The Business Break-up Part I: The “Friendly” Split

Perhaps you’ve been buddies since high school or college; or maybe mutual interests or kinship brought you together. Over the years you entered into a joint venture (whether as a partnership, an LLC or a corporation). But now, for whatever reason you and your business partner have decided to part ways. Assuming you’ve agreed that you would buy him out, what things do each of you need to consider? Buying out a fellow partner can be relatively straightforward, so long as the proper procedures are followed.

1. Mutual Releases: If this is going to be a clean break, the both of you need to execute mutual releases releasing each other from any causes of action or claims you might have against the other. If this is an amicable split, it might not seem necessary, but if you’re leaving not on the best of terms, this is an absolute must.

2. Release of Company Liabilities (Seller): If you’re the one leaving the business venture, the business still might have some liabilities and debts, for which you are personally liable, such as bank loans which you were required to personally guarantee. Some lawyers simply have the buyer sign an indemnity for you, which simply means that he (the remaining partner) agrees to pay the loans, and to protect you from liability against them. The problem with this is that the bank is not bound by this agreement, and if your partner at some point is unable to make the payments, the bank can still come after you. Sure you’ve got a contract, but your ex-partner is now bust, so what good is that going to do? Instead, ensure that your break is a clean one by getting the bank to release you from your personal guarantees when you leave.

3. Proper Corporate Filings (Buyer): If you’re buying out a fellow shareholder (corporation) or member (LLC), it is important to execute the proper corporate paperwork and filings. For example, if buying out a fellow shareholder in a closely-held corporation, you need to have prepared proper corporate minutes in which the stock certificates are conveyed, and in which the seller resigns from all corporate offices, directorships and registered agency, if applicable. If the seller is a member in an LLC, you must make sure that he resigns as manager and (if there is more than one remaining member of the LLC) that all members consent to the seller leaving and to the sale, if any, of his membership interest.

Consider this example published by a colleague:

If, in your “partnership” (whether it be in form a two-person LLC, corporation or a true partnership), you believe there is beginning to be inequities in the amount of output you are producing versus the amount of profits you are receiving, you should immediately take stock of your situation. What circumstances am I talking about?
1. Perhaps your partner put up the money, and you’re doing the work; or
2. Perhaps you’re both 50/50 owners of the company, but feel like you’re putting in more time and effort, and/or are producing more profits.

The longer your relationship continues, the more “in-equity” you might build. For example, consider Mr. A and Mr. B who twenty years ago set up a two-man corporation. The corporation owns their company vehicles, their building, and some cash assets invested over the years. At the end of the year, most of the profits are taken out of the company and given in equal shares to the two shareholders.

Over the years, however, Mr. A has developed a niche market in their business. His clients and their jobs are higher-end, require more labor, but produce a larger profit. Mr. B has not grown his side of the business over the years, and in fact, has let a few of his clients drop since he’s getting older and doesn’t want to work as many hours.

In fact, now, Mr. A brings in approximately 70 percent of the company’s gross earnings, and Mr. B only 30 percent. Finally, Mr. A has enough, and tells Mr. B it’s time they split up. At this point, if the two can’t agree, Mr. A can ask the courts to split up and dissolve their corporation, pay off debts, and then divide the assets. Unfortunately for Mr. A, however, the assets will be split in proportion to stock ownership: 50 percent each; which is not in proportion to the amount worked.

Perhaps Mr. A had, when he set up his company, entered into some sort of agreement by which he could buy out Mr. B at some point. That’s savvy, but if the purchase price is determined by the company’s value, Mr. A has hurt himself by letting things drag on so long. He’s increased the value of the company by his own labor, and is now going to have to pay Mr. B a premium for his stock–stock that rose in value primarily by Mr. A’s actions!

The lesson to be learned from this story is that if you enter into a small company or joint venture, be aware that if the labor and/or production starts to skew unevenly, do not let the situation linger, or you may end up not only working harder than your partner, but one day having to pay more for the valuable product you created.

Of course, this article is a highly simplified version of the truth. Certainly proper documentation needs to be considered but the reality of any buy-out is rarely an amicable determination of the value of a partner’s interest in the company. Those issues however will be addressed in a separate discussion.

The Law Office of Jeffrey K. Davis, Esq. is a full service business-law firm dedicated to providing business owners with resourceful counsel at all stages of the business life-cycle. Providing Practical Legal Solutions. Call for a free consultation.

