Forming an Inadvertent Partnership – Part 2

Posted on April 3, 2017 by Steve Robinson

A few weeks ago, I wrote a post entitled "Forming an Inadvertent Partnership".  You can find it here.   That post discussed the Texas Supreme Court's 2009 decision in Ingram v. Deere.

Since the Texas Supreme Court issued its opinion in Ingram v. Deere in 2009 establishing a new standard for courts to use in determining whether a general partnership has been formed among two or more persons, courts across the state have wrestled with applying Ingram’s “totality-of-the-circumstances test” to various factual situations.

The necessarily somewhat subjective nature of the test has sometimes led courts to opposite conclusions on fact patterns which do not appear to be readily distinguishable. Often the only way to reconcile those cases is by considering whether the fact-finding at the trial court was performed by a jury and the consequent standard of review engaged in by the appellate court.

For example, in Rojas v. Duarte, 393 SW 837 (8th Court of Appeals, El Paso, 2012), the court used a “legal sufficiency standard” to review a jury’s finding that the two men had formed a general partnership. The court explained that under this standard of review:

[We] review the evidence in the light most favorable to the jury’s verdict…. If more than a ‘scintilla of evidence’ exists to support the jury’s findings, it is legally sufficient…. More than a ‘scintilla of evidence’ exists when the evidence supporting the finding, as a whole, would enable reasonable and fair-minded people to differ in their conclusions…. [The] jury is entitled to resolve any conflicts in the evidence and to choose which testimony to believe…. Accordingly, we do not substitute our judgment for that of the jurors if the evidence falls within this zone of reasonable disagreement.

The court then measured the evidence produced at trial relevant to each prong of the partnership test identified in, and weighted as described in, Ingram:

1. Sharing profits: Rojas claimed Duarte was paid as an independent contractor for his efforts and the court agreed there was no evidence Duarte received a share of the profits. But Duarte testified the men had an oral agreement (all of the agreements Duarte alleged were merely verbal) to split profits and (unfortunately for him) Rojas had prepared written “split sheets” allocating net profits between them or, in Rojas’s testimony, showing what allocations would have been had the men been co-owners. The court concluded Duarte’s testimony and the “split sheets” of Rojas “constitute more than a scintilla of evidence of an agreement to share profits.”

2. Expression of intent to be partners: Despite Rojas testifying that he did not want Duarte to be his partner, three friends of Duarte testified that the two men presented themselves as partners at meetings. Scintilla of evidence established.

3. Control of business: The court looked for evidence that each partner possessed or lacked the right to make “executive decisions” including exercising authority over the business’s operations, writing checks on the business bank account, access to records and management of assets and money. Again, Duarte prevailed, not because he possessed equal authority with Rojas to make all executive decisions but because Duarte testified that he had power to make some executive decisions either alone or together with Rojas. Sharing or agreeing to share profits and participating in or having the right to participate in control of the business are the two most important factors in determining whether a partnership has been formed.

4. Sharing losses or liability: Sharing or having an agreement to share losses or liabilities to third parties “is not necessary to create a partnership” but “the existence of such an agreement supports the existence of a partnership” according to Ingram. The business here had no losses, but Duarte prevailed again because he testified (and the split sheets arguably reflected) that the two men agreed to share third party liabilities.

5. Contributions: Although Rojas denied that Duarte contributed any money or property to the business, Duarte testified that he agreed to leave his profits in the business (as well as contributed some tangible property).

The appellate court concluded that the trial court record contained:

more than a scintilla of evidence in support of each of the five factors …. Though the evidence as to each and every factor may not be conclusive, it is nonetheless sufficient to enable reasonable and fair-minded people to differ in their conclusions…. [There] is ample evidence in the record that Duarte shared profits and control over some aspects of the business, the two factors … that will probably continue to be the most important factors in determining whether a partnership exists.

Then, because Rojas lost his argument that there was no partnership between him and Duarte, he lost his argument that he had not breached a fiduciary duty to Duarte.

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Current Changes to Rules 504 and 505 of Regulation D

Posted on March 20, 2017 by Steve Robinson

Regulation D under the Securities Act of 1933 is amended, although not frequently, but a pair of amendments announced by the SEC in late 2016 are taking effective now.

The amendments to Rule 504 — the “lowest hurdle” of what had been Regulation D’s three safe harbor exemption portals — took effect January 20, 2017. The two important changes are:

  1. the aggregate dollar limit for offerings in any rolling 12 month period has increased from $1 million to $5 million, and
  2. the “bad boy” disqualification conditions found under Rule 506 now apply to Rule 504 offerings.

With the dollar cap on 504 offerings jumping to match the dollar cap for Rule 505 offerings, Rule 505 is being eliminated effective May 22, 2017. Rule 505 had become almost useless since federal preemption of state Blue Sky registration laws for Rule 505 offerings took effect years ago.

