Introduction:
We see it all the time. The patriarch or matriarch of the family wants the family business to continue to the next generation or perhaps for several more generations. The business makes money, the owner is proud of it and perhaps did some training of one or more of the family members to operate it. So he or she puts it into a trust, all the family are beneficiaries, has that trained family member act as the trustee and operator of the business, and assumes that the business will continue to operate in the future, the trustee-operator making good money and parceling out the profits to the other family members who are not involved in the business.
Sometimes that works. Quite often it does not and at those times the lawyers become involved and the family is put under tremendous stress or is even destroyed by the disputes inherent in that structure. That structure can work more often than not but only if various safeguards briefly described below are instituted. Such safeguards have to be created before the death of the founder and at times the founder of the company shrugs and says that the next generation will just have to adjust and work it out themselves. By then it is often too late.
Few businesses can survive a family fight and few operator/trustees are happy to be involved in such a business structure. This article discusses why that structure is a dangerous one to create and how such dangers can be lessened.
The Basic Problem:
Operating a business is one of the most difficult tasks in our society. Few who have not performed that task can understand the myriad requirements imposed. One not only must create a service or product that people wish to purchase, but must maintain quality control, retain or hire qualified employees and contractors, beat the competition, pay the taxes, plan for the future changes in the industry, comply with numerous local and federal laws, and decide what profits need to be reinvested for the future or distributed to the owners.
The person not operating a business often has an inaccurate view of the life of the operator. The fringe benefits and apparent “good life” available to the operator are obvious: One sees owners who may engage in dinners and lunches with clients and vendors or perform business travel and all that may seem glamorous or enjoyable. The long hours and stresses are not fully grasped.
Concurrently, the owner/operator may feel unappreciated and hindered by the expectations of noninvolved owners. Most wise operators wish to keep a significant reserve in the company coffers for unexpected expenses or wish to reinvest profits for maintenance or expansion. They may also want to declare bonuses for certain employees-including themselves. To the passive owner who sees generous bonuses being declared while receiving only a small distribution, this can seem extremely unfair.
Unstated but very real feelings then emerge. The passive owner feels the operator is milking the business, enjoying the good life while the other owners are not given their due share. The operator feels that the owners are parasites, sitting back and expecting far too much and not understanding the actual tasks the operator must perform and the need to reinvest monies or reward key employees…including the operator. Feelings harden and if anything goes wrong in the business the reaction is anger and a desire to change management. Knowing that possibility, the operator may either become extreme in keeping money in the company or become disinclined to invest the monies needed to keep the business healthy.
Above all, a level of complexity and tension is added which can not help the business succeed. As one CEO of such a company wrote the writer, “It’s hard enough running this business. With X and Y breathing down my neck, it’s not only that much harder, but it makes me want to just stop trying…”
Many founders of businesses, who have the respect and love of all the family and who are, after all, the ones who have operated the business successfully for many years, do not understand that once a member of the next generation takes over the same feelings of respect may not exist. And as resentment builds and trust declines, the pressure becomes all the greater.
It also must be remembered that as the next generation often includes people not really known to the founder. People marry…married people divorce and marry others. Children grow up and their personalities may alter significantly. In-laws become involved in advising the next generation and unexpected events…illness or accidents…can make the income of vital importance to a passive owner.
The writer recalls very well a company operated by a brother while the sister raised her own family, content with the relatively small distributions since the brother was investing to enter another market. Her husband was disabled in an accident and suddenly she needed a doubling of her income from the business and her brother felt it could not be done. The family was destroyed by those pressures and he ended up buying her out for an inflated price after very expensive litigation. Their father would have been dismayed…but how could he have anticipated that accident? (The answer is he could have anticipated unexpected events…and should have built that into the structure, as more fully discussed below.)
The failure was not in not anticipating the accident but in not creating a structure flexible enough to handle unanticipated events…as discussed further below.
- The Fiduciary Duty of the Trustee.
The highest duty of loyalty which includes avoiding any unfair self dealing is the fiduciary duty which exists only in particular relationships. Husband and wife, lawyer and client, employee to employer, are all held to the highest standard of care and avoiding conflict of interest. And…so is the trustee to all beneficiaries.