The Business Break-up Part II: The Messy Divorce

There are many ways a “partnership” can go awry. In the article Now You’re Buying Out Your Business Partner, I discuss a scenario where a business-separation is amicable. But the fact remains most splits, especially in the context of closely held businesses or family owned businesses, are rarely amicable. Preventing a business-separation is probably hard to do as relationships are unpredictable. However, preventing a messy business-divorce is certainly preventable…. with the right legal advice and the right corporate governance contracts in place. Before understanding the “fixes” however, it is important we understand what the situation looks like when things go wrong. The best way to do that is to quickly review some common litigated issues and causes of action.

Breach of Contract: Breach of contract can take many forms. It can mean the breach of an operating agreement, partnership agreement, or shareholder agreement. It can also mean a breach of a management agreement or employment agreement. These claims can and often do co-exist. Understanding these contracts inside and out can make the difference between a strong lawsuit and a frivolous lawsuit. Consulting with a knowledgeable business attorney can help you and your business partner discuss and envision potential issues. When those issues are identified you can then work with your business attorney and business partner to craft ways of mitigating the risks associated with litigating those issues. You can’t predict or prevent everything but you can certainly spend the time and money now to ensure you won’t have to spend 10 times the time or money later.

Derivative Claims: A shareholder derivative suit is a lawsuit brought by a shareholder  (or partner or member depending on the legal form of the entity) on behalf of a corporation against a third party. Often, the third party is an insider of the corporation, such as an executive officer or director.  These claims take shape in the form of claims brought on behalf of the company against your business partner (who is often a manager, executive, or director) alleging that he/she committed some act or acts which have damaged the company’s profitability, reputation or good standing. As such your claims “derive from” (hence derivative) the harm caused to the company as a result of said business partner’s unlawful conduct. These claims often take the form of “breach of fiduciary duty”, “embezzlement”, or “waste” just to name a few.  Under New York law there are very specific procedural requirements for commencing a derivative action including demanding that management cause the company to sue the member whose conduct is unlawful.

Oppressed Shareholder:  “Although the term ‘oppressive actions’ is not statutorily defined, the Court of Appeals has held that ‘oppression should be deemed to arise when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner’s decision to join the venture.” In re Dissolution of Upstate Medical Assoc. P.C., 739 N.Y.S.2d at 767. Oppression is analytically distinct from illegality and is subject to a “reasonable expectations” test. As the Courts have explained, “oppression should be deemed to arise only when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner’s decision to join the venture”. Given the broad “reasonable expectations” test, there is no all-encompassing list of acts that can be deemed oppressive, nor will the same acts be considered oppressive in every circumstance. Nonetheless, the most common and recurring forms of oppression include:

  1. The failure to declare dividends;
  2. Termination of a minority shareholder’s employment;
  3. Removal of a minority shareholder from management;
  4. Excessive compensation to the majority shareholders;
  5. Diversion of opportunities to other corporations and mergers under unfair terms;
  6. A change of policy concerning the distribution of corporate income, designed to offer no return on the oppressed shareholder’s investment in an attempted “squeeze-out.”;
  7. A shareholder who reasonably expected that ownership in the corporation would entitle him or her to … a share of corporate earnings, …, or some other form of security, would be oppressed in a very real sense when others in the corporation seek to defeat those expectations and there exists no effective means of salvaging the investment.
  8. Efforts of majority shareholders to void a minority shareholder’s shares, falsify corporate documents, and prevent minority shareholder access to corporate records;
  9. The actions of a majority shareholder group in eliminating the petitioner and associated persons from participation in the active operation of a corporation in which they had previously participated, and in which have included they had every reasonable expectation of being able to continue to participate.

As you can imagine the analysis is fact sensitive and law sensitive and particularly messy especially where the parties’ expectations are not sufficiently laid out in well drafted corporate governance agreements.

Embezzlement or Misappropriation: This refers to theft or misappropriation of funds placed in one’s trust. Often these allegations rear their ugly heads when the money gets tight and paranoia sets in.  Again, having the right business structure can further a quicker resolution to these types of disputes.

Self Dealing: Self-dealing is the conduct of a fiduciary or trustee that consists of taking advantage of his position in a transaction and acting for his own interests rather than for the interests of the company, shareholders or other beneficiaries.

