Preventive Legal Medicine for Business Owners

Preventive Legal Medicine to Avoid Shareholder Disputes: A Workable Fair-Value Buy-Sell Agreement.

Many people start businesses with friends or relatives but what happens if one of the owners, partners, shareholders become physically sick, or sick of the business, dies, divorces, or just wants to retire? All business entities should have an agreement to enable its owners to end their relationship without litigation. Statutes and case law require corporations or LLCs to treat minority shareholders with good faith and loyalty. Under the law, owning 51% of the shares does not give you total control.

If you operate an enterprise with two or more shareholders, partners, or LLC members, you could face emotional and financial costs of a serious shareholder legal dispute. You should have a workable shareholder exit strategy in the form of a buy-sell agreement that works! Do it before a shareholder dies, gets divorced, becomes seriously ill, or simply wants to leave the business.

There are many reasons that owners fail to create a buy-sell agreement including inertia, legal cost, fear of causing strife, and not believing such buy-sell agreements are necessary. Not having a buy-sell agreement could lead to uncertainty and costly litigation. The critical lesson for any owner comes too late. Owners should create the appropriate buy-sell agreements at the onset of the relationship and revise the agreement periodically. The owners' buy-sell agreement should address death, disability, retirement, or termination. The agreement transforms a previously illiquid investment into a liquid one. A buy-out mechanism is vital if owners no longer get along.

What Is Wrong with The Typical Buy-Sell Agreement?

Attorneys, who create the business entity by-laws, often insert a boilerplate buy-sell agreement primarily designed to protect the entity from an outside buyer. The restrictions incorporated in the typical shareholder buy-sell agreement impose restrictions on the transfer of shares. Here is an example of a typical boilerplate¹ buy-sell agreement:

“Prior to the resale of any shares, the Stockholder/Seller must offer the Same to the corporation for purchase at fair market value. The Corporation must advise the Stockholder/Seller of its intent to repurchase said shares within seven days of notification of intent to Sell. Said repurchase must be completed within 30 days unless all Parties to the transaction consent to an extension beyond 30 days. In the event the corporation fails to purchase the shares from the Stockholder/Seller within 30 days, or if the corporation notifies the Stockholder/seller that the corporation will not purchase the shares. The stockholder/Seller must then offer the shares for sale to the other stockholders of record, at fair market value. The other stockholders of record must advise the Stockholder/Seller of their intent to repurchase said shares within seven days of notification of intent to sell. Said repurchase must be completed within 30 days unless all parties to the transaction consent to an extension beyond 30 days. If other shareholders fail to purchase the shares, the Stockholder/Seller may sell to an outsider.”

Business entity shareholder/owners buy-sell agreements are commonly called 30-60-90-day agreements. Typically, the agreement states that the company, when presented with an offer to sell, has 30 days to respond, then 60 days to act, and 90 days to close. Another type of buy-sell agreement is a form of arbitration agreement. The selling shareholder engages an appraiser/arbitrator² to provide the “fair market” selling price. The company engages an appraiser/arbitrator to provide its “fair market value” buying price. If the two arbitrators cannot agree, then the two arbitrators chose a third arbitrator. When two of the arbitrators agree on a “fair market value,” the selling shareholder and buying company or other shareholder are bound by the arbitration agreement to conclude the sale.

Neither of these examples work. Why? One reason is the undefined term ‘fair market value.'³ Another reason is that neither the company nor other shareholders agreed to buy the shares? The company does have the right of first refusal to buy but the company is not compelled to buy at any price. If the company chooses not to buy, then the selling shareholder can offer to sell to the remaining shareholders. If the remaining shareholders choose not to buy, then the selling shareholder can try to find an outsider to buy his or her shares. That will be a difficult sale. What benefit would pass to the outsider should the selling shareholder find such a buyer? What benefit would the outsider acquire?

What if neither the company nor the remaining shareholders agree to purchase? The poorly written buy-sell agreement protects the enterprise from an unwanted outside buyer. But it does not provide an unambiguous method for a shareholder/owner to exit in a situation where neither company nor other shareholder chose to buy. This type of buy-sell agreement only protects the company from a stranger becoming a shareholder/partial owner.

Who Should Not Provide an Enterprise Valuation for a Buy-Sell Agreement?

