When cyber crime makes the headlines, it usually involves a large business, such as TJ Maxx http://www.msnbc.msn.com/id/17871485/, which is thought to have suffered the largest data breach to date. A company of this size manages large volumes of customer information, allowing a single security breach to expose the privacy of millions. It was only a matter of time before cyber criminals targeted small businesses to steal credit card numbers, social security numbers and other important personal information.

If you think about it, small businesses are an easy and attractive target for cyber criminals. Simply put, they lack many of the high-priced cyber defenses in large enterprises can implement.

According to an April, 2009 Verizon study, 33 percent of all data breaches in 2008 were directed at businesses with 100 employees or fewer. http://www.verizonbusiness.com/resources/security/reports/2009_databreach_rp.pdf. By comparison, large businesses with more than 10,000 employees sustained fewer data breaches in 2008, totaling 25 percent.

As small businesses increasingly find themselves the victim of cyber crime, they have a duty to ensure they implement the programs to protect their information. Using appropriate safeguards is critical to inspire consumer confidence in at least two respects:

1) Ensuring Customer Confidence. Acquiring and maintaining the trust of employees, customers, vendors and suppliers is indispensable for a successful business. Cyber crime can ruin a company’s reputation and impact sales, which only reduces confidence and trust among those who do business with the company. Having a quality cyber-security framework and compliance program firmly in place can help companies prevent cyber crimes and, in the event they do occur, help the company minimize damage and restore services quickly.

2) Managing Liability Risk. Failing to develop and implement an effective cyber-security framework could lead to serious civil penalties for a business and even personal criminal liability for officers and company directors. When determining a company’s accountability, courts assess whether the company had an adequate compliance plan in place and if it was followed.

Information Security Program – The Fundamentals

As cyber criminals shift their focus to “Main street” companies, small businesses need to play catch-up with their larger counterparts to maximize protection of sensitive information.

To help small businesses develop a more reliable data security plan, I offer the following ideas that help to comprise an optimal security and liability prevention program. These ideas made use of several sources, including current legislation, standards, guidelines and regulations. Because no cyber-security program provides 100 percent protection against a data breach, businesses must work to minimize their risk. If properly implemented performed and followed, these suggestions provide protection from most legal claims for negligence.

1. Management must be involved

Under the law, the company’s managers have a duty of care to ensure that the company safeguards legally protected information. Management must develop and follow adequate security procedures and systems.

2. Identify and Manage Threats

The use of information technology creates a high level of communication with vendors and others. As a result, vendors and others may assess your existing security and confidence in these systems is critical to a small business. Three major steps in assessing your risk often involve:

Step 1: Identify and analyze threats

A threat assessment focuses on common threats that include hackers, possible inside-employee illegal/improper activity, and error or neglect from within that exposes cyber networks.

Step 2: Identify and analyze your vulnerabilities

Assessing your technological weaknesses in the company’s network and security infrastructure examines the ability of your system to deter or prevent breached under the existing security procedures and controls. Vulnerability assessments are used to (1) identify weaknesses that could be exploited and (2) predict the effectiveness of additional security measures in protecting information.

Step 3: Assess your risks

Assessing your risks is the final step for the business to perform and is based on the analysis of threats, vulnerabilities, services, and other tangible factors. The analysis informs management about possible risks to the company’s data and what is (or is not) being done about it.

3. Test Your Own Security

Penetration testing should take place to find gaps and holes in your system so you can fix any areas that are found to be unprotected.

4. Demand that Employees Understand Cybersecurity Policies

Employees and independent contractors must be made aware the importance of improving the company’s security. Training should include employees’ legal and policy duties for reporting intrusions and suspicious activities to management. Company policy should also address appropriate use of e-mail, use of bandwidth, and downloading activity and systems protection against virus attacks via e-mail attachments;

5. Use Encryption Technology

Encryption is an important tool in improving cybersecurity and reducing liability. You should consider encrypting electronic customer information while it is in transit or in storage on networks.

6. Transfer Risk Where Possible: Insurance

As cybersecurity risks continue to grow, insurance has become a critical measure in protecting companies against the costs of cyber incidents such as malware, phishing, insider thieves and hackers. Insurance can protect against losses resulting from theft of money or assets due to a data breach. Insurance can also mitigate other costs, including incident management, notification of affected parties, and legal defense. The more appropriate measures a company takes, the better position it will be in to negotiate coverage.

Conclusion

As cyber criminals set their eyes on smaller targets, small businesses owners and managers must be prepared to protect themselves, their employees and their customers. Many small businesses overlook the importance of a reliable data security plan in ensuring three core aspects of their business: 1) the ability to maintain the confidence of a solid customer base, 2) prevention of liability for failing to protect customer data, and 3) the potential for growth as the economy and consumers adapt to increasingly-advanced technologies that require increasing levels of security. To protect these elements, small business owners must take concerted steps to assess the security of their cyber assets and educate their employees about company security policies.

