September 23, 2016 8:52 am
Worcester made its mark in the 19th and 20th centuries as a manufacturing center, giving rise to industrial giants such as Norton Company and Wyman Gordon, many of which were owned for generations by small family groups. Home to inventors and entrepreneurs, our city has also fostered many smaller businesses, founded and operated by families or friends.
Oftentimes the stockholders, directors and officers in these “close” corporations are the same two or three people, each one performing multiple roles simultaneously in the corporate structure. Such companies play a significant role in the Commonwealth’s economy, but their very smallness creates a unique set of risks for the owners.
Close Corporation Defined
In Donahue v. Rodd Electrotype of New England, 367 Mass. 578 (1975), the Supreme Judicial Court identified a number of factors that define a close corporation and also articulated the duties that the stockholders, directors and officers owe to one another.
The Court noted that a close corporation “. . . bears a striking resemblance to a partnership. . . . Just as in a partnership, the relationship among the stockholders must be one of trust, confidence and absolute loyalty if the enterprise is to succeed. . . . [The stockholders] . . . owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another. . . . They may not act out of avarice, expediency or self-interest in derogation of their duty of loyalty to the other stockholders of the corporation.” (Donahue at 586-587, 593.)
My experience dealing with litigation involving stockholders who strayed from the Donahue guidelines has taught me how easily a stockholder can find himself or herself in a morass of avoidable trouble, despite having acted in a way that he or she considered defensible. The following fictional story, a composite of factual situations I have actually encountered, draws on that experience.
The Sad Tale of Joe and Pete
While in their early twenties, Joe and Pete were hired by the Worcester Widget Company. Because of his technical training and inclination, Joe began working on product development in the machining end of the business. Pete, who had attended business school, focused on maintaining relationships with existing customers and cultivating new customers. In short, Joe was Mr. Inside and Pete was Mr. Outside.
The owner of Worcester Widget, George, was in his late 70s. None of George’s children wished to take over the business, and he soon saw Joe and Pete as his potential successors. George paid Joe and Pete well. In return, they worked long and hard for the business, even as they started their own families. After a few years, George decided to sell the company to Joe and Pete.
The two friends formed their own corporation to purchase all the assets of George’s company, naming it ”Newco.” They became Newco’s only stockholders, directors and officers, with Joe as President and Pete as Treasurer. Having seen the potential for growth of Worcester Widget Co., Joe and Pete threw themselves into the operation of the business with even greater energy. They increased its customer base, its territory, and its profits. Joe and Pete took identical salaries and benefits. They made every effort to share equally, not only the responsibilities of the business, but also the fruits of its success.
As Joe approached his mid-50s, he decided to retire from his active role in the company and to spend most of his time in Florida. Joe and Pete saw no need to involve lawyers or accountants in Joe’s retirement. Joe simply gave Pete a letter that read, “Dear Pete, following my retirement, I agree that you are entitled to earn more money than I do from the company. Sincerely, Joe.” At the time of Joe’s retirement, he and Pete each were earning $250,000 per year.
Joe went off to Florida for a life of sun and golf. He returned to Massachusetts once or twice each year to visit friends and family, and between visits he occasionally checked with Pete by phone to see how Newco was doing. Their brief conversations left Joe untroubled. He perceived no need to request detailed business reports, because Newco dutifully and punctually sent him a monthly salary check, paid his health insurance premiums, and gave him a substantial year-end distribution.
About two years after Joe left Newco, it occurred to Pete that because he was shouldering all of Newco’s executive responsibilities, it would be fair if he increased his salary above Joe’s and took a greater distribution, too. As Pete pondered that idea, he remembered Joe’s retirement letter, which stated clearly that Pete had the right to earn more money than Joe. With that in mind, Pete saw no problem with increasing his annual salary to $750,000. In addition, he hired his college-student daughter for a part-time position with Newco at an annual salary of $150,000. Pete later said that he honestly felt he had done nothing wrong. After all, Newco’s profits grew handsomely every year under his 50 percent leadership.
After five years of retirement, Joe returned to Massachusetts for an extended visit. He decided to meet with Pete for an overview of Newco’s financial condition. Pete readily opened Newco’s books and records for Joe’s inspection.
You can imagine what happened next. Joe soon realized that since his retirement, Newco had paid Pete and his daughter nearly $3 million more than Newco had paid Joe during the same period. When Joe saw that figure, he was outraged. He walked out of Newco’s building and called his lawyer.
Joe and Pete opened the door to litigation that would cost them dearly in legal fees, imperil the future of their valuable corporation, and destroy a decades-long friendship.
What Could They Have Done Differently?
Here are some ways you can avoid Joe’s and Pete’s fate:
1. Assess candidly your own weak points and those of your business partner. Be totally forthcoming with each other about any factors, whether personal or financial, which might divide you.
2. At the beginning, not at the end, identify and engage an experienced lawyer and accountant to help you create a sound business structure. Task the lawyer and the accountant with serving the corporation, not any individual. They will assist you in the due diligence process of evaluating any business that you buy, and they will help you decide how best to structure its financing. Above all, they will document your agreements concerning the governance of the company and the distribution of its income.
3. Prepare a clear and specific outline of each stockholder’s duties and responsibilities. Make sure that everyone has the same information.
4. Explain to spouses, in detail, exactly what is going on, what you expect from your business partner, and what he or she expects from you.
5. Meet with your co-owner at least once a month. Discuss what is happening in the business, especially in your areas of supervision.
6. Meet with your lawyer and accountant every six months. Have them serve as a check on your compliance with the terms and conditions of your obligations and agreements with each other, with your lender, and with your customers and vendors.
7. Commit to each other and to your professional advisors, as well as to family members, that you will follow this schedule for three years, after which you will reassess your needs based on the status of the business at that time.
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Image Credit: Celso Pupo Rodrigues