Some attorneys in preparing a by-law covering buy-sell agreements, state that the company's tax accountant should perform the fair market valuation.⁴ The company's CPA tax accountant is employed by the entity to prepare and file tax returns and give financial advice to the entity and its board of directors. The company's tax accountant is not an independent unbiased appraiser. The use of the company's tax accountants to value the company has an inherent conflict of interest. The valuation should be by someone other than the company's tax accountant. Another reason most tax accountants should not be engaged to value the enterprise is the CPA's fixation on compliance with IRS Revenue Rules and Regulations. There are specific IRS Revenue Rules⁵ governing the valuation of enterprises for Decedent Estate Tax Returns, Non-cash Charitable Donations, and Gift Tax Returns. CPAs are particularly important aid to business enterprises. CPAs should be familiar with IRS Regulations. However, CPAs and others similarly situated tend to accept the IRS Regulations as authority. IRS Revenue Rules simply do not apply to the valuation for purposes other than tax disputes.⁶ See Bernier v. Bernier 449 Mass. 774, 873 N.E.2d 216.

If you search for a business enterprise appraiser, you will find dozens listed as “business appraisers.” One such promotion offers a 10-page report that is “certified” by accredited appraiser, providing a “fair market value” calculation and an explanation of the value conclusion for a fee of $1,400. The word certified is overused and a misleading term of accreditation. Certified means warranted, credentialed. Accredited appraiser means some private association gave the appraiser a membership certificate. What is meant by a calculation and what is meant by value conclusion. A CPA only provides a conclusion of value because giving a researched opinion of value⁷ presents potential liability. There are a few CPA firms that provide independent professional appraisals, but most are stuck on using IRS business valuation rules and AICPA standards.

Business Brokers are in the business of selling businesses. Their approach is to sell the owner's discretionary income by combining the salary of management with the net cash flow and capitalizing the larger net to arrive at what they call enterprise value to a new owner.

What Are the Key Elements That Should Be Contained in A Business Enterprise Buy-Sell Agreement?

The old style buy-sell system just does not work. Seriously flawed agreements are worse than no agreement. A situation where there is no agreement or there is a flawed agreement can and usually does lead to a costly legal dispute. The key elements of a ‘buy-sell” agreement are the price, payment, timing, and the agreement should be set forth in clear language.

1. Define the Value standard. The appropriate standard of value if fair value as opposed to fair market value of market value⁸, etc. The standard of value in Massachusetts for shareholder dealings is fair value defined in Massachusetts General Laws 156D, § 13.01: The Massachusetts approach to the determination of “fair value” is consistent with the position taken by the American Law Institute and the national trend of interpreting “fair value” as the proportionate share of a going concern without any discount for minority status or lack of marketability. [American Law Institute, Principles of Corporate Governance, § 7.22(a) (1994)]. Also see Bernier v. Bernier 449 Mass. 774, 873 N.E.2d 216 and Koshy v. Sachdev, N.E.3d (2017) Mass SJC-12222 2017.
2. The enterprise value should be valued as a going concern using five years of historical net cash flow and there should be an analysis of the net asset value utilizing, if necessary, a revaluation of the assets and liabilities.
3. The valuation process description should identify the professional standards applicable. There are two standards of practice, the Uniform Standards of Professional Appraisal Practice Standards Rule 9 and 10 (USPAP).⁹ and the American Institute of Certified Public Accountants (AICPA) Statement of Standards for Valuation Services (VS§100).
4. Set the terms of payment which can be cash or note with payment over a term of years depending on the financial strength of the company at the time of the buy-sell sale.
5. Describe the Appraiser. The independent qualified outside business enterprise appraiser based on education, training, and especially experience in the valuation of private enterprises.

Disagreements Among Equity Holders of Family-Managed Businesses

Equity holders of family-managed businesses commonly develop disagreements and strong differences of opinion, which lead to heated clashes. These disputes are not unique to your specific family business, and they are especially common in second- and third-generation family-managed businesses. One way to avoid a legal dispute is to devise an effective exit strategy for shareholders before it is too late.

Family businesses represent 80% of U.S. privately-owned enterprises.¹ Businesses owned jointly by family members can and do survive and prosper. The oldest family-owned business in the United States is the Zildjian Cymbal Co. of Norwood, Massachusetts, which was founded in Constantinople in 1623. It moved to the United States in 1929 and continues to be managed by the Zildjian family. However, this is not the norm. Only about 30% of family-owned businesses survive into the second generation, and about 12% survive into the third generation.¹⁰

Why Do Shareholder Disputes Arise?

