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When is a liquidated damages clause enforceable?

Posted on Sep 25th, 2023

In the case of Cummings Properties, LLC vs. Darryl C. Hines, the Massachusetts Supreme Judicial Court considered the enforceability of a liquidated damages clause in a commercial lease agreement. The court upheld the clause and ruled in favor of Cummings Properties, LLC.  https://www.mass.gov/files/documents/2023/09/25/p13406.pdf

 

Here are the key points from the summary:

  1. Background: The case involved a commercial lease between Cummings Properties and Massachusetts Constable’s Office, Inc. (MCO), with Darryl C. Hines as the personal guarantor. The lease had a provision for liquidated damages in case of rent default.
  2. Liquidated Damages Clause: The liquidated damages clause allowed Cummings Properties to terminate the lease and collect the entire balance of rent due as liquidated damages if MCO failed to pay rent after a ten-day grace period.
  3. Default and Lawsuit: MCO failed to pay rent shortly after the lease took effect, leading Cummings Properties to initiate legal action. MCO vacated the premises, and Cummings Properties subsequently leased the space to a new tenant.
  4. Enforceability of Liquidated Damages Clause: The central issue was whether the liquidated damages clause was enforceable. The court applied the “single look” approach, which focuses on the circumstances at the time of contract formation.
  5. Two-Prong Test: To enforce a liquidated damages clause, two conditions had to be met: (a) actual damages at the time of contract formation were difficult to ascertain, and (b) the sum agreed upon as liquidated damages represented a reasonable forecast of damages in case of a breach.
  6. Burden of Proof: Hines, as the party seeking to invalidate the clause, had the burden of proving that either actual damages were easily ascertainable at the time of contract formation or that the damages specified in the clause were disproportionate.
  7. Court’s Findings: The court found that Hines failed to provide evidence to support his claims that actual damages were easily ascertainable or that the damages specified in the clause were disproportionate.
  8. Mitigation Not Required: The court emphasized that under the single look approach, mitigation of damages, such as rent collected from a new tenant, was not a consideration in determining the enforceability of the liquidated damages clause.
  9. Sophistication: Hines argued that he was not a sophisticated party and should not be bound by the clause. The court found that Hines demonstrated some business acumen and sophistication, making him accountable for the contract terms.
  10. Judgment: The court affirmed the judgment of the Superior Court, upholding the enforceability of the liquidated damages clause and ruling in favor of Cummings Properties.

In summary, the court upheld the liquidated damages clause in the commercial lease, emphasizing that it was enforceable because it represented a reasonable forecast of damages at the time of contract formation. The court also considered Hines to be sufficiently sophisticated to be held accountable for the contract terms.


Massachusetts Appellate Court Rules On General Release Provisions As They Relate To Severance Agreements And Promises Of Equity

Posted on Jan 17th, 2018

Ryan S. Carroll

The Massachusetts Appeals Court recently affirmed the practice that a general release, including one provided in the context of an employment separation, extinguishes the signing party’s rights to all claims predating that release.  However, that general statement does not come without some caveats.

Alan MacDonald (MacDonald), had two separate terms of employment with Jenzabar, first as a CFO and later as a “Mergers and Acquisitions Researcher”.  During his first term of employment, MacDonald executed an employment agreement which provided for: (i) the issuance of a number of shares of preferred stock and (ii) an option to acquire 1,516,000 shares of common stock.  MacDonald and Jenzabar would enter into two additional agreements relating to his equity.  MacDonald then left Jenzabar and had not received his preferred shares nor exercised any of his vested interests.  At a later date, MacDonald joined Jenzabar for the second time and left shortly thereafter.  After his second departure, MacDonald and Jenzabar executed a severance agreement which provided for Jenzabar to continue to pay MacDonald’s salary and other benefits for six months in exchange for a general release of all claims, an affirmation and extension of a confidentiality obligation and an agreement that the severance agreement terminated and supersedes all other oral and written agreements or arrangements between MacDonald and Jenzabar.  After he signed the severance agreement, MacDonald attempted to exercise his option and Jenzabar denied the request, citing the release.  Litigation then ensued as to MacDonald’s rights to the equity and the enforceability of the severance agreement.

In MacDonald vs. Jenzabar, the court ruled that the general release provision and a merger and integration clause in the severance agreement extinguished MacDonald’s rights to the equity.

