Private Company Proxy Contest – Examples

Posted on June 26, 2014 by Steve Robinson

In this third part of the series on private company proxy contest series, I want to illustrate the problem — or opportunity — which I have been hypothesizing in the prior two parts.

Definitions of Ownership Interests — the Gap Between Statutes and Governing Documents

In reviewing several representative versions of limited partnership agreements (LPA) and LLC company agreements (Company Agreement) [some I drafted, others were prepared by other law firms for their clients or CLE presentations, by bar association workgroups, or by treatise authors],  I noticed that the problem/opportunity arises at the core definitional level in most governing documents and the single significant way in which it usually differs from the corresponding statutory definition.

For example, in a Company Agreement, the definition of "Membership Interest" for purposes of the agreement might read like this one pulled from a Delaware  Company Agreement:

“Membership Interest” means the interest of a Member in the Company, including rights to distributions (liquidating or otherwise), allocations, information, all other rights, benefits and privileges enjoyed by that Member (under the Act, the Certificate, this Agreement or otherwise) in its capacity as a Member and otherwise to participate in the management of the Company….

Pay attention to the last part of the definition:  "all other rights, benefits and privileges enjoyed by that Member … to participate in the management of the Company…."

Even the State Bar of Texas, in its form Company Agreement, defines "Membership Interest" in much the same way:

The Member’s Membership Interest is such Member’s right (a) to an allocable share of the profits, losses, deductions, distributions, and credits of the Company; (b) to a distributive share of the assets of the Company; and (c) to vote on those matters described in this Agreement and the Code and to participate in the management and operation of the Company as set forth in this Agreement.

But attention must be paid to the statutory definition of the closest corresponding statutory term set forth in the Delaware Limited Liability Company Act:

"Limited liability company interest" means a member's share of the profits and losses of a limited liability company and a member's right to receive distributions of the limited liability company's assets.

And to the statutory definition of the corresponding statutory term in the Texas Limited Liability Company Act, which shows explicitly the difference between the statutory definitions and the contractual examples given above:

"Membership interest" means a member's interest in an entity.  With respect to a limited liability company, the term includes a member's share of profits and losses or similar items and the right to receive distributions, but does not include a member's right to participate in management.

Conflict  in Use of Contractually Defined Term in Transferability and Voting Sections of Governing Documents

Both Company Agreement examples cited above define "membership interest" to include a member's right to participate in management — which is explicitly NOT a right contained in the statutory definition of that term.

That point is why the transferability restrictions contained in the Company Agreements are somewhat confusing.

In the Delaware version, members are strictly prohibited from making any "Disposition" of "all or any portion of such Member’s Membership Interest" except to the extent expressly provided in the Article on transferability.  "Disposition" is defined as:

any direct or indirect transfer, assignment, sale, gift, inter vivos transfer, devise, transfer by operation of the rules of intestacy, pledge, hypothecation, mortgage, hedge or other encumbrance, or any other disposition (whether voluntary or involuntary or by operation of law), of Membership Interests or Units (or any interest (pecuniary or otherwise) therein or right thereto), including without limitation derivative or similar transactions or arrangements whereby a portion or all of the economic interest in, or risk of loss or opportunity for gain with respect to, Membership Interests or Units is transferred or shifted to another Person.

Notice that the definition appears to focus on the economic interests of a membership interest and not on the voting or management participation rights.  Nevertheless, the definition of "Membership Interest" expressly includes the right "to participate in the management of the Company…." so the question is whether or not the prohibition against unpermitted transfer, assignment or other disposition applies to the power to vote and participate in management.  The Article setting forth exceptions to the bar against any Disposition is silent on this issue, which suggests that the grant of a proxy to vote a member's Membership Interest is NOT a "Disposition" of a partial interest in the Membership Interest, despite the definition of that term in the Company Agreement.

In the section on member voting, this Company Agreement provides convincing evidence to support that interpretation:

Proxies. (i) Each Member entitled to vote at a meeting of Members or to express consent or dissent to action in writing without a meeting may authorize another Person or Persons to act for him by proxy.

So the conclusion that should be drawn in interpreting this Delaware Company Agreement is that the grant of a proxy is NOT a direct or indirect "Disposition" of any interest in or right of a "Membership Interest" (despite the inclusion of management participation rights in the definition of that term) and, not being prohibited or limited elsewhere in the Company Agreement, a member's right to grant a proxy to vote on any matter upon which he, in his capacity as a member, has the right to vote is measured by the applicable statutory provision of the Delaware Limited Liability Company Act — which specifically provides that a member may grant a proxy to another person to act in his place.

To reach any contrary interpretation, would be to ask a court to distinguish between "good proxies" (the proxyholder is acting  as agent for a principal who is unable himself to participate at the members' meeting and instead is acting indirectly through an agent who acts strictly in the principal's interest and at his direction, to vote the member's interest as he himself would do if present) and "bad proxies" (the proxyholder is acting pursuant to the authority granted in or by the proxy and may act in the proxy's interest whether or not that conflicts with the member's desires).