The primary reason for this failure to survive is that controlling shareholders often abuse their position by setting entitlement salaries and other types of compensation higher than industry norms, including setting up self-serving retirement plans, misusing company credit cards, and allowing for company-paid luxury vehicles, vacations, and club memberships. Often, controlling shareholders attempt to justify these fiduciary embezzlement schemes by claiming that the excess compensation is tax-deductible, and, therefore, lowers the corporate income tax.

Minority shareholders in closely held companies are usually resistant to litigation–the only source of recourse. They are often unsure whether they should bring a legal claim when things start going badly, often debating if the uncertainty and cost of a lawsuit is worth the potential benefits. Therefore, before you file a lawsuit, it is crucial to consult with a knowledgeable shareholder law attorney to ensure that you fully understand the potential implications and the remedies that are available to you.

Significant Massachusetts case-law exists relative to family shareholder disputes. In Donahue v. Rodd Electrotype Co. of New England, Inc. 328 N.E.2d 505 (1975), the court held that in close corporations, the relationship among the stockholders must be one of trust, confidence, and absolute loyalty and that shareholders owe one another a strict fiduciary duty. In Spenlinhauer v. Spencer Press, Inc. 81 Mass. App. Ct. 56 (2011), the court cited cases in support of its decision that the fair value of a minority interest was the pro rata value. In Shawnee Telecom Resources, Inc. v. Brown 354 S.W.3d 542 (Kentucky 2011), fair value was stated not as a hypothetical price at which the shareholder might sell his or her shares, but as the proportionate interest in the company as a going concern. Fair value does not consider what a hypothetical buyer might pay or what a hypothetical seller might sell. Rather, it considers the fair value to be a pro-rata share of the whole. In the Demoulas family shareholder feud, the conflict eroded a trusted family relationship and became the longest and most expensive shareholder dispute in Massachusetts.¹¹

Although it should be a critical component of business management curriculum, college courses seldom cover family-owned and closely held businesses. Such businesses typically face unique issues and challenges not usually encountered by publicly held enterprises. The family-owned business board of directors is usually filled by self-serving family employees. They usually have informal management rules and lack the formality associated with the three main functions of business: marketing, financial controls, and production. To survive or prosper, family-owned businesses require more formal management rules.¹²

Only a third of family businesses have buy-sell agreements. Most buy-sell agreements incorporated in the by-laws of the enterprise are defectively worded, boiler-plate prescriptions for failure. The best preventive legal medicine is an effective, achievable shareholder exit strategy in the form of a buy-sell agreement that is attainable! Do it before a shareholder dies, gets divorced, becomes seriously ill, or simply wants to leave the business.

People often start a business with friends or relatives. What happens if one of the shareholders, members, or partners becomes physically sick, tires of the business, dies, divorces, retires, or just wants to leave the business? The enterprise should have an agreement to enable its owners to end their relationship without litigation. Statutes and case law require the corporation or LLC to treat minority shareholders with a high degree of fiduciary good faith and loyalty. Owning 51% of the enterprise does not give you total control.

If you operate a corporate enterprise with two or more shareholders, you could face emotional and financial costs of a serious shareholder legal dispute over mismanagement, breach of fiduciary duty, overcompensation, or the value of the business.

What Is Your Situation?

Are you a minority shareholder who is considering the benefits of proactively creating a buy-sell agreement for your family's company? Are you contemplating a lawsuit based on a developing conflict? We can help in either situation. We have been providing business valuations for over 45 years in litigating business disputes.¹³

Two Examples of Shareholder Dispute Cases among the thousands.

Avon Tape, Inc. et al. v. Stephen J. Shuman. Mass Superior Court. Suffolk, Sep 27, 2004

This is an unfortunate suit by two closely held corporations, founded, and controlled by Howard Shuman against his son, Stephen Shuman, over matters relating to the businesses in which Stephen was once employed and/or had interests. Stephen has returned the fire with his counterclaims, upping the ante by naming Howard personally. The Court suspects that personal issues, rather than business considerations, may be dominating the situation and clouding the ability of father and son to reach an amicable resolution privately, rather than to slug it out in court.

 In Avon Tape, the terms under which the price would be set were ambiguous. The Company Buy/Sell Agreement required the purchase of shareholder's interest at book value subject to certain adjustments, within 60 days of the shareholder's retirement. What is ‘book value' with certain adjustments?

