The most important thing that you can do to salt a slug is to address the potential for undesirable behavior when negotiating your founders’ agreement – whether that’s an LLC operating agreement, the governing instrument of a statutory trust, the shareholder agreement of a C-corp, or a partnership agreement for a general or limited partnership or even an LLP. Proposing the right terms can frighten away a slug, or can reshape their behavior.
Key terms can be considered as *covenants*, *incentives*, or *penalties*. Typically, breaching a covenant will trigger a harsh penalty, such as dissociation. Lesser penalties also can be built into an agreement; these are basically the inverse of incentives. I discuss each of these three types of terms, beginning with covenants.
Covenants
A “covenant” is a commitment to do or to refrain from a specific action or a general type of action. A partner’s fiduciary duty to the partnership is a covenant that was implied by common law and now is embedded in statutory law. A member of an LLC has a similar fiduciary duty. So does a trustee of a statutory trust. On the other hand, shareholders of C-corp have no duty to the corporate entity.
Thus, for most forms of business entity, specific covenants in an agreement may only expand or modify the statutory duty (with some limits on modifications). For a closely-held C-corp, any duty that you want to impose on a shareholder needs to be in a shareholder agreement.
It’s important to understand that violations of a covenant can only be addressed by court action. For example, if a trustee of a statutory trust fails to uphold their fiduciary duty, the Probate Court may be petitioned to remove the trustee. Thus, covenants are not a particularly effective way to address the problem of a slug.
Incentives
Incentives condition a stakeholder’s benefit from the agreement on their performance of certain acts. For example, an LLC operating agreement may specify that in order for any given member to receive a distribution, a certain number of other members must agree that the member is active in managing the LLC. The operating agreement also may include a discretionary bonus structure, under which the members vote to allocate bonus distributions at specified intervals. An LLP agreement may specify that each partner will receive a bonus share of the income that the partnership derives from that partner’s efforts.
It is hard to get incentives into a shareholder agreement. The basic idea of a C-corp is that the shareholders get paid dividends based on how many shares they hold, not anything else. However, the C-corp bylaws can be structured to pay pre-dividend bonuses to shareholders who take an active role.
Often, incentives are symmetric, that is, each stakeholder has the same incentive package. However, incentives may be tailored. For example, in a partnership of an accountant, a sales person, and an architect, the accountant may be encouraged to avoid taxes, the sales person may be incited to bring in new business, and the architect may be rewarded for timely completion of projects. Incentive plans may be quite creative.
Penalties
Under most forms of business entity, stakeholders can be financially penalized or fined for non-compliance with a covenant or condition in the basic agreement. This is hard to accomplish with a C-corp; it would have to be built into the shareholder agreement as a give-back clause after distribution of dividends. It also is hard to accomplish with a trust, where the trustee has great discretion as to their own compensation.
Give-back clauses in a C-corp shareholder agreement or a trust instrument typically require a court order to enforce them. That is an expense that would make it hard to deal with a slug. On the other hand, in an LLC or any form of partnership, distributions can be conditional on compliance with various terms of the fundamental agreement. Getting paid, when other members have determined that a slug is non-compliant, would require the slug to sue the other members or the entity (or both).
Either way, implementing penalties is likely to cost money somehow. The very description of “penalties” puts people off and inspires conflict. Therefore, it is better to structure an agreement with *incentives* where the slug can get paid more if they are compliant and active, rather than with penalties where something will be “taken away” from them if they are slimy and lazy. The net effect is the same, it’s all in how it’s characterized.
The harshest penalty is involuntary *dissociation*. This can be structured with fair compensation, with diminished compensation, or even with **no** compensation (the last one might be challenged as an “unconscionable” term or aspect of the agreement).
Involuntary dissociation can be discretionary or mandatory.
Discretionary dissociation typically involves a term of the agreement that **permits** other stakeholders to *vote* on dissociating the slug. This can be structured so that **one** or **several** stakeholders may be required to propose the vote, and so that dissociation may happen only if a **majority** or some sort of **supermajority** of stakeholders vote in support. Be careful – if the agreement specifies certain events or actions that permit a vote for involuntary dissociation, the slug may say that any *other* event or action cannot be grounds for dissociation. On the other hand, limiting the scope of discretionary dissociation can protect you from being frozen out by faithless business partners.
Mandatory dissociation typically involves a term of the agreement that specifies events or actions that **automatically** cause the slug to be dissociated. There also are statutory provisions for this, in the context of general partners, limited partners, and LLCs – two that often come up are **death** and **bankruptcy**. For C-corp and statutory trusts, there are no statutory provisions for automatic dissociation of a shareholder or trustee.
Practically, a mandatory dissociation clause has to be enforced by the stakeholders against the slug, which requires a vote to take corporate action. Thus, there is not much difference in how many hoops the other stakeholders have to jump through in order to get rid of the slug. A mandatory dissociation clause slightly reduces the impression that a slug is being unjustly “frozen out” – possibly making the dissociation decision easier to defend against a lawsuit by the slug. However, you want to be careful about making such a harsh penalty **mandatory** – there may be unexpected occasions when you would want to *waive* dissociation. A waiver provision could be helpful here.
Closing
Slugs can be deterred by making an effort at the outset of your business relationship to set enforceable boundaries against undesirable behavior. Keep in mind, the business slug is a lot like a toddler – they will respect you to the extent that you set clear rules with clearly understandable consequences.
