Commercial Disputes and the Law:
Poor Planning and Informal Record-keeping
Pave the Way for Future Problems
By Richard Kuslan, Esq.
When business is good, business partners can often resolve differences of opinion on their own. Cooperation isn't for charitable purposes, but to protect each party's self interest. Minor disagreements are usually disposed of quickly in the interests of profit and time-saving. It is in the best interests of both to come to agreement quickly.
When a dispute escalates in severity, partners will attempt to protect themselves, throw cooperation to the winds and declare war, and civil litigation often ensues. An escalation in emotion increases the complexity involved in resolving a dispute. How much more the case when a business fails!
A small business will not necessarily succeed. According to the Small Business Administration, about one- third of all small businesses shut down after two years of operation. After four years of operation, only about 44% of new small businesses remain in operation.
In such a case, parties attempt to save assets for their own benefit and decrease their obligations. When partners begin to blame each other, things can really heat up. Then they think about hiring an attorney. But shouldn't they be thinking more proactively, earlier on?
Some people are of the opinion that American law is a kind of weapon, at once objective and overpowering. Many are of the opinion that the law will assuredly allow them to vanquish their enemies and bring them the recompense that they deserve. Sometimes this is the case, but more often this idea is more imaginative than of any practical benefit.
A sues B. Each hires a lawyer. Lawyer A wishes to persuade the decision-maker, either judge or jury, that the facts of the case and the law support his client's claims. Lawyer B, on the opposite side, will attempt to do the same for his client. The decision-maker may be persuaded by either or may have his own view of the case. A result, therefore, is impossible to guarantee, but good, hard-working attorney will make the best use of his intelligence, knowledge, persuasive ability and experience to represent his client's interests. Generally speaking, settlement before trial can save money and pain. In the cases where settlement is not possible, however, one must be prepared to fight.
Many small businesses are informal, relying upon a shake of the hand, doing business in cash and keeping few records. The lack of written documentation leads to circumstances that are far from perfect. Some small-business owners believe that all they have to do to receive a favorable judgment is to tell their story to the judge. But the court needs to consider evidence. Those who think they may have a great case may not necessarily succeed.
The Value of Keeping Good Records
What is evidence? It can be many things: a written contract, a bank book, an electronic receipt, a patent, oral testimony, etc. One who cannot provide persuasive evidence in court is unlikely to prove his case.
The informal way in which small-business owners run their businesses save them from a good deal of inconvenience. But it also conceals a less innocent purpose, including the employment of illegal aliens, the evasion of tax by means of cash purchases, the hiding of income from partners, and such.
When business is good, most small-business owners fail to consider the possibilities when things go wrong. "Everything will be fine. I will deal with a problem when it occurs," one often hears a small-business owner say.
This may be a practical way of dealing with everyday problems. After all, who can divine the future? For that reason, many have never given much thought to the operation of their business one year, five years or 10 years down the road. The small-business owner who steps foot into the legal system usually comes to regret that lack of foresight.
However, planning and good record-keeping is essential. Let's take two hypothetical cases that show the value of thinking ahead.
Do You Have Proof of Your Capital Contribution to the Business?
Prior to the formation of a company, partners negotiate and decide the amount of capital they will contribute to the business. What constitutes a capital contribution depends upon state law and the promises partners have made to one another. Capital may include, for example, cash, personal property, real estate or professional services.
Jackson and Chen have decided to start a business. They signed an operating agreement in which they promise to each invest $1 million. Theoretically, both Jackson and Chen had a 50% share in the business. According to the operating agreement, profits and losses were shared equally as well, and both of them understood this to be the case.
What is an Operating Agreement?
An operating agreement is a document that memorializes the rules agreed upon regarding the operation of the business, including the legal structure, the rights and responsibilities of the investors, company management, capital contributions, meetings and voting, dissolution etc. An oral operating agreement, while giving an appearance of freedom to make changes on the spot, is excessively simple and unreliable. It presents an unreasonable risk for any business owner. Where partners disagree, how can one prove the terms of an oral operating agreement?
