How to Force an LLC Member Out – Judicial Dissociation
What happens when you’re in business with someone whose behavior harms the LLC but who refuses to leave voluntarily?
Ideally, you have a well-drafted buy-sell agreement or operating agreement that addresses this exact situation and clearly lays out next steps. If not, you may be able to go to court to pursue judicial dissociation, the court-ordered removal of a member from an LLC.
South Carolina courts are typically reluctant to take such a drastic step, but it can be done. This blog will cover what it takes for a court to grant judicial dissociation in SC according to state statute and look at a case where the appeals court did not grant judicial dissociation, reversing the circuit court’s earlier decision. Note: We previously covered this case, The Boathouse v. Richard Stoney (2024) (read it here), on the issue of whether a single member “class of one” can bring a derivative action in SC.
South Carolina Statute on Judicial Dissociation
South Carolina Code Section 33-44-601 lays out the many ways in which a member of an LLC may be dissociated from the LLC, with subsection (6) specifically listing the circumstances under which a member may be expelled by judicial determination:
- If the member engaged in conduct that “adversely and materially” affected business;
- If the member committed a “material” breach “wilfully or persistently” of the operating agreement or duty owed to the company and other members, as described in Section 33-44-409 (covering General standards of member’s and manager’s conduct); OR
- If the member’s conduct relating to the business made it “not reasonably practicable” for the business to carry on with that member.
If a member’s conduct fits into one or more of the categories above, he or she may be removed from the LLC by the court.
Factors to Consider Whether Judicial Dissociation Is Warranted
That’s what the law says, but it’s up to the court to apply it on a case-by-case basis.
In the Boathouse opinion, the SC appeals court cited an “instructive” decision from the Supreme Court of New Jersey, IE Test, LLC v. Carroll (N.J. 2016), which laid out several factors to consider (while noting that it’s not binding on the South Carolina court):
- The nature of the LLC member’s conduct relating to the LLC’s business;
- Whether, with the LLC member remaining a member, the entity may be managed so as to promote the purposes for which it was formed;
- Whether the dispute among the LLC members precludes them from working with one another to pursue the LLC’s goals;
- Whether there is a deadlock among the members;
- Whether, despite that deadlock, members can make decisions on the management of the company, pursuant to the operating agreement or in accordance with applicable statutory provisions;
- Whether, due to the LLC’s financial position, there is still a business to operate; and
- Whether continuing the LLC, with the LLC member remaining a member is financially feasible.
The New Jersey Supreme Court states that mere conflict isn’t enough to warrant dissociation. Members seeking to expel another member through forcible dissociation must “clear a high bar” and prove that it’s not reasonably practicable to carry on the business with the member.
The Boathouse case: Judicial Dissociation in Practice
All of that sounds well and good, but it’s very theoretical. What does it look like in real life?
In the Boathouse case, the circuit court granted a motion for judicial dissociation of a member, which the appeals court later reversed.
For a more thorough look into the interesting background of this case, read our previous blog. Briefly: Cousins Laurence Stoney and Richard Stoney are both members, along with other individuals, of an LLC that runs the popular Charleston-area restaurant The Boathouse on Breach Inlet. Over the course of many years, Laurence alleged, Richard misspent company funds, taking money earned by the Boathouse and spending it in his other businesses and on personal expenses such as vacations and polo ponies. Richard, through a different but related LLC, ended up owing the Boathouse LLC $4 million.
But the motion for dissociation was not against Richard, it was against Laurence. Laurence sought to bring a derivative action as a “class of one” against Richard for his conduct. In turn, Richard and a few other third-party Intervenors filed a motion to dissociate Laurence from the company. The circuit court granted the motion to dissociate Laurence, based on:
- Laurence denigrating the company to vendors,
- Laurence’s efforts to change ownership and management during Richard’s divorce, and
- Laurence’s efforts to purchase land that Richard had an interest in without disclosing his efforts to Richard
The court of appeals looked at whether this behavior reached the high level required for forcible judicial dissociation.
Why the Appeals Court Reversed the Circuit Court
The South Carolina Court of Appeals found that “none of these incidents evidence conduct relating to the Company’s business that would warrant judicial dissociation.” In addition, the animosity between the members was not substantial enough to warrant judicial dissociation, as much of the animosity stemmed from disagreements over Richard’s use (or misuse) of company funds.
As to the other factors laid out by the New Jersey court, cited above, the South Carolina appeals court notes that Laurence was not in a position to create a deadlock or interfere with the running of the business, owning just a 5% stake; the Boathouse restaurant still brought in money and was projected to continue with strong sales; and the LLC would not be prevented from continuing to operate if Laurence remained a member.
The appeals court ultimately held that the circuit court erred when it found Laurence “engaged in conduct relating to the company’s business which makes it not reasonably practicable to carry on the business with the member” and reversed the grant of the motion for dissociation.
A Better Option: Solid Corporate Governance Documents
You don’t know what the future holds for your LLC, but you can be sure that it won’t always be smooth sailing. So figure out what to do in advance, instead of deciding how to handle the storm only after it strikes. When a situation does arise in the future, you can turn to your corporate governance documents instead of the courts.
At the least, when you are going into business with another person you should have:
An Operating Agreement. An operating agreement lays out the roles and responsibilities of each party so everyone is clear on what his or her job is and knows when a member is not living up to his or her duties. An operating agreement often includes provisions for removing or dissociating a member in certain situations such as misconduct or breach of duty.
A Buy-Sell Agreement. A buy-sell agreement sets the rules for how and when changes in ownership occur due to things like death, disability, divorce, or dispute. Members can agree in advance on what to do if one member does not live up to his or her duties as outlined in the operating agreement, which could include buying him or her out. Read more about buy-sell agreements here on our blog.
It’s best to have these drawn up when you start up your business, while all members are still on good terms. However, if you’ve been in business for a while and still don’t have anything in place, you can do it now – it’s never too late.
For Corporate Governance Documents and Strategic Legal Advice, Call Gem McDowell
To draw up or review operating agreements, buy-sell agreements, and other corporate governance documents, or for strategic business advice, call Gem at the Gem McDowell Law Group. Gem and his team help South Carolina businesses and business owners with starting, buying, selling, and more. With over thirty years in practice in the state, Gem has the experience to help you grow, avoid mistakes, and protect your interests.
The Gem McDowell Law Group has offices in Myrtle Beach and Mt. Pleasant, SC. Call 843-284-1021 today to schedule your free, no-obligation consultation.
Can Buy-Sell Agreements Determine Business Value for Tax Purposes? The IRS Says…
Buy-sell agreements cannot be relied on to determine the value of a business for the purposes of estate tax or gift tax.
If the IRS believes that a closely held business, or an interest in it, has a higher fair market value (FMV) than the one determined by a buy-sell agreement, it may use that higher value to determine the tax liability. This is to prevent business owners from artificially lowering the value of a company for the purpose of reducing or evading taxes.
If you’re part owner in a closely-held company – particularly a family-held company – here’s what to know.
How Buy-Sell Agreements Can Affect Sales Price and Company Value
It’s the same old story: Business owners want to protect their assets and pay as little as possible in taxes to the federal government, while the IRS wants to get all the money it’s entitled to under the law.
One way some business owners have tried to reduce the amount taxes owed to the IRS is by artificially reducing the value of a closely held company, or interest in that company, through certain provisions in the company’s buy-sell agreement.