Subchapter S corporation was promulgated to enable small business to incorporate and avoid the double taxation normally imposed on corporate income as seen in a C corporation.  In many ways the Subchapter S Corporation is treated as an incorporated partnership for income tax purposes only.  This treatment allows profits and losses to “pass through” directly to shareholders.  At the same time, shareholders are shielded from individual liability.  While, there are no limits on the size of the corporation’s assets or income under Subchapter S, a business must comply with some detailed statutory and regulatory requirements.  The main advantages and disadvantages of Subchapter S status are summarized as follows:

ADVANTAGES:

1. Limitation on Shareholders’ liability of shareholders;

2. Avoidance of double taxation normally imposed on corporate income;

3. Easy transferability of shares;

4. Pass through of losses to shareholders;

5. Avoidance of taxes on unreasonable accumulations of income under per  I.R.C. §531.

6. Continuity; death of a shareholder does not require dissolution of the corporate organization.

DISADVANTAGES:

1. 25% limitation on “passive investment income” for three consecutive years;

2. Number of shareholders limited to 100;

3. Limitations on deductibility of losses to the sum of the shareholder’s basis in his stock and the indebtedness of the corporation to the shareholders;

4. Unintended termination of Subchapter S status for violation of Subchapter S eligibility requirements;

5. Technicality of tax treatment of Subchapter S corporations under the Internal Revenue Code.

6. Restricted transferability of shares to preclude sales to a non-qualifying shareholder.

7. State tax laws often do not provide for Subchapter S status.

Discussion

An “S” corporation is advantageous when a business organization desires to pass through losses and to retain sound limited liability for its shareholders.  It is often used in new businesses in which high net operating losses are initially expected.

A Subchapter S election allows shareholders to offset income on an individual level rather than at the corporate level.  A Subchapter S election may become disadvantageous when the organization begins to earn significant income or if the organization will earn a substantial portion of its income from what are known as “passive investments” typically rents, dividends, interest or sales or exchanges of stocks.  Where the corporation produces income, individual shareholders will be liable for their proportionate share of income taxes regardless of whether the income was actually distributed to the shareholders.

A Subchapter S corporation must make an election under I.R.C. § 1362 using form 2553.  Once an election is made, the business will not be liable for taxes at the corporate level, except for certain capital gains taxes (I.R.C. § 1374).  Again, income will be taxed to shareholders, with a few exceptions, even if it is not actually distributed.

Requirements

The major requirements of a Subchapter S corporation (I.R.C. § 1361-1379) are highlighted below.  An S corporation is a small business corporation for which a Subchapter S election is in effect for the taxable year.  An election under Subchapter S can be made only by an eligible “small business corporation.”

Small Business Corporation

The corporation must be limited as to the maximum number of shareholders permitted, the type of person who is eligible to hold shares in the corporation, and the classes of stock allowed in the corporation.  I.R.C. § 1361(b) (1).

Domestic Corporation

The corporation must be organized in the United States or under the laws of the United States or one of its territories.

Maximum of 100 Shareholders

The number of shareholders permitted is 100.  In determining who is a shareholder, the general rule is that the beneficial owner of the stock must be deemed to be the shareholder.  In general, each beneficial owner of jointly held property is considered a shareholder.  Thus, property held in joint tenancy or tenancy-in-common is deemed owned by each tenant for purposes of computing the maximum number of shareholders.  However, a husband and wife, and their estate, are treated as one shareholder.

Certain trusts are allowed to be shareholders of S corporations and the general rule is that the individual deemed to own the trust, the current income beneficiary, or the decedent’s estate are considered to be the shareholders.

Qualified Shareholders

Stock in a Subchapter S corporation must be held by qualified shareholders.  Under the IRC only the following may be shareholders in a Subchapter S corporation: An individual who is not a non-resident alien, the estate of an individual in bankruptcy, a decedent’s estate, and certain trusts.  Corporations and partnerships may not hold shares in an S corporation.

Eligible Corporations

Many types of businesses are explicitly excluded from the list of corporations eligible for S status.  An S corporation may not be a subsidiary of another corporation or a member of an affiliated group of corporations.  An S corporation also cannot be a bank, mutual savings and loan association or insurance company.

Very Important One Class of Stock

An S corporation may have only one class of stock outstanding.  However, the corporation may have differences in voting rights among the shares of common stock, without losing its S status.  However, all issued stock must be identical in terms of the shareholders’ interest in the profits and assets of the corporation.

Shareholder Loans

In certain cases, loans issued to shareholders may be considered a second class of stock which would disqualify the corporation from S corporation status.  However, there is a statutory safe harbor for loans having no “equity characteristics.”  This means that the debt must be a “straight debt,” or one which is an unconditional promise to pay on demand or on a specified date a certain sum of money.  The interest rate and interest payment date cannot be contingent on profits, the borrower’s discretion, or other uncertain factors.  Further, the loan cannot be convertible into stock and the creditor must be an individual, estate or a trust which would be eligible as a shareholder in an S corporation.  A debt that does not meet these safe harbor criteria would be considered a second class of stock which would disqualify the corporation from Subchapter S status.

