Legal Landmines

Reporting Personal Information of Business Owners

Happy New Year from Congress! Overriding President Trump’s veto, on January 1, 2021, Congress passed the Corporate Transparency Act to require reporting personal information of business owners. Millions of small businesses will be required to report the names, birth dates, addresses and driver’s license numbers of their “beneficial owners” (those who own 25% or more of the equity or exercise “substantial control”). The stated purpose of the new law is to combat use of “anonymous shell companies” for money laundering, terrorism and other illegal activities. The reported personal information may also be used for tax and other enforcement purposes. Willful failures to report or submitting inaccurate reports result in $500 per day penalties and up to two years imprisonment. As with most legislation, implementing regulations are required to detail the requirements and performance standards.

Relief. Legislative sledgehammers equally impact legitimate companies with targeted offenders. Some relief from this additional layer of business regulation includes:

• Companies existing on the effective date of the implementing regulations may defer reporting for up to two years after effective date. Companies created after the regulations effective date will likely be required to report earlier.
• Taxable entities that employ more than 20 full-time employees in the U.S., annually report more than $5 million in gross receipts to the IRS and have a physical office in the U.S. will be exempt from reporting.
• Certain regulated entities already subject to significant reporting requirements (political organizations, banks, insurance companies, securities broker and investment advisors, and insurance companies) will be exempt from reporting. However, financial institutions will be subjected to significant operational requirements.

Privatized Enforcement. Whistleblowers will receive 30% of monetary penalties collected in enforcement actions seeking more than $1 million in sanctions. Acting in effect as deputized private enforcers, whistleblower employees and others will be protected by law.

Two Questions with a $5.8 Billion Answer…

Q1. Can an acquirer cancel a hotel chain acquisition if the business suffers a “material adverse effect” (“MAE”) after the M&A agreement is signed? On November 30, 2020, a Delaware court answered this question by analyzing the following COVID-19 scenario: two out of 15 hotels were closed; food and beverage operations in the remaining 13 hotels were limited or eliminated; 5,200 employees were furloughed; and work weeks and compensation of the remaining employees were reduced.
Answer: NO. In AB Stable VIII LLC v. MAPS Hotel and Resorts One LLC, 2020-0310, a 200+ page opinion, the Delaware court held that the buyer could not terminate the acquisition for these material and adverse effects on the business.

Q2. Did the M&A agreement provide other mechanisms for acquirer to cancel its purchase?
Answer: YES.

MAE and Other Closing Conditions. Most M&A agreements have multiple termination mechanisms. This case illustrates one “back door” when the MAE “front door” is closed.

1. The definition of an MAE in acquisition agreements typically excludes several types of events (thus causing the acquirer to assume the risk of the listed events). In this case, the court assumed that an MAE had occurred. To avoid closing, the acquirer argued that the MAE exclusions did not list pandemics, thus leaving the seller with this risk. The seller countered that pandemics fell within the listed exclusion for “natural disasters and calamities.” The court agreed forcing the acquirer to look elsewhere for a termination right.

2. M&A agreements condition closings on seller’s performance of its covenants and on seller’s representations and warranties being true at closing. This M&A agreement contained, as do most, an interim operating covenant (IOC) requiring the seller to conduct business “only in the ordinary course of business consistent with past practice in all material respects.” While acknowledging that the seller was forced to make extraordinary business changes to survive the pandemic, the Court held that these changes breached seller’s IOC covenant.

Outcome: Not only did the acquirer avoid closing, it recovered its deposit and litigation costs.

See here, here and here for more M&A-related articles and the effect of confidentiality agreements on selling your business.

Don’t Let an Impasse Stop You

No Impasse Required

Conventional Wisdom? Shareholder differences can paralyze and destroy a business. Even without economic justification, conventional wisdom recommends an “impasse” to exercise a “push-pull,” “Texas shootout or showdown,” “Russian roulette” or similar “reversible” buy-sell provision.  Too often disputes destroy working relationships long before the shareholder or director impasse trigger is reached.

No Fault Divorce. An easily exercised push-pull prevents bitter feuds rivaling the epic “no holds barred” divorce battle in “The War of the Roses” movie. Rather than damaging the business and share value, push-pull provisions should avoid standards requiring business impairment. Legal documents cannot adequately capture concepts such as disgruntled, recalcitrant or uncooperative – yet each of these underlying conditions can damage a business and the value of the ownership interests before an impasse finally occurs.