Breach of Fiduciary Duty: A claim for breach of fiduciary duties can take many forms including allegations of: (1) waste of company assets, (2) self-dealing, (3) breach of duty of loyalty, (4) breach of duty of confidentiality, (5) breach of implied covenants (6) oppression, etc., but those claims are not absolute. Again, one would have to turn to the corporate governance agreement to determine the extent of those duties, whether the accused has a managing interest in the company, the expectations of the parties, whether the statutory body of law provides certain exceptions, and the available defenses under statute or case law such as the “business judgment rule” or Section 409 of the NY LLC Law. Breach of fiduciary duty claims are highly complex and often involve analysis and research by attorney, CPA’s and perhaps forensic accountants in order to understand the extent of one’s breach and the damages to the company or its shareholders.

Shareholder Status Disputes: In order to bring a dissolution proceeding for the variety of reasons that may be permitted under the Business Corporation Law, Partnership Law, or LLC Law, a threshold matter is proving your status as a shareholder/partner/member of the Company. In theory one could rely on tax documents such as K-1’s and the like. However, these are not absolute arguments. That is why it is critical that if you are going to establish any kind of partnership or be compensated by becoming a “part owner” of a company in any respect whatsoever, you have to have your agreement and status properly documented. The last thing you need is to spend $15,000.00 litigating a threshold issue.

Demand for an Accounting or Access to the Books and Records: Fiduciaries have a responsibility to account for the assets and liabilities of the company they manage. As such demanding an accounting from a fiduciary who has allegedly breached his duties to the company or its shareholders is a common sense cause of action in most shareholder disputes or business-breakups.

The “Fixes”

Some of the above causes of action are based in statute, some on contract theory. But they all can be prevented or mitigated by well drafted corporate governance agreements such as a “partnership” agreements, employment agreements, or buy-sell agreements. Having the right corporate governance agreement accomplishes one critical thing. It manages and sets forth the expectations of the parties which when looking to the “breach of fiduciary duty” claim or “oppressed shareholder” claim, is a critical part of the analysis. In doing so, issues regarding management of the company, compensation, special duties, shareholder status, and company purpose are all (hopefully) clarified and explained at length.  The buy-sell agreement is of particular import. The buy-sell agreement sets an objective valuation mechanism which can substantially mitigate against the extraordinary costs of a shareholder valuation dispute.

 I find that these issues are most common in the closely held business or family owned business where good friends or family work together in a casual manner under the illusion that the relationships that bind them are unbreakable.  Let’s set the record straight. Business is the most personal thing there is for the startup, entrepreneur or investor.  Bringing personal relationships into a highly personal venture without setting proper boundaries and expectations is nothing short of a recipe for disaster.

Spend the money now so you don’t have to spend 10 times the money later, or worse, lose the hard earned fruits of your labor.

The Law Office of Jeffrey K. Davis, Esq. is a full service business-law firm dedicated to providing business owners with resourceful counsel at all stages of the business life-cycle. Providing Practical Legal Solutions. Call for a free consultation.

Construction Contracts: Some Basics

Not all construction contracts are created equal. That’s because every construction project is different. There are however two underlying themes (which arguably are necessarily intertwined) from the attorney’s perspective and that is (a) proper risk allocation and of course, (b) getting paid.

However, before allocating risk one must first understand the specific risks in the given project. Risks become apparent when taking into account site conditions, accessibility, safety, scheduling, and other project specifications. These conditions all dictate how the contractor will perform its work which in turn effects the liabilities the contractor has assumed.

There are various provisions in a construction contract which specifically address risk and they include (without being an exhaustive list): (1) scope of work (2) scheduling (3) changes to the scope of work (4) delay and damage provisions (5) insurance (6)  standard of care, (7) storage of materials and risk of loss and (8) express warranties of the work performed.

An effectively negotiated contract protects the contractor, owner or subcontractor (depending on the client) from potentially devastating disputes by consistently ensuring the fairest and legally enforceable provisions when it comes to risk allocation. The same is true whether we are talking about a simple job or a complex project. Simple contracts quite frankly make me nervous. They make me nervous because they don’t address all of the different possible circumstances that may impose risk or liability on the contractor or business owner. As an attorney, simplicity can be frightening, if not frustrating, because  that means when the time comes for a dispute between the owner and contractor, matters of risk allocation are left for interpretation by the Court i.e. expensive litigation.

