The Business Judgment Rule and Director Liability

The business judgment rule is a legal concept that gives the directors and officers of a corporation a measure of protection against liability while they are conducting business for their corporation.  Directors and officers are entrusted with the responsibility of managing the corporation’s affairs.  In this role, they often face difficult questions concerning whether to sell assets, acquire or merge with other businesses, expand to new areas of business, or issue stocks and dividends. In addition, they may  be forced to deal with  hostile takeovers by other businesses.

The courts have been sensitive to the challenging nature of  the  decisions the directors and officers must make. Under the business judgment rule, the officers and directors of a corporation are protected from liability for losses incurred in corporate transactions within their authority, as long as there is sufficient evidence that the transactions were made in good faith and with reasonable skill and forethought.

Doing business inherently involves having to make decisions which may be controversial or risky in nature. Boards of directors might not be able to act freely and in the best interest of their corporations if they had to constantly be concerned about the potential for a lawsuit from shareholders. The business judgment rule gives them the freedom to make decisions without the constant fear of litigation.

Drafting a Buy-Sell Agreement

A buy-sell agreement is meant to protect the interests of the business and all the partners involved by establishing guidelines for selling the business shares. A company’s buy-sell agreement should dictate when shares can be sold, in what manner they can be sold, and the price at which they can be sold. The agreement will protect the business in the event that certain life changes occur, such as divorce, bankruptcy, death, or the dissolution of partnerships.

When you sit down with your partners to discuss a buy-sell agreement, there are a number of things you should consider to avoid future conflict. You should decide how to handle the sale of shares by a partner in the event of a partnership dissolution. Will a partner be allowed to sell shares to a third-party buyer, or will the partner be required to offer the shares to another partner before offering shares to a third party? Will the selling partner need the consent of the other partner(s) before selling shares?

A buy-sell agreement should also establish  procedures in the event that a partner faces  divorce. Will his or her former spouse be required to sell any shares received through the divorce back to the other partner(s)? If so, how will the value of these shares be determined?

Another important issue to discuss when drafting the agreement is how to proceed in the event of a partner’s death.  Will the remaining partner(s) be obligated to buy the deceased partner’s stock from his or her surviving family members? Alternatively, will the family be obligated to sell the shares to the remaining partner(s)?

Finally, your buy-sell agreement should detail how you will manage a partner’s personal bankruptcy. Will the bankrupt partner be required to give the other partner(s) notice before filing for bankruptcy?

When drafting a buy-sell agreement, it’s a good idea to consult a corporate attorney, who can offer advice on avoiding conflicts.

Important Considerations When Investing in Private Placement Offerings

Some people consider an investment in a Private Placement Offering (PPO) to be speculative and highly risky. While there is a certain amount of risk to investing in PPOs, there are regulations in place that are meant to protect those investors who choose to participate in these offerings. Generally, investors must meet the qualifications of accredited status in order to participate in a PPO. Investors must be capable of enduring the loss of their total investment and must not require the invested funds for living expenses, retirement, or other purposes.

Before investing in a PPO, a potential investor should consider the following questions:

• How well do you know the company or entrepreneur offering the investment?
• How much do you stand to lose or gain with the investment?
• How does the law protect you and does the investment comply with all applicable regulations?
• What type of investment is it? Debt or equity?
• Can the impact of taxes be minimized?
• Can you protect yourself by establishing an entity with which to do business ?
• What are the rights and obligations of investors?
• How does the company plan to use the proceeds of the PPO?
• What is the subscription procedure for the investor?
• Are there  conflicts of interest involved with the investment?

Most PPOs are accompanied by a Private Placement Memorandum (PPM). This document is intended to provide investors with detailed information about the investment so that investors can make informed decisions.

Initial Staff Guidance on Revised Net Worth Test for “Accredited Investor”

In our post dated July 19, we noted that as a result of the adoption of the Wall Street Reform Act, one of the definitions of “Accredited Investor” was amended to exclude from the calculation of an investor’s net worth the value of the his or her primary residence.  In late July, the SEC Staff offered interpretive guidance with this new provision.  The staff noted that Section 413 of the new act does not take into account mortgages and other indebtedness that may be secured by an investor’s primary residence. Until such time of issuance of amendments to Regulation D to reflect the new accredited investor standard, the staff indicated that any such secured indebtedness, in an amount up to the “fair market value of the residence, should be excluded in calculating an individual’s net worth.”  However, “any such secured indebtedness in excess of ‘fair market value’ of the residence should be ‘considered a liability and deducted from the investor’s net worth.’”

