.  This gave the bank discretion on its right to terminate.  Due to Mr. Right’s omission of the jointly-owned property in the first-provided financial statement, the bank promptly terminated the agreement.

   Plaintiffs alleged as part of their breach of contact claim that the bank acted in bad faith and the bank’s decision to terminate the agreement based on the financial statements was against usual and prudent banking practices.

   For a claim of breach of implied covenant of good faith and fair dealing to survive, a party must prove a contractual relationship existed and a breach of the implied covenant. This second prong occurs when either (1) a party acts dishonestly where that party has a clear contract right, or (2) where a party acts arbitrarily or unfairly in the case where a party has discretion in performance.  Thus, an important question to determine is whether a party has a clear contractual right or has discretion in performance.

   The district court described the applicable standard as follows:  when parties to a contract create valid and binding rights, the implied covenant of good faith and fair dealing is inapplicable to those rights.  But a party may not exercise contractual discretion in bad faith, even when such discretion is vested solely in that party.

   Broadly speaking, every exercise of a contractual right involves some “discretion” in determining if a right has accrued or whether to exercise a right that has accrued.  The court drew a legal distinction between an exercise of discretion and an exercise of a contractual right.  A good example provided by the court of when a party has discretion in performance was the case of Virginia Vermiculite, Ltd. v. W.R. Grace & Co.  In that Fourth Circuit case, a family contracted with a mining company for the sale of mining rights to their land.  The family was paid in proportion to the amount the mine produced.  The contract gave the mining company the “sole discretion” whether to mine the land.  When the mining company donated the land to a trust, the court held that there was a breach of the duty of good faith because the trust forbade any mining of the land, and the purpose was to frustrate a competitor.  156 F.3d 535 (1998).

   In the case at hand, Plaintiffs argued that the defendant bank was required to use “usual and prudent business and banking practices” when determining whether a financial statement had a material representation or omission in order to uphold its duty of good faith and fair dealing.  Plaintiffs did not argue that the bank’s decision to exercise its contractual right amounted to contractual discretion, but instead argued that the bank’s determination of whether a contractual right had accrued amounted to contractual discretion.  The court recognized the novelty of this question: whether the implied duty of good faith and fair dealing requires a party to be reasonable in ascertaining whether a contractual right has accrued.

   The court reasoned that because the accrual of the bank’s right to terminate the agreement was not committed to the occurrence of an objective, undisputed fact, but was committed to the bank’s determination or discovery that the financial statement contained a material omission, the case was like Virginia Vermiculite.  The review of the financial documents was committed to the discretion of the bank, just as the mining of land was committed to the discretion of a mining company.  The mining company could not decide to not mine land, to get an advantage over a competitor.  “Both the deliberations there and here were committed to experts and were antecedent to the exercise by the expert of a purported right –to mine or not mine, or to consummate or not consummate a settlement.”  Op. at 12-13.

   Therefore, the court held that the bank, in determining that a financial statement of plaintiff contained a misrepresentation or omission, acted in bad faith and against usual and prudent business and banking practices.

3. Business Breakups

   June 21, 2013 2:21 pm Leave a Comment

   The Russian author Leo Tolstoy famously said in his novel Anna Karenina that “Happy families are all alike; every unhappy family is unhappy in its own way.” While Tolstoy was writing about 19th century Russia, this quote is equally prescient in the 21st century about the internal relationships between owners of businesses, whether bound together as a company, partnership or corporation. Our lawyers have handled many business breakups over the years and written much about the legal issues surrounding them.  (Click here to see our Business Breakup Practice Team.)  This article and the ones to follow, however, focus not on the legal issues but on the emotional, financial and psychological reasons that can cause friction between co-owners and ultimately drive a business breakup; legally known as a dissolution.

   Laying the Foundation: Designing Ownership and Compensation Structures

   Businesses are often born out of a desire to either create something new or build a better mousetrap whether through new technology, process or attitude; or through better pricing. Other reasons include the desire of some people to work for themselves, try to make more money or even desperation to find work.