For example, terms in a buy-sell agreement might:
- Set a fixed price for sale that’s significantly below FMV
- Set a formula to determine price that’s below FMV
- Restrict sale back to the company at a particular price
- Restrict sale to family members only, which lowers value by reducing marketability
- Give right of first refusal for purchase to existing owners at below FMV prices
When the owner eventually dies, the value of the business or business interest is reported as the value determined by the buy-sell agreement and not an objective appraiser. This may mean a lower – sometimes substantially lower – tax liability.
The IRS Will Disregard Such Terms
Terms like those above can lead to the under-valuing of a company which could mean less taxes for the IRS to collect. Under Section 2703(a) of the Internal Revenue Code (IRC), the IRS will disregard such terms in buy-sell agreements:
“(a)General rule For purposes of this subtitle, the value of any property shall be determined without regard to—
- “any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or
- “any restriction on the right to sell or use such property.”
If the IRS rejects the valuation of a business based on a buy-sell agreement, then it will use the value determined by a qualified appraiser or other method.
However, such terms are not necessarily illegitimate. The IRS will not disregard these kinds of terms if certain conditions are met.
The Three “Safe Harbor” Conditions for Buy-Sell Agreements
Exceptions to the general rule above are found in the “Safe Harbor” provisions of Section 2703(b) of the IRC. The IRS will respect the valuation in a buy-sell agreement if all three of the following conditions are met:
(b)Exceptions Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements:
- “It is a bona fide business arrangement.
- “It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth. [the “device test”]
- “Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.” [the “comparability test”]
More on the “arms’ length” standard below.
The “Arms’ Length” Standard
IRC Sections 2703(a) and (b) apply to all closely held businesses, but in practice, they most commonly apply to family-held businesses. The IRS is more likely to scrutinize family-held companies and transfers between family members, as family members are more likely to want to give each other the most favorable terms possible.
This is where the “arms’ length” standard comes in. A buy-sell agreement’s terms should reflect the reality of doing business with unrelated parties, not family members. When business is done at arms’ length, all parties involved act in their own self-interest; the transaction is free from manipulation, duress, and favoritism; and transfers occur at fair market value. A transfer between family members at below-market value is a big red flag to the IRS.
Other red flags to avoid:
- Terms in the buy-sell agreement that are not supported with sound business reasons
- Fixed sales price or price formula in the buy-sell agreement that doesn’t reflect the current market
- Evidence the company’s purpose is more for estate planning than conducting business
As a business owner, one proactive step you can take is to have your buy-sell agreement reviewed by a business attorney and updated as needed to ensure it reflects the current market and aligns with the arms’ length standard.
Strategic Legal Advice to Protect and Grow Your Business
When was the last time your buy-sell agreement and other corporate governance documents were reviewed? Laws and circumstances change, and it’s smart to make sure your company’s documents reflect those changes. Business attorney Gem McDowell and his team can help.
For strategic legal advice and help with contracts, corporate governance documents, and starting, buying, or selling a business in South Carolina, contact Gem. Gem has over 30 years of experience helping individuals and business professionals across the state protect their interests, avoid mistakes, and plan for the future. Call the McDowell Law Group, with offices in Myrtle Beach and Mt. Pleasant, SC, at 843-284-1021 today to schedule a free consultation.
The Family Investment Company: Benefits and Risks (Avoid These 3 Mistakes)
Family investment companies (FICs) are becoming increasingly common among high-net-worth families. An FIC is typically a family-held LLC or family limited partnership (FLP) in which a wealthy founder transfers assets into the company, and other family members become partners or members in the business.
Creating an FIC can be a good way to protect and manage assets, pass on wealth to future generations, and reduce tax liabilities. However, over the years the IRS has cottoned on to the fact that some FICs exist for the sole purpose of reducing or avoiding taxes. This has led to increased scrutiny.
If you have an FIC, or are thinking about creating one for your family, here’s what you should know.
You Need a Legitimate Non-Tax Reason to Operate a Family Investment Company
The purpose of the FIC cannot be to reduce or avoid taxes. There must be a legitimate non-tax reason for the family investment company to exist in the first place.
For many families, centralized asset management is reason enough. FICs allow for assets to be pooled, managed, and overseen by multiple family members, rather than keeping those assets in separate trusts or an individual’s account(s).
Other potential legitimate reasons for creating and maintaining an FIC include:
- Asset protection (from creditors, family members, impending divorce, etc.)
- Business succession planning
- Preservation of larger assets by avoiding fractionalization
These are just some of the possible legitimate reasons to have an FIC; discuss your unique situation with your tax preparer, wealth advisor, business attorney, and/or estate planning attorney.
If the IRS determines that the FIC exists solely to evade paying taxes, it may be able to disregard the transfer of certain assets under Internal Revenue Code Section 2036 and count them in the estate of the donor/founder at death – a bigger topic we may cover in the future. For now, just remember that an FIC must have a non-tax purpose for existing.
You Must Respect the Business Entity and the Business
The IRS may look to see if the company is being run like a company or if it’s only “on paper.” A business that’s just on paper will have little to no activity and may serve solely as a place for assets to sit and generate income passively.
In contrast, a legitimate business in the eyes of the IRS is one that has a clear structure, maintains formalities such as holding meetings and keeping minutes, and engages in substantial economic activity such as managing and investing assets.
In addition, members/partners must respect the business entity itself and avoid piercing the corporate veil (read more about this on our blog).
Watch Out for Fractional Gifts
Why did the IRS start looking at family investment companies more closely over the past decade or so? Because some people got a little too greedy. Here’s what happened.
High-net-worth individuals discovered that the use of fractional gifts was a good way to handle the logistics of passing on assets to future generations, and it provided a tax benefit, too. A fractional gift in the context of an FIC typically involves a founder transferring a partial ownership interest in the FIC to a family member who is also a member/partner of the FIC.
This partial interest is eligible for discounts, often a discount for lack of control (when the stake in the business is under 50%) and a discount for marketability (because it’s harder to find buyers for a smaller, non-controlling share of a business). These discounts lower its value and, consequently, reduce the amount of gift taxes the donor is liable for. (Read more about discounts and on valuation of closely held companies here on our blog.)
But pigs get fat, hogs get slaughtered, as we often say. Not too long ago, some people tried to push the limit on these discounts, reducing the value beyond what the IRS found reasonable. This is what led to the IRS cracking down on families using FICs and fractional gifts, in particular, as tax evasion tools.
What’s a reasonable discount? There is no set number. This is something that needs to be determined on a case-by-case basis, ideally with the advice of an attorney, tax professional, and/or financial advisor.
Legal Advice on Business Matters and Estate Planning
For help with short-term and long-term estate planning and business planning, including succession planning, speak with Gem McDowell. Gem and his team help individuals and business professionals protect their interests and plan for the future with customized estate plans, corporate governance documents, and strategic advice. Gem also has many years of experience in tax law and holds a master’s degree in tax law from Emory University, and he is ready to help advise you on your tax issues.
Call the Gem McDowell Law Group, with offices in Myrtle Beach and Mt. Pleasant, SC, today at 843-284-1021 to schedule your free consultation.
What is Covenant of Good Faith and Fair Dealing? About the How, Not the What, and Road, LLC.
If you sign a contact, you and the other parties signing are automatically subject to the covenant of good faith and fair dealing, an implied principle that holds parties to a standard of fairness and honesty in carrying out the contract.
The covenant does not create or impose new obligations on parties to a contract; it applies to the how of the parties’ behavior, not the what. This is an important distinction that was reinforced in a 2024 South Carolina Supreme Court decision, Road, LLC. v. Beaufort County (find it here), which we’ll look at below.