Mechanics. When a push-pull provision is exercised, one of the shareholders is leaving. The reversible nature of the offer insures fairness. The party proposing the buyout submits the price and terms on which it would buy the other owner’s shares or, at the election of the receiving party, sell its own shares.

Don’t Overlook. Taking a lesson from the multi-decade Hatfield and McCoy feud, push-pull mechanisms should include the seller’s affiliates and permitted transferees (typically family members) as part of the selling group. Since push-pull provisions typically use a “price per share” offer approach, a shareholder making a disproportionate cash infusion needs to consider loaning the funds with appropriate loan documents. Other arrangements in these provisions should include mutual releases, repayments of amounts owed between the Company and the departing shareholder(s), and indemnification for corporate obligations which have been guaranteed by the departing shareholder(s). For additional considerations, see Legal Landmines – Partnerships and Sinking Ships.

Neither this post nor any other content on this website creates an attorney-client relationship or constitutes legal advice for any particular situation.

Founders Forever with Multiclass Equity

With multi-class equity, founders can retain control of a business even after its ownership has been broadly dispersed by estate planning, equity incentive and other transfers.

Originating with dynastic enterprises that continue to control major U.S. enterprises, modern tech giants developed a more sophisticated approach that is useful to smaller enterprises. Although applicable to all business entities, corporate terminology will be used for simplicity.

Historically, buy-sell agreements and voting trusts have been used to maintain control of closely held companies. Permitted share transfers to family trusts and their subsequent distributions of shares to beneficiaries create uncertainty as the trust (prepared by the shareholder’s attorney) may not operate as anticipated due to death, incapacity or withdrawal of trustees or unforeseen contingent events. While usually enforceable, the objectives of buy-sell agreements may be frustrated by (i) a shareholder’s bankruptcy, (ii) unsatisfied corporate law proxy requirements, and (iii) arcane legal doctrines (such as the Rule Against Perpetuities) invalidating voting and family trusts based on hypothetical events and timing.

Anticipating contingent events affecting estate plans and third party arrangements is a challenge best avoided. If business control is the objective, narrowing the focus to a founder’s control of shares owned by trusts and other entities simplifies documentation and increases the odds of success.

Founder control can be organically preserved by granting in the corporation’s charter (certificate of formation) super-voting rights only to shares held by founders and, if the founder retains exclusive voting control and dispositive power over the shares, their estate planning entities (“Permitted Transferees”). Examples of Permitted Transferees include family trusts of which the founder is the sole trustee or an entity exclusively controlled by the founder through ownership, contract or other means. A founder’s loss of exclusive voting control or dispositive power becomes a “Conversion Event” with an automatic “step-down” in the voting rights of the affected shares.

Illustration

Three classes of common stock (identical in all respects except voting) are designed for the following shareholder classes:

Share Ownership

* Class C (10 votes per share) = 10,000 of 11,000 votes; Class B (1 vote per share) = 1,000 of 11,000 votes.

Conversion Event. A founder transfers 500 Class C shares to a non-Permitted Transferee (which automatically convert to 500 Class B common shares in the hands of the non-Permitted Transferee):

Finale. At the time when none of the founders have exclusive voting and dispositive rights, all Class C shares (including those owned by their family trusts and other entities) automatically convert into Class B shares for a traditional single vote per voting share.

Flexibility

Founder control structures may be calibrated to specific targets by class voting arrangements and different definitions of Conversion Events (IPO, minimum ownership, disability, etc.). Publicly traded companies frequently exempt additional situations from voting step-downs to spread control among broader groups of family members and senior management.

Relationship to Buy-Sell Agreement

Dual class equity structures focus on control to enable founders to pursue their vision for the business. Buy-sell agreements (see part II of Family Business Succession Planning) for privately held companies remain important for preserving the economic benefits of ownership through share transfer restrictions (shareholder bankruptcy, death, default, disability, divorce, etc.), rights of first refusal (by class), push-pulls, drag-alongs, tag-alongs, shareholder contributions and insurance funded buyouts.

