SEC Approves Making Material Disclosures on Social Media

The SEC recently approved of executives making material disclosures about their company via social media sites like Facebook and Twitter.  I find this fascinating for two reasons.  First, because of the change this brings to the painful securities disclosure regulatory scheme that has been in place for so long, which has required companies to disseminate information broadly and non-exclusively through filings and press releases.  Often cumbersome, but at least it was consistent and predictable for the investing public.  And second, because this information could now be at risk of being released without the sanitizer of the company's PR and legal departments.  

So now investors will have to follow the feeds and tweets of corporate officers to keep up with the latest material information -- as long as the company tells them to look there.

Corporations scam arriving in your mailbox

The year-end is approaching and companies should start to think about annual meetings.  The Massachusetts corporate law is similar to many other state laws requiring corporations to hold an annual meeting for the purpose of electing board members and other corporate governance.  For many smaller corporations, this is a typically an easy process, but that does not mean you should ignore it. However, recently I received some forms in the mail from "Massachusetts Corporate Compliance" that would help me complete this process - for a fee.  You do have to file a notice annually with the Commonwealth of Massachusetts, but these forms are not it.  The Massachusetts Secretary of the Commonwealth even posted a notice about this solicitation.

When you are filing your annual reports in Massachusetts, you can do so with a simple online filing at the Secretary of the Commonwealth's Web site.  Happy New Year!

Can a Court Rewrite Your LLC Agreement? You Might Be Surprised.

What do you do if you never put a limited liability company operating agreement on paper?  In some cases, the answer may be decided against your wishes by a court. I was recently speaking with a small business owner who ran into trouble with the other member of his limited liability company.  The two had formed the LLC six years ago by filing with the Commonwealth but never put an operating agreement on paper.  However, he indicated that they had an oral agreement on a variety of things that would normally be in an operating agreement - how the LLC is managed, how the profits and losses are divided, how to buyout a member who leaves, etc.  Now he wanted to use some of those agreements to resolve the conflict.

In Massachusetts (as well as many other states), a written operating agreement is not required; members can have an oral agreement on how their company is structured and operated.  But that flexibility can bring risk.  Here's why.

States have a common law concept called the "statute of frauds".  (For those of you who eyes are immediately starting to glaze over at the sight of technical legal talk, you can skip to the paragraph that begins "So what does this mean for your company?" to understand the practical implications.) State laws vary, but generally the statute of frauds states that certain contracts must be in writing and signed if you are going to enforce them.  In addition to other things, this common law principal includes any contract that cannot by its terms be performed within a year.  Note that an agreement that happens to take more than a year is not automatically subject unless the agreement specifically states that it will take more than a year.  If so, the contract is not automatically void, but one party can raise the statute of frauds in order to have the contract voided.  Remember that this is a complex topic because there are some exceptions, but as a general principal, long-term unwritten agreements carry some uncertainty.

This issue became much more relevant to LLCs last year when the Delaware Chancery Court ruled that an oral LLC agreement was subject to the statute of frauds.  In Olson v. Halvorsen, C.A. No. 1884-VCL (Del. Ch. Dec. 22, 2008), a hedge fund founder who was removed by the other members demanded that the court enforce a multi-year earnout agreement that was included in their unsigned draft of an LLC agreement - an earnout worth well over $100 million!  The court held that because the earnout was to be paid over the course of six years, it falls within the statute of frauds and was therefore unenforceable.  The former hedge fund manager's claim for the payout was rejected.

The applicability of this case in Delaware adds some uncertainty to the operating agreements of LLCs formed there.  Other states, including Massachusetts, have yet to decide this issue definitively, but the Delaware courts often serve as a model for other courts when they are facing corporate and LLC issues.  So this decision may eventually have implications for your agreement.

So what does this mean for your company? If your LLC is operating under an oral operating agreement, many of the provisions with respect to management and such may be enforceable because they can be performed within a year.  However, as the court decided in Delaware, if you have an oral agreement with the other members that entitles you to some benefit that extends beyond one year, you may lose that right in a dispute.  For example, if the members agree that if you were to be hit by a bus tomorrow, the other members would buy back your membership interest with installment payments over five years, the other members might be able to successfully void that provision upon your untimely demise under the statute of frauds.

