Does a negative “Say on Pay” vote trigger a breach of fiduciary duty claim?

The Dodd-Frank Act, passed in 2010, includes the so-called “Say on Pay” provision for publicly traded companies. This provision requires that, at least once every three years, the shareholders of a publicly traded company must vote on its executive compensation arrangements. In addition, the shareholders also vote at least once every six years on the frequency of the “say on pay” vote.  Shareholders are able to elect whether the vote will happen once every one, two, or three years.  In most companies, the shareholders have chosen to have the “say on pay” vote conducted annually.  Publicly traded companies are also required  to disclose, in any proxy solicitation asking for the approval of a merger, acquisition, or other sale of the company, any compensation from “golden parachutes” that would be triggered.  Shareholders also have a chance to “approve” (or not approve) such golden parachute payments. [Read more...]

Do managers of Delaware LLCs have the same fiduciary duties as directors of Delaware corporations?

Recently, the Delaware Court of Chancery issued a ruling on the question of whether a manager (or managing member) of a Delaware limited liability company owes fiduciary duties to the company and its members.  The court ruled that it does.

As a legal practitioner, this result is unsurprising.  I think most business lawyers, both when representing LLC managers and when representing LLCs and their members, operate under the assumption that a manager owes a fiduciary duty of care and loyalty to the company and its members.[1]  What is somewhat surprising is (a) that this conclusion was ever in doubt and (b) more importantly, in light of recent comments made by the Chief Justice of the Delaware Supreme Court, this conclusion may still be in doubt if the ruling is appealed. [Read more...]

5 Legal Mistakes Often Made By Startups

Entrepreneur magazine recently posted an article on their blog describing five overlooked legal mistakes that entrepreneurs often make. It’s a good worthwhile read. The mistakes mentioned are:

  1. Making handshake deals (i.e. not in writing) with clients and vendors.
  2. Choosing the wrong business structure (i.e. sole proprietorship, LLC, Corporation).
  3. Entering into a partnership without a detailed written agreement.
  4. Entering into a 50-50 partnership.
  5. Filing a trademark without doing a detailed and extensive search before hand.

I wholeheartedly agree with four out of the five common mistakes. Perhaps the one I may partially disagree with is mistake number 4: entering into a 50-50 partnership. 50-50 partnerships can certainly present challenges when it comes to governing a company and general decision-making when there is a deadlock between the partners. However, I think categorically ruling out such an arrangement is a mistake. Rather, if the partners desire to establish a 50-50 partnership and that relationship is important to them, they should plan ahead and consider adding detailed provisions in their partnership agreement which deals with deadlocks. In addition, the company buy-sell provisions will have to be carefully considered as well.

Article Referenced: Five Overlooked Legal Mistakes Entrepreneurs Make

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Even in deals with “yourself,” you still need proper legal documents.

One situation I often encounter with small businesses is that sometimes they don’t always document the transactions they enter into with their owners and other related parties. For instance, let’s say that two owners of a corporation decide that their corporation needs more funding. However, they don’t want to invest more equity into the business. They are willing to extend a loan to their company and expect to get paid back over the next few years with interest. Here’s how that should work (assuming this company is a C Corporation):

The corporation would make payments of principal and interest back to the shareholders. The corporation would be able to deduct the interest as an expense. The owners would not need to pay taxes on the principal but would pay taxes on the interest. There are no double taxation issues because the interest expense is deducible to the corporation.

Unfortunately, small business owners often don’t take the time to properly document transactions like this. They may enter it into their accounting books, but the don’t prepare any loan documents, nor do they prepare any board resolution authorizing the company to enter into the loan. After all, from the owners’ perspective, this is a loan to “themselves” and it seems like a waste of time and money to have official documents prepared. This can cause a couple of problems down the road.

First, if the IRS audits the company, they will ask to see the loan documents and resolutions authorizing the transaction. When the owners can’t produce them, the IRS can (and often does) recharacterize the transaction as a dividend. As a consequence, the loan interest is no longer deductible. Therefore the owners will pay double taxation on the interest. In addition, depending on the capital structure, the principal payments could also be deemed a taxable distribution, thus causing the owners to pay income taxes on the return of principal (which never would have happened had the transaction been properly documented as a loan).

Another area where this can cause problems is when the owners decide to sell their business or sell an interest in it to outsiders. Failing to properly document earlier transactions can cause problems in due diligence, which any sophisticated purchaser or investor would perform on a business he intends to acquire. The process of cleaning the mess up could be expensive (far more expensive than simply having documents prepared from the outset.)

A loan is just one example of the type of transaction that should be documented even when made between related parties. Another example is leases. Many business owners lease their own property to their business. But if they don’t prepare a written lease, the rent payments could be recharacterized as dividends or distributions. Here’s a couple of other examples: employment agreements, service agreements, purchases and sales of assets, and sale-leaseback transactions. All of these transactions between a business and its owners should have some level of legal documentation.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Should new business owners set up their business as a Wyoming LLC?