The general release language (“from any and all claims, liabilities, obligations, promises, agreements, damages, causes of action, suits, demands, losses, debts, and expenses . . . of any nature whatsoever, known or unknown, suspected or unsuspected, arising on or before the date of this Agreement.“) was held to be both clear and broad and that MacDonald released all rights to the preferred stock and option.  Further, the court cited that, “a general release disposes all claims and demands arising out of any transactions between the parties” and that “any intended exception should have been expressly stated.

Lastly, the court ruled the merger and integration clause contained in the severance agreement clearly extinguished all rights to the promised preferred shares and the option.

This case is an overall win for employers with respect to their separation arrangements. The case also illustrates the significance of any single word or phrase (or lack thereof) in a tightly-worded document, such as a release, when under the microscope of a court’s review.  Any ambiguity in this context creates risk for each party, and conversely creates negotiating leverage in terms of pre-litigation negotiations, leading to unnecessary cost and other negative impact for both parties.


Recent Federal Court Decision Clarifies Fiduciary Duty Interpretation for Delaware Corporations Doing Business In Massachusetts

Posted on Oct 5th, 2016

By: Richard Gauthier

A recent decision by the Massachusetts federal district court held that Massachusetts corporate law relating to fiduciary duty does not apply to Delaware corporations doing business in Massachusetts.  As most privately held tech-based companies started in Massachusetts are typically formed in Delaware and qualified here as a foreign corporation, this decision, while not surprising, provided comfort and clarity on this important issue.

Paul Nahass, a shareholder and former director and officer of FlexLite Corporation, sued a group of FlexLite shareholders, for terminating him as an officer and director of FlexLite.  Nahass alleged the termination violated their fiduciary duty to Nahass as a minority shareholder in a close corporation and FlexLite’s corporate bylaws.  Nahass argued that because FlexLite was a close corporation, under the famous Massachusetts Donohue v. Rodd decision, the other shareholders owed him a fiduciary duty that he claimed was breached.

The Court rejected this argument.  Pursuant to the Massachusetts “internal affairs” doctrine, the law of the state of incorporation applies to disputes over the internal workings of a corporation, including allegations that majority shareholders breached a fiduciary duty to shareholders. Because FlexLite is a Delaware corporation, The Court held that Massachusetts law does not apply.

The Court then went on to clarify that, unlike Massachusetts, under Delaware law shareholders in a close corporation do not have a fiduciary duty to each other.  Instead, Delaware courts have expressly rejected the Massachusetts Supreme Judicial Court’s reasoning.  The Court noted that some Delaware courts have held that “majority stockholders have fiduciary duties to minority stockholders as stockholders …” in certain circumstances, which were not alleged in this case.[1]

The Court also upheld Nahass’ removal from the FlexLite board that was effected by a written consent of stockholders.  While he claimed the corporate bylaws entitled him to a stockholder vote, the Court rejected this argument based on the provisions in the DGCL and the corporate bylaws that permitted action by written consent.


[1] The Court noted that under Delaware law, a shareholder may owe a fiduciary duty where it owns a majority interest in or exercises control over the business affairs of the corporation. In appropriate circumstances, multiple stockholders together can constitute a control group, with each of its members being subject to the fiduciary duties of a controller.

 


Federal Court Holds Uber’s “Sign-In-Wrap” Online Agreement Enforceable under Massachusetts Law

Posted on Sep 12th, 2016

By: Richard Gauthier

In a recent consumer class action case brought against Uber Technologies, the Massachusetts U.S. District Court held that the binding arbitration clause in Uber’s Terms and Conditions (“Terms”) was enforceable and prevented the consumers from seeking a class action in a court of law.  This decision is noteworthy because along with the ruling on arbitration clauses, it provides a thorough summary of the Massachusetts case law on the enforceability of online agreements.  It also highlights that Massachusetts law is favorable for the enforcement of such online agreements, perhaps more so than New York.

The plaintiffs in this case alleged that Uber overcharged them by imposing fictitious fees hidden in charges for legitimate local tolls. They sought class action relief for unfair and deceptive practices pursuant to Chapter 93A and common law claims for unjust enrichment. Uber moved to enforce the arbitration clause in the Terms pursuant to the FAA, and the Court agreed.

The Terms contained the following provision related to arbitration:

“[You] agree that any dispute, claim or controversy arising out of or relating to this Agreement or the breach, termination, enforcement, interpretation or validity thereof or the use of the Service or Application (collectively, “Disputes”) will be settled by binding arbitration, except that each party retains the right to bring an individual action in small claims court. . . . You acknowledge and agree that you and Company are each waiving the right to a trial by jury or to participate as a plaintiff or class User in any purported class action or representative proceeding. Further, unless both you and Company otherwise agree in writing, the arbitrator may not consolidate more than one person’s claims, and may not otherwise preside over any form of any class or representative proceeding.”