But first, more about the covenant of good faith and fair dealing, and what it does and doesn’t do.
The Covenant of Good Faith and Fair Dealing
The concept of the covenant of good faith and fair dealing comes from English common law and is now an implied covenant in agreements in American jurisprudence. “Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement,” according to Section 205 of the Restatement (Second) of Contracts, a legal resource on contract law used by legal professionals across the country.
A key aspect of the covenant is that a party must not undermine or interfere with the other party’s ability to fulfill their obligations under the agreement or to benefit from it. A party who intentionally behaves in such a way is in breach of the covenant.
The covenant of good faith and fair dealing does not mean that a contract itself or its terms are fair. That is, just because one party believes the contract isn’t fair, that doesn’t mean the other party has violated the covenant of good faith and fair dealing.
This is the issue in the Road case. Essentially, the plaintiff did not like how a deal turned out, but does that necessarily mean another party breached the covenant of good faith and fair dealing? Let’s see what the court said.
Did Beaufort County Violate the Covenant of Good Faith and Fair Dealing? The Road case
The background to Road, LLC v. Beaufort County (2024) is long and rather convoluted, so we’ll just cover the most pertinent facts here.
In 2006, a developer purchased some undeveloped waterfront property in Beaufort County with the intention of developing it. The 229-acre property is a peninsula connected to the mainland via an access road on a narrow isthmus.
Two lawsuits soon arose from this, one of which was about Beaufort County denying the developer’s request to relocate and improve the access road. Both lawsuits were settled in a 2011 agreement (the Settlement Agreement) which meant the developer could continue developing the property.
Road, LLC (Road) was not a party to the Settlement Agreement. But it stepped in at this point to help out the developer by buying an 0.85-acre parcel of land at the end of the access road from the neighbors for $1.3 million. The developer agreed to buy back that same parcel of land from Road for $5 million once development was complete, giving Road a nice profit.
Here’s where it gets interesting. The developer defaulted on the loan for the peninsula property before developing it, so the lender ultimately took possession of it. Beaufort County then purchased the peninsula property with the express intention of preserving it and not allowing further development.
Road sued.
The Lawsuit: Road Contends Beaufort County Breached the Covenant
Road, LLC and Pinckney Point, LLC (the original 2006 purchaser of the peninsula property) sued Beaufort County, alleging (among other things) that the County breached the implied covenant of good faith and fair dealing. The matter eventually went to the Supreme Court of South Carolina, which issued its decision in May 2024.
Road contended that all parties to the Settlement Agreement expected the peninsula property to be developed eventually, even if not by the original developer. Road also argued that facilitating the development of the peninsula property was, in fact, the purpose of the Settlement Agreement.
By purchasing the land with the express intent of not developing it – and doing so quickly, without allowing another developer the chance to see and purchase it – Beaufort County effectively destroyed Road’s opportunity to sell the 0.85-acre parcel at the expected profit in the future. This, Road contended, constituted a breach of the covenant of good faith and fair dealing.
The question before the supreme court boiled down to this: Did the Settlement Agreement impose an obligation on Beaufort County not to interfere with Road’s opportunity to find another developer for the peninsula property?
The court’s answer: No.
Beaufort County Did Not Breach the Covenant
“The implied covenant of good faith and fair dealing cannot create new contractual duties not already expressed or implied in the contract,” the court said in its decision, which affirmed the result but not the reasoning of the appeals court.
Continuing: “Rather, the implied covenant serves only to govern the manner in which parties to a contract enforce their existing contractual rights and carry out their existing contractual duties—express or implied.”
The Settlement Agreement did not expressly require Beaufort County to give another developer the opportunity to purchase the peninsula land. The court determined there was no such duty from implied contract terms, either, as the Settlement Agreement contained language stating it was the full and complete agreement between parties. Finally, since, in the court’s words, “the covenant may not be relied on to create new contractual duties not expressly stated or fairly implied in the contract itself,” no such duty existed under the covenant of good faith and fair dealing, either.
Additionally, the court says that the purpose of the Settlement Agreement was not to facilitate the development of the peninsula property, as Road contended. It was clearly to settle the two pending lawsuits regarding the land.
Had Road, LLC been a party to the Settlement Agreement, perhaps the court would have interpreted things differently. It might have found that Beaufort County did indeed violate the spirit of the agreement and its intended purpose. We don’t know for sure. But as it is, unfortunately for Road, it took a gamble and lost.
Takeaway: Contract Language Matters
As we’ve covered many times on this blog before, the language in a contract matters. Do not depend on implied contract terms or the unwritten understanding of the purpose of the agreement. If something is important to you, put it in writing.
For help with contracts, business law, and commercial real estate transactions in South Carolina, call Gem at the Gem McDowell Law Group. Gem and his team help start, grow, and sell businesses across the state. Gem has over 20 years of experience solving problems, preventing mistakes, and helping businesses thrive. Call or contact us today to schedule your free consultation.
A Classic Squeeze-Out: Minority Member Oppression in Wilson v Gandis
In the previous blog, we looked at one of the risks of being in an LLC, minority member oppression. This happens when a member or members of the LLC act to reduce a minority member’s involvement in the company against their will. The majority member(s) may try to “squeeze out” or “freeze out” the minority member from the company altogether. Or they may engage in conduct like withholding distributions and reducing the minority member’s involvement in the company while essentially trapping their investment in the LLC with no way for the minority member to get it back out.
This was the central issue in a case heard by the South Carolina Supreme Court in June 2019, Wilson v Gandis, in which the oppression was described as a “classic squeeze-out.” It’s rather convoluted, with multiple lawsuits and issues, but we’ll focus on the issue of minority oppression and exactly what constitutes it in the eyes of South Carolina courts.
The Background
In 2007, David Wilson and John Gandis formed Carolina Custom Converting (CCC), a company selling film, resin, and other materials. It was a manager-managed LLC, with each owning 50% membership interest. Importantly, Wilson and Gandis never executed a formal operating agreement and had no employee, noncompete, nondisclosure, or nonsolicitation agreements. Many of their oral conversations and agreements were memorialized through email, however.
CCC’s business was intricately linked to other businesses owned by Wilson and Gandis. When CCC was formed, Wilson owned Eastern Film Solutions (EFS) and Gandis owned DecoTex and M-Tech. Wilson agreed to wind down EFS and bring that business over to CCC, for which he was compensated $8,000 per month, later raised to $12,000 per month. Gandis agreed to extend a line of credit to CCC from DecoTex and M-Tech. Plus, CCC operated out of a building owned by M-Tech, so Gandis received the benefit of the rent money paid by CCC.
Gandis brought on Andrea Comeau-Shirley, a CPA, to help with accounting and advice. In 2009, Gandis and Wilson each transferred 5% of their interest to Shirley. She didn’t have a formal voting interest but was actively involved in managing CCC.
Not long after, things started to go south for Wilson. Shirley and Gandis grew closer and began excluding Wilson from discussions about the company’s operations. Over the course of years, they exchanged many emails, which later the trial court said “provide[d] evidence of their oppressive conduct against Wilson.”
The Lawsuits: Wilson v Gandis
After a long period of behavior unfavorable to Wilson, lawsuits followed. The main issue we’ll be looking at is Wilson’s claim against Gandis and Shirley for minority member oppression. (Other issues not relevant here include Gandis’s and Shirley’s counterclaim against Wilson for breach of fiduciary duty, which they lost, and CCC’s claim against Wilson and companies he worked with after CCC for misappropriation of trade secrets, which they also lost.)