However, Jackson and Chen didn't actually invest the sum they had promised in the operating agreement. Jackson invested $250,000 by writing a check from his personal account to company coffers. Murphy invested $100,000 in cash, but did so in an irregular fashion. Knowing that the company offices needed interior design, Chen had his cousin remit the cash by wire from his cousin's account in a foreign bank in a third world nation directly to the company's account in the US. Chen also had a small warehouse which he agreed to contribute to the company as capital. Chen knew the value of the warehouse was $100,000. Jackson had no knowledge of the real estate market, but because the company had great need for warehouse, he quickly agreed to a value of $400,000, which was fraudulent. Recently, the real estate market was suffering from a downturn. After signing the operating agreement, the two partners did not contribute any further amount of capital to the company. In this way, the promises made in the operating agreement were not fulfilled. The partners thought nothing of it, and continued do business as if there was nothing wrong.
Per the operating agreement, Jackson and Chen presumably held 50% stakes in the business. But their actual capital contributions leads one to a different conclusion. On the face of it, Jackson's contribution totals $250,000; Chen's, $500,000. Per actual contributions, Jackson would only have a one-third share in the business, and Chen a two-thirds share.
However, only Jackson's capital contribution can be documented as having come directly from him. Chen will have some difficulty showing that the $100,000 remitted by a person with a different family name, located halfway across the world, was actually his capital contribution. As to Chen's warehouse, there also seems to be a problem. At the time it was made a contribution, the warehouse was not necessarily worth the $400,000 claimed. How can it be proven? Perhaps with an appraiser. How will that value effect the percentage interests of the partners? And each partner's share of profits and losses? One foresees turmoil and struggle ahead. A good deal more foresight at the beginning -- before the operating agreement had been signed -- would have been of very great value.
Hiring Undocumented Workers: Will the Owner Take It on the Chin?
Small-business owners may adopt certain practices in pursuit of maximizing their take-away, such as under -reporting wages paid to lessen tax and social welfare obligations, such as FICA, or the hiring of undocumented aliens. Pournaras and Tong were both naturalized citizens. They decided that they would not retain any documentation with regard to the aliens they hired in their restaurant, whom they paid in cash. They believed that it was smart to avoid the creation of a paper trail. Furthermore, they agreed never to tell anyone that they were hiring undocumented aliens. In their estimation, they could simply deny knowledge of any connection. How could they go wrong? They couldn't have been more wrong, as we will see.
After about a year of operating in what they believed was total safety, the two of them heard of a plan which would make them big bundles of cash. They would front for people wishing to enter the United States on work visas. Tong's cousin knew a person in a foreign country who made a living smuggling undocumented aliens into the United States. Tong's cousin wasn't an attorney, but he had established a so-called "Immigration Office" in a large metropolitan city and seemed to be making a good deal of money.
The two began auctioning off company positions for very large sums of money and forging documentation required by the Department of Labor and the Immigration Service. Both agree never to leak any information to anyone and if one of their paying aliens encounters any difficulty, they will completely disavow any connection to him. For a while, things go quite smoothly and the money is pouring in.
One of the undocumented aliens, Liao, worked for the restaurant for a period of time and became very unhappy with both his salary and safety conditions in the kitchen. When he complained, the partners fired him. Unfortunately for the partners, Liao was a reckless character. Enraged, he went to the police department and to the immigration services, informing them that the partners had both an illegal scheme for immigration and were importing illicit drugs. An investigation was begun. What was thought to have been smooth sailing, became a serious problem very quickly.
All bets were off. Each partner wished to save himself. All charitable thoughts regarding his former comrade in business vanished. Suddenly, the partners who had promised each other so much, decided, in the face of pressures, but no promises had ever been made. One blamed the other, but there were no records to support either the one or the other. On the other hand, it was easily shown that the partners had not maintained records of their employees as required by law, nor paid their tax and social welfare obligations when due.
How long do you think this company will last?
Conclusion
To protect one's own interests, do not neglect to plan for the future. At a minimum:
• One should thoroughly understand the contents of an Operating Agreement, reached through negotiation between the parties. Should there be changes made as the business grows, they should be memorialized in amendments.
• Document transactions as required by law and as determined by your own judgment. At a bare minimum, one needs to keep good records of capital contributions, income, expenses, employee information, etc.
Start thinking about the future today, rather than the day it arrives on your doorstep. This doesn't guarantee nothing will ever happen to your business, but action on your part in advance may minimize the impact on your business when something does happen.
Click for Attorney Kuslan's contact page.
