A law firm as creative as you are.
image001
You have the ambition. We can help you get there.

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.

 

 

 

 

 


Massachusetts Appeals Court Rejects Stockholder Representative’s Appeal to Deny Partial Settlement Out of Escrow Fund

Posted on Dec 4th, 2013

A recent decision by the Massachusetts Appeals Court interprets the right of a seller shareholder to bypass a stockholders’ representative and settle directly with a buyer claimant and to use for such settlement the proceeds from an escrow fund established as part of the sale transaction.  This opinion is an important read for anyone engaged as a stockholders representative or serves as counsel to one.   While the decision is somewhat limited by the specific provisions of the merger and escrow agreements at issue, corporate practitioners may find the facts useful for tightening up standard provisions on these issues in future deals.  The case also provides a handy explanation of the oft-used (and misunderstood) term “power coupled with an interest”, which we have summarized below.  A full copy of the opinion can be found here.

The case arises from a stock purchase merger in September 2007 of Atlantis Components, Inc. by Astra Tech, Inc.  for $71 million. Per common practice, $6.3 million of the purchase price was placed into an escrow fund, to be disbursed to the former Atlantis shareholders on a pro rata basis on December 31, 2008, the release date. The purpose of the the escrow fund was to indemnify Astra Tech if it paid any claims asserted against Atlantis after the closing date but before the release date. The merger agreement designated a Shareholder Representative as the agent of the former Atlantis shareholders, which had the duty of approving or challenging any indemnification claim on the escrow fund.

Shortly after the closing, Astra Tech brought a claim against Atlantis for failing to disclose  certain correspondence alleging that Atlantis was infringing on the patents of one its competitors.   The parties disagreed on the merits of AstraTech’s claims and various lawsuits ensued.  As legal costs for these matters ballooned to nearly $2.5 million, in October 2010 certain of the Atlantis shareholders opted to settle directly with Astra Tech, using their pro rata share of the escrow fund as payment.  After reaching an agreement, the settling shareholders and Astra Tech moved in Superior Court for approval of their settlement. The shareholders’ agent opposed the settlement, on the basis that neither the merger agreement nor the escrow agreement permitted the settling shareholders to seek disbursement absent the consent of the shareholders’ agent. A judge approved the settlement agreement between Astra Tech and the settling shareholders and this appeal followed.

The Court’s decision involved the interpretation  and interplay of three contracts between the parties: (1) the escrow agreement between Astra Tech, Atlantis, the stockholders rep, and the escrow agent; (2) the merger agreement between Astra Tech, Atlantis, and the stockholders rep; and (3) the settlement agreement between Astra Tech and the settling shareholders.

On the escrow agreement, the Court determined that that the express provisions of that Agreement did provide for a procedural mechanism to allow the settling shareholders to seek court approval of their settlement.  An excerpt of that provision is provided below for reference. (1)

On the merger agreement, the stockholders rep argued that it had the exclusive right to negotiate with Astra Tech under under Sections 8.6(a) and (e) (pasted as footnote (2) below).  While the Court agreed that these provisions granted the Stockholders Rep with broad powers to negotiate and make decisions for the settling shareholders, it held that these rights were not exclusive, which would be required to bar the settling shareholders from negotiating for themselves.  The Court refused to construe the provision that the rep’s decisions and acts “constitute a decision of all Company shareholders” and are “final, binding and conclusive upon each such Company Shareholder” as granting the rep with exclusive rights.   To create an exclusive agency, the parties must expressly and unambiguously indicate such an intent in the contract.”  The Court noted that if the parties had wished to give the shareholders’ agent the sole or exclusive authority to negotiate on behalf of the settling shareholders, they should have provided for that expressly in the contract. (“We will not contort the plain language of the merger agreement to interpret “final, binding and conclusive” as synonymous with “irrevocable” or “exclusive.”)

Finally, the stockholders rep contended that its agency was irrevocable because it has a “power coupled with an interest.”  The Court disagreed.   Despite general agency law principles (which allow a creator of the agency relationship to revoke the agent’s authority at any time, even if their agreement expressly states that the principal may not revoke), the agent’s authority can be made irrevocable when it is a “power coupled with an interest”.  The Court explained that a ”power coupled with an interest is not technically an agency relationship because “it is neither given for, nor exercised for, the benefit of the person who creates it.”  In an agency relationship, granting authority to the agent is solely for the benefit of the principal, but when a “power is coupled with an interest, the donee holds that power for his own benefit (or for the benefit of a third party), but not for the benefit of the donor.”  The reference to “interest” in this phrase means that the agent (donee of the power) must have a present interest in the property upon which the power is to operate.  It is generally accepted that the “interest” must be ownership of the property itself and it is this ownership which makes the power irrevocable.