The statute does not make that distinction.  To the contrary, the statute clearly contemplates that a proxy may be coupled with an interest of the proxyholder (or his agent) which is not shared with nor subservient to the interest of the grantor of the proxy, and in that sense, the proxy holder is NOT the agent to the proxy grantor as principal.

In the preceding paragraphs, I have worked through a Delaware Company Agreement to highlight the drafting problem.

I could have worked through another example of a Delaware Company Agreement where the document dispenses with its own definition of  membership interest and relies instead upon the Delaware Limited Liability Company Act definition, which does NOT include the power to participate in management.  So when that Company Agreement provides that  "No Member may sell, assign, encumber or otherwise transfer all or any portion of its Membership Units other than with the prior written consent of the board of managers…." it is simple and obvious that grant of a proxy does not fall within the scope of that transferability restriction.

Working likewise through the Texas version Company Agreement cited above yields essentially the same outcome.  That example says:

A member shall not encumber or make a sale, assignment, transfer, conveyance, gift, exchange, or other disposition … of all or any part of his Membership Interest … without the prior written consent of all the remaining Members.

But that Company Agreement also says:

A majority of the outstanding Membership Interests, represented in person or by proxy, shall be necessary to constitute a quorum at meetings of the Members.

The Texas statutory "default" provision on LLC proxies says that members may vote in person or by proxy.  No condition or limitation is attached to the use of a proxy, except that  it be executed in writing by the member.  And if an LLC's existing management wants to direct a court's attention to the fuller TBOC corporation provisions on proxies in an attempt to find a basis upon which to refuse to recognize a proxy's validity based upon its being a "bad proxy" instead of a "good proxy" (as those terms are used above), management's claim will be dismissed even faster by a Texas court than a Delaware court.  The TBOC's corporation provisions on proxies expressly state state that a valid irrevocable proxy includes a proxy coupled to the interest of a  pledgee, a creditor, a transferee, or a party to a voting or shareholders agreement, persons (in other words) who clearly would exercise the proxy in their interests and not in the interests of the shareholder.

Looking Forward to the Final Installment in this Series

In the next and final installment in this series, I will offer up my comments on how this seeming gap in the fence erected by private LLCs against outsiders is just as big when it comes to private partnerships and (sometimes) corporations but how the hole can be boarded up with different drafting of the governing documents.

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Private Company Proxy Contest – Legal Basis

Posted on June 25, 2014 by Steve Robinson

Is it possible for your closely held business to become the subject of a private company proxy contest?

Contrast with Public Companies

I ended the first part of this blog by noting that changes in control of public companies may be effected by purchasing publicly traded equity from the company's owners and thereby outflanking management; the new owner of that equity thereupon has the power to replace old management with management of his choosing; BUT private companies generally guard themselves against this maneuver by ownership transferability restrictions in their governing instruments.

As a result, an outsider — or a dissident insider who craves seizing control of the company, but is disfavored by existing management supported by the other owners — is easily frustrated from acquiring economic control and accompanying voting control of the privately held entity.

But another way to seize control of a public company is by acquiring only the voting power of its outstanding equity by means of a proxy contest.  Armed with the the power to vote a controlling percentage of the ownership equity, an outsider or dissident insider can replace existing management with his own selected management group.  Or he can impose his will indirectly, by exercising that voting power to compel existing management to accede to fundamental changes that, in the absence of that concentrated voting control, they would refuse to take.

Why Private Companies Can Be Vulnerable To a Proxy Attack

An outsider, or dissident insider, of a privately held corporation, partnership or LLC who wants to change management, force the entity's dissolution, merger or sale of assets, or otherwise take control of a company he thinks is being mismanaged, frequently cannot overcome the restrictions against transferability of ownership interests.  To do so might require bringing and winning a lawsuit over the validity of those restrictions, or making an offer to buy out the entire company, or at least a majority of its ownership interest, on financial terms that would result in a windfall to the existing owners and a financial sinkhole to the buyer [which, by the way, is yet another reason for those transferability restrictions: like poison pills and antitakeover bylaw provisions for public companies, transferability restrictions compel a potential acquirer to negotiate with existing management or to overpay existing owners to persuade them to amend or lift the restrictions].

But the contractual transferability restrictions generally set forth in private companies' governing instruments are almost always limited to the sale, gift, pledge or other transfer of a part or all of the economic interest of the ownership interests.

What is rarely covered by those restrictions — or any other limitation in the governing agreements, especially those of partnerships and LLCs— is the granting of a proxy to exercise the voting or participation in management rights of the ownership interests.

The first key to understanding why this gap exists, is found in the state statutes under which partnerships and LLCs are created, operated and governed.

