Pitfalls of Affiliated Companies

Since its humble beginning in Wyoming in 1977, the limited liability company (“LLC”) type of entity formation has gained rapid acceptance as a way to avoid personal liability and still maintain administrative flexibility. In addition, many lenders now insist that borrowers create a separate single-purpose entity for each project. Thus, most businesses consist of multiple affiliated companies that are each supposed to be treated discretely under the law. However, since non-corporate entities such as partnerships and LLCs are not required to hold regular meetings or even appoint officers, the owners of those entities tend to overlook other company formalities as well. This lackadaisical attitude may inadvertently create a situation where creditors come to rely on assets of affiliates, not just the entity with which they have a contract. In a bankruptcy proceeding, the creditors may go so far as to ask the court to substantively consolidate the affiliated companies.

The following are the most common pitfalls that affiliated companies should avoid in effort to preserve the benefit of each company’s independent existence:

Entangled Finances – If affiliated companies co-mingle their funds or one entity pays the bills for another entity without appropriate inter-company transfer records, it becomes increasingly difficult to distinguish the assets and liabilities of each company. Moreover, many affiliated companies produce only consolidated financial statements that imply that additional resources are available to satisfy an entity’s debts. If the entities share bookkeeping personnel, then mistakes become even more likely.

Reliance on Credit of Affiliates – If affiliated companies pledge any of their assets to secure loans to another entity or guarantee such loans, creditors may be entitled to rely on the credit of all of the entities. Creditors often request financial statements from such affiliates and require joint and several liability among the affiliates. Creditors may press hard for consolidation if some entities are asset-rich while others have major liabilities.

No Separate Stationary and Signatories – Often a group of companies will have one overarching trade name and will not clearly indicate the particular affiliate that is acting with respect to a transaction. Similarly, sometimes multiple entities will be executing the same document. If the same person signs the documents for several different entities, it is very easy to make a scrivener’s error and confuse the entities. Likewise, with modern computer technology, duplicated and revised documents with global changes to names, may not reflect the actual intent of the parties in every cases. These similar, yet different, documents can lead to unintended consequences and may require extra time and expense to audit and correct errors.

Undercapitalization – If a company does not have sufficient assets to pay for its liabilities in the ordinary course of business and is dependent on an affiliate for funding, then creditors may seek recovery against the finding entity too.

If a business is structured with several affiliated companies, the owners must still be diligent about ensuring that each entity is capable of standing alone both financially and contractually. Owners should also make clear to creditors that only that particular company may be relied on for payment. If not, all of the effort put into creating the separate companies may be disregarded in favor of producing more equitable results for creditors of affiliated companies.

Shareholder Oppression – The Texas Supreme Court has Spoken

On June 20, 2014 in the case of Ritchie v. Rupe, the Texas Supreme Court declined to recognize a common-law cause of action for shareholder oppression. Much of this article is quoted from the actual opinion.

The Texas Supreme Court found that existing statutory law adequately protects and provides remedies for various categories of conduct identified as frequent causes of shareholder oppression.  The Court addressed each of the common complaints of conduct giving rise to the shareholder oppression cases and identified the statutory cause of action for each.  They are as follows:

  1. Denial of Access to Corporate Books and Records.  A common complaint of those alleging shareholder oppression is the denial of access of the corporation’s books and records.  The Court held that Texas Business Organizations Code, Chapter 21 expressly protects a corporate shareholder’s right to examine corporate records. See Tex. Bus. Orgs. Code §§ 21.218 (examination of records), 21.219 (annual and interim statements of corporation), 21.220 (penalty for failure to prepare voting list), 21.222 (penalty for refusal to permit examination), 21.354 (inspection of voting list) and 21.372 (shareholder meeting list).
  2. Withholding or Refusing to Declare Dividends.  A second complaint of those alleging shareholder oppression relates to the corporation’s declaration of dividends, including the failure to declare dividends, the failure to declare higher dividends, and the withholding of dividend payments after a dividend has been declared.  With regard to the latter, shareholders already have a right to receive payment of a declared dividend in accordance with the terms of the shares and the corporation’s certificate of formation, and they can enforce that right as a debt against the corporation.  When a dividend is declared, it becomes a debt owing by the corporation to the stockholders.   With regard to the failure to declare dividends or the failure to declare higher dividends, those decisions fall within the discretion of a corporation’s directors, and those decisions must be made in compliance with the formal fiduciary duties that they owe to the corporation, and thus to the shareholders collectively.  Shareholders can sue the directors for breach of those duties on behalf of the corporation through a derivative action.  In sum, a remedy exists for dividend decisions made in violation of a director’s duties to the corporation and its shareholders collectively, but no remedy exists for decisions that comply with those duties, even if they result in incidental harm to a minority shareholder’s individual interests.
  3. Termination of Employment.  A third common complaint of those alleging shareholder oppression relates to the termination of the minority shareholder’s employment with the corporation.  Texas is steadfastly an at-will employment state.  The general rule has been absent a specific agreement to the contrary, employment may be terminated by the employer, or the employee at will, for good cause, bad cause, or no cause at all.  There may be situations in which, despite the absence of an employment agreement, termination of a key employee is improper, for no legitimate business purpose, intended to benefit the directors or individual shareholders at the expense of the minority shareholder, and harmful to the corporation.  Such a decision could violate the director’s fiduciary duties to exercise their uncorrupted business judgment for the sole benefit of the corporation and to refrain from usurping corporate opportunities for personal gain.  In such a case, a shareholder may enforce these duties through a derivative action.  Such action could also be potentially “oppressive” under Tex. Bus. Orgs. Code §11.404 and thus justify the appointment of a rehabilitative receiver under Tex. Bus. Orgs. Code §11.404 (a)(1)(c).
  4. Misapplication of Corporate Funds and Diversion of Corporate Opportunities.  A fourth complaint of those alleging shareholder oppression involves the misapplication of corporate funds and diversion of corporate opportunities.  The duty of loyalty that officers and directors owe to the corporation specifically prohibit them from misapplying corporate assets for their own personal gain or wrongfully diverting corporate opportunities to themselves.  These types of actions may be redressed through a derivative action, or through direct action brought by the corporation, for breach of fiduciary duty.
  5. Manipulation of Stock Values.  The final complaint of those alleging shareholder oppression involves the directors’ manipulation of the value of the corporation’s stock.  As a general rule, claims on such conduct belong to the corporation, rather than the individual shareholder.  The individual shareholders have no separate and independent right of action for injuries suffered by the corporation which merely result in the depreciation of the value of their stock.

Importantly, the Court also recognized that the business judgment rule is applicable to decisions made by office and directors in actions under the Tex. Bus. Orgs. Code §11.404 (a)(1)(c).  The Court held that “a corporation’s directors or managers engage in “oppressive” actions under §11.404 when they abuse their authority over the corporation with intent to harm the interests of one or more of the shareholders, in a manner that does not comport with the honest exercise of their business judgment, and by so doing so create a serious risk of harm to the corporation”.

The Court further ruled that the statue (Tex. Bus. Orgs. Code §11.404) does not authorize a buy-out remedy of a minority shareholders shares, even if such actions are deemed oppressive under the statute.

The case can be found here.

Reversing the Dallas Court of Appeals

On June 20, 2014, the Supreme Court, in what will certainly be seen as a landmark decision, issued an opinion reversing the Dallas Court of Appeals in the case of Ritchie v. Rupe. The Dallas Court of Appeals had affirmed the trial court’s ruling that a minority shareholder was entitled to fair market value for her shares, including discounts for lack of marketability and for the stock’s minority position. On June 20th, the Supreme Court held that it was not “oppressive conduct” for the majority shareholders to refuse to meet with prospective purchasers of the company, that the Business Organizations Code does not authorize courts to order a corporation to buy out a minority shareholder’s stock, and that there is no common-law cause of action for minority shareholder oppression. The Texas Supreme Court’s opinion represents the single most important decision to-date on the rights, or lack thereof, of minority shareholders.

More on this topic in a blog post coming soon.

Prepetition Waivers of the Automatic Stay – Are They Enforceable?

In recent case law, bankruptcy courts are beginning to consider prepetition waivers of the automatic stay in bankruptcy as a consideration in determining whether “cause” exists to lift the automatic stay. In In Re 4848, LLC, 490 B.R. 343, 345 (Bankr. E.D. Wis. 2013), the court found the following language to constitute such “cause”:

“Relief from the Automatic Stay. As a material inducement to Lender to enter into this Agreement, Borrower hereby stipulates and agrees that Lender shall be entitled to relief from the automatic stay imposed by 11 U.S.C. § 362 or any similar stay or suspension of remedies under any other federal or state law in the event Borrower becomes subject to a bankruptcy or other insolvency proceeding, to allow Lender to exercise its rights and remedies with respect to the Collateral.”