   Regardless of the reason, if there is more than one owner of a business, then they have more than just a business to manage. The owners need to handle the delicate nature of managing their relationships with one another. Surprisingly, many people when deciding to form a business together do not focus on the relative strength of their relationships and whether they are compatible as business owners. And they often do not think about, much less discuss or negotiate, the proper allocation of work, capital risk and (if all goes well) reward. Even more rarely do co-owners examine their available legal rights should their internal relationships go sour and a dissolution becomes desirable to some or all of the owners. Yet by becoming owners and possible officers or directors, they may create any number of fiduciary duties between themselves or the company.

   There are many reasons why potential business co-owners avoid engaging in these types of conversations. One reason is that everyone has their own blind spots that make them vulnerable to overlooking key issues. For instance, people often assume their co-owners will work approximately the same schedule as they do. Some people will commit to working seven days a week to get the business off the ground, and they will expect their co-owners to do the same. Others, however, may firmly believe that their career five-day-a-week schedules are perfectly appropriate to successfully launch the new business. That effort difference by itself can cause major friction. Those blind spots, thus, lead people to assume facts about their business partners or events that can be painfully inaccurate for all involved.

   People also avoid conversations about compensation for the simple fact that just having owner believes that they should receive vis-à-vis their co-owners. There are many reasons why compensation differences might be appropriate, such as differences in skill, time commitment, performance or seniority. But, even if someone believes that unequal compensation is appropriate, presenting those arguments to that person’s co-owners can be an unpleasant task. And it is a task that many people would rather avoid even to their financial detriment.

   To avoid this unpleasantness, some business focus on equalizing the system for earning compensation rather than equalize what people earn. Such a system is designed to reward performance. To create an effective system, the owners must agree upon which efforts are compensable and how compensation will be calculated. Designing the compensation system is usually done at the outset of the business. And, while the owners can change it at any time, they often do not. But designing such a system can also be fraught with difficulties because people often overemphasize the value of the areas in which they excel and minimize the other areas.

   Like compensation systems, structuring the ownership interests are often cut with the rough edges of a timber saw rather than with a scalpel.  Fifty-Fifty and and similar equal split deals are common. This is true even when the owners know that one or more of them will commit more of their time to the enterprise. Again, the difficulty of having the conversation, perceived or actual, can silence owners from “rocking the boat.”  And because many owners perceive their relationship to be easy to describe, they often do not seek legal counsel to draft the corporate documents.

   Once the internal ownership structure and compensation system are resolved (or resolved enough) owners begin the business itself and the internal process of working together. The business can either succeed, be stuck in neutral or fail. Each outcome can cause friction between business owners, but perhaps paradoxically, some of the bitterest conflicts are born out a business success. We will explore that issue the next article.

4. A Law Firm’s Role in the New Economic Reality

   June 21, 2013 2:12 pm Leave a Comment

   The new economic reality that is struggling to emerge from the recent “Great Recession” is forcing industries across the United States to rethink their business models.  This process includes taking a hard look at how they are using outside counsel and which counsel to use.

   Skilled attorneys will always be in demand.  But skill alone is no longer the only factor in selecting an attorney or law firm.  Law firms must have attorneys with focused skills, who understand how each matter fits within their clients’ overall objectives and budget, and who have the ability to drive a result.

   A law firm’s attitude towards its clients and their legal issues is as vital as its legal skills.  But attitude is often overlooked because it is difficult to measure, particularly at the outset of an engagement.  Clients want to know that their attorneys will devote their energies to positively managing the clients’ legal matters, without throwing endless resources at minor issues.  To balance these objectives, law firms must have the right attitude to recognize and discuss with the client how best to tackle a legal issue, considering the costs, risks, and potential benefits of that matter in context with the business’s overall objectives.

   The Great Recession’s impact on certain law firms’ culture and attitude can also be substantial.   Many law firms have cut their associate and partner ranks and reduced the surviving lawyers’ salaries.  And the surviving lawyers can feel increased pressures to justify their existence by escalate their revenues, which, for many attorneys, can only occur by billing more hours.

