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SJC issues key interpretive decision in employee-shareholder context

Posted on Mar 18th, 2014
Last week’s decision by the Massachusetts Supreme Judicial Court in Selmark Associates et al. v. Ehrlich is a critical reminder to corporate lawyers and fiduciaries of the extensive protections of minority shareholders of Massachusetts corporations and the necessity for carefully drafted shareholder and employment agreements with shareholder employees in such companies.  Two key takeaways from this decision are as follows:
  • In closely held corporations, Massachusetts has long afforded minority shareholders the protection of a fiduciary duty owed to them by the other shareholders that is more extensive than other states, such as Delaware, for example.  While courts will allow shareholders to provide otherwise in written agreements, Selmark holds that if the shareholder agreements are not specifically on point, the fiduciary duty standard will apply.
  • Going the other way, Selmark holds that the solicitation of customers by a former employee shareholder (who is then still a shareholder) is also breach of such shareholder’s fiduciary duty to his fellow shareholders, even where the employment was terminated by the corporation and was considered a “freeze out” under corporate law.  While this holding certainly could give companies more leverage in separation discussions with former employee shareholders, the potential uncertainty created over the scope of such a non-solicitation duty that was not reduced to writing could present significant challenges to practitioners on both sides of the matter.

Because of the potential uncertainly to fiduciary duty claims added by this decision, parties on both sides would be well advised to address the issue of fiduciary duty head-on in their agreements, and to define as specifically as possible the scope of any limitations to that duty.  While this point is not addressed by the Court, both employers and employees may also consider the advantages (and disadvantages) of using holding companies and special purpose entities to separate the legal identity of the employee from that of the shareholder.

In addition, potential buyers and sellers of Massachusetts corporations should take note of this case in the planning of their transaction.

If you have any questions about this topic, please feel free to email us.

Background

They say that bad facts often make bad law.  If that is true, then this case certainly does not disappoint.  The case ultimately arises from a sudden (and apparently unwarranted) termination of employment of a shareholder employee, Ehrlich, who  had been a long term valued employee of Selmark and its affiliate Marathon.  Ehrlich originally was employed by Marathon and had informally been promised equity in the company by its founder.  As part of Marathon founder’s planned retirement and succession plan a number of years later, Erhlick entered into a series of agreements with the sole stockholder of Selmark (Elofson) involving the gradual sale of Marathon to Ehrlich and Selmark. These agreements comprised a stock purchase agreement, an employment agreement, a conversion agreement and a stock (shareholders) agreement.

The purchase agreement provided for the gradual acquisition of Marathon stock by the two purchasers through monthly payments pursuant to promissory notes. Upon full payment, Selmark would own 51% and Ehrlich 49%. Under the terms of the purchase agreement, Marathon bore primary responsibility for the monthly payments and Ehrlich and Selmark were each separate co-guarantors.

The employment agreement between Ehrlich and Marathon provided for a term of employment through 2002, with extension possible on the written agreement of the parties. Per its terms, Ehrlich became the vice-president of Marathon and potentially a director, and could only be terminated for cause. If the agreement was not extended, at the conclusion of the initial contract term, it would terminate and Ehrlich would be required to resign as an officer and director of Marathon.

Pursuant to a separate  conversion agreement, Ehrlich had the option, once he and Selmark fully paid off the purchase of Marathon, to convert what would his then 49% interest in Marathon into a 12.5% interest in Selmark (and then Selmark would own 100% of Marathon).  This agreement also required that, upon conversion, Selmark offer Ehrlich an employment agreement that would provide “for compensation, bonuses, expense payments, and benefits consistent with his percentage ownership of [Selmark].”  Independent of employment, upon conversion, Ehrlich was to become an officer of Selmark and member of its board of directors.

Under a separate “stock agreement”, if Ehrlich paid off his purchased stock and exercised his conversion option, Ehrlich’s rights as a minority stockholder of Selmark would be governed by that agreement.  This agreement provided both parties with the opportunity to end their business relationship through the sale of Ehrlich’s stock, which included a cross-purchase put and call rights for the parties.

After these agreements were executed, Marathon and Selmark remained separate entities, but presented themselves as “Selmark” to the outside world.  Ehrlich identified himself as a VP of Selmark even, while technically  he was an employee and vice-president of Marathon.  Ehrlich’s employment agreement expired by its terms in 2002, but Ehrlich remained an employee of Marathon and retained his position as vice-president. In 2003, Ehrlich began to report directly to Selmark’s management and received no complaints about his job performance.

