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

March 15, 2012 By Leave a Comment

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.

However, except for the vote on the frequency of “say on pay” votes, none of these votes are actually binding.  They are simply there to provide an outlet for the shareholders to express their views on management’s compensation.  In addition, the law specifically states that the vote doesn’t create any new or alter existing fiduciary duties of the company’s board of directors.  To date, only 37 companies’ boards have received a negative “say on pay” vote.

However, a number of creative plaintiff’s lawyers have tried to use a negative “say on pay” vote as evidence of a breach of fiduciary duty.  How have these claims fared?  Not very well.  Below is a quick summary of the cases where this line of reasoning has been used and the results thus far:

Teamsters Local 237 Additional Security Benefit Fund, derivatively on behalf of Beazer Homes USA, Inc. v. McCarthy (Georgia Superior Court; decided September 16, 2011).  This case, litigated in Georgia Superior Court applying Delaware corporate law, arose out of a negative “say on pay” vote that occurred after the board voted to increase executive compensation.  The court reasoned that because the negative vote occurred after the board’s action, the negative vote could not be used to prove a breach of fiduciary duty by the board.  In addition, the court ruled that, under Delaware law, the negative vote of the shareholders could not be used as evidence to rebut the business judgment rule presumption.[1] (Unfortunately, the ruling was given orally and no written opinion was issued to date, limiting its precedential value).

NECA-IBEW Pension Fund, derivatively on behalf of Cincinnati Bell, Inc. v. Cox (Southern District of Ohio; decided September 20, 2011).  Here, a federal court applying Ohio corporate law, refused to dismiss a similar case prior to discovery and trial.  The basis used is that Ohio law differs from Delaware law.  While Ohio has its own version of the business judgment rule, according to the court, it “imposes a burden of proof, not a burden of pleading” which effectively means a board can’t have the case dismissed prior to discovery (or even trial).  Thus Ohio corporate law would seem to be more friendly territory for plaintiff’s attorneys in “say on pay” suits.

Plumbers Local No. 137 Pension Fund v. Davis (U.S. Federal Court, District of Oregon; decided January 11, 2012).  This case is another “say on pay” suit involving a company called Umpqua Holdings Corporation.  In this case, a magistrate judge recommended that the case be dismissed.  The court applied Oregon corporate law, though the court noted that Delaware law often provides guidance for Oregon courts in areas of corporate law that are undeveloped.  The court adopted the holding of Beazer and criticized the holding of Cincinnati Bell, rejecting the notion that a negative “say on pay” vote can rebut the presumption of the business judgment rule.

Laborers’ Local v. Intersil (Northern District of California; decided March 7, 2012).  Here, a federal court applied Delaware law and dismissed a derivative claim against a board of directors based on a negative “say on pay” vote.  The court held that a “say on pay” vote “alone is not enough to rebut the presumption of the business judgment rule.”  The opinion also criticized the Cincinnati Bell decision.

The Cincinnati Bell decision has caused great concern within corporate America.  It has the possibility of encouraging further lawsuits each and every time the shareholders of a corporation vote against the company’s compensation package.  That said, other courts appear to be rejecting its holding, which may in the long run establish a firm rule that negative “say on pay” votes may not be used as evidence of a breach of fiduciary duty by a board.

Footnotes

[1] Essentially, the business judgment rule, under Delaware corporate law provides that a court will not substitute its own notions of what is or is not sound business judgment if the directors of a corporation “acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”

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© 2012 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.

Filed Under: General Business Law Tagged With: , , , , , , ,

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

March 1, 2012 By Leave a Comment

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.

The case is called Auriga Capital Corporation v. Gatz Properties, LLC.  It arose from a failed golf course venture, where the land on which the golf course is situated was leased by an LLC from a family affiliate of the LLC’s manager.  The LLC was funded by outside investors who owned a minority interest in the LLC.  The LLC then subleased the land to American Golf Corporation. The terms of the sublease permitted American Golf to terminate its sublease in early 2010. Because the golf course was unable to operate profitably, American Golf exercised its early termination option.  Ultimately, the LLC was put up for auction and was bought by the manager at a low price, resulting in a large investment loss to the minority members.  The minority members filed suit alleging that the manager engaged in a pattern of intentional mismanagement, including rejecting a serious offer from a 3rd party for a purchase of the LLC that would have earned the minority members a full return on their investment.   They further alleged that this intentional mismanagement constituted a breach of the manager’s fiduciary duties.

One of the issues in contention was whether, in the absence of any language explicitly addressing the issue, a manager of a Delaware LLC owes fiduciary duties to the company and its members.  While the Delaware Limited Liability Company Act does not expressly provide that the traditional fiduciary duties of care and loyalty apply by default to the managers or members of an LLC, the court concluded that such duties are implicit. Indeed, the Delaware General Corporation Law also does not explicitly provide for fiduciary duties for a corporation’s management and yet they are indisputably present.

This conclusion is in line with the expectations of most parties to Delaware LLC operating agreements and with the expectations of most attorneys who draft them.  However, whether this conclusion will be upheld on appeal is somewhat in doubt.  At a recent seminar, Chief Justice of the Supreme Court of Delaware Myron Steele stated that “[c]ourts should not imply traditional fiduciary duties when LLC agreements are silent.”  He based this on the fact that limited liability companies are new entities based on contracts and are not derived from common law.  Given that Delaware’s LLC Act emphasises freedom of contract (in section 18-1101(b)) and that contract law provides some level of protection to parties of LLC operating agreements through the implied covenant of good faith and fair dealing, his conclusion was that if an LLC’s operating agreement does not expressly provide for fiduciary duties of managers, “courts should assume the parties did not want [fiduciary duties] to apply at all.”  These statements are in direct contradiction to the holding of Auriga, and if Chief Justice Steele should find that two or more other justices on Delaware’s Supreme Court agree with him, the holding may be overturned on appeal. [2]

In light of this decision and in Chief Justice Steele’s subsequent comments, drafters and parties to LLC operating agreements should be careful to include unambiguous language on whether they intend to include, eliminate, or restrict fiduciary duties. In addition, while this is not a new issue, in contrast to the Delaware General Corporation Law or the limited liability company acts of many other states, Delaware’s Limited Liability Company Act permits parties to an LLC operating agreement to waive a manager’s fiduciary duties.  This itself may come as a shock to many seasoned corporate practitioners since fiduciary duty, especially the duty of loyalty, is generally regarded as an unwaivable duty in many other situations.

Footnotes

[1] The fiduciary duties of care and duty of loyalty arise from common law.  Under Delaware corporate law, the fiduciary duties of care and loyalty require that a corporation’s directors (1) must act in good faith, with the care of a prudent person, and in the best interest of the corporation; (2) must refrain from self-dealing, usurping corporate opportunities,
and receiving improper personal benefits; and (3) make decisions made on an informed basis, in good faith, and in the honest belief that such action was taken in the best interest of the corporation.

[2] The Delaware Supreme Court has five members.

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© 2012 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.

Filed Under: General Business Law Tagged With: , ,

5 Legal Mistakes Often Made By Startups

September 14, 2011 By 5 Comments

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.

Filed Under: Startups and Venture Capital Tagged With: , , ,

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

September 8, 2011 By 2 Comments

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.

Filed Under: General Business Law Tagged With: , , , , , ,

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

September 5, 2011 By 30 Comments

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.

Filed Under: General Business Law Tagged With: , , , , , ,
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