Texas Statutes on Proxies

In Texas, the statutory rules regarding proxies are found in the Texas Business Organizations Code (TBOC).  The general rule is found in Section 6.151: Voting of ownership interests in a Texas corporation, partnership or LLC is determined by the entity's governing documents, EXCEPT TO THE EXTENT the provisions of the TBOC specifically applicable to that type of entity require otherwise.

Corporate Proxies

As one would expect, the corporations part of the TBOC contains the most extensive and binding rules on proxy use.  Sections 21.367 through .370 govern voting by proxy, revocability of a proxy, enforceability and term of a proxy.  The most significant point here is that the statute guarantees that a shareholder is entitled to vote either in person or by proxy.

A corporate proxy is limited in duration (11 months, unless otherwise expressly provided in the proxy itself) and is revocable unless stated otherwise in the proxy AND the proxy is "coupled with an interest."

What does that mean?

It means that the shareholder who grants an "irrevocable" proxy cannot later change his mind and revoke it, provided that the grant is "coupled" with one of the interests (enumerated in the statute) of the grantee or the person on whose behalf the grantee is acting.  Some of those listed interests do not concern me here; for example, a contract to sell the underlying shares or  pledge of the underlying shares is a valid interest to support a proxy's irrevocability, but the transferability restrictions under consideration here apply to sales and pledges.  Two recognized interests that may operate even in the presence of typical transferability restrictions are those of a creditor to the corporation (not the shareholder) and a party to a shareholders agreement or voting agreement.

Partnership Proxies

The simplest category, because there are NO statutory rules about voting or consenting as a general partner or a limited partner.  All such matters are left to the owners to address in their partnership agreement.

LLC Proxies

LLCs lie somewhere between corporations and partnerships.

Like corporations, there ARE default statutory rules (Sections 101.351 et seq.) which provide that each member has an equal vote with every other member on matters upon which members are entitled to vote (whether by the terms of the company agreement or the default rules of the TBOC).  And there is a default rule (Section 101.357) that entitles a member to vote in person or pursuant to a signed proxy.

Unlike corporations, there are NO conditions or limitations set by the statute about a proxy's duration or revocability or irrevocability.

Like partnerships, what matters members are entitled to vote upon, the manner in which votes may be cast,  what constitutes a quorum for acting on a matter, and what minimum vote is necessary to approve a matter, are subject to the members' agreement as expressed in their company agreement.  The statutory rules cited above apply ONLY if the company agreement is silent on those topics (which is why we refer to those rules as "default" rules).

 Delaware Statutes on Proxies

Unlike Texas, Delaware has not aggregated its business organizations statues within a single code.

Corporate Proxies

The Delaware General Corporation Law (DGCL) Section 212 covers voting by proxy.  Proxies are generally valid for three years and are only irrevocable if coupled with an interest "sufficient in law to support an irrevocable power."   However, Delaware recognizes a broader range of interests sufficient to support an irrevocable proxy than does Texas, because Section 212 provides that the coupled interest may be "an interest in the stock itself or an interest in the corporation generally."

Partnership Proxies

Delaware's Limited Partnership act provides in Section 17-302(e) that unless otherwise provided in the partnership agreement, the limited partners may vote in person or by proxy upon any matter they have the right to vote on.    Like Texas statutory law, there are no requirements or conditions on the proxy.

Delaware's Revised Uniform Partnership Act provides in Section 15- 407(d) virtually identical language regarding voting in person or by proxy.

LLC Proxies

Delaware's Limited Liability Company Act is modeled upon its Limited Partnership act, which explains why Section 18-302(d) contains voting language virtually identical with Limited Partnership act 17-302(e).

Summary

The governing documents of private entities should and usually do contain restrictions on the transferability of the economic interests of owners, but as I will show in the next installment of this blog series, those agreements rarely address the transferability of the voting powers of owners.   The Texas and Delaware statutes concerning partnerships, limited partnerships and LLCs in general leave owner voting procedures to be set forth, as the owners agree, in the governing documents of their entities, although both states establish "default" provisions in some cases  to govern in the event the governing documents omit to address that topic or the owners fail to enter into written governing documents for their entities.  Corporations differ significantly from partnerships and LLCs on this matter, as the state statute entitles equity owners to vote by proxy and set forth certain requirements for proxies which cannot be modified by agreement of the owners.

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Private Company Proxy Contest – Introduction

Posted on June 24, 2014 by Steve Robinson

A PRIVATE COMPANY PROXY CONTEST??

Public Company Changes in Control

An outsider (or insider) who wants to take control of a public company may buy up its  ownership interests, which are purchasable in the open market, by private acquisitions, or through tender offers.  Or the acquirer may instead try to take control of the public company by winning a proxy fight.  One method focuses on first acquiring economic control, which then results in managerial control; the other method reverses the procedure.

