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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 MA SJC Noteworthy Decision, so to speak

Posted on Apr 19th, 2013

A recent decision by the Massachusetts Supreme Judicial Court is noteworthy for transactional practitioners:

In T. Butera Auburn vs. Williams, the Court held that a purchaser of a veterinary business was not entitled to withhold payment on a promissory note issued in connection with the purchase of defendant’s business.  The case involved the purchase of a veterinary clinic business from the defendant via an asset purchase agreement, where $800,000 was paid at the closing, the another $400,000 was payable via a promissory note over 15 years.  According to the decision, when plaintiffs discovered that the defendant was in violation of her covenant not to compete and other post-closing obligations, they brought suit and sought to hold back payment on the note to set off their damages.  Plaintiffs argued that they were excused from performance under the Note based on language on the APA that a default under a related transaction document (such as the Note) would be a default under the APA.  The Court rejected this argument, noting that this case involved the opposite scenario.  Here the breach occurred under the APA provisions, not the Note, and the Note did not contain a cross-default provision that would have potentially allowed the Plaintiffs to stop payment.  The Court did comment however, that if the plaintiffs could have shown that “the damaged business itself was supposed to generate the income from which the debt … was to be repaid, [the defendant] might well be estopped from obtaining judicially compelled acceleration on the basis that the Note was breached when payments were not subsequently made on time by the borrower.”

This case is a useful reminder that:

  • cross-default provisions and rights for setoff in the event of an indemnification or other claim should be included in Notes and other transactional documents
  • Language such as that quoted below may be helpful to add as an acknowledgment to a remedies section in the transaction documents to prevent a similar result

 


Recent decision by Massachusetts Supreme Judicial Court Strictly Construes Transfer Restrictions and Co-Sale Rights in S Corporation

Posted on Apr 19th, 2013

 

Since the 1974 landmark decision in Donohue v. Rodd, Massachusetts courts have held that majority stockholders in close corporations owe minority stockholders a fiduciary duty akin to that owed in a partnership. This type of duty has been relied up to protect minority shareholders from squeeze-out or freeze-out scenarios. It has also been used as an offensive tactic to argue for implied rights of shareholders that are not expressly provided in the corporate documents, such as the articles of organization, bylaws or shareholder agreements.

In Merriam, et. al. v. Demoulas Supermarkets, Inc., the Supreme Judicial Court refused to extend the duties provided under Donohue v. Rodd to restrict stock transfers that were not expressly restricted under the Corporation’s governing documents.

While a fiduciary duty may exist, the Court encouraged shareholders of close corporations to enter into a shareholder agreement or specify in the corporate bylaws “rights, protections, and procedures that define the scope of their fiduciary duty in foreseeable situations.” The Court held that good faith compliance with the specific terms will not implicate that fiduciary duty. “A claim for breach of fiduciary duty may arise only where the agreement does not entirely govern the shareholder’s actions.”

In this case the plaintiffs attempted to use the concept of fiduciary duty in a creative way to prevent the transfer of stock because the corporation was an S corporation and the transfer could blow the S election. After reviewing the shareholder agreement and bylaws, the Court held that the challenged actions fell within the scope of those agreements – which did not restrict such a transfer – and that the fiduciary duty was not implicated in this case.

The court also rejected the argument that the fiduciary duty could be used to create an implied right of first offer or co-sale rights on a transfer to a third party. Transfer restrictions are to be construed narrowly in Massachusetts, and the Court reasoned that had the parties intended to create such rights and restrictions, they would have stated so expressly in their shareholder agreement.

Certainly, this decision does not present any major news to most corporate practitioners. While it is nice to know that shareholder agreements are still given weight in Massachusetts, the key takeaway is the importance of having such an agreement in the first place. Close corporations, particularly those with employee shareholders, should be strongly encouraged to enter into detailed shareholder agreements to provide for situations dealing with transfers, rights of first refusal, preemptive rights and potential divorce and dissolution. Majority stockholders may feel some reluctance to spend money and time on such a document, when the protection is often for their fellow stockholders. However, as shown by this decision, not having such an agreement will subject everyone to the vague principles of applicable fiduciary duties, which could have wide-ranging and negative implications.

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


Recent Massachusetts Supreme Judicial Court decision summarizes Massachusetts Law on Statute of Limitations on Promissory Notes and Successor Liability

Posted on Apr 17th, 2013

If you look at promissory note in your form file, odds are that the signature line indicates that the note was signed “under seal.” Aside from custom, there are several reasons why this somewhat archaic language was included. The most important reason, at least in Massachusetts, was that the language elevated the note from a plain contract to a sealed instrument. This extended the statute of limitations relating to the Note from six years to twenty.

In 1998, in connection with the revision of Article 3 of the UCC, Massachusetts adopted G. L. C. 106, § 3-118, which provided for a uniform six year statute of limitations for all negotiable instruments. In its recent decision in Premier Capital, LLC v. KMZ, LLC, the Massachusetts Supreme Judicial Court held that Section 3-118 governs all negotiable instruments, sealed and unsealed. However, to the extent that a cause of action predates this adoption of law, the Court held that the law in effect prior to 1998 will apply. As there are probably few instruments still lying around that predate this adoption, odds are that we may start see the “under seal” language slowly disappear from these types of documents.

The other significant aspect of this decision is the Court’s concise restatement of Massachusetts law on successor liability. (The issue in the case was whether a promissory note could be enforced against KMZ, an entity that the plaintiff claimed to be a successor in interest to Max Zeller Furs, Inc., the party that signed the original note.)

First, in order to be deemed a “successor corporation”, there must be a transfer to that entity of “all or substantially” of another corporation.

If the first test is met, then to impose liability on the successor corporation, one of the following factors must also be met:

  • the successor assumes the predecessor’s liability expressly or impliedly
  • the transaction is a “de facto merger”
  • the succession is merely a continuation of the predecessor, or
  • the transaction is really just a fraudulent attempt by the predecessor to avoid liability.

Here, the Court affirmed the ruling in favor of the defendants, holding that there were no undisputed facts proving that Zeller transferred “all, or substantially all” of its assets to KMZ. While Premier argued that Zeller transferred its good will to KMZ, it could not show any actual agreement memorializing that transfer. The court also held that engaging in the same business and having the same stockholders, without meeting the transfer test, was not enough.

The take away from this case is that successor liability can only be established with a clear showing of facts within the established guidelines of the case law. Courts are not likely to find successor liability for purposes of summary judgment without undisputed proof of transfer of liability.

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.