In the summer of 2007, Ehrlich provided notice to Elofson that he intended to accelerate his final payments on his 49% share of Marathon stock by December 2007.  According to the Court, Elofson then decided that he did not want Erhlich as a business partner and in October 2007 informed Ehrlich that his employment with Marathon was terminated and offered for  Selmark to purchase Ehrlich’s 49% interest in Marathon for the same price he would have received had he converted his Marathon shares into Selmark stock and then Selmark had exercised its call rights pursuant to the stock agreement.  To assuage him to sell his shares, Elofson also told Ehrlich that Marathon did not have the cash-flow to support the continuing payments under the Notes, and that Ehrlich would have to meet the shortfall if he did not sell his shares to Elofson.

In November 2007, Ehrlich took a job with a competing manufacturer’s representative company and afterwards solicited some of Marathon’s customers. After his termination, Ehrlich received a small severance, but did not cash in his Marathon stock under the terms offered in the termination letter and remained a minority shareholder of Marathon.

Following his termination, Ehrlich did not believe that Marathon had insufficient funds to make its remaining payments under the notes.  Taking matters somewhat into his own hands, he suspended payments to Marathon which appears to have only complicated the parties disputed because of the default issues that arose.  While it appears that Ehrlich did eventually pay off his portion of the Notes and attempted to cure the default, the ambiguity over whether he perfected his conversion rights and his shareholder rights under the stock agreement added additional complexity to the dispute.

In 2008, Selmark and Marathon sued Ehrlich for breach of fiduciary duty for his solicitation of Marathon customers, and  Ehrlich responded with thirteen counterclaims against counterclaims, also including fiduciary duty claims.  At trial, the jury ruled in favor of the plaintiffs on their fiduciary duty claim, and in favor of Ehrlich (with respect to Selmark and Elofson) on his breach of contract, fiduciary duty and 93A counterclaims, netting a significant verdict in his favor.  (The trial judge also later doubled the 93A damages and awarded attorney’s fees. )  The parties then appealed.

Discussion

While many aspects of this decision are worth a careful reading in its original, unabridged version, the most interesting parts of this case for me relate to its holdings on the fiduciary duty issue.

1.  Fiduciary Duty owed to Ehrlich as an Employee Shareholder.  The jury found that Selmark and Elofson breached their fiduciary duties to Ehrlich in relation to the termination of his employment by Marathon.  Citing the long standing precedent in Massachusetts protecting minority stockholders in closely held corporations, the SJC held that a “freeze-out” can occur “when a minority shareholder is deprived of employment”.

Although the Court acknowledged that fiduciary duties of good faith and loyalty may be inapplicable where the parties have negotiated a series of agreements intended to govern the terms of their relationship, the challenged conduct must be clearly contemplated by the terms of the written agreements.  The presence of a contract “will not always supplant a shareholder’s fiduciary duty, ” and when the contract does not entirely govern the other shareholders’ or directors’ challenged actions, a claim for breach of fiduciary duty may still lie.   To supplant the otherwise applicable fiduciary duties of parties in a close corporation, the terms of a contract must clearly and expressly indicate a departure from those obligations.

In this case, while the parties had entered into multiple, complex written agreements, the Court still held that none of these agreements covered the duties at issue.  The Court reasoned that none of the agreements contained terms that addressed Ehrlich’s employment rights upon expiration of his Marathon employment agreement and before conversion of his Marathon stock.  Finding that fiduciary duty did apply, the Court affirmed the trial court’s findings in favor of Ehrlich on these issues.  Among its reasoning, the Court noted that Elofson could have sought less harmful alternatives before resorting to termination, and cited precedent that a fellow shareholder employee is owed “real substance and communication, including efforts to resolve supposed complaints by less drastic measures than termination.”

2.  Fiduciary Duty owed by Ehrlich.   At trial, Marathon and Selmark argued that Ehrlich violated his fiduciary duties of good faith and loyalty to Marathon when he solicited Marathon’s customers for his new employer. The jury agreed, and awarded them $240,000 in damages.  On appeal, Ehrlich contended that, because he was fired by Elofson and essentially “frozen out” of Marathon, he had the right to compete with Marathon without committing a breach of his fiduciary duties to the company.

Ruling in favor of the employer in this case, the Court cited long-standing precedent under Massachusetts law that  shareholders in close corporations owe fiduciary duties not only to one another, but to the corporation as well.  (See, e.g., Chambers v. Gold Medal Bakery, Inc., 464 Mass. 383, 394 (2013); Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. at 593.)