Election, Termination or Revocation

Election

A Subchapter S election must be unanimously agreed to by the shareholders.  A Subchapter S election is made by filing the appropriate form with the Internal Revenue Service and attaching a signed statement indicating consent by each of the shareholders n form 2553.  As a general rule, beneficial owners should be treated as shareholders for consent purposes.  Where stock is co-owned by spouses or owned as joint tenants or tenants-in-common, both parties must separately consent to the election.

Generally, a Subchapter S election becomes effective on the first day of the taxable year if made on or before the fifteenth day of the third month of the corporation’s taxable year.  Thus, a Subchapter S election can be achieved retroactively if elected within 75 days of the first day of a taxable year.  In order to receive this retroactive treatment, a corporation must meet the following two requirements: (1) qualify as a small business corporation on each day through the election date and (2) have unanimous shareholder consent.  Otherwise, an election will not take effect until the first day of the following taxable year.  This prevents pre-election allocation of income or loss to shareholders who are either ineligible to be S corporation shareholders or shareholders who did not consent to the election.  Once a valid Subchapter S election is made, it remains in effect until revoked or terminated.

Revocation

Revocation will occur when the majority of the shareholders consent to a termination of the S corporation election.  Under the current rules, unanimous consent of all shareholders is not required.  Unless otherwise specified, the revocation is retroactively effective on the first day of the taxable year, if the revocation is made on or before the fifteenth day of the third month of the taxable year.  Otherwise, the revocation is effective on the first day of the following year.  The revocation may provide for a prospective effective date, which is not the first day of the taxable year, in which case there will be a “split year.”

A revocation statement should include the numbers of voting and non-voting stock issued and stock outstanding at the time the election is made and the date that the revocation becomes effective.  This must be accompanied by a consent statement which states the number of issued and outstanding, voting and non-voting stock, held by each shareholder who consents to the revocation.  Each consenting shareholder needs to sign this statement.

Termination

The following events can cause termination of Subchapter S status:

(1) Exceeding the maximum number of shareholders;

(2) Issuance of a second class of stock (including debt classified as a second class of stock);

(3) Transfer of stock to an ineligible shareholder (e.g. a corporation, partnership or non-eligible trust);

(4) Acquisition by the corporation of 80% or more of another corporation’s stock (I.R.C. § 1361(a)(2));

(5) Commencing business operations prohibited by I.R.C. § 1361(b)(2) (e.g. operation of a bank or insurance company);

(6) Passive investment income exceeding 25% and Subchapter C profits and earnings for three consecutive years.

A Subchapter S election termination is effective on the date the corporation ceases to be eligible for the Subchapter S election and once a termination is effected, a new Subchapter S election will not be permitted for five (5) years.

If the termination is “inadvertent,” the I.R.S. has discretion under I.R.C. § 1362(f) to set aside the termination.  This waiver will be granted if the corporation eliminates or corrects any causes for the termination, within “a reasonable period of time after discovery of the event resulting in such termination” and there is no tax avoidance from continued Subchapter S treatment.

Ask yourself if you really want to depend on the IRS’s good graces and discretion to reinstate your S-status.

Once upon a time firings were financially painful only for the employees. However, today terminated employees are often using state and federal agencies to bring suit and collect from former employers to get what I have deemed a form of an “extorted” severance package.  Whether or how much an employee can recover depends on who was fired, why and what a judge or jury decides.

The Protected Classes

Federal and state laws prohibit termination because of race, gender, religion, national origin, citizenship, disability, union activity, age (between 40 and 70 under federal law), filing benefit claims, protesting discrimination, asking for a benefit or whistle blowing. Employees can file charges with state and local agencies as well as the federal Equal Employment Opportunity Commission. If these agencies don’t help, private lawyers will happily sue.

If a terminated employee contends that a personnel manual or somebody in authority said that employment would be “permanent” or that termination would be only for “just cause,” the employee is entitled to a trial to determine whether the reason for termination was sufficient. In some states, like California and Massachusetts, even if nothing is said in the manual there is an implied obligation to act in good faith in terminating an employee.

Employees can win big — reinstatement, back pay, lost future pay, damages for pain and suffering, and even punitive damages.

Approach every termination as if it will be attacked in court. Once in court, the employer must present a reason for the termination that is consistent with any statute or other law. During that litigation, all the company’s records on this employee and others in similar situations will be brought into court and will probably have to be explained to a judge or jury.

I. WHAT HAPPENS IN TERMINATION LITIGATION

Terminated plaintiffs most commonly claim they were terminated because they were members of a group protected from employment discrimination by federal, state or local laws. To prevail, the terminee must prove that protected group status was a determining factor in their selection for adverse treatment. A successful defense requires a sound fair reason for the termination which can convince a jury that the real reason had nothing to do with illegal discrimination.

This issue normally turns on the intent of the employer. The only direct evidence of intent is generally the testimony of the actor, but triers of fact are skeptical of self serving testimony.

