Image a home buyer finally finds their dream house. There’s just one problem.

During their home inspection, they discover the foundation is cracked. But they buy the house anyway, fully aware of the issues with the foundation.

In the sale agreement, there’s a clause stating the house’s foundation is flawless.

Should the seller be liable to the buyer for breaching the sale agreement, even though the buyer knew the foundation was not flawless at the time they signed the agreement?

In other words, and to have some fun with legal terminology, should the buyer be able to “sandbag” the seller?

The unsatisfying answer is that it probably depends on if the sale agreement addresses sandbagging.

“Sandbagging” is the term used to refer to what happens when a buyer, who enters an agreement knowing that one or more of the seller’s representations or warranties are not true, brings a post-closing lawsuit against the seller regarding a breach of those same terms.

With sandbagging, it isn’t easy to determine who the bad actor is.

Is it the seller? They made an inaccurate representation which could have mislead the buyer.

Or is it the buyer? They knew the truth but decided to lie in wait for an opportune time to use it against the seller.

Like most legal disputes, sandbagging isn’t always black and white. That’s why different jurisdictions have differing views on the legality of it.

In this post, we’ll briefly explore how sandbagging is viewed in Delaware and Pennsylvania. The key takeaway is that any contract you sign should not be silent on sandbagging.

The “modern” and “traditional” sandbagging rules

In the mergers and acquisitions context, sandbagging provisions in a purchase agreement are often a source of contention between a buyer and seller.

The buyer will push for a “pro-sandbagging” provision, which would ensure the buyer would lose none of their remedies under the agreement, even if the buyer knew, either before or at the closing of the deal, about the facts or circumstances giving rise to their breach claim.

On the other hand, the seller will push for the agreement to include an “anti-sandbagging” provision, so that the buyer cannot turn around post-closing and seek indemnity for a breach of a representation or warranty that the buyer knew not to be true.

If the agreement is silent on the issue, then the sandbagger’s fate is at the mercy of the governing choice of law. Jurisdictions take one of two approaches toward sandbagging.

“Modern rule” jurisdictions are pro-buyer and pro-sandbagging. They believe a buyer has a right to rely on negotiated contractual obligations. In these jurisdictions, if a seller represents something is true, but it isn’t, a buyer should be able to hold the seller accountable for that misrepresentation—whether or not the buyer knew it wasn’t true when they entered the agreement.

“Traditional rule” jurisdictions are pro-seller and anti-sandbagging. In these jurisdictions, a buyer must show it relied on the allegedly breached representation or warranty of the seller. Reliance can be difficult to prove, if not impossible, when the buyer knew the representation or warranty was false before entering the agreement.

Delaware’s stance is clear: Pro-Sandbagging

A recent decision by the Delaware Court of Chancery, John D. Arwood et al. v. AW Site Services, LLC, C.A. No. 2019-0904-JRS (Del. Ch. March 24, 2022), made it clear that Delaware is a modern rule jurisdiction that is pro-buyer and pro-sandbagging. The case involved a buyer who, after purchasing the assets of a waste disposal business, discovered an alleged sham billing scheme, among other issues. The buyer then sought indemnification from the seller for breach of contract.

The seller argued the buyer’s reliance on the representations in the asset purchase agreement was not reasonable, but the court held it did not matter whether the buyer knew those representations were false prior to the closing because Delaware law allows a buyer to sandbag a seller. (The court made clear that sandbagging did not occur in this case.)

The court traced Delaware’s stance back to its “strong contractarian propensities.” Notably, this includes the rights of contracting parties to allocate the risk of sandbagging in the contract. As the court emphasized, anti-sandbagging clauses are “effective risk management tools that every transactional planner now has in her toolbox.”

In short, Delaware’s view is that sandbagging is fair and square, so long as the governing agreement does not expressly prohibit it.

Pennsylvania’s stance opens the door for sandbaggers

A recent Third Circuit decision, SodexoMAGIC, LLC v. Drexel Univ., 24 F.4th 183, 214 (3d Cir. 2022), sheds some light on how Pennsylvania courts would view sandbagging.

SodexoMAGIC provided on-campus dining services at Drexel University for nearly twenty years when their business relationship—but hopefully not the food the company provided—soured. In 2014, after receiving an unsolicited offer from a SodexoMAGIC rival, Drexel kicked off a heated bidding process for its on-campus dining contract, estimated to be worth up to $300 million over its full term.

SodexoMAGIC was one of several bidders for the contract. During the solicitation process, Drexel highlighted that its strategic plan called for a roughly 30% increase in its overall student population over the course of the next several years but noted that only first-year undergraduates were required to have all-inclusive meal plans. Drexel projected a first-year class size of 3,100 students for the then-upcoming 2014-2015 school year.

Internally, however, the school was singing a different tune. For internal budget purposes, Drexel estimated the size of that same class to be 2,800 students.

SodexoMAGIC ultimately won the contract, but the worst of the problems between SodexoMAGIC and Drexel was yet to come. As SodexoMAGIC continued to provide on-campus dining services for the 2014-2015 school year, it engaged in rocky negotiations with Drexel regarding the finalization of the new contract.

One obstacle centered on Drexel’s first-year student enrollment numbers. SodexoMAGIC wanted Drexel to guarantee annual enrollment increases. Instead, the parties ultimately agreed they would renegotiate in good faith if Drexel’s enrollment did not increase by at least two percent annually.

At last, both parties executed the new contract on May 28, 2015. That same day, The Philadelphia Inquirer reported that Drexel’s first-year class was down by nearly 200 students compared to the prior year. Shortly thereafter, Drexel’s president informed stakeholders, including SodexoMAGIC, that the university was focused on the quality, rather than quantity, of its students, and that class sizes would be smaller than in previous years.

SodexoMAGIC expressed shock over the shrinking enrollment. Through internal correspondence, a Drexel official shrugged it off, stating: “I guess they were going to find out sooner or later.” In the end, Drexel enrolled seven percent fewer first-year students for the 2015-2016 school year. This reduction had an immediate effect on SodexoMAGIC’s revenues.

The parties continued to battle over various aspects of the new contract, with each party trying to exercise the termination options it provided. Ultimately, Drexel replaced SodexoMAGIC with a new vendor effective after the Fall 2016 semester. In the meantime, SodexoMAGIC sued Drexel in federal court.

The parties brought a plethora of claims against each other. Of relevance to us here was SodexoMAGIC’s fraudulent inducement claim against Drexel. The claim alleged Drexel misrepresented and concealed its future student-enrollment projections, leading SodexoMAGIC to bid more favorably on the new contract than if Drexel’s projections were truthful.

The district court tossed out the claim, but, as discussed below, the Third Circuit appellate court put that claim back into play.

Drexel tried to defeat the claim by pointing to the new contract’s integration clause, which stated that the agreement contained all agreements between the parties on the subject matter of the agreement. Drexel argued that Pennsylvania’s “parol evidence” rule prohibits SodexoMAGIC from using any extrinsic evidence (i.e., evidence of prior discussions or agreements outside the parties’ written agreement that contradict or change any contractual terms) to prove that Drexel misrepresented or concealed any information concerning first-year student enrollment numbers.

The Third Circuit disagreed.

According to the court’s unanimous decision, the parol evidence rule prevents the use of extrinsic evidence to alter the terms of an integrated contract—which the one at issue in this case was because it included an integration clause. But the court explained extrinsic evidence that a party wants to bring in regarding fraudulent inducement claims is used for a different purpose: “to prove a precontractual misrepresentation or concealment.”

The court noted that when an integrated contract contains “fraud-insulating” clauses—referred to as an “integrated-plus” contract—the parol evidence rule would block the use of extrinsic evidence to vary the fraud-insulating term.

For illustration, the court mentioned several types of fraud-insulating clauses:

  1. No-Reliance Clauses. One party disclaims any reliance on the other party’s precontractual representations.
  2. Joint Responsibility Clauses. The parties assume joint responsibility for precontractual representations.
  3. Superseding Reps Clauses. The representations in the contract supersede all prior representations or are the only representations made.

These clauses effectively prevent sandbagging. That’s because under the parol evidence rule, a party to a contract can’t bring in outside evidence regarding earlier conversations to counter the language of these fraud-insulating clauses. These clauses state a party can’t rely on those prior conversations. As a result, a party will not be able to establish they relied on those prior conversations to prove their fraud claim.

Regarding the contract at issue in the case, the court held the parol evidence rule did not prevent the use of extrinsic evidence to prove Drexel’s alleged precontractual representations because the contract did not include a fraud-insulating provision. Here, SodexoMAGIC wasn’t using parol evidence to change contractual terms—it was using it to prove Drexel’s alleged fraud.

For that reason, by being allowed to bring in outside evidence about Drexel’s enrollment numbers, SodexoMAGIC could have sandbagged Drexel if SodexoMAGIC knew those enrollment numbers were untrue when it signed the new contract.

(As with the Delaware case we mentioned earlier, there doesn’t appear to have been any sandbagging here.)

The Third Circuit ultimately remanded SodexoMAGIC’s fraudulent inducement claim to the district court. More importantly for our purposes, the court’s decision indirectly gives sandbaggers the green light in Pennsylvania—unless an “integrated-plus” contract is involved.

It’s might always be sandbagging season in Pennsylvania and Delaware

 Based on the two court decisions discussed above, both Pennsylvania and Delaware appear to allow sandbagging. However, both jurisdictions also allow contracting parties to include anti-sandbagging provisions in their governing agreements.

The Third Circuit’s holding arguably takes Pennsylvania law to the “we love sandbagging” level by holding that not even the parol evidence rule—a substantive rule of contract law which may vary from state to state—can prevent sandbaggers from succeeding on their legal claims.

(Of course, the Third Circuit doesn’t have final say over Pennsylvania law; the Pennsylvania Supreme Court does. The latter could decide a case with sandbagging implications differently than the Third Circuit did in the SodexoMAGIC case and create new law regarding the issue.)