The Court began by analyzing whether the Terms were valid under general Massachusetts contract law principles.  A significant portion of this discussion relies on Ajemian v. Yahoo!, Inc.,  a 2013 Massachusetts court decision that we previously discussed here.  In this analysis, the Court provided a very helpful summary of Massachusetts law on the various types of online agreements:

  • Adhesion Contracts:  Massachusetts law applies the same general analysis as other jurisdictions with respect to the enforceability of online adhesion contracts.  Such agreements will be enforced provided they have been “reasonably communicated and accepted” and “it is reasonable to enforce the provision at issue.”

The Court then compared the different types of online agreements, which evolved from shrinkwrap software licenses that have come into use since the computer era:

  • A “Browsewrap” agreement is where the user “does not see the contract at all but in which the license terms provide that using a Web site constitutes agreement to a contract whether the user knows it or not”, or “[w]here the link to a website’s terms of use is buried at the bottom of the page or tucked away in obscure corners of the website where users are unlikely to see it.”
  • A “Clickwrap” agreement is an online contract “in which website users are required to click on an “I agree” box after being presented with a list of terms and conditions of use.
    • The Court commented that Clickwraps are more enforceable than Browsewraps because they “permit courts to infer that the user was at least on inquiry notice of the terms of the agreement, and has outwardly manifested consent by clicking a box.”
  • A “Sign-In-Wrap” Agreement (a term coined in a 2015 decision by Judge Weinstein of the EDNY) is somewhat of a hybrid between the Browsewrap and Clickwrap.  A “Sign-In-Wrap” Agreement does not have an “I accept” button and the user is not required to view the terms and conditions to use the related web service.  These agreements typically make terms and conditions available by link and provide that by registering for an account, or signing into an account, the user agrees to those terms and conditions.

In this case, the Court adopted the “Sign-In-Wrap” terminology and held that such agreements may be enforceable under Massachusetts law.  Here, the Court found that Uber’s Terms were a Sign-In-Wrap agreement.  The Court then summarized Massachusetts law on the enforceability of online agreements in general, as follows:

  • Online consumer agreements “will be enforced provided they have been reasonably communicated and accepted and if, considering all the circumstances, it is reasonable to enforce the provision at issue.”
  • The party seeking to enforce the contract has “the burden of establishing, on undisputed facts, that the provisions of the online agreement were reasonably communicated and accepted, which requires “[r]easonably conspicuous notice of the existence of contract terms and unambiguous manifestation of assent to those terms by consumers.” 

Reasonably Conspicuous Notice

  • The Court held that Massachusetts law does not require proof of actual notice of the terms of the Agreement.  All that is required is that the users have reasonable notice.  Uber’s language on the final screen of the account registration process (“By creating an Uber account, you agree to the Terms of Service & Privacy Policy”) was found sufficient. 
  • While the dispute resolution/arbitration clause did not appear until the user scrolled down to the 8th/9th page, the Court was satisfied that the user had reasonable notice because the heading for the clause was in bold and much larger than other non-heading text.
  • Notably, the Court refused to adopt the four-step process used by the EDNY Court that first coined the Sign-In-Wrap phrase, which would have required a factual analysis of the actual notice to the user.  The Court held that such an analysis would be impractical and make online agreements much more difficult to enforce, which this Court was unwilling to do.

Manifestation of Assent

  • The Court adopted a similar reasonable test for determining whether the user’s assent can be found.  Specifically, the Court held that the “Done” button on Uber’s website (as opposed to “I accept” or other similar buttons) was sufficient for finding that the user understood that by clicking this button it has consummated account registration and was bound by the Terms.

Having found that the Terms were enforceable, the Court quickly made its way to conclude that the binding arbitration clause and the waiver of class action remedies too were enforceable.  The Court noted that this standard favors arbitration and that the only exception would be where the arbitration itself would be an “illusory remedy.” Here, as Uber offered to pick up the arbitration costs for any claims up to $75,000, arbitration would not be illusory and that the clause should be binding.

 

 


Recent Massachusetts Cases Rule on Contract Enforceability

Posted on Mar 13th, 2016

By: Ryan Carroll

The main purpose of a contract is to establish an agreement between parties to express their rights and obligations.  However, just because you may agree to something, in writing or verbally, does not mean that it will be enforceable if a legal dispute is to arise.  Two recent Massachusetts Appeals Court cases are examples of how this can work in practice.

