Business Divorce Red Flag #5: Business With Unsupervised & Distant Branch

“When the cat’s away, the mice will play.”

Proverb

Introduction

Nothing screams business divorce potential like an unsupervised and distant branch office of a business. 

By unsupervised I mean that the people in charge of the branch are not well known to the owner who put them there, or that the owner is so infrequently present to oversee its operations that resident owners or personnel are tempted to steal, self-deal and treat the branch like their personal piggy bank and playground.

By distance I mean that it is usually an office in a different state or country. Typically, if the branch is outside of car commuting distance, the potential for business divorce skyrockets. Trips often have to be announced, giving the branch office time to prepare for a visit. Offices in foreign countries provide extra opportunities for things to go awry. Naturally the company’s main office is relying on the expertise of the branch’s resident owner to know the foreign arena in which the branch operates.  Legal, accounting and financial complexities of a foreign country give the branch owner cover to plot and hatch nefarious deeds under the radar.

In the following case study, a foreign company client learned the hard way that opening up a United States branch by going into business with a stranger who ran the business unsupervised was a recipe for business divorce.

The Case Study

SwiftTube is a foreign leading manufacturer of pneumatic (airtube) systems. These systems transport materials by using pressurized air to propel containers from one area to another. Examples of their applications include bank drive through systems that carry money and documents between the customer and teller; hospital systems that transport patient specimens from treatment areas to internal labs; and retail systems that allow a cashier to transport money from a register to an internal safe.

SwiftTube sought to expand its operations into the United States. In order to do so, SwiftTube entered into a distribution agreement with a smaller company located and operating in the United States, VacuPipe, owned by Charlie. The agreement appointed VacuPipe to sell, market, distribute and service SwiftTube’s products in the United States. Subsequent discussions between SwiftTube and Charlie led to the agreement to jointly form a new company to sell, market, distribute and service SwiftTube’s products in the United States. In furtherance of the agreement, SwiftTube USA was formed. Charlie was made a 30% owner (LLC member) and CEO of SwiftTube USA; SwiftTube was made a 70% owner of SwiftTube USA; and Javier, the CEO of SwiftTube, was made managing member of SwiftTube USA. Also as part of the agreement, SwiftTube purchased the assets of VacuPipe. The agreement, however, provided that VacuPipe was solely responsible for any outstanding debts it owed to creditors. In addition, Charlie agreed to cease operations of VacuPipe and to carry on the business of selling, marketing, distributing and servicing SwiftTube’s products in the United States under SwiftTube USA. Moreover, SwiftTube periodically infused SwiftTube USA with working capital.

Economic conditions and other market challenges negatively affected SwiftTube USA’s financial performance. As a result, SwiftTube was compelled to infuse it with additional working capital. Charlie, however, had never contributed working capital to SwiftTube USA. Because SwiftTube USA was in near financial collapse, SwiftTube agreed to allow SwiftTube USA to withdraw funds from the bank account of SwiftTube’s wholly owned subsidiary, SwiftTube Canada. The monies withdrawn by SwiftTube USA from the bank account of SwiftTube Canada, less genuine installation expenses incurred by SwiftTube USA, was a loan by SwiftTube to SwiftTube USA payable on demand. Factoring in genuine installation expenses, SwiftTube USA owed SwiftTube nearly half a million dollars. SwiftTube separately loaned SwiftTube USA another six figure sum so that SwiftTube USA could have working capital to perform work for a large retail client in the United States and Canada.

Due to distance and vastly different time zones, SwiftTube experienced difficulty overseeing SwiftTube Canada’s operations. Accordingly, Charlie was tasked with management of SwiftTube Canada’s affairs. Because SwiftTube questioned Charlie’s transactions concerning SwiftTube Canada, it arranged for a comprehensive audit of SwiftTube USA and SwiftTube Canada to be carried out by its accountant. Because Charlie failed to give SwiftTube’s accountant free access to the financials of SwiftTube USA and SwiftTube Canada, he was unable to conduct a complete investigation. The accountant’s partial investigation revealed that the bank accounts and books of SwiftTube USA and SwiftTube Canada were commingled, giving an inaccurate financial picture of both entities.