For now, there are two takeaways about sandbagging that owners of closely held companies need to keep in mind.

First, choice of law matters. Before signing contracts, know how the jurisdictions governing those contracts view sandbaggers. Do they follow the modern rule or the traditional rule?

Second, do not stay silent. Address sandbagging in your contracts.

If you’re the buyer, push for pro-sandbagging provisions that would allow you to use what you learned before signing the agreement against the seller if there is a misrepresentation.

If you’re the seller, push for integration and anti-sandbagging provisions to create “integrated-plus” contracts that prevent a buyer from using what they learned against you.

Because, according to these two recent judicial opinions, it’s might always be sandbagging season in Pennsylvania and Delaware, the owners of closely held companies who enter into agreements covered by either state’s laws need to be aware of sandbagging and know how to avoid being the one left holding the bag.

Over the past few years, the term “receipts” has entered the pop culture lexicon to mean something broader than its traditional definition of a document that acknowledges either the receiving of a product or service, or money in exchange for a product or service.

These days, if you hear “receipts” mentioned in a song, television show, or movie, or see it on social media, there’s a good chance it is being used to mean proof that something is how a speaker claims it to be. For example, someone might claim to have the “receipts” that another person cheated on their spouse—perhaps in the form of screenshots of now-deleted social media posts or direct messages.

Well, when it comes to proving ownership of a closely held business, receipts—in the trendiest sense of the word—are a good thing. In fact, receipts are required.

A recent case out of the U.S. District Court for the Eastern District of Pennsylvania, Salvitti v. Lascelles, deals with this very issue. While the case doesn’t break any new legal ground, it serves as a reminder of the evidence a purported owner of a business must show to prove they are, in fact, an owner of the business.

Sharp knives, dull business planning?

Salvitti involves a dispute over who owns an LLC established to facilitate the management of Colonel Blades, a company that designs and sells knives. In 2013, Alfred Salvitti and Nico Salvitti patented and designed the Colonel Blade knife, and partnered with John-David Potynsky to produce it. At the end of 2013, Alfred, Nico, and John-David brought on Scott Lascelles to assist with the marketing and sales of the knives.

Since 2013, Scott has managed the day-to-day operations of marketing Colonel Blades, including overseeing internet sales, manufacturing, and distribution. He brought on his wife, Dana DiSabatino, to help develop a business plan.

In early 2014, Scott was advised by his accountant that it would be beneficial to form an LLC to better manage Colonel Blades.

In March 2014, Alfred, Nico, John-David, Scott, and Dana agreed to form an LLC. Soon after, Scott registered The Colonel, LLC with the Pennsylvania Department of State and listed himself on the registration documents as the sole member. He managed the day-to-day operations of the LLC and maintained a bank account on behalf of it. The tax liability of the LLC flowed through his personal taxes. Dana continued to be involved in the LLC’s operations, including marketing and contracting with vendors.

In 2015, a draft agreement was circulated among the five individuals that proposed a new legal entity be established to sell Colonel Blades, with all five as members. They did not execute that agreement. Nor did they execute an agreement in 2018 that proposed that Alfred, Nico, and John-David would become members of The Colonel, LLC.

Nor did Alfred, Nico, John-David, Scott, and Dana ever agree in writing about how they would split the LLC’s profits. Instead, there was only an understanding of how the profits would be distributed: in equal thirds.

After roughly five years of not distributing profits and instead investing them back into the business, Scott distributed profits in Spring 2018. Alfred and John-David both received $10,000, and Dana received $15,500 that was, according to Scott, intended to cover his distribution and the work Dana did for the LLC.

In February 2019, Alfred, Nico, and John-David sued Scott and Dana alleging several causes of action centering on the fact that the three men believed they were co-owners of the LLC and that Scott and Dana had violated their legal rights as co-owners of the LLC.

 The plaintiffs’ ownership claims are cut down to size

Unfortunately for Alfred, Nico, and John-David, U.S. District Judge Eduardo Robreno was not persuaded that they and Scott had ever actually agreed they would become equal co-owners of The Colonel, LLC. For that reason, he dismissed most of their legal claims.

Judge Robreno held that, despite Alfred, Nico, and John-David’s arguments, there was never a true agreement for they, Scott, and Dana to become co-owners of the LLC.

Alfred, Nico, and John-David claimed they came to such an agreement during a March 2014 conference call when they, Scott, and Dana decided to form the LLC for Colonel Blades. They argued that during that call, they, Scott, and Dana agreed to form the LLC—as co-owners.

In addition, Alfred, Nico, and John-David argued that four other pieces of evidence showed there was an agreement with Scott and Dana to be co-owners of the LLC:

  1. An unsigned meeting agenda prepared before a meeting with Scott that said he “need[s] to set up an LLC in all our names”;
  2. The unsigned ownership agreement from 2015 mentioned above;
  3. Scott’s deposition testimony during which he agreed the “ownership agreement should reflect equal ownership interest;” and
  4. A 2015 email from Scott to a potential business partner regarding an agreement involving Colonel Blades that noted he had to have a discussion with Alfred, Nico, and John-David as they had a vote regarding whether to move forward with the agreement.

Scott argued he, Alfred, Nico, and Jean-David never agreed to be co-owners of the LLC. In addition, he pointed to the fact that Jean-David testified he knew Scott was the sole member of the LLC according to the LLC’s registration documents as early as when the LLC was formed, and Alfred testified he knew this as early as 2015.

Based on the parties’ evidence and the factual record in the case, Judge Robreno ruled that none of the evidence in the case supported Alfred, Nico, and Jean-David’s claim that they, Scott, and Dana agreed or consented to the three being members of the LLC. For that reason, Judge Robreno ruled there was no evidence that could lead a reasonable jury to find the parties entered into a membership agreement in 2014 under which they’d be co-owners of the LLC.

As for a claim that Scott breached an oral agreement about how to distribute the LLC’s profits, Judge Robreno ruled that Alfred, Nico, and Jean-David could not point to any evidence in the case’s factual record that showed the four of them came to a specific agreement about what constituted “profits” and when they were to be distributed.

(Scott never disputed their argument that the four of them orally agreed to share the profits from the LLC at some point and in some manner. But he argued the four of them never agreed to the specifics of what that profit sharing would look like. He cited Jean-David’s deposition testimony in which Jean-David admitted there was no agreement on how the profits would be calculated or distributed.)

Therefore, Judge Robreno denied Alfred, Nico, and Jean-David’s motions for summary judgment regarding all but one of their legal claims.

As for that claim, Judge Robreno held there was evidence that supported a legal claim, and thus a reasonable jury could find, that Scott and Dana unjustly benefitted from being the sole members of the LLC. The benefits came in the form of commingling company and personal funds, failing to maintain books and records for the LLC, and failing to observe customary LLC formalities when operating the LLC.

Any way you slice it, receipts matter for LLC co-ownership

Judge Robreno did not exactly break new legal ground. But his decision is a reminder of the relatively high bar someone claiming co-ownership of an LLC must clear before a court will rule they were a co-owner. Although oral and implied operating agreements are permissible under the Pennsylvania LLC statute, courts and especially juries will often demand that a putative plaintiff-owner show the receipts in the form of a signed operating agreement to establish ownership.

Business partnerships are built on the trust and loyalty of their participants. Without mutual coordination and honesty among all involved, tensions will inevitably arise that could derail a partnership’s success. The resulting fallout could be costly in several ways, as lost profits, ruined business opportunities, protracted litigation, and busted personal relationships would surely follow.

Given the dark clouds that quickly form overhead as tensions increase among partners in a partnership, one would assume it would make good business sense, if not common sense, for those partners to look out for each other.

It certainly would make legal sense to do so because partners in a partnership, and, generally speaking, co-owners of all businesses, will typically be deemed to owe a fiduciary duty to each other. At its core, a fiduciary duty is the legal duty of a fiduciary (i.e., one business owner) to act at all times in the best interests of the beneficiary (i.e., the other owner(s) of a business). This requires partners in a partnership to act loyally toward each other, with care, with good faith and fair dealing, and to disclose material information to each other.

In most instances, the interests of partners in a partnership will be aligned with each other and with those of their business. Presumably, the co-owners will be unified in their desires to maximize their business’s profits and value and their own salaries and distributions, and minimize their and their business’s tax burdens.

But what happens when a partner lies to their partners about sales transactions, withholds material information about key business opportunities, and engages in self-serving transactions that did not consider the wishes of other partners? Sounds like a recipe for a breach of fiduciary duty lawsuit, right?

Now consider if it is still a breach of fiduciary duty if the partner in question’s actions not only complied with the agreement governing the partnership but also benefited the other partners?

Would the partner’s actions still constitute a breach of fiduciary duty?

The Pennsylvania Superior Court recently tackled this question, issuing a decision that has implications for business partnerships where the partners are given autonomy to act unilaterally on behalf of their partnerships.

A series of unilateral moves by a partner passes legal muster—at first

In Slomowitz v. Kessler, 2021 Pa. Super. 230 (2021), the namesake plaintiff, Marvin Slomowitz, served as a general partner with two of his colleagues, Stuart Kessler and John Rosenthal, in three limited partnerships that ran and maintained Section 8 apartment buildings for elderly and low-income tenants. All three partnerships were established in the 1970s. Rosenthal actively managed all three partnerships from their establishment until his death in 2008.

After Rosenthal’s death, as the remaining partners grappled with their responsibilities, disputes arose between Slomowitz and Kessler regarding their respective roles. Slomowitz believed the governing partnership agreements allowed him to act unilaterally on behalf of the partnerships without securing any other partner’s approval. Kessler, on the other hand, believed he and Slomowitz were general partners on equal footing. Therefore, Kessler believed any decisions made on the partnerships’ behalf required the consent of both him and Slomowitz to move forward and bind the partnerships.

