Business Divorce Red Flag #3: Insufficient or No Written Ownership Agreement

“It is not worth the paper it is written on unless it is backed by the kind of force that will make the other side consider the penalties too heavy to break the agreement.”

Yitzhak Rabin

Introduction

You would be surprised by the number of businesses with significant revenues that I have run across over the span of three different decades that have either an insufficient written agreement, or no written agreement at all. This precarious state of affairs is a sure signal for a business divorce waiting to happen.

With respect to insufficient agreements, fundamental and crucial terms are either absent, unclear and/or ambiguous. Topics include valuation, voting and deadlocks, voluntary and involuntary owner removal, voluntary and involuntary transfer of ownership, restrictions on transfer of ownership, inspection of books and records, dispute resolution, succession, and adjustment of profit sharing due to changed circumstances.

The complete absence of a written agreement typically is found in family businesses where trust or, more often, the matriarch or patriarch, reigns supreme. Although the business laws of most states have “gap filler” provisions—the imposition of terms by law in the absence of an agreement—they are often disadvantageous to some business owners, and are frequent culprits of business divorce. 

One problematic example is a default unanimous vote. A business matriarch with majority ownership may be surprised by a lawsuit filed by some of her children to prevent the new son-in-law from being appointed her successor. The matriarch and her children always operated under the assumption that majority vote ruled. But the children, threatened with the loss of power and control of the business, consulted an attorney who informed them that their mother needed a unanimous vote in the absence of a written agreement providing otherwise. 

Another gap filler that may cause problems leading to business divorce is one that allows owners to demonstrate that there was an oral operating agreement, or imply one based on the owners’ course of conduct. A fact-sensitive claim of this sort is sure to result in protracted and expensive litigation that will likely require a trial to resolve disputed issues of fact.  And do not forget that the side that loses has the right to appeal to multiple higher courts.

In addition, some state business laws have as their default provision in the absence of an agreement to the contrary that distributions and allocations of profits and losses are made on a per capita basis and not, as most businesses typically operate, on the percentage ownership of each shareholder.

A further example is a default gap-filler that gives all owners equal voting power on all issues, regardless of their percentage of ownership. While such a voting structure may be desirable to approve actions outside the ordinary course of business, the largest or majority shareholder may not want that arrangement. It certainly would not be desirable to most such high percentage owners for decisions in the ordinary course.

A final example of a troublesome gap filler is one that requires mandatory indemnification of all owners, regardless of the charge levied against them. Do you really want to indemnify an owner charged with intentional bad conduct such as sexual harassment if he loses the lawsuit? A more troubling example may be the owner who breaches his fiduciary and loyalty duties to his co-owners, is sued by the company and her co-owners, and they have to indemnify him. Such a provision leaves the non-breaching co-owners in a precarious spot. Do they really want to sue and pay the breaching owner’s legal fees? Dissolution may be a better alternative. A preferable provision is one that generally allows for indemnification but carves out certain exceptions for intentional misconduct.

The following case study demonstrates that having an unclear or ambiguous agreement is a certain red flag for business divorce.

The Case Study

Holly was a successful mortgage broker and the sole shareholder of her own mortgage company, Excelsior Mortgage. Holly was introduced to principals of my client, Trustworthy Bank. Their meeting was serendipitous, as the Bank was looking at that time to acquire another mortgage company in order to lend monies that it had acquired through an aggressive interest rate offer on its savings accounts and certificates of deposit. 

Discussions between Bank executives and Holly regarding the Bank’s acquisition of Excelsior ultimately resulted in the execution of a Letter of Intent in which the parties agreed on the basic terms of the deal, including that Holly would become a minority shareholder of the Bank and that the Bank would purchase Excelsior for a certain high six-figure sum.  After the acceptance of the Letter of Intent, negotiations between the parties ultimately resulted in the execution of a written agreement.  Importantly, pursuant to the terms of the agreement, the Bank contracted to do the following:

[Bank] shall have obtained all necessary governmental or regulatory approvals to permit it to acquire [Excelsior’s] Stock and operate [Excelsior] as a subsidiary . . . .

At the time of the Letter of Intent, the Bank had acquired another mortgage company, Major Mortgage.  In reliance upon the Letter of Intent and on the representations of Bank executives that the deal would go through, Holly merged Excelsior’s operations into those of Major Mortgage at Major Mortgage’s location.  To that end, Holly relocated all of Excelsior’s furniture, equipment and staff to Major Mortgage’s offices.  Although Excelsior continued to operate under Holly’s control, she was designated and assumed the function of managing the entire operation, including those of Major Mortgage.  Holly was not employed by Major Mortgage, but she was held out to the public as being one of its Vice Presidents.  In addition, some of Excelsior’s staff working at the Major Mortgage location performed services for Major Mortgage without Excelsior being compensated for it.

