Tuesday, April 24, 2018

'Pittsburgh History': Boring Name, Big Development for Attorney-Client Privilege


You represent a privately held corporation considering a restructuring. You believe that the proposed transaction would violate the securities laws and advise the board of directors accordingly. The board, however, disregards your advice and proceeds with the transaction anyway. It violates the securities laws as you advised and several shareholders initiate derivative claims against the board on behalf of the company. The plaintiffs propound discovery seeking your communications with the board related to the transaction. Can the company assert the attorney-client privilege against plaintiffs? Pennsylvania courts have been surprisingly quiet on this common issue until recently.

A company’s assertion of privilege against a derivative plaintiff creates the unusual problem of a client asserting privilege against those purporting to act on the client’s behalf. Moreover, the people invoking the privilege for the corporation are generally the same people whose conduct gave rise to the derivative claim. Allowing defendants to invoke the company’s privilege may deprive derivative plaintiffs of the information they need to vindicate the company’s interests.  A rule that allows a derivative plaintiff free access to otherwise privileged communications may impact the corporate client’s willingness to seek legal advice for fear that the request or the advice could later be used against it.

Any discussion of a corporation’s assertion of attorney-client privilege in the context of shareholder litigation begins with Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970). In Garner, a class of shareholders brought a derivative action on behalf of a corporation against various officers, directors and controlling persons. The plaintiffs sought communications between the corporation and its counsel relating to the conduct giving rise to the plaintiffs’ claims. The corporation asserted the attorney-client privilege seeking to prevent disclosure of the communications. Both the corporation and the American Bar Association, as amicus curiae, asserted that the corporation had an absolute right to assert attorney-client privilege in such circumstances. The plaintiffs took the equally extreme position that the privilege simply does not apply in the context of derivative claims.

The U.S. Court of Appeals for the Fifth Circuit rejected both positions and adopted a “goldilocks” approach that affirmed the applicability of the attorney-client privilege for a corporation involved in litigation with its shareholders, but allowed shareholder plaintiffs to pierce the privilege for good cause: The attorney-client privilege still has viability for the corporate client. The corporation is not barred from asserting it merely because those demanding information enjoy the status of stockholders. But where the corporation is in suit against its stockholders on charges of acting inimically to stockholder interests, protection of those interests as well as those of the corporation and of the public require that the availability of the privilege be subject to the right of the stockholders to show cause why it should not be invoked in the particular instance.

The court identified a nonexclusive list of “indicia” used to evaluate whether a derivative plaintiff has good cause for piercing the attorney-client privilege: the number of shareholders and the percentage of stock they represent; the bona fides of the shareholders; the nature of the shareholders’ claim and whether it is obviously colorable; the apparent necessity or desirability of the shareholders having the information and the availability of it from other sources; whether, if the shareholders’ claim is of wrongful action by the corporation, it is of action criminal, or illegal but not criminal, or of doubtful legality; whether the communication related to past or to prospective actions; whether the communication is of advice concerning the litigation itself; the extent to which the communication is identified versus the extent to which the shareholders are blindly fishing; and the risk of revelation of trade secrets or other information in whose confidentiality the corporation has an interest for independent reasons. Both the Restatement (Third) of the Law Governing Lawyers and the American Law Institute’s Principle of Corporate Governance: Analysis and Recommendations also adopted the substance of Garner.

There are two Pennsylvania cases addressing Garner. They reached contrary results and have not settled the law in this area. In Agster v. Barmada, 43 Pa. D. & C.4th 353, 359–60 (Com. Pl. 1999), Judge R. Stanton Wettick addressed a dispute among owners of a closely held business. A minority shareholder of a medical practice sued the majority shareholder for a variety of claims related to the majority’s diversion of business away from the practice. The minority shareholder plaintiff sought communications between the majority shareholder and the corporation’s counsel arguing that the attorney client-privilege does not apply to such communications. The court rejected this argument and prevented disclosure of the communication. Reasoning that the Pennsylvania Supreme Court had never recognized a conditional attorney-client privilege, the court expressly rejected Garner’s “good cause” analysis as inconsistent with Pennsylvania law.

The only Pennsylvania appellate court to address the attorney-client privilege in the context of derivative litigation did so on an unusual fact pattern. In Pittsburgh History & Landmarks Foundation, 161 A.3d 394 (Pa. Commw. Ct. 2017), a group of former board members of two related nonprofit corporations asserted derivative claims against the president and current board members alleging a variety of misconduct. In response to the lawsuit, defendants formed a committee to evaluate whether the derivative action was in the best interest of the nonprofit corporations. The committee determined that the litigation was not in the best interest of the corporations and defendants filed a motion to dismiss the derivative claims on that basis. The plaintiffs sought all the information provided to the investigative committee, including communications with counsel that would otherwise be privileged. The Commonwealth Court explicitly rejected the holding in Agster and adopted Garner’s “good cause” analysis. It emphasized that the possible exception to privilege only applied to communications that were “roughly contemporaneous with the events giving rise to the litigation,” presumably excluding communications that occur after a derivative plaintiff files suit.

