The role of counsel in preserving and protecting a closely held business
Richard H. Goldman.
Many lawyers, accountants and business consultants advise closely held and family businesses. A critical time for these counselors occurs when the founder and sole owner starts to consider the role and responsibilities of the next generation, particularly if some of those adult children are employees of the business.
There are any number of scenarios that can play out and, of course, each client and each situation could demand a customized approach. That said, a seasoned counselor can simplify and efficiently tackle some issues.
The founder’s estate plan
If all the founder’s children work in the business, the founder will probably want each of them to receive an equal amount of stock in the business. If they don’t all work in the business, the founder may want to leave other assets to those not in the business.
When there are not enough business assets to provide a share or shares equal in value to the business assets, the founder may want to take out additional life insurance for the benefit of the nonactive child or children.
If there are still not enough assets to provide a share or shares for the child or children not active in the business, the founder should consider providing the nonactive child or children with a minority interest in business real estate, first and second, an interest or interests in the operating company.
If one or more nonstockholders have an interest in real estate leased to the business, there should be an arms-length lease between the landlord and the operating company. Separate counsel (as opposed to company counsel) should be engaged to represent the landlord.
Employment contracts
Each family member of the founder should have a written employment contract, which should include without limitation: term, compensation, duties, termination provisions (including death or disability), and what happens to the employee’s stock on termination.
If the stock is to be redeemed by the company, consideration should be given to funding the redemption, in whole or in part, by life insurance on the life of the employee.
If a stock redemption may be involved and is payable in installments, counsel has to examine the terms of any bank loan as to whether the bank will require the selling stockholder to subordinate his or her note to bank financing and whether the bank will permit payments on the note to seller, so long as there is no default to the bank.
The decisions here could include the respective roles and duties of the employees, including offices and service on the board of directors.
As a part of this phase, counsel should review the articles of organization, bylaws and other applicable agreements in light of the proposed changes in ownership and control.
Conflicts of interest and fiduciary duties
When the founder of a business transfers ownership to the next generation, the attorney for the founder has to re-examine who he or she can represent. If there is more than one stockholder and there are employment or other agreements between or among the stockholders and the company, the lawyer should not represent the company and a stockholder in connection with any agreement between the company and a stockholder.
The lawyer should explain to the client the duties of stockholders or owners of a closely held business to each other, including but not limited to the fiduciary duty of the majority owner to the minority and of the minority to the majority. This explanation should be based on state law applicable to the entity.
If the lawyer makes an investment in the company, he or she must make sure that the company is represented by another firm in connection with the investment transaction.
For example, in Baker v. Wilmer Cutler Pickering Hale & Dorr, a Massachusetts appeals court stated that “even though counsel for a closely held corporation does not by virtue of that relationship alone have an attorney-client relationship with the individual shareholders, counsel nevertheless owes each shareholder a fiduciary duty.”
In that case, the court noted that given the protections contained in the operating agreement, the minority members should have been able to rely on counsel hired by the company to have consulted with the minority prior to undoing protections which the minority had in the operating agreement.
Dispute resolution and deadlocks
Counsel to a closely held business should discuss with the client ways to resolve disagreements or disputes prior to commencement of litigation.
One possibility is an agreement that any unresolved dispute be submitted to mediation or arbitration. Counsel should explain to each client what is involved in each procedure.
In a mediation, a licensed mediator will meet with the parties, with or without counsel, and help the parties arrive at a mutually satisfactory solution. In many cases, the parties are accompanied by their counsel. The mediator is generally appointed by the president of a local bar association.
Many mediators are retired judges, but there are many experienced and well-respected mediators who are retired practicing lawyers or lawyers still in practice. The role of the mediator is to help the parties arrive at an acceptable resolution. The mediator has no authority to make any decisions. In many cases, mediation is successful.
If mediation is not successful, or the parties do elect to go to mediation, the parties may agree to have the matter resolved by binding arbitration without any right of appeal. Some parties do not like arbitration because they feel that the arbitrator may compromise the case rather than deciding for one party or the other.
However, it is a process that may be less time-consuming and less expensive than litigation. Also, the matter is not on the public record as would be the case in litigation.
Suppose you have a corporation which has two 50% owners who cannot work together. Neither is willing to sell the business to a third party or the other.
Consider negotiating a purchase and sale agreement without agreement on who is the seller and buyer and what the price will be. Each party then submits a sealed bid in writing to be opened in the presence of both parties and their attorneys. The successful bidder is the buyer, and the other party is the seller. Each party signs the agreement, and the buyer pays the deposit in escrow to an escrow agent selected by the parties in advance.
An alternative to this procedure is to have the parties agree on a purchase and sale agreement in advance and then have a private auction between them, conducted by a third person selected by the parties. Each party will be accompanied by his or her counsel. The high bidder becomes the purchaser, and the other party is the seller.
Either one of these procedures is an exit strategy that can enable the parties to solve an impasse.
Checklist for Transfer of Ownership
Despite the fact that it is a “business,” next-generation planning and dividing family-owned business assets can regenerate long-standing animosities and resentments. A savvy legal counselor will have to navigate the various personalities involved and coordinate the various legal proceedings during a stressful period. Having a checklist of key components to cover is a useful tool.
Review the founder’s estate plan. If possible, leave business interests and related real estate to family members in the business.
Review the articles of organization, bylaws for the business and operating agreements for any limited liability company.
Review the life insurance for the founder and any key employees.
Prepare employment contracts for the business, founder and key employees, including but not limited to family members.
If any real estate occupied by the business is owned by another entity, prepare leases at fair market rent between the real estate owner and the company; consider separate counsel for the company and real estate owner.
Consider stock redemption agreements between the company and the founder and/or others.
Examine any other transactions between the company and any employees and/or stockholders. If applicable, are they on fair market terms?
If there are to be any employment or other agreements and any stockholder(s), make sure the other party is represented by counsel other than company counsel.
Are there, or should there be, members of the board of directors or a separate board of advisers other than the family of the founder to advise on strategic planning included on relationship issues?
Should disputes be submitted to mediation and/or arbitration? Are there any other provisions, like a private auction between the stockholders, which should be considered?
If there are plans for future stock redemptions of stock, review the terms of any bank loans and make sure that if the bank requires subordination by selling stockholders, that the bank will permit payments to the seller, so long as there is no default to the bank.
One final point: The success of any business is in part due to the culture of the leadership. This includes their generosity in making compensation and other financial decisions and willingness to make concessions for others and having in mind the long-term future of the enterprise.
Richard H. Goldman is senior counsel at Sullivan & Worcester in the firm’s real estate and trusts and estates groups. His practice includes acquisitions and sales of commercial real estate, leasing, financing, probate and estate planning and representation of closely held businesses and nonprofit entities. He also is an adjunct professor of law at Boston University School of Law.
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