Naturally, this tension led to substantial friction between Slomowitz and Kessler. In the ensuing years, Slomowitz engaged in actions that he felt were necessary to maintain or increase the profitability of the partnerships. Many of those actions, however, were taken against Kessler’s wishes. Some actions Slomowitz took included:

  • Excluding and failing to communicate with Kessler about critical partnership matters and transactions he knew Kessler would have quashed;
  • Securing necessary approvals from limited partners to sell off all partnership real estate assets without Kessler’s knowledge or consent;
  • Misleading Rosenthal’s estate into believing that the sale of a specific partnership property was the only option available to consider, without raising or discussing Kessler’s preferred option of refinancing the property; and
  • Knowingly misleading a limited partner into moving forward with the sale of a partnership property by misrepresenting to that partner that Rosenthal’s estate supported a sale when it was merely open to considering the idea absent other options.

The trial court, the Court of Common Pleas of Luzerne County, acknowledged that Slomowitz’s conduct “may have been repugnant,” as well as “offensive and un-businesslike.” However, the court noted that all three of the partnership agreements that governed Slomowitz’s activities granted each general partner the individual and complete authority to execute documents and other instruments on a partnership’s behalf. It further found that no partner needed to secure mutual consent in the process.

Therefore, the trial court concluded, based on its interpretation of the partnership agreements and Pennsylvania’s statute governing partnerships, that Slomowitz acted within his authority as a general partner and that nothing appeared wrong with the disputed transactions. Thus, he did not breach his fiduciary duty to Kessler.

The Pa. Superior Court sees things differently

As was to be expected, Kessler appealed the trial court’s ruling. On appeal, the Pa. Superior Court disagreed with several aspects of the trial court’s ruling.

Although the Superior Court acknowledged that all three governing partnership agreements gave each general partner unfettered authority to act unilaterally on behalf of each partnership, the court noted the specific language in the agreements requiring the general partners to exercise their responsibilities in a “fiduciary capacity” at all times to maximize relevant tax advantages. Since none of the partnership agreements defined what the term “fiduciary capacity” meant, the court determined that the fiduciary duties owed by Slomowitz under the partnership agreements were actually a combination of duties provided for by (i) Pennsylvania statutes, (ii) the partnership agreements, and (iii) common law by application of agency principles, i.e., the duty of loyalty, care, good faith and fair dealing, and the duty to disclose.

The court found that under the statutes that govern Pennsylvania partnerships, “a partner must account to the partnership for any benefit and hold as trustee for it any profits derived by him without the consent of the other partners.” Even more critically, the court noted that at least one of these statutes simultaneously subjects partners’ fiduciary duties to Pennsylvania agency law.

As for the applicable partnership agreements, the court noted that, as set forth in the agreements, Slomowitz owed a fiduciary duty to Kessler because he was required to perform actions under the agreement in a “fiduciary capacity.”

And finally, under agency law principles, the court noted each partner is considered an agent of the partnership. Thus, each partner owes duties of loyalty and care to their fellow partners. Additionally, each partner also owes a duty to act in good faith and fair dealing and disclose material information.

Underlying the court’s discussion of partners’ fiduciary duties under Pennsylvania law was Meinhard v. Salmon, a 1928 New York State Court of Appeals decision written by then-Chief Judge Benjamin N. Cardozo (four years before he joined the U.S. Supreme Court) that the Supreme Court of Pennsylvania followed and adopted in a 1970 decision. In Meinhard, Judge Cardozo wrote that

A [co-owner of a business] is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions. * * * Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court.

The Superior Court observed that this duty was not grounded in contract or in statute, but in a more elementary basis: trust.

Guided by the applicable statutes, language in the partnership agreements, and Meinhard’s tenets, the court found Slomowitz’s acts did not rise to the fiduciary standard he needed to satisfy, as he should have been more forthright, honest, and transparent with Kessler and his other partners. Notably, Slomowitz’s actions may have caused Kessler to incur more tax liability than if Slomowitz pursued an alternative option that Kessler preferred—thus contradicting one of the goals of the partnership agreements to maximize tax advantages. The court, therefore, remanded the case back to the trial court to make findings regarding damages stemming from Slomowitz’s breach of fiduciary duty.

What Slomowitz means for partners in Pa. partnerships moving forward

The Superior Court’s decision here does not break new ground as much as it reminds partners in business partnerships that the fiduciary duties they owe to each other will not allow favorable business results to excuse the “repugnant,” “offensive[,] and un-businesslike” actions that led to those results. That Slomowitz might have unilaterally engaged in actions that benefited the partnerships did not, in the court’s eyes, mean that he could avoid complying with his fiduciary duty to Kessler.

Going one step further, the court appears to honor the “Spider-Man Rule”: With great power comes great responsibility. The trial court focused on Slomowitz’s full, exclusive, and complete right under the applicable partnership agreements to directly control the business of a partnership in holding that he didn’t breach his fiduciary duty to Kessler. After all, the trial court presumably believed if Slomowitz had the right to do whatever he wanted, he could do whatever he wanted without concern about how it would affect Kessler.

The Superior Court, however, made clear that because Slomowitz had to act in a fiduciary capacity under the partnerships’ agreements, he still had a responsibility to rein in his unilateral powers and employ them in a way that did not breach his fiduciary duty to Kessler.

For some owners of closely held companies, installing a board of directors may seem more painful than cutting off one of their pinkie fingers.

They’d have to give up control of their business.

They’d have to share confidential information.

They’d have to waste time on the formalities of having a board.

They’d have to waste money on compensating directors.

Putting aside for a moment whether these concerns are valid (they’re not), for many owners of closely held companies, installing a board could be one of the best things they do for their companies—and their sanity.

The guidance, knowledge, and wisdom provided by a board, and the healthy separation a board creates between a closely held company and its owner(s), can be invaluable to the maturity and growth of the company.

The kinds of boards closely held companies could install

Before we go deeper into the benefits the owners of a closely held company can realize by installing a board, let’s look at the kinds of boards a closely held company could install.

Compliance board

On one extreme is the compliance board. Many states require incorporated companies (but not LLCs) to have boards. A compliance board is a non-functional board meant to meet legal requirements—and little to nothing else. Often, the only members of a compliance board will be the owners of a business.

Insider board

One step away from a compliance board and toward a functioning board is the insider board. An insider board will often include family members of the owner(s) and members of the company’s management team. The insider board may be created by the founder(s) but is designed to involve the family and senior management in big-picture planning for the company. However, the owner(s) will retain the authority to make decisions.

Inner circle board

Moving past a board stocked with family members of the owner(s), the inner circle board contains directors the founder(s) or owner(s) know well and who possess knowledge and wisdom beyond that possessed by the owner(s) that can guide the company toward growth—and perhaps challenge the thinking of its owner(s). An inner circle board may even establish committees, such as an audit committee. However, the owner(s) will retain decision-making authority.

Quasi-independent board

Finally, the most independent board structure we’re likely to see in a closely held company is the quasi-independent board. With this structure, there will be outside/independent directors who have no tie—employment, familial, or otherwise—to the company aside from their roles as directors. With no ties to the company, these directors are likely to be more objective and less deferential to ownership than their counterparts in the above three board structures. They will expect their input will be considered when decisions are made. With a quasi-independent board, the owner(s) may not retain full decision-making authority like they would with the other board structures.

Why owners of closely held companies should consider installing a board

As a lawyer representing closely held companies and their owners, I have seen firsthand the advantages a board of directors can provide.

Yes, having a board will help closely held companies comply with the laws of their states where those laws require corporations to have boards.

Yes, having a board will help streamline the process of establishing a special litigation committee (as we described a while back in this post).

Yes, (and as I mentioned above), directors bring with them knowledge and wisdom beyond that possessed by the owners. Directors’ experience and their areas of expertise—sales, marketing, operations, legal, finance, whatever—can only add to whatever experience and expertise the owner(s) and their employees are already bringing to the table.

But most importantly, a board can help the owners of closely held companies get of out of their own way. A board can provide much needed separation between owners and their businesses. Separation that is necessary for both the owners and their businesses to prosper.

Directors bring the perspective of strategic, big-picture thinkers who are not mired in the day-to-day operations of a business. They have a bird’s eye view of the business, the company’s industry, and (hopefully) relevant trends that will impact both. This separation is something owners of closely held companies are unlikely to have until they’ve scaled their business and have a management team in place to handle day-to-day operations and firefighting. Spared from having to play WHAC-A-MOLE®, directors can focus on strategic initiatives that would have otherwise been impossible to conceive and implement if left to the owners given the stress they’re under simply to keep the business running.

Equally as important, directors don’t take personally the issues that arise in the day-to-day operations of a business that owners often do.

There is a tendency for owners of closely held companies to view their companies as extensions of themselves. If something bad happens to their company, then something bad has happened to the owner too. This emotional involvement creates an unduly stressful environment in which it becomes increasingly difficult to make sound, rational business decisions.

When a customer doesn’t pay, it’s as if someone mugged the owner.

If an employee sues the business, it’s as if the owner is under personal attack.

The business’s problems become the owner’s problems—and both are worse for it.

It is far healthier and more functional to view the business for what it is: a tool. If a farmhand breaks a tractor wheel, the owner of the farm doesn’t react as though a part of them had been destroyed. The broken tool is not a personal affront; it is merely a problem that needs to be addressed.

If we apply this mindset to the ownership of closely held companies, the stress similarly begins to melt away.

If a customer refuses to pay, perhaps the business needs to adjust how it handles its accounts receivable, or change its payment structure.

If an employee sues the company, maybe the company ought to consider Employment Practices Liability insurance in the future.

Good business decisions can’t be based on fleeting passions and grievances. They should be grounded in a rational and impersonal assessment of the situation. A board can help ensure such an assessment is the norm.