Private Company Changes in Control Effected by Outside Events and Conditions

On the other hand, managers/owners of a private company often consider themselves relatively invulnerable to uninvited changes in control.  Only "relatively," because they recognize that the impersonal marketplace/economy may trigger involuntary changes in control.  For example,  impersonal and general economic conditions, such as more competitive market conditions or economic downturns, may eventually force a private company to close its doors, to seek or to be forced into bankruptcy, or to sell out to a more successful competitor.   Personal injuries on the company's premises, a thieving cashier, or a casualty loss — that is, not impersonal or general economic conditions, but adverse events or circumstances affecting that company specifically but not others in the same line of business or in the same geographic region -- may lead to the same or similar results.

Some of those and many other risks can be guarded against or at least ameliorated, either by careful management practices or third party insurance.

What both categories of risk have in common is that, by and large, they originate from outside of the company's governance and ownership structure (assuming minimum competency and integrity of the management team).

Private Company Protections Against Changes in Control  Triggered by Shifts in Ownership or Changes in Management Composition

But what if control of the company were at risk from within?

Many founders of private companies engage good legal and accounting advisors, and follow their counsel, to build a stable, compliant structure for the business.  Among other things, they select a suitable legal structure (corporation, limited partnership or limited liability company, for example)  and require the managers/directors and owners to enter into appropriate internal governance agreements (shareholders agreement, limited partnership agreement, or company agreement, for example).

The founders are absolutely right to follow the advice of their attorneys when it comes to insisting that all owners and managers/directors execute appropriate internal governance instruments.  In another blog, I may discuss some of the consequences that ensue if a privately held company's owners and managers fail to enter into such contracts.  For now, I will just observe that if the owners and managers omit to agree upon how the company is to be funded, how profits and losses are to be allocated, how cash is to be distributed, how the entity is to be managed, whether and how an owner may transfer his ownership interest, and when the company is to be dissolved and terminated, then the law will supply the answers to fill that vacuum.  Few founders, managers/directors and owners will be likely to find the law's default provisions  on those topics satisfactory in all circumstances.

Any well drafted shareholders agreement, partnership (and limited partnership) agreement, or company agreement will address the two matters that open this blog: change of ownership and change of management control.

For a private company, changes in ownership can have fatal consequences.   After all,  the owners of a private company usually want exactly that — "privacy" in their affairs.  The precondition for privacy is to exclude everyone from the ownership group except the small circle of original owners, which means their mutual agreement not to transfer their ownership interests to outsiders.  Narrowly drafted exceptions to the transferability prohibition are usually admitted in order to permit intrafamily transfers and transfers for estate planning purposes.  And because an absolute prohibition against alienation of personal property is not permitted by law, the agreement's transfer restriction provisions should make the restrictions conditional instead of absolute.  An example of a conditional restriction is one that bars an owner (shareholder/partner/member) from selling his  interest (shares/partnership interest/membership interest) to any person that is not already an owner of the entity, without first offering to sell the same interest on the same financial terms to the entity or to all of the other owners; a requirement like that means the company's ownership will remain in the hands of the original owners (minus one).

Similarly, a change in managerial control can have devastating effects on a private company.  That is why the shareholders agreement/partnership agreement/company agreement usually designates the specific individuals to serve as (or to be elected or appointed) the initial directors/managers.  (In the case of a limited partnership agreement, the general partner must be the manager, while the limited partners in general must not have managerial authority over the entity; even in this situation, where the general partner is itself an entity and not an individual, the limited partnership agreement often includes covenants or conditions that specific individuals must at all times be the managers of  the general partner.)  Those agreements usually address the possibility of future changes in the composition of management, whether due to resignation, removal from office or other reason, by establishing a methodology by which the circle of original owners will control the selection of managerial successors.

Comparing the observation made at the beginning of this blog about how changes in control may be effected in public companies by means of purchasing ownership control (by purchasing existing ownership interests) or by  exercising voting control over the selection of management, it would at first appear that private companies governed by properly prepared governing agreements would simply not be vulnerable to similar uninvited changes in control.

But in the next part of this blog, I will point out a potential gap in the private company's fence.

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Protecting Trade Secrets – Part 2

Posted on June 15, 2014 by Steve Robinson

So what are the laws of Texas that protect the holders of  "trade secrets"?  My potential client wants to hear them, so he can sleep at night after disclosing his great new idea to a prospective funder — who signed a written confidentiality and NDA with my prospective client BEFORE getting a peek at the "trade secret."  (That's my hopeful assumption.)

Here are two — one criminal, one civil.  There may be others (but this blog would go on too long to discuss them), including  breach of fiduciary duty (depending upon the relationship between the parties), tortious interference, unfair competition, and liability for theft under the Texas Theft Liability Act.  However, exactly which alternative causes of action survive after enactment of the Texas Uniform Trade Secrets Act (see discussion below) isn't yet definite, because that Act states that it "displaces" all conflicting tort law and other laws providing civil remedies for trade secret misappropriation.