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Business Entity Three Year Statute of Repose

Posted on March 11, 2017 by Steve Robinson

Potential clients wanting to dissolve a Texas business entity frequently tell me they “want the three year period to start running” although they can’t really explain what it is or why it needs to begin, but they are sure that it is very important and must commence immediately. What it is, is a statute of repose; what it does, is not exactly what they sometimes think it does.

The current statute of repose is found in Section 11.356 of the Texas Business Organizations Code and applies to any corporation, limited partnership, limited liability company, professional association, cooperative or real estate investment trust formed under the TBOC. Section 11.356 applies after a Texas entity’s existence has “terminated” within the meaning of the TBOC. If the termination is voluntary and the entity completes the winding up of its business as required by the TBOC, then its existence terminates on the date it files a certificate of termination with the Secretary of State.

But pursuant to Section 11.356, the entity continues to exist until the third anniversary of its termination date but only for strictly limited purposes. The most common of those purposes are:

  • a lawsuit or other proceeding against the entity or brought by the entity;
  • or an “existing claim” against the entity or of the entity.

The litigation exception is pretty clear.

The “existing claim” exception requires examination of what the term “existing claim” means. A terminated entity is liable only for an “existing claim,” which is a “claim” that either

  1. existed before the entity terminated AND is not barred by the applicable limitations period OR
  2. is a contractual obligation incurred after the date of termination.

The inquiring client is probably concerned about the first situation if he wants to “get the clock started.” He may be concerned that the counterparty to one of the entity’s pre-termination contracts may assert post-termination a claim for breach or contractual indemnification, or that an individual may assert post-termination that he suffered personal injury in an incident that occurred prior to the termination date, or that the beneficiary of a guaranty made by the terminated entity prior to termination may make demand for payment under the guaranty when the primary obligor defaults post termination. Depending when the possible claims accrued, it is possible that the applicable statute of limitations has not yet expired.

The client may have good cause for wanting to start the three year period. The definition of “claim” means “a right to payment, damages or property, whether liquidated or unliquidated, accrued or contingent, matured or unmatured.” That definition is broad to begin with— for payment, like the cash due in payment of a promissory note; damages, like the monetary remedy awarded in a slip and fall case; or property, like a tangible good deliverable pursuant to a commercial contract or a an intangible contract right, trademark or copyright. And it stretches much further: the damages may be uncertain, the note may not yet be matured, and whether or not any payment or performance is owed may depend on the occurrence or nonoccurrence of one or several events or conditions. The claim — even the basis for a potential claim — may be unknown to the entity at the time of its termination: the claim likely was not asserted prior to the termination date and a cause of action probably had not accrued by that date. Or the entity may have been aware prior to termination that a basis for a potential claim might exist but no claim had been asserted, or a claim may have been asserted before termination but the entity believed it was without merit and that the entity had no obligation or liability to the claimant. But in any of those situations, a “claim” existed because of the broad scope of the meaning of the term “claim.”

The client is seeking to reach the repose offered by Section 11.359(a):

an existing claim by or against a terminated filing entity is extinguished unless an action or proceeding is brought on the claim not later than the third anniversary of the date of termination of the entity.

But the client needs to be advised that the third anniversary is not a solid wall against an existing claim. Section 11.356(c) provides that if an action on an existing claim is brought against the entity before the third anniversary of its termination, then the three year survival period of the entity automatically extends for that claim until “all judgements, orders, and decrees [with respect to that action] have been fully executed” and the subsequent and consequential application by the terminated entity of its property to discharge its obligation or liability (if the claimant wins) or to distribute property to the entity’s owners (if the claimant loses in whole or in part).

The client may also be interested in hearing about a way to accelerate — to shorten — the three year period for existing claims, but he’ll not hear about that alternative in this post.

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An “Investment Contract” is a “Security”

Posted on March 3, 2017 by Steve Robinson

Why is the term "investment contract" which appears in the definition of "security" in the federal Securities Act of 1933, the federal Securities Exchange Act of 1934, and the Texas Securities Act corporate stock so important? Corporate stock is a "security" of course — that’s clear on the face of the statutory definitions. Bonds and debentures? Yes, for the same reason. [Because the securities laws elevate substance over form, in some very unusual circumstances an instrument denominated “stock” may not be treated as a security for purposes of the securities laws where it in economic reality is utterly lacking in the attributes of typical corporate stock; but because the statute says “stock” is a security, anyone contending that an instrument labeled “stock” is not a security faces a very heavy burden of proof to establish otherwise.]

What about a limited partner interest in a limited partnership? A member interest in a limited liability company? Or even a general partner interest in a general partnership or joint venture? Other than the TSA (where a limited partner interest is included in the statutory definition of “security”), neither of these common forms of equity ownership is among the list of instruments within the statutory definitions of “securities.” Yet, there is a nearly conclusive presumption that LP interests are “securities” under federal and state securities laws; a presumption that member interests are; and a possibility that general partner interests may be (although presumably they are not).

Why? The reason lies primarily in another type of “security” listed in the definitions sections of the statutes: “investment contract”.