Employee resigned. The buy/sell agreement redemption provision reads as follows. Redemption. The parties hereto agree that, upon the occurrence of a Triggering Event with respect to a Shareholder, as hereinafter defined, the Corporation shall buy, and such Shareholder (or the legal representatives of his estate) shall sell, all his shares, upon the terms and conditions hereinafter set forth. a. Triggering Event. For the purposes of this paragraph, a Triggering Event shall mean: (ii) the Retirement of a Shareholder ..."Retirement" is defined to mean, among other things, "the cessation of a Shareholder's employment by the Corporation for any reason.” Further: "The closing of any redemption provided for shall take place at the office of the Corporation sixty (60) days after the occurrence of a Triggering Event, or at such other time and place as the Corporation and the Selling Shareholder or his legal representatives may agree."

Facts:

• Howard Shuman, the father of Stephen Shuman, is the founder, sole director and CEO of Avon and American Shoe. Howard owns all the stock in American Shoe and 88% of the stock in Avon. The remaining 12% of the Avon stock is owned by Stephen, subject to a Buy/Sell Agreement. Pursuant to the Buy/Sell Agreement, Stephen is entitled to purchase Howard's majority interest in Avon upon Howard's death.
• Also pursuant to the Buy/Sell Agreement, Avon is required to purchase Stephen's 12% interest in Avon, at book value subject to certain adjustments, within 60 days of Stephen's retirement from the company.
• Stephen was also an employee of Avon until his resignation on August 6, 2002.
• Similarly, Stephen was an employee of American Shoe, from which he also resigned on August 6, 2002. Additionally, Stephen had an option to purchase Howard's stock in American Shoe upon Howard's death. Stephen, however, does not own any shares in American Shoe.
• Further: "The closing of any redemption provided for [in the Buy/Sell Agreement] shall take place at the office of the Corporation sixty (60) days after the occurrence of a Triggering Event, or at such other time and place as the Corporation and the Selling Shareholder or his legal representatives may agree."
• By a letter dated June 20, 2003, Howard advised Stephen "that the corporate accountants had not yet determined the purchase price [of Stephen's Avon stock] and that [Howard] would let [Stephen] know when that determination has been made."
• Almost 10 months later, by a letter dated April 15, 2004, counsel for Howard wrote counsel for Stephen, advising that the accountants had completed their work and had determined the purchase price for Stephen's Avon stock to be $10,447.35. Howard's counsel asked for a suggested date for closing. On April 21, 2004, counsel for Stephen responded with a one-sentence letter stating, "In regard to your letter of April 15 would you please send me a copy of the calculations prepared by the `corporate accountants' you reference."
• The parties' papers suggest that the closing of the purchase of Stephen's Avon shares has not occurred, but do not reveal what, if anything, concerning that issue happened after April 21, 2004.
• The amended counterclaim recites, in general, that Stephen and Howard worked together in a relationship common in a family-controlled business. When Stephen would ask for a raise in pay, Howard is alleged to have told Stephen “That they were building the business together and monies for raises weren't available."
• Stephen further alleges that he resigned when "he learned the full extent of his father's bad faith conduct." Stephen then lists an array of things that he claims were improper acts by his father, including: diversion of corporate receivables to a Swiss bank account; charging Avon and American Shoe as corporate expenses charges for personal matters; draining profits by taking excessive bonuses and salary; conspiring with third parties to bill personal expenses to the companies; and paying his wife a $250 per week "no show" salary and health benefits.

Count I charge Howard with breaches of his fiduciary duty and duty of loyalty to Avon, American Shoe, and Stephen.

Count II asserts that Howard's actions have stripped Avon and American Shoe of value, affecting Stephen's rights under the Buy/Sell and option agreements. This count seeks an accounting and to have Howard repay "each company all monies wrongfully spent, charged, and taken or make an appropriate payment to Stephen of his share of those monies."

Count III charges Howard with conversion of "assets of business entities in which Stephen has a present or contingent interest," and claims that Stephen has been damaged thereby.

Count IV charges that Howard has brought the underlying action for the purpose of injuring Stephen, who is now a competitor, and that Howard "intends to use litigation for the improper purpose of driving Stephen out of business by financially ruining him." Stephen suggests that these actions are a violation of MG.L.c. 93A.