The Pennsylvania Supreme Court granted cross-petitions for allowance of appeal from the Commonwealth Court’s decision and heard oral argument on April 11. If upheld, Pittsburgh History has obvious implications for both derivative plaintiffs and corporate counsel. For the derivative plaintiff, the case provides the potential to access a variety of highly relevant communications regarding the conduct that gave rise to their claims. For corporate counsel, the case injects uncertainty as to whether the attorney-client privilege will apply to communications with a corporation in the event of shareholder litigation. Counsel should advise their client of this possibility and, in the context of a closely held company, consider whether a majority owner should obtain personal counsel in circumstances where the majority owner wants to ensure the application of the privilege.

Reprinted with permission from the April 20, 2018 issue of The Legal Intelligencer. 
© 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. 
All rights reserved.

Wednesday, March 28, 2018

What You Need to Know When Representing a Minority Shareholder in a Corporate Dispute


You represent a minority shareholder of a closely-held corporation and the company is having an off year. The majority shareholder is the sole member of the board and serves in every officer position. She draws significant compensation. Without a business justification, she decides to double her salary and have the company pay the mortgage on her vacation home. Your client is the only other shareholder and likely the only person hurt by the majority shareholder’s self-declared raise. Although the minority shareholder suffers a clear injury, characterizing the injury as direct or derivative can have a significant impact on the outcome of the litigation.

Until recently, minority shareholders in closely-held companies could assert claims for breach of fiduciary duty and corporate waste directly against the majority owner. If the claimant was successful, a court could order the majority shareholder to disgorge the spoils of her behavior and pay them to the minority shareholder. This type of direct recovery is no longer permissible.  Since 2014, Pennsylvania courts have made clear that claims arising from breach of the duties owed to a corporation, even a closely-held one, belong to the corporation and must be asserted on a derivative basis. This requirement creates procedural and substantive complexities when compared to direct claims. Bringing such claims requires strategic and creative analysis and careful attention to detail.

Without a shareholder’s agreement, minority shareholders are largely at the mercy of the majority shareholder. Minority shareholders have no formal ability to direct how the company spends money, compensates employees or hires vendors. Some majority owners use their power to disadvantage the minority shareholder by excessively compensating themselves or causing the corporation to contract with vendors affiliated with the majority on unfair terms. Although the minority shareholder is the party ultimately damaged by this behavior, the Pennsylvania Business Corporation Law (“BCL”) makes clear that “[t]he duty of the board of directors … is solely to the business corporation … and may not be enforced directly by a shareholder.” To obtain redress for the majority shareholder’s misconduct, the minority shareholder is therefore required to assert their claims on a derivative basis on behalf of the corporation. 

In this regime, attorneys representing minority shareholders are required to look for opportunities to assert direct claims in lieu of derivative claims. The same facts that support a derivative claim may also be the basis of a direct claim. This is particularly common when the minority shareholder is involved in the operation of the business.  For example, claims arising from the wrongful termination of a minority shareholder’s employment may form the basis of a direct claim on behalf of the minority shareholder, as well as a derivative claim against the majority shareholder for the breach of duty of care owed to the company. 

Shareholder oppression claims are direct claims and may provide a viable method for a minority shareholder to obtain an individual recovery. Pennsylvania has long recognized that a majority shareholder has a quasi-fiduciary duty not to use their power in such a way as to exclude the minority shareholder from the “benefits accruing from the enterprise.” Carefully structured, a shareholder oppression claim can often address the same conduct that a court might otherwise classify as giving rise to a derivative claim. A claim that a majority shareholder increased their compensation to a level that leaves no profits available to be distributed to shareholders is likely a direct shareholder oppression claim. It may also be a derivative claim if the compensation is excessive by objective measure.

Fraud claims against majority shareholders may also be asserted directly if they arise from a misrepresentation made to the minority shareholder. The misrepresentation, however, must not be related to malfeasance in relation to the company. For example, misrepresenting the financial status of the business to induce a minority shareholder to invest additional capital that is subsequently lost is likely a direct claim. Falsely representing the terms of the majority shareholder’s excessive compensation is likely derivative because it is so closely related to the breach of the majority’s duty owed to the company itself.

When developing claims, keep in mind that counsel’s labeling of claims in pleadings as direct or derivative is not dispositive. Courts look to the substance of the allegations to determine the nature of the wrong.

The distinction between direct and derivative claims presents a variety of challenges in the context of closely-held business disputes. Recognizing the issue at that outset of the litigation and developing theories for asserting direct claims is critical to the successful representation of the minority shareholder.