In its analysis, the Court broke down the term “a power coupled with an interest”  into two components: first, does the agent have “a power”, and second, is the power “coupled with an interest.  On the first point, the Court held that the  rep did not have “a power” in the escrow fund, as it did not have  exclusive or irrevocable power under the merger agreement or the escrow agreement.  The rep also did not have unilateral power in the escrow fund (a distinguishing factor in other cases cited by the Court) but rather was required to reach an agreement with Astra Tech before the escrow agent could be compelled to release the funds.

On the second point, the stockholders rep did not have “an interest” in the escrow fund sufficient to create a power coupled with an interest.  Citing cases going back to 1823, the common thread requires the agent to have title or some other form of ownership of the underlying asset to assert that the power is “coupled with an interest”.   Even though the shareholders rep (as a Atlantis shareholder) had a personal interest in a portion of the escrow, it did not have a property interest in the entire fund in its capacity as shareholders’ agent.  The Court emphasized that the critical distinction between an agent and the donee of a power coupled with an interest lies in who receives the benefit of the relationship. “In a principal-agent relationship, the principal receives the benefit; for a power coupled with an interest, the benefit inures to the donee himself (or to a third party), but not to the donor.”

After concluding that the stockholders rep had neither the exclusive right to negotiate under the merger agreement nor a power coupled with an interest in the entire escrow fund, it then held that the settling shareholders did have a right to bypass the rep and enter into a direct settlement with Astra Tech.  In the absence of an agreement, the settling shareholders retain their common-law rights as principals. Notwithstanding any agreement between principal and agent, an agent’s actual authority terminates … if the principal revokes the agent’s actual authority by a manifestation to the agent. Because a principal may revoke part of the agent’s authority, it follows that a principal may, in the absence of an agreement to the contrary, negotiate on his own behalf without infringing on the agent’s ability to perform his duties.  Because nothing in the agreements abrogated these common-law rights, the Court held that the settling shareholders had the power to negotiate a settlement agreement with Astra Tech.

This opinion illustrates a number of interesting drafting points for preparing escrow and stockholder rep provisions in complex merger and sale agreements.  At the very least, practitioner may wish to counsel their clients on the alternatives of exclusive and nonexclusive roles of the rep and the possible ways those results can be effected.  Based on this decision, it appears likely that a Massachusetts court facing a similar issue will construe these agreements strictly and will require the exclusivity and revocability to be expressly stated to be enforceable.

If you have any questions regarding the issues discussed in this point, please feel free to contact us.

Footnotes:

 

(1) ”Any Disputed Claim and any other dispute which may arise under this Escrow Agreement with respect to the rights of [Astra Tech] or any other Indemnified Party and the Shareholders’ Agent or the Company Securityholders to the Escrow Fund shall be settled by mutual agreement of [Astra Tech] and the Shareholders’ Agent (evidenced by joint written instructions signed by [Astra Tech] and the Shareholders’ Agent and delivered to the Escrow Agent); provided, however, that upon receipt of a copy of a final and nonappealable order of a court of competent jurisdiction with respect to payment of all or any portion of the Escrow Fund, … the Escrow Agent shall deliver the portion of the Escrow Fund specified in such award or order to [Astra Tech] or other Indemnified Party and/or the Shareholders’ Agent for the benefit of the Company Securityholders as directed in such award or order.”

(2)  ”[T]he Shareholders’ Agent shall be, and hereby is, appointed and constituted in respect of each Company Securityholder, as his, her or its agent, to act in his, her or its name, place and stead, as such Company Securityholder’s attorney-in-fact, as more fully set forth in this Section 8.6. Without limiting the generality of the foregoing, the Shareholders’ Agent shall be constituted and appointed as agent for and on behalf of the Company shareholders to give and receive notices and communications, to authorize delivery to [Astra Tech] of the monies from the Escrow Fund in satisfaction of claims by [Astra Tech] Indemnified Persons against the Escrow Fund, to object to such deliveries, to agree to, negotiate, enter into settlements and compromises of, and demand arbitration and comply with orders of courts and awards of arbitrators with respect to such claims, and to take all actions necessary or appropriate in the judgment of the Shareholders’ Agent for the accomplishment of the foregoing.” [FN13]

Section 8.6(e) further delineates the actions that may be taken by the shareholders’ agent:

“A decision, act, consent or instruction of the Shareholders’ Agent shall constitute a decision of all Company shareholders … and shall be final, binding and conclusive upon each such Company shareholder, and the Escrow Agent and [Astra Tech] may rely upon any decision, act, consent or instruction of the Shareholders’ Agent as being the decision, act, consent or instruction of each and every such Company shareholder.”

 

 


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.