Count V asks for a declaratory judgment to the effect that because the 60-day period for closing on the purchase of Stephen's Avon stock was not met, the Buy/Sell Agreement has been breached, and Stephen may retain his stock.

Count VI alleges that the actions of Howard "violate the inherent obligations of good faith in regard to the Buy/Sell Agreement and the Option Agreement," causing financial losses to Stephen.

DISCUSSION. "Summary judgment is appropriate when, viewing the evidence in the light most favorable to the nonmoving party, all material facts have been established and the moving party is entitled to judgment as a matter of law." M.P.M. Builders, LLC v. Dwyer, 442 Mass. 87, 89 (2004); Kesler v. Pritchard, 362 Mass. 132, 134 (1972). Mass.R.Civ.P. Rule 56(c).

The essence of the grounds for summary judgment on the counterclaims is twofold: (1) that the claims are effectively derivative actions brought on behalf of Avon and American Shoe and Stephen must be a shareholder to bring them; and (2) that the c. 93A claim cannot survive "because this is an intra-organizational dispute."

The Court will assess the counts in reverse order, focusing first on the Chapter 93A claim. It reads more like a claim for abuse of process than a claim under c. 93A for an unfair or deceptive act or practice in the conduct of trade or commerce. A reading of the complaint, as amended, however, reveals in its face that the process is not being used to accomplish some ulterior purpose for which the process was not designed or intended, or that was not a legitimate purpose for the process employed. See, e.g., Ladd v. Polidoro, 424 Mass. 196, 198 (1997). If an abuse of process claim was intended, it fails on a simple reading of the complaint. Consequently, the Court assesses Count IV as a claim under c. 93A.

To prevail on a c. 93A claim, Stephen must prove that Howard — the only party charged in Count IV was engaged in "trade or commerce" in his dealings with Stephen. However, neither claims by an employee about his employer's conduct toward him, Manning v. Zuckerman, 388 Mass. 8, 12 (1983), nor transactions and disputes between shareholders in a close corporation, Zimmerman v. Bogoff 402 Mass. 650, 660 n. 1, 662-63 (1988), nor dealings confined to members of a single entity, Szulla v. Locke, 37 Mass.App.Ct. 346, 354 (1982), meet the necessary "trade or commerce" test for a c. 93A claim. At heart, this is an unseemly fight between a father and son over the spoils of a family business. It is not the kind of claim for which c. 93A was enacted. Count IV must be dismissed.

Most of the remaining counts, although suggesting damages to Stephen himself, have a distinct aroma of a shareholder's derivative suit. For example, Count I charge breaches of duty to Avon and American Shoe, as well as Stephen. Count II asks for an accounting and repayment to the corporations and, in the alternative, to Stephen. Count III seeks recovery of allegedly converted "assets of business entities." Only Counts V and VI speak solely to claims of Stephen's, as opposed to claims of the corporations.

Avon, American Shoe, and Howard argue that several of the counts do not articulate any discrete claims or theories that are uniquely "individual" to Stephen, and that the claims are, in substance, derivative. In Bessette v. Bessette, 385 Mass. 806, 809 (1982), the Supreme Judicial Court spoke to the issue as follows:

The plaintiffs argue that in this case a fiduciary duty is owed directly to them as minority stockholders. They contend that if a majority stockholder received distributions from a close corporation in the form of an excessive salary and payments on notes for which the corporation received no consideration, individual stockholders may recover on their own behalf. See Donahue v. Rodd Electrotype Co., [367 Mass. 578,] 578. However, our holding in Donahue applies if "it would be difficult for the plaintiff .to establish breach of a fiduciary duty owed to the corporation." Supra at 589 n. 14.

The SJC went on to hold that the "judge correctly ruled that the plaintiffs could assert their claims only as a stockholder's derivative action.” Bessette, supra 385 Mass. at 810.

What is presented here in Counts I, II and III of the counterclaims is like the situation in Bessette and should be treated accordingly. See also Crowley v. Communications for Hospitals, Inc., 30 Mass. App.Ct. 751, 764-65 (1991). A shareholder of Avon or American Shoe would not find it difficult to establish these various claims of the corporations and, therefore, these claims should be treated as derivative actions.

To bring a shareholder's derivative suit, the claim must be brought on behalf of the corporation "by one or more shareholders." Mass.R.Civ.P. Rule 23.1. See, e.g., Schaeffer v. Cohen, Rosenthal, Price, Mirkin, Jennings Berg, P.C., 405 Mass. 506, 513 (1989); Besette, supra, 385 Mass. 809-10.