   Our firm, however, was born during this economic crisis.  And we have embraced the changes caused by it.  Thus:

   • We think about and communicate with our clients about how a particular matter fits within their overall goals.  This includes advice that a matter may not be worth pursuing.

   • We look for ways to coordinate our fee structures with our clients’ goals.

   • We direct work to the appropriate person within our firm to capture the correct experience and rate structure.

   • We structure our compensation systems to promote stability and accommodate growth.

   • We push our attorneys to continually expand and deepen their skills to remain focused on quality.

   • We provide updates on legal issues that matter to businesses through our website’s blogs and other articles.

   • We have a secure extranet to help coordinate a client’s legal matters with our clients, saving time and money.

   These firm values flow down through the practice teams to the individual lawyers.  For example, our Unfair Business Practices team was formed to help businesses guard against unfair competition.  Our firm co-authors the Unfair Business Practices blog, found here, to help our clients track cases that define the boundary between legal and illegal competition.  Since forming our firm six months ago, several clients have tasked our Unfair Business Practice Team to investigate and pursue claims against competitors or disloyal managers/employees for unfair competition.  The Team has also defended clients in these matters.

   Because some unfair business practices can severely harm or even destroy a client’s business, our Team’s attitude towards understanding and advancing the client’s objectives is paramount.  Similarly, the Team is dedicated to sustaining a robust defense in cases brought against our clients, while providing our client with objective advice.  Finally, the Team has experience developing creative solutions to unfair competition claims representing both plaintiffs and defendants.
   Our firm’s other Practice Teams take similar approaches in their respective areas.  For those readers fortunate enough to eat at Hyman’s Seafood in Charleston, South Carolina, you are aware of the Attitude Statement by Chuck Swindol that defines the restaurant’s success, which states, in part:

   The remarkable thing is we have a choice everyday regarding the attitude we embrace for that day. We cannot change our past…we cannot change the fact that people act in a certain way. We cannot change the inevitable. The only thing we can do is play on the one string we have, and that is our attitude…I am convinced that life is 10% what happens to me and 90% how I react to it.

   Our firm’s attitude was forged in the one of the worst economic times in living memory.  Our attitude is defined by our Teaming with Today’s Business philosophy that is focused on taking constructive steps in helping our clients achieve their goals.

5. Careful Contract Drafting is Crucial when Intellectual Property is Involved

   May 3, 2013 4:58 pm Leave a Comment

   Companies providing services to clients and the clients themselves should pay close attention to language in the contract for services, particularly when the services involve the production of intellectual property by the company, such as software, plans, drawings, designs or other trade secret information.  If conflict arises between the company and client and the contract is terminated, then a dispute can develop over who owns that partially paid for and partially completed creative work.

   In a recent case, a federal court in Virginia found that due to language in a contract between an architectural firm and its client, the client had the right, after firing the architectural firm mid-performance, to provide the firm’s design documents including drawings, plans, and specifications to a new firm to finish the work.  The court found that the express license to use the documents survived even though the client refused to pay the full contract price because part payment constituted only a “partial” breach of the contract and the contract did not condition the use rights on the occurrence of any event, such as full payment of the contract price.

   The specific facts of the case involved St. Thomas Aquinas Seminary Association decision to prepare a new seminary building in Buckingham County, Virginia, and formed a corporation called STAS, Inc. (“STAS”) in the process.  STAS hired Cram & Ferguson Architects to provide architectural and engineering documents for the design and construction services of the building (“Design Documents”).  The contract was negotiated between the two parties, and modifications were made to the standard form agreement provided by the American Institute of Architects (“AIA”).

   STAS terminated the contract with the project only being partially complete. STAS hired another architect to pick up where Cram & Ferguson left off.  Cram & Ferguson objected to the use of its Design Documents.

   The contract states that STAS may “use drawings, plans and specifications without restrictions.  This is not intended to create any rights by any other party in the drawings, plans, and specifications.”  STAS claimed that this language gives it an express license to have another architect copy, modify, and alter the Design Documents without restriction and without Cram & Ferguson’s involvement.  STAS argued that the second sentence only provided that the Contract doesn’t transfer the ownership of any copyright in the Design Documents to any other party.  Cram & Ferguson claimed that the second sentence simply declines to extend tothird parties those permissions granted to STAS itself by the first sentence, and that the use rights are restricted to STAS only.

