Many Texas lawyers and their private company clients continue to refer to the claim for shareholder oppression as if it remains a viable cause of action under Texas law. And yet, for all practical purposes, the claim for minority shareholder oppression met its demise more than five years ago in 2014 in Ritchie v. Rupe
Historically, the sale of a private company carried with it a significant risk of claims by the purchaser. Months or even years after the sale closed, purchasers would frequently contend that the seller’s representations and warranties in the purchase agreement had been breached. This claim would support demands by the purchaser for the seller to forfeit some or all of the purchase price held back in escrow, and give rise to other claims, as well. The often contentious relationship that existed between company buyers and sellers began to change, however, when representation and warranty insurance (“R&W Insurance”) emerged and began to gain acceptance.
Although it was almost unheard of ten years ago, R&W Insurance is now widely used in today’s seller-friendly merger and acquisition (“M&A”) market. This post therefore provides an overview of R&W Insurance, explains how R&W Insurance works, and reviews how this type of policy allows buyers and sellers to an M&A transaction to allocate risk for their mutual benefit.
Role of R&W Insurance
At its most basic level in this context, R&W Insurance is an insurance policy issued to the buyer of a private company, and it protects the buyer from unanticipated losses that result from a breach of the seller’s representations and/or warranties in the purchase agreement. Some R&W policies are issued to company sellers, but more often the buyer is the insured party.
The concept of R&W Insurance is not new, but it has gained a much broader market acceptance over the past decade due to a number of factors, including, seller-friendly market conditions and an increase in the number of new insurers entering the market. The existence of multiple insurers providing R&W Insurance has led to lower costs (premiums), better policy terms, and a quicker underwriting process allowing the policies to be issued more promptly.…
Fiduciary. The term applies broadly to cover all types of companies, as well as spouses in marriage, and is defined as “of, relating to, or involving a confidence or trust.” In the private business context, the company’s shareholders or members trust that their directors, managers and officers will make good faith decisions and act with loyalty to the business. When company leaders breach this trust and violate their fiduciary duties, however, they may become personally liable for any damages resulting from their improper conduct. This post focuses on the fiduciary duties that apply to private company leaders and reviews the legal guideposts that will help these company leaders, as well as the company’s shareholders and members better understand what constitutes compliance with these fiduciary obligations.
The Core Fiduciary Duties
Regardless of the entity structure, Texas law imposes fiduciary duties on company directors, managers and officers, which they owe to their company. Apart from Texas law, the fiduciary duties owed by company leaders are also typically addressed in the company’s bylaws, agreements, or regulations. What precisely are the fiduciary duties that Texas law imposes on business leaders, and do they vary based on the role as director, officer, or manager? The remainder of this post takes a closer look at these fiduciary duties.
- The Duty of Care
When making decisions for the company, the directors, managers, and officers are expected to exercise and adhere to the standard for the “duty of care.” Under Texas law, this duty is generally described as the obligation to use the amount of care an ordinarily careful and prudent person would use in similar circumstances. Gearhart Indus., Inc. v. Smith Intern., Inc., 741 F.2d 707, 720 (5th Cir. 1984). The decisions that company directors, manager, and/or officers make on behalf of the company involve a certain amount of risk as they seek to act for the benefit of the company. Recognizing that directors, managers and officers must make decisions for the company that cannot be fairly judged with the benefit of hindsight, Texas law applies the “Business Judgment Rule” to protect company leaders in their decision-making process. The Business Judgment Rule specifically precludes directors, managers, and officers from being held liable for business decisions that turn out poorly provided that they acted in an informed manner an on a good faith basis. To overcome the Business Judgment Rule as a defense, a shareholder or member who desires to assert a claim against a governing person at the company is typically required to show that this company leader engaged in self-dealing or other bad faith conduct. “. . . the Texas business judgment rule precludes judicial interference with the business judgment of directors absent a showing of fraud or an ultra vires act. If such a showing is not made, then the good or bad faith of the directors is irrelevant.” Gearhart Indus., Inc. v. Smith Int’l, Inc., 741 F.2d 707 (5th Cir. 1984);