In Goddard v. Goucher, a Massachusetts Appeals Court recently held that parties may not stipulate to legal conclusions (as opposed to factual) and that courts are not bound by these stipulations.  In this case, the parties sought to enforce a purchase and sale agreement to sell a parcel of land; never having been a final signed version of the purchase and sale agreement, they entered into pretrial stipulations that this purchase and sale agreement was a valid and enforceable contract.  At trial, the trial judge rejected the stipulation that a valid and enforceable contract was created, and the appellate court agreed.  Because the issue of whether the contract was valid is a question of law, as opposed to whether it was actually signed by parties or there was a meeting of the minds, which are factual issues that a party can stipulate to, the Court concluded that the trial judge was within his authority to reject the stipulation.

In Downey v. Chutehall Construction Co., Ltd., a Massachusetts Appeals Court recently concluded that a waiver of statutory requirements by an individual homeowner did not preclude a contractor, who violated the statute, from being liable.  In this case, the contractor alleged that the homeowner did not allow the contract to comply with state’s building code requirements relating to roofing – specifically, the contractor argued that the homeowner did not wish for the contractor to strip the existing roof materials, which was required by the code.  The contract claimed that this was a waiver by the homeowner and it was a defense to claims under Chapter 93A.  The Court concluded that the waiver did not preclude the contractor from being held liable of violations of the building code and resulting 93A violations, especially because the violation carried potential public safety concerns.  While the court did acknowledge that a statutory right or remedy may be waived if it would not frustrate the public policies of the statute, it did state that such right may not be disclaimed if the waiver could do violence to the public policy underlying the legislative enactment.

These recent cases are just examples.  There is a plethora of past cases that illustrate instances in which, despite the parties’ intents and agreements, a court could deem an entire agreement or terms contained therein, unenforceable.  That is why it is always a good idea to have legal counsel review your contracts, especially if big stakes are involved.

 


Regulation Crowdfunding – SEC assists smaller, non-public U.S. companies with raising capital

Posted on Nov 12th, 2015

Ryan S. Carroll

On October 30, 2015, the SEC voted to adopt Regulation Crowdfunding, the final rules allowing private companies to raise capital through crowdfunding and providing additional protection to investors in crowdfunding investments.  This post provides some background on crowdfunding, a summary of Regulation Crowdfunding’s rules and forms and how we can assist in helping you in your next crowdfunding financing.  While we are lawyers, this blog is not intended to be legal advice and should not be relied on as such.  If you would like legal advice on any of the information contained in this post, please contact us.

Background on “Crowdfunding”

Crowdfunding is a new and evolving financing method that can be used to raise relatively small amounts of capital from a large number of investors at a low cost using the Internet as a means to market the offering.  Regulation Crowdfunding are the new rules which will be applicable to crowdfunding offerings relying on Section 4(a)(6) of the Securities Act of 1933 (“Securities Act”).  This Section was added by Title III of the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”) which allows private companies to raise capital through new “crowdfunding” exemptions.  We last wrote on the topic of crowdfunding in this post.

Many provisions of the JOBS Act require rulemaking by the SEC.  Regulation Crowdfunding and its forms will be effective 180 days after they are published in the Federal Register (tentatively, May 2016). This will complete the SEC’s major rulemaking requirement as mandated under the JOBS Act.

The final rules can be found here.

Summary of the Rules:

The recommended rules would, among other things:

1)      Permit issuers to offer the sale of and for investors to purchase securities in crowdfunding offerings, subject to limitations.

  • Such limitations on crowdfunding include:
    • the maximum aggregate amount of financing an issuer can raise through crowdfunding in a 12-month period is $1 million;
    • across all crowdfunding offerings, an individual investor, over a 12-month period may only invest, in the aggregate:\
      • the greater of $2,000 or 5% of the lesser of their annual income or net worth (if their annual income or net worth is less than $100,000); or
      • 10% of the lesser of their annual income or net worth, not to exceed $100,000 in value (if both the investor’s annual income and net worth are equal to or more than $100,000); and
    • an issuer will only be able to make an offering through a registered broker-dealer or through a funding portal and can only use one intermediary for an offering made pursuant to the exemption.

2)      Require issuers raising capital through crowdfunding to disclose certain information regarding their business and the securities being offered through Form C and other requirements.

