Owners of small or closely-held businesses may encounter certain challenges with respect to operational excellence that are less applicable in larger entities. Often times these small businesses operate less formally due to pre-existing or familial relationships, which can result in oversights to certain areas of the business. Examples of such oversights include: the lack of or sparsely worded agreements; a lack of documentation of important business decisions or transactions; and, improper use of business profits.
In April 2015, there was a case which involved such careless governance in a business. In Robl Construction vs. Homoly, No. 13-3607 (8th Cir. 2015), the business involved a two-member LLC which had poorly drafted governing documents and inadequately maintained records. This lapse in proper organization of the entity cost the parties a significant amount of time and money in court.
An even more recent case which came out of the Supreme Court of Mississippi, Scafidi v. Hille, No. 2014-CA-01261-SCT (Dec. 10, 2015), involved a dispute between two siblings, Gerald and Jo Ann. The dispute was over three family corporations and land they inherited from their parents. Although the ownership of the entities and the land were joint between the estranged siblings, they ran the businesses more like sole proprietorships. In the roughly eight years following their parents’ death, the siblings held only two shareholders’ meetings. No agreements were documented, nor were any minutes recorded.
Gerald made numerous decisions pertaining to the businesses he operated without consulting the co-owner, Jo Ann. Gerald used funds from these businesses to pay off his personal credit card, pay for utility and phone bills, and purchase a truck. In addition, Gerald conducted side ventures on the business property, and commingled income from those endeavors with funds of the family business. There was only one year during this time in which Gerald correctly split rental income related to the family business with Jo Ann, and thereafter stopped and refused to divide the income or provide Jo Ann with any details related to the rental income, to which she was entitled. The books, records and tax returns Gerald maintained were found to be false and incomplete as to both gross receipts and expenditures. Furthermore, Gerald had failed to file tax returns for the most recent years.
Jo Ann operated one of the other family businesses in a similar manner. She drew income from the business and used the funds to operate side ventures on the property she jointly owned with Gerald. In addition, Jo Ann used business funds to pay for the repair of her home’s roof, health insurance, attorneys’ fees, and a car. The forensic accounting firm hired by the court could not confirm the completeness of revenues for the business Jo Ann operated, and the evidence pointed to below-market rental rates and the misappropriation of funds.
The Scafidi case involves complex issues, procedural history and fact patterns. In the simplest of terms, the primary dispute in the case related to Jo Ann’s claims for an accounting of corporate profits and expenses, a forced shareholder meeting to dissolve the corporations, and breach of fiduciary duty. The lower court determined that, because the parties had failed to observe corporate formalities, they were not entitled to protections of the corporate form. Such protections are at the core of why business owners operate under corporations or limited liability companies. Therefore, the lower court held (and the Mississippi Supreme Court affirmed) that Jo Ann and Gerald were each entitled to full ownership of one separate corporation. The third corporation was sold with the proceeds divided between the siblings. The court also adjusted the property lines of the property to grant each sibling a 50% interest in the land. The parties were ordered to execute the necessary documents to effectuate the court’s ruling, which included the deeds, bills of sale and stock certificates.
It is likely that the prolonged and expensive litigation between these two siblings could have been avoided had they consulted with an attorney at the time of their parents’ death. With the assistance from competent legal counsel, the siblings potentially could have come to understand the importance of written agreements and records, maintenance of separate business and personal bank accounts, and proper accounting.
It is never too late to consult with an attorney about the organization, ongoing operation and maintenance of your small or closely-held business. Together with an attorney, you can ensure that your entity is properly established; review, revise, amend or possibly restate documents that govern how you operate and manage your business, and create a plan moving forward to help adequately maintain business records in an orderly and consistent fashion.