   The court decided that the “use” described in the contract clause constituted an express nonexclusive license for STAS to use the materials Cram & Ferguson developed without restrictions, even if Cram & Ferguson is no longer associated with the Project.  The court elaborated that this includes the right to hand off the documents to another architect, as STAS did in this case.  The court added that STAS cannot acquire, transfer, or assign any “rights” from that use, although STAS did not intend to do so.

   Cram & Ferguson allowed many of the protections for architects in the original AIA standard form contract to be removed.  The court held that questions concerning how provisions of the contract interacted with one another (e.g., whether the exclusive license terminated if and when STAS failed to pay for services rendered), do not terminate STAS’s license.

   Cram & Ferguson also claimed that because STAS owed $194,661.67 for the work completed through the date of termination, STAS had materially breached the contract, and therefore STAS could not avail itself of the contract rights.

   The Court explained that a party who commits the first material breach of a contract is not entitled to enforce the contract.  The Court stated “a breach will justify rescission of a licensing agreement only when it is so material and substantial a [sic] nature that it affects the very essence of the contract and serve[s] to defeat the object of the parties. . . . The breach must constitute a total failure in the performance of the contract.”  Op. at 14 (internal quotes and citations omitted).  The Court reasoned that the provision in the contract provided no “condition of the license” and so STAS obtained the ability to use the Design Documents without restriction, and without meeting any specific conditions precedent, such as paying the full contract price.

   The court held that an express license existing in a contract will survive so long as the licensee’s breach of that contract is not material or a total failure of performance.  STAS’s breach is only a partil breach due to the several hundred thousand dollars paid to Cram & Ferguson, and, therefore, STAS kept its right to use the Design Documents as it pleased.

6. Business Breakups

   February 9, 2013 4:16 pm Leave a Comment

   The Russian author Leo Tolstoy famously said in his novel Anna Karenina that “Happy families are all alike; every unhappy family is unhappy in its own way.” While Tolstoy was writing about 19th Century Russia, this quote is equally prescient in the 21st Century about the internal relationships between owners of businesses, whether bound together as a company, partnership or corporation. Our lawyers have handled many business breakups over the years and written much about the legal issues surrounding them.  (Click here to see our Business Breakup Practice Team.)  This article and the ones to follow, however, focuses not on the legal issues but on the emotional, financial and psychological reasons that can cause friction between co-owners and ultimately drive a business breakup; legally known as a dissolution.

   Laying the Foundation: Designing Ownership and Compensation Structures

   Businesses are often born out of a desire to either create something new or build a better mousetrap whether through new technology, process or attitude; or through better pricing. Other reasons include the desire of some people to work for themselves, try to make more money or even desperation to find work.

   Regardless of the reason, if there is more than one owner of a business, then they have more than just a business to manage. The owners need to handle the delicate nature of managing their relationships with one another. Surprisingly, many people when deciding to form a business together do not focus on the relative strength of their relationships and whether they are compatible as business owners. And they often do not think about, much less discuss or negotiate, the proper allocation of work, capital risk and (if all goes well) reward. Even more rarely do co-owners examine their available legal rights should their internal relationships go sour and a dissolution becomes desirable to some or all of the owners. Yet by becoming owners and possible officers or directors, they may create any number of fiduciary duties between themselves or the company.

   There are many reasons why potential business co-owners avoid engaging in these types of conversations. One reason is that everyone has their own blind spots that make them vulnerable to overlooking key issues. For instance, people often assume their co-owners will work approximately the same schedule as they do. Some people will commit to working seven days a week to get the business off the ground, and they will expect their co-owners to do the same. Others, however, may firmly believe that their career five-day-a-week schedules are perfectly appropriate to successfully launch the new business. That effort difference by itself can cause major friction. Those blind spots, thus, lead people to assume facts about their business partners or events that can be painfully inaccurate for all involved.

