A few years ago Harvard University disclosed that it had used anonymous proxies to purchase 52 acres of land in Boston. Boston officials exploded in outrage, but Harvard responded that the secrecy was motivated by a desire to avoid price gouging (not to mention that the lower purchase price reduced Harvard’s property tax bill). The motivations expressed by Harvard are not uncommon. Indeed many business owners take advantage of the secrecy provided by the various corporation acts and limited liability company acts for legitimate business reasons. Forming a new entity often does not require disclosure of the owners.

The relative informality of American corporate law varies significantly from most of the world. Privately held corporations and limited liability companies typically do not have to publicly disclose their owners, can issue stock with relatively few restrictions and often can be formed within 24 hours of submitting an application. Also unusual is the patchwork of corporate law across the 50 states reflecting varying public policy decisions in each of these jurisdictions. While there have been attempts to encourage states to standardize corporate and commercial laws in the last 50 years through the adoption of model statutes, the corporation acts and limited liability acts often vary markedly. Some states, like Nevada, have aggressively marketed their jurisdiction as a venue for incorporation by trumpeting the limited disclosure requirements of their corporate laws.

Entity formation abroad is significantly more regulated. In many European countries stock is not certificated but instead has to be registered with a public authority. Some countries impose a public auditing requirement on all businesses. Forming a new company can take up to a month and “expedited” filings could take as long as a week. While American lawmakers often abhor European style regulations of businesses, in a post 9/11 world Congress and American law enforcement have approvingly noted the security benefits from European Union laws requiring disclose of beneficial owners of corporations.

Congress is considering Senate Bill 569 that would require states to implement a system requiring the disclosure of each beneficial owner of new corporations and limited liability companies (including indirect owners if the owner is a corporation, LLC or other entity) at formation. The bill does not address ownership of limited partnerships and other partnership entities.

In addition, beneficial ownership must be updated by annual reporting or each time when a change occurs. If beneficial owners are not citizens or permanent residents, a formation agent must verify their name and address and obtain a copy of the government owned identification with photograph. Intentionally failing to provide or update this information could result in penalties of up to $10,000, or up to 3 years in prison, or both. The bill requires “formation agents” (which definition includes attorneys or accountants who assist in the formation of the corporation or limited liability company) to certify that they verified the identity of any beneficial owner who is not a United States citizen or permanent residence.

The potential legal liability of accountants and attorneys guarantees that this bill, if enacted into law, will increase the transaction cost and time needed to form a new entity.

The bill also creates the likelihood of a patchwork of differing laws across the states. Since the states will collect the beneficial information, each state will decide whether the ownership information should be disclosed to the public or simply transmitted to the federal government. Also, some states may simply collect information for domestic corporations while other may collect this information for foreign corporations qualifying to do business.

Overlooked in this discussion is the fact that the federal government already has beneficial ownership information for many small businesses, particularly those taxed as “pass-through” entities. Businesses have to disclose ownership information when they obtain their federal tax identification numbers. In addition, the Internal Revenue Service already receives Schedule K-1 forms reporting income allocated to owners of S-Corporations, limited liability companies and partnerships. Since the current draft of the bill does not include limited partnerships and other partnerships, proper analysis of the information already in the government’s possession should provide it with more information than the bill would provide. It is unclear whether the burdens and penalties of the proposed bill outweigh the benefits.

Many commercial leases contain provisions granting landlords a lien on the tenant’s assets. These leases often provide that property abandoned by the tenant upon termination of the lease belongs to the landlord. These lease provisions reduce the security granted to commercial lenders because they can create conflicting priorities of liens.

Article 9 of the Uniform Commercial Code does not always address the priority of non-Article 9 liens. Worse, landlord liens are expressly excluded from the scope of Article 9. See 810 Ill. Comp. Stat. 5/9-109(d). If the debtor defaults, the secured creditor is likely to find itself in a priority fight with the landlord over the collateral.

It can get worse than a simple priority fight. In this economy it is not uncommon for businesses to abruptly close shop and abandon their property on the leased premises. As a result, the landlord is often the first party to discover the debtor’s insolvency. This gives the landlord a huge head start in the race to the courthouse door to obtain a judicial order confirming the landlord’s ownership. In some cases the secured creditor is not aware of the location of the collateral. In such a scenario, the landlord may have disposed the debtor’s property before the secured creditor became aware of the default. In addition, if the landlord does not cooperate the secured creditor may not be able to access the premises to remove the collateral without a court order.

However, the secured creditor may be able to reach an agreement with the landlord regarding the collateral. Many landlords do not have the interest or ability to hold auctions for abandoned property. So long as they obtain some redress for their damages, the landlord may permit the secured creditor to remove the collateral from the premises. Removal of the collateral also makes it easier to relet the premises.

