The following outline is an example of the many, complex, and diverse aspects of a closely-held corporation where small business contracts become critical for its perpetuation. Elniski Law has the experience and knowledge to ask the right questions when forming your business or contractually solidifying corporate protocol in a growing company.
What is a Pre-Nup in Business?
- Clarification of relationships and roles in a small business, closely-held corporation, or partnership.
Why do we need Business Pre-Nups?
- Simply, and plainly, to avoid disputes in even the closest of relationships.
What is a Closely-held Corporation?
When businesses incorporate.
Ownership and management overlap.
Decisions can be made more easily and rapidly.
*No ready market exists for trading the shares*
Public Company Differences Essentially:
More strict corporate governance.
Compliance with securities laws.
More ability/access to working capital.
Can delegate debt throughout all shareholders.
Common but not-so-common Facts about Closely-held Companies:
95% are family owned.
Provide employment for approximately 50% of the nation’s population.
Only 20% of family-owned businesses survive longer than a generation.
Great potential for shareholder oppression because minority shareholders cannot escape mistreatment by selling stock on public market to exit corporation.
Chernichaw A, Oppressed Shareholders in Close Corporations: A Market-Oriented Statutory Remedy, Cardozo L. Rev., (1994).
Means, Benjamin, A Voice-Based Framework for Evaluating Claims of Minority Shareholder Oppression in the Close Corporation, 97, Georgetown Law Journal, (2008).
Key Types of Contracts to Consider Upon Incorporation:
Articles of Incorporation
Employment Contracts for each shareholder
Stock Option/Purchase Agreement
Example of Minority Shareholder Freeze Out.
Investor or Beneficiary
Families tend to disregard basic corporate protocol.
Families have emotional attachments to business.
Points To Pre-Consider If and When Dissension Arises.
- Triggering Events
- Disability (consider length of necessary disability)
- Divorce by one owner (ex-wife digging through company financials?)
- Bankruptcy by an owner (bankruptcy trustee involved in company?)
- Desire of one party to get out of the company
- Valuation Issues
- Determine value of shares by unanimous agreement either through an appraisal or formula.
- Triggering event should trigger appraisal update.
- “Chinese Auction” – one party submits price he would either be willing to buy OR sell. Other party has option to either buy OR sell for that price.
- Funding Issues.
- Installment Contract
- Cash reserves
- Company redemption v Cross purchase
- Will company redeem shares or will majority shareholders?
- This decision affects the valuation of the company and a shareholder’s basis in the company.
Minority Shareholders and Oppression in Closely-held Corps.
Majority shareholders take unfair actions against minority shareholders
Minority shareholders’ shares are valueless
Majority shareholders may harm minority’s economic interests
Refuse to declare dividends
Attempting squeeze out or freeze out.
Physically locks minority out of their business by changing locks
Denying minority right to inspect records and books
Majority Rule basically allows shareholder majorities to use minority’s investment without paying for it.
All makes it necessary for minority to sue in order to receive compliance, benefits, or a fair market exit.
What is the Minority Shareholder’s Remedy?
BCL affords limited options
Requires minority to raise issues (ex. Majority self dealing) at Board meeting and motion for Board take action against the self dealers
Note: BCL terms ‘minority shareholder freeze out actions’ as deadlock among shareholders.**
Shareholder’s Derivative Action (expensive) (win-ask company for fees)
Involuntary Dissolution under BCL 1104 (deadlock) or 1104a (illegal and/or oppressive conduct)
Can trigger buyout-must be willing to accept
Risk = illiquidity discount
Ownership of capital stock is by no means identical with or equivalent to ownership of corporate property.”
Agreements tend to provide for voluntary sale and do not normally anticipate an action for dissolution or an election to purchase minority interest (1118) as a remedy for fraud, corporate waste…minority freeze out based on majority wrongdoing
Direct Action against majority individually (must be able to pay for it)
Ask court to hold majority accountable for fiduciary responsibilities or dissolve
What is the “reasonable expectations” of the minority shareholder?