Obviously, this is easier said than done. One can’t simply flip a switch and instantly separate business from emotion. But having a board of directors is tremendously helpful in creating that separation. A healthy separation between closely held companies and their owners reminds owners they are not their companies, and vice versa. Directors don’t take delinquent customers or lawsuits from problem employees personally, and their presence helps owners not take such things personally either.

Dispensing with the perceived drawbacks of a board

I’d be remiss if I didn’t revisit the drawbacks I mentioned at the beginning of this post that owners of closely held companies fear come with installing a board. I can dispense with each of them easily.

Owners who fear they’d have to give up control of their businesses if they install boards will be happy to learn that so long as they are the controlling shareholders, they remain in control of their businesses no matter how independent their boards are.

Owners who fear they’d have to share confidential information with board members can have directors sign nondisclosure agreements or choose to have only insiders on their boards.

Owners who fear they’d have to waste time on the formalities of having boards can bring in coworkers to compile agendas and materials and take notes. (The goal, of course, would be for boards to provide so much value to the owners and their businesses that any administrative costs of having boards is a small price to pay for unlocking such value.)

Finally, owners who fear they’d have to waste money on compensating directors can provide equity to their directors. (Again, hopefully the directors create the kind of value that dwarfs their compensation.)

Bringing boards aboard closely held companies

I assume that when many owners of closely held companies think about boards of directors, they envision mahogany-lined boardrooms at huge, publicly held companies filled with people in suits methodically proceeding through an agenda before enjoying an exquisitely catered dinner. They might shudder at what they believe are the time and financial investments required to install and maintain a board at their own companies.

Given what I’ve seen in my legal practice, those owners stand to lose more by standing pat than if they were to bring aboard a board of directors.

For owners of closely held companies serious about growth and increasing their revenues while also being serious about creating healthy separation between them and their businesses, installing a board of directors may be the kind of investment that provides an incalculable—and indispensable—return on investment.

 

“Piercing the corporate veil” is one of those legal terms that makes a legal action seem more romantic than it really is. When a party to a legal dispute attempts to pierce the corporate veil of a corporate adversary, they are asking a court to move aside the metaphorical veil created by the adversary’s corporate structure and hold the owners of the corporate entity personally liable for the entity’s actions or debts.

Corporate veil piercing—or at least attempts to pierce a corporate veil—arise more frequently in closely held businesses than in other settings. That’s because the owners of closely held businesses tend to be intimately involved in their businesses’ operations and are more likely to attempt to use the limited liability created by their businesses’ corporate structures to shield them from legal liability for the wrongdoing they or their businesses engage in.

We haven’t discussed veil piercing much on the blog. But a recent Pennsylvania Supreme Court decision, in a case captioned Mortimer v. McCool, et al., provides us with an excellent excuse to do so. That’s because with its ruling, the court took a major step towards making closely held businesses more vulnerable to having their corporate veils pierced, and in turn making their owners more vulnerable to being held personally liable for their businesses’ wrongdoing.

A suspicious liquor license transfer

The Mortimer case arose from the collection of a judgment obtained in a personal injury action. Ryan Mortimer obtained a $6.8 million judgment against various individuals and corporate entities in connection with injuries she suffered after her car was hit by a drunk driver. McCool Properties, LLC, owned the restaurant in question that served the intoxicated driver. Another entity, 340 Associates, LLC, owned the liquor license used by the restaurant. Both entities had common owners.

During Mortimer’s personal injury lawsuit, 340 Associates transferred the liquor license to another entity, 334 Kayla, Inc.—an entity with no affiliation with the owners of McCool Properties or 340 Associates—in exchange for a $75,000 note. 334 Kayla also signed a lease with McCool Properties for the restaurant space.

After the entry of the judgment in her favor, Mortimer filed a lawsuit against 340 Associates and 334 Kayla, alleging the liquor license transfer was fraudulent and an attempt to shield it from Mortimer recovering it in her original lawsuit. Mortimer was successful in that action, took possession of the liquor license, and sold it for $415,000. Mortimer then filed actions against 340 Associates and McCool Properties to collect the rest of the judgment and to pierce 340 Associates’ corporate veil in order to reach both the McCool Properties assets and those of their shared individual owners.

An enterprising attempt to pierce a corporate veil

Historically, Pennsylvania has had a strong presumption against piercing the corporate veil, as the Pa. Supreme Court recognized: “There appears to be no settled rule . . . as to exactly when the corporate veil can be pierced and when it may not be pierced,” such that it “seems to happen freakishly. Like lightning, it is rare, severe, and unprincipled.”

The trial court in this case, relying upon two separate decisions, recognized a series of factors to consider in Mortimer’s claims. The trial court noted a corporate structure may be disregarded “whenever one in control of a corporation uses that control, or uses the corporate assets, to further his or her own personal interests.” Additional factors include “undercapitalization, failure to adhere to corporate formalities, substantial intermingling of corporate and personal affairs, and use of the corporate form to perpetrate a fraud.” The trial court decided to apply these additional factors to Mortimer’s claims against 340 Associates, and determined none of them allowed her to pierce that entity’s corporate veil.

Regarding her claims against McCool Properties, Mortimer advanced two separate veil-piercing theories at the trial level: the “alter ego” theory and the “enterprise liability” theory. The trial court quickly dismissed the alter ego theory, which applies only where the individual or corporate owner controls the corporation to be pierced and the controlling owner is to be held legally liable for wrongdoing, as not applicable because McCool Properties had no ownership interest in 340 Associates.

Moving on to the enterprise liability theory, which allows two or more corporations to be treated as one if five factors are met, the trial court recognized that Pennsylvania had yet to adopt the theory. But it didn’t let that stop it. It considered the theory’s five factors:

  • Identity of ownership;
  • Unified administrative control;
  • Similar or supplementary business functions;
  • Involuntary creditors; and
  • Insolvency of the corporation against which the claim lies.

While it indulged Mortimer and considered the enterprise liability theory, the trial court did not find in her favor. It ruled that she did not show there was identical ownership and unified administrative control among McCool Properties and 340 Associates.

The Pennsylvania Superior Court later affirmed the trial court’s rulings in all respects.

A moral victory for Mortimer

Mortimer appealed her case to the Pa. Supreme Court on multiple grounds, but the court only granted review of whether the court should adopt the enterprise theory of piercing the corporate veil “to prevent injustice when two or more sister companies operate as a single corporate combine.”

Mortimer re-emphasized the application of the enterprise theory’s five factors to her case, and cited cases from multiple jurisdictions that have already adopted enterprise liability as models for Pennsylvania’s adoption of the theory. After looking at decisions from courts in Alabama, Indiana, Connecticut, Massachusetts, Colorado, and South Carolina, among other states, the Pa. Supreme Court determined “most jurisdictions that recognize an enterprise liability variant also retain a requirement of wrongdoing and resultant injustice no less stringent than that which applies in any piercing case.” That being said, the court noted that “[e]nterprise liability cases in which relief is granted seem to be very few and far between, and typically involve some truly egregious misconduct.”

In laying out its version of the enterprise liability theory, the court explained that in its most logical form, it “requires an alter ego component” from which substantial common ownership can arise; effectively the affiliate corporations are “siblings – of common parentage.” Thus, according to the court, there must be “common owners and/or an administrative nexus above sister corporations.”

From there, the court said that “enterprise liability in any tenable form must run up from the debtor corporation to the common owner, and from there down to the targeted sister corporation(s)” in a “triangular” fashion. But the court noted this “requires a mechanism by which liability passes through the common owner to the sibling corporation” and acknowledged the theory of “reverse-piercing,” where a plaintiff suing the owner of a corporation must establish the misuse of corporate form to protect the owner’s personal assets.

The court then settled on a two-pronged test for using the enterprise theory to pierce a corporate veil. First, there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, and adherence to corporate fiction under the circumstances would sanction fraud or promote injustice. Second, there must be some fraud, wrong, or injustice.

Unfortunately for Mortimer, the Pa. Supreme Court relied on the trial court’s findings and held that Mortimer did not satisfy either prong of the two-pronged test the court established. The court did, however, signal that lower courts in Pennsylvania were free to apply the two-pronged test in the future, stating that “it remains for the lower courts in future cases to consider its application” consistent with prior case law and the guidance provided by the court.

A new weapon in business divorce litigation?

While the Pa. Supreme Court has adopted what appears to be a broad version of the enterprise theory for corporate veil piercing, it remains to be seen whether lower courts in the state will take up the court on its invitation to apply it, and under what circumstances.

But based on the Pa. Supreme Court’s decision here in Mortimer v. McCool, it seems enterprise liability is now a viable theory in Pennsylvania through which a party to a business divorce lawsuit could attempt to pierce the corporate veil of an adversary. Interestingly, the enterprise theory may be an effective weapon with which to hold the owners of “just-out-of-reach structures”—which we covered on the blog a while back—liable for wrongdoing if an opposing party can show a unity of interest and ownership that eviscerates separate personalities of the companies and the individuals, and there is fraud, wrong, or injustice on their parts.

Corporate attorneys advising closely held businesses should be aware of the potential for enterprise liability to arise. They should strongly consider indemnification provisions and adequate insurance for directors and officers as necessary.

Additionally, litigators should also evaluate the viability of this theory in preparing their claims and choosing appropriate defendants. Litigators will need to conduct an in-depth investigation into their adversaries’ corporate ownership to allow their clients to show a court they’ve satisfied the shiny new two-pronged test for enterprise liability established by the Pa. Supreme Court in Mortimer v. McCool.

There is arguably no more prevalent legal claim in business divorces than a claim of breach of a fiduciary duty. Simply put (and I do mean simply), when one person owes a fiduciary duty to another, the person with the duty must act in the best interests of the person to whom they owe the duty.

When the co-owner of a closely held business owes a fiduciary duty to another shareholder of the business, the co-owner must act in the best interests of that shareholder. That means, among other things, treating the other shareholder in a way that allows them to realize the value of their interest in the business.