In a 5-day bench trial in 2014, a trial court found Gandis and Shirley had engaged in oppressive conduct against Wilson, saying “This is a classic squeeze-out,” and that the body of emails between Gandis and Shirley “abounds with evidence of calculated oppression” and “could serve as a script” for minority member oppression. The court found in favor of Wilson and ordered Gandis and Shirley to buy out Wilson’s interest in CCC as individuals, rather than having CCC buy him out.
Gandis and Shirley appealed, and in an unpublished decision, the appeals court agreed with the trial court and adopted the order in its entirety. They appealed again, and the South Carolina Supreme Court heard the case in June 2019.
Examples of Oppressive Conduct
In its opinion, the supreme court states that it’s not necessary for the plaintiff to prove illegal or fraudulent conduct in order to prove minority oppression. The minority investor instead needs to show that their investment is “trapped” and that they’re facing exclusion from participation in business returns for an indefinite period of time. What constitutes oppressive behavior must be determined on a case-by-case basis.
In this case, the supreme court agrees with the trial court’s conclusions about oppressive conduct on the part of Gandis and Shirley. Here are many of the acts Gandis and Shirley engaged in that the courts found oppressive:
Conspiring together to “get Wilson out.” Many emails exchanged between Gandis and Shirley blatantly and boldly discussed their plans to get Wilson out by different means, including making him an employee with a 5-year noncompete agreement and firing him on the smallest of pretexts.
Withholding distributions. From 2007 to 2010, CCC set aside funds to cover members’ individual tax liabilities, which were proportional to their membership interests. In 2011, this changed. Shirley emailed Gandis and encouraged him to use the funds that would have gone to members to help pay their tax liabilities to instead pay back what was owed on CCC’s line of credit from Gandis’s other business, which would directly benefit Gandis and leave Wilson without money to pay his tax liability. Shirley let Wilson know that there would be no distributions that year to members to cover tax liabilities.
Secretly monitoring Wilson’s emails. Gandis and Shirley began reading Wilson’s emails and referenced them in their own email exchanges. In 2011, they read an email to Wilson from his wife in which she expressed frustration over how Shirley and Gandis were managing CCC. From then on, Gandis’s and Shirley’s efforts to exclude Wilson from the LLC increased.
Gandis and Shirley later said in court that they were simply archiving all of CCC’s incoming emails in order to keep customer quotes and so forth available, but the trial court said this testimony was not credible, and the supreme court agreed. They also said that the employee handbook makes it clear that company email should not have an expectation of privacy – but the handbook was never issued.
Withholding income from Wilson. Not long after reading the email to Wilson from his wife, Gandis and Shirley stopped paying Wilson the monthly $12,000 they had agreed upon to compensate him for bringing his previous company’s business over to CCC.
Plus, they began classifying Wilson’s distributions as loans. When the situation came to a head in October 2011, Gandis (on Shirley’s advice) gave Wilson two options. 1. Surrender his membership interest in order to satisfy his loan balance of $123,000, which began accruing once they recategorized his distributions as loans. Or 2. Become an at-will employee of CCC (with the aim of firing him for the smallest of reasons, according to an email from Shirley).
From there, Wilson and Gandis entered into back-and-forth negotiations. Wilson was trying to find a way to either stay involved fairly or leave with his rightful share of what he was owed, while Gandis was trying to find a way to get Wilson out paying as little as possible.
Revoking financial authority. Around this time, Shirley removed Wilson as signatory on CCC’s bank account, leaving Gandis as the only signatory on the account, and revoked Wilson’s authority to make wire transfers. Wilson’s ability to access CCC’s financial information was also limited.
Misrepresenting the company’s finances. Gandis and Shirley made it look as if CCC had less cash than it had and later manipulated the December 2011 pro forma balance sheet to make it look like Wilson’s interest in the company was less than it really was.
Locking Wilson out of the building. In January 2012, after Wilson and Gandis were unable to come to an agreement about what should happen, Wilson arrived at the office to find Gandis there with a police officer and a locksmith. Since Wilson was a co-owner, the officer didn’t make him leave, and Wilson was able to enter the building and take two laptops, a Blackberry, and a number of files with him before he left and the locks were changed.
Emails between Gandis and Shirley showed that this was their plan. They discussed the legality of it and what to use as a cover story – first that Wilson had resigned (which he protested he didn’t), then that they did it because Wilson was competing with CCC.
Terminating Wilson’s health insurance coverage and cell phone services. These benefits were cut off for Wilson – but not for other members of the LLC – after he was locked out. Plus, from here Gandis and Shirley increased CCC’s monthly rent, which, remember, directly benefited Gandis since CCC rented a building from Gandis’s company M-Tech. They also raised the rate on the line of credit, which again directly benefited Gandis.
Starting up a competing company. In July 2012, Gandis and Shirley started up another LLC, ZOi Films, without telling Wilson. They said they founded it in an attempt to rebrand CCC and it was to be a wholly-owned subsidiary of CCC, but the trial court characterized it as an attempt to “siphon off” business from CCC.
Minority oppression must be determined on a case-by-case basis, says the supreme court, and in this instance it was not ambiguous – the trial court, court of appeals, and supreme court all agreed that Gandis and Shirley engaged in oppressive acts that were “brazen” and “unconscionable” (in the words of the trial court).
A Point of Disagreement
There was one point on which the supreme court disagreed with the trial court, and that’s the issue of who should be responsible for buying Wilson out. Gandis and Shirley argued against the trial court’s order that they must buy out Wilson’s share with their own money, as they argue that the LLC should protect them. They cited subsection 33-44-303(c) of South Carolina Code which protects LLC members from personal liability when acting in the course of ordinary business. But engaging in acts of calculated oppression is not in the course of ordinary business, the court determined.
Still, the supreme court did reverse the trial court’s order for Gandis and Shirley to personally buy Wilson out and remanded the case back to the trial court. CCC is ordered to buy out Wilson’s share, and if it doesn’t do that in a timely manner, then Gandis and Shirley will have to do so personally in a way that’s proportional to their interest in the business.
Protect Your Interests with LLC Governing Documents
The supreme court’s opinion called out that Wilson and Gandis did not have an operating agreement, employee handbook, or other optional but important documents to help them run their business. While having governance documents can’t entirely prevent minority oppression, they can help protect minority members’ interests and give recourse should the issue go to court. Not all instances of minority oppression are as blatant (and numerous) as in the case above.
If you are planning to start up an LLC with other people, or even if you already run one but don’t have anything beyond Articles of Incorporation, get your governance documents drafted and done. Call business attorney Gem at the Gem McDowell Law Group in Mount Pleasant, SC. He and his associates can draft documents that are tailored to your business that are fair to members and will help as you run the business and run into questions. Call today to schedule a free consultation at 843-284-1021.
Your Risks as a Minority Member in an LLC: Oppression and Squeeze-Out
A limited liability company (LLC) is a great thing for many entrepreneurs. Among other things, it provides liability protection while requiring fewer formalities than a corporation. But it’s not risk-free. One of the potential risks is minority oppression of members who own less than 50% of the LLC.
Today we’re going to look at what minority member oppression is, what your rights are as a minority member of an LLC, and what you can do to protect yourself.
Risk of Oppression for Minority Members in an LLC
Minority member oppression occurs when a member or members of an LLC act to reduce a minority member’s involvement in the LLC against their will.
