GPSolo Magazine - April/May 2004

Beyond the Basics:
More Danger in Forming a Business

Events prompting changes in business organization are everywhere in today’s business world, where takeovers and defeats occur with headlining regularity, and in many cases even a well-established business may find itself needing the services of a business organizational or transactional lawyer—and in a hurry.

Events prompting such changes can be both external and internal. External factors include new business relationships, business lines, legislation, tax status, and facility locations (especially if they involve new states, territories, or nations). Internal factors may arise from management succession, owner succession, and consolidation. This article focuses on a few common circumstances that illustrate how lawyers can best help clients at this phase of their business development.

In documenting and incorporating changes to the business entity, the lawyer must before all else identify the client for purposes of conflict management and tracking. And in a milieu where success helping one client results in referrals to that client’s owners, friends, and business associates, this is sometimes difficult. Even with a solid software system and the best intent, a lawyer may find it hard to balance offending present and potential clients and the professional and ethical constraints of the legal profession. Once through this hurdle, however, the lawyer can move into analysis of and action on the client’s new needs.

Joint Ventures

Two companies that agree to develop and market a new product may want to go ahead and create a joint venture. Although dressed up in sometimes lengthy agreements, the joint venture is essentially a general partnership (although perhaps more limited in scope and duration than a traditional one), unless the parties establish a formal entity as part of the new formation. In joint ventures, the parties share profits, losses, and control; thus such arrangements can be hazardous from an assumed liability standpoint. As in a general partnership, the venturers or partners are liable in full—in addition to the assets of the joint venture or partnership—for claims arising in both tort and contract. Owing to default general partnership rules, ownership through a specific entity or as a result of establishing a separate entity structure is recommended.

Like partnerships, limited liability companies, and limited liability partnerships, joint ventures have significant freedom of contracting. Variations may occur as a result of how any of the following factors are drafted and implemented: purposes of the joint venture; limitations on fiduciary duties of investors; limitations on scope of the venture; relaxation or restriction of rules on business dealings between the investors and the joint venture; method of contribution of capital; methods of control and management of the entity and processes; buyout provisions; dissolution provisions; capital allocation; withdrawal from the joint venture; transferability of interests (or lack thereof); admission requirements for new investors; methods of dispute resolution or preventing deadlock; and dissolution processes.

In addition to variances in the agreements (contract variances), the second major area of potential differences involves the prevailing law of the state or country in which the entity is formed. The mix of these factors makes generalizations the order of the day, rather than specific applications as often occur for more standard corporate structures.

Limited Liability Limited Partnerships

Limited liability limited partnerships (LLLPs) are a newer form of entity that is gaining increasing acceptance. LLLPs provide a mechanism for going through capitalization or insurance provisions, registering with state agencies (typically a specific secretary of state), and enjoying limited liability. Having jumped through appropriate legal hoops, the general partner of an LLLP does not have personal liability for business entity operations, as would a general partner of a traditional limited partnership.

Although numerous states and the District of Columbia have passed enabling statutes for LLLPs, a substantial range of legislative difference is apparent. For instance, New York and California exclude limited partnerships from becoming LLLPs, but other states do not. Illinois and other states allow LLLP election by a limited partnership without specific statute, citing to the Revised Uniform Limited Partnership Act (RULPA). In such a state, the purpose of the election would be to protect the personal liability of a general partner in the limited partnership. In the event of an entity general partner, whether a limited liability company (LLC) or a corporation, the benefit may be of small consequence.

If the limited partner takes an active role in management, which ordinarily would make the limited partner generally liable, a second benefit to seeking LLLP status would attach, which is still more protection against liability for the limited partner. However, if the limited partner needs to take an active role in management, other avenues are possible, including formation of a separate LLC or corporation added as a general partner, through which the individual or entity may act.

Another scenario in which LLLP would be desirable covers the commonly encountered estate planning area of a family limited partnership. In this instance, a general partner may be the individual who desires to reduce estate tax liability by transferring assets into a limited partnership and then over a period of time transferring limited partnership interests to children or other beneficiaries. The individual retains operational control as a general partner. The estate tax benefit, frequently challenged on valuation by the IRS, is that the limited partnership interest may be illiquid, without an established market, and subject to discounts for lack of control. These reductions in valuation of the limited partnership interest reduce the estate taxes that might otherwise be due at the time of death on amounts over the 2004 federal limit of $1.5 million.

LLLP status adds significantly to the planning toolbox. It is part of an overall business movement to add flexibility and limited liability options. However, confusion with regard to state-to-state variances and differences in statutes, recognition, and registration processes will limit the LLLP entity until more uniformity develops in these listed areas.

Mergers and Acquisitions

Mergers and acquisitions is the area in which a business acquires the assets (with or without liabilities) or stock or membership interest of a corporation, a limited liability company (LLC) general partnership, or a limited partnership (LP). In acquisitions involving a limited partnership, one may seek to acquire assets or ownership interests of the general partner(s) or limited partners, together or separately.

After acquiring existing assets, the purchaser generally is given a step-up in tax basis for the purchase, and the liabilities assumed are thus easier to quantify. Frequently this is a preferred method of acquisition for the purchaser because the due diligence list may be shorter and the liabilities are more easily limited to a specified listing. If the ownership position is purchased, whether through corporate stock or membership interest, a step-up in tax basis generally does not occur, and the purchaser carries over the existing tax basis. This often is a preferred method for the seller because it may be more advantageous for tax purposes. The purchaser more frequently is at risk owing to the potential for unknown or contingent liabilities to transfer with the ownership interests.

In the event of a merger or acquisition involving a general partnership or limited partnership, the general partners have continued personal liability for the liabilities, even post-merger, and this must be safeguarded in representing the purchaser. Due diligence for a purchaser of a limited partnership interest pays off and should include attention to unpaid contributions and to the likelihood of an additional assessment to the limited partners.