Fiduciary duties owed by 50% co-owners under Pennsylvania law

Under Pennsylvania law, equal shareholders in a business tend not to owe fiduciary duties to each other. That makes perfect sense. It is awfully difficult (though not impossible) for a 50% co-owner of a business to railroad their fellow 50% co-owner. Assuming each co-owner has the same power, control, and rights over the business as the other, neither co-owner should be able to abuse their authority. After all, each co-owner should have the power to stop the other’s abuse.

But when shareholders are not co-equal, Pennsylvania imposes a fiduciary duty on majority shareholders to protect the interests of minority shareholders. Without this duty, majority shareholders could use their power to elbow out minority shareholders and take a disproportionate share of their businesses’ profits or take advantage of other benefits provided by their businesses at the expense of those minority shareholders.

This majority-to-minority fiduciary duty exists when shareholders have equal ownership of the company but not equal power or control. In situations where there are two 50% co-owners of a business, but one has more voting power than the other or has greater authority to run the business than the other, Pennsylvania courts will likely rule that the more powerful 50% co-owner owes a fiduciary duty to the less powerful 50% co-owner.

But what about when two 50% co-owners with equal power, control, and rights have a falling out and one tries to terminate the other’s employment? It would seem neither would owe a fiduciary duty to the other given that they’re on equal footing.

But a recent decision from the U.S. District Court of the Eastern District of Pennsylvania suggests that once that firing occurs, the co-owner doing the firing has more power and control than the co-owner who was just fired and, therefore, would owe a fiduciary duty to the fired co-owner.

Crossing the equality chasm

In Meyers v. Delaware Valley Lift Truck, Inc. et al., No. 18-1118, E.D. Pa. (May 13, 2021), two brothers, Jack and Jim, each owned half the shares of a closely held industrial equipment rental business, Delaware Valley Lift Truck, founded in 1985 by their father John. A shareholder agreement between the brothers contained a clause (albeit a sloppily drafted one) that allowed John to break any ties between them in the event of disagreements about “major decisions.” The brothers had equal power, control, and rights to make business decisions.

In late 2017, the relationship between Jack and Jim soured. They clashed over whether to fire a particular employee. Jack, the president, was intent on terminating this employee, believing that his conduct cost the company an important business deal. Jim, the secretary and treasurer, was close with the employee and tied his own continued employment at the company to the continued employment of the person about to be fired.

John apparently gave his blessing to Jack to “to do what he had to do that was best for the company and the employees” and supported whatever decision Jack made about whether Jim would continue working at DVLT. But John did not attend the meeting between Jack and Jim where their dispute came to a head. Thus, as the court recognized, it wasn’t clear if John broke the tie. The two brothers had differing views about what happened at the meeting, but agreed that Jack fired Jim.

According to the brothers’ shareholder agreement, Jim’s firing triggered a provision where the remaining brother had the legal right to buy out the one who was fired using a particular formula. However, Jack and Jim had different opinions on how the formula was to be applied. Again, the shareholder agreement did their arrangement no favors thanks to poor drafting. The two brothers could not agree on the purchase price, so the recently fired Jim kept his 50% ownership stake in the company.

In deciding whether to grant either party’s motion for summary judgment regarding Jim’s breach of fiduciary duty claim against Jack, U.S. District Judge Wendy Beetlestone broke some new legal ground. After walking through Pennsylvania law on breach of fiduciary duty, Judge Beetlestone determined that there were two separate stages of the brothers’ relationship with each other. When they had equal authority, and John had the tie-breaking power between the two, the court held Jack did not owe Jim a fiduciary duty.

But according to the court, this absence of a fiduciary relationship changed the moment Jack fired Jim. At that point, Jack clearly had more power than Jim, power that he used to bar Jim from the premises and deny him access to corporate records. Ironically, the court imposed a relationship of trust on Jack only after he seemingly broke trust with his brother by firing him.

After explaining that Jack owed Jim a fiduciary duty in this situation, the court held Jim’s breach of fiduciary duty claim against Jack should proceed to trial to determine whether Jack breached that duty.

A new paradigm for equal shareholders in closely held Pennsylvania businesses?

The key holding in Meyer, that a fiduciary duty between co-equal shareholders can come into existence based on shifts in the balance of power between them, is potentially a significant one.

There was no change in the number of shares owned by Jack or Jim, no new operating agreement, no new allocation of voting shares or rights, and no change in corporate structure. The only thing that changed was one co-equal shareholder fired the other co-equal shareholder in connection with a disagreement over a personnel issue that snowballed into a much larger disagreement.

Yet the court looked at that termination as an event that took the brothers off equal footing despite no change in their ownership of their business. When Jack fired Jim, Jack suddenly became, in the court’s eye, the majority shareholder.

Interestingly, Jim alleges Jack breached his fiduciary duty by doing certain things—barring Jim from their business’s premises, denying him access to corporate records, denying him a voice in running the company, misappropriating corporate funds for Jack’s own personal benefit, and initiating bankruptcy proceedings on behalf of the company in bad faith—that seem to be lifted straight out of the playbook for misbehaving majority shareholders. Had Jack simply taken more than his fair share of profits, the court might have ruled differently. But Jack’s actions seem like those of a majority shareholder acting without fear of accountability or reprisal from a less powerful minority shareholder.

The Meyer decision could transform how 50% co-owners interact with each other. Should the balance of power become imbalanced, a court adopting Judge Beetlestone’s reasoning could hold that the imbalance created a fiduciary duty owed by the more powerful 50% co-owner. Additionally, courts may want the parties to develop a more detailed factual record in these cases because the cases will turn on specific facts regarding the relative power, control, and rights a co-owner had and used at the expense of the other.

The ink on the Meyer decision is barely dry, so we will have to wait and see what impact the decision has on business divorce cases in Pennsylvania. But for now, Meyer has injected some uncertainty into what many Pennsylvania businesses thought was not up for interpretation: whether co-equal owners of those businesses are equal in the eyes of the law.

When legal disputes between owners of closely held companies turn the corner past “Let’s resolve this issue without litigation” and head toward “See you in court,” the owners and their lawyers typically begin jockeying for the upper hand in a potential lawsuit. The most effective way to grab the upper hand is to be the party that files the lawsuit. That party gets to shape the lawsuit to their liking—both in terms of which court they decide to file the lawsuit in and the legal claims and supporting facts they include in the lawsuit.

These legal claims and supporting facts often signal what kind of legal battle the parties are looking at. The more incendiary the legal claims and supporting facts, the more contentious the lawsuit will be.

A lawsuit alleging a breach of a company’s operating agreement supported by straightforward factual allegations will have a much different feel than one alleging fraud and embezzlement supported by factual allegations seemingly ripped from a movie script.

And then there are civil RICO claims.

RICO primer

RICO stands for the Racketeer Influenced and Corrupt Organization Act signed into law by President Richard Nixon in 1970. RICO was part of the Organized Crime Control Act of 1970. Congress’s purpose in bringing the law was to:

seek the eradication of organized crime in the United States by strengthening the legal tools in the evidence-gathering process, by establishing new penal prohibitions, and by providing enhanced sanctions and new remedies to deal with the unlawful activities of those engaged in organized crime.

RICO was conceived as a new way to fight the mob and other illegal criminal enterprises by targeting the underlying activities that criminals took part in to keep their enterprises going. Through RICO, Congress defined racketeering activity broadly to include both violent crimes such as kidnapping, bribery, extortion, and counterfeiting, as well as white-collar crimes such as wire fraud and mail fraud.

In criminal RICO cases, prosecutors must prove beyond a reasonable doubt that a RICO “enterprise,” defined as “any individual, partnership, corporation, association, or other legal entity, and any union or group of individuals associated in fact although not a legal entity,” engaged in at least two related racketeering activities, known as “predicate acts,” in furtherance of that enterprise.

In addition to criminal RICO claims, Congress also created new civil RICO claims. Civil RICO claims can be brought in private litigation like litigation between owners of closely held companies. The winning party in a civil RICO case is entitled to treble (that is, 3x) damages and to have their adversary pay their attorneys’ fees.

A hammer in search of a nail?

When an owner of a closely held company lobs RICO allegations against their co-owner(s) in a lawsuit, they are throwing down the gauntlet as part of their jockeying for the upper hand. RICO allegations are the kind of legal claims that may arouse the interest of media outlets, get a company’s clients, vendors, employees, and shareholders buzzing (not in a good way), and cause significant reputational and business damage to closely held companies.

Thus, the thinking goes, if a party can allege RICO claims that survive multiple attempts to dismiss the lawsuit, those claims become strong leverage in settlement negotiations down the road. Knowing that your co-owner could have you dead to rights on a civil RICO claim will bring even the most stubborn co-owner to the settlement table given the treble damages and attorneys fees waiting for them on the other side of an unfavorable jury verdict.

But just how potent are civil RICO cases in the business divorce context in Pennsylvania?

Apparently, not very.

Few civil RICO cases in the business divorce context have been litigated in Pennsylvania. Of those that have, the plaintiffs have generally been unsuccessful with their claims. As you will see shortly, the nature of the events that tend to lead to business divorces do not fit nicely within the kind of factual allegations needed in a RICO case to survive judicial scrutiny.

Because of this, the parties against whom RICO claims are alleged in the business divorce context know their adversaries are going to have a tough time getting those RICO claims to survive attempts to dismiss them. With few successful civil RICO claims in the business divorce context, the claims’ effectiveness as a hammer used to jockey for position in a potential or newly filed lawsuit is greatly reduced.

The following four Pennsylvania cases show just how hard of a sell civil RICO claims are in the business divorce context.