Many of the secured creditor’s nightmares with respect to landlords can be avoided with two simple measures (1) regular inspections of the tenant’s business facilities to ensure that the collateral has not been moved; and (2) obtaining landlord waivers where the landlord recognizes the lien and permits the secured creditor to remove the collateral upon default. Most landlords understand that the health of their tenant’s business depends on their ability to secure adequate financing. As a result landlords generally are willing to waive their lien rights in exchange for a relatively nominal amount (often partial rent while the premises are accessed by the secured creditor).

One final item to note, which is overlooked with surprising frequency.  Secured creditors should not engage in self help when their collateral is under lock and key under premises owned by another party.  Article 9 security interests will not provide a defense to a charge of breaking and entering.

A previous entry dealt with a member’s obligation to keep funding an LLC. This entry briefly reviews something even dearer to the investor’s heart, getting their money back.

Since LLCs are flow-through entities for taxes, its members are liable for taxes on the portion of the LLC’s income allocated to them. At a minimum, the operating agreement should provide for quarterly tax distributions to meet this liability.

Privately held LLCs do not have a readily available market for their membership interests. Unless the LLC’s business plan is designed towards making it an attractive acquisition target, distributions are the only return on investment that a member is likely to receive in the foreseeable future. The issue of discretionary distributions is often a delicate balance between the need to fund ongoing operations, projected expenses and contingencies versus the investor’s desire for a monetary return on their investment. Ever since the Dodge brothers took Henry Ford to court (See 204 Mich. 459 (Mich. 1919)), the questions of distributions can get contentious or trigger litigation.

While management has an interest in preventing nervous members from disrupting its business plan, an operating agreement that leaves distributions at the sole discretion of management is equally problematic to members. Ideally the operating agreement will provide an appropriate percentage of the membership interest with the final decision on whether to make distributions. The decision to make discretionary distributions should be tailored to satisfy the capital needs of the LLC and its members.

As a practical matter, investors in an LLC may find that their minority stake will be insufficient to force a distribution. In such a scenario, a member should consider incorporating a “put right” in the operating agreement allowing the member to cash out after a specified period for an appropriate measure of fair market value. The timing of the put right should be structured to prevent liquidity problems for the LLC. The operating agreement’s buy-sell provisions should also include drag-along and tag-along rights to ensure that a minority member can cash out if the majority members sell their membership interest.

As with capital call requirements, investors should carefully review provisions in the operating agreement regarding distributions or other methods of receiving a return on their investment.

One of the often overlooked components of a limited liability company operating agreement is the portion dealing with capital contributions, allocations and distributions. This is not because of lack of interest, but rather because the statutory legalese can be enough to intimidate many investors and attorneys. However, ensuring this section is satisfactorily drafted is critical since it concerns the most important investment motive of the member – Money.

This entry focuses on capital contributions, more specifically on capital calls. If an LLC is likely to need additional infusions of capital in the future it may make sense to provide for mandatory capital calls. However, the two issues that must be addressed are: (a) who makes the decision; and (b) what are the consequences for a failure to make the payment.

This is where the interests of management and membership often diverge. The controlling members are likely to want a quick low-hurdle method to make the capital call. Minority members may not have the financial wherewithal to keep making additional contributions. If they are dissatisfied with management or the company’s performance, they may not want to double down on a bad investment. Onerous capital call provisions can be misused by management trying to squeeze out unwanted minority members.

The consequences for a failure to make a mandatory capital call can be severe. The operating agreement could provide for the reduction or elimination of the defaulting member’s interest or voting rights, subordination of the defaulting member’s interest to that of non-defaulting members, a forced sale of the defaulting member’s interest, the lending by the other members of the amount necessary to meet the defaulting member’s commitment, etc.

As a result, investors should closely review the capital call requirements in the operating agreement to limit their legal and financial exposure.

Latching onto a footnote in a 1991 decision of the Delaware Court of Chancery referring to an expansion of directors’ fiduciary duties when a corporation is in the “zone of insolvency”, creditors started asserting breaches of fiduciary duties when directors did not accede to their claims. SeeCredit Lyonnais Bank Nederland, N.V. v. Pathe Commc’ns Corp., Civ. A No. 12150, 1991 WL 277613, at *34 n. 55 (Del. Ch. Dec. 30, 1991). Delaware courts have now rolled back these claims clarifying that Credit Lyonnais intended to shield the board and management of a Company from fiduciary claims by shareholders and that the expansion of fiduciary duties to include creditors did not create an independent cause of action by creditors. SeeProd. Res. Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004); N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del.2007).