Under Texas law, the acquirer of a general partnership may not be accountable for pre-closing liabilities. However, the distinguishing features and implementation of the pre-closing and post-closing liability distinction can become unclear. Frequently a solution is built into the contractual indemnification language in the event of a well-capitalized acquirer, but confusions also can be dealt with by set-asides or escrows, through which the purchaser puts up additional money or standby letters of credit to secure the obligation. Another solution is to obtain releases from creditors, but the identification of creditors, logistics involved in creditor identification, and the level of cooperation of the creditors in this approach can vary.

Mergers or acquisitions in the non-corporate environment require special considerations, although the functions are similar. One of many key issues is that the statutes may not specify which procedures to follow, leaving parties to rely instead on contract law as embodied in the entity’s formative documents. A key issue in the instance of a foreign entity (whether a state or nation) merger or acquisition is that foreign statutory review is required to determine prohibitions and necessary procedures under the state of formation (and treaties, if a foreign nation). If the foreign governing statutes prohibit or restrict the merger or acquisition, a two-tiered or other more complex strategy may be required.

Procedurally, a merger or acquisition requires the approval of specific persons in advisory and ownership roles. A corporation must obtain approval by the directors and shareholders. An LLC or LP has considerable freedom to contract for provisions regarding the merger or acquisition and any required approvals. Generally, the managers of an LLC (if they exist) function as a “corporate” board of directors and must approve the action. For LPs, the general partner (one or more) and the ownership (the limited partners) generally approve a merger or acquisition, subject to contract variances. Unless otherwise stated in the formative documents, LLCs and LPs generally have no structure for appraisal rights and no other formal structure for minority dissent.

In addition to internal approvals by the acquiring and acquired entities, and dependent on the size and type of business, government approval may be required. In industries that are closely regulated by entities such as the Federal Communications Commission or the Office of the Comptroller of Currency, the external approval process may be required for small transactions. In industries with significant market consolidation, the approvals may include documented compliance with the Hart-Scott-Rodino Act or other statutes. The business entity’s permits or licenses also may create external approval requirements.

In addition to governmental approvals, mergers or acquisitions may create contractual approval requirements among external vendors or customers of the entity. These may include consent or approval by the lender, landlord, or another lessor, and occasionally the approval of a customer. I have most frequently encountered approval requirements within the Department of Defense, although they arise in other areas with output or requirements contracts in place.

Mechanically, the merger process requires the adoption of a formal plan of merger. Once the merger is to be finalized, articles of merger generally are filed to document the completion. This general plan of action follows regardless of the type of entity involved.

Conversions

Conversions from one entity to another follow a pattern similar to that for mergers in that the entity has a plan of conversion and, after it is implemented, files articles of conversion with the appropriate state agency (generally the secretary of state). The agency then issues a certificate confirming the conversion. Conversions commonly occur with general partnerships, corporations, limited liability companies, and limited partnerships.

Businesses convert from a current type of entity to gain the advantages of the other structure. The advantages can be in the area of liability, federal tax, or state tax.

Liability advantages are most apparent when converting a general partnership to eliminate unlimited personal liability of the partners. An example in federal tax savings would occur when converting a corporation to an LLC, in that pass-through taxes for that entity might be more advantageous to the owners. With regard to state taxes, substantial state variance exists; in Texas it has become common for corporations or LLCs to convert to limited partnerships in an effort to save franchise taxes (the Texas version of corporate income tax). Efforts to change the law during the last legislative session were not successful in Texas, so it is still a viable option.

Conversion of an entity generally does not impair prior creditors. Pending litigation does not require restyling, and the liability of a pre-conversion entity flows through to the new entity. Similarly, the assets of the pre-conversion entity flow through, without transfer or restyling, to the post-conversion entity without requiring further action.

Effects of Bankruptcy, Insolvency, or Near Insolvency

If an entity is not doing well and nears the point of potential insolvency, additional fiduciary duties accrue to management and advisers. Ignoring these duties risks personal liability on the part of management and advisers. In general terms, a corporate director owes no particularized duties to a creditor. If the corporation is insolvent, however, a fiduciary duty is owed by both the directors and officers because the creditor stands to get paid before owners in such a circumstance.

Actions that benefit management or owners to the detriment of creditors can create personal liability in the zone of insolvency. The term “zone” is used intentionally because the test is not actual insolvency but near insolvency. Unfortunately for the officer and director, there is no bright-line rule to follow in removing this as a potential concern. The inquiry becomes fact-laden and specific, lending itself to considerable litigation expense when allegations are raised. Accordingly, if a company approaches insolvency, actions and inactions require additional documentation and examination to prevent the expansion of liability to a personal level for the directors and officers.

Generally such fiduciary duties are analyzed in bankruptcy court, as with Enron and the other corporate debacles. Although some of the Enron inquiries include criminal proceedings, and these cannot be discounted, it is more common for allegations to reach out to claim the assets of directors or officers who are alleged to have violated their fiduciary duties to creditors. In these civil complaints—frequently tried as adversary matters in bankruptcy court—the risk is not incarceration but divestment of assets of the directors, officers, or other advisers. If the entity representatives were assisted by professionals such as accountants and lawyers, the inquiry can expand to attempt personal liability from them as well. A prudent practitioner should be extremely cautious in “near insolvency” circumstances for these reasons.

Darrell G. Stewart practices law in San Antonio, Texas. He can be reached at darrell.stewart@abanet.org. His article “Danger: Business Arrangements Ahead,” which covers the basics of business formation, appeared in the April/May 2003 issue of GPSolo.

 

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