The court determined that the public policies in favor of freedom of contract and encouraging out-of-court restructurings and workouts of a debtor’s relationships with its creditors outweighed the public policy behind the automatic stay.

Although prepetition waivers of the automatic stay are enforceable, they are not per se enforceable, nor are they self- executing.  Instead, the courts will consider the following factors:

  • The sophistication of the waiving party
  • The consideration for the waiver, including the creditor’s risk and length of time covered by the waiver
  • Whether other creditors’ rights are impacted
  • The feasibility of debtor’s plan
  • Whether there is evidence that the waiver was obtained through coercion, fraud, or mutual mistake of material factors
  • Whether enforcing the waiver will further the public policy in favor of out-of-court workouts
  • Whether there appears to be a likelihood of reorganization
  • To what extent the creditor will be harmed by not enforcing the waiver
  • The length of time between the date of the execution of the waiver and the date of the bankruptcy filing and whether a compelling change in circumstances has occurred during that time
  • Whether the debtor has any equity in the property

We suggest that all lenders should consider including the language cited above in all of their future loan documents, and in all forbearance agreements.

Traps for the Unwary: New Texas Property Owners Association Laws

In 2011, the Texas legislature completely overhauled the laws related to the actions of Property Owners Associations (“POAs”) in the state under the provisions of the Texas Residential Property Owners Protection Act.  Many POAs had used their assessment lien rights to force homeowners out of their homes for relatively minor infractions of POA rules and regulations. The goals of the overhaul were to create a more transparent relationship between the POAs and their members, to make foreclosure available only through judicial process, to create a six (6) month redemption period, and to require all “Dedicatory Instruments” (which means each governing instrument covering the establishment, maintenance, and operation of a residential subdivision [or the administration or operation of the POA of any such subdivision]) to be filed of record in the real property records of the county where the relevant subdivision is located and also made available  on the POAs website, if any.

RECORDING OF DEDICATORY INSTRUMENTS. Now, if the Dedicatory Instruments are not recorded, the POA cannot enforce their respective terms against the subdivision’s property owners (Texas Property Code Section 202.006). In the past, POAs have typically recorded the Declaration of Covenants, Conditions, and Restrictions for the subdivision and the Bylaws of the POA, but not necessarily the other documents that are included within the scope of the term “Dedicatory Instruments.”

The other documents that should be recorded to be clearly enforceable include:

  • The Open Records Production and Copying Policy of the POA (which must conform to mandatory ceiling prices)
  • The Document Retention Policy
  • Alternative Payment Plan Guidelines for delinquent property owners
  • The Architectural Control Committee’s Design Guidelines
  • The POAs Rules and Regulations for the subdivision

OVERRIDE OF CONFLICTING PROVISIONS IN EXISTING DEDICATORY INSTRUMENTS. Several changes to Texas POA law override previous provisions that were slanted heavily in favor of the subdivision developer:

  • Within 120 days after the date that 75% of the lots have been sold, at least 1/3 of the board must be elected by non-developer owners (versus typical provisions maintaining developer control until 90+% of lots have been sold)
  • Dedicatory Instruments can now be amended by 67% of the owners, not whatever higher percentage is actually in the Dedicatory Instruments
  • Board meetings must be open and at least 10 days prior notice must be provided to owners of the meetings
  • Owners have access to the POA’s records upon request
  • Assessment lien filings must now be prepared by an attorney not a POA employee
  • Architectural Control Committee Guidelines with respect to certain items is specified by law (flag displays, rain barrels, religious symbol displays, solar energy devices, and certain roofing materials)

Thus, a POA that relies on the wording of its Dedicatory Instruments may find that it has inadvertently broken the law, may not be able to enforce restrictions against owners, and may even have opened the door to liability for the POA.

All POAs should review their Dedicatory Instruments for compliance with the 2011 laws, record all required documents, and notate any provisions of their Dedicatory Instruments that have been overridden by such laws.