   People also avoid conversations about compensation for the simple fact that just having owner believes that they should receive vis-à-vis their co-owners. There are many reasons why compensation differences might be appropriate, such as differences in skill, time commitment, performance or seniority. But, even if someone believes that unequal compensation is appropriate, presenting those arguments to that person’s co-owners can be an unpleasant task. And it is a task that many people would rather avoid even to their financial detriment.

   To avoid this unpleasantness, some business focus on equalizing the system for earning compensation rather than equalize what people earn. Such a system is designed to reward performance. To create an effective system, the owners must agree upon which efforts are compensable and how compensation will be calculated. Designing the compensation system is usually done at the outset of the business. And, while the owners can change it at any time, they often do not. But designing such a system can also be fraught with difficulties because people often overemphasize the value of the areas in which they excel and minimize the other areas.

   Like compensation systems, structuring the ownership interests are often cut with the rough edges of a timber saw rather than with a scalpel.  Fifty-Fifty and and similar equal split deals are common. This is true even when the owners know that one or more of them will commit more of their time to the enterprise. Again, the difficulty of having the conversation, perceived or actual, can silence owners from “rocking the boat.”  And because many owners perceive their relationship to be easy to describe, they often do not seek legal counsel to draft the corporate documents.

   Once the internal ownership structure and compensation system are resolved (or resolved enough) owners begin the business itself and the internal process of working together. The business can either succeed, be stuck in neutral or fail. Each outcome can cause friction between business owners, but perhaps paradoxically, some of the bitterest conflicts are born out a business success. We will explore that issue the next article.

7. Virginia Supreme Court overturned a multi-million dollar goodwill damages award

   July 11, 2012 2:10 pm Leave a Comment

   Recently in the case of 21st Century Systems, Inc. v. Perot Systems Government Services, Inc. (“Perot Sytems”) (available here), the Virginia Supreme Court overturned a multi-million dollar goodwill damages award.  On appeal, the Virginia Supreme Court found that Perot Systems did not present adequate proof of the value of its lost goodwill.

   The facts in Perot Systems are forthright, Perot Systems alleged that Defendants, former Perot Systems employees, conspired to “destroy [Perot Systems] and steal away tens of millions of dollars a year of [Perot Systems] business by unfairly and improperly using [Perot Systems’] confidential and proprietary information.”  The case centered on a group of ex-Perot Systems’ employees who left the company to join 21st Century Systems, a rival government contracting firm.  Perot Systems filed suit, alleging violation of Virginia’s business conspiracy act, violation of Virginia’s Uniform Trade Secret Act, breach of fiduciary duty, breach of non-disclosure agreements, and breach of non-compete and non-solicitation agreements.  After the employees left but before the trial, Perot Systems was sold to Dell for $3.878 billion.  As part of the sale Dell assigned $1.6 billion in goodwill to Perot Systems.  Perot Systems’ valuation expert used the Dell sale as a benchmark for assessment purposes when calculating the total loss of goodwill resulting from the defendants’ actions.  The jury ultimately accepted this assessment in awarding Perot Systems damages.

   When dealing with tangible assets the valuation of a company is often more easily understood; firm values can be assessed to real estate, machinery and equipment, inventory and receivables.  But businesses are not valued solely based upon tangible assets. Goodwill is a non-tangible asset that a business can earn over time.  It is the benefit and advantage of the good name, reputation and connection of a business, the attractive force which brings in customers.  Goodwill has been defined as “the excess of the sales price of a business over the fair market value of the business’ identifiable assets.”  Advanced Marine Enters. v. PRC Inc., 256 Va. 106, 501 S.E.2d 148 (1998).  Valuation of this asset is subjective and difficult to clearly calculate.  When a business is sold, goodwill can greatly enhance the sales price.

   On appeal the Virginia Supreme Court overturned the jury’s award of lost goodwill damages.  The Court held that Perot Systems failed to use any data concerning the sales of comparable business.  It also faulted Perot Systems from failing to demonstrate that the sale price was negatively affected as a result of the defendants’ actions.  And merely taking the later sales price attributed to goodwill and applying that amount to the defendants’ prior conduct is insufficient to support a claim for loss of goodwill.