Reprinted with permission from the February 28, 2018 issue of The Legal Intelligencer.
© 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.


Thursday, February 22, 2018

Improve Your Writing in the Time it Takes to Read This


“It is perfectly okay to write garbage—as long as you edit brilliantly.” – C. J. Cherryh

Many people think that litigation involves a Perry-Mason cross examination or Jack Nicholson losing it on the stand.  We love courtroom dramas too but the truth is, if you can handle it, is that most commercial cases resolve after a judge decides a client’s case based on written submissions.  This means that in most cases we are professional writers, presenting our clients’ cases not in the courtroom but through written briefs.

Although legal writing can be technical, good writing is good writing.  The same techniques we use to persuade judges are techniques our clients and friends can use to persuade their team, their boss, their board and their clients.  Here are 5 simple tips that will improve your writing right now.

Outline Everything

We outline every brief before we put pen to paper.  In fact, we outline almost everything.  Letters, substantive emails, even this blog post gets outlined.  Your outline does not have to be long.  The outline for this post is scribbled on the back of a magazine. 

The outline does more than organize your writing, it organizes your thought process.  There have been a number of times when we were headed in one direction only to go another after playing with an outline for an hour.  Bad writing is often a result of fuzzy thinking.  If you skip your outline, it will take you twice as long to straighten yourself out.

The more detailed your outline the more detailed your thinking.  Try to make the subject headings in your outline as detailed as possible.  Use a declarative sentence if possible.  Even if you decide not to create separate sections in your piece, using headings in an outline will help to keep you on track.

Learn to Stop Worrying and Embrace the Ugly First Draft

Our best finished product usually starts with an ugly, near stream-of-consciousness, first draft.  Do not even consider rewriting sentences or correcting grammar this round.  We will sometimes simply close our eyes while typing out the first draft to avoid the temptation.  It also has the added benefit of not having to look at the scary empty white space on the page.  Some of us will dictate a first draft. 
The point is to let your ideas flow unimpeded.  Don’t worry about missing punctuation, words or even sentences.  Once you grind out that ugly first draft, put it down for the day without editing or refinement.

When you pick it up again is when writing starts to get more fun.  You can start filling the inevitable gaps, improving flow and adding pithy one liners where appropriate.  If you try to skip the ugly first draft, it never turns out as well.

Stop Using Passive Voice

We have all heard this before but it is true.  If you are not sure whether you are writing in the passive voice ask yourself, “who is the actor in this sentence?”  For example, “plaintiff’s motion should be dismissed.”  Who should be doing the dismissing?  You can’t tell from this sentence and so know it is in the passive voice.  The active voice doesn’t hide the actor – “the judge should dismiss plaintiff’s motion” – and it makes for better writing.  It sounds better and provides more information.

If you find yourself using the passive voice often, consider whether you have an issue with your writing or your thinking.  When we find ourselves using the passive voice, it is often because we do not fully understand our topic and are using the passive voice as a crutch.  Who is the actor in your sentence?  If you do not know, you may need to clean up your thinking.

Please, No Corporate Speak, Made Up Words or Weblish

Corporate speak, made up words and “weblish” continue to work their way into our lexicon.  They do not have a place in your writing.  If you use corporate speak, your reader may not understand you.  Using the word “solution” to describe a product (often software) is a good example.  “We sold the customer a solution that will help them extract more useful information from their database.”  Rather than use a not so subliminal marketing tool, just describe what you sold.  If you use made up words (“I would guestimate that…”), you risk looking like someone who does not have the command of the English language needed to express themselves.  If you use weblish, you sound like a computer (“I don’t have the bandwidth for that…”).

You can usually avoid these issues by asking yourself a few questions.  If I used this term with a family member who knows nothing about my business, would they understand me?  If I looked in a dictionary, would this word appear?  Was this word or term in existence in 1970? If the answer to any of those questions is “no”, then keep it off the page.  

Lose the Adverbs Unless They Really Change the Meaning of Sentence

We are habitual offenders of this rule and often slash “-ly” words from our first drafts.  Overuse of adverbs tends to make your writing wimpy and bloated.  Use them sparingly and only when they change the meaning of a sentence.

The first sentence of this section is a good example.  Removing the adverbs “habitual” and “often” does not change the meaning of the sentence and removing it makes for a stronger sentence: “We are offenders of this rule and slash ‘-ly’ words…”

You can also reduce the tendency to overuse adverbs by using more descriptive verbs.  Rather than saying “he shook my hand very firmly,” you could say “he crushed my hand.”  Using a stronger verb allows you to remove the adverb “firmly.”

Conclusion

Good writing takes time but little changes can have an immediate impact.  Try these the next time you have a scary blank page in front of you.