So here are some tips with respect to operating agreements in light of this case law:

  1. Put your LLC operating agreement in writing.  Operating Agreements do not have to be fancy.  You can write the provisions of your agreement in any way that expresses the true intent of the parties.  Working with a lawyer may help save a tremendous amount of agony since they have experience in drafting agreements that will be enforceable.  But don't get caught up in the formalities - just get it in writing.
  2. Make sure everyone signs the agreement.  A critical element of the statute of frauds is that the agreement must be signed by the person against whom it will be enforced.  As in the Olson case described above, the members wrote out the provisions of an agreement, but the courts did not enforce it because the parties never signed it.  I have dealt with other situations where clients "forget" to sign a document.  It may be easily overlooked a the end of a negotiation, a critical issue to protecting your rights.
  3. Revisit your agreement periodically.  Companies that have been operating for several years might be surprised by what is in their operating agreements because the needs of the members and the company may change over time.  This is even more important if you are operating with an oral agreement.  After a few years, the members may have very different recollections of your agreement, which may lead to messy disputes down the road.  I would recommend that you take a fresh look at your agreement annually when you have an annual meeting.

What happens next? Four tips for planning succession in small businesses.

I have been working with a few small companies that are run by founders or the children of founders and they inevitably come to a point where they start thinking about how the business would run without them. Early on, this idea doesn't even cross their minds; they naturally spend their energy on how to run the business and are not thinking about how to leave the business. This often comes up in the context of retirement, particularly where one or more of the partners does not have an "heir" to take their place.  Depending on who the current partners are, those willing to take the helm may or may not be seen as "worthy".

But all small businesses should also think about the dreaded unplanned exits:  what if one member dies or is permanently disabled?  Some planning now in the form of a Shareholder Agreement (sometimes known as a "Buy/Sell Agreement" or "Cross Purchase Agreement") can save the company and its partners stress and expense down the road.

So what should you consider when planning such an agreement?  Like any contract, you can choose from a number of options, but I typically advise as a baseline to consider the following:

  1. Restriction on transfers of stock or membership interest.  A small company will likely want to restrict who is coming and going as an owner because of the inherent close nature of the partners's relationship.  The partners may want to prevent one partner from going out and selling his ownership interest to someone undesirable to the other partners.  This is typically done with an outright restriction on transfer unless the interest is first offered to be sold to the company and/or the other partners first.  This offers some stability to the company and the other partners to move forward.  In the event they refuse, then the selling partner may transfer the interest with the inferred consent of the others.
  2. What are the "trigger" events for a purchase of a partner's interest?  This agreement generally allows the partners or the company (or both) the right or obligation to purchase one partner's interest in the company in the form of stock or some other membership interest.  Many companies will have a trigger on the event of the partners death so that the interest is purchased from the surviving spouse (this is both as a consideration to the spouse and because the other partners may not be interested in partnering with that spouse).  But you should also consider whether there should be a trigger for a partner's permanent disability preventing them from continuing in the business.  Or, under better circumstances, what if one partner just wants to retire?  The last one is harder because of the lack of objective measures, but will certainly be of interest to the partners at some point.
  3. How do you define the trigger events? A partner's death is a pretty easy trigger to recognize, but when is someone considered disabled to the point that the company should repurchase her interest?  Generally, the disability should be described in detail with objective standards (e.g. mental or physical illness that incapacitating a stockholder from performing normal duties as director, officer, or employee for a period of six consecutive months or any six months in a 12-month period).  Obviously, these can change depending on the circumstances, but are an example.  Often, that determination must be made by a licensed physician, or in some cases, more than one if a second opinion is required.
  4. How do you fund the cross purchase? (and yes, you should fund it).  When the agreement is triggered and the repurchase of stock by the company or the cross purchase by the other partners is required, what if they don't have the money?  There are insurance products that can help here.  For example, when one of the partners dies, a life insurance policy taken out on her life can be used to pay for the stock repurchase.  But if you have a trigger for disability, you might also want disability insurance to cover (in which case your trigger should match the insurance policy definition of "disability").  This gets a bit more complicated when you decide how to purchase the policies - whether the company is the insured or the individual partners take out personal policies on the lives of the other partners.  The premium prices will be different depending on the age and health of the partners, and there are some different tax treatments depending on whether the company of the partners hold the policies.  Finally, in the event of a partner's retirement, funding cannot be done through insurance so you may consider paying by financing the purchase price over a period of time.  That of course will depend on the nature of the business (and the partner's view of the long-term success of the business).

There are many other considerations you may want to take into account in negotiating among the partners, but these should be considered as a baseline.  Your attorney and accountant can also provide additional thoughts on how your agreement will impact your particular situation.