Corporate governance and the family business

Clients who own small and family businesses, particularly in these tough economic times, are often resistant to the suggestion of spending money on legal fees to document the ownership of the corporate entity, draft a shareholders’ or operating agreement and/or document the responsibilities of key personnel. The mere suggestion by counsel that the time and money be expended to properly document the ownership and operations of the business immediately becomes scrutinized by the business person as just another self-interest effort by counsel to churn fees. However, the small and family business owner is often unaware that the legal fees associated with such preventive measures likely will be far lower than the financial and emotional cost of future litigation. This article addresses the need to document ownership and to outline the duties and responsibilities of key employees in small and family businesses.
It is usually not until a moment of urgency, frequently occasioned by a breach of the trust between friends or family members, that the small business owners realize that there is a need to definitively know who owns the shares of the corporate entity, or who the officers and directors are, or who is responsible for certain liabilities of the company. Now that a crisis has arisen, there is a mad scramble to locate the Corporate Kit, only to discover that shares have never been issued and/or there is no Shareholders’ Agreement or Operating Agreement. With no documentation to support the owners’ respective claims, the corporate attorney must inform his or her client that it is too late to begin observing corporate formalities, and that the business will likely incur thousands of dollars in litigation fees and expenses to determine the ownership and/or responsibility for liabilities of the business through litigation.
So how does it come to pass that shares of stock are not issued when the business entity is formed? Although there are probably too many situations to elaborate upon, a few scenarios come to mind. It may be that the corporate attorney was involved at the inception and told not to do any work or put off by the client. The business entity may have been formed by an accountant or other non-lawyer. Perhaps the business person did not have the funds sufficient to pay his or her attorney to do anything other than form the corporate entity and order a Corporate Kit, or perhaps the business person imprudently believed that an oral understanding was sufficient.
Small businesses are often informally started between friends or family members with an idea, a discussion and a handshake. In many instances, the business owners are busy getting their business operations up and running and just want to make their business “official” with the least amount of time, effort and money. So the owners will quickly form a corporate entity, obtain a tax identification number and then store the unopened Corporate Kit on an out-of-the-way shelf to collect dust, while they focus on operational issues like financing, production and sales. However, once the often chaotic period accompanying a business start-up is over, small and family business owners rarely return to the Corporate Kit to issue shares of stock or draft an operating agreement. Rather, they simply continue to operate in reliance on the trust between family members or friends without taking the time to document ownership or enter into operational agreements, exposing not only their business, but also their personal relationships to damage and dissolution.
For example, ABC Corp., a thriving family business, is owned by second and third generation family members, Father A, Son B and Daughter C. ABC Corp. exercises its lease option to purchase the multi-million dollar warehouse complex where its business operates and advances ten percent of the purchase price as a down payment. Just prior to closing, the corporate attorney for ABC Corp. forms a holding company, DEF Corp., for the purpose of holding the real property separate and apart from ABC Corp.’s other business activities. Of course, the shares of stock for DEF Corp. are never issued, and there is no shareholders’ agreement or other document which definitively identifies the share owners. Unbeknownst to the shareholders of ABC Corp., the Son B, who has been acting as President of ABC Corp. begins to hold himself out as the President, sole owner and shareholder of DEF Corp. in correspondence and financial statements, and files tax returns on behalf of DEF Corp., in which he indicates that he is the sole shareholder. When confronted, Son B refuses to acknowledge the other family members as owners of DEF Corp. and claims that it was the understanding in the family that he would be the sole owner of the warehouse complex, despite ABC Corp. paying the down payment and mortgage on the property. One can easily imagine that besides the raging indigestion at the next family Thanksgiving dinner, the substantial financial cost to unscramble this matter through the court system could have been avoided had the family simply expended a relatively small amount of money in legal fees to document the ownership when DEF Corp. was formed.