I point out to my potential client that theft of a "trade secret" is a third degree felony under Texas criminal law — two to ten years in state prison, plus a fine of up to $10,000.  Section 31.05 of the Penal Code makes it a criminal offense for anyone "without the owner's effective consent" (that's one critical reason for obtaining a signed NDA before disclosing the trade secret — otherwise, there may be some doubt, or some "he said, he said" argument, as to whether my potential client consented to the third party's misconduct) to knowingly do ANY of the following:

  • steal a trade secret
  • make a copy of an article (a writing, drawing, sample, object, device, etc.) representing a trade secret
  • communicate or transmit a trade secret.

The definition of "trade secret" under the Penal Code is broad.  For example, a trade secret includes ANY PART of scientific or technical information, design, process, procedure, formula or improvement PROVIDED that (1) it has value AND (2) the owner has taken steps to protect it from access by anyone other than those persons the owner chooses to disclose it to for limited purposes.  If you reread (2), then you recognize ANOTHER reason for my potential client not to show his special idea to any possible funding source who hasn't first signed a NDA.

But criminal prosecution is a big, big thing; will require the victim's persuading the District Attorney (usually) to vindicate his rights; and has a higher standard of proof to meet than would apply in a noncriminal tribunal.  (On the other hand, the word "felony" is a pretty powerful noun that may cause a third party some hesitation, if he is tempted to steal the trade secret, copy it, or disclose it.)

On the civil side, Texas adopted its version of the Uniform Trade Secrets Act in 2013 (Chapter 134A of the Civil Practice and Remedies Code).

The Texas Uniform Trade Secrets Act offers my potentially wronged potential client three tools against the person who misuses or wrongly discloses his trade secret (or tries to):

  • Injunctive relief by a court against actual or threatened misappropriation
  • Monetary damages, including not only actual loss suffered by my potential client but also recovery from the bad actor of the profits he gained from his bad conduct (called his "unjust enrichment"); or in lieu of those damage measures, the court may impose a royalty for the benefit of the true owner on the bad actor's wrongful disclosure or use of the trade secret; PLUS, if that actor's misappropriation was "willful and malicious," my potential client may recover treble damages
  • Attorney fees.  This goes right to the heart of my potential client's worry that he won't be able to afford an attorney to pursue the wrongdoer, because where the court determines the misappropriation was "willful and malicious" it may award attorney's fees.

The definition of "trade secret" under the Texas Uniform Trade Secrets Act is far broader — as you would expect — than it is under the Penal Code.

A "trade secret" entitled to protection under the Texas Uniform Trade Secrets Act means ANY INFORMATION with two characteristics:

  1. it has economic value that comes from NOT being generally known by others and not being something they can readily obtain by proper means, and which would have economic value to them if they could use or disclose it;
  2. its reasonable owner has exercised reasonable efforts to keep the information secret (recognize another reason to insist on a NDA?)

So my potential client ought to feel pretty secure about demonstrating or disclosing his great new idea to third party investors, lenders or other capital sources BUT ONLY IF he has taken reasonable steps to guard the privacy of his idea, including  getting the other person to sign a confidentiality agreement and NDA BEFORE sharing the "trade secret."

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Protecting Trade Secrets – Part 1

Posted on June 13, 2014 by Steve Robinson

A potential client called me for help in starting up a company to develop, produce, market and finance a manufacturing idea — a confidential, proprietary “trade secret” — he had conceived and refined after many months of hard work.

But what we wound up talking mostly about that day was his fear that when he disclosed his idea to potential capital partners to attract their interest, they would politely pass on financing him but would steal the idea for their own benefit. And he was sure that those big companies could outspend and outlast him in any lawsuit he could bring against them for stealing his idea.

This was my advice to him.

First, you do your homework to identify sound, creditable and trustworthy (insofar as you can determine) potential capital sources who have demonstrated an interest in funding the kind of idea or invention you are offering (how to do that, is not the topic of this blog; but many inventors and entrepreneurs could avoid a great deal of remorse if they took this step seriously).

Second, you only show them your idea, gadget, invention, algorithm or invention AFTER you get their signature to a good, strong confidentiality and nondisclosure agreement. (I wrote about NDAs back in 2012.) Whether or not they have any interest in pursuing the idea with you, they will be contractually bound not to use it or disclose it to any other person.

But, he said, companies break contracts all the time; how can a piece of paper stop them?

Third, I explained that, if he had taken the first step listed above, he would likely be dealing with a reputable counterparty, someone who would value his own good reputation (and his opinion of himself above the sleazy chance to pocket some money by stealing another man’s idea. There is a strong moral power in a good confidentiality and nondisclosure agreement.