In Domico v. Kontas, No. 3:12CV1449, 2013 WL 1248638 (M.D. Pa. Mar. 26, 2013), Dennis Domico, an investor in a corporation that operated the Hollywood Diner in Hazle Township, Pa., claimed he was tricked into investing $145,000 in the company for 50% ownership of it through his co-owner’s use of doctored bank statements, fraudulent invoices, and altered bank checks. While a state court business divorce lawsuit was pending between Domico and his co-owner, he brought a federal civil RICO case against the co-owner and a number of the co-owner’s business associates, alleging both a civil RICO claim and a conspiracy to commit civil RICO claim. The relevant predicate acts were wire, mail, and bank fraud.

Unfortunately for Domico, the court determined the predicate acts actually formed the basis of a claim for securities fraud because they all related to his investment in the corporation that operated the diner. This was a problem because the Private Securities Litigation Reform Act of 1995 eliminated securities fraud as a predicate act for a civil RICO claim. The court ruled that all of the defendants’ actions were part of a single fraudulent scheme to trick Domico into purchasing securities in the corporation that owned the diner. As a result, the court dismissed both civil RICO claims.

In Gintowt v. TL Ventures, 226. F. Supp. 2d 672 (E.D. Pa. 2002), Kristoff Gintowt, a co-owner of a successful staffing company claimed that after his company was merged into a new company, Broadreach, his equity in it was wiped out due to fraud and misrepresentations by the defendants who were corporate executives of, and entities affiliated with, Broadreach. Gintowt brought civil RICO claims against the defendants, alleging that the defendants committed various predicate acts of mail fraud and wire fraud, such as when they assured Gintowt that he and his co-owners would have a seat on the board of Broadreach and when the company made misleading statements about its business to potential buyers.

The court dismissed Gintowt’s complaint. While noting that Gintowt adequately alleged the existence of an enterprise (Broadreach) and damages in support of his RICO claim, the court held that Gintowt failed to do so when it came to how the alleged fraudulent acts committed against him furthered the scheme to defraud him or were related to an essential part of that scheme. According to the court, because Gintowt did not tie the alleged fraudulent acts together, he did not properly allege that the acts constituted “a pattern of racketeering activity” required by RICO (which is often properly alleged by claiming those acts are part of an ongoing entity’s regular way of doing business).

In Bardsley v. Powell, Trachtman, Logan, Carrle & Bowman, P.C. et al., 916 F. Supp. 458, 463 (E.D. Pa.), aff’d, 106 F.3d 384 (3d Cir. 1996), Norman Bardsley, a shareholder and director of Inofast, a manufacturer and distributor of fasteners, claimed that a number of Inofast’s minority shareholders—including his twin brother and father!—concocted a scheme involving a number of improper and fraudulent transactions to divest him of his majority shareholder status. The scheme was allegedly hatched to thwart Bardsley’s attempts to replace Inofast’s management after the company found itself in financial trouble. As was the situation in the Domico case I discussed above, while a state court business divorce lawsuit was pending between Bardsley and a number of Inofast shareholders, two of their outside lawyers, and their law firm, he brought a federal securities fraud and civil RICO case against those defendants.

The court dismissed the securities fraud claim on the basis that Bardsley did not bring his claim within the required period of time under the federal securities laws. The court also dismissed Bardsley’s civil RICO claim. The court held that Bardsley did not show that the defendants’ alleged fraudulent scheme included a pattern of racketeering activity as required by RICO. Specifically, he did not allege that the defendants’ scheme was continuous. According to the court, he alleged the scheme lasted seven or eight months, was directed only toward him, and was implemented for a single purpose. The court determined that the defendants’ alleged misconduct fell short of RICO’s “continuity” requirement.

(Note that this case was decided soon after the Private Securities Litigation Reform Act of 1995 was passed. Though the PSLRA was not mentioned, it would not have changed the ultimate result.)

Finally, in Ferdinand Drexel Inv. Co. v. Alibert, 723 F. Supp. 313, 326 (E.D. Pa. 1989), aff’d, 904 F.2d 694 (3d Cir. 1990), Vernon Alibert, the co-owner of a number of family-owned companies, claimed he was fraudulently divested of his ownership in them thanks to their majority shareholders (who were his family members). Alibert brought securities fraud claims against the majority shareholders, as well as a civil RICO claim with predicate acts of securities fraud and of mail fraud.

The judge dismissed the securities fraud claims, in part because Alibert could not have relied on allegedly false statements in certain documents because he refused to accept those documents when the United States Postal Service delivered them to him. Regarding the RICO claims, the judge dismissed them as well, focusing on the mail fraud claim because he had already dismissed the securities fraud claim. He held that even if the notices mailed to the plaintiff were fraudulent, there were only two of them and they were sent within the same month. This fell short of RICO’s “continuity” and “pattern” requirements for predicate acts. In addition, the judge held that Alibert could not have been injured as a result of the shareholders’ alleged racketeering scheme because he did not detrimentally rely on the alleged fraudulent mailed notices because (as was the case with his securities fraud claim) he never read them.

(Note that this case was decided six years before the PSLRA was passed. As with the Bardsley case I mentioned above, the PSLRA would not have changed the ultimate result.)

No go, RICO

There have not been many civil RICO cases in Pennsylvania arising in the business divorce context to begin with, let alone ones where the plaintiff has prevailed. That civil RICO cases are so few and far between suggests to me that lawyers and their clients involved in business divorces understand that civil RICO claims are tough hills to climb in that context.

Given the lackluster track record of previous plaintiffs in civil RICO cases in the business divorce context, would-be plaintiffs likely do not want to spend the required time and money for their lawyers to draft the kinds of detailed legal complaints necessary to properly allege RICO claims—assuming the facts of a particular business divorce support such claims—only to stand a good chance of those complaints being dismissed early in the litigation process. Thus, fewer civil RICO cases in the business divorce context are being filed.

Perhaps there are those rare business divorces that provide the factual and legal basis for a dead-to-rights civil RICO claim. But short of that, I do not expect many co-owners of closely held companies in Pennsylvania to raise civil RICO claims in Pennsylvania federal courts to complement, or in place of, bread-and-butter business divorce lawsuits in Pennsylvania state courts. The chances of winning a civil RICO case are simply too low to justify the likely expense of mounting one.

For these reasons, when co-owners of closely held companies and their lawyers begin jockeying for the upper hand in a potential lawsuit regarding a business divorce, it seems a civil RICO claim will almost certainly be a hammer without a nail.

Last month, we tackled Pennsylvania’s “universal” demand requirement. As a refresher, unlike many states, Pennsylvania will not excuse the shareholder of a company who wants the company to sue its executives or directors from making a written demand on the company’s board of directors prior to filing a lawsuit even when doing so would be futile. “Futility” means that the composition of the company’s board makes it incapable of impartially deciding whether to bring suit on behalf of the company based on the wrongful conduct alleged by that shareholder in their demand. Normally, if such a demand would be futile, a would-be shareholder-plaintiff can skip the written demand and move straight to filing their lawsuit.

As I explained in that blog post, this “universal demand” requirement makes sense in Pennsylvania because the Commonwealth’s laws allow a company’s board to appoint a special litigation committee (known in legal circles as an “SLC”) composed of independent third-party members to investigate the complaining shareholder’s allegations and determine whether bringing a potential lawsuit based on those allegations would be in the best interests of the company. A demand in Pennsylvania should never, strictly speaking, be futile because it is always possible for a board to take good faith action in response to a demand, even if the entire board is conflicted.

Not every company jumps at the chance to commence these investigations, especially a closely held company that might not have the cash flow or balance sheet needed to fund one. But there may be a way for closely held companies to carry out these investigations and reap the benefits of doing so without breaking the bank.

Spend money on an investigation now, save money on litigation later

In publicly held companies and private companies with many shareholders, it is common for a board of directors to appoint an SLC after receiving a shareholder’s complaint. Usually, the SLC then retains an outside law firm to help it investigate the complaint. Most times, those law firms will thoroughly and independently investigate the complaint and issue a report, dozens of pages long, explaining why the shareholder’s allegations are without merit, and thus why the board should not file the lawsuit the shareholder is asking it to file.

The boards at these companies know that whatever they pay for the investigation and report —likely anywhere from the low six figures to the high seven figures—will provide a meaningful return on investment on the backend. That’s because the investigation and report could be a proper basis, according to a court, on which a board can rely to not pursue a lawsuit against its own company, thus putting an early end to litigation over the shareholder’s complaints. The cost to the company of litigating the shareholder’s complaints to the bitter end would inevitably be multiples of what that investigation and report cost.

But when it comes to closely held companies, in my experience, the controlling owners/shareholders rarely appoint an SLC to investigate a complaining shareholder’s claims. The funny thing is, they probably should. By not doing so, they are missing an opportunity to show Pennsylvania courts that a complaining shareholder’s allegations of wrongdoing were investigated by a law firm and found to be without merit, and thus related litigation should be dismissed as early as possible. Moreover, the cost of most litigation means that disputes over relatively small amounts (500k to 2 MM) would not be in a company’s best interests, thereby creating an additional justification for dismissal of a plaintiff’s claim. The board of a closely held company that fails to appoint an SLC misses these opportunities to end litigation early and the potentially significant ROI that an SLC’s investigation can bring.

So why don’t more closely held companies appoint SLCs to investigate a complaining shareholder’s allegations of wrongdoing?

It might seem to closely held companies that the cost of conducting such an investigation would be prohibitive. The price to hire an outside law firm to conduct this kind of investigation at a closely held company likely begins in the mid-five figures and tops out in the mid-six figures.

But Pennsylvania courts have held that a board’s decision to not pursue litigation against its own company is subject to the business judgment rule (under which a court will uphold a board’s decisions if they are made in good faith, using reasonable care, and with the best interests of the company in mind). The business judgment rule focuses on process. Therefore, how the board of a closely held company arrived at its decision not to pursue litigation against its company regarding a complaining shareholder’s allegations of wrongdoing is what counts, not necessarily who its SLC hired to help it investigate those allegations.