‘Fair Dealing’ standard is also sometimes used by courts.
Difficult to determine how to deal with the rights of the minority shareholder without destroying the corporation, while still respecting the rights of the majority shareholder
LLC Differences and Dissolution
The LLC Dissolution Statute Distinguished from its Corporate and Partnership Counterparts
The analysis section in 1545 Ocean, as its first order of business, tells the bench and bar what the standard for LLC dissolution is not, namely, it is not the standard developed for close corporations under the Business Corporation Law (BCL). Matter of 1545 Ocean Avenue, LLC, 2010 NY Slip Op 00688 (2d Dept Jan. 26, 2010).
The Standard: (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.
Upon the enactment of New York’s LLC Law in 1994, the statute contained a single section denominated §702 governing judicial dissolution of the newly recognized entity. The section provides in its entirety as follows:
On application by or for a member, the supreme court in the judicial district in which the office of the limited liability company is located may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement. A certified copy of the order of dissolution shall be filed by the applicant with the department of state within thirty days of its issuance. [Emphasis added.]
The section’s sparse language — drawn from the limited partnership dissolution statute but rarely examined in the partnership case law — created a vacuum into which many judges imported the relatively well-developed grounds for dissolution employed in cases involving close corporations under BCL §§1104 and 1104-a. It’s easy to understand why courts did so given the many similarities between, on the one hand, corporate shareholder-officers and, on the other, LLC member-managers, at least when it comes to the day-to-day realities of their internal relations and the pressures that lead to internal dissension.
Justice Austin notes that §702 was left unchanged when the LLC Law was amended in 1999 to conform to changes in federal tax treatment of LLCs, and from that concludes:
Since the Legislature, in determining the criteria for dissolution of various business entities in New York, did not cross-reference such grounds from one type of entity to another, it would be inappropriate for this Court to import dissolution grounds from the Business Corporation Law or Partnership Law to the LLC.
He then observes that, while there is no definition of “not reasonably practicable” in the context of LLC dissolution, “[s]uch standard . . . is not to be confused with the standard for the judicial dissolution of corporations or partnerships” (citations omitted). He notes that the BCL and Partnership Law by statutory definition apply only to business corporations and partnerships, respectively, and that “[l]imited liability companies thus fall within the ambit of neither the Business Corporation Law nor the Partnership Law.” He also cites §102(m) of the LLC Law, which likewise excludes corporations and partnerships from its ambit, in concluding that “the existence and character of these various entities are statutorily dissimilar as are the laws relating to their dissolution.”
Further reading on the LLC remedies, Dunbar Group, LLC v Tignor, 267 Va 361, 593 SE2d 216 (2004), where the Supreme Court of Virginia, calling the statutory standard for dissolution a “strict one,” reversed an order of dissolution based on deadlock between two 50-50 members of an LLC after the lower court had expelled one of the two members from participating in management; Kirksey v Grohmann, 2008 SD 76, 754 NW2d 825 (2008), where the South Dakota Supreme Court found the standard satisfied in a deadlock situation that left two of four sisters without any meaningful say in the LLC’s business affairs contrary to the operating agreement; and a partnership case, Taki v Hami, 2001 WL 672399 (Mich. App. 2001), in which a Michigan appellate court granted dissolution where the two partners had not spoken in years and there were allegations of violence and expulsion.
Second, LLC Law §411 permits an LLC to avoid contracts entered into between it and an interested manager or another company in which a manager has an interest, unless the manager can prove the contract was fair and reasonable. Crown Royal could have, but did not, take action against the contract with VHC under §411. On the contrary, Justice Austin stressed, Crown Royal “ratified, albeit grudgingly at times, Van Houten’s unilateral efforts.” In any event, he continued, “a fair reading of LLCL 702 demonstrates that an application to dissolve 1545 LLC does not flow from a claim under LLCL 411.”