The Texas Business Organizations Code does permit a company to limit or even eliminate a director’s personal liability for money damages to the company or its shareholders or members for breaches of their duty of care. Tex. Bus. Orgs. Code § 7.001. These so called “exculpation clauses” do not eliminate the fiduciary duty of care, but by limiting or eliminating the remedy of a cash payment for the breach of this duty, the practical effect is the same (a breach of the duty of care could give rise to non-monetary damages even when the company’s governing documents include an exculpation provision).…
The fact of the matter is that co-founders spend most of their time fighting . . . But no one talks about it. Los Angeles venture capitalist Mark Suster. (Fighting Co-Founders Doom Startups)
Setting up a private company on a 50-50 owned basis is typically a bad idea, but many founders of new businesses continue to embrace this perilous ownership structure. We wrote last year about problems that plague 50-50 owned businesses (The Potential Pitfalls of a 50% Ownership Stake in a Privately-Held Company), and a google search on the topic produces articles such as: “50/50 Partnerships; Never a Good Idea,” and “Why You Shouldn’t Enter into a 50-50 Partnership.” Venture capitalist Mark Suster explained in a column called the The Co-Founder Mythology that most people form 50/50 partnerships, “because they’re afraid to to start alone.” Mr. Suster advises entrepreneurs to “take the leap” in starting their new company, but to do so without entering into a 50-50 ownership with a co-founder. Mr. Suster states: “. . . I meet far more people who had problems with [their current partner-ship] than founders who didn’t have problems. People just don’t talk about it publicly or in blogs.” (The Co-Founder Mythology)
50-50 Owned Businesses – High Risk for Failure
The evidence backs up Mr. Suster’s negative views regarding the problems with 50-50 owned businesses. In 2013, Noam Wasserman, a Harvard Business School professor, published The Founder’s Dilemmas after studying 10,000 different business founders. According to Prof. Wasserman’s book, 65% of high-potential startup companies fail as a result of conflict among the co-founders. Pairs and groups bring a variety of skills, but there is also more potential for conflict—over the company’s leadership, finances, strategy, credit and blame. (Fighting Co-Founders Doom Startups)…
As we noted in a previous post (Read Here), the disruption and dysfunction caused by a bad business partner who holds a substantial minority stake in the company can lead to the ultimate failure of the business. This is especially true when the company founder has no buy-sell agreement in place that will allow him/her to redeem the minority investor’s interest in the company. When the majority owner has no contract right to force the minority investor to exit the business, the owner’s options are essentially limited to: (i) going out of business and dissolving the company, (ii) selling the business to a third party (iii) or selling the majority owner’s interest to another party who will step into the owner’s shoes and take on the task of dealing with the minority investor.
None of these “end the business” options are likely to satisfy a company founder who worked very hard to bring the company to life. This post therefore considers options for the majority owner of the company to consider when no buy-sell agreement exists with the minority investor who has become a major stumbling block in the path to the company’s continued success.
Setting the Stage for the Exit of the Bad Business Partner
The bad business partner may believe that he/she has the upper hand in negotiations with the majority owner. Specifically, at the same time the minority investor is wreaking havoc at the company, the investor is refusing to be bought out or is demanding a grossly inflated price for the purchase of his/her minority stake in the business. In this situation, the majority owner may appear to be “stuck” with no recourse to force the exit of this bad partner and fix the problems the investor is causing at the company.…
Navigating a successful business exit when a marriage ends in divorce often presents challenges for both parties. Leaving aside the emotional tensions present in divorce, resolving conflicts regarding the ownership of business interests in the marital estate is also daunting. This post therefore reviews options for divorcing spouses to in their divorce proceeding. If couples can ratchet down the emotions and the acrimony, the tools discussed in this post may help allow the couple to optimize the financial outcome of their divorce settlement and preserve the value of the company they own or in which they share a large ownership stake.
