Bottom Line Business Insights : Maryland Business Lawyer & Attorney : Wagonheim Law Firm : Mergers & Acquisitions & Contractual Negotiation

The addition or removal of a principal in any business, especially one with fewer than 500 employees, is one of the most important events in a company’s development. How well it is accomplished, both from a moral and a financial perspective, often dictates whether the business will succeed or fail. For this reason, every business owner should know two things: (1) such change is inevitable; and (2) the question of success or failure hinges upon advance preparation.

First and foremost, it is imperative that if a business has more than one owner, the principals should create and sign written agreements detailing:

• When and how any principal can go about leaving the company;
• The amount of money (either stated outright or derived through an agreed formula) the departing principal is to receive, if any;
• How a buyout is to be structured;
• Post-separation obligations;
• The conditions for bringing on a new principal.

When the subject of Buy/Sale Agreements or Stockholders’ Agreements comes up, most people envision a 50 page single spaced contract written in Latin by an attorney at the cost of tens of thousands of dollars. Fortunately, unless we are talking about a Fortune 500 company, this is simply not the case. A skilled attorney will work with the company’s principals to create an agreement which reflects their beliefs and company culture and, most importantly, is written for the non-lawyer.

The necessity for these documents is especially true where the principals are family members or close friends. Where money is concerned, few things preserve a relationship like a clear written agreement prepared well in advance of any issue that may arise.

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It’s every business owner’s worst nightmare: the company bookkeeper, who has been a loyal employee for eight years, has suddenly disappeared – along with $250,000 of the company’s money. Unless the company has the resources and know-how of the FBI, there is little that the company can do in such a situation. For the year, the company will end up taking a charge against earnings (which will affect its bottom line), and may have some explaining to do to agitated shareholders (who will wonder where their annual dividend is) and upset employees (who will not be receiving Christmas bonuses).

Yet as bad as this situation may be, it could be worse. In fact, having a one-time fraud committed by an employee or officer who then disappears will at least provide the business owner with a finite loss and a red flag with respect to gaps in company procedures that need to be remedied. Infinitely worse is a “creeping fraud,” a situation where your company’s Chief Financial Officer has been quietly diverting $5,000 each month into an out-of-state bank account which he controls, and after 10 years retires and buys himself a villa in Italy. In a creeping fraud, a dishonest employee exploits a continuing company weakness over an extended period of time; which is a bigger violation of the company’s trust, not to mention its financial position.

However, it is not only a company’s employees who may have the impetus and wherewithal to commit fraud or embezzlement. Often, fraud is committed by other entities with whom the company does business, including the company’s contractual or transactional partners, vendors, and even customers and clients.

It doesn’t have to be this way. In fact, it should never be this way. With proper planning and certain simple and easy-to-implement procedures, a business can make itself virtually “fraud-proof.”

Here are 5 ways to Protect your company from Fraud and Embezzlement:

1)      Ensure that all disbursements over a certain amount (say, $1,000) require the signature of more than one company officer

2)      Check (and re-check) your company’s numbers every month with your accountant to ensure there is no “creeping” fraud or unexplained irregularities

3)      When signing a material contract with a contractual counter-party, consider using an escrow arrangement for any sums to be advanced prior to completion of work or services

4)      Resist attempts by contractual counter-parties to be paid in advance for work to be performed or products to be provided – instead, set benchmarks for performance and pay in installments once benchmarks are achieved

5)      Do some basic due diligence on your contractual counterparts. Do they have any judgments against them? What do other companies who do business with them say about them? Does your customer have an in-state bank account? Have you done a credit bureau check on your counter-party?

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Every month, I ask our Empty Hourglass Clients to meet with me, free of charge, so that I can keep a better handle on their businesses and answer any questions they may have. You see, many business owners have questions that arise in the day-to-day operation of their companies which, while important, do not seem to rise to the level of immediacy required for the payment of legal fees. So the questions sit…unanswered. The issues remain unaddressed. And frequently, though not always, large problems grow out of what could have been minor inquiries.

I have noticed a trend in these meetings. In more than half of them, my clients ask me if I would review their Personnel Manual/Employee Handbook. 

In view of this trend, I thought it might be beneficial to list and comment on one of the most common issues I have found in company after company … industry after industry:

The Manual Should Reflect Policies, Not Aspirations

The purpose of the Manual is to describe the rules by which the company operates. Time and time again, after reading a company’s Manual, I find myself asking clients “is that really what happens in your company?” Often, the answer is “no.” Maybe there is no formal procedure such as that described in the Manual.  Many there are no written forms or step-by-step investigatory approach. 