But — fourth — he should not rely upon moral rectitude alone to keep the counterparty honest. He should rely upon the law and a well-written NDA.

This man wasn’t aware of two key factors. The law provides several civil and criminal inducements to encourage persons on the receiving end of intellectual property to not misappropriate that property. And trial court attorneys are happy to represent you on a contingency basis — so they, not you, are really funding the lawsuit — if you bring them a well built, winning set of facts.

In Part 2 of this blog, I will write about the Texas statutes every inventor, designer, programmer, entrepreneur, intellectual property owner and businessman in the state ought to be familiar with, when it comes to protecting their trade secrets and other valuable information.

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A Little Statute of Frauds Knowledge

Posted on June 12, 2014 by Steve Robinson

Over the years, I've had to pull out the old Statute of Frauds whenever potential clients tell me stories of the "agreements" they have to buy, sell or lease property, goods or services; to earn a fee for putting together a deal for another person or for closing a sale; and so on.  And the stories turn into questions: How do I collect what's owed me? The other side won't perform its promise, how do I get what I am entitled to?

I say "potential clients" because more often than not, after I answer their questions, they go looking for another attorney to tell them what they want to hear.

The reason is often a principle learned the first semester of law school although often forgotten by practitioners: the Statute of Frauds. In Texas, the Statute of Frauds appears as Chapter 26 of the Business and Commerce Code.  The second part of that chapter — Section 26.02 — is one that many consumers are aware of: it's the statute which requires loan agreements to be in writing in order to be enforceable.  Individuals generally like that statute, because it is designed to protect  borrowers against lenders.

But the real Statute of Frauds appears in Section 26.01 — "Promise or Agreement Must be in Writing."  (There are other statutes of frauds, too, of less general applicability, like the one in Article Two of the Uniform Commercial Code, which says that an agreement to sell goods for $500 or more isn't enforceable absent a written agreement signed by the person against whom enforcement is sought.  So if you stumble upon an antique desk at a garage sale that is "a steal" at $600 and get the seller to agree by word of mouth to hold it half an hour until you return with the money, don't threaten legal action upon discovering 30 minutes later that he sold the desk for $650 to another guy while you were gone.)

In a nutshell, what Section 26.01 says is that some kinds of promises and agreements are NOT enforceable unless contained in a WRITING that is SIGNED by the promisor. What types of promises and agreements? Among others: Real estate leases for a period of more than one year; contracts to sell real estate; promises to pay commissions for selling oil, gas or mineral interests; any  other agreement "not to be performed within one year from the date of making the agreement"; or a promise to cover another person's debt.

That means that the "contract" you have by way of oral agreement or handshake to buy the house your spouse loves, or to sell your house to that couple that immediately fell in love with it, cannot be enforced — either by Seller or the Buyer.

That means that when you got that fabulous oral lease of a house for your family for the next two years, or shook hands with the landlord on a five year lease of that commercial space, it cannot be enforced — either by the Landlord or the Tenant.

That means that when you got that fabulous handshake agreement for home services, or employment, for the next three years, it cannot be enforced — either by the obligee/promisee (you) or the obligor/promisor (the other guy).

And that means that when the majority stockholder and president of the corporation told you — in front of witnesses, no less — that he absolutely personally guaranteed to pay you the money you were loaning to his company should it default — sorry, you have a problem.

Clever litigators, sympathetic courts, and many antifraud statutes have punched exceptions into the Statute of Frauds for especially egregious or seriously inequitable factual situations or circumstances, especially where the parties were not acting at arm's length but there existed some relationship of trust between them or there was a substantial disparity of bargaining power between the parties, and it is sometimes possible to staple together three or four emails or handwritten notes to create the semblance of a single authenticated writing, BUT the initial hurdle still remains — IF YOU DIDN'T GET IT IN WRITING SIGNED BY THE OTHER SIDE, YOU MAY HAVE A STATUTE OF FRAUDS PROBLEM.

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Unfinished Business Doctrine: Federal Judge Gets it Right!

Posted on June 12, 2014 by Steve Robinson

Big news today in the development of the unfinished business doctrine and defunct law firms!

On June 11, 2014, the US District Court in San Francisco ruled CONTRARY to the shocking decision issued earlier this year by a California bankruptcy court.  That bankruptcy court, issuing a ruling in the Heller case before it, had refused to dismiss claims brought by Heller's trustee seeking disgorgement of profits earned by law firms to which former Heller attorneys had decamped prior to Heller's dissolution but after its financial distress had begun.

The US District Court concluded that the old Heller firm has NO RIGHT to the profits earned from uncompleted legal matters which Heller's old partners took to their new law firms.  The court dismissed the Heller trustee's lawsuits against Davis Wright Tremaine, Foley & Lardner, and Orrick, Herrington & Sutcliffe.