Neither this post nor any other content on this website creates an attorney-client relationship or constitutes legal advice for any particular situation.

Legal Landmines – Feeling Trapped in your Business?

Early Exit Planning is the Key

Preparing for Departure. It’s inevitable – you will leave your business. To avoid being trapped in your business, early exit planning allows you to leave by attracting buyers and improving valuations. While there are various exit scenarios, statistically speaking selling your business is the most viable voluntary exit. Proper planning can maximize business value for sale or for your family.

Protect Assets and Retain Key Employees. Protecting the business assets (with employee intellectual property assignments, confidentiality and noncompetition agreements) and incentivizing key employees to transfer increases the value of a business. “Golden handcuff” bonus arrangements can boost business valuations by:

• tying employee bonuses to performance benchmarks impacting value (such as EBITDA in most cases); and
• vesting employee bonus awards over time (economically incentivizing employees to continue with a purchaser).

Time Improves Outcomes. There is a reason that most professionals recommend exit planning start at least three years in advance. In the chart below, the left axis and golden columns depict annual growth in business value (assuming a 6X multiple of EBITDA growing at 5% per year from $100,000). The right axis and blue line reflect the unvested employee bonuses forfeitable on quitting (assuming employee bonuses equal 15% of EBITDA with awards paid over five years). These results improve with the length of time that the bonus arrangements have been in place.

May 6, 2019

Legal Landmines – Partnerships and Sinking Ships

Owner Buy-Sell Agreements Make A Difference

Lifeboats. Owner Buy-Sell Agreements are the lifeboats keeping your business partnership afloat by addressing avoidable internal risks.

Sinking Ships. I woke up this morning to rising water when I found out:

• I am in business with:
  • my partner’s ex-wife, widow and/or children
  • my competitor
  • someone I don’t know
• I am running the entire business while sharing the upside with:
  • a departed or incapacitated owner
  • a departing employee/owner who walked away from his employment “commitment”
• I can’t make estate planning transfers for my family
• my co-owner sold his interest on lucrative terms leaving me behind
• my business is dying from an owners’ impasse
• my co-owners are “free-riding” on my capital without contributing their share
• my business sale is being held up by a small co-owner’s “ransom” demand
• my S corporation tax election was terminated by a co-owner’s sale

Plug, Bail or Abandon? Plugging holes requires less pain, cost and effort than bailing against rising water. If neither of these work, abandoning ship may be the final alternative. All business relationships end. Even the record-setting 104-year-old relationship between Ford and Firestone ended acrimoniously in 2001. If you don’t want to go down with the ship, have lifeboats ready for the inevitable and unavoidable! Additional information regarding buy-sell agreements is available in Part II (Buy-Sell Agreement) of this post.

June 13, 2019

Legal Landmines – It’s the Little Things

Signatures…           and…          You Can’t Sell What You Don’t Own

I Signed Up for Personal Liability. The different signature blocks in a recent Canadian transaction reminded me of a frequent and costly mistake. An agent signing on behalf of a principal is not liable for the principal’s obligations under U.S. law. When signing as an officer (agent) on behalf of a company (the principal), the company, and not the officer, would be liable on the $1.5 million contract… assuming the officer properly signed as an agent. Otherwise, with the stroke of a pen, the officer exchanges zero liability for $1.5 million personal liability on the contract. A proper signature format is:

COMPANY NAME

By: ______________________

John Doe, President

What Do You Mean My Tech Company Doesn’t Own Software? The buyer’s attorney tells his client that your company does not own its principal asset and that your company can only sell a copyright infringement lawsuit. Herein lies the faulty assumption that you own the software you hired a consultant to write. Although there is never a good time to make this discovery, some times are worse than others:

• during due diligence for the sale of the company;
• after the software becomes enormously valuable (leading the consultant to realize he was grossly underpaid when he wrote the software); or
• after the consultant has died.

One week ago, the Second Circuit Court of Appeals joined the 7th and 9th Circuits by ruling that a “work made for hire” agreement must be signed with a contractor/consultant before the “work” is created. Because a “work made for hire” written agreement did not predate the magazine columnist’s writings, his estate was allowed to sue the magazine for copyright infringement when it republished the columnist’s articles.

August 8, 2019