When minority shareholder oppression occurs in a corporation, the shareholder can simply sell their shares (albeit at an unfairly low price in many cases) and walk away. However, in an LLC and close corporations, it’s often not so easy. The minority member may find that their investment is essentially being held hostage, and they don’t have a legal avenue to get it out of the company. Walking away means losing their investment.
The oppression often entails reducing the minority member’s income from the business, keeping them out of the loop regarding company business, and excluding them from important management decisions. Another tactic is for the majority member(s) to create a new, separate business entity and merge that with the existing business without giving the minority member any ownership in the new merged business, instead exchanging their interests for cash or eliminating it altogether.
When the end goal of this oppression is to force the minority member to give up their ownership in the LLC altogether, that’s commonly referred to as a squeeze-out or freeze-out.
LLC Minority Members’ Rights Under South Carolina Law
If your LLC does business without important governance documents (covered in the section below) and a dispute arises and goes to court, then South Carolina laws regarding LLCs apply. These vary somewhat depending on what kind of LLC it is (member-managed or manager-managed), but under SC law, minority members can expect certain rights, including:
- The right to a share of distributed profits
- The right to a share of proceeds of a sale if the LLC is sold or dissolved in proportion to their ownership
- The right to see the company’s books and financial records
- The right to sue another member or members for breach of fiduciary duty if they engage in misconduct
These protections sound great but they may not play out the way you want in real life. For example, majority members may take an income as an employee (rather than a distribution as an owner) or spend the company’s money in another way to avoid making distributions to minority members. Or they could structure a sale of the LLC in such a way as to legally cut out a minority member from the proceeds.
In short, don’t rely on default South Carolina laws to protect your interests as a minority member in an LLC. It’s best to have governance documents including an operating agreement with terms that are favorable to minority members and for you as a minority member to know, understand, and agree to those terms.
How Minority Members Can Protect Themselves: The Operating Agreement
In South Carolina, the Articles of Incorporation is the only document your LLC is legally required to have to be in business. Other governing documents are optional but extremely important for multi-member LLCs, the most important of which is the operating agreement.
An operating agreement details the ways in which the LLC will operate, covering such topics as ownership, members’ and managers’ duties, voting rights, how decisions are made, how profits and losses are handled, and more. Terms regarding buying and selling ownership or the LLC may be included or can be handled in a separate buy-sell agreement. Same with raising capital, which may be included in the operating agreement or detailed in a separate capital call agreement.
It’s important to understand that an operating agreement is not bulletproof. Majority members may still try to squeeze out or freeze out a minority member. However, when drafted in a way that protects a minority member’s interests, an operating agreement can help. If an issue arises and goes to court, then the court will look at the terms of the operating agreement rather than defaulting to SC law, which will be better for you (assuming the agreement is drafted well).
Work with a Business Attorney to Draft Your LLC’s Governing Documents
Each LLC is different and the members within each LLC are different, so no two operating agreements are alike. If you’re planning on joining or starting up an LLC with other people, or if you’re already in one but don’t have governing documents, talk to a business attorney. They can not only draft an operating agreement (and other documents) tailored to you and your business, they can also advise you on potential pitfalls and situations you may not have considered. Because what you don’t know can hurt you.
Gem McDowell is a business attorney in Mount Pleasant, SC, serving clients in the Charleston area and across the state. He and his associates at the Gem McDowell Law Group help people start, grow, and protect their businesses and business interests. Gem is a problem solver who has seen a lot in over 30 years of experience, and he can advise you on your situation and help you protect your interests. To schedule a free consultation, call 843-284-1021 today.
How to Word an Enforceable Provision: Invention Assignment Agreements and Confidentiality Agreements
Some of the most valuable assets a company can own are its trade secrets, patents, and inventions. Losing control of these assets can be very costly, so protection is a must.
To protect their intellectual property, companies often include clauses and provisions regarding trade secrets and inventions. Confidentiality agreements and nondisclosure agreements stop employees from sharing trade secrets and sensitive information. Assignment of Inventions clauses ensure that relevant inventions made by employees during their time at the company are assigned to the company. Trailer Clauses do the same thing but cover a period after the employee leaves the company’s employment.
For businesses in South Carolina with sensitive information, trade secrets, and other intellectual property to protect, it’s important to understand that having such clauses and agreements with your employees isn’t enough. They must be worded precisely in order to be enforceable by a South Carolina court.
A Supreme Court of South Carolina case, Milliken & Company v. Morin (2012) (find it here), gives a real-life example of what happens when these types of agreements come under the scrutiny of the state’s highest court.
Background to the Milliken & Company v. Morin case
Brian Morin is a research physicist who started working for Milliken, an industrial chemical and textile producer, in April 1995. While employed, he began working on a new multifilament fiber, but Milliken did not agree to support its research and development. Morin resigned from Milliken in May 2004 and filed for a patent for the new fiber which he assigned to Innegrity, a company he founded the same week he quit Milliken.
Milliken found out about what Morin was doing and demanded he stop working with the fiber and furthermore said that under an employment agreement Morin had signed, the invention rightfully belonged to Milliken.
Eventually, Milliken and Morin’s case ended up in the South Carolina Supreme Court. The issue of interest to us here is Morin’s argument that the agreement he signed was overbroad and therefore unenforceable. He argued that the inventions assignment provision and confidentiality clause in his agreement should be scrutinized and enforced to the same standard of covenants not to compete.
The Supreme Court disagreed.
Why are Covenants Not to Compete Disfavored in South Carolina?
As we’ve discussed in previous blogs (here, here and here), South Carolina courts tend to side with the employee rather than the employer when it comes to covenants not to compete. The South Carolina Supreme Court has stated that “restrictive covenants not to compete are generally disfavored and will be strictly construed against the employer” and that they must also be reasonably limited in time and geographical scope. (See Rental Uniform Service of Florence, Inc. v. Dudley, 1983)
This is a high standard to hold all provisions to. However, it’s important to understand why these agreements are often found unenforceable by South Carolina courts. It’s because when they are overly broad and badly worded, they violate public policy by hampering an individual’s ability to make a living in their profession.
The same is not true about the provisions at hand, which do not hamper Morin’s ability to make a living within his profession. The Supreme Court found the inventions assignment agreement and the confidentiality agreement to be clear, reasonable, and enforceable. That’s why it upheld the Court of Appeals’ decision and decided against Morin.
What Employers Need to Know About Drafting These Provisions
While this South Carolina Supreme Court decision is good news for employers in this state, it’s important to understand that the Court upheld the enforceability of reasonable provisions. A reasonable provision is one that protects legitimate business interests yet does not violate public policy by hampering an individual from making a living in their profession.
In this particular case, the exact wording of the relevant parts of the employment agreement signed by Morin was important to the Court. Let’s look at the specific language used and upheld by the Court to understand what businesses can do when wording their own provisions in the future.
- Clear Definitions
For both the confidentiality clause and the invention assignment agreement, the Court’s opinion stressed that the definitions were extremely clear. Here they are, as presented in the opinion.
Milliken’s definition of confidential information contains five elements, all of which must be met for information to be considered confidential. The Court wrote “It does not take much elaboration to see that rather than covering general skills and knowledge, it encompasses only important information […]” As defined by Milliken in the agreement, confidential information is:
- Competitively sensitive information
- Of importance to and
- Kept in confidence by Milliken,
- Which becomes known to the employee through his employment with Milliken, and
- Which is not a trade secret.