This judge gets it!  His order says "Heller ceased to be able to represent its clients, leaving them with no choice but to seek representation elsewhere.  [The defendant law firms] came to the rescue of these clients and provided them with legal services on ongoing matters…. [and] did the work that generated the fees at issue here.  With [those law firms] those fees should stay."

The Heller trustee vows to appeal.

This could not have come at a more opportune time, because just last week New York's Court of Appeals heard arguments on the very same issue (albeit different state law). (See my blog posted June 10, 2014.)  That court must be influenced by today's decision of the US Court in San Francisco.

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Unfinished Business Doctrine in NY

Posted on June 11, 2014 by Steve Robinson

I wrote blogs last year about the unfinished business doctrine as applied to defunct law firms.  To summarize: I am strongly against it, both on legal grounds and on practical, economic grounds.

Now we await a major decision in the development of that doctrine as it may or may not apply to law firms.

On June 4, 2014, New York's Court of Appeals (the highest state court) heard oral arguments on whether or not the doctrine should apply in the disposition of Coudert Brothers and Thelen LLP.  As The Wall Street Journal wrote last week, the court's decision "will provide clarity into how much money, if any, should flow back to [those defunct firms'] creditors" but more importantly, whether New York law firms "risk serious financial consequences if they recruit lateral talent" from law firms that are at or near insolvency.

Arguments against applying the doctrine (as California has done) include the unique nature of legal services, in particular that clients have the right to choose their attorneys and if those attorneys depart from a collapsing enterprise they  "and their new employers shouldn't be punished for sticking with an assignment after a law firm collapses."

Those successor firms argued that client work is NOT a property like a piece of real estate, but rather is a service, and  the attorney and firm which perform the service have the right to be paid for their work, as matters of law, of good public policy, and of the ethical rules governing attorneys.

(If the arguments above and below against the doctrine sound familiar, remember, you read them in my earlier blogs.)

Creditors' and estates' attorneys argued that this was ridiculous, and that there exists "no evidence anywhere" that the client's freedom to select counsel of his choosing had been affected in the slightest.  (What planet are they from?)  Bankruptcy trustees in the Dewey, Howrey and Heller bankruptcies demanded that New York follow California on this question, offering this absurd argument: "If a partner understands that his fiduciary duty to his … dying law firm does not end by him simply walking out the door, [he] will be incentivized to address the underlying problems … rather than flee at the first sign of trouble."  (In other words, he will NOT enjoy any of the rights of free association and market movement that other professional and employees have, but will be forever chained to a company -  often very large, with many offices around the globe, whose financial distresses he did not create nor can he improve — AND, by the way, his clients will be very happy if he (A) remains and their cases suffer disastrously for that reason or (B) they have to find new counsel elsewhere at great expense and possibly great harm to their pending matters.)

Fortunately, at the hearing, the Court judges asked some common sense questions, like “Isn’t this [the unfinished business doctrine] an anachronism in the world we have today where we value the mobility of lawyers?” and “How does it [the unfinished business doctrine] benefit a client?”  An attorney for one of the firms that hired "fleeing" laterals tried to explain that if the doctrine is widely accepted, it will have the effect of creating a non-competition agreement that would block attorneys from moving to new firms.

Thankfully, the Court seemed skeptical of the arguments advanced by the trustees and creditors.

We will have to wait for the decision.

 

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Reinstatement of Your Terminated Texas Entity

Posted on May 16, 2014 by Steve Robinson

In my last blog, I explained and tried to offer general information and advice about the consequences that ensue if your Texas corporation, LLC or LLP misses the deadline for filing a report or making a payment to the Comptroller for the company's franchise tax.  Those consequences may include termination of the Texas entity.

In this post, I want to offer a different kind of information and advice — GOOD NEWS!

The good news is that — in most situations — it is possible to remedy the delinquency and get your entity reinstated with the Secretary of State.  Reinstatement won't always fix all problems — the biggest being the imposition of personal liability for company debts, which in some cases can become irredeemable— but reinstatement will get the entity back in the state's good graces, and the personal liability exposure will stop expanding.

Assume the worst happened — the Comptroller certified to the SOS that the company's corporate privileges were forfeited and the company failed to revive itself within 120 days of the forfeiture date, and the SOS then terminated the company's charter.

Revival, or reinstatement, is still possible.  You should contact the Comptroller's office and verify the reason for the delinquency and what is required to cure it.  With that information, you can complete and submit the missing reports  and pay the past due amounts (making sure to get a "payoff" number from the Comptroller that includes all taxes, interest and penalties).   When you deliver the missing reports and pay the delinquent amounts, you will ask the Comptroller for a "tax clearance letter," which essentially says that the company's account is cleared up.

Remember that the company itself is "dead," so it requires a director, officer or shareholder of the company (if it was a corporation) or individuals holding corresponding roles of the company (if it was an LLC or a LP) AT THE TIME OF FORFEITURE to formally request the SOS to set aside the forfeiture (done on a form prescribed by the SOS); you include the tax clearance letter as an attachment to that written request.