The Valuation Dilemma
The most contentious business issue in many divorce proceedings is the value of the business that must be divided as part of the divorce settlement. Valuation is an inexact science, and the divorcing couple can easily spend hundreds of thousands of dollars on expert and legal fees battling it out over the value of one or more private companies included in the marital estate. This challenging issue is not subject to any easy fix. But there are some options the couple may want to consider before engaging in an expensive and time-consuming valuation battle.
(a) Marital Agreements. Couples can eliminate the private company valuation battle by entering into a marital agreement that specifies what specific assets will be shared on divorce, or what amounts will be paid, and the agreement can also specific how the value of any assets will be determined. While a pre-nup is more common, couples can also agree to enter into a post-nup that details a property division and removes any conflict regarding the valuation of specific assets. Texas statutes set forth strict requirements to follow for marital agreements be enforceable. See Chapter 4 of the Texas Family Code
(b) Designated Valuation Expert. The couple can agree to pre-select and designate a valuation expert they both trust to conduct the valuation for them and to be bound by whatever value is determined by this mutual, trusted expert. Alternatively, there are variations on this approach, which give the couple the right to retain valuation experts if they don’t like the value that is determined by the designated expert and the results of these additional experts will then be averaged to determine the final value. …
Entrepreneurs launching new companies today take on a significant gamble, because statistics show that roughly 30% of all new start-ups fail within two years, and only half survive for a full five years. Many businesses fail due to the owners’ inability to meet the challenges of the marketplace, but some start-ups shut down when conflicts arise within the ownership group. Companies can go under over these ownership disputes even when their governance documents include dispute resolution provisions—if these terms fall short of keeping the business intact.
Given the many business risks that business entrepreneurs face, they should not also have to accept the gamble that a future serious conflict with their co-owners will torpedo the business. This post therefore focuses on dispute resolution terms that are designed to resolve ownership disputes, but which will preserve the continued operation of the business. While not fool-proof, the best mechanism for resolving ownership conflicts in our experience on a prompt, confidential and cost-effective basis is through a set of well-crafted fast track arbitration provisions. These arbitration terms are included in the company agreement (LLC’s), in the bylaws (corporations) or in the limited partnership agreement (limited partnerships), and they are discussed below.
Faster – Prompt Date for Final, Evidentiary Hearing
Litigation will often drag on for months and, in some cases, years, and at great cost. By contrast, arbitration is a dispute resolution procedure that is created by agreement of the parties, and as a result, the parties can choose to adopt a specific timetable in their arbitration provision that requires the final arbitration hearing to take place on a prompt schedule. The manner in which a fast-track schedule for the arbitration hearing plays out is described below.
After one of the parties files a demand for arbitration, the arbitration company, which is typically either AAA or JAMS, will assist the parties in selecting the arbitrator, or if the parties opted for a panel, a panel of three arbitrators, to preside over the dispute. Once the arbitrator or the arbitration panel is appointed, a scheduling conference will be held promptly, and the date for the arbitration hearing will be set at that time. If the parties require the hearing date to take place within a specified period in the arbitration provision, e.g., 60 or 90 days, the arbitrator or panel will enforce the parties’ agreement and adopt the schedule to which they agreed. In short, the parties will get what they bargained for, a prompt hearing with no delays/continuances. …
It’s my party, and I’ll cry if I want to
Cry if I want to, cry if I want to
You would cry too if it happened to you.
—Its My Party, by Lesley Gore
Almost five years have passed since the Texas Supreme issued its decision in Ritchie v. Rupe in 2014 abolishing shareholder oppression as a claim under common law by minority shareholders in private Texas companies. Specifically, in Ritchie, the Supreme Court eliminated a court-ordered buyout as a remedy for minority investors complaining of oppressive conduct by the company’s majority owners. The legal landscape remains bleak for minority shareholders, and when the five year anniversary of Ritchie arrives in June, minority shareholders still have no legal remedy to secure a buyout of their ownership interest if they failed to obtain a buy-sell agreement or other contract exit right at the time of their investment in the company.