A. What Employers Stand To Lose

Losing employment discrimination litigation means the employer pays two people for the same work: the retained employee and the terminee. Losing an age discrimination claim can mean paying three times because a terminated employee wins double damages if the plaintiff shows that the unlawful age discrimination was “willful.” Losing a federal discrimination claim concerning sex, national origin, religion or the like can add up to hundreds of thousands of dollars for “pain and suffering,” future “pecuniary losses” and even punitive damages.

B. Remember The Time To Defend Begins Before You Hire

There is an old saying I once heard a senior attorney tell a client, “either you pay me $500.00 now or $5,000.00 later. Either way, it does not matter to me because your money is going to become my money.”  The saying applies here, the only way to win employment litigation is to avoid it.

If an employer wants to retain the prerogative of terminating an employee for any reason (other than those that are contrary to a statute), it had better be spelled out in writing and signed by the employee before or at hire. The best places are in a signed employment application spelling out at-will employment as well as in any employee manual.

C. Beware of Unintended Promises

Thoroughly review personnel manuals, employee bulletins and other documents that state terms of employment. High minded promises of fair treatment or other vague lofty aspirations result in lawsuits where the court system decides what is fair.

D. Minimize Your Risks Before You Use The Ax

Before you use the ax, be sure there is a provable, unassailable business reason for the decision — such as a clear violation of published work rules or a documented record of warnings for poor performance or excessive absenteeism — for any termination the reasons should be reviewed and established before the employee is let go, not after.

A great way to invite a disastrous lawsuit involves a long term employee who received wage increases every year and whose personnel file contains no written warnings.  Then someone decides that a formerly acceptable level of performance is inadequate and the employee is unceremoniously shown the door. If the employee had been warned of substandard performance, given fair warning and a reasonable opportunity to improve, the employer would have a far better case.

Another invitation to court occurs when there are several employees with a chronic problem (like absenteeism), but the older (or female or other protected class member) employee is the first one fired. Instead discipline the bottom of the barrel first.  When younger people, not in any protected group, with similar problems are not terminated, the employer faces a strong inference that the real reason for termination was age, sex or otherwise. But if those with the worst absenteeism records are let go first, especially after numerous warnings, it is harder to prove that hidden pre-textual discrimination was the real reason.

E. Ten Ways To Avoid (Or Win) Employment Termination Litigation

1. SAY WHAT YOU MEAN — YOU MAY BE STUCK WITH WHAT YOU SAY

This may seem elementary, but before hiring, review documents like employment applications and personnel manuals, that are likely to be involved in a termination dispute. Be sure that they promise only what you want them to deliver. Be sure that they spell out that oral promises will not change the written rules.

2. SHUT UP

Be sure no one in authority makes promises you do not intend to keep.

3. DON’T SOFTEN THE BLOW

Kind employers may seek to soften the blow by downplaying an employee’s marginal or bad performances and telling an employee “we are eliminating your position” or “it’s because we want to get new or more vigorous talent on board.”  When a jury hears this is false (especially when the employee is replaced shortly thereafter) or assumes “new” means younger, you will lose.

4. BE AWARE OF WHO IS ON DECK

Scope out who is going to do the terminee’s job after they go. If a protected class individual’s job is going to be done by a non-protected class individual (a terminated minority replaced by a white male, or a 65 year old replaced by a recent college graduate), the termination reason needs to be above all solid.

5. FAIR WARNING WINS LAWSUITS — COMMUNICATE WORK RULES AND WARNINGS

Have written work rules and make clear that infractions lead to discipline and discharge. Don’t adopt overly rigid rules by using rules like honesty, courtesy, excessive absenteeism, sobriety and a duty to cooperate in company investigations. Be sure every employee receives a copy and signs for it. Use (but don’t promise) progressive discipline for lesser infractions — that is, give an employee an opportunity to correct unacceptable behavior. This might include a written warning or two acknowledged by the employee and perhaps even a suspension before termination for less serious offenses.

6. DISCIPLINE THE WORST FIRST

If discipline is necessary, deal with the worst offenders first.

7. LOOK BEFORE YOU LEAP

Get the employee’s side of the story in front of witnesses and, if possible, in writing signed by the employee. Then, investigate it before you act. It is best to recognize factual weaknesses in your case before it is too late. If you really don’t want the employee on the payroll until the facts are clear, suspend the employee during your investigation.

8. CONSISTENCY IS A GOOD PREVENTATIVE

Be consistent in discipline — similar infractions should receive similar punishment. Being harsher on members of protected classes is a recipe for an expensive lawsuit.

9. FAIR TREATMENT WINS CASES

Review the employee’s personnel file with an eye to fairness: Fair treatment as well as fair warning. Ask yourself how you would react if you were an impartial juror. For example, employees with longer seniority merit more opportunities to correct their actions than newly hired people.

10. YOU JUST MAY HAVE TO BUY OUT THE BAD RISKS

If you have to fire someone but think your termination rationale could be viewed as suspect, give some serious thought to severance pay in exchange for a release from any claims that might arise from the termination. Not the severance pay or vacation pay that you give to anyone who is terminated, but additional compensation.