The SOS will then reinstate the company and you are back in legal shape to resume business!

The company's filing history, which is publicly available, will always show that the company's corporate privileges were forfeited and its charter subsequently terminated, and will also show the reinstatement.  But because most third parties seem unaware of the personal liability consequences which can arise upon forfeiture, and are frequently uninterested in performing due diligence on a  company's non- financial history, it is possible that third parties that deal with the company in future transactions won't make themselves aware of the company's past forfeiture or worry about what problems might arise to the company's insiders from that lapse.

One step that sometimes trips up people trying to reinstate their Texas entity is that during the interim when the company's charter was forfeited, another company takes their corporate name.  (Remember, again, that a company which has had its charter forfeited is "dead" and it has ceased to hold any right to its corporate name.)  If that has happened, then your company cannot be reinstated under its old corporate name — someone else has it.  In conjunction with your written request for reinstatement, you will have to submit to the SOS an amendment to the company's certificate of formation to formally change your company's name.

The other condition you should bear is mind is that the reinstatement should be accomplished before the third anniversary of the date your charter was terminated.

Sometimes the owner of a company which has been terminated assumes that he cannot revive or reinstate the old company, so he instead forms a new one.  He should be aware that revival is not just a possibility but can be a better, less expensive choice that continues the old company as though the termination never occurred.

 

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Texas Franchise Tax Delinquency

Posted on May 12, 2014 by Steve Robinson

Texas franchise tax delinquency may lead to having your Texas company (corporation, LLC, LP) involuntarily terminated by the Secretary of State and Comptroller (administrative termination, in contrast to judicial termination).  A company may become delinquent because it  failed to pay or file a report on franchise tax by the due date, a fact which may appear to come as a  “surprise” to clients.

It shouldn’t, because it means the company did NOT file a report on time or did NOT pay the tax (including interest and penalties) when due and then ignored repeated delinquency notifications.

Nevertheless, we all overlook things, or the employee charged with compliance left the company and that task wasn’t picked up by another employee, or the paperwork kept getting shuffled to the bottom of the inbox until it disappeared entirely.

But Texas franchise tax delinquency is something that really should not be overlooked.

In the first place — even before charter termination occurs — the Comptroller by statute must “forfeit” the corporate privileges of a company if it fails to file a missed report or pay an unpaid amount within 45 days after the Comptroller has sent the company a notice that it is delinquent.  (See my previous blog post about maintaining a registered agent office; the Comptroller only has to mail its notices to the company’s last address known to the Comptroller; if the company moves and neglects to update the Comptroller’s records with  a new address, that is the company’s problem, not the Comptroller’s).

What does “forfeiture” of privileges mean?

Bad things:  the company is barred from filing suit in a Texas state court, or defending itself in a suit against it in a Texas state court; AND each director and officer (or, in the case of an LLC or limited partnership, the corresponding offices) becomes personally liable for company debts incurred in Texas after the date the report or payment was due and up until the date privileges are revived.

The second bad thing should grab the attention of every company principal — it means that he or she is personally liable, just like a general partner in a partnership (so says the statute), for the unpaid franchise taxes, penalties and interest AND all other debts the company incurs after the original due date.   What if the company fails to file the franchise tax report due every May 15, closes a $2 million borrowing on May 16, and fails to cure?  Then the lender doesn’t have to produce a personal guaranty by the directors and officers to sue them for the entire $2 million if the company defaults.  All the lender has to do to collect a judgment against the individuals is to establish that the debt was incurred while the privileges of the company were forfeited (assuming the company doesn’t timely revive the privileges).

What if the company cures the delinquency?  Depends when that happens.  If the company files the missing report and makes its delinquent payment BEFORE the date privileges are forfeited, then the personal liability hammer never drops; if AFTER the date privileges are forfeited but BEFORE the date the company’s charter is terminated, then the personal liability hammer is holstered as if it never happened.

But if the company’s privileges have been forfeited AND the company fails within 120 days after the forfeiture date to pay all amounts necessary to revive the privileges (including the $50 fee for a late filing, whether or not any franchise tax was due), then the Comptroller certifies that fact to the Secretary of State, who thereupon sends  the company notice (again, at the last address for the company known to the SOS) that its charter has been involuntarily forfeited or terminated.

And this is where the personal liability becomes very sticky, because if the charter has been forfeited, then subsequent revival (the procedure for revival in that situation to be outlined in a future blog post) has NO effect on the personal liability of directors and officers.

Returning to the hypothetical above where the company didn’t file its franchise tax report by May 15 and later closed on a multimillion dollar borrowing: if the company becomes so delinquent that its charter is forfeited later that year, then the directors and officers REMAIN personally liable for that debt.

OUCH!

 

 

 

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