Regarding the invention assignment agreement, the Court notes that at first Milliken defines inventions broadly, then provides the following broad exception to that definition:
“for which no equipment, supplies, facility or proprietary information of Milliken was used and
Which was developed entirely on your own time, and
- Which does not relate
- Directly to the business of Milliken or
- To Milliken’s actual or demonstrably anticipated research or development, or
- Which does not result from any work performed by you for Milliken.”
Both of these provisions had clear definitions that protected Milliken’s interests without limiting Morin’s ability to find employment.
- Reasonable Time Limitations
The Court stated that the confidentiality agreement was “reasonably limited” to “only” three years and it called the one-year restriction attached to this provision “eminently reasonable.”
Businesses should be conservative, not greedy, when attaching time limitations to any and all provisions.
- Reasonable Geography Limitations
Although not discussed in this decision, geographical limitations on such provisions are also important. The Court of Appeals decision in this case cited a previous South Carolina Supreme Court decision which found “geographic restriction is generally reasonable if the area covered by the restraint is limited to the territory in which the employee was able, during the term of his employment, to establish contact with his employer’s customers.”
For companies that do business with customers across the country and across the globe, this means that a provision unlimited in territory may not be considered unreasonable if the company actually does do business all over. For companies that do business solely in South Carolina, it would be unreasonable to have a provision unlimited in territory.
Employers should err on the side of being conservative when it comes to limitations in geography.
Get Help with Business Contracts, Employment Agreements, and More
As you can see, the wording in an employment agreement or provision can make the difference between being enforceable and unenforceable here in South Carolina’s courts. If you have business interests to protect, you should be working with an experienced attorney.
Gem McDowell is a business attorney with over 25 years of experience solving legal problems and helping businesses protect their interests. For advice and help with your business legal matter, contact Gem McDowell Law Group in Mt. Pleasant, SC today at 843-284-1021.
Protect Your Business Interests with Anti-Raid and Anti-Disparagement Provisions
We’ve talked before about how South Carolina courts tend to favor employees over employers in regards to covenants not to compete. This means that employers must be very careful in wording covenants not to compete to ensure they’re not overly broad or too restrictive.
But this bias against employers doesn’t extend to all covenants employers use. South Carolina courts are more likely to enforce covenants that don’t have clauses and provisions limiting an employee or former employee from earning a living in their profession.
Two other provisions that can help protect an employer’s business interests and should be considered when drafting a covenant not to compete are anti-raid provisions and non-disparagement provisions. As with covenants not to compete, the purpose of these provisions is to protect the employer’s interests after an employee leaves the company. Let’s look at them in turn.
Anti-Raid Provisions
The anti-raid provision typically states that for a period of time after the employee is no longer with the company (and possibly during employment as well), they may not approach or attempt to solicit anyone working for the company to leave in order to compete with the company. This is intended to prevent an employee from leaving the company and taking along other employees, which is clearly detrimental to the company’s interests.
Like covenants not to compete, these provisions must be reasonable. In practice, that means limiting the provision to a restricted period of time, often a year after leaving employment. South Carolina courts are likely to interpret these more favorably for the employer rather than the employee, as they don’t harm the employee’s ability to make a living in their profession after leaving their employer.
Non-Disparagement Clauses
This clause prohibits an employee from disparaging, or making negative comments, about the company, its officers, and its employees, whether orally or in writing. This provision can be found in both employment agreements (often as a clause within the covenant not to compete) and in severance or settlement agreements at the end of the employee’s tenure. The purpose is to protect the company’s reputation. Again, South Carolina courts may be favorable towards these clauses because they don’t have anything to do with restricting the employee’s right to work. Employers should consider using this clause as a matter of course upon either hiring or dismissing employees.
Still, employers need to use caution with this clause. The agreement must be clear to both parties, as a lack of clarity can lead to unintended consequences. Great care is warranted with these clauses, in part because they are greatly disfavored by state and federal agencies.
Work with an Experienced Business Attorney in Mt. Pleasant, SC
As always, remember that issues like this depend very much on the state where business is being done and arbitrated.
If you need legal advice on business contracts, employment or severance agreements, business real estate transactions, corporate taxes, or other business matters in South Carolina, contact Gem McDowell Law Group in Mt. Pleasant, SC. Gem and his associatess help businesses of all sizes protect their interests so they can continue to grow. Call today to schedule an initial consultation at 843-284-1021.
When Covenants Not to Compete and NDAs Reach Too Far
South Carolina courts are clear in their general dislike of covenants not to compete and any provisions that restrict an individual’s ability to work. They are also clear in their tendency to rule in favor of the employee rather than the employer in related cases. This was the issue at hand in a recent case decided by the South Carolina Court of Appeals.
Covenants not to compete and non-disclosure agreements (NDA) were covered on this blog previously, because it’s so important for employers to be extremely careful in their wording on non-compete and non-disclosure agreements. If they try to restrict their employees’ actions too much, an employer may discover their agreement has reached too far and is invalid.
Fay vs. Total Quality Logistics
That’s essentially what happened in the South Carolina Court of Appeals case at hand, Fay vs. Total Quality Logistics (2017) (find it here). TQL, an Ohio-based transportation and logistics company, hired Joshua Fay in late 2012. As required by the company, Fay signed TQL’s Non-Compete, Confidentiality, and Non-Solicitation Agreement before commencing work. The Agreement was signed in Ohio and was to be enforced under Ohio law.
The following summer, Fay was fired. He then founded JF Progressions, LLC, in Mount Pleasant, SC, providing logistics services to another company. TQL found out and notified Fay that TQL intended to pursue legal action if he didn’t stop what he was doing. Fay then filed suit against TQL to seek a declaratory judgment that the Agreement he had signed was invalid and not enforceable. He argued that the Court must invalidate the Agreement if it is contrary to SC public policy, even if Ohio law applied to the interpretation of the Agreement.
The South Carolina Court of Appeals ultimately sided with Fay and found that, though it was to be enforced under Ohio law, the Agreement offended South Carolina public policy and was therefore not enforceable. The appeals court found that the lower court (the circuit court) erred when it ruled against Fay, stating that the Agreement was enforceable under Ohio law and did not offend SC public policy.
When non-compete and non-disclosure agreements are too broad
To understand why the South Carolina Court of Appeals ruled as it did, it’s important to understand the basics of non-compete agreements. Two important clauses in a non-compete agreement are about time and geography; agreements place limits on the length of time and the geographical area in which an employee or former employee can work. An enforceable agreement strikes a balance between protecting the employer’s interests and giving the employee or former employee the freedom to earn a living in their profession.
South Carolina has determined that these limits must be “reasonable.” In the Agreement Fay signed, the limits were not reasonable under South Carolina’s standards. The non-disclosure agreement was worded so as to effectively be a non-compete agreement, which was to be in effect “at all times.” Under the Agreement, Fay was restricted from working with “Competing Businesses,” which was defined as “any person, firm, corporation, or entity that is engaged in the Business anywhere in the Continental United States.” If TQL’s Agreement were enforced, Fay would not be able to work in the field of transportation and logistics in the Continental U.S. “for an indefinite time, if not forever,” in the Court of Appeal’s wording. South Carolina determined that these restrictions were too broad and violated the state’s public policy, as they restrict an individual’s right to exercise their trade.
The Court of Appeal’s decision cited the Stonhard case, quoting “The agreement fails to limit the covenant to a particular geographical area. To add and enforce such a term requires this [c]ourt to bind these parties to a term that does not reflect the parties’ original intention. Therefore, we hold that the covenant, despite any reformation, is void and unenforceable as a matter of public policy.”</P
In addition, the Court of Appeal’s decisions reaffirmed the fact that South Carolina does not follow the “blue pencil” rule. In non-compete cases, this rule allows courts the discretion to invalidate certain portions of an agreement while maintaining others and to create terms the court believes the parties should have agreed on in the first place.