   The court did acknowledge, however, that “damages for loss of goodwill may be recovered if proven” even if it is “impossible of valuing with mathematical precision . . . .”  Like many things in life, proving loss of goodwill can be done- you just have to do it the right way.

8. Constant bickering among partner-siblings results in a judge dissolving their partnership

   June 20, 2012 2:12 pm Leave a Comment

   In Russell Realty Associates, et al. v. C. Edward Russell, Jr., the Supreme Court of Virginia upheld a trial court’s order that dissolved a partnership due to discord between the partners which “frustrated the economic purpose” of the partnership and a kept the partnership from being able to practicably operate under the written partnership agreement.

   Nina Russell Randolph (“Nina”) and her brother, C. Edward Russell, Jr. (“Eddie”), were partners in Russell Realty Association (RRA), a partnership formed to acquire and invest in properties, with Eddie having a slightly larger interest.

   When their father died, the siblings constantly disagreed over whether properties should be developed or sold, whether RRA should be converted to an LLC, and issues regarding the operational control of the partnership.  The siblings hired a consultant to facilitate the relationship between them and advance RRA partnership affairs.

   Under the written Partnership Agreement, Eddie had ultimate decision-making and management authority in the event of disagreement.  However, he still went ahead and filed a proceeding to dissolve the partnership due to conflicts over constant disagreements between the partners.

   The statutory basis for judicial dissolution of a partnership are when: (1) the economic purpose of partnership is unreasonably frustrated, (2) another partner has engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with that partner, or (3) it is not reasonably practicable to carry on the partnership business in conformity with the partnership agreement.

   After a 13-day bench trial in the Circuit Court of the City of Chesapeake, the court dissolved RRA based on the first and third prongs.

   The case was appealed to the Supreme Court of Virginia to decide whether the trial court erred in holding that Eddie met the strict standards for judicial dissolution of a partnership under Va. Code § 50-73.117(5).  The Supreme Court upheld the lower court’s decision.

   The court applied the same standard applicable to LLCs to the partnership dissolution issue because of the statutes’ similarities. Despite arguments by Nina that RRA was an ongoing profitable business and therefor its economic purpose was not frustrated, the court opined that the decision regarding whether to dissolve the partnership under the “economic purpose” prong is not dependent upon whether the partnership is financially successful.  The court concluded that poor financial performance may be a basis for dissolution under the economic purpose prong but is not the sole basis for dissolution under that prong.

   The Supreme Court found that the purpose of RRA was to acquire, hold, invest in, and lease and sell investment properties.  The partners’ expectations for realizing these purposes included not only expectations of economic success, but also the ability to undertake these activities in an efficient and productive manner to maximize return to the partnership.  Due to significant distrust and disagreement between the partners, their relationship frustrated the ability of the partnership to take advantage of a lucrative offer for the sale of property and to secure certain zoning and appraisals for another property in a timely manner.

   The record demonstrated that the disruptive relationship between the partners resulted in the partnership incurring substantial added costs relating to the conduct, recording, and transcribing of meetings and minutes of the partnership meetings, as well as the costs incurred in addressing discord and litigation filed or threatened to be filed aside from the instant case.  The parties’ relationship imposed unnecessary economic costs on the partnership in a number of ways including preventing the partnership from taking advantage of and conducting its business in a timely and efficient manner.  Because nothing in the record suggested the relationship of the partners would improve, the court determined that the economic purpose of the partnership had, in fact, been unreasonably frustrated.

9. Virginia Courts are Giving Wider Discretion to Noncompete Agreements in Business Sales and Settlement Agreements than to Similar Noncompetes Contained in Traditional Employer/Employment Agreements

   January 11, 2012 7:52 pm Leave a Comment

   A noncompete entered into as part of a settlement agreement to end litigation between an employer and former employee receives more latitude than a traditional noncompete signed before or during the employment period.

   In a recent case, Plaintiff McClain & Co. Inc. sued a former employee for breach of an agreement not to compete that was included in a post-employment settlement and release contract to which the two parties agreed.