Whether dealing with an existing client or a new one, when no shares of stock have been issued and there are no shareholders’ or operating agreements, how does the corporate attorney determine what the ownership percentage is or who is entitled to assets and responsible for the liabilities of a small business? In New York State, the Courts have recognized that closely-held corporations and small and family businesses often rely on family bonds and trust, and corporate formalities are frequently neglected. Thus, the Courts can look to other evidence of ownership in the absence of issued shares of stock and shareholders’ agreements. Kun v. Fulop, 71 A.D.3d 832 (2d Dept. 2010) leave denied, 15 N.Y.3d 701 (2010). The most significant factor which will be considered is evidence of payment or an obligation to make payment for the shares of the stock of the corporation as, pursuant to Business Corporation Law §504, payment of consideration for shares of stock is required to attain shareholder status. United States Radiator Corp. v. State, 208 N.Y. 144, 149-50 (1913); Heisler v. Gringas, 90 N.Y.2d 682, 688 (1997); LaRosa v. Arbusman, 74 A.D.3d 601, 604 (1st Dept. 2010).
But what about the tax returns? Are the tax returns a definitive indicator of the ownership of the corporate entity? It is clear that a party will be stopped from taking a position which is contrary to a position taken on his or her tax returns, and thus, the signer of the tax return will be held to the designation of ownership set forth in the return. Friedman v. Ocean Dreams, LLC, 15 Misc. 3d 1146(A), 2007 N.Y. Slip Op. 51188(U), at 11-12 [2007], aff’d, 56 A.D.3d 719 (1st Dept. 2008). But what about the non-signing party? If the non-signing party received either a copy of the tax returns which contained the ownership designation or a K-1 without objecting to an inaccurate designation of ownership, it can be argued that the non-signing party is precluded from his or her later objection. See, e.g., In re Rivera, 9 Misc.3d 1102(A), 2005 N.Y. Slip Op. 51378(U) at 7-8 [Surr. Ct., Nassau Co., Sept. 1, 2005]. But what if the non-signing party does not receive copies of the tax returns, does not receive a K-1 (where he or she is unaware that they are entitled to a K-1) or where the corporate entity is a C-Corp? How then will ownership be determined? A prudent attorney will consider equitable ownership arguments, including the imposition of a constructive trust, if the facts so warrant.
Another important matter which should be addressed and documented at the earliest point in time is the duties and responsibilities of the key employees. In the context of a small or family business, this would mean documenting the duties and responsibilities of the owner/employees. The client’s response to this suggestion is usually, “we have an oral understanding of who is going to do what.” However, when asked to describe the duties and responsibilities of each owner/employee, either the client is unable to do so or the respective owners have a drastically different version of this “understanding.”
It is important not only have a written description of the duties and responsibilities of each key employee, but also to tie the performance of those duties and responsibilities to compensation. Understanding that business is dynamic and things do change, this proposed written guideline should be revisited and updated at logical intervals and/or annually.
For example, the owners of a successful widget factory bring their respective sons into the business, both earning the same compensation. The son of the first shareholder works endless hours managing the production line and logistics, and the other shareholder’s son joins the USTA and travels for nine months every year to play competitive tennis, with the dream that somehow his tennis prowess will translate to the sale of millions of widgets to the linesmen. This is clearly a formula for disaster for the business down the line. However, by enumerating the duties and responsibilities of each son, as well as tying compensation to some objective criteria, such as production of widgets and widget sales, this dysfunctional situation can be avoided. So if, in fact, the tennis linesmen do have a need for widgets, and sales can be generated while on tour, any disparity in compensation between the two sons can be appropriately proportioned.
Although it is quite easy to provide criticism after the fact, the point here is that as counsel for a small or family business, it is important to stress the need to document corporate ownership at the earliest possible occasion, with at least annual meetings with the corporate attorney to document any anticipated changes. Likewise, and equally important, small businesses should document the duties and responsibilities of its key employees and tie the performance of such duties and responsibilities to the employees’ compensation – even if the key employee is an owner. The prevention aspect can be best summed up by the slogan of the Midas Muffler commercial in which the mechanic states “you can pay me now or pay me later,” thus implying that the costs associated with prevention are substantially less than the later cost to cure. So the message to the small and family business owners is – it’s your choice.
Richard G. Gertler, Esq. is a partner of the firm Thaler & Gertler, LLP, which concentrates its practice in the areas of commercial litigation, bankruptcy, and corporate governance.