Back in 1981, the 5th Circuit Court of Appeals (which includes Texas) considered in Williamson v Tucker whether joint venture interests may be securities and concluded that under certain narrow circumstances, the answer is yes. The analytical tool for making that determination was first announced in a 1946 opinion by the US Supreme Court in Howey, where the court described what the term “investment contract” means (important, since the statutes do not define the term):

1. An investment of money
2. In a common enterprise
3. With an expectation of profit
4. Solely from the efforts of others

Whether a transaction involves the first and third elements is usually obvious. As the 5th Circuit observed, the “solely” standard in the fourth element should be read flexibly and not literally, and in Williamson the court adopted “a more realistic test, whether the efforts made by those other than the investor are … those essential managerial efforts which affect the failure or success of the enterprise.” In subsequent decisions, the 5th Circuit (unlike some other US Circuit Courts) extended the term “common enterprise” in the second element to include “vertical commonality” between a single investor and the promoter as well as “horizontal commonality” among multiple investors.

In Wiliamson, the 5th Circuit concluded that an investor claiming his general partnership interest is an “investment contract” has a difficult burden to overcome because as a general partner, the investor normally “retains substantial control over his investment and an ability to protect himself from the managing partner or hired manager.” But the investor might prevail

[if he can ] demonstrate that, in spite of the partnership form which the investment took, he was so dependent on the promoter or on a third party that he was in fact unable to exercise meaningful partnership powers.

It is the Howey test (as modified) which, in Texas, the 5th Circuit and most of the US, is the appropriate test against which to measure whether a limited partner interest, member interest, or general partner interest is a “security.”

AND to measure whether another investment transaction — regardless of its form — in substance involves the first three elements of Howey and a dependence upon the efforts of others sufficient to satisfy the fourth element.

That is why — along with more conventional forms of investment vehicles like partnerships and LLCs — the individual who transfers cash or other property to acquire an ownership interest in, a consulting agreement regarding, a nominally commercial contract concerning, or another contractual arrangement involving, fruit trees, a hog raising program, a thoroughbred horse syndication, viatical agreements, cemetery lots, a livestock breeding program, whiskey, rabbits, public pay phones, recording agreements or almost any other tangible or intangible property, may become the holder of an “investment contract” and entitled to the protections afforded investors under federal and state securities laws.

And also why the counterparty to whom he transfers that money may find himself or itself on the opposite side (read “subject to criminal or civil liability”) of the same laws.

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Forming an Inadvertent Partnership

Posted on February 24, 2017 by Steve Robinson

You intentionally form a Texas corporation, limited liability company or limited partnership by filing a Certificate of Formation with the Texas Secretary of State.

How do you form a Texas general partnership?

Sometimes … without intending to form it at all.

A general partnership is created upon the “association of two or more persons to carry on a business for profit as owners” (Texas Business Organizations Code Section 152.051) “regardless of whether … the persons intend to create a partnership [emphasis added]”!

“Inadvertent partnerships” are created frequently — and their “founders” often wind up in courtrooms arguing about whether they are legally partners with each other or not. Serious consequences can depend upon the answer, because general partners owe each other fiduciary duties, the violation of which can cost one partner dearly and benefit the other partner handsomely.

It is not a question of having a written agreement; an oral agreement can suffice. It isn’t necessary to prove that the agreement constitutes a legally enforceable contract. And it isn’t necessary to establish any agreement at all.

What matters in Texas is whether the relationship of the persons exhibits all — and sometimes less than all — of the five factors listed in TBOC Section 152.052(a):

receipt or right to receive a share of profits of the business;
expression of an intent to be partners in the business;
participation or right to participate in control of the business;
agreement to share or sharing losses of the business or liability for third party claims against the business; and
agreement to contribute or contributing money or property to the business.

There were many “inadvertent partnership” cases decided under Texas common law before Texas adopted its first general partnership statute, and there were many cases decided under the versions of that statute which preceded Chapter 152 of the TBOC. But in 2009, the Texas Supreme Court in Ingram v. Deere, 288 SW 3d 886, rendered an important decision in “a matter of first impression for this Court” : “how many of the [five statutory] factors are required to form a partnership”? The Supreme Court adopted a “totality-of-the-circumstances test” in part at least because the statute does not specify whether there must be proof of all or only some of the factors to establish that a partnership exists, and announced the current test in Texas:

— “an absence of any evidence of the factors will preclude the recognition of a partnership” ( “Even conclusive evidence of only one factor normally will be insufficient to establish the existence of a partnership”)

— “On the other end of the spectrum conclusive evidence of all of the …factors will establish the existence of a partnership as a matter of law.”

— “The challenge of the totality-of-the-circumstances test will be its application between these two points on the continuum.”
And that is why you can find dozens of cases since 2009, because Texas courts have to analyze the many various arrangements people get into with one another and then measure them against these five factors. Find all five: partnership! Find none or just one: no partnership! But find two: maybe a partnership, especially if the two are the sharing of profits and business control (the two elements given the greatest weight). Find three: likely a partnership; but if none of them are profit sharing or shared business control, likely not a partnership. Find four: almost certainly a partnership, especially if the missing factor is the sharing of losses or liabilities (the element afforded the least weight).

