Governance Forensics

Governance Forensics

When a company is initially founded – whether an LLC or Inc. – a Certificate of Formation/Incorporation is filed the Secretary of State. This establishes the proper legal structure, and puts on the public records, certain details like the name, the incorporator, the number of shares or units, and other details of the corporate structure. Then companies add an Operating Agreement or Bylaws. These documents combined, along with certain State and Federal laws, determine the operating rules for any company. Most companies rarely update these documents over time. Sometime in the future, if there is a problem or an issue, these documents control how it can be enabled or blocked.

What is Governance Forensics?
If a company has a disagreement over majority control of the enterprise – Inc or LLC, and they need to find a legitimate way to gain or block certain rights or goals, they engage Dennis’ Governance Forensics skills. Buried deep within the corporate documents there are often overlooked clauses that will either allow or disallow any number of actions. Finding a hidden path to accomplish the goals of the company owners, board of directors, or management, within the company’s records, requires unique knowledge and breadth of experience. This process, known as “governance forensics,” is the discovery of those hidden gems and loopholes that allow the client to accomplish their goals, even when attorneys have told them that they could not.

What the problem?
When a company is initially incorporated the founders file an initial request with the Secretary of State of the state where they wish to incorporate. Whether the entity being formed is a corporation, a limited liability corporation, a for-profit or a not-for-profit, all states require a Certificate of Incorporation or Certificate of Formation. This establishes the proper legal structure, and puts on the public records, certain details, like the name, the incorporator, the number of shares or units, and other details of the corporate structure.

In addition, the entity is also required to complete, sign, and retain a variety of other documents that do not necessarily need to be filed with the state. Over time, as the company grows and evolves, many of the initial documents get changed. These changes can involve filing amended documents with the state, or just amending internal documents due to changes, additions, or deletions, as approved by the board of directors or the shareholders. This can involve anything from a simple name change to a such actions as a complex acquisition, raising capital/selling equity, taking on debt, changing the bylaws, implementing a stock option plan, adding board members, and much more. One can imagine that over decades these changes can mount up, and it can sometimes take research and understanding to determine the exact status or rules about something in particular.

Some companies manage to keep their documents current over the years, and their archives well organized, and they have been careful to retain only the actual approved and signed versions of documents – not several different draft versions. When they have brought in investors, or borrowed money, the subscription agreements, shareholder agreements, promissory notes, etc. have all been properly executed and filed. When they have awarded incentive equity, or authorized other actions requiring board or shareholder approval, all the documentation is properly worded, executed and retained. The keywords here are – some companies. Large corporations can afford legal and administrative staff, and outside attorneys, to make sure that all these details are properly attended to. However, most companies that are smaller, and particularly those that are privately held, often cannot afford this level of diligence. They resort to using anyone available, including the founders or executives, to attend to these tasks, and it the rule rather than the exception that the company’s document files are less than organized. Therefore, when something comes up, as it often does, where founders, owners, boards, minority shareholders, or even majority shareholders want to take specific actions or find a creative way to accomplish something, they often find that documentation allowing the action is actually not in place.
The first stop in these circumstances is usually a lawyer. Sometimes the one who drafted the documents, but often not the same one. They will review the best available information they are given, but more frequently than not, the documentation is incomplete, or inaccurate, or both. The attorneys will usually stop there with a prompt conclusion that you cannot do what you want to do. Those actions are not allowed under the existing corporate governance structure, and it may be too late to change anything – or you simply do not have the votes.
This is the time you need to involve someone who has the breadth of experience and understanding to be able to drill down, reviewing every available piece of information, following the thread of actions over all the proceeding years, looking for any telltale clause or resolution that could shed light on a way to accomplish the objective – in other words, governance forensics.

Documents & Materials:
Clues to what can and cannot be done, and how to do it, can be hidden in any number of places. Documents can be in draft or final versions and can be signed or unsigned, sometimes even in multiple conflicting copies. The enterprise can be a corporation (C corporation), an LLC, an S or sub-S corporation, a B Corporation, or even a partnership. Each one will include some version of the following documents:
Certificate of Incorporation/Formation
Bylaws/Operating Agreement
Organizational Consents/Joint Consents/Unanimous Written Consents
Board of Directors (or Managers) minutes
Plans for Equity Incentive, profit-sharing, or synthetic (phantom) equity
Grant notices/documents for equity grants
Amendments to documents
Capitalization schedules
Promissory Notes
Investment Documents including Subscription Agreements and Shareholder Agreements
Loan Agreements
… and more.
If the entity has been operating over a number of years this can add up to a substantial stack of very confusing content.

Generally, the process starts when the company’s Board of Directors, management, founders, or shareholders want to either do something, or not do something, and one or more lawyers tell them that they cannot accomplish what they wish to. Typically, this is when a friend or colleague hears about their problem and refers them to a Governance Forensics expert (GFE) – of which there are very few who are qualified. The first thing the GFE does is ask a lot of questions to get a full understanding of the problem or issues, and what they have been told by the previous advisors (lawyers).
The GFE will then request all the available documents, in whatever forms they exist. The professional will then go back to the very start. What were the original terms of governance and company legal structure, what changes or amendments were made, and what was further added in the form of resolutions and amendments? How did the ownership evolve from the original holders to the present holders? This will include all transactions for buying or selling equity, awarding equity, etc. It is also affected by other transactions like debt – personal, corporate, bank, private, etc. What rights, particularly voting, were granted to which equity holders over the years, and under what circumstances? Looking for that potential gem of information or term within this mass of content often involves asking the right questions as much as anything else.