An Alternative Financing Option: SBA 504 Loan

PURPOSE
For many fledgling or small businesses, traditional commercial bank loans are either unavailable or cost-prohibitive. So other than finding a new equity investor, which may be difficult or undesirable, what choices does an entity have for infusing capital? If a potential borrower has overall project costs between $250,000 and $12,500,000, one answer may be the use of a Small Business Administration (SBA) 504 loan. Project costs may include land and building purchases, build-outs, remodeling, equipment, professional fees, and refinancing. However, inventory, goodwill, working capital and other fees are excluded. SBA 504 loans are 40% guaranteed by the Federal government in order to promote job creation and retention in “small” businesses. SBA 504 loans are not actually made by the SBA. Instead, certain SBA approved lenders make loans that conform to the SBA’s requirements so that the SBA will agree to guarantee such loans. New, emerging, established or expanding businesses may request SBA 504 loans in amounts up to around $5,000,000. The SBA 504 loans are further restricted to owner occupied (50 %+) real estate and equipment purchases.

ELIGIBILITY
A business in considered “small” for SBA 504 loan purposes if it meets the following conditions:
– Conducted for profit
– Profits are less than $5,000,000 after tax
– Tangible Net Worth is less than $15,000,000
– Appropriate use of proceeds
– Doing business in the United States

STRUCTURE
An SBA 504 loan involves the following entities: a commercial lender, a credit development company (CDC), the SBA, and the borrower. The lender loans 50% of the project cost and takes a first lien; the CDC loans 40% of the project cost and takes a second lien that is guaranteed by the SBA, and the borrower contributes 10% of the project cost (the equity). The borrower’s contribution may even be in the form of land previously purchased. Numerous lenders in the Houston area offer SBA 504 loans. Likewise, several CDCs are active in this market. Specific lenders and CDCs may be targeted by accessing the SBA’s website and searching by zip code.

GUARANTIES
Any person or entity that holds 20% or more of the equity of the borrower will be required to execute a personal guaranty for the SBA guaranteed portion of the loan. This provision insures that the borrower has a strong incentive to succeed in business and repay the financing.

APPLICATION REQUIREMENTS
Before applying for a SBA 504 loan, the borrower should collect the following documentation:
– Entity formation documentation
– Licenses/Permits to conduct desired business
– Personal credit reports for individuals that hold 20% or more of the equity in the borrower
– Business credit reports for the borrower and any entities that hold 20% or more of the equity in the borrower
– Biographical information about the owners and the borrower
– Business Plan
– Financial Statements ( including a Balance Sheet, Cash Flow, and Profit and Loss Statements) for the last 3 years
– Income tax returns for the last 3 years

ADVANTAGES
SBA 504 loans have lower fees and costs because a portion of the risk is being assumed by the SBA. The commercial lender is also only loaning 50% of the funds, so its default risk is lowered. The borrower is only required to inject 10% of the financing, which is lower than the typical 25% requested in a traditional commercial loan.

The CDC’s loan has a much longer term—from 10 years for equipment up to 20-25 years for real estate. This situation allows the borrower to decrease its debt repayment amounts in the near term.
Borrowers that do not have other financing options are able to obtain funding

MYTHS
SBA 504 loans take longer to receive approval and fund. If the borrower supplies a complete application package at the outset, the timing should be comparable. The SBA approval of a CDC’s loan request normally takes about 3 weeks. Once the CDC loan approval has been issued, the borrower essentially has no further contact with the SBA.

SBA 504 loans require two sets of loan documents, so they are more costly. Although there are two sets of loan documents, the SBA’s set is essentially non-negotiable and contains no covenants. Also, any financing with two lienholders will require two sets of loan documents.

The prepayment penalty in the SBA guaranteed portion of the loan makes it unattractive. First, the SBA 504 loan is assumable and current rates are low, so fixing that low rate for the long term may actually be an advantage. Second, the penalty decreases over time, and disappears after year 10. Third, it is only logical that the CDC wants to be made whole for any losses on its debentures that financed its loan.

DEFAULT CONCERNS
Once the loan proceeds have been advanced, the SBA has no involvement in the borrower’s daily business. Even in the event of a default, the first lienholder may negotiate the major terms of any workout or restructure of the financing without the need for SBA approval.

SBA 504 loans are an often underutilized financing mechanism that should appeal to manufacturers, heavy equipment users, real estate owners and developers, medical practices, and other entities that wish to preserve their working capital.