A cautionary tale for silent partners.
Our client, Michael, had money from a settlement. He was in a bad motor vehicle accident and had lost the use of his legs in his late teens. While in his late 20s, Michael was introduced to Steve, who was dating Michael's sister Lisa at the time.
Steve was in the automobile business and professed to have broad knowledge about the operations of car dealerships. Steve convinced Michael to fund the purchase of a troubled auto dealership that Steve would run for a few years. By agreement, Steve was not to invest any of his own money. His contribution was his sweat equity. The two planned to sell the dealership after a few years and pay Michael back. Steve and Michael would then split the profits. Michael invested $750,000 and, along with Steve, personally guaranteed the financing used to purchase inventory for the dealership.
Steve arranged for a Massachusetts-based law firm to provide representation. Michael paid the lawyers' initial fees with his personal funds. Virtually all of the contact with the lawyers was through Steve. The lawyers provided Steve with relevant corporate documents for execution. After the first few documents, Michael's signature was forged. The lawyers created a corporation to own the dealership and, at Steve's suggestion, gave him 51 percent of the ownership.
The dealership did not have an outside accountant. Instead, Michael thought he would be protected by insisting that his second sister, Tracy, be retained as the dealership's office manager and accountant. Tracy had worked as an accountant and Michael trusted her.
The lawyers settled the claims against them prior to trial without admitting any wrongdoing. Their defense was that they never represented Michael and, thus, did not owe him a duty to provide competent advice. Even though Michael had paid the lawyers' fees, he did not see their fee agreement. The fee agreement identified Steve as the client. Later, the lawyers claimed that they only represented the corporation they formed and not Steve or Michael.
Steve, as it turns out, did not have extensive experience in running auto dealerships. Michael had not completed any due diligence about Steve's work experience or finances. Steve's only experience was that he worked as an auto wholesaler, buying used cars at auction and reselling them to dealers. Steve also misrepresented his personal assets on his financial statement, claiming to have $250,000 in a bank account that did not exist.
Even if Michael was committed to being a silent partner who funded the entire acquisition--which was foolish in itself--he did not structure his contribution in a way that would have given Steve an incentive to ensure the business was a success.
Michael could have, for example, lent Steve half of the investment and then had Steve contribute his share to buy the business. Michael also did not obtain a security interest in any aspect of the business or its assets. By signing a personal guaranty, Michael became an easy target for the lender if the business failed.
Steve paid himself a substantial salary beginning on the first day the dealership opened. This, despite his promise to contribute his work to offset Michael's monetary contribution and despite the fact that the dealership was financially distressed. Michael, for his part, failed to study the dealership's monthly financial statements or annual corporate tax returns, either of which would have revealed the unauthorized salary. Instead, he relied on assurances offered by Steve and his sister Tracy.
Before too long, the dealership was in financial trouble. Sister Tracy began kiting checks between her personal account and the dealership's account to inflate the apparent cash balances in the business. The local bank where the dealership had its account recognized the illegal banking activity and duly reported it to Steve. The bank did not report the criminal activity to the authorities or to Michael.
The bank removed Tracy as a signatory on the accounts. Steve did not disclose Tracy's conduct to Michael. Steve consulted accountants who advised that controls be placed on Tracy so that she would not be solely in charge of the dealership's books, if she kept her job.
Steve ignored all of the accounting advice and issued a rubber signature stamp to Tracy.
Eventually, the business was sold. Michael was told that his $750,000 would be returned and that he would share in a substantial prof it. He did not independently confirm these representations from Tracy and Steve, and they turned out to be untrue. A $300,000 check to the secured lender bounced, and Michael was sued on his personal guaranty.
Steve took control of the inventory that was not sold to the new owners. There has never been a full accounting for these cars.
Tracy was found to have deposited counterfeit checks into the dealership's account and was eventually prosecuted in federal court. Steve has never been prosecuted. He denied all liability at trial and blamed Tracy for the losses. Lisa, the sister who dated Steve, now works for him in the wholesale business. It is unclear if Lisa knew that Steve was married while he was dating her.
Michael has won a $2 million judgment against Steve, but Steve claims to have no ability to pay. The lawyers have agreed to pay Michael about a third of the judgment without admitting liability. It is unclear if Michael will ever be made financially whole.
Michael was ill-served by not having independent accountants or lawyers to assess the business deal offered by Steve. He likely would not have completed the deal if Steve's misrepresentations were disclosed from the start.
Even if the misrepresentations were not found, the deal could have been structured both to make Steve responsible for his actions and to make it harder for him to convert assets. Monthly reporting could have tipped Michael to problems much earlier in the operation of the dealership.
It would be unusual to find another instance in which all of the problems encountered by Michael existed, but some of the manipulations by Steve and Tracy are possible in many transactions, and silent partners are well advised to protect against them, even if they know this could never happen to them.
Andru Volinsky, managing partner of Bernstein, Shur, Sawyer end Nelson's New Hampshire offices, specializes in employment law, commercial litigation and white collar criminal law.
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|Title Annotation:||RESOURCES: law|
|Publication:||New Hampshire Business Review|
|Date:||Mar 28, 2008|
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