Frequently the Governance Forensics process will unearth a clause, or term, or other details that had been hidden from less knowledgeable and experienced eyes, which will enable you to accomplish your goal – often with surprising ease. Sometimes the process will simply confirm the original verdict that ‘there is nothing you can do and having gone through the process simply assured you that you have done everything possible to accomplish your goal, but the company’s structure and history did not offer the necessary circumstances.

If the goal is important enough, it is worth the additional investment in a Governance Forensics audit.
The following vignettes will give some actual examples of surprising outcomes for real clients.

Case Study Vignettes

Background: A private investor (“Larry”) in Houston directly owned 5% of a financial software company in Silicon Valley, and he was on the board of directors. The company was in need of capital, and Larry was willing to invest additional capital under one condition – the company needed to appoint him as the CEO. The bylaws of the company exclusively allowed the board to appoint the CEO. The other members of the board did not like Larry and refused to make him the CEO. Larry went to two different prestigious law firms in Houston to have them review the circumstances. After studying the situation, they informed him that there was nothing he could do, beyond being appointed by the board. Larry was introduced to and engaged Caganco.

Actions: Caganco reviewed all the applicable historical documents and asked a number of additional questions. Based on a deep analysis and an acquired understanding of all the relevant circumstances, Caganco authored two written consents, delivered by Larry to the company board by email. Upon receipt of these emails, Larry was automatically and unilaterally elected CEO. After checking with their counsel and determining that Larry’s actions were completely legal, two of the board members resigned. Caganco authored two additional written consents, also delivered by email, electing two new directors, who then elected Larry as the chairman of the board.

Justification: The original attorneys that Larry consulted had failed to fully investigate the overall ownership of the company, beyond Larry’s 5% ownership. Further investigation by Caganco determined that a separate LLC owned 48% of the company. This LLC was formed specifically to invest in the company. The operating agreement of the LLC dictated that a majority vote of the LLC members controlled the LLC. Caganco’s research determined that Larry owned 70% of the LLC units. Therefore, by voting the 48% of the company shares owned by the LLC and the 5% he owned directly, Larry was able to submit a written consent, as the majority shareholder of the company (voting 53%), which amended the company bylaws changing the election of the CEO from the board to a majority of shareholders. This was followed by the second resolution that elected himself as CEO.

Background: A small software company, co-founded by a husband and wife, had a modest number of minority shareholders. Two of these minority stockholders together owned 15% of the company. These two individuals had originally been granted restricted stock in return for business development activities, which they never accomplished before the restrictions expired and they owned the stock. For many years the co-founders remained upset by the prospects that these two shareholders would eventually benefit to that degree (15%) from the sale of the company.

Actions: Caganco reviewed all the applicable historical documents and asked a number of additional questions. Based on a deep analysis and an acquired understanding of all the relevant circumstances, Caganco authored one board resolution. This resolution served to effectively reduce the two minority shareholders’ ownership percentage to 7% from 15%.

Justification: The company was very closely held and all the shareholders beyond the two individuals were actually employees of the company. This allowed the board to grand a large number of previously authorized, but unissued shares, in the form of restricted stock, to all the employee-shareholders. Thereby diluting the two individuals.

Background: A mid-sized family-owned business was originally founded in 1976 by the father of the current CEO. The company’s original incorporation included only a very basic Record of Authorization (Certificate of Incorporation) and bylaws. Forty-six years later the oldest son is the CEO. Over four-plus decades the company records had been severely obfuscated by multiple name changes, transfer of 100% of the original shares to other entities, including an LLC, issuance of additional shares (with questionable documentation), and distribution of the LLC units into six different trusts – all ultimately controlled by the widow of the founder (CEO’s mother). At some point, the son/CEO was appointed to the board by the founder/father. Although the bylaws required a third director, no one was ever appointed. Upon the mother’s passing, the trusts would be dissolved, and the company shares would be split 50/50 between the CEO and his younger brother. The brother was not involved in the company in any way, although he did receive a monthly salary. The CEO was concerned that upon the mother’s passing, the control of the company would come into question since it would be owned equally by the brothers. The CEO simply wanted to acquire a few additional shares to ensure that he could continue to manage the company, to the benefit of the families, without the potential inference of his brother. The CEO consulted with multiple attorneys in his home state and was told that the only resolution would be for the mother to release (or sell) some shares to the CEO son, in advance of the expiration of the trusts, so that when the trusts were divided 50/50, he would retain a slim controlling position.

Actions: Caganco reviewed all the applicable historical documents and asked a number of additional questions. Based on a deep analysis and an acquired understanding of all the relevant circumstances, Caganco authored one board resolution, to be signed by the board, that would give the CEO controlling interest in the company. Although this action would have been completely legal, the CEO was concerned that this action could cause some problems within the family. Instead, he used the possibility of his issuing this resolution to encourage his mother to gift him some shares out of the trusts. The balance of trust-held shares would later be divided 50/50.

Justification: In following the thread of share ownership from 1976 to the present, Caganco determined that the original bylaws had never been changed, and they actually contained some very rare language (easily overlooked by attorneys with weak corporate governance experience) which allowed this straight-forward solution. There were originally authorized but unissued shares. The bylaws authorized the board (CEO only at this point) to dispose of those shares in any way they see fit. These details had been buried under many hundreds of pages of corporate and trust documents.