   McClain accused the former employee of misappropriating $285,793 of McClain’s funds while he was an employee by submitting false payroll records for employee services that the employees did not actually perform.  The parties then entered into a Settlement Release and Agreement a few months after the former employee was no longer employed by McClain where McClain released him from claims relating to his supposed misconduct in exchange for a payment of $250,000, and his compliance with a noncompete restrictive covenant, among other things.

   The covenant provides:

   The former employee agrees that for a period of thirty (30) months immediately following the Termination Date . . . , he shall not provide perform or undertake any Competing Services anywhere in the territory . . . (ii) instruct, hire, engage, or contract with any other person or entity to provide, perform, or undertake any Competing Services anywhere in the Territory; and (iii) own . . . , serve as director, officer or manager of, or control . . . any entity or business that provides, performs or undertake Competing Services anywhere in the Territory. 

   McClain accused the former employee of establishing a competing business, MPT, just six days after signing the settlement agreement.  As a result, McClain sued for breach of contract against the former employee for violation of the non-competition covenant in the contract as well as conversion and tortious interference with contract.

   The former employee moved to dismiss on the ground of failure to state a claim for which relief can be granted because the noncompete is unenforceable as a matter of law.  His motion was denied as to the breach of contract and conversion counts.

   The court decided that McClain’s allegation that the former employee established a business on a certain date that competed with McClain’s business is sufficiently specific and factual in nature to pass muster under Federal Rule of Civil Procedure 8.  The court also held that the phrase “upon information and belief” can be used when the factual basis supporting a pleading is only available to the defendant at the time of the pleading.

   The former employee’s other attack on the breach of contract is a claim that the non-competition clause is unenforceable.  “In considering the enforceability of restraints on trade, Virginia courts focus on the reasonableness of the restraint because the law looks with favor upon the making of contracts between competent parties upon valid consideration and for lawful purposes and therefore courts are averse to holding contracts unenforceable on the ground of public policy.”  Opinion at 7 (internal citations omitted).

   The court held that agreements not to compete in the employer/employee context as part of an employment contract are subject to more careful scrutiny.  The test is whether the contract is narrowly drawn to protect the employer’s legitimate business interest, and is not unduly burdensome on the employee’s ability to earn a living, and is not against public policy.  Id., quoting Omniplex World Servs. Corp. v. U.S. Investigations Servs., 270 Va. 246, 249 (2005).

   The court noted that a noncompete like the one in this case which is part of a post-employment agreement has yet to be reviewed in Virginia.  The court stated that greater latitude is allowed in determining a convenant’s reasonableness when it’s a covenant not to compete between a vendor and buyer than when it’s related to an employment contract.

   Restraints are given more leeway for being acceptable when the noncompete is between a buyer and seller than between an employer and employee because “employees often have comparatively little bargaining power and less leverage for negotiating a fair deal, while the sale of a business more typically involves sophisticated parties coming to an agreement after an arms-length negotiation process.”  Op. at 9, citing Centennial Broad., LLC v. Burns, 2006 U.S. Dist. LEXIS 70974, at *27-29 (W.D. Va. Sept. 29, 2006).  “Restrictions on an employee’s means of procuring a livelihood for himself and his family” are more likely to threaten public policy interests than restrictions on a seller . . . .”   Op. at 9, citing Centennial Broad., 2006 U.S. Dist. LEXIS 70974, at *28-29.  The court noted that this same reasoning applies with the noncompete is between partners in a professional firm.  Op. at 9.

   In the instant case, the court held refused to hold the noncompete to the more restrictive standard applicable in employment cases because the former employee was not an employee when it was made and it was negotiated at arm’s length while the former employee was represented by counsel.  There was consideration for both parties and it was not a “take it or leave it” situation where the former employee was concerned with securing a job.  The court concluded that bargaining power was more equally distributed and reasonable in general.  Therefore the noncompete was sufficiently circumscribed to survive the former employee’s facial attack on a motion to dismiss.