At issue here was whether those fiduciary duties to the corporation continue once a shareholder has been “frozen out,” or wrongfully terminated, by that corporation.   Declining to follow precedent from the Supreme Court of Wyoming that held that a freeze out does extinguish such a duty, the Court held that the fiduciary duty does, in fact, survive a freeze out.  The Court saw what Ehrlich proposed as a “drastic step” and reasoned that “allowing a party who has suffered harm within a close corporation to seek retribution by disregarding its own duties has no basis in our laws and would undermine fundamental and long-standing fiduciary principles that are essential to corporate governance.”

Because the Court did not address what would be the scope and extent of such a duty, parties are still advised to address all such issues in a written non-solicitation agreement, which can define more precisely the specifics such as the term, geographic scope and other similar issues.

 

 

 

 

 


Recent Delaware Chancery Court Decisions Opines on Arbitration Clause in Merger Agreement

Posted on Oct 1st, 2013

A recent letter opinion by the Delaware Chancery Court in a case between Shareholder Representative Services (SRS) and a buyer of a business processing business raises an interesting interpretation of an arbitration clause in a merger agreement. The case can be read here.  The dispute between the parties arose from indemnification claims brought by the buyer under the merger agreement, which SRS claimed did not comply with the requirements of the merger agreement.  While the merger agreement contained a mandatory arbitration provision, it also provided that the Arbitrator did not have authority to grant “injunctive relief, specific performance or other equitable relief”.  Relying on this provision, SRS brought various claims in the Chancery Court, including a claim for injunctive relief to stop buyer from a breach of the merger agreement by seeking indemnification to which it did not have a right.  The court disagreed with SRS and compelled arbitration.

The court first noted that since the arbitration clause did not explicitly commit the determination of substantive arbitrability to the arbitrator, the court had jurisdiction to decide on this specific issue.  In a footnote, the court noted that these issues are presumptively determined by a court.  (One drafting note from this determination is that parties that wish to avoid any court proceedings altogether may want expressly cover the issue of substantive arbitrability in their agreement.)

The court cited a 2002 Delaware Supreme Court decision for the steps to be taken by a Delaware court to assess an arbitration clause:

  • First, the court must determine whether the arbitration clause is broad or narrow in scope.
  • Second, the court must apply the relevant scope of the provision to the asserted legal claim to determine whether the claim falls within the scope of the contractual provisions that require arbitration. If the court is evaluating a narrow arbitration clause, it will ask if the cause of action pursued in court directly relates to a right in the contract. If the arbitration clause is broad in scope, the court will defer to arbitration on any issues that touch on contract rights or  contract performance.

The court cited a few examples of a “broad” arbitration clause:  “any dispute, controversy, or claim arising out of or in connection with the …Agreement” and “any unresolved controversy or claim arising out of or relating to this Agreement” (the language at issue in the parties’ merger agreement). Finding this clause to be of the broad category, the court ruled that the determination of whether the indemnification claims were time-barred should be made by the arbitrator.

In support of its argument, SRS cited a 2006 decision involving an arbitration clause in a LLC operating agreement where the parties also sought injunctive relief from the court to compel a member to assent to a capital contribution.  The court distinguished this situation from the instance case, finding that SRS’s claims were really legal claims, not equitable ones, and colorfully noted that “[s]emantic legerdemain does not transform a legal claim into an equitable claim.”  The court reasoned that the relief that SRS has requested requires an analysis of the merits of the claims, which is legal (as opposed to equitable) in nature.   Accordingly, a plaintiff cannot “convert a claim for money damages arising from a breach of commercial contract . . . into a claim maintainable in equity by the expedient of asking that the defendant be enjoined from breaching such duty again.”

This decision is a useful reminder that boilerplate provisions such as arbitration clauses (and carveouts to those clauses) should be carefully considered in the context of any agreement, especially one relating to the sale of a business or other major transaction of a company.  While there may be varying opinions on the benefits of arbitration over litigation, once a path is chosen, the parties should carefully review these provisions to reduce ambiguity around any substantive and procedural issues that may arise.

If you have any questions about this topic, please feel free to email us.