  • The initial disclosure an issuer must file about the offering is a Form C, which must be provided to the SEC, investors and the intermediary facilitating the offering.
  • Information that must be disclosed on a Form C includes:
    • the price of the securities offered to the public or the method for determining the price, the target offering amount, the deadline to reach the target offering amount and whether the issuer will accept investments in excess of the target offering amount;
    • a discussion of the issuer’s financial condition, a description of the business and how the issuer plans on using the proceeds from the offering, information about the officers and directors of the issuer, information about owners of 20% or more of the issuer and certain related-party transactions; and
    • financial statements of the issuer that are accompanied by information from the issuer’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor.

3)      Create a regulatory framework for intermediaries facilitating the crowdfunding transaction.

  • An issuer must use a registered broker dealer or a funding portal.
  • A funding portal is required to register with the SEC on new Form Funding Portal and become a member of a national securities association (currently, FINRA).
  • Regulation Crowdfunding requires the registered funding portals to:
    • provide investors with educational materials that explain the process for investing on the platform, the types of securities being offered and information an issuer must provide to investors, resale restrictions and investment limits;
    • take certain measures to reduce risk of fraud by having reasonable basis for believing issuers on the platform comply with the Regulation Crowdfunding and that such issuers have a way of keeping accurate records of security holders;
    • make information that an issuer is required to disclose available to the public on its platform for a minimum of 21 days before any security may be sold and throughout the entire offering of such security; and
    • provide channels of communication for discussions about the offerings on the platform, provide disclosure to investors about compensation to the intermediary, only accept an investment commitment after such investor has opened an account, has a reasonable basis for believing an investor complies with investment limitations, provide investors notices once they made investment commitments and confirmations at or before completion of the transaction, comply with maintenance and transmission of funds requirements and comply with completion, cancellation and reconfirmation of offerings requirements.
  • Regulations prohibit intermediaries to engage in certain activities, such as:
    • providing access to their platforms to issuers that they have reasonable basis for believing there is a potential for fraud or other investor protection concerns;
    • having a financial interest in an issuer where it is offering or selling securities on its platform, unless the intermediary is receiving such interest in the issuer as compensation for its services, subject to certain conditions;
    • compensating any person for providing the intermediary with personally identifiable information of any investor; and
    • offering investment advice or making recommendations, soliciting purchase, sales or offers to buy securities, compensating promoters and other solicitors, and holding possessing or handling investor funds or securities.

4)      Require issuers raising capital through crowdfunding to be subjected to ongoing reporting requirements, such as annual reports, to be filed with the SEC and provide such annual reports to investors through the intermediary.

  • If an issuer is raising $100,000 or less, the following are required to be reported (among other things):
    • amount of total income, taxable income, total tax as reported on federal tax forms (if any) and financial statements of the issuer certified by the principal executive officer of the issuer.
  • If an issuer is raising more than $100,000 and less than $500,000, the following are required to be reported (among other things):
    • financial statements of the issuer reviewed by an independent public accountant.
  • If an issuer is raising more than $500,000, the following are required to be reported (among other things):
    • financial statements of the issuer audited by an independent public accountant.

This post is only a summary of selected sections of Regulation Crowdfunding.  Crowdfunding is a very new and nuanced form of raising capital and we recommend you contact your attorney before pursuing any such transaction.  If you have any questions concerning the information in this post, please do not hesitate to contact me at ryan.carroll@hermanlawllc.com.  


Recent Massachusetts case finds defendant liable on a verbal personal guaranty, notwithstanding Statute of Frauds

Posted on Aug 13th, 2015

By: Richard Gauthier

In Chivian vs. Lepler, the Massachusetts Appellate Court recently held that an unsigned personal guaranty is valid, notwithstanding the Statute of Frauds writing requirements.  This case is a somewhat surprising result and a reminder that great care should be made with verbal promises or assurances of personal guarantees or liabilities.

In 2003 the defendant, who was married to the plaintiffs’ daughter, approached the plaintiffs about a real estate investment. The parties agreed to invest $150,000 in the opportunity. Initially, the plaintiffs were equity investors, but after their initial investment turned a profit, the parties agreed that the equity would be converted into loans payable with interest. Both plaintiffs repeatedly asked the defendant to execute written personal guaranties; the defendant apparently agreed to do so, but never actually did. As of 2010, they had not received repayment and filed this action. At trial, the defendant admitted that he had promised to provide personal guaranties of the loans, but never signed them. He then asserted that the Statute of Frauds barred recovery on the personal guaranties absent a writing.