So how can a closely held company’s SLC investigate these allegations without breaking the bank? A 2008 Pennsylvania appellate court suggests a path worth following.

LeMenestrel v. Warden: A roadmap for DIY SLC investigations

The dispute at the center of LeMenestrel v. Warden, 964 A.2d 902 (Pa. Super. Ct.  2008) is common amongst closely held companies. The LeMenestrel siblings, who were minority shareholders of Superior Group, brought a breach of fiduciary duty claim in a derivative action against the company’s SLC, controlling shareholders, and controlling officer. The SLC was formed in response to a demand letter sent by the LeMenestrels regarding losses to some of Superior Group’s subsidiaries, and business decisions by the majority shareholders relating to the sale and liquidation of other subsidiaries. The LeMenestrels also claimed that the SLC breached its fiduciary duty to Superior Group’s shareholders in its investigation of the self-dealing allegations.

The trial court granted the defendants’ motion to dismiss the lawsuit. The court held that the SLC formed by Superior Group’s board of directors in response to the LeMenestrels’ demand letter “was disinterested, independent, impartial and adequately informed in reaching its good faith conclusion that it was not in the best interests of [Superior Group] to proceed with the LeMenestrels’ shareholders’ derivative suit.”

The LeMenestrels appealed that decision to the Pennsylvania Superior Court. In its decision, the Superior Court upheld the trial court’s decision.

LeMenestrel is one of the few Pennsylvania court cases that evaluated the actions of an SLC. In its decision, the Pennsylvania Superior Court explained why Superior Group’s SLC’s deference to its attorney was proper and why the committee was “adequately informed” when it decided not to pursue the LeMenestrels’ lawsuit. The court focused on the work of the committee’s lawyer, John G. Harkins, Jr.:

  • Harkins was independent, had no conflict of interests, and was “an eminently qualified practitioner” who conducted an “extensive investigation”;
  • He developed an investigation plan and met regularly with the committee to discuss matters regarding the investigation, including the scope of the investigation, the general procedures to follow, the kinds of claims raised in the demand letter and which claims could be subject to a lawsuit based on particular legal theories;
  • He reviewed thousands of documents, including deposition transcripts from a related litigation and documents provided by the LeMenestrels’ lawyer;
  • He interviewed at least eight witnesses knowledgeable about facts relevant to the LeMenestrels’ claims;
  • He interviewed the LeMenestrels’ lawyer, met with him regarding the scope of the investigation to ensure that it considered issues his clients felt were significant, and tailored the scope of the investigation after talking with the lawyer; and
  • His investigation took five months, resulting in a 106-page final report that explained “in a thorough, evenhanded manner, the background and events leading up to the LeMenestrels’ claims, the response of Superior Group’s board and formation of the committee, the scope of the investigation, and findings and recommendations in light of the fiduciary duties owed by the defendant directors and officers.”

Following the roadmap without paying a fortune

Based on the LeMenestrel court’s description of the Superior Group’s SLC’s investigation, the company probably spent somewhere between $200,000 and $400,000 on it. That cost was likely justified by the fact that potentially tens of millions of dollars were at stake.

But rarely is that amount of money at stake in legal disputes between the shareholders of closely held companies. In those disputes, a more likely amount at stake is $500,000 to $2 million. At those amounts, a $200,000 to $400,000 investigation does not make much financial sense. But a $20,000 or a $40,000 investigation might.

If that’s the case, how could a budget-minded SLC at a closely held company conduct a process-driven and thorough investigation like John Harkins did for Superior Group that is strong enough to pass judicial muster and serve as the appropriate basis for the dismissal of a shareholder’s lawsuit early in the litigation process?

Here’s one possible way: hire “an eminently qualified” lawyer to lead the investigation and be the “quarterback” of it, but assign company personnel and other qualified non-lawyers the brunt of the legwork. That will cut down on the fees charged by a lawyer because it reduces the time they will spend investigating.

To be clear, an SLC should hire a lawyer to lead the investigation. Only a lawyer can determine, based on what the investigation finds, whether the SLC and ultimately its company’s board should agree to the shareholder’s demand to bring a derivative lawsuit on behalf of the company. This decision will be a result of the facts uncovered during the investigation and the law of the company’s jurisdiction regarding whether those facts constitute legal wrongdoing. That is the exclusive domain of a lawyer.

But uncovering the facts is not. If we look at the aspects of the Superior Group’s SLC’s investigation that the LeMenestrel court lauded, we see many tasks that can be delegated to non-lawyers partially or entirely, including directors on the SLC, disinterested executives, and disinterested third parties:

  • Developing an investigation plan;
  • Meeting with the SLC to update them on the investigation;
  • Reviewing documents, including deposition transcripts;
  • Interviewing witnesses; and
  • Drafting a final report

Surely, the lawyer hired by the SLC will be intimately involved with the investigation, guiding the non-lawyer(s) and assisting them. But the lawyer need not be the person sitting for an interview with a witness—they can help the interviewer prepare for one. Same thing for the first draft of a final report. Merely by reducing the amount of “doing” by a lawyer while maintaining the same amount of strategic thinking they provide, SLCs at closely held companies can reduce the cost of an investigation of a shareholder’s demand. This cost reduction could lead to a wider adoption of investigations at these companies, which as I mentioned above, would generally be a good thing for them.

A few dollars of prevention is worth exponentially more of cure

When faced with shareholder demands regarding significant alleged wrongdoing at their companies, the boards of Pennsylvania closely held companies may be doing themselves and all of their shareholders a disservice when they fail to convene an SLC to investigate the allegations. An SLC’s investigation and subsequent report can provide the means to an early exit from what could end up being a costly lawsuit.

If cost is a factor, the LeMenestrel case provides a roadmap for closely held companies to follow that could help them obtain the litigation benefits of an SLC without breaking the bank.

 

Attorneys that represent shareholders of publicly traded companies in securities litigation are intimately familiar with the pre-suit demand required by the corporate law of many states. The purpose of the demand is to give the board of a company an opportunity to investigate and remedy alleged wrongdoing on the company’s behalf before a shareholder is permitted to bring a derivative action. In many states, including Delaware, a potential plaintiff is not required to make a pre-suit demand when the board is not capable of making an independent decision—typically because board members are accused of wrongdoing themselves. Pennsylvania’s business corporation law (“BCL”) does not include a “futility” exception and requires the prospective derivative plaintiff to make a pre-suit demand in nearly all circumstances.

Whatever the merits of Pennsylvania’s universal demand requirement for litigation involving companies with many shareholders, its justification breaks down in disputes involving closely held businesses. Absent a persuasive justification, it amounts to a procedural trap for the unwary practitioner. A recent decision from the Eastern District of Pennsylvania is a reminder of the hazard.

Pennsylvania’s “Universal Demand” Requirement

A fundamental principle of Pennsylvania corporate law is that a corporation’s board – not its shareholders – is responsible for the management of the company. This includes the decision to initiate litigation on behalf of the company against those who have damaged it. Pennsylvania’s corporate law, however, recognizes that members of the board and corporate officers themselves may cause harm to the company and are unlikely to cause the company initiate litigation against themselves. It allows shareholders to initiate derivative claims on behalf of the company in limited circumstances.

The 2016 revisions to the BCL require a prospective derivative plaintiff to make a written demand on a company’s board of directors prior to initiating suit. 15 Pa.C.S.A. § 1781(a). Upon receiving a demand, the board may choose to appoint an independent committee to investigate what action, if any, the corporation should take in response to the demand. For example, the committee might choose to have the corporation bring an action in its own name based on some or all the claims in the demand, or to allow the prospective derivative plaintiff to do so on its behalf. The committee is a surrogate decisionmaker for the board that allows it to make a business decision – whether and under what circumstances to initiate litigation. The demand is intended to give the board time to form a litigation committee and make this business decision prior to litigation.

Many states will excuse a plaintiff from the demand requirement when it would be futile. “Futility” means that the composition of the board is such that it is incapable of making an independent decision regarding the alleged wrongful conduct that would have been included in a pre-suit demand. For example, a demand would be futile if it alleged the entire board were engaged in self-dealing and there were no disinterested directors able to make a good faith decision on behalf of the company.

Litigating whether a demand is futile can be a complex, time consuming and expensive task. It is also ancillary to the merits of the ultimate issue of whether the corporation suffered harm because of a defendant’s conduct. For that reason, some states, including Pennsylvania, have no futility exception and require a pre-suit demand in nearly all circumstances. The BCL only excuses the demand requirement “if the plaintiff makes a specific showing that immediate and irreparable harm to the business corporation would otherwise result.” 15 Pa.C.S.A. § 1781(b)(1).

This “universal demand” requirement is defensible because the BCL allows the board to appoint a litigation committee comprised of independent third-party members. A demand in Pennsylvania should never, strictly speaking, be futile because it is always possible for a board to take good faith action in response to a demand, even if the entire board is conflicted. In contrast, many states require that a litigation committee be comprised of board members.

The Practical Reality in Closely Held Company Disputes

Practitioners that focus their practice on disputes among the owners of closely held companies may have trouble recalling a time where a client made a demand on a corporate board, which then diligently appointed an independent committee, retained independent counsel and performed a good faith investigation into the alleged wrongdoing. The practical reality is that demand futility is the norm in shareholder disputes involving closely held companies.

The prototypical fact pattern is a company with a majority / minority ownership structure. The majority owner is the sole director, president, treasurer and secretary of the company. The minority owner believes the majority owner is skimming from the company by having it pay him excessive compensation and his personal expenses. Notwithstanding the common-sense conclusion that the majority owner is unlikely to cause the company to hire an attorney to sue him or form a special committee to investigate his conduct, the BCL requires the minority owner to demand that he do just that. In fact, the BCL’s demand requirement appears to apply even when the board is deadlocked—which is common in closely held company litigation— and incapable of appointing a litigation committee.