It is vital to note that the fiduciary duty is a personal duty imposed upon the trustee. Violation of that duty results in possible personal liability. If the duty is violated, the trustee is personally sued, not the trust.
It is true that most managers of businesses, including the President, CEO and Managing partners or managers of a limited liability company also have a fiduciary duty to the company. However, it is common that trustees are held to a higher degree of scrutiny than the fiduciaries who may run a business. While a business operator is allowed to make a good faith mistake in business, even losing money or making errors without incurring breach of duty, many courts require a trustee to generate a certain minimum return on capital for the beneficiaries, as described in the articles on this site. Essentially, many courts require the Trustee to make as much or more as if the assets were invested into a relatively safe investment account. (See our article on the Prudent Investor Rule.) The Trustee cannot be too conservative in investments or too risky.
But risk is often inherent in operating most businesses and, indeed, may be an essential aspect of what a good manager should consider appropriate. Venturing into a new market, purchasing new machinery, renovating an entire building, offering new pricing or hiring expensive but competent personnel are often appropriate steps for a business manager but may be viewed by a court in a different light. Remember, most judges and arbitrators are not business owners.
To have the double fiduciary duty as trustee and CEO more than doubles the obligations imposed upon the fiduciary.
- Income versus Reinvestment.
The owner of a business seeks to protect the business, generate profits, but look ahead to anticipated challenges. The fiduciary of a trust has the sole duty of acting in the interests of the beneficiaries.
Perhaps an example will illustrate the dangers facing the trustee. A CEO may wish to amass a reserve fund sufficient to purchase the locale of the business, save rental, and have a hard asset in the business. This will require not only a down payment, to be amassed over several years, but payment on a Note to finance the purchase. Over a ten- or twenty-year period, this would be extremely useful for the business. But it also means that distributions of net income to beneficiaries will be reduced significantly for a decade or more. Where does the duty lie?
- Bonuses and Incentive Pay versus Income.
To keep good employees, large bonuses or salaries are often needed. Including to the Trustee-CEO who is operating the business. But every dime paid to the Trustee-CEO will be viewed with deep suspicion by every beneficiary whose own income is depleted by the bonus. While the Trustee-CEO is probably safe if he/she can show his/her pay is akin to others in the field, what if the Trustee-CEO is better than the others and wants more pay? Is the Trustee-CEO doomed to only receive average pay?
- Other Beneficiaries Want Into the Business.
Another common area of friction is when the other beneciaries either want to work in the business or participate in management decisions on the board of directors or management committees. As one CEO complained to the writer, “How am I going to fire my nephew who is lazy and spoiled when his mother owns a third of this company?”
This is a problem that can go down the generations. Grandchildren can want into the business. Spouses of children, just graduating from college, may demand employment. And as the years pass, more and more beneficiaries or relatives of beneficiaries may want into the structure.
- Planning for the Future.
An essential task for any good CEO is to make ten and twenty year plans of succession. Often key employees are groomed to operate the business when the CEO retires. This may be impossible due to the other beneficiaries wanting to operate the business and wanting first rights to do so.
And there are many other issues confronting the CEO-Trustee, but the above list gives a fair idea of the unique challenges that type of arrangement can create.
Must It Fail?
Most businesses in the United States are family businesses and that would not be the case if the loyalty and mutual love within a family was not a valuable addition to the business. Even transfer to the next generation, while challenging, can be achieved without rancor IF the structure recognizes the unique problems confronting use of that method.
A CEO-Trustee can help him or herself a great deal by communicating effectively and often with the beneficiary owners and getting their input for many decisions. For reasons that are unclear to the write, many CEOs become overly secretive and controlling and more often than not fail to communicate at all with beneficiary owners aside from quarterly or annual distributions. This, of course, often creates unwarranted concern on the part of the beneficiaries and need not happen if the CEO-Trustee merely explains plans and goals.
And the beneficiary not involved in the business can also avoid much turmoil if inquiries are made in a calm and helpful manner, not accusatory. Do not assume a nefarious conspiracy is in place simply because distributions are delayed or lessened. Find out why but do not accuse automatically.