That’s also why you can find cases that don’t seem reconcilable with each other, where one court determines that a partnership definitely was formed but another court confronting similar facts concludes there was no partnership.

But that story is for another post.

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TBOC AND SHAREHOLDERS’ AGREEMENTS

Posted on July 12, 2014 by Steve Robinson

I described last week's blog -- Ritchie v. Rupe: Segue to Private Company Agreements   — as a bridge from our recent series on the use of proxies in private company situations to an upcoming series on preparing private company agreements.  This week's blog begins that new series by looking at the provisions of the Texas Business Organizations Code (TBOC) underpinning private company agreements for corporations, that is,  the TBOC and shareholders' agreements.

Texas Statutes on Shareholders' Agreements

The Texas For-Profit Corporation Law (that portion of the Texas Business Organizations Code applicable to business corporations) explicitly approves several types of agreements that shareholders of a privately held business corporation may enter into for the management, operation and ownership of the company, including but not limited to:

  • voting agreements (TBOC Section 6.252);
  • shareholders'  agreements (TBOC Sections 21.101 through 21.109); and
  • agreements restricting transfer of shares and other securities (TBOC Sections 21.210 through 21.211)

(Another kind of agreement among shareholders is a shareholders' agreement among the owners of a close corporation (TBOC Chapter 21, Subchapter O).  But because it is uncommon to find a Texas corporation that has chosen to be a "close corporation," an election which must be made publicly in the corporation's Certificate of Formation filed with the Texas Secretary of State, I won't address close corporations in this blog post.)

What the Texas Statutes Allow Shareholders' Agreements To Cover

Voting.  Written voting agreements under TBOC Section 6.252 bind their shareholder parties to vote their shares in the manner provided by the agreement; for example, the agreement could obligate every shareholder to vote all of his shares for the election of Mr. X to the board of directors. Restrictions on Transferability of Shares.  TBOC Section 21.210 permits a written agreement among some or all shareholders or among some or all shareholders and the corporation that restricts the transfer or registration of transfer of the shares covered by the agreement ("registration of transfer" is a technical but vital step in transferring an ownership interest, because only when a transfer is registered on the books of the issuer may the issuer recognize the transferee as the proper owner of the shares for most purposes, the most significant of which is voting).  However, TBOC Section 21.211 only validates a transfer restriction that falls within one or more of the following categories, and then only if the manner of effecting that restriction is "reasonable":

  1. requires that the shares to be transferred must first be offered to the corporation or the other shareholders;
  2. obligates the corporation "or another person" to buy the shares;
  3. conditions the transfer on approval by the corporation or other shareholders as necessary in order to prevent a violation of law;
  4. blocks transfer of the shares to a designated person or group, provided the designation isn't "manifestly unreasonable;"
  5. maintains the corporation's S corporation status;
  6. preserves a tax advantage of the corporation;
  7. maintains the corporation's "close corporation" status under the TBOC;
  8. obligates a shareholder to transfer some or all of his shares to the corporation, other shareholders or another "person or group of persons;" or
  9.  transfers automatically some or all of a shareholder's shares to the corporation, other shareholders or another "person or group of persons."

Governance of the Corporation.  TBOC Section 21.101 is surprisingly expansive, listing 12 categories of governance matters which an agreement may cover, BUT unlike voting agreement and share transferability agreements, a Section 21.101 shareholders' agreement requires joinder by ALL of the corporation's shareholders.  The agreement may:

  1. restrict the board of director's discretion or powers;
  2. eliminate the board entirely and authorize one or more of the shareholders "or other persons" to manage the corporation's business;
  3. establish the persons who will be the officers or directors;
  4. fix the term and conditions for removing or continuing any person's directorship, officership or employment;
  5. establish the manner for declaring and making dividends and other distributions whether or not in proportion to share ownership;
  6. determine the way profits and losses are to be allocated;
  7. govern the division and exercise of voting power among shareholders, directors and "other persons" including disproportionate voting rights and director proxies;
  8. fix the terms for transactions with affiliates;
  9. provide a manner for resolving deadlocks within the corporation's governing authority;
  10. require the corporation's winding up and termination upon the request of a shareholder or group of shareholders or the occurrence of an event or contingency, and deem the winding up and termination to have been approved unanimously by all the shareholders;
  11. establish rules for authorizing actions and exercising the corporation's powers in furtherance of  "social purposes" specified in the corporation's certificate of formation; or
  12. establish rules for authorizing actions and exercise the corporation's powers "as if the corporation were a partnership."

 Summary

Whew!  Those statutory provisions offer a corporation's shareholders a wide range of tools to craft a corporation's governance structure and to preserve its ownership community composition (and consequently that governance structure). In the next installment in this series, I will present a form of shareholders' agreement to illustrate how these contractual schemes on voting, share transfer restrictions, and governance can be put into effect through a single legal instrument among the corporation and its shareholders.