Prior to the BCL’s 2016 amendments, Pennsylvania courts recognized that demand futility is common in closely held company disputes. The Superior Court put it bluntly: “[T]he demand requirement appears to be the very type of procedural rule that makes little sense in the context of a dispute between shareholders in a closely held corporation.” Hill v. Ofalt, 85 A.3d 540, 556 (Pa. Super. Ct. 2014)

A Trap for the Unwary

The 2016 amendments to the BCL leave no room for a futility exception. The Eastern District recently confirmed the same.

In Julabo USA, Inc. v. Juchheim, two brothers battled over how each of them ran their respective parts of the family business. One brother asserted a derivative claim against the other brother and an employee. The brothers each owned 50% of the company but the defendant brother served at the sole member of the board of directors, president, secretary and treasurer. The plaintiff brother did not make a demand prior to initiating the derivative action.

The Court, in what appears to be the first reported case on the issue, granted the defendant brother’s motion for summary judgment on that basis. In reaching its conclusion, the Court engaged in a plain-language reading of the BCL to conclude that it “does not include an exception [to the demand requirement] for closely-held corporations[;] And the Court has no basis to infer one.” The Court further rejected the plaintiff brother’s argument that pre-2016 cases, including Hill, predicted the Pennsylvania Supreme Court would adopt a futility exception as inconsistent with the 2016 amendments to the BCL. The Court ultimately concluded that the demand “requirements apply whether [a company] is a closely-held family business or a Fortune 500 company.”

Sidestepping the Trap

The demand requirement in the context of a closely held company dispute is the kind of procedural formality that keeps lawyers up at night. It is not intuitive and can have big consequences if ignored. Given that nearly all such demands will be ignored, the most efficient and safest way to comply with the requirement is to prepare a demand that references and attaches a copy of the complaint the derivative plaintiff intends to file.

When reading a recent New Jersey court’s opinion regarding an employee of an LLC claiming to have been given a share of ownership of the company by its sole owner, I couldn’t help but think of method acting – the technique in which “an actor aspires to encourage sincere and emotionally expressive performances by fully inhabiting the role of the character.” (Cite). Dustin Hoffman, Heath Ledger and Daniel Day-Lewis all used method acting to deliver outstanding performances. Although a putative LLC owner doesn’t need an agent, “fully inhabiting the role of” an LLC owner is a critical part of getting a court to recognize an ownership interest in the event of a dispute.

The murkiness of employees being offered ownership in the LLCs they work for

Before we look at that New Jersey case, let’s talk about LLC ownership for a moment.

It would probably not surprise you to learn that LLC ownership is not always cut and dry. I frequently receive calls from potential clients who claim they were promised equity in a company they have been working at, only to come to realize that the company did not and does not recognize their ownership interest.

(When I receive these calls, one of my first questions is, “Were you given a K-1 earlier this year?” As I have previously discussed, Schedule K-1s are helpful in identifying the owners of a business because entities taxed as partnerships or S-corporations must prepare a Schedule K-1 for each of their owners.)

Obviously, whether someone is an equity owner of an LLC is a big deal on its own in terms of compensation and power. But in the context of Pennsylvania business divorces and the litigation that often accompanies them, equity ownership of an LLC confers certain rights and privileges on owners that non-owners do not have. For example, LLC owners can file derivative claims against their LLC for breach of fiduciary duty. They can also demand the LLC’s books and records for inspection.

Things tend to get murky when employees of an LLC claim to have been given equity in the company. That’s because many employment arrangements have profit-sharing provisions that are designed to provide the benefits of ownership without actually giving an employee ownership. When you add in the fact that these relationships are not always well-documented or are captured in DIY-ed agreements penned (i.e. downloaded from the Internet) by business people, it is easy to see how confusion can reign.

Two guys, an email, and an unchanged LLC operating agreement

Interestingly, there have not been recent notable Pennsylvania court decisions on this issue. But thankfully, judges in the Commonwealth’s neighbor to the east recently decided a case that shows why supposed grants of LLC ownership to an employee can easily become murky.

In Funsch v. Procida Funding, LLC, et al., No A-3899-18T4 (N.J. Super. Ct. Dec. 3, 2020), Kyle Funsch sued his former boss Billy Procida, Billy’s real estate investment company, Procida Funding, LLC, and another employee, John Mullane. Billy was the sole member of Procida Funding.

At the heart of the case was what Kyle believed was an equity share of Procida Funding that he claims Billy promised him in May 2011 but never gave him by the time he left the company in December 2015.

A trial court ruled against Kyle in April 2019. According to the court, the evidence showed that he did not have and knew he never had an equity interest in Procida Funding. Kyle appealed the ruling to the New Jersey Superior Court.

As proof that he was given an equity share of Procida Funding, Kyle relied heavily on a May 2011 email from Billy to him and another employee (the other defendant, John Mullane) that said:

[Y]our work to date has been admirable and your skill sets improve daily. I am proud to work with you both (despite that I beat you to the office today) therefore I am making you partners. [T]he terms of which are as follows: for as long as you work here, you will each own and be entitled to 12.5% of the combined  companies [sic] net earnings. [Y]ou will receive a draw against those  earnings  .  .  net income will be calculated by all income less all expenses exclusive of interest income on my investments. [S]hould either of you leave the firm you will forfeit any rights to future earnings or ownership. [S]ince talk is cheap I wanted to put something in writing, so we can consider this legally binding. [A]s we’ve got many things to do save this email.

[I]f I die or become disabled it is my wish that you guys own 50% and send the balance to my kids. [Y]ou are now to refer to yourselves as my partners. [W]e will fine tune this over time. [W]e will do a press release to announce this shortly.

Seems like reasonably strong evidence of ownership. Kyle claimed further support for Billy giving him an ownership share by pointing to Procida Funding’s public announcements regarding his becoming a partner, as well as references to him being a partner on Procida Funding’s website, a private placement memorandum, in Billy’s emails to clients and to a Procida Funding attorney, and in a business magazine story.

Unfortunately for Kyle, both the trial court and the New Jersey Superior Court found what happened after the May 2011 email, or perhaps more accurately, what didn’t happen, to be more persuasive. The Superior Court affirmed the trial court’s ruling against him.

First and foremost, Billy provided Kyle with four proposed amendments to the Procida Funding LLC operating agreement. Kyle rejected each one. Had he signed one of them, the agreement would have admitted him as a member. According to both courts, this was an indication that Billy and Kyle never came to an agreement about Kyle becoming a co-owner of Procida Funding.

Second, the May 2011 email lacked “core, basic, and material terms” related to Kyle’s claimed co-ownership that would have been expected in a document admitting a new LLC member. The email did not address important co-owner responsibilities and obligations such as capital contributions and loss sharing. The May 2011 email was deemed by the trial court to be merely a notification to Kyle about his promotion and the new way his compensation would be calculated. According to the courts, further supporting the fact that the May 2011 email did not grant co-ownership to Kyle was an email Billy sent just two months later to Kyle and others outside of the company in which Billy stated he was the 100% owner of Procida Funding and referred to Kyle as a “cash flow partner.”

Third, Kyle testified that he was paid as a W-2 employee and did not receive any Schedule K-1s reflecting owner distributions.

Finally, both courts did not view Billy’s references to Kyle as a “partner” as an indication that Kyle was a co-owner. They relied on Billy’s testimony that he used “partner” imprecisely to give Kyle authority for negotiation purposes—not to confer LLC ownership on him.

As a result, Kyle was unable to use the court system to do what he could have done with a stroke of his own pen if he signed one of those four amendments to Procida Funding’s operating agreement: create an ownership interest for himself in Procida Funding.

Sign the darn papers, or at least, walk the walk

As the Funsch case shows, whether someone is an owner of an LLC is ultimately a question of contract law. When deciding a case involving an employee claiming to have been given an ownership interest in an LLC, the first place a court will look will be the LLC’s operating agreement. If it was amended to include the employee as an owner, and signed by the required parties, a court would almost certainly rule in favor of the employee because the signed agreement shows the parties had a “meeting of the minds” regarding the employee’s newfound ownership.

But what about when an LLC does not have an operating agreement? Pennsylvania, for one, does not require an LLC to have a written operating agreement in order for the LLC to be officially formed in the Commonwealth. (New Jersey also does not have such a requirement).

In those situations, any oral agreement regarding an employee supposedly being given an ownership interest, and the employee’s subsequent conduct after any agreement, will be closely examined. In the absence of an amended written operating agreement, a court is going to want to see whether the supposed new owner took on the responsibilities and obligations an owner would take on. In other words, did the new owner walk the walk?

If Billy Procida’s LLC was a Pennsylvania LLC without an operating agreement, and Kyle Funsch brought a similar case against Billy in a court that applied Pennsylvania law to the dispute, chances are good that Kyle would lose that case as well. He did not walk the walk.

According to the New Jersey Superior Court’s opinion, Kyle:

  • Received W-2s from Procida Funding and never any Schedule K-1s—which would have provided a record of his share of Procida Funding’s profits;
  • Never asked why he did not receive Schedule K-1s;
  • Never received membership certificates;
  • Never made capital contributions to the company;
  • Never shared in the company’s losses;
  • Never possessed any voting rights; and
  • Never managed the company.

In other words, he did not act like a co-owner of Procida Funding.

For Pennsylvania LLC owners and would-be owners alike, when a question arises over whether an employee was actually granted ownership of an LLC, Kyle Funsch’s failed legal campaign provides a clear takeaway.

If there are changes in the ownership of an LLC that has an operating agreement, the operating agreement should be amended to reflect the change and then signed by all of the LLC’s owners.

When an LLC has no such agreement, the would-be owner must show by their subsequent actions after supposedly being granted the ownership share that they walked in the shoes of an owner.

In other words, if they want to be treated like an LLC owner, they need to have acted like one.