11. NEVER DISPARAGE THE RECENTLY DEPARTED

Don’t stand in the way of the terminated employee’s future employment. An employee who has a new job is much less likely to bring a lawsuit against you. Bad references will only lead to expensive lawsuits. However, good references are an admission that there was not proper cause to terminate. So, adopt a policy of simply confirming dates of employment and title.

CHECKLISTS FOR TERMINATIONS

I. PRE-TERMINATION CHECKLIST FOR INDIVIDUAL FIRINGS

A. WHY?

- Does it make sense?

- Does it seem fair?

- Does it seem excessive?

- How serious is the infraction?

- How long is the employee’s seniority?

- How have others been treated?

B. DID THE EMPLOYEE DO IT?

- Get the employee’s side of the story in writing

- Prepare evidence if needed

- Consider mediation or arbitration

C. REVIEW PAPER TRAIL

- Personnel file

- Grievance procedure

- Other writings

D. DISPARATE TREATMENT

- How have employees been treated in the past for this type of behavior?

- Who is going to replace the terminee?

E. CONSIDER SETTLEMENT OF TROUBLESOME CASES

- Valid release (reviewed by your labor attorney)

- Out-placement

F. NEUTRAL REFERENCES

- Only provide title and dates of employment

Well as a general rule, when one corporation sells or otherwise transfers all of its assets to another corporation, the purchasing corporation is not liable for the debts and liabilities of the selling company (unless the debts are specifically assumed by the purchaser).  There are a few narrow exceptions to this rule of thumb:

(1) When the purchaser expressly or impliedly agrees to assume such debts or liabilities;

(2) When the transaction amounts to a consolidation or merger instead of the sale of assets;

(3) When the purchasing corporation is merely a continuation of the selling corporation; or

(4) When the transaction is entered into fraudulently in order to escape liability for the seller’s debts and liabilities.

Part of the first exception to the rule of thumb, where a purchaser expressly agrees to assume certain debts or liabilities is simple enough.  However, there a little case law examining whether or not a purchaser impliedly agree to accept any debts or liabilities—probably because it would be a difficult case to make.  Be that as it may, it obviously does not come up too often or courts would have examined it more thoroughly.

Generally (and each jurisdiction should be examined) the second exception to the general rule–i.e., that the transaction effectively amounts to a merger or consolidation (a de facto merger) are:   (i) a continuation of the selling company’s management, personnel and general business operations; (ii) a continuity of shareholders resulting from the purchasing corporation paying for the assets with shares of its own stock so the selling corporation stockholders remain a shareholders of the purchasing corporation; (iii) the selling corporation’s ceasing ordinary business operations and dissolving as soon as possible; and (iv) the purchasing corporation’s assuming the obligations of the selling corporation necessary to continue normal, ordinary business operations.  Some thing else to keep in mind that it is not necessary for a court to find all of these elements in order to find a de facto merger.

In finding de facto mergers, courts generally examine the following types of evidence in coming to their decision: (a) the agreement by which the purchasing corporation acquired the seller’s assets is silent about most of the sellers employees, but does provide employment of the seller’s officers and other higher level management while the purchaser continued the seller’s general business operations; (b) the seller’s assets were purchased by issuing stock of the purchasing company, which was given to the selling company’s stockholders, making them shareholders of purchasing entity; (c) the transaction agreement required the seller to be dissolved as soon as possible; and (d) the purchaser assumed the obligations of the seller that were necessary to continue the sellers ordinary course of business.  These types of circumstances all point to a de facto merger.

The third exception to the general rule–i.e., when the purchasing corporation is a mere continuation of the selling corporation some jurisdictions use a narrow construction to the requirement the purchaser is a “mere continuation” of the selling party (in my opinion the better rule from a policy perspective).  Otherwise simply the continuation of the enterprise or its product line might lead a court to conclude that the purchaser is a mere continuation of the seller.

In a jurisdiction which applied a narrow interpretation of the “mere continuation rule” the court rejected the claim that a purchaser was a “mere continuation” of the seller even when: (1) the purchaser did not purchase all of the seller’s assets; (2) the seller remained in business for more than a year after the transfer of its assets to the purchaser; (3) upon the liquidation of the seller, none of its remaining assets were sold to the purchaser; (4) the seller and the purchaser had no common incorporators, directors, officers or shareholders; and (5) the purchaser was not created to acquire the seller’s assets.

The fourth exception is also relatively self explanatory.  Often called a “flush and switch” when the sale of assets is a mere shell game designed to enable the seller, through fraud, to escape liability for its obligations to its creditors, courts will impose successor liability on the purchasing entity.

In short, I assured my client that none of these circumstances applied to our transaction since it was completely above board.  I am glad he asked though because it showed that he was really thinking through the consequences of buying this business—something too many clients don’t do.