   As we begin to see more categorization of noncompete agreements, Virginia courts are giving wider discretion to noncompetes in business sales and settlement agreements than to traditional noncompetes in employer/employment agreements.  This raises the question whether a different standard may be applied to even more potential categories of noncompetition agreements.

10. Expedited Discovery requires “Unusual Circumstances”

    December 13, 2011 7:54 pm Leave a Comment

    A recent opinion out of the Eastern District of Virginia states that “unusual circumstances” must be shown to grant a party expedited discovery.  And the court adopted two prongs of the prior test for granting a preliminary injunction to determine when sufficient unusual circumstances exist:  a strong showing on the merits and a showing that irreparable harm is likely.

    A software development company, ForceX, Inc., sued its former vice president for allegedly forming a competing company that violated a noncompete agreement.  ForceX’s complaint alleged (1) beach of duty of loyalty and fiduciary duty, (2) breach of contract, (3) violation of the Virginia uniform trade secrets act, and (4) intentional interference with contract.  ForceX filed a Motion for Expedited Discovery seeking discovery in the form of requests for production of documents and a deposition to determine the extent of competitive activities.  Plaintiff argued for two standards of review: one for an expedited deposition and another for expedited document requests, but the court found that “all requests for expedited discovery should be governed by the same standard….”

    “Courts have found that immediate discovery ‘should be granted when some unusual circumstances or conditions exist that would likely prejudice the party if he were required to wait the normal time.’”  Opinion at 5-6, quoting Fimab-Finanziaria Maglificio Biellese Fratelli Fila, S.p.A. v. Helio Import/Export, Inc., 601 F. Supp. 1, 3 (S.D. Fla. 1983).

    It is not clear when these “unusual circumstances” exist.  The court looked to a history of cases for guidance.  Before 2008, the first two prongs of the Blackwelder test for a preliminary injunction—(1) the likelihood of irreparable harm to the plaintiff if the preliminary injunction is denied and (2) the likelihood of harm to the defendant if the preliminary injunction is granted—were weighed against the third prong—the likelihood that the plaintiff will succeed on the merits—to determine whether “unusual circumstances” existed.  Opinion at 6.  This test was a sliding scale so that as the plaintiff’s showing of a likelihood of irreparable harm grew weaker, their showing of success on the merits would need to be stronger to gain a preliminary injunction.

    But after the Supreme Court decision in Winter v. Natural Resources Defenses Council, Inc., 555 U.S. 7 (2008), the Fourth Circuit determined that the Blackwelder test was replaced with the Winter test but did not say which portions of the Winter test a court should use when deciding a motion for expedited discovery.  As a result, courts have considered two different standards in evaluating expedited discovery motions: (1) a modified preliminary injunction factors test and (2) a reasonableness or good cause test.  The court in this instance rejected the reasonableness test, saying it is most logical to treat the motion for expedited discovery under a standard similar to the preliminary injunction standard.

    Finding no clear answer as to when “unusual circumstances” exist, the court in the instant case used a variation of Blackwelder and considered two elements that were emphasized by the Fourth Circuit and the Supreme Court: a strong showing of the merits and a showing that irreparable harm to plaintiff is “likely” and not simply “possible.”

    The court ultimately found that the ForceX was not entitled for expedited discovery.  Plaintiff did not show it was likely to suffer irreparable harm in the absence of the expedited discovery.  Despite Plaintiff’s argument that expedited discovery was necessary to find out about defendants’ products and potential customers in order to prevent loss of customers and business before it occurred through improper means, the court held that a potential loss of customers causing a decrease in revenue is not an unusual type of harm.

    In many business litigation cases, lost profits can be a critical component of damages.  Damaged companies may also be required to take steps that would mitigate their damages.  But it can be difficult to take mitigating steps before discovering information about which clients were impacted by the defendant’s tortious conduct.  This factor, however, must be balanced to protect a potentially innocent company from being bombarded by litigation pressure.  So plaintiff companies in fast action cases, such as those involving business conspiracies, tortious inference and trade secrets, must be prepared in some courts to explain why their particular case is unusual in needing expedited discovery.