When business is good, business partners can often resolve differences of opinion on their own. Cooperation isn't for charitable purposes, but to protect each party's self interest. Minor disagreements are usually disposed of quickly in the interests of profit and time-saving. It is in the best interests of both to come to agreement quickly.
When a dispute escalates in severity, partners will attempt to protect themselves, throw cooperation to the winds and declare war, and civil litigation often ensues. An escalation in emotion increases the complexity involved in resolving a dispute. How much more the case when a business fails!
A small business will not necessarily succeed. According to the Small Business Administration, about one- third of all small businesses shut down after two years of operation. After four years of operation, only about 44% of new small businesses remain in operation.
In such a case, parties attempt to save assets for their own benefit and decrease their obligations. When partners begin to blame each other, things can really heat up. Then they think about hiring an attorney. But shouldn't they be thinking more proactively, earlier on?
Some people are of the opinion that American law is a kind of weapon, at once objective and overpowering. Many are of the opinion that the law will assuredly allow them to vanquish their enemies and bring them the recompense that they deserve. Sometimes this is the case, but more often this idea is more imaginative than of any practical benefit.
A sues B. Each hires a lawyer. Lawyer A wishes to persuade the decision-maker, either judge or jury, that the facts of the case and the law support his client's claims. Lawyer B, on the opposite side, will attempt to do the same for his client. The decision-maker may be persuaded by either or may have his own view of the case. A result, therefore, is impossible to guarantee, but good, hard-working attorney will make the best use of his intelligence, knowledge, persuasive ability and experience to represent his client's interests. Generally speaking, settlement before trial can save money and pain. In the cases where settlement is not possible, however, one must be prepared to fight.
Many small businesses are informal, relying upon a shake of the hand, doing business in cash and keeping few records. The lack of written documentation leads to circumstances that are far from perfect. Some small-business owners believe that all they have to do to receive a favorable judgment is to tell their story to the judge. But the court needs to consider evidence. Those who think they may have a great case may not necessarily succeed.
The Value of Keeping Good Records
What is evidence? It can be many things: a written contract, a bank book, an electronic receipt, a patent, oral testimony, etc. One who cannot provide persuasive evidence in court is unlikely to prove his case.
The informal way in which small-business owners run their businesses save them from a good deal of inconvenience. But it also conceals a less innocent purpose, including the employment of illegal aliens, the evasion of tax by means of cash purchases, the hiding of income from partners, and such.
When business is good, most small-business owners fail to consider the possibilities when things go wrong. "Everything will be fine. I will deal with a problem when it occurs," one often hears a small-business owner say.
This may be a practical way of dealing with everyday problems. After all, who can divine the future? For that reason, many have never given much thought to the operation of their business one year, five years or 10 years down the road. The small-business owner who steps foot into the legal system usually comes to regret that lack of foresight.
However, planning and good record-keeping is essential. Let's take two hypothetical cases that show the value of thinking ahead.
Do You Have Proof of Your Capital Contribution to the Business?
Prior to the formation of a company, partners negotiate and decide the amount of capital they will contribute to the business. What constitutes a capital contribution depends upon state law and the promises partners have made to one another. Capital may include, for example, cash, personal property, real estate or professional services.
Jackson and Chen have decided to start a business. They signed an operating agreement in which they promise to each invest $1 million. Theoretically, both Jackson and Chen had a 50% share in the business. According to the operating agreement, profits and losses were shared equally as well, and both of them understood this to be the case.
What is an Operating Agreement?
An operating agreement is a document that memorializes the rules agreed upon regarding the operation of the business, including the legal structure, the rights and responsibilities of the investors, company management, capital contributions, meetings and voting, dissolution etc. An oral operating agreement, while giving an appearance of freedom to make changes on the spot, is excessively simple and unreliable. It presents an unreasonable risk for any business owner. Where partners disagree, how can one prove the terms of an oral operating agreement?
However, Jackson and Chen didn't actually invest the sum they had promised in the operating agreement. Jackson invested $250,000 by writing a check from his personal account to company coffers. Murphy invested $100,000 in cash, but did so in an irregular fashion. Knowing that the company offices needed interior design, Chen had his cousin remit the cash by wire from his cousin's account in a foreign bank in a third world nation directly to the company's account in the US. Chen also had a small warehouse which he agreed to contribute to the company as capital. Chen knew the value of the warehouse was $100,000. Jackson had no knowledge of the real estate market, but because the company had great need for warehouse, he quickly agreed to a value of $400,000, which was fraudulent. Recently, the real estate market was suffering from a downturn. After signing the operating agreement, the two partners did not contribute any further amount of capital to the company. In this way, the promises made in the operating agreement were not fulfilled. The partners thought nothing of it, and continued do business as if there was nothing wrong.