Thursday, January 11, 2018

When Forming a Business Entity, Equal Partnership Isn't All It's Cracked Up to Be

“The worst form of inequality is to try to make unequal things equal.” ~Aristotle
              
Aristotle got it right. Some things were not meant to be equal. One quarterback should call the play. One physician should determine the treatment. And one person should steer the ship. Sometimes egalitarianism leads to impasse, confusion and even disaster. Yet, every month enthusiastic clients ask for assistance in setting up new businesses.  The conversation goes something like this: “My partner and I have a great idea for a business!  We want to form a company! We want to split everything 50/50!” 

There is a certain appeal in a 50/50 ownership split.  An equal split means “we share the risks, we share the rewards and we’re in this together!”  Splitting equity equally suggests obvious analogies to a marriage and - like marriages - creates the expectation that the business arrangement is “until death do us part.” Dividing ownership interests equally also avoids awkward conversations about the value of each partner’s contribution and the compatibility of individual goals.

Unfortunately, as in marriages, some business ventures do not work out. Management styles may clash and the business may outgrow the talents of its founders. Partners may pursue divergent personal and professional goals. One partner may be in search of a “lifestyle” business - a business that is essentially a life time job - while the other may be a “serial entrepreneur” intent on starting-up and selling out. In the most extreme examples, a business owner may find his or herself partnering with an irrational or self-interested owner, who puts his own needs ahead of the demands of the business.

Any Decision is Better than None

When managerial control is evenly divided between owners, there generally must be unanimous agreement before the business can act.  In the case of strategic decisions such as entering a new market, hiring a high level executive, or borrowing money, the need for unanimity may result in stalemate. Disagreements over strategic decisions may well reflect good faith differences of opinion in how the business should operate. At worst, however, a disgruntled fifty percent owner can use the veto power to exact concessions from a co-owner that have little to do with business strategy. An owner who is piqued at a partner can refuse to pay employee wages, vendors or company debts unless the other owner accedes to his or her demands.  An owner with signing authority at a bank can abscond or move money out of the other partner’s reach. Feuding owners that give conflicting directives to employees makes for a particularly toxic work environment. Employees may be forced to “choose sides” or decide to look for new jobs.

Once the internal dissension becomes public, third parties may decide to take a defensive posture to avoid being “caught in the middle.” Banks, payroll companies and other vendors may refuse to act without the authorization of both owners. The process can be cumbersome, frustrating and damaging to the business. Customers may be reluctant to make further commitments to an entity whose days seem numbered. Over time, the inability to reach any decision might be more damaging than implementing the “wrong” decision.

But Our Operating Agreement Says That…

There are a variety of devices that can be included in operating agreements and other organizational documents to help reduce the perils of 50/50 ownership. While such provisions offer some relief, they are not a panacea.

Many operating agreements contain “shoot out” provisions. Such provisions allow an owner to offer to purchase the other partner’s interests at a formula price or at a price determined by the offeror.  In the event the offer is rejected, the situation is reversed: the other partner is required to purchase the offering partner’s interests for the same amount.  While such provisions may offer an opportunity for “uncoupling” incompatible partners, there may be practical limits to their efficacy. A purchasing owner must have the financial resources to complete the buyout.  Privately-held businesses may be difficult to value and may not be able to attract third-party financing. Borrowing to fund the buy-out may also weaken the company’s financial posture and potentially trigger defaults with existing bank loans.

Even if an owner is successful in selling his fifty percent interest to the other owner, there may still be continuing obligations to the business. The sale of his or her interest will not extinguish an owner’s obligations under a personal guarantee. Third party creditors may have no incentive to release a departing owner from his guarantee obligations to the business.

When amicable negotiation fails to resolve 50/50 disputes, the parties frequently litigate. Unfortunately many county courts are unfamiliar with shareholder disputes. Some courts deal with fewer than a dozen commercial cases each year.  As a result, the tendency of the court is to act slowly and cautiously, which can prolong the often daily combat between owners and frustrate normal business operations.

The Takeaway

When considering a 50/50 split, understand that a dispute between the owners can have a crippling effect on the business that cannot be wholly mitigated by dispute resolution techniques.  While there are many ways of starting the discussion about equity distribution, one approach is to identify and weight key attributes necessary for business success and then evaluate each partner against such attributes. While such percentage weightings are not necessarily dispositive of equity ownership, they offer an objective approach to discussing roles and responsibilities. Such an exercise may also highlight talent “gaps” which must be filled for the venture to be successful. Allocating a percentage of ownership for future managers and deciding how that will affect the existing owners may make recruiting of high level talent easier and more efficient.

Frank, honest conversations at the beginning of a venture can build trust and lay the foundation for effective collaboration. Recognizing differences in talents, resources, management styles and commitment can lead to proportionate - and appropriate - equity distribution. In a business venture, the greatest inequality really is the effort to make unequal things equal.