 


Forum Selection Clause Valid in Delaware

Posted on Jun 29th, 2013

In a major win for corporations worried about choice of law, the Delaware Court of Chancery held that forum selection bylaws adopted by corporation boards are at least facially valid as a matter of contract under Delaware General Corporation Law (DGCL). Boilermakers Local 154 Retirement Fund v. Chevron Corporation stands for the proposition that bylaws which designate a specific forum for legal dispute resolution will stand up in court, taking some of the concern away for corporations in the realm of multiforum litigation.

In the case at bar, both Chevron and FedEx had adopted bylaws in their certificates of incorporation which indicated that Delaware would be the sole forum for any stockholder litigation. The court rejected the plaintiffs’ challenge of these forum selection provisions and held that the DGCL in fact does permit this kind of forum designation contractually.

The court’s reasoning was in part that the DGCL permits corporations to regulate themselves in order to function smoothly, and these kinds of bylaws assisted the smooth governance of the corporation. The court also found that both federal and Delaware law rendered forum selection bylaws contractually enforceable. This finding is based on the fact that the charters of the corporations in question granted unilateral power to the boards to adopt bylaws, and that this binding power was known to stockholders.

If you have any questions about this topic, please feel free to email us.


Delaware Court of Chancery Holds that a Reverse Triangular Merger is not a Transfer or Assignment by Operation of Law

Posted on Mar 13th, 2013

 

Last month the Delaware Chancery Court allayed the concerns of corporate transactional lawyers by ruling under Delaware law that a reverse triangular merger (RTM) does not constitute a transfer or assignment by operation of law. The decision, Meso Scale Diagnostics, v. Roche Diagnostics, C.A. No. 5589-VCP (Del. Ch. 2013), involved a restriction on assignments and transfers in a license agreement, which the Court held as a matter of law was not triggered by the RTM.

In brief, a reverse triangular merger structure involves a merger of a selling company (Target) with a subsidiary of the buyer company (Buyer), which is often a special purpose entity created just for the transaction. The transaction is referred to as a “reverse” type of merger because the acquired entity here ends up being the surviving entity in the merger and becomes a subsidiary of the Buyer. This structure is desirable because it resembles a stock acquisition in its final result, but has the added advantages of (1) requiring less than unanimous approval from the Target’s stockholders and (2) allows for more flexibility than a stock swap under the tax laws relating to what are called “tax free” reorganizations.

For years, corporate lawyers have taken the position that a RTM does not trigger anti-assignment provisions in contracts. That’s because in this structure, just like in a stock acquisition, no contracts are being assigned or transferred per se. The acquired entity remains in place and the only change is that its stockholders before the deal have been replaced with a single stockholder, which is either the Buyer or one of its subsidiaries. However, starting with a somewhat obscure 1991 California court decision involving Oracle, there has been a growing national trend of courts calling this line of reasoning into question. The Oracle court reasoned that a change of stock ownership in a target was a change of its legal form, which resulted in an impermissible transfer of intellectual property rights. Most recently, an earlier Chancery Court decision in 2011 in this same case created ambiguity under Delaware law – previously thought to be safe territory by most Delaware practitioners – by refusing to dismiss the case based on the stock acquisition cases cited by the defendants.

The recent Meso Scale holdings resolve these issues. The Chancery Court rejected the Oracle decision as persuasive authority on this issue. The Court reasoned that the California court’s holding that a RTM constitutes an assignment by operation of law conflicts with Delaware’s jurisprudence regarding stock acquisitions. This is because Delaware courts have consistently found over time that when a corporation lawfully acquires the ownership of another corporation and with it the corporation’s stock, this change of ownership does not imply any assignment of the contractual rights of the corporation whose securities the buying corporation purchased. Therefore, the Court of Chancery held that because both stock acquisitions and RTMs are changes in legal ownership, and not in the underlying interest of that entity, they should produce parallel legal results.

The lessons from this case are two-fold:

1.   For contracts governed by Delaware law, parties can continue to rely on stock acquisitions and RTMs as a structure where third party consents should not be required to a “transfer” or “assignment” type of contractual clause. For contracts governed outside Delaware, such as in California, the doubt still remains, so it may be prudent to get the third party consent for those contracts just in case.

2.   For Delaware-governed contracts, parties that want the right to consent to a RTM (or other similar transaction) should include a “change of control” provision in their contracts. While this is common in more complex agreements, such as financing agreements and real estate leases, commercial agreements such as software license agreements and customer and vendor contracts generally do not go to this level of drafting.

If you have any questions about this topic, please feel free to email us.