By rolling back fiduciary claims, the Delaware courts decisions highlight the importance of properly drafted covenants in credit agreements. Many borrowers dislike the cumbersome package of affirmative, negative and financial covenants that populate the credit agreements, often with good reason. The standard covenant package in most form credit agreements shackles the operations of the borrower by blocking many business decisions without a creditor’s permission slip. However, from the creditor’s perspective it bears the downside of risky behavior by the borrower. A properly drafted covenant package measures the financial health of the borrower and promptly alerts the creditor when there is a deterioration of the borrower’s business. Even if the borrower has not yet defaulted on its payment schedule, covenant breaches get creditors a seat at the table for any reorganization prior to formal insolvency or payment defaults.

It is possible to find a somewhat happy medium between the competing interests of the borrower and creditor by carving out certain activities and expenditures from the covenants. However, the recent credit crisis has shown the downside for creditors who too often lend money with light covenant requirements to borrowers being aggressively wooed by other lenders. Many creditors (particularly banks) are in the business of lending money, not operating businesses. While it is in their interest to maintain a long term relationship with the borrower, creditors should craft a covenant package that does not leave them in the position of a firefighter who shows up after the house has burned down to cinders.

A previous entry highlighted some of the perils of stock pledges. It can get worse.

The most glaring limitation in a pledge of stock of a privately held company is the absence of a public market for the stock. This potentially saddles the creditor with stock that it cannot sell (absent a shareholder agreement with mandatory buy-sell provisions).  Additionally, if the stock pledge does not include all or a controlling amount of the company the creditor may not be able to elect directors of the company to force a sale of the company.  This could leave the creditor in the position of Don Quixote tilting at windmills.

However, even with these limitations stock pledges are still fairly common.

To begin with, they are often the most cost effective way to obtain a security interest.  Since the lien is perfected by possession of the stock certificate or blank stock powers, both parties can avoid UCC filing costs (or even worse, mortgage filing costs) and requirements.  Enforcing the lien upon default involves simply signing over the stock to the creditor’s name and enforcing rights as a shareholder to sell the stock or vote to force a sale of the company.  This may permit the creditor to act without court action, particularly when the pledge gives the creditor vote of a controlling interest in stock.

Stock pledges are often not as intrusive in the day to day operations of the business and do not preclude the ability to obtain additional financing or trigger defaults on existing financing (Note: encumbering stock can trigger a default under many standard bank documents).  In some cases, the company may have sufficient value that even the acquisition of a minority interest may have inherent values.

While stock pledges are not perfect even when properly perfected, the circumstances of the transaction may make them the appropriate form of security.  The pros and cons of doing so should be carefully considered.

Here is a scenario to ponder.  A Debtor issues two Promissory Notes, one to Creditor A and the other to Creditor B.  The Note to Creditor A is dated earlier and is secured by a properly perfected pledge in the Debtor’s stock.  The Note to Creditor B is secured by a properly perfected and filed UCC financing statement on all assets of the Debtor.  There is no Intercreditor and Subordination Agreement between Creditor A and Creditor B.  Debtor defaults.  Would you rather be Creditor A or Creditor B?

Article 9 of the UCC addresses a number of priority scenarios when different creditors lien against the same asset. See 810 ILCS 5/9-317 to 810 ILCS 5/9-339. However, it does not provide much guidance as to the practical economic effect of two creditors who properly perfected their liens against different assets.

In the scenario above, Creditor A may enforce its pledge to gain voting control of the Debtor and attempt to sell the business.  However, Creditor B still has a valid lien against the Debtor’s assets that will not be extinguished by Creditor A assuming control of the Debtor.  Creditor B can still proceed against the assets and recover its obligations, possibly leaving Creditor A with a shell company.

Creditor A would be in a better position if it had an Intercreditor and Subordination Agreement with Creditor B that ensured Creditor A was paid off before Creditor B.  However, this scenario also presents the lesson to creditors often cited by Alastor “Mad-Eye” Moody in the Harry Potter books – “Eternal Vigilance.”  Know what your debtors are up to and what encumbrances they are racking up.

This scenario also highlights certain limitations of using stock pledges to secure debt.  These will be explored further in a later blog.

Dissociation occurs when an owner of a business ceases to be associated in operating the business, voluntarily or involuntarily.  In such a case, the withdrawing owner may want his ownership interest redeemed.

Shareholders of closely held corporations typically do not have the right to require a corporation to redeem their shares.  Unless a shareholder acquires redemption rights by contract or can have the corporation dissolved for certain misconduct (See 805 Ill. Comp. Stat. 5/12.50), the shareholder will not be able to withdraw from the corporation and receive payment for his shares.