In short, effective and cooperative communication is vital to avoid the typical problems and if the CEO is worried as to how the family will react to some plan or expense…then face that danger head on…tell them your plans and why you are doing it. They will find out sooner or later and it is better you are the one to tell them and be there to justify from a business point of view why it is being done.
Some wineries in California actually have put psychologists on the Board of Directors precisely to avoid the type of intra family squabbling that can often occur in families. The Board meets regularly, discusses business plans and puts on the table the fears and concerns rather than letting them simmer.
Power: What it is All About:
Often when a beneficiary or group of beneficiaries wish to reclaim control of the business, they seek to use the tools available to owners to remove or limit the CEO. The reader is directed to other articles on the website as to those available tools. The powers the beneficiaries have, however, are not just limited to the corporate or limited liability company tools, but they can seek relief in court as to breach of fiduciary duty by the trustee under the high obligations imposed upon a trustee under the trust.
But most courts are loath to second guess a trustee who makes a business decision even if the business decision turned out to be wrong. If the CEO-Trustee can point to legitimate business rationale, the court is unlikely to overturn him or her. The one exception is self-dealing. If the CEO-Trustee is paying him or herself a salary twice that of anyone else in the field without showing good results for the business or is only hiring his or her own children in the business and paying them inflated salaries or renting personal property to the business at an inflated price, the court may consider such actions a violation of duty.
The CEO-Trustee is also subject to the powers of other owners in the business. If in a minority ownership position, the CEO could be fired, assuming the CEO does not have an employment contract protecting him or her. If the CEO is caught in self-dealing, the minority owners can seek relief in court claiming embezzlement or breach of the duty a CEO owes the other owners and not involve the trust at all…or use both forums.
Thus, the CEO-Trustee faces dual review in two different forums and minus an employment agreement or control of the ownership majority, is subject to termination.
Above all, the CEO-Trustee faces increased scrutiny which can lead to too cautious decisions or overly hostile reaction to questions or challenges from the other beneficiaries.
SOLUTIONS:
Every family and every business is different, and planning has to be tailored to each…but we have found that a good long-term solution is an advance carefully structured ownership and reporting regime with clear and continuing methods of communication achieved from the beginning, including educating all owners to the fact that businesses do not always generate a good return. Such education should begin long before the CEO-Trustee assumes a position of authority. Getting all to “sign on” to the business realities and priorities may avoid many issues. Note, however, that as the years go by, such earlier understandings may no longer be remembered…or the following generation, who never attended that earlier meeting is now an owner.
Protecting the CEO while protecting the other owners may require a mix of ownership rights; a mix of employment contract rights; a commitment by the trustee to provide either certain returns or at the least regular reports and information to the other owners; and an understanding of the needs of beneficiaries to be measured with the needs of the business.
As an example, if the CEO is going to give him or herself a significant raise, that should be communicated to the other owners with clear explanation as to why appropriate and how it compares to others of like achievement in the field. If dividends are not going to be declared for a period of time, that should be communicated and explained by the CEO, not simply announced.
What has worked for some of our clients in the past is minimum performance criteria being inserted into an employment agreement for the CEO which, if achieved, results in bonuses and extension of the employment agreement. Another client inserted minimum income being paid out to passive owners on an annual basis and if such minimum income was not achieved, they can insist upon change in management.
But perhaps the best method allows the family to part ways in a fair and appropriate manner if either side is unhappy with the relationship. A typical criterion is that the CEO has the right to buy out the other owners for a formula price, ten percent down, five years to pay out the rest. Alternatively, the passive owners can insist upon being bought out for a similar formula price.
The advantage is that the formula, if fair, removes the entire issue of value and both sides knowing they have an option to get out of the company or the conflict often stops conflicts before they begin. One does not feel “trapped.”
Conclusion:
Unintended consequences are what this is all about. A founder wishes to benefit his or her entire family and, instead, causes friction, threatens the business itself, and disrupts family relationships. The founder has to realize that the CEO-Trustee that follows may not have the gravitas that the founder does and adjust the structure accordingly…or the court or attorneys will.
You want to help your family. Creating the right structure is perhaps the most important help you can provide.