Negotiating Shareholder Agreements

Shareholder agreements are documents that provide businesses with a roadmap of how to act in certain situations.  A shareholder agreement is negotiated and executed so that common procedures will be established before any business problems develop.  Generally, the most important issues contained in shareholder agreements are those that address stock ownership.  A shareholder agreement can achieve two important purposes with regard to stock ownership: it can control when a stock is sold and to whom.

A shareholder agreement can also limit a stockholder’s actions after his are sold.  Some shareholder agreements include non-compete clauses that prevent a stockholder who sells his shares from directly competing with the business for a defined period of time.  In order to be enforceable, this provision must be carefully written so as to allow the selling shareholder the opportunity to make a living and not unduly restrict economic competition.  If these previsions are discussed thoroughly when the agreement is being drafted, it is less likely that shareholders will run into conflicts in the future.

A shareholder agreement can also contain other important provisions regarding how a business is run.  A shareholder agreement can:

• explain the process for the addition or withdrawal of a shareholder.
• require a majority vote among stockholders on certain issues.
• describe how future capital contributions will be made to the business and how these contributions may affect ownership rights.
• outline how deadlocks will be resolved.
• establish procedures for conflict resolution if a dispute arises among stockholders.

These are only a few of the elements a shareholder agreement can contain. Shareholder agreements should be carefully and thoroughly discussed and prepared.  These agreements will prove to be invaluable to your company, and it is important that all shareholders have the opportunity to discuss the terms they’d like included.

Conducting Follow-On Offerings

After completing  an initial public offering (IPO), a company may  decide to offer additional securities, either debt or equity, to the public. These offerings are referred to as “follow-on” offerings because they follow the IPO. There are two different types of follow-on offerings:

• A primary offering is a public offering of securities that is made directly by the company, usually  in an effort to raise additional capital. This kind of offering is referred to as dilutive, because as the new shares are created and sold, the number of shares outstanding increases and this causes a dilution of earnings on a per share basis.
• A secondary offering is a public resale offering by stockholders or other security holders of the company. This is not newly-issued stock, and the offering does not increase the number of shares of stock  outstanding. In a secondary offering, the company does not receive any proceeds; the proceeds go to the stockholders. This type of offering is referred to as non-dilutive because no new shares are created.

Sometimes a follow-on offering consists of both a primary and a secondary offering, such as when a company is registering additional shares of common stock but also allows some of  its stockholders to sell  shares in the same offering. Companies may choose to make follow-on offerings  to raise financing for expanded operations; because they have become cash-deprived and need to finance their current operations; or because they wish to repay debts.

If your company is considering  a follow-on offering, you should consult a corporate attorney who can advise you of the legal issues involved.

The Benefits of a Multi-Tier Corporate Structure

As businesses grow, it is not uncommon for them to establish and control several subsidiary companies. Establishing subsidiary companies can be of great benefit to a parent company, as they offer the opportunity to expand the business with minimal risks. Subsidiaries can be formed in different ways and for various reasons. A corporation can form a subsidiary either by purchasing a controlling interest in an existing company or by establishing the company itself.

One of the most important benefits of having a subsidiary company is that, in general, liabilities and credit claims are locked in that subsidiary and cannot be passed on to the parent company. This is because, although a parent company may control a subsidiary, the subsidiary and the parent company are considered separate legal entities. A company would choose to establish a subsidiary if it prefers not to expose its assets to the liabilities associated with the new enterprise. If the subsidiary company runs into financial trouble, the parent company’s assets and its credit rating may be legally protected.

While subsidiaries and their parents are considered separate legal entities for liability purposes, they can be considered a single economic entity for the purpose of filing financial statements. In choosing to establish a subsidiary, a parent corporation can, therefore, gain valuable tax benefits. Adopting a subsidiary structure gives the parent company the ability, on federal income tax returns, to offset profits in one part of the business with the losses in another.

If your business is considering establishing a subsidiary company, you should contact a corporate attorney who can help you navigate the legal and tax issues involved.