Drafting Tips from Recent Chancery Court Decision in Viacom “RockBand” Debacle

Posted on Jan 27th, 2013

Drafting Tips from Recent Delaware Chancery Court Decision in Viacom “RockBand” Debacle

The most recent decision in the saga between Viacom and Harmonix – the maker of “RockBand” – awards $12 million to the seller stockholders of Harmonix for amounts held in escrow to back up their indemnity to Viacom. Even though four separate claims for infringement of intellectual property were brought against Harmonix after the closing, and the Harmonix executives admitted that they were aware of the other patents that led to the claims, the Court found that the seller did not breach its representations and warranties in the merger agreement and that Viacom did not have a right to an indemnity against the escrow. As one can imagine, this case brings up some interesting drafting issues worth considering before your next M&A deal.

In September 2006 Viacom bought Harmonix for a cash payment of $175 million plus an earn-out based on Harmonix’s earnings for 2007 and 2008. The deal included a $12 million 18-month escrow to indemnify Viacom for losses from breaches by Harmonix of its representations and warranties. At the time of the deal, GuitarHero had already been released, but other products such as RockBand were still in the works. Since intellectual property was likely a key asset in the transaction, there were a number of representations by Harmonix relating to its intellectual property. As discussed below, those reps were qualified in various ways, and those qualifications made the difference in this decision.

After the closing, four different sets of patent, trademark and copyright infringement claims were brought against the acquired business. While some of those claims had been raised prior to the closing and disclosed to Viacom, others were not. Viacom took on the claims, spending almost $30 million in legal fees, and then sought to set off its losses against the escrow, claiming a right under the indemnification provisions in the merger agreement. The Delaware Chancery Court disagreed.

Viacom argued that the seller stockholders had a duty to defend pending the determination of whether there was a duty to indemnify. Distinguishing a number of earlier decisions, the Court strictly construed the indemnification clause in the merger agreement to read that there was no separate no duty to defend unless there was an underlying duty to indemnify. The duty to defend arises from specific contract language and guarantees coverage independent of the outcome of the legal conflict it covers; the duty covers the cost of defending the claim regardless of the claim’s merit. However, indemnification involves the guarantee by the party to cover any judgment against the other party. Viacom wanted its legal fees independent of the outcome of the legal conflicts, but it was only indemnified against judgments in those cases (if at all). So, from a buyer’s perspective, one drafting consideration would be to clearly separate a duty to defend as one of the remedies in the agreement, potentially limiting that obligation to specific claims or litigations that may have been known or foreseen at the time of the closing.

Here, a right to indemnity arose only from breaches of representations and warranties of the merger agreement. It is important to note that had there been a separate indemnification obligation for third party claims arising from any intellectual property of Harmonix, or relating to business conduct prior to the closing, the outcome of this case may have been very different.

To determine whether there was a breach, the Court focused on two types of reps relating to the intellectual property. The first represented that the Company had sufficient rights to all intellectual property as necessary for the “current use” of its products. Because the claims for which Viacom sought indemnity related to the commercial version of RockBand, which was only in prototype stage at the time of the deal, the Court found that there was no breach.

It is worth noting that there could have been a claim here if the language specifically included the underlying intellectual property in the prototypes or other works in process, as integrated into the final work product. Also, while there was a broader representation regarding rights in “Company Developed Software”, that particular term also did not expressly include RockBand.

The other representations at issue related to potential infringement and were qualified by knowledge.While the Court agreed that management did have knowledge of the other parties’ patents, the crucial distinction here is that Viacom could not show that management had knowledge that they Harmonix’ products were infringing on those patents. That said, it is a bit surprising that there was no special indemnity for claims arising from that known third party intellectual property.

While it is easy to critique with 20/20 hindsight, the scenario represented in this decision is not uncommon and presents a good case study. Hundreds of startups each year are acquired for their talent and nascent technology, and buyers often take over product direction after the closing. Particularly with the explosion in patent troll litigation, often brought after the announcement of an acquisition (or investment) to target the buyer’s deeper pockets, the risk of infringement litigation that relates back to the pre-closing period is significant. In that situation, as here, sellers should look to limit their liability to current technology and known infringement, shifting the freedom to operate and infringement risks on the buyer. On the other hand, buyers would be well-advised to look for broader indemnification obligations with longer survival periods (and lots of exceptions and exclusions for key material reps), with an express duty to defend, for any third party infringement claims relating to the sellers’ products that existed at the time of the transaction, whether in a final production or prototype stage.

If you have any questions about this topic, please feel free to email us.