That’s OK. Many companies have not formalized their processes. My recommendation, however, is that management take the time to figure out small, doable steps to put into place and describe them.  By spending page after page describing procedures which everyone in the company knows will never take place, the company has generated a Manual that is simply not worth the paper it’s printed on.  Other than double checking paid holidays and the amount of vacation, the rest of the Manual is just wasted words on useless paper.

If you’re wondering whether your Personnel Manual needs an overhaul…or even if you’re thinking of writing one for the first time, take a look at any sections which detail company procedures – from requesting Paid Time Off to describing disciplinary procedures – and ask whether the words on the page reflect what happens in reality.  If not, change one or the other.

Because when it comes to Personnel Manuals, Shakespeare was right: 

To thine own self be true.

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To many business owners, the question of “legal structure” begins and ends with the completion of a pre-printed form from Office Depot and the payment of a nominal filing fee to the State Department of Assessments and Taxation. The fact of the matter is that many business owners leave money on the table by failing to select the right business entity when they start out or by forgetting to reexamine their choice at different stages in the company’s development.

There are three primary reasons to select a business entity:

1. Tax considerations;
2. Day-to-day operations; and
3. Exit strategy. 

Sole proprietorships, limited liability entities, S corporations and partnerships are the so-called pass-through entities in which profit and loss are taxed at a personal level for the owners. Other entities, of which there are many, are subject to different tax treatment. The failure to match the type of business to the legal structure can result in significant (and often unnecessary) tax liability.

Depending upon the type of business, limited liability entities and corporations are often vastly preferable to other structures inasmuch as they insulate their owners from personal liability for acts of the entity. An owner’s personal assets (such as a house, cars, bank accounts, and personal property) are often directly at risk when business is being conducted through a sole proprietorship or in a partnership setting. Protection from risk constitutes a fundamental basis for selecting a business structure. 

All good things must come to an end. Whether the business owner is anticipating a 40 year career or a two year cash-out in the business, exit strategy must always be considered in business formation. If one is looking to approach the investment community for a capital infusion, anticipate banks financing or hopes to sell to employees at a later date, it is best to select a business structure most amenable to the particular option envisioned. 

Finally, regardless of their current business entity, business owners can decide to change their structure at any point in the company’s evolution. Although there may be tax ramifications and other challenges involved in such a restructuring, the benefits of the end product often outweigh the convenience of standing pat. 

Bottom line: The business owner must know and understand the pros and cons of the legal structure in which he or she is conducting business.

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The first response I usually get from most businesspeople when I mention “corporate formalities” is a puzzled look. Which is not surprising, since the term is rarely used except by lawyers.  The second response is invariably a request by my clients for another cup of my famous high-octane coffee, since the mere mention of “corporate formalities” usually results in the realization that the meeting isn’t over yet (the end of a meeting with me being the highlight of most of my clients’ days). Fortunately, high-octane coffee is plentiful around my office. In extreme cases, I can even produce a finger or two of single-malt scotch if I notice my client snoring and slumped over in their chair mid-discussion.

But I digress. “Corporate formalities” is a term with which you ought to become familiar if you intend to run, or are already responsible for running, a business.

The reason I even bring this arcane term of art up is because of an admonition I included in my last blog (which you can access by clicking here. In that blog, I suggested that even if you make proper filings with the appropriate State agencies to set up your company, you would still not be adequately protected from company liabilities if you failed to also adhere to “corporate formalities” and maintain proper corporate records. So, what did I mean by that?

Let’s discuss a major misconception about “incorporating” (which is a term I use to mean forming any corporate entity, whether an LLC, corporation, partnership, or something else).  The misconception is that all one need do to obtain the “magic bullet” of limited liability is to file a document with the proper State agency, and voila! -- instant “teflon” for the company’s owners.  But the reality is quite different.

You see, incorporating involves a trade-off between you and the State (you didn’t really think that the State was going to give you a freebie, did you?). In exchange for limited liability for the owners of a company, the State insists that the company adhere to certain laws, keep certain records, and adhere to certain procedures.  Those laws, records, and procedures include the following:

• The company must keep a separate bank account, and cannot commingle its funds with its owners’ funds and bank accounts. (Note that this is more straightforward in theory than in practice. I’ve seen numerous businesses get tangled up in banking and segregation of funds issues that could potentially lead to loss of the owners’ limited liability).
• The company must make certain information public, such as the identity of the owners, the address of its corporate headquarters, and the identity of its agent for service of process.
• The company must carefully authorize and document all actions taken by the company, usually in the form of signed resolutions (this is one of the most frequently overlooked corporate formalities, and potentially one of the most serious if the company is ever sued by a shareholder, employee, or customer).
• The company must not engage in activities that are extraneous to its corporate purpose, or that properly belong to the owner or owners (e.g., don’t have your company pay for your tickets to Tahiti, or take on any tasks related to your spouse’s widget factory).