(Update: the Supreme Court of South Carolina granted cert in 2018, but in 2019 it dismissed the case upon request of the parties involved.)
Lesson for employers on covenants not to compete and NDAs
The lesson here for employers is to be extremely careful in the wording on covenants not to compete, NDAs, and other contracts that have any limiting effect on your employees’ current or future ability to work. As we can see from this case, strict wording of an NDA can effectively be interpreted as a non-compete agreement, even if that wasn’t the original intention.
Employers also need to be cognizant of these issues with regards to different states’ laws. Even if your state’s courts find your contracts “reasonable,” another state’s courts may not, depending on the state’s public policy. The internet cannot provide reliable guidance on this topic, which is why it’s important to discuss it with an attorney who’s well versed in this topic.
For guidance on how to craft your company’s covenants not to compete and NDAs, or for advice on one you’ve already signed, contact Mt. Pleasant business attorney Gem McDowell. He can be reached at Gem McDowell Law Group in Mount Pleasant at (843) 284-1021 or by filling out this contact form online. Contact them today.
How South Carolina Courts View Covenants Not to Compete
Update: This case was reversed by the Supreme Court of South Carolina in 2018; find that opinion here and see the discussion on the decision below.
On the surface, covenants not to compete look simple. One party agrees not to compete against another party – either by working for a competing company, or by starting their own competing company – for a specified amount of time and within a specified location. But as simple as they seem, covenants not to compete aren’t so straightforward.
When two parties end up disagreeing over a covenant not to compete, the matter sometimes ends up in the South Carolina Court of Appeals. That happened recently, in a matter called Palmetto Mortuary Transport, Inc. v. Knight Systems, Inc. (2016) (read it here). This case shows how the courts of South Carolina view and enforce covenants not to compete, and why, as a business owner, it’s important to do everything you can to draw up covenants not to compete that are enforceable.
The Background: Seller’s Remorse
In 2007, Seller sold its mortuary transportation business to Buyer. Among other things, the two parties agreed that 1) Seller would not provide mortuary transportation services within 150 miles of the business for a period of ten years after the sale, and 2) Buyer would buy certain types of body bags exclusively from Seller (at discounted prices) for ten years.
The terms of the sale worked well for several years, but then two things happened.
First, in 2011, Richland County sent out an RFP (request for proposal) for mortuary services. As part of the sale, Buyer had bought an existing contract for mortuary transportation services with Richland County. The covenant not to compete would bar Seller from providing mortuary services to Richland County for 10 years from the date of sale, because it was located within the agreed upon 150-mile radius. However, Seller was interested in submitting an RFP.
Second, Seller accused Buyer of breaking their agreement by purchasing body bags from someone other than Seller. It was found that Buyer had purchased over $45,000’s worth of body bags from Seller since 2007, but had also purchased $478.50’s worth of body bags from a third party. Because Buyer was in breach of contract, Seller said, Seller was no longer bound by the rules of the covenant not to compete.
Seller ended up winning the contract with Richland County. Buyer wasn’t happy.
The case was tried in late 2013, and the judge (actually a court-appointed special referee) found in favor of Buyer. Seller appealed and the decision by the South Carolina Court of Appeals is recorded in the May 4th Advance Sheets.
The Court of Appeals’ Verdict: Throw out the Baby With the Bathwater
The Court of Appeals did not agree with the lower court.
The lower court held that the terms of the covenant not to compete were “reasonably limited” in time and geographic scope. The Court of Appeals disagreed, stating, “In our view, the 150-mile restriction was overly broad and did not protect the rights and interests of [Buyer] in a reasonable manner.”
The Court also wrote that “In South Carolina, our courts will generally uphold and enforce a covenant not to compete arising out of the sale of a business if it is (1) reasonably limited as to time and territory, (2) supported by valuable consideration, and (3) not detrimental to the public interest.”
So for a covenant not to compete to be enforceable in South Carolina, it must meet all three requirements. If it fails one of the requirements, the entire agreement becomes void. Some other states allow courts to “blue pencil,” which means a court can say something like “150 miles is too much, but 50 miles is acceptable, so the rest of the agreement remains intact except for this part.” Not South Carolina. It throws the baby out with the bathwater.
Because the covenant not to compete in question failed to satisfy requirement #1, the entire covenant is not enforceable.
What it means for the parties: Seller is free to provide mortuary services in South Carolina without the restrictions originally laid out in the terms of the sale. Buyer lost a valuable contract as well as a competitive advantage because the covenant not to compete wasn’t enforceable. What Buyer thought was a smart move – restricting business activities of Seller in the manner it did – didn’t end up working out.
Why 150 Miles Wasn’t “Reasonable”
The United States is a large country. From Washington, D.C. to San Francisco, it’s over 2,400 miles. So restricting a business within a 150-mile radius doesn’t seem like a large area. How could that be “unreasonable”?
But consider the State of South Carolina. If you buy a business in Columbia, is it reasonable to expect the seller to abstain from business within a 150-mile radius? Columbia to Hilton Head is 125 miles as the crow flies. Columbia to Myrtle Beach is also 125 miles. And it’s just shy of 100 miles to Greenville. The seller would effectively be barred from conducting business in the entire state.
Also consider that the State of South Carolina is just over 30,000 square miles. The area in a circle with a 150-mile radius (πrr) is over 70,000 square miles – more than twice the area of the State of South Carolina.
150 miles doesn’t seem quite so reasonable now.
How to Determine “Reasonable” Geographic Restriction
It would be helpful to business owners if the courts would give a firm number that’s reasonable. But it doesn’t work that way. Among other things, the nature of the individual business determines what’s reasonable.
One way to think of it is how far a customer would travel to patronize a business. Would a customer drive 20 miles to go to a convenience store? Unlikely. That’s like driving all the way from Isle of Palms to Avondale in West Ashley. The vast majority of people are not going to drive that far for a soda and a lottery ticket. So in this example, even a 20-mile radius would be too large.
Or think of it from the salesperson’s point of view. Could a company that installs pools expect to serve customers in both Summerville and Folly Beach (a distance of 35 miles)? Possibly, yes. In this example, a 20-mile radius might be perfectly reasonable.
Update: What Does the Supreme Court’s Reversal Mean for Covenants Not to Compete?
The Supreme Court of South Carolina took up this case on appeal and in its 2018 opinion, it REVERSED the appeals court’s decision.
So does this mean that discussion and conclusions above are incorrect and South Carolina courts now view covenants not to compete more favorably?
No – at least not when it comes to employement contracts.
Covenants not to compete in the context of an employer-employee agreement are still held to great scrutiny by South Carolina courts. However, in the context of the sale of a business, courts may be more “relaxed,” to use the court’s word.
The supreme court made it clear that there is a significant difference between the two situations:
“As for the subject matter of the contract, we stress the non-compete covenant between Knight and Palmetto arose out of the sale of a business between two sophisticated parties. Non-compete covenants executed in conjunction with the sale of a business should be scrutinized at a more relaxed level than non-compete covenants executed in conjunction with employment contracts.”