Stephen concedes that he is not, and never has been, a shareholder of American Shoe. His option to purchase American Shoe stock upon Howard's demise does not make him a current shareholder for purposes of bringing a derivative action. See, e.g., Parkinson v. West End St. Ry. Co., 173 Mass. 446, 448 (1899); Pratt v. American Bell Telephone Co., 141 Mass. 225, 229-30 (1886). Stephen cannot, therefore, front a derivative claim on behalf of American Shoe.

Stephen's status as a shareholder of Avon is less clear. He resigned from Avon on August 6, 2002. This suit was not filed until January 7, 2004. Under the Buy/Sell Agreement, Avon was obliged to purchase all of Stephen's stock in Avon, with a closing to occur in 60 days from his resignation. That closing, as far as this Court understands, has yet to occur. Stephen argues, therefore, that there is a breach of the Buy/Sell agreement by Avon, and he remains a shareholder.

The issue of breach of contract has not been thoroughly briefed or argued. At this stage, this Court has serious doubts as to whether there was a breach of the Buy/Sell Agreement. It sees no section of the agreement suggesting that time was of the essence. Indeed, since there is a very real possibility that a death of a shareholder could be a Triggering Event, and the company would have to deal with an estate's representative, in all probability no representative with authority to act would be in place within 60 days of the death. Further, the Court has not been shown any demands or complaints by Stephen over the timing of the closing here. This does not sound like a breach of contract situation. See, e.g., Blum v. Kenyon, 29 Mass.App.Ct. 417, 420-21 (1990).

But even assuming there to be no breach, following the logic of the venerable cases of Parkinson v. West End St. Ry. Co and Pratt v. American Bell Telephone Co. cited above, the ownership of Stephen's 12% shareholder interest in Avon has yet to change hands. Stephen, therefore, can serve as a shareholder for the purposes of any derivative claims brought on behalf of Avon.

The matter does not end here, however. To bring a derivative suit, Stephen must comply with the provisions of Mass.R.Civ.P. Rule 23.1, including the more detailed pleading requirements and issues relating to making a pre-suit demand or explaining such a demand's futility. See, e.g., Harhen v. Brown, 431 Mass. 838, 844 (2000); Bartlett v. New York, N.H., H.R.R. Co 221 Mass. 530, 532 (1915). None of these issues was raised or briefed upon the present motion. They are, therefore, left for another day.

ORDER For the foregoing reasons, the Motion of Defendants-In-Counterclaim, Avon Tape, Inc. American Shoe Shank Co., Inc. and Howard D. Shuman, for Summary Judgment Upon Counterclaims, (Paper #12), is: (1) ALLOWED as to Count IV in its entirety, and as to Counts I, II and III insofar as they relate to derivative claims on behalf of American Shoe Shank Co., Inc.; and (2) DENIED in its entirety as to Counts V and VI, and as to Counts I, II and III insofar as they relate to derivative claims on behalf of Avon Tape, Inc. [Avon Tape, Inc. v. Shuman 18 Mass. L. Rptr. 329, 2d, 2004 WL 2341467 Mass.Super.,2004].

A Legal Case Demonstrating the Tragic Results of a Shareholder Dispute

The Supreme Judicial Court of Massachusetts issued a precedent-setting decision (Koshy v. Sachdev, SJC-12222 (2017) ordering the sale of the company to a third party or buy-out of one party's interests. decision made new law in private company shareholder disputes.

This shareholder legal dispute, known as Koshy v. Sachdv,¹⁴ tells the tale of friends starting a successful business and then developing a severe mutual animus that resulted in the court ordered demise of the business entity.

This case concerns the demise of a long-standing business relationship between two men who were once close friends.” The parties formed a company Indus Inc. in April of 1987. Later the parties established a subsidiary eSystems Software Pvt. Ltd. (eSystems), an Indian corporation, to provide support services to Indus. Koshy and Sachdy were equal shareholders of Indus Corporation. Each owned 49.9% interest and each a director. It was in fact like an equal partnership. They were both authorized to act on the company's behalf.