Upon further investigation, Javier learned through a SwiftTube USA employee that Charlie admitted to the use of SwiftTube USA’s funds in a six-figure amount to pay debts of his company, VacuPipe. This occurred despite Charlie’s agreement that he was responsible for VacuPipe’s debt and that SwiftTube did not assume its debts as part of the deal. Moreover, Javier uncovered that Charlie also used SwiftTube USA’s funds for personal use. 

That was the last straw for Javier. Frustrated with trying to run SwiftTube USA from overseas, and faced with the prospect of continued dealings with and misconduct of Charlie who he could not trust, Javier wanted out. Against my advice, he attended an attorney-free meeting with Charlie and they drafted a “back of the envelope” memorandum of understanding (MOU). In the MOU, SwiftTube agreed to a potential deal to sell its 70% interest in SwiftTube USA to Charlie, but Charlie had to fulfill several conditions. Those conditions included Charlie purchasing a life insurance policy in the amount of the purchase price and naming SwiftTube as the beneficiary; personally guaranteeing the purchase price payment; and indemnifying Javier for any tax liability imposed by the IRS. Because Charlie failed to meet those conditions, and never made efforts to reduce the MOU to a written agreement, Javier asked me to get Charlie out of SwiftTube USA and recover the loans and stolen funds.

We filed suit on behalf of Javier and SwiftTube against Charlie and SwiftTube USA. The complaint alleged claims for breach of contract, unjust enrichment, conversion, breach of fiduciary duty, breach of the duty of loyalty and expulsion of Charlie as a Member of SwiftTube USA. Charlie unsuccessfully moved for summary judgment, arguing that the MOU was a binding contract to sell the business and that Javier and SwiftTube breached the agreement by filing the lawsuit. The court denied the motion and flatly rejected this argument, with the obvious conclusion that no binding contract resulted from the MOU. Throughout the lawsuit, Charlie failed and refused to produce key financial documents and a deposition witness that would shed light on the issue of whether he had used SwiftTube USA funds for personal expenses. This resulted in an Order suppressing Charlie’s Answer and dismissing his Counterclaims, paving the path to victory for Javier and SwiftTube.

Summary

The story of SwiftTube is a testament that a business with an unsupervised and distant branch is a flaming red flag for business divorce. While expanding markets to different states and countries is always an exciting proposition, it is one fraught with risks. In counseling my clients in business divorce prevention in this area, I always advise that it is highly desirable to put mechanisms in place to greatly reduce the risk of malfeasance. For example, ideally, a trusted owner or executive from your own office should relocate to the branch and spend a year or more getting the branch up and running, and developing a level of trust for the remote owner. This is not always possible, however. Regardless, the company should do other things to decrease risk. For example, the branch should maintain a Web based accounting platform so that the books can be accessed at all times; the owners should have access to all bank accounts, and they should be internet accessible; two signatures on checks over a certain amount should be required; you should hire independent accountants and attorneys in the foreign jurisdiction who are not connected to the branch owner (you can do this by leveraging your own network); you should have the foreign accountant prepare monthly and quarterly audited financials, and your own domestic accountant should review and, if they are suspicious, audit them; and you should have regularly scheduled meetings (weekly, monthly, quarterly and annual), and at least the annual meeting should be in person. 

Of course, the financial practicalities will likely govern the extent to which a company can and should oversee the operations of its foreign branch. But whatever the budget, it is imperative to take a measured effort to reduce the risk of opening an unsupervised and distant branch.

For a complimentary 15 minute strategy session with Rocco Luisi about mediation of business divorce, text “mediation” to (646) 759-1974 or go to www.businessdivorcebook.com