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Ritchie v. Rupe: Segue to Private Company Agreements

Posted on July 3, 2014 by Steve Robinson

Two weeks ago the Texas Supreme Court issued its opinion in  Ritchie v. Rupe.  While there's much to take from the majority opinion, I title this post "Ritchie v. Rupe: Segue to Private Company Agreements" because the case serves to connect our recent series on the use of proxies in private company situations with an upcoming series on negotiating and drafting private company agreements.

In the first installment of that proxy series —  called "Private Company Proxy Contest - Introduction" — I alluded to the importance of private company owners agreeing in writing among themselves on certain essential matters, like transferability restrictions for the ownership interests and election of management, and the bad consequences which can follow if they neglect that vital task.

Ritchie v. Rupe: The Facts, Heavily Condensed

Rupe Investment Corporation was a privately held family corporation.  The President, Buddy Rupe, married Ann Rupe.  Ann was his second wife and the rest of Buddy's family never approved of or accepted her.   And when Buddy died, his family no longer even had to invite Ann to Thanksgiving dinner.

Ann (for herself and Guy, the child born to her and Buddy)  held 18% of the corporation's stock.  She was content to sell those shares back to the corporation — at a fair price.

But Buddy's family members, who sat on the board and controlled the other 82% of the corporation's stock, declined to cause the corporation to redeem her shares except at a bargain basement price that Ann's attorney called "absurd."

Now we come to the heart of the matter:  "There was no shareholders' agreement."

So you can already figure out how the next few chapters of the story turn out.

The corporation won't raise its redemption offer;  Ann is left technically free to sell her shares to an outsider in a private transaction (because there was no shareholders' agreement restricting transferability), but no outsider will purchase her minority position because it is a minority position and because the corporation's board and officers refuse to disclose the corporation's affairs to a prospective outside purchaser [more on this later; let's just say the corporation, unlike Ann, has good attorneys in this case];  and the two sides wind up in a Texas trial court and, eventually, before the state's highest judicial body.

And that pithy bit of information — "no shareholders' agreement" — can also inform you why Ann has lost her case.

(Lost, for the time being.  The Supreme Court ruled that the appellate court beneath it had wrongly sanctified the "oppression" theory.  It was only that issue which reached the Supreme Court.  Ann's much better contention — at least I consider it superior — is that the corporation, its officers and directors stood in an informal fiduciary relationship with her and her child because of the "special relationship" among family members and that they breached their fiduciary duties to her and the child.  The Supreme Court remanded the case for consideration of that breach of fiduciary duty issue.)

Ritchie v. Rupe: What the Other Attorneys (the Litigators) are Saying About It

Before plunging into the key practical lesson private business owners should take from the Supreme Court's decision, I should point out what other attorneys think the court's decision means.

The blogs I've read on this decision focus predominately on the court's announcement that there is NO common law cause of action in Texas for minority shareholder oppression — as though that is actually news.  These commentators are certainly right — there is no "oppression" cause of action under Texas law — but what they don't mention is THERE WASN'T SUCH A CAUSE OF ACTION BEFORE THIS CASE.  Admittedly some lower courts  indulged that claim in several cases within the past few years, but the Supreme Court had never recognized it.

What the Court actually said in Ritche v. Rupe on this subject was

we decline to recognize or create [emphasis added] a Texas common-law cause of action for "minority shareholder oppression."

Because the Court also refused to be confused by the argument of the minority shareholder's attorneys that the subchapter on "Receivership" for Texas entities found in the Texas Business Organizations Code and its predecessor provisions in the Texas Business Corporations Act should apply where NO RECEIVER has been appointed or even requested, the plaintiff in this case also struck out in her assertion of a statutory basis for her claim of "oppression."

Ritchie v. Rupe:  What the Business Attorneys should be Saying About Private Company Agreements

This case perfectly highlights the risks that owners of a privately held company run when they do NOT enter into a comprehensive agreement governing the company's management and transferability of ownership interests, among other key terms.

The family members should have entered into a shareholders' agreement when the company was formed, and updated it as circumstances warranted.   Ann's late husband should have insisted upon rectifying that omission when he married Ann, realizing that his family might view her as an outsider and not treat her with the same beneficence and affection they accorded him.  As the estrangement between Ann and Buddy's family became obvious, the need to have a shareholders' agreement should  have become desperate for Buddy, but to the same degree probably was becoming less desirable to the other members of the Rupe family.

Maybe it will help to put this problem in quantitative financial language.

The corporation offered to redeem Buddy's shares for $1 million.  Ann said no.  The trial court ordered the corporation to purchase Buddy's shares from Ann for $7.3 million.  The Court of Appeals said that amount was a little too high, given the shares' lack of control and marketability.

The Texas Supreme Court said Ann can recover $0 based on the oppression theory.

 

 

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Unfinished Business Doctrine: Dead at Last

Posted on July 1, 2014 by Steve Robinson

The "unfinished business doctrine" as applied to defunct law firms is dead.