Sometime in the late 2000s, the relationship began to fall apart. They developed a fundamental difference of opinion concerning the future of the company. While Koshy wanted the company to focus primarily on its existing services for government agencies, Sachdev believed that it should explore new markets. Both parties viewed their counterpart's vision of Indus's future as gravely flawed. Koshy saw Sachdev's efforts to develop new markets as quixotic and costly, while Sachdev considered Koshy's focus on existing clients myopic and shortsighted. This difference in viewpoints bred growing distrust as well, as is evident from a dispute arising around 2010 in connection with payments made from Indus to eSystems. While Sachdev preferred to make prepayments to eSystems for services to be performed, Koshy favored payments only for services rendered. Koshy believed that prepayments, which could not easily be recovered due to jurisdictional obstacles, provided Sachdev with a means clandestinely to direct company resources into new projects. Notwithstanding Koshy's stated concerns, Sachdev routinely made prepayments to eSystems without consulting with Koshy. As these disagreements strained the parties' relationship, an incident in the fall of 2011 furthered its disintegration.

At that time, Indus had approximately $1.4 million in retained earnings. Koshy wanted this money to be paid out to himself and Sachdev as a distribution, while Sachdev did not. In November, Koshy wrote himself a check for $690,000 from Indus's corporate account, as a distribution, without Sachdev's consent. Koshy encouraged Sachdev, who was in India at the time, to take a matching distribution. Sachdev instead reacted by effectively locking Koshy out of the company. He initiated a lawsuit against Koshy on behalf of Indus, seeking a return of the distribution; stopped payment of Koshy's salary; terminated his company credit cards; and changed the locks on the door of Indus's offices. He also refused to consent to a tax distribution to the parties, as had been the practice in prior years.

A deadlock is more likely to occur in a small or closely held corporation, particularly one where ownership is divided on an even basis between two shareholder-directors. See comment to Mass.G. L. c. 156D, § 14.30, Section five of the Indus corporate articles provides a means to break a deadlock. That provision, however, requires the parties to agree upon an arbitrator who then will value the selling shareholder's stock. The Court said, “we discern no indication in the record that the parties would agree upon such an arbitrator, particularly given their previously demonstrated inability to agree on the price for a buyout of each other's shares.

Mass. Gen. Laws Ann. at 72 (dissolution remedy) The distinguishing features of close corporations make them particularly vulnerable to deadlock. Moreover, in closely held corporations, the lack of a ready market for a shareholder's stock and the greater likelihood that a shareholder is reliant on the corporation for a salary, tends to increase the potential for deadlock and accompanying oppressive tactics. See Donahue v. Rodd Electrotype Co. of New England, 367 Mass. 578, 588-589, 328 N.E.2d 505 (1975)

The Court, in Koshy, concluded that the fundamental nature of the deadlock between the parties threatens irreparable injury to Indus because the parties' mutual antipathy renders them unable to effectively manage the company. Their impasse regarding every major corporate decision has cast a cloud on Indus's future. The parties cannot agree on anything of substance. The palpably corrosive acrimony between them prevents them from functioning even in areas of theoretical agreement. Meanwhile, as their dysfunctional relationship continues to deteriorate, the parties repeatedly have resorted to costly litigation, in efforts to outmaneuver each other and gain the upper hand in steering the corporation. Resort to management by litigation is neither a viable means of corporate governance nor an adequate substitute for functional management and planning. The trajectory of Indus plainly points south, and a threat of irreparable injury has been shown. We therefore conclude that the parties' dispute constitutes a “true deadlock” within the meaning of § 14.30 (2) (i).

The Massachusetts corporate dissolution statute provided that a Superior Court judge “may dissolve a corporation.” The statute authorizes the “extreme” remedy of dissolution. The Court, however, concluded that the statute also authorizes lesser remedies, such as a buyout or the sale of the company as an ongoing entity. Brodie v. Jordan, 447 Mass. 866, 873 n.7, 857 N.E.2d 1076 (2006).

Shareholder Law

Shareholders in a closely held corporation may not act out of avarice, expediency, or self-interest towards their fellow shareholders.

Like partners, shareholders owe to one another a duty of “utmost good faith and loyalty.” Donahue. Accordingly, they may not “act out of avarice, expediency or self-interest” towards their fellow shareholders.

Shareholders in a close corporation owe fiduciary duties to both their fellow shareholders and the corporation itself. See Demoulas v. Demoulas Super Mkts., Inc., 424 Mass. 501, 528-529, 677 N.E.2d 159 (1997); Donahue, 367 Mass. at 593, 328 N.E.2d 505.