In this blog post, we will review efforts made to address the problems created by the Supreme Court’s holding in Ritchie, both legislatively and in the courts, consider how the predictions the Court made in Ritchie have played out, and discuss the state of the current legal battlefield between minority shareholders and majority owners in Texas private companies.
No Legislative Fix for Ritchie Has Been Adopted or is Pending
In the aftermath of the Ritchie decision, the Texas legislature took a run at creating a statutory fix to address the Court’s removal of a buyout legal remedy for oppressed minority shareholders. In 2015, the year after Ritchie was issued, Rep. Ron Simmons, a second-term Republican from Denton County, introduced Bill 3168 in the Business and Industry Committee of the Texas House. This proposed Bill would have applied solely to closely-held entities rather than to all private Texas companies, and the provisions of Bill 3168 were broader than the pre-Ritchie state of the law.
More specifically, as originally proposed, Bill 3168 would have granted broad statutory powers to Texas trial courts, including the right to appoint a “fiscal agent” to report periodically to the court on the operations of the business. This new type of statutory agent is different than a receiver and would likely be more akin to a monitor. In addition, the Bill intended to provide the oppressed minority shareholder with more than a buyout right as it authorized shareholders to pursue a claim for a dividend to share in the retained earnings stockpiled by the company, as well as the right to recover damages from the majority owner and/or board members who engaged in oppressive conduct that was shown to be harmful to the minority shareholder.…
“The only way to get rid of temptation is to yield to it.” -Oscar Wilde
“I generally avoid temptation unless I can’t resist it.” -Mae West
“That which is hateful to you, do not do unto your neighbor.” -Hillel the Elder
Temptation is powerful. We all know this well, which is why these quotes by author and bon vivant Oscar Wilde, and actress and legendary sex symbol Mae West evoke nods of agreement. But giving into temptation can result in significant harm to ourselves and others. That is why more than 2000 years ago, the revered Jewish religious leader and biblical sage, Rabbi Hillel, implored his followers to treat others as they would want to be treated.
In the modern business world, temptation wins out when managers and majority members of Texas limited liability companies (“LLCs”) exploit their controlling power for their own benefit to the detriment of the company’s minority investors. These self-serving actions by governing persons may result in breach of fiduciary duty claims being filed against them, causing these governing managers or members to turn to the Texas Business Organizations Code (“TBOC” or the “Code”) in search of a legal defense. The TBOC does not provide governing persons with a “get out of jail free card,” but the Code does contain an “Interested Director” provision that may be helpful to LLC majority owners and managers who have to defend against breach of fiduciary duty claims. See TBOC § 101.255. This post evaluates the scope and the limits of the TBOC’s Interested Director provision.…
Hospitality – the friendly and generous reception and entertainment of guests, visitors, or strangers in which the host receives the guests with goodwill.
It is a common complaint that companies now provide a disappointing level of customer service. But merely providing good service is not enough for a business to be assured of success. In a superb article on the Skift hospitality website, 6 Basic Lessons in Hospitality From Danny Meyer, Deanna Ting summarizes a discussion held with Mr. Meyer at New York University in which he encourages businesses to go beyond service to providing customers with remarkable hospitality. Mr. Meyer is a renowned restauranteur and the force behind acclaimed New York based restaurants such as Shake Shack, The Modern, Gramercy Tavern, and Union Square Café.
Ms. Ting’s article reviews six lessons from Mr. Meyer on hospitality, which have broad importance for entrepreneurs. This post considers lessons for business owners from all types of industries from the discussion with Mr. Meyer at NYU and from his New York Times best-selling book, Setting the Table: The Transforming Power of Hospitality in Business. Mr. Meyer explains it this way:…