Recent Posts, for Context

As we wrote on June 12 in "Unfinished Business Doctrine: Federal Judge Gets it Right!", a federal court judge in California killed the doctrine last month; this week, in an opinion issued in an appeal we wrote about on June 11  in "Unfinished Business Doctrine in NY",  New York's highest court nailed the coffin shut and buried it.

Background of the Two Cases Presented to the NY Court of Appeals

In the Thelen and Coudert bankruptcies, the trustee/administrator of each debtor had sought to recover for the debtors' estates — and ultimately for the benefit of creditors of those estates — legal fees paid by former clients to law firms where former Thelen and Coudert attorneys had jumped, after the Thelen and Coudert firms had started to dissolve, and taken their clients with them.   The basis for the claims was the "unfinished business doctrine" — the argument that the attorneys who had departed Thelen and Coudert in effect had absconded with "unfinished business" (pending client legal work) belonging to those dying firms, thereby breaching their fiduciary duties to those law firms and to their fellow partners there, and the way to remedy the breach was for those scoundrel attorneys and their new law firms to turn over to the bankruptcy trustee/administrator all of the fees earned on those matters at the new firms.

The NY Court's Holding

The claim had been advanced in the bankruptcy court cases of both Thelen and Coudert, working its way through the US District Court and the US Court of Appeals of the Second Circuit, and the Second Circuit had certified to the NY Court of Appeals the exact question of New York law:

whether, for purposes of administering [a] … related bankruptcy, New York law treats a dissolved law firm's pending hourly fee matters as its property.

The NY Court of Appeals was starkly clear in its answer:

We hold that pending hourly fee matters are not partnership "property" or "unfinished business" within the meaning of New York's Partnership Law.  A law firm does not own a client or an engagement, and is only entitled to be paid for services actually rendered.

The NY Court Explains the Logical Error Underlying the Trustees' Claim

The court in effect said that the trustee/administrator in both cases had begged the question when they contended that "departing partners owe a fiduciary duty to the dissolved firm and their former partners to account for benefits obtained from use of partnership property [that is, pending client legal matters] in winding up the partnership's business."  Their error was assuming that pending client matters constitute partnership property.

Because clients always have the "unqualified right to terminate the attorney-client relationship at any time without any obligation other than to compensate the [law firm] for the fair and reasonable value of the completed services," it follows that

no law firm has a property interest in future hourly legal fees because they are "too contingent in nature and speculative to create a present or future property interest" given the client's unfettered right to hire and fire counsel.

In short, "client matters are not partnership property…."

The court went on to apply the same analysis to contingent fee matters, correcting the trustee/administrator's arguments that even if hourly fee work isn't subject to the unfinished business doctrine, contingent work is.

[S]tatements [in prior court opinions] that contingency fee cases are "assets" of the partnership subject to distribution simply means that, as between the departing partner and the partnership, the partnership is entitled to an accounting for the value of the cases as of the date of the dissolution.  [Those] decisions involving contingency fee arrangements do not suggest that law firms own their clients' legal matters or have a property interest in work performed by former partners at their new firms.

NY Court Goes Further to Proclaim Trustee's Argument Against Public Policy

The judges went on at add, at the conclusion of their opinion, that the whole doctrine pushed by the trustee/administrator violates the public policy of the state:

Treating a dissolved firm's pending hourly fee matters as partnership property, as the trustees urge, would have numerous perverse effects, and conflicts with basic principles that govern the attorney-client relationship under New York law and the Rules of Professional Conduct.  By allowing former partners of a dissolved firm to profit from work they do not perform, all at the expense of a former partner and his new firm, the trustees' approach creates an "unjust windfall"…. Next, because the trustees disclaim any basis for recovery of profits from the pending client matters of a former partner who leaves a troubled law firm before dissolution, their approach would encourage partners to get out the door, with clients in tow, before it is too late….  And attorneys who wait too long are placed in a very difficult position.  They might advise their client that they can no longer afford to represent them, … a practical restriction on a client's right to choose counsel.  [And] these attorneys would simply find it difficult to secure a position in a new law firm.

In a final shot at the absurdity of the trustee/administrator's position, the court unleashed two comments:

The notion that law firms will hire departing partners [from collapsing firms] or accept client engagements [brought along with those departing partners] without the promise of compensation ignores commonsense and marketplace realities.  Followed to its logical conclusion, the trustees' approach would cause clients, lawyers and law firms to suffer, all without producing the sought-after financial rewards for the estates of bankrupt firms….

[If] a client's pending matter is partnership property, why doesn't every lawyer whose clients follow him to a new firm breach fiduciary duties owned his former law firm and partners?  In the end, the trustees' theory simply does not comport with our profession's traditions and the commercial realities of the practice of law today….

THAT'S LOWERING THE BOOM!

 

 

 

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Private Company Proxy Contest — Practice Illustrations

Posted on June 28, 2014 by Steve Robinson

Real life examples of private company proxy contest?  In this brief blog post, I will relate two practice experiences we have had.  [Factual information is deliberately omitted or obscured as necessary to preserve client confidences and secrets and otherwise comply with applicable ethical standards of professional conduct.]