Previously, I have written about the advantages and disadvantages of incorporating in Delaware or Nevada as a small business owner. With regards to Delaware, my conclusion was that, for most small companies, the disadvantages outweigh any advantages. With regards to Nevada, my view was that it is highly uncertain that many of the advertised benefits of incorporation in Nevada, such as greater asset protection and greater liability protection, would actually materialize. In this piece, I’ll cover my thoughts on another state that is frequently pitched as a good place for forming your business: Wyoming.

Wyoming limited liability companies are heavily marketed on the internet as a great option to form a new business. Wyoming has the distinction of being the first state to have a limited liability company statute, which apparently was created as special interest legislation for an oil company. Because of Wyoming’s long history with LLCs, Wyoming LLCs are highly promoted as being superior to the LLCs of other states (usually by companies that offer to do the formation for you…for a fee). The fact that Wyoming was the first state to have an LLC statute doesn’t really benefit a business owner, of course. The three major substantive selling points that are used to promote Wyoming LLCs are: (1) superior asset protection, (2) lower taxes, and (3) lower fees. For the reasons described below, it is highly unlikely that a business owner would actually realize any of these benefits if they were to organize their business as a Wyoming LLC.

The first major substantive selling point is that Wyoming LLCs supposedly have superior asset protections. Wyoming law provides that the sole remedy available to creditors of owners of LLCs is a charging order. A charging order is an order by the court directed to the company ordering the company to send all distributions that would have gone to the owner/debtor to the judgment holder instead. This limitation can make it more difficult for a creditor to collect on their judgment because the creditor will not be able to force the debtor to sell his ownership interest in the company. Usually, after a creditor obtains a judgment against a debtor, the creditor is entitled to sell the debtor’s personal property to satisfy that judgment. However, if the creditor’s sole remedy is a charging order, then the creditor is entitled to whatever distributions are produced from the ownership interest (if any at all), but the creditor cannot transfer or sell that ownership interest. Having this protection can give a debtor more leverage in negotiating a settlement. However, the charging order limitation is not unique to Wyoming. Most states’ LLC statutes provide that the sole remedy to a creditor of a member is a charging order. It is true that Wyoming has extended the charging order limitation to single member LLCs, whereas many other states do not provide such a protection in the case where an LLC has only one owner. However, it is important to note that if a lawsuit takes place in your home state or in some other state besides Wyoming, conflicts of laws principles may cause the law of a state other than Wyoming to control whether a creditor may be able to obtain a lien on or a forced sale of a debtor’s interest in a Wyoming single member LLC. In other words, judges often have a lot of discretion as to which state’s laws apply in multi-state cases and often begin with the assumption that the law of the forum applies, unless a party can show that another state’s laws have greater contacts or interests in the case. Therefore, you cannot be sure that your own home state won’t go ahead and apply its own law to the situation, notwithstanding whatever Wyoming law states. Therefore, for people interested in asset protection, I’d recommend taking steps other than forming a Wyoming LLC. See my post on Nevada corporations and LLCs for links to more information on what steps your should take for asset protection.

Another major selling point that is used in promoting Wyoming LLCs is that Wyoming has no income tax. Unfortunately, since most LLCs are pass through entities, which pay no taxes themselves, this is of limited benefit. For instance, if you live in another state that has a personal income tax, and form a Wyoming LLC, all the income would be passed through to you and you would still end up paying state income taxes. Therefore, forming an LLC in Wyoming is not an effective tax avoidance method. In addition, if your state does impose an income tax on LLCs at the entity level (which for instance my own state of Tennessee does), and your LLC operates a business in your state, then your LLC would still end up paying the state income tax regardless of Wyoming’s income tax, because it is the entity’s presence in a state which controls whether it is taxed there, not its state of incorporation.

The final major selling point that is used to promote Wyoming LLCs is that the fees to organize them and the ongoing annual fees are lower than other states. This is certainly true. But if you live outside of Wyoming, and organize your business as a Wyoming LLC, your business will almost certainly be doing business in your home state. In that case, your LLC will be required to qualify to do business in your state, which usually involves paying a fee equal to what your company would have paid had it simply been organized in your own home state. Therefore, you are unlikely to realize any cost savings from organizing your LLC in Wyoming (Nevada and Delaware entities present this same issue as well).

As with Delaware and Nevada entities, I don’t think there is much advantage to using a Wyoming LLC, as opposed to an entity formed in your home state (unless of course, your home state is Wyoming). You will end up incurring double the fees, because you will have to pay Wyoming’s fees and then pay your own state’s fees to obtain authorization for your Wyoming LLC to do business in your own state. Despite this additional cost and complication, it is uncertain whether you will see any of the benefits, such as greater asset protection, that are often promised in connection with incorporation in Wyoming, nor are you likely to see any tax savings. In addition, if there were ever litigation among the owners, you may be forced to conduct that litigation in Wyoming, which could end up being highly inconvenient and expensive. Therefore, unless there is some specific reason to set up your company in Wyoming, I’d avoid using a Wyoming LLC.

As always, your final choice in entity selection should be based on your own specific situation. Therefore, before making any final decisions on your form of business, you should speak with your attorney.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.