On appeal, the defendant claimed that because the Statute of Frauds bars recovery in contract on a personal guaranty absent a sufficient writing, it was error for the trial judge to send the case to the jury on a theory of promissory estoppel.  The Court held that it was “unpersuaded by the defendant’s contention that a partial writing is necessary to overcome the Statute of Frauds defense in the context of promissory estoppel.”  Because promissory estoppel is an equitable doctrine, the Court reasoned that it would be “harsh injustice to permit the Statute of Frauds to bar recovery for the plaintiffs where the defendant admits he induced the plaintiffs’ reliance by promising to execute a written agreement, the absence of which he now seeks to use to avoid the debt.”


Delaware extends statute of limitations to 20 years for breach of contract claims

Posted on Sep 6th, 2014

The State of Delaware recently passed legislation that authorizes a statute of limitations of up to 20 years for breach of contract claims.  Delaware is the first state to adopt a statute of limitations of such length for breach of contract claims.  The legislation, which amended Section 8106 of Title 10 of the Delaware Code, was effective on August 1, 2014.  The new amended Section enables parties to a written contract involving at least $100,000 to provide that up to a twenty year limitations period will apply to any breach claims arising from the contract.

Historically, the Delaware statute of limitations for contract type claims was either three years (for general contracts) or four years (for UCC claims).  Because claims for other types of liabilities (such as say ERISA or tax claims) a buyer could be find itself liable for these third party liabilities without a remedy against a seller if the shorter limitations period had already expired.  For this reason, practitioners have tried to draft around this issue by allowing claims from certain types of reps (often referred to as the “Fundamental Representations”) to survive by contract for a longer period of time.  However, the case law on whether this actually would be enforceable has been unclear and the issue often turns on whether a contract was signed “under seal”.   While a physical seal is not necessary in Delaware, it is important to reference those key words (signed under seal, executed under seal, etc.) next to the executory signature.  Clearly a somewhat an antiquated process, and a trap for the unwary waiting to happen.

The Delaware legislature has now responded by allowing the parties to contract for this extended limitations period, without the need for the arcane “seal” language.  Now that this period is up to 20 years, the parties’ bargained-for terms will be given much greater effect under typical asset purchase or merger agreements involving the acquisition of a private company.  Since many commercial contracts also are governed by Delaware law, even where the parties are not based in Delaware, it is important to note this change for that context as well.

Although the legislation does not specifically indicate whether it would apply to contracts entered into prior to August 1, case law discussing amendments to statutes of limitations as “remedial” and not affecting “substantive or vested rights,” particularly where a statute of limitations is not shortened so as to cut off a plaintiff’s right to bring suit, suggests that this legislation should apply to contracts entered into prior to its effective date.

 


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.

 

 

 

 

 


SEC Proposes New Rules under JOBS Act to Facilitate Investment in Private Companies

Posted on Jan 16th, 2014

Pursuant to the Title IV of the JOBS Act, in December 2013  the SEC proposed new rules to facilitate start ups and smaller companies to raise capital.  Title IV of the JOBS Act created a new exemption under section 3(b)(2) of the Securities Act of 1933, as amended (Securities Act), for smaller offerings. As directed by section 3(b)(2), the proposed rules would amend  the existing Regulation A, an exemption for unregistered public offerings of securities up to $5 million.

These proposed rules could be significant. The amended Regulation A, commonly referred to as “Regulation A+,” is intended to facilitate capital formation for small companies by addressing certain issues in the current Regulation A that have deterred companies from using Regulation A to raise funds, including the low maximum offering amount and the high costs of state blue-sky compliance requirements.  The proposed rules would create two tiers of Regulation A offerings: Tier 1 for offerings of up to $5 million in a 12-month period and Tier 2 for offerings up to $50 million in a 12-month period.  Both tiers would be subject to certain basic eligibility, disclosure, and procedural requirements that are derived from the existing Reg A framework, with certain updates to conform to current practices for registered offerings. Tier 2 offerings would be subject to additional requirements, including the provision of audited financial statements, ongoing reporting obligations, and certain investment limitations.  Tier 2 offerings would provide federal law preemption and thus be exempt from having to comply with state blue-sky requirements.

The proposed rules are subject to a 60-day public comment period after publication in the Federal Register. If adopted, Regulation A+ has the potential to provide start-ups and private companies with a viable alternative for raising capital quickly and inexpensively, while improving the liquidity of their securities in secondary markets.  We will continue to monitor these developments and will post updates as they become available.