The Clueless Limited Partners and Their Obtuse Attorneys

We represented a principal in connection with his capital raises to fund newly formed privately held partnerships.   As commonly done in that particular industry, each partnership was formed to hold and manage a unique set of assets.  That commonly used industry model means that, at any time, the principal and his affiliates are managing multiple separate small partnerships.

When the Great Recession hit, the business of all the partnerships was severely depressed.  Many of the limited partners in those partnerships were suffering individually, too, because of economic contractions.  So what did they do?  A handful of them found a plaintiffs' law firm and sued the principal.  Of course, the litigation they initiated brought about the collapse of the partnerships.

But here is where that story ties back to the theme of a private company proxy contest.

The attorneys for the plaintiff limited partners repeatedly insisted that they represented many of the limited partners, but they would not produce a complete list of their clients.  The principal was convinced from his communications with limited partners that only a minority of the limited partners (for some entities a minority by percentage interest and by headcount, in other entities a minority by percentage interest) in each partnership were behind the lawsuits.  (Here it should be remembered that in many disputes, there are not just two adversarial  groups willing to openly confront each other; there is often a third group which prefers to play the role of spectators, and who may have sympathies for one side or the other but are definite only in their earnest desire to avoid direct confrontation with either of the other groups.)  The facts that the dissident limited partners who were named plaintiffs in the suits held collectively only minority interests in each partnership AND also made no attempt to seek removal of the general partners of the entities by vote of the limited partners, left the principal (and us too) convinced that the entire litigation must have been driven by a minority group of disgruntled investors and that, as weeks passed, those same dissidents had been unable to get a majority of limited partners in any entity to join them.

Eventually we discovered that the plaintiffs did represent partners in some of the partnerships who were not named as plaintiffs in the lawsuits, and in the other entities had known (to them) sympathetic supporters among partners who were not clients of their attorneys.  In hindsight, there seems no doubt that in most of the partnerships, the suing limited partners could have secured sufficient votes from among themselves, by proxies  from their colleagues who were unnamed in the suits, and by proxies granted by legally unrepresented sympathetic partners who were reluctant to confront the principal directly, either to replace the general partners of those partnerships, to make a powerful equitable argument before the trial court for replacement of the management, or to persuade the principal that a majority of the investors wanted him to step aside (a step he would have taken voluntarily, because he would then have had to recognize the inevitability of his removal).

Why the named plaintiff limited partners and their attorneys elected not to take that course of action, we never learned, although I have my surmises.

In our opinion,  the plaintiff limited partners possessed excellent and inexpensive contractual and statutory remedies for advancing and attaining their goal of displacing management by  vote of their own partnership interests and vote, by proxy, of the partnership interests of other partners who, for one cause or another, preferred to remain in the background for as long as possible.  And in our judgment, their failure to follow that route led to the needless expenditure of hundreds of thousands of dollars in attorneys' fees and court costs; caused the partnerships to miss out on several highly valuable commercial opportunities involving millions of dollars; and, in the end, resulted in the loss of many of the core assets of the partnerships.

The Hidden Control Key

In another practice illustration, an LLC's management strictly enforced the company agreement transferability restrictions against existing members, especially those with significant ownership percentages in the entity.  Management was favorably disposed toward many small owners, whose aggregated interests could pose no threat to management's power, and to  significant owners friendly with management; but management was wary  of any large owner whose loyalty to it was uncertain.

The company's operating agreement left the term "membership interests" undefined, thereby deferring to the statutory definition of that term.

As a consequence, there was not even the slightest basis for an argument that the transfer restrictions in the company agreement applied to proxies.  Management perhaps thought that the transferability restriction against pledges of membership interests would be adequate to block a member from granting a proxy to another member or an outsider.

But we structured a transaction where a significant member gave another party (our client) an irrevocable proxy to vote his membership interests, although those membership interests were not pledged to the grantee.  Because the grantor's ownership was significant, and management had considered him favorably disposed toward it, the proxy grant substantially weakened management's position while at the same time shifting to our client veto type control over any significant financial transaction proposed by management.

 

 

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Private Company Proxy Contest — Near Final Thoughts

Posted on June 28, 2014 by Steve Robinson

The problem I identified in LLC Company Agreements in the prior part of this series — here — applies likewise to private partnerships and sometimes, although not as frequently, to private corporations when it comes to private company proxy issues.

Example of Proxy Gap in Limited Partnership Agreement

Here is a typical definition of "Partnership Interest" in a Texas Limited Partnership Agreement (LPA):

the percentage interest of a partner in the Partnership at any particular time as set forth herein … and specifically includes the right of that partner to any and all benefits to which that Partner may be entitled as provided in this Agreement and in the Act, together with all obligations of that partner to comply with all the terms and provisions of this Agreement and the Act.

Exactly like the LLC Company Agreement's definition of membership interest, the LPA's definition of partnership interest includes the management participation right although the applicable statutory definition of that term is limited to the economic rights only and expressly provides that the term "does not include a partner's right to participate in management."