A “buy-sell agreement” is a contract that provides for the mandatory or optional repurchase of a stockholder's shares by the corporation or by the other stockholders upon the occurrence of a certain event,

In closely held corporations, two of the more common remedial mechanisms are buy-sell agreements and agreements providing for methods of alternative dispute resolution. “The most common deadlock solution ... is the well drafted ‘buy-sell agreement.'

Durkin Law, P.C. 59 Lowes Way, Suite 204, Lowell, MA 01851 (617) 720-0332

www.durkinlawpc.com

¹ Boilerplate clauses are standard, ready-made, simplified, broad, generic, reusable, legal clauses.

² Arbitration is a form of Alternative Dispute Resolution (ADR) wherein a professional arbitrator facilitates communication between two sides of a dispute. An arbitrator may be an appraiser or an attorney. The most effective arbitrators have knowledge of, and experience in, the subject of valuation in a dispute.

³ Fair Market Value is a commonly used term often misunderstood; The IRS Regulations officially use the term fair market value. In Massachusetts it is fair value, a pro rata share of the whole without any minority or marketability discounts and no consideration of a hypothetical buyer or seller. In Spenlinhauer vs. Spencer Press, Inc.81 Mass. App. Ct. 56 (2011), the court clearly articulated fair value as the standard under Massachusetts case law. The Massachusetts approach to defining “fair value” is consistent with the position taken by the American Law Institute and the national trend of interpreting “fair value” as the proportionate share of a going concern “without any discount for minority status or, absent extraordinary circumstances, lack of marketability.” American Law Institute, Principles of Corporate Governance: Analysis and Recommendation, § 7.22(a) (1994) (ALI Principles of Corporate Governance). In Spenlinhau the court cited a number of cases in support of his decision to apply fair value to the minority interest at the pro rata value. Quoting Shawnee Telecom Resources, Inc. v. Brown 354 S.W.3d 542 (Kentucky 2011), where fair value was stated “not as a hypothetical price that a hypothetical buyer might pay, but rather as the shareholders proportionate interest in the company as a going concern.

⁴ The phrase fair market value with the emphasis on “fair” is embedded in legal, economic, and tax literature than in economic literature. The IRS regulations use the term fair market value for application to decedent estates, gift taxes, and non-cash charitable donations. The banking regulators require the term market value defined as economic exchange-value. Fair market value, as a term, evolved from a 1909 California Supreme Court eminent domain case wherein the court held that the market value presented by the railroad was not “fair.”

⁵ IRS Rev. Rule 59-60 sets out eight valuation principles, IRS definition of value is fair market value as defined in the Code that simply do not apply to private shareholder issues. The IRS Rules and Tax Court are about government versus taxpayer disputes.

⁶ The IRS business valuation standards are applicable when a taxpayer is dealing with the IRS. IRS Revenue Rule 59-60 and IRS case law apply to taxpayer disputes and does not apply to an equitable division of a marital estate. Fair value is applicable rather than fair market value. Marketability and minority discounts do not apply, nor does the concept of a hypothetical buyer and seller.

⁷ The Uniform Standards of Professional Appraisal Practice (USPAP) defines an Appraisal as the act or process of developing an opinion of value, an opinion of value. CPAs avoid using term opinion.

⁸ There are many definitions of economic exchange value. The Bankruptcy Code has thirty-four definitions of market value, the banking industry by law FIRREA Title XI uses their own definition of market value. Insurance underwriters use replacement value and actual cash value. Torts can apply the term Peculiar Value.

⁹ See www.appraisalfoundation.org. The Appraisal Foundation sets the national Standards for Real Property, Personal Property, and Business Valuation. Most national appraisal associations require their members to perform in compliance with USPAP.

¹⁰ J.H. Astrachan and M.C. Shanker, “Family Businesses' Contribution to the U.S. Economy: A Closer Look,” Family Business Review, September 2003. Joseph Astrachan, Ph.D., editor, Family Business Review

¹¹ Demoulas v. Demoulas Super Mkts., Inc., 424 Mass. 501, 524-526 (1997)

¹² The Daily Drucker. Pages 394-95, Peter Drucker insight by Joseph Maclayiello, Harpers Collins, 2004

¹³ See Durkinvaluation.com for statement of qualifications.

¹⁴ Koshy v. Sachdev, N.E.3d (2017) Supreme Judicial Court of Mass. SJC-12222

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