In contrast, many partnerships were formed as “partnerships at will” giving a partner greater flexibility in withdrawing from the partnership. See 805 Ill. Comp. Stat. 206/801.

Since LLCs are hybrid entities with characteristics of both corporations and partnerships, the drafters of the state LLC Acts had to decide which entity they wanted LLCs to resemble.

Delaware treats LLCs similar to corporations by preventing the resignation or withdrawal of a member unless specifically authorized by the operating agreement.  See Del. Code Ann. 6, § 18-603.

Illinois has a more nuanced position. Illinois treats “member-managed” LLCs similar to partnerships by granting members the power to dissociate. See 805 Ill. Comp. Stat. 180/35-50. However, if the dissociation violates the terms of the operating agreement, the LLC may recover its damages as a result of such wrongful dissociation. The Illinois LLC Act does not provide much guidance as to how such damages are to be calculated. If the LLC does not dissolve as a result of the dissociation, the dissociated member’s interest must be purchased within 30 days after dissociation.

In contrast, a “manager-managed” LLC is treated akin to a corporation. The right to dissociate exists only if expressly granted by the operating agreement.

The different dissociation rights granted by the Illinois LLC Act is a major factor to consider in choosing the management structure of the Illinois LLC.  An obligation to repurchase a member’s interest could be a major financial burden on the LLC. Also, the entity may not be viable if one or more members have the ability to withdraw their investment at any time. Likewise, the operating agreements of Illinois manager managed LLCs should be reviewed to ensure that they do not unintentionally grant dissociation rights.

The recent plight of American automakers in trying to reduce the number of their dealerships is bringing into focus the often overlooked reach of franchise law. Car dealerships are “franchise owners” whose contractual rights with automakers are protected by regulations issued by the Federal Trade Commission and various state franchise laws. As a result, the termination of these relationships is an expensive proposition for automakers.

The reach of franchise law extends beyond your local McDonald’s, Burger King or Dunkin’ Donuts. It can trap the unwary business owner who never intended to create a franchise relationship.

If the business operates under a marketing plan prescribed by the alleged franchisor and its business is substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising, or other commercial symbol designating the franchisor or its affiliate, a franchise may have been created. See 16 C.F.R. 436 and 815 Ill. Comp. Stat. 705. Illinois franchisors are required to register a Uniform Franchise Offering Circular with the Illinois Attorney General addressing the rights and responsibilities of the franchisor and franchisee.  See  The Illinois Franchise Disclosure Act & Rules.

The termination of a franchise is limited to good cause (bankruptcy, criminal conduct significantly impairing franchisor’s goodwill, repeated failure to comply with agreement, etc.) and the non-renewal of a franchise could trigger repurchase obligations for the franchisor, similar to those bedeviling the automakers.

In times of economic uncertainty, accidentally stumbling into an inflexible contractual relationship mandated by statute may outweigh the natural urge to protect your goodwill and trademarks.  Businesses should review their distribution, licensing and independent contractor relationships to ensure that they did not inadvertently create a franchise.

The Florida Supreme Court will shortly deliver its decision on the question certified to it by the Eleventh Circuit under FTC v. Olmstead, et al, 2008 US App LEXIS 11393 (May 29, 2008) as to whether creditors of single member Florida LLCs are limited to charging order remedies.

Ever since LLCs came into existence, legal and financial planners have taken advantage of the asset protection granted by the limited liability company acts (“LLC Acts”) limiting creditor remedies to charging orders. A charging order provides a creditor with a lien on the debtor’s distributional interest in the LLC. By denying the creditor the right to levy on the debtor’s membership interest and obtain voting rights, it limits their remedy to the amount of distributions (if any) made by the LLC.

The charging order remedy originated in common law to protect non-debtor partners from being unwittingly forced into partnership with a creditor. Nevada has extended this concept to certain small business corporations. See Nev. Rev. Stat. 78.746(1)(bb) and Nev. Rev. Stat.78.746. However, this justification does not exist in a single member LLC. Even though the LLC Acts do not limit charging order protections to multi-member LLCs, the plain language of the statutes is under attack in cases like Olmstead.

Charging order protections for single member LLCs were first overturned by the United States Bankruptcy Court for the District of Colorado in In re Ashley Albright, 2003 Bankr. Lexis 291. However, that case has not yet been followed by any state court interpreting its own LLC Act. The decision of the Florida Supreme Court in Olmsteadcould be the next domino to fall. It is time for planners to reassess whether single member LLCs meet their intended purpose and to what extent alternative asset protection plans can avoid judicially created creditor remedies.