The bottom line is that the failure of your company to adhere to corporate formalities can result in a “disregard” of the corporate form by a court if your company is ever sued. Legally, this is known as “piercing the corporate veil,” and it’s a disaster by any measure. How? Well, if the court awards damages to the person suing your company, it means that YOU, as an owner of the company, are personally liable for those damages. It could also result in fraud and shareholder actions being upheld against you, and the literal unraveling of your company. 

Finally, let’s take the example of a corporate acquisition: your company has been approached by a competitor with a buyout offer, or you decide that, after 15 years in business, you want out and you want to sell your company. As a mergers and acquisitions attorney, I can tell you that the first thing the lawyers on the other side are going to ask for are your corporate books and records. Because the acquirer wants to know what they’re acquiring, and they want to ensure that they’re not inheriting any potential liabilities that they don’t want to inherit. Inadequate books and records can quickly scuttle a potential deal.

Again, I would urge you to ask yourself the following question: Is the modest cost of keeping adequate corporate books and records worth the potential personal liability, or the risk of scuttling a potentially lucrative sale of the company? Only you, as the business owner, can answer this question.

Has your company properly adhered to corporate formalities? Need help getting your corporate house in order? Give me a call. 

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In an unfortunate rite of fall, Maryland law requires the State Comptroller “immediately after September 30 of each year,” to prepare, and send to the State Department of Assessments and Taxation (“SDAT”), a list of every Maryland corporation that has not paid any tax due (other than a purely local tax) by October 1 of the year following the year in which the tax was due. The requirement also applies to Maryland Limited Liability Companies (LLCs), and includes a failure to make any required unemployment insurance contributions or reimbursement.

When SDAT receives the list from the Comptroller, it sends each entity on the list a notice that the entity’s charter will be forfeited if the taxes due are not paid by the date stated in the notice. Unfortunately, mailing of the notice is sufficient – failure to receive the notice does not affect or delay the forfeiture or annulment of corporate existence. 

Most companies, though, find another aspect of the forfeiture law even more troubling, as it is a trap for the unwary business owner. Maryland entities, as well as those formed outside of Maryland but subject to jurisdiction in Maryland (which likely means doing business in Maryland) must file an annual report, and pay the annual report fee.  Because the form, found here, is called a personal property tax return, many business owners understandably believe that they need not file the form unless the business owns property in Maryland. 

Unfortunately, this is not so. The filing requirement (and $300 annual fee) apply to domestic and foreign corporations, limited liability companies (LLCs), limited liability partnerships (LLPs) limited partnerships (LPs, Business Trusts, and Real Estate Investment Trusts (REITs), whether or not they own personal property in Maryland. Immediately after September 30 of each year, the Comptroller certifies to the SDAT a list of entities that have not filed their personal property returns. The SDAT then issues a “proclamation” forfeiting the charters of all non-compliant entities. When a forfeiture occurs, the SDAT will mail notice of forfeiture to the affected entity, at the entity’s address on record with the SDAT.

There are two significant consequences to forfeiture: first, any person who knowingly transacts business in the name of a corporation whose charter has been forfeited and not revived is guilty of a misdemeanor “and on conviction is subject to a fine of not more than $500.” Second, once a corporation’s charter is forfeit, the corporation in its own name can no longer maintain or defend any suit in any Maryland court. Rather, the directors of the corporation become trustees for the assets of the corporation. 

Revival of a forfeited charter is a fairly simple matter. First, the forfeited corporation must correct the problem that led to the forfeiture. Once this is done, the corporation should file Articles of Revival (form and instructions here). For an LLC, LLP, or LP, file Articles of Reinstatement (form and instructions here).    

As a matter of careful housekeeping, the forfeited entity should, after revival, adopt resolutions expressly ratifying all actions taken during the period for which it was without a charter. 

Bottom Line:  Make sure that your business has paid all necessary taxes and has filed a Personal Property Return for 2009, even if the business does not own any property. If you are unsure, you can check the SDAT website listing entities subject to forfeiture.   You can also check whether your company entity is in good standing via the SDAT’s Charter Search Page.  If your entity has been forfeited, revive it promptly; this will avoid many headaches later. 

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