FINRA to Brokers – Time to (Further) Open Up the Kimono

Financial Industry Regulatory Authority (FINRA) has announced that it is expanding its free, online service, BrokerCheck, to reveal additional and more detailed information concerning brokers and brokerage firms.

Changes being made to BrokerCheck include the following:

•           All historic complaints dating back to 1999 for individual brokers who are currently registered or whose registrations were terminated within the preceding 10 years will be listed.  Generally, historic complaints are defined as “customer complaints, arbitrations or litigations more than two years old that have not been adjudicated or have been settled for an amount less than the reporting requirement (currently $15,000).”

•           The expanded BrokerCheck will make a former broker’s record public for 10 years, so investors can access information about individuals who may work in other sectors of the financial services industry or who have attained other positions of trust.

•           Additional information that has been reported to FINRA since 1999 will become permanently available – including reportable criminal convictions or pleas of guilty or nolo contendere; civil injunctions or findings of involvement in a violation of any investment-related statute or regulation; and arbitration awards or civil judgments based on the individual’s involvement in alleged sales practice violations.

•           Brokers will be able to submit a written notice of the dispute to FINRA – FINRA will post the appropriate form on its website – with all available supporting documentation. If FINRA determines that the dispute is eligible for investigation, it will add a general notation to the broker’s BrokerCheck report, stating that the broker is disputing certain information in the report, and that notation will only be removed when FINRA has resolved the dispute. If its investigation shows the information is, in fact, inaccurate, FINRA will update, modify, or remove that information as appropriate.

•           All of these changes will be implemented by the end of the year.  The BrokerCheck expansion will be implemented in two phases. In late August, historic complaints will be added to the public records of all current and former brokers. By the end of the year, full records will be publicly available for all brokers whose registrations have terminated within the last 10 years. Also by the end of the year, the additional information that will be permanently available will be added to the records of the appropriate former brokers, and the formal dispute process will be fully in place.
 
Full details on BrokerCheck’s upcoming expansion will be available in a FINRA Regulatory Notice to be published in the near future.

Modifications to “Accredited Investor” Definition

Buried deep in the (literally) thousands of pages in The Dodd-Frank Wall Street Reform and Consumer Protection Act are changes to Regulation D and the accredited investor definition.

Currently, individuals are accredited investors if either:

• their net income exceeded $200,000, or joint net income with their spouse exceeded $300,000, in the two most recent years (and there is a reasonable expectation of reaching the same income level in the current year), or
• their net worth, or joint net worth with their spouse, exceeds $1 million.

Although Dodd-Frank does not currently change these dollar thresholds, the value of an individual’s primary residence must now be excluded in determining whether his or her net worth exceeds $1 million; until now, the value of home was allowed to be included in determination of net worth.  This change will be effective immediately upon President Obama’s signing the bill into law and will remain in effect for at least four years thereafter.

We recommend that our investment banking and broker-dealer clients review and update their subscription documents and offering materials to reflect this new definition of accredited investor.  In addition, careful attention should be paid to updating the files of current investors to ensure they meet the new standard.

Furthermore, under Dodd-Frank, the SEC has been ordered to review and adjust any other accredited investor standards applying to individuals during the four-year period after the law’s enactment.

Adopting an Operating Agreement

The purpose of an operating agreement is to establish the rights, powers, duties, liabilities, and obligations of the members between themselves and with respect to the LLC. An operating agreement aids your LLC by guarding your limited liability status, heading off financial or management misunderstandings, and making sure your business is governed by the rules you establish.

All of the elements in an operating agreement should be carefully considered and then customized to fit the needs of all involved parties. This is especially important when an LLC consists of two or more members.

Generally, an operating agreement should address the following issues:

• The purpose of the LLC, including its scope of activity
• The members’ percentage interest in the LLC
• The members’ rights and responsibilities
• Voting power of each member 
• Day-to-day management of the LLC
• How conflicts of interest will be resolved
• How minor and major decisions will be made
• The distribution of profits and allocation of losses
• Guidelines for admission and withdrawal of members
• Buyout provisions

Each of these elements will depend on the scope and nature of your business. When drafting an LLC operating agreement, it is best to consult a corporate attorney who can help you adopt operating rules that will allow your company to reach its full potential.

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