Per the operating agreement, Jackson and Chen presumably held 50% stakes in the business. But their actual capital contributions leads one to a different conclusion. On the face of it, Jackson's contribution totals $250,000; Chen's, $500,000. Per actual contributions, Jackson would only have a one-third share in the business, and Chen a two-thirds share.
However, only Jackson's capital contribution can be documented as having come directly from him. Chen will have some difficulty showing that the $100,000 remitted by a person with a different family name, located halfway across the world, was actually his capital contribution. As to Chen's warehouse, there also seems to be a problem. At the time it was made a contribution, the warehouse was not necessarily worth the $400,000 claimed. How can it be proven? Perhaps with an appraiser. How will that value effect the percentage interests of the partners? And each partner's share of profits and losses? One foresees turmoil and struggle ahead. A good deal more foresight at the beginning -- before the operating agreement had been signed -- would have been of very great value.
Hiring Undocumented Workers: Will the Owner Take It on the Chin?
Small-business owners may adopt certain practices in pursuit of maximizing their take-away, such as under -reporting wages paid to lessen tax and social welfare obligations, such as FICA, or the hiring of undocumented aliens. Pournaras and Tong were both naturalized citizens. They decided that they would not retain any documentation with regard to the aliens they hired in their restaurant, whom they paid in cash. They believed that it was smart to avoid the creation of a paper trail. Furthermore, they agreed never to tell anyone that they were hiring undocumented aliens. In their estimation, they could simply deny knowledge of any connection. How could they go wrong? They couldn't have been more wrong, as we will see.
After about a year of operating in what they believed was total safety, the two of them heard of a plan which would make them big bundles of cash. They would front for people wishing to enter the United States on work visas. Tong's cousin knew a person in a foreign country who made a living smuggling undocumented aliens into the United States. Tong's cousin wasn't an attorney, but he had established a so-called "Immigration Office" in a large metropolitan city and seemed to be making a good deal of money.
The two began auctioning off company positions for very large sums of money and forging documentation required by the Department of Labor and the Immigration Service. Both agree never to leak any information to anyone and if one of their paying aliens encounters any difficulty, they will completely disavow any connection to him. For a while, things go quite smoothly and the money is pouring in.
One of the undocumented aliens, Liao, worked for the restaurant for a period of time and became very unhappy with both his salary and safety conditions in the kitchen. When he complained, the partners fired him. Unfortunately for the partners, Liao was a reckless character. Enraged, he went to the police department and to the immigration services, informing them that the partners had both an illegal scheme for immigration and were importing illicit drugs. An investigation was begun. What was thought to have been smooth sailing, became a serious problem very quickly.
All bets were off. Each partner wished to save himself. All charitable thoughts regarding his former comrade in business vanished. Suddenly, the partners who had promised each other so much, decided, in the face of pressures, but no promises had ever been made. One blamed the other, but there were no records to support either the one or the other. On the other hand, it was easily shown that the partners had not maintained records of their employees as required by law, nor paid their tax and social welfare obligations when due.
How long do you think this company will last?
Conclusion
To protect one's own interests, do not neglect to plan for the future. At a minimum:
• One should thoroughly understand the contents of an Operating Agreement, reached through negotiation between the parties. Should there be changes made as the business grows, they should be memorialized in amendments.
• Document transactions as required by law and as determined by your own judgment. At a bare minimum, one needs to keep good records of capital contributions, income, expenses, employee information, etc.
Start thinking about the future today, rather than the day it arrives on your doorstep. This doesn't guarantee nothing will ever happen to your business, but action on your part in advance may minimize the impact on your business when something does happen.
Click for Attorney Kuslan's contact page.
11o Whitney Avenue
New Haven, CT 06510
(203) 562-8808
New Haven, CT 06510
(203) 562-8808
60 Chelsea Harbor Drive
Norwich, Ct 06360
(860) 531-8808
Norwich, Ct 06360
(860) 531-8808