In the economic downturn that we are still experiencing, owners of companies are under a great deal of pressure to survive, much less prosper.  When a publicly traded company’s shareholders are upset about the actions of the company, often lawsuits are filed that make their way into the news rooms.  Recent shareholder lawsuits against Bank of American and 3Com have all made headlines.  Those suits are the tiny minority of oppression actions.  Shareholders in non-public companies or members of limited liability companies make up the vast majority of oppression actions filed with the courts today.  When a minority shareholder in a closely held company feels they are being taken advantage of, they look to shareholder oppression lawsuits.

Holders of minority positions in closely held companies at some point will feel that the majority owners are running rough shot over them particularly when there is an economic downturn.  Majority shareholders on the other hand, can use bad economic times as cover to strengthen their ownership position.  The current economy creates serious pressure on companies that can cause owners to harass each other. Shareholder oppression laws are the weapon of choice when minority owners want to convey their anger over how they, as minority shareholders, are treated.

States address shareholder oppression in a wide variety of ways.  Some states take an approach that can be described as purely equitable, in simple terms that means no statute controls shareholder oppression and so only case law can be relied upon.  At the other end of the continuum, states can have very specific statutes that address each and every aspect of shareholder oppression suits in that jurisdiction.  Naturally, most states fall somewhere in between the two extremes.  Typically, a statute gives the basic structure, but the key concepts are expressed through court decisions.

These three basic approaches illustrate the major issues present and understand the shareholder oppression generally.

Oppression Based Purely On Equitable Principals

What do we mean when we say “equity” ? In essence when courts exercise their equitable powers they are trying to do the fair thing by court order such as correction of property lines, taking possession of assets, imposing a lien, dividing assets, or injunctive relief (ordering a person to do something) to prevent irreparable damage.

Some states do not have a shareholder oppression statute as part of their corporation and/or limited liability company laws.  While this could be interpreted to mean that shareholder oppression should not be a cause of action, most jurisdictions without a statue have created through case law some type of duty amongst shareholders that have many similarities with partners in partnerships.  The influential case Donahue v. Rodd Electrotype, 328 N.E.2d 505 (1975) states that close corporations are typified by: “(1) a small number of stockholders; (2) no ready market for the corporate stock; and (3) substantial majority stockholder participation in the management, direction and operations of the corporation.”

Using this or a similar definition for close corporations, courts impose a fiduciary duty from those in control of the corporation (a “majority stockholder” or the “controlling stockholder”) to minority stockholders.  Since close corporations are essentially incorporate partnerships, the courts believe that stockholders “owe one another substantially the same fiduciary duty in the operation of the enterprise that partners” in particular a duty of the “utmost good faith and loyalty.”

These partnership like duties are moderated by an opportunity to show a legitimate business purpose for the allegedly “oppressive conduct.” Following a process of give-and-take between the parties, a court will then balance the equities to determine if the complained of conduct amounts to shareholder oppression.

Statutes

Some states completely govern oppression actions by legislative statutes as part of their corporate and or limited liability company laws.  In these jurisdictions, the statute as passed by the legislature is complete, and applying an individual case is normally based upon the plain language of the statute.  Any argument that seeks to deviate from the language of the statute will not be well received by the courts.

Combinations of Statute and Equity

As oppression is not always defined by the statutes, courts are left to their own devices to fashion an appropriate, equitable definition of conduct that amounts to shareholder oppression.  In many states, these equitable concerns can be just as, if not more, important than the statutory provisions.  But in other states, the statute may be complete enough to carry the day.

Conclusion

Shareholder oppression cases are an ugly affair—often compared to a divorce in the corporate setting.  Once allegations or conduct has risen to the level of shareholder oppression, the damage is done and can not be repaired between the parties which can have a crippling effect on the business hurting everyone involved (except the lawyers).  Having clear shareholders agreement stating the expectations of all parties involved can help mitigate any misunderstandings.

An S corporation must be a small business corporation, which can have only one class of stock. If an S corporation issues a second class of stock, it ceases to meet the definition of a small business corporation, and its S corporation status is automatically terminated triggering significant adverse tax ramifications for its owners.  A corporation that has issued only one class of stock may conduct its business or enter into agreements that treat certain shareholders or creditors in a manner that causes the company’s actions/agreements to be considered a second class of stock.

The one-class-of-stock rule prevents the corporation from having the complexity related to  allocating earnings to multiple classes of owners.  A corporation has only one class of stock if all outstanding shares provide for identical rights to stockholders regarding distribution and liquidation proceeds.  However, differences in voting rights among shares of stock of a corporation do not automatically indicate that there is more than one class of stock.

A corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.  Relevant to a determination of whether all outstanding shares of stock are of the same class requires that the stock confer identical rights to distribution and liquidation proceeds (versus voting rights) and is based on the terms of the articles of incorporation, bylaws, applicable state law, and any binding agreements relating to distribution and liquidation proceeds.

An Interesting Case.