The court goes on:
“Non-compete covenants executed in the context of an employment contract are generally disfavored and are strictly construed against an employer […] The probability of unequal bargaining power that may exist between an employer and employee is significantly reduced when the restriction arises in the context of a sale of a business between two sophisticated parties.” (Emphasis added)
What You Should Do
Before drawing up or signing any covenant not to compete in South Carolina, take time to see if it will satisfy the three requirements listed above. In particular, look at restrictions on time and geographic scope. Consider the nature of the business you’re selling or buying to determine what seems reasonable. Don’t be greedy; that’s often the underlying case of such disputes. Rather, be conservative. You stand a better chance of having an enforceable agreement if you do.
You should also seek out the advice of an experienced business attorney like Gem McDowell. Contact Gem at their Mount Pleasant office at (843) 284-1021 today.
How to Protect Your Interests With Enforceable Covenants Not to Compete
South Carolina is a state that values an individual’s freedom to work. Because of that, it does not look kindly on contracts that try to restrict a person from working.
This can be tricky for employers trying to protect their interests. Many employers require employees to sign covenants not to compete, which are intended to prevent them from taking trade secrets and sensitive information to a competitor and/or staring their own competing company. But if the covenant not to compete isn’t written correctly, it won’t be worth the paper it’s written on. So here’s how to write one that might hold up in South Carolina court – and a couple extra things to think about, too.
Three things to address in your covenant not to compete
The keyword is reasonable. You have to be reasonable about what, when, and where your employee can work after they leave your employ.
1) Scope
The scope of duties cannot be restricted in an unreasonable way. If one of your employees writes the company newsletter, you cannot restrict them from writing anything at all after leaving your company. The scope in that case is simply too broad.
2) Duration
A “safe,” reasonable duration is typically two years. Any longer might cross over into unreasonable territory.
3) Geographic Location
This one’s interesting. Many covenants not to compete contain seemingly innocuous clauses that say something to the effect that the employee cannot work at a similar company within a 50-mile radius. That doesn’t seem that unreasonable at first glance – surely that leaves plenty of potential customers and places to do business – but it is.
You’ll remember from high school geometry that the area of a circle is πr2, which in this case equals over 7,854 square miles (3.14159*50*50). The state of South Carolina is only 32,000 square miles. Not so reasonable now, is it? A full quarter of the state is now off-limits. Even a 10-mile radius essentially covers all of Charleston County.
There’s no hard-and-fast rule here about what is considered “reasonable.” You’ll need to use your judgment, and get the advice of a business attorney, to draft a geography clause in your covenant not to compete that’s more likely to hold up in court.
How you, the employer, can protect your interests
As stated above, South Carolina is not known for looking kindly on strict covenants not to compete. But some states are. So a company may add a “forum clause” that says if disputes arise, they’ll be settled in a court in a state like Florida, which is more favorable to employers in these cases.
Another way to protect your interests and keep sensitive information out of competitors’ hands is to focus more on non-disclosure agreements (NDAs) and confidentiality agreements than on covenants not to compete. Because NDAs and confidentiality agreements don’t tend to restrict a person’s freedom to work, the South Carolina Court doesn’t enforce them so heavily in favor of the employee as it does with covenants not to compete. That is, the Court’s decision is likely to be more favorable towards you, the employer, rather than the employee. (The 2012 case Milliken & Company v. Morin set this precedent.)
Get advice on creating your reasonable covenants not to compete
Need help with your contracts, covenants not to compete, and other business documents? Contact business attorney Gem McDowell at their Mount Pleasant office at (843) 284-1021 today.
How A Buy-Sell Agreement Is Like Monopoly
Imagine sitting down with someone to play Monopoly, and it’s the first time ever for both of you. What do you do first? After you each pick a token – the top hat, the Scottie dog – you read out the rules so you both know how the game works.
Pass Go, collect $200. Not $600. Not $800. Land on Free Parking, you get the money in the middle of the board. You don’t just take the money when you feel like it. The game works best when every player is aware of the rules and follows them.
Business is the same way.
When you start a business with other people, you all have to agree on “the rules of the game,” the way things will work in your business. Drafting corporate governance documents is the best way to do this. One of the most important documents is the buy-sell agreement.
The Buy-Sell Agreement Sets the Rules of Business in Advance
A buy-sell agreement is like a pre-nuptial agreement for the business. Instead of saying what will happen when you divorce, it says what will happen when a particular event arises, like a partner being convicted of fraud or becoming disabled.
With a solid buy-sell agreement in place, owners run the company knowing that whatever arises, there is a pre-determined course of action that will take place. It can prevent partners from panicking and having to figure out what to do on the fly or, in some cases, suing each other.
Every business with more than one owner should have a buy-sell agreement in place.
The 8 Parts of a Buy-Sell Agreement
When you prepare a buy-sell agreement for your business at Gem McDowell Law Group, you and your partners will be taken through eight parts. Together with Gem, you’ll create a document that is tailored to your business and meets your needs. That is to say, this is not a cookie cutter document. It’s created for your business alone.
Each one of the eight parts asks you to consider a potential situation and how you’d like to deal with it, should it occur. They are:
1. Borrow money against shares. When an owner or shareholder borrows money against their shares, it can have an impact on the business. Many companies only a partner to borrow against their shares if 75% or 100% of the partners agree to it.
2. Voluntary transfer. What if one of the owners wants to give some shares to his wife? Well, you agreed to be in business with him, not his wife. The buy-sell agreement can prevent that transfer from taking place. Partners can agree upon who can and cannot be given shares in the business through voluntary transfer.
3. Involuntary transfer. This could happen when a bank forecloses on a shareholder’s shares of stock, for example.
4. Discontented owner. Let’s say that in a company with 8 owners, 7 think that the 8th is untrustworthy and want her out. Your buy-sell agreement can make a provision where if a quorum wants that partner gone, she can be forcibly bought out.
5. Crimes of moral turpitude. This legal term refers to a variety of crimes contrary to community standards of justice, honesty or good morals. If an owner of the business is convicted of such a crime, it could be very bad for the company as a whole. For that reason, the remaining owners may decide that a partner guilty of such a crime can be forcibly bought out.
6. Buyout because of retirement. AKA, one of the partners is not working hard enough. The agreement can include a stipulation about how many hours each owner must work in order to be in good standing, and if they don’t work that many hours, what the consequences are. Each owner may have a different number of hours, if, for example, one partner contributes money rather than manpower.
7. Disability. What happens to the business if one of the owners becomes disabled and can no longer work?
8. Death. A buy-sell agreement can include the terms of the buyout of the deceased partner’s share, such as whether the buyout is immediate or part immediate, part later.
Creating a buy-sell agreement early on in your business is smart because you and your partners are more likely to think about each situation in a clear and fair manner. After problems arise, it’s more difficult to get everyone on board – it’s like trying to create the rules of Monopoly after someone has landed on Free Parking. It’ll be a lot tougher getting the other players to agree that landing on Free Parking means you get the dough from the middle of the board. At that point, you’ll wish you had agreed on the rules at the start.
“Do I Really Need a Buy-Sell Agreement?”
The only way it’s remotely close to being okay to not having a buy-sell agreement is if you’re the only person in your business. If you’re in business with someone else, you need to have this and other corporate governance documents. Even if they’re not required by law, it’s just smart business to have them.
Learn More About Buy-Sell Agreements
Whether you’re in the early stages of creating a new business or you’ve been in business for years, call the Charleston office of business attorney Gem McDowell at 843-284-1021 to discuss how he and his associatess can help you. They work with companies to create tailored buy-sell agreements, capital call agreements, non-disclosure agreements, covenants not to compete and more.