Notwithstanding the fact that the terms of Excelsior’s purchase had not yet been memorialized, the Bank agreed to compensate Holly.  As part of the deal, Holly would be a contract employee of Excelsior for five years at a six figure salary.  In that role, she managed an office of approximately 60 employees and worked, on average, approximately 70 hours a week.  

All seemed to be going according to plan. As part of its due diligence, the Bank arranged for a consultant to conduct a due diligence review of Excelsior’s operations.  Afterwards, negotiations for the purchase of Excelsior continued and later culminated in the execution of the agreement.

After the agreement was signed, the Bank approached Holly to modify it to decrease the purchase price of Excelsior.  Holly alleged that the Bank’s executives coerced Holly to attend a meeting without her counsel and induced her to execute an amended agreement that restructured and lowered Excelsior’s purchase price.  The amended agreement included the same provision quoted above that required the Bank to obtain government approval of the deal. After that time, Excelsior was essentially functioning as an independent operation at the Major Mortgage site.  However, with the execution of the amended agreement, Excelsior began processing all its business through Major Mortgage.  As such, Excelsior ceased operating as an independent entity and lost its identity in the marketplace.

Throughout the course of negotiations, Holly proceeded under the assumption that the Bank had been filing all of the necessary documents to obtain government approval for the Bank’s acquisition of Excelsior pursuant to the terms of the agreement and the amended agreement.  The Bank had sought and obtained approval from the State Department of Banking.  The Bank, however was unable to obtain federal regulatory approval from the Board of Governors of the Federal Reserve System.  Due to the Bank’s deteriorating financial condition, the federal regulators issued a Cease and Desist Order that prevented the Bank from acquiring additional assets. 

As a result, the Bank terminated the amended agreement, and terminated Holly’s employment.  Holly then moved Excelsior out of Major Mortgage’s facility to another location. According to Holly, the Bank successfully coerced several of her key employees to remain at Major Mortgage, essentially stripping Excelsior of its operational capability.

Holly and Excelsior sued the Bank and several of its executives personally, seeking damages for the failed transaction. They asserted two claims for breach of contract, one focusing on the alleged failure of the bank to submit an application to obtain regulatory approval for the transaction, and the other on the Bank’s alleged knowledge of and failure to disclose its poor financial condition and inability to obtain regulatory approval before Holly moved Excelsior to Major Mortgage. They also asserted three fraudulent non-disclosure claims concerning (1) movement of Excelsior’s operations, (2) the agreement, and (3) the amended agreement. They also included a cause of action for civil conspiracy. 

In essence, counsel for Holly and Excelsior tried to turn a breach of contract case into a tort case by painting the Bank executives’ conduct as fraud. I successfully moved for summary judgment and obtained dismissal of the three fraud claims, as well as the conspiracy claim.  In addition, the Court granted my motion to bifurcate liability and damages, which meant that the first part of the trial would only involve evidence about liability and, if plaintiffs lost, they would never present a case on the monetary value of their damages. This was strategically important because evidence of damages typically favors the plaintiffs, as they get to weave into their story to the jury the amount of money and nature of the damages they allegedly suffered. 

Due to my pre-trial motion victories, all that was left for trial were the two breach of contract claims. My theory of the case was simple: the agreement provision about obtaining regulatory approval did not require the Bank to submit an application to the federal regulators because the Federal Reserve Bank had already prohibited the Bank from acquiring additional assets. Plaintiffs, on the other hand, claimed that it required the Bank to submit an application to the federal regulators. While the Bank had knowledge of its declining financial condition prior to execution of the agreement, the fact that the Federal Reserve Bank issued its Order barring the Bank from acquiring additional assets after the amended agreement was executed also weighed in the Bank’s favor. Seeing that the case was not going their way, we were able to settle the case for a song in the middle of trial.

Summary

The case study of Holly and Trustworthy Bank illustrates a key lesson in business divorce: make sure you have an agreement that contains clear and unambiguous terms, as well as terms that address essential issues. The provision about the Bank obtaining regulatory approval was unclear. It did not compel the Bank to submit an application to either state or federal regulators. It only stated that the Bank needed to obtain approval. It did not contemplate the situation that occurred, i.e., that the regulators barred the Bank from going through with the transaction. From Holly’s perspective, it should have compelled the Bank to submit an application to approve the transaction to both sets of regulators by a date certain. The agreement also from her perspective should have included a provision that the Bank had a continuing obligation to represent it was in sufficient financial condition to obtain regulatory approval. Holly also should have insisted on a provision compensating her if the transaction was not approved so she could be made whole from moving and merging Excelsior into Major Mortgage. Liquidated damages, a guaranteed employment contract, or ownership in the Bank or Major Mortgage could have been remedies under such a provision.

For a video that reviews some gap fillers in the Delaware LLC Act, text “delaware” to (646) 759-1974 or go to www.businessdivorcebook.com