A shareholder used the second-class-of-stock rule in a court case when the shareholder’s parents had a janitorial and paper-supply company that elected S status.  As the shareholder’s parents aged, the shareholder and her brother took control of the company, each owning half of the stock.  The corporation retained most of its earnings, but did distribute enough dividends to enable shareholders to pay their personal income tax on their shares of corporate income.  The corporation suddenly stopped making the tax-payment dividends, leaving the shareholder with substantial income tax liabilities and no company distributions to cover the taxes. The shareholder knew this was part of an effort by the father and brother to squeeze the shareholder  out of the business.

As a stockholder, the shareholder took a very unusual position: that the S election had been lost, and the tax on corporate earnings be imposed on the corporation rather than on the shareholders. According to the shareholder, certain extra payments made to the parents from the S corporation indicated that the parents had preference as to dividends.  This preference meant there was a second class of stock.  If the shareholder won, then the S election had been lost and no taxes would be owed.
The court found little evidence on which to base a conclusion regarding the nature of the extra corporate payments to the parents. The shareholder was unable to meet the burden of proof needed to show that there was a second class of stock and was liable for the income taxes.  Too bad for the shareholder, but an interesting legal argument since shareholders rarely try to terminate an S election as they usually fight to maintain it.

Situations that create a second class of stock.

1.  S Corporation has a binding agreement with its shareholders to modify its normal distribution policy by making upward adjustments of its distributions to those shareholders who bear heavier state tax burdens. The adjustments are based on a formula that will give the shareholders equal after-tax (i.e. after state tax) distributions. The agreement relates to distribution or liquidation proceeds and is a governing provision that alters the rights conferred by the outstanding stock of S to distribution proceeds therefore, those rights are not identical thereby treating the company as having more than one class of stock.

2. Interest on debt is paid only if the corporation has earnings, or is interest payments are tied in some way to dividend policy. The corporation may be treated as having more than one class of stock.

Cases that typically do not create a second class of stock.

The IRS regulations list the following situations that do not involve a second class of stock.   Caution is advised, because the result may be different if the circumstances indicate there is an attempt to avoid the one-class-of-stock requirement, etc. When in doubt seek appropriate counsel.

1. Straight Debt. Debt is not treated as a second class of stock if: it is a written unconditional obligation, regardless of whether embodied in a formal note, to pay a sum certain on demand, or on a specified due date; it does not provide for an interest rate or payment dates that are contingent on profits, the borrower’s discretion, the payment of dividends with respect to common stock, or similar factors; It is not convertible (directly or indirectly) into stock or any other equity interest of the S corporation; it is held by an individual (other than a nonresident alien), an estate, or certain trusts.

2. Debt held proportionately. Obligations of the same class that are considered equity under general principles of federal tax law, but are owned solely by the owners of, and in the same proportion as, the outstanding stock of the corporation, are not treated as a second class of stock.

3. Buy-sell agreements. Agreements among shareholders restricting the transferability of stock, are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation.

4. Redemption Agreements. Bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation’s shares of stock confer identical rights.

5. Fringe Benefits. S Corporation is required under binding agreements to pay accident and health insurance premiums on behalf of certain of its employees who are also shareholders. Different premium amounts are paid by S Corporation for each employee-shareholder. S Corporation is not treated as having more than one class of stock.

6. Employment Agreements. A and B are shareholders of S Corporation. A is also an employee of the company. By agreement, the company will redeem A’s shares on the termination of employment. The agreement is disregarded in determining whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds.

7. Change in Stock Ownership. An S corporation governing instrument provides that the amount of distribution will be adjusted to take into account the fact that a stockholder owned stock for less than the full year. The corporation is not treated as having more than one class of stock.

Voting Rights

The Subchapter S Revision Act of 1982 added the flexibility of allowing a company to issue voting and non-voting stock without running afoul of the one-class-of-stock requirement. Voting stock may be given to those family members who are most qualified to run the business, with non-voting stock given to other family members. However, the stock must have the same rights to distributions, or the S election will be lost.

Given the impact that losing an S election can have on a company and its shareholders, one is well advised to seek counsel before undertaking matters that could cause the loss of the election.

In response to corporate abuses at Enron, Tyco and other companies, militant shareholders in both public and private companies are increasingly trying to hold management and directors accountable for their actions (not a bad thing at all).  The bottom line of any of this type of activism is that directors and officers are held to elevated expectations and greater scrutiny of their performance.

In making decisions on behalf of the company, directors (and officers) are held to two duties: one of care and the other of loyalty.  If directors and/or officers comply with these duties, the decision is protected by “the business judgment rule,” a standard of court review where courts will defer to a decision unless there is palpable evidence that the parties have ignored or breached their duty of care or loyalty.  Directors may also breach their duty of oversight by failing to make a decision at all; that is, by not acting to hold management accountable for their actions.

Key board decisions, such as whether to sell the company or issue or redeem stock present the possibility that the board may not be acting in the best interests of the shareholders but instead to entrench itself in power.  The Delaware Courts sent a message in In re The Walt Disney Co. Derivative Litigation case by not dismissing claims that the board members were grossly negligent in approving key executive compensation agreements.  While the directors were eventually exonerated the series of decisions in the Disney litigation highlighted the importance of corporate minutes.