Similar to the LLC Company Agreement's restrictions against transfer of membership interests, the LPA states that a "purported transfer of a Limited Partner's Partnership Interest not in conformance with [this Article governing transferability] shall be null and void and of no effect."

So, a purported transfer of the right to participate in management, or vote, will be invalid unless effected in compliance with the LPA's section on transferability conditions?  No.  That section clearly focuses upon economic transfers and says nothing about assignments of voting powers by way of proxies.

And like the LLC Company Agreement, the LPA's own language confirms that interpretation in the provisions on meetings of partners:  "A Partner may vote by proxy."

Proxy Gap in Corporation's Shareholders Agreement

The problem is less often present in the shareholders agreements or voting agreements among a privately held corporation's shareholders.  That is because, I think, the issue is plainly visible when a voting agreement is negotiated and drafted.  The sole purpose of a voting agreement being to bind the owners to vote together, as a block, on the matters identified in the voting agreement, it would be surprising if the agreement only bound the shareholders with respect to votes cast  in person at a shareholders' meeting but ignored or excluded voting by way of consent.  For the same reason, it would be surprising — and like an omission regarding actions by consent, it would frustrate the essential purpose of the voting agreement — if the agreement did not cover casting votes by proxy.

But where shareholders enter into a shareholders agreement instrument only and not a separate  voting agreement instrument also, they sometimes omit to include a voting agreement as part of the shareholders agreement.  I believe this happens largely for the same reason that proxy voting is rarely considered in Company Agreements for LLCs and LPAs for partnerships — the parties and their attorneys become so focused on what they consider to be the primary purpose of the shareholders agreement  (restricting the sale, gift, pledge or other change or potential change in ownership of the shares) that they simply forget about a shareholder's capability to transfer his voting power to an outsider.

 How to Fill the Gap

For privately held LLCs and partnerships, at least two basic approaches are available for correcting this common omission in Company Agreements and LPAs (and general partnership agreements).

First Alternative — JUST SAY NO

The first method is the simpler, but is the more problematic in practice.  Unlike corporation statutes, the statutes governing LLCs and partnerships (as I have shown) grant the owners nearly unfettered authority and power to establish by their own agreement such restrictions (or absence of restrictions) on ownership transferability and management participation rights (voting) as those parties desire.  This is absolutely true of proxies, which is why the simpler method would be to outlaw voting by proxy.   Members and partners would be contractually allowed to vote or consent only in person and not by proxy or agent.

The bright line rule of a flat prohibition is very easy to draft, but frankly not pragmatic in practice.  Where the private company is owned by a very small number of owners who at the same time are all active in its management, then obviously all the owners interact in person on a regular basis; the idea of acting through a third person proxy would normally be unusual.

In other privately held companies — such as real estate investment partnerships — the managers and the owners are often different persons.  This is basically the same problem/opportunity that exists in publicly held companies, with the real difference between the two categories being whether or not there exists a readily available market for the sale and purchase of the ownership interests.

And like public companies, all of the owners of such privately held companies do not regularly attend member and partner meetings of the company and do not not routinely take active roles in reviewing the company's activities and monitoring its management.  Those "semi-absent" owners just want the company to be profitable and to distribute the monies from those profits among the owners.  And those owners often do not want to expend their time interacting in person with other owners — many of whom they do not actually know — or other management.  (I can attest from experience that management frequently wants to limit its time communicating with and otherwise interacting with those owners.)

Second Alternative — Limit Who Can Serve as Proxy Holder

It would be self-defeating, offensive and pointless to attempt to bar owners from exercising their statutory rights to grant proxies, BUT as with restrictions on transferability of economic interests, it would be defensible and valid to impose reasonable conditions upon the exercise of proxy use.

The Delaware and Texas statutes governing LLCs and partnerships expressly permit owners to modify the statutory default provisions on proxies.

A prudent modification of those default provisions could include imposing restrictions similar to the economic transferability restrictions.  For example, proxy grants to other members or partners might be permitted while grants to third persons could be prohibited or be subject to prior discretionary approval by management (or a committee of owners) to  insure that the proxy holder will act merely as the agent of the granting owner and not in the proxy holder's own interest.  To expedite the approval process, owners might be allowed to request preclearance for specific individuals, whose background, relationship with the owner and company, and potential conflicts of interest with the company could be fully vetted well before the casting of critical votes; and to afford adequate time to conduct a proper vetting, owners wanting the convenience to act through a proxy holder might be required to submit the proxy holder's name some time prior (perhaps 45 days) to any vote or consent.

CONCLUSION

More thoughtful drafting of private company governing documents can close the proxy loophole.  Principals of the private company will have to be persuasive in explaining to potential investors why their agreeing to limitations on proxy voting will protect the integrity of the company, in much the same way management of public companies have to persuade their owners why staggered boards, poison pills, and other devices preserve and promote the company's stability and future growth and earnings.

And like their public company counterparts, private company principals will have to be ready to give a strong defense against accusations that placing limits on the use of proxies is not actually a way to entrench management and disenfranchise the company's owners.

 

 

 

 

 

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