As mentioned before, attorneys (and their clients) are not only concerned with risk allocation but are (or should be) very concerned with getting the client paid if the client is the contractor or subcontractor. This is where it is important to review and understand (1) any conditions to getting paid, (2) procedures that need to be followed in order to get paid (3) strict procedures for any change orders or extra work and (4) the timelines that limit one’s right to bring a lawsuit to enforce a debt. Each of the foregoing can critically effect your ability to get paid and as such it is imperative that you have a properly drafted contract which sufficiently and fairly addresses the process of getting paid for your services, labor, and materials.  Although conditions to getting paid or enforcing a debt may be strict, that doesn’t necessarily make them enforceable. Therefore, if your attorney cannot assist you in negotiating more favorable terms, your attorney can at the very least assist you in understanding the critical payment-related provisions of the contract and help you structure an effective contract management process.

Construction Contracts: Managing Disputes

The purpose of this guide is to briefly address some of the legal issues and tools pertaining to a breach of a construction contract. This is not an all-inclusive list but a very good start for any construction company looking to collect or enforce a debt, foreclose on a lien, or assert any other contractual right.

1

Mechanic’s Liens

A mentor once told me “anytime I’m asked to file a lien for a client the first thing I do is break out in a cold sweat”. A little dramatic? Well, not necessarily. There are many nuances to filing a lien.

First, you have to make sure you named all the correct and proper parties in your lien. This always requires some additional research into the proper legal name of the entity or individuals who own the property you are seeking to lien against.  Therefore you certainly want to consider reviewing the New York Department of State website, ACRIS, and you should probably order a title search as well if you are going to be extra prudent.  Failing to name the correct parties in your lien could be devastating to your claim.

Next, you should evaluate whether you have a right to even file the lien against the party in question. For instance, you may not be able to file a lien against a tenant (i.e. a non-owner) unless the owner had actual knowledge of the work you were performing at that property. This is a fact sensitive inquiry and may require review of things such as the lease/commercial lease.

Another important issue pertaining to the filing of the lien is whether your work is the type of work contemplated under the lien law. For instance, the installation of networking capabilities in an office building may not be considered lienable work because it may not be considered the type of “permanent improvement” contemplated under the lien law.

You should also consider in great detail the amount claimed under your proposed lien. Overstating your lien could subject you to a counter claim for a willfully exaggerated lien which could expose you to liability.  Prior to filing a lien you may want to consider an informal accounting.  This would entail creating a functional spread sheet breaking down your claim into dates of service, invoices, dates of invoices, and dates of any claims extra work. You should also gather all signed contracts and correspondence pertaining to completed work, resolved issues, and authorization to perform additional work.

In sum, before filing your lien you should review your claim with a skilled attorney so you can ensure that upon demand (or in response to a demand for a verified statement) you can easily and readily substantiate your position. Finally, remember that timing is everything. Just because you file a lien within the time period under the lien law statute doesn’t mean you’ve necessarily preserved your claim. The contract between you (the contractor) and the owner may impose additional limitations to commencing a lawsuit which in turn might effect the time period to foreclose (enforce) your lien. Again, review of the contract documents by an attorney is always a wise investment.

2

Trust Fund Accounting Claims

As a subcontractor (or a contractor) you are entitled to what’s called a trust fund accounting claim. By way of example, a general contractor receives money from the owner. The general contractor has an obligation by law in New York to pay those monies out to its subcontractors. The general contractor is under the lien law a “trustee” in that it holds in trust for the benefit of its subcontractors the monies received from the owner. The subcontractor in this scenario is the trust beneficiary. You as the subcontractor are entitled to demand from the general contractor a verified accounting of all the monies received and paid out by the contractor as it pertains to the project or work. This is no small demand. It requires the sophistication of a skilled attorney or accountant and it is expensive to produce. As such, it is a powerful tool for the subcontractor. What makes this an even more powerful tool is the fact that under New York Lien Law there may be personal liability where an accounting is not produced under the assumption that failure to produce the accounting is part of a scheme to embezzle or misappropriate trust funds. Do not overlook this weapon in your breach of contract arsenal! Feel free to email me for a free form or demand letter.

3

Account Stated

An account stated cause of action is when you send someone invoices and they do not contest those invoices for a prolonged period of time (generally more than 5 months) the amount stated in the invoices is deemed “admitted”.  This is a powerful claim as well and highlights the importance of having a well developed paper trail especially when it comes to billing. A defense to an account stated claim would essentially be that one either never received the invoices or that one contested the invoiced amount in a timely manner.  Therefore, after you’ve sent several invoices and there has been no response from the other side, the wise thing to do is to send the invoice by certified mail so you have a record of sending the invoice and a record of the other side having received the invoice.  It’s not rocket science but since the overwhelming majority of small business owners do not implement strong debt collection practices, it is worth reiterating here the importance of proper business correspondence and accounts receivables protocol.