The Necessity of Maintaining Accurate Minutes

Corporations are required by law to keep accurate books and records, and specifically to prepare and maintain minutes recording the proceedings of any meetings of directors and shareholders.  Regularly maintaining corporate minutes is also a key component of observing corporate formalities, which is essential to recognition of the corporate form.  Failure to observe these formalities can result in creditors “piercing the corporate veil” and imposing liability on the shareholders for corporate obligations.

Minutes are prepared not just for internal use but also for review by third parties such as shareholders.  In addition to shareholders, those who may seek to review corporate minutes include underwriters in connection with due diligence reviews for capital raising transactions and buy-side counsel in connection with sale, merger or acquisition.

In re NetSmart Technologies, Inc. Shareholders Litigation is a poster child for poor minutes preparation practices in connection with a critical decision such as the sale of the company.  The case illustrates how courts focus on relevant minutes to determine whether the board complied with the heightened standards that apply to significant corporate transactions, such as a merger, the need for consistency between the minutes and the disclosure documents describing background events in such transactions, and the importance of preparing and approving minutes promptly (and properly) while events are still fresh in the minds of the directors who were present.

Responding to overtures from private equity buyers, the NetSmart board formed a special committee to oversee a rapid auction process among identified private equity bidders that led to execution of a cash merger agreement with the winning bidder.  Shareholders complained that the agreement was the result of a defective sales process because it excluded strategic buyers and that the proxy statement omitted material information.  The Court noted that once the board determined to sell the company for cash, it had a duty under Revlon to secure the highest price realistically achievable given the market for the company.  Concluding that the plaintiff’s had established a reasonable probability of success on the merits of two of their claims that the board had failed this standard, and the court preliminarily enjoined the shareholder vote on the merger to provide time for the defendants to amend the proxy statement to respond to the plaintiff’s disclosure claims.

The court was highly critical of the company’s minute-taking practices.  It pointed to a May 19 meeting, described in the proxy statement as an informal board meeting because no minutes were taken, where a determination was made to attempt to sell the company and to focus on private equity buyers without an active canvass of strategic buyers.  The court noted that no minutes were taken at a July 13 meeting to consider an acquisition proposal, also referenced in the proxy statement, held by a special committee created by the board.  Thus, if the board had, in fact, considered carefully and rejected the option of opening the sale process to strategic bidders, the absence of minutes clearly recording such deliberations greatly impaired the directors’ ability to make that argument.

As you can see properly drafted minutes are an important part of owning or running a corporation and should not be dismissed as merely a lawyer’s fetish.  Ask yourself a question; are the potential consequences of failing to keep accurate, well drafted minutes worth taking a chance on?  Would you bet your company on it?

Now I don’t begrudge these software makers for making a product that fills a need.  What I am telling you is that bankers and any other investors worth their salt can spot these so-called business plans a mile away and these canned plans materially decrease your credibility in their eyes.  And who can blame them?  If you were about to land or invest money into an enterprise run and/or founded by someone who wouldn’t even take the time or the effort to create their own work, what would you think?  I’ll tell you what they think; they think you’re a joker.  A business plan is meant to focus its writers on their vision of how the venture will work, benchmark its goals and explain the need their business will fill now and in the future.

A business plan is not something that “couldn’t be easier.  Just answer a series of straightforward questions, and the software determines the next steps based on your specific answers.”  Good business plans are hard to write, require much thought and considerable effort.  Moreover, if you think a banker or an investor wants to read 40 pages of the same crap they’ve been handed over and over by lazy entrepreneurs, think again.  Most lenders and investors want your business plan to be no more than 10 and at the most 15 pages after that they just lose interest.  The surest way to get your loan, SBA financing, or investment capital denied is to walk into their office and hand them one of these canned documents.

So please, I’m begging you: stop using that software and sit down and write and I mean actually write your business plan. Writing will force you to think about your business, give you credibility, and save everyone a lot of time and effort by not having to redo it.

The next form is a “limited liability company.  An LLC is an entity separate from its owners, so ownership can involve one, two or more owners. As a separate entity, the LLC (not its owners) is responsible for the liabilities of the business.  If the business fails you may lose your investment, but your assets are not at risk. Corporations are the oldest form of business entity and as a result, people are generally at ease with a corporation.

Corporations provide the strongest protection against personal liability but may or may not have the same tax advantages of an LLC.   An “S-Corp.” is made for small business and can’t have more than 100 shareholders; however, it does feature pass-through tax treatment like an LLC.   A “C” corporation has a big disadvantage for start-ups; that is, that the income or loss of a C corporation only taxable to the corporation and does not pass through to shareholders.  Shareholders cannot use start-up or other losses to against income received by sources other than the corporation.  Neither an LLC nor a corporation is the best choice for all businesses.

The form of entity that is appropriate for your business will depend upon your situation.   One would be well advised to seek counsel before starting up a company because the tax and legal ramifications of the choice are significant.