Posts in Category: Small Business

Gibson Sings Supply Chain Blues, Again

Gibson Guitar Corp., one of the most widely known makers of guitars in the world, was recently raided by the U.S. Fish and Wildlife Service for a failure in the compliance arena. It was not for a violation of the Foreign Corrupt Practices Act, U.K. Bribery Act, OFAC or other more widely recognized anti-corruption statutes.  Gibson was raided through an investigation regarding alleged violations of the Lacey Act of 1900.

The Lacey Act

Originally passed to protect wildlife, the Lacy Act was expanded in 2008 to cover wood products. It now requires companies to make detailed disclosures about wood imports and bars the purchase of goods exported in violation of a foreign country’s laws.  Congress passed the amendment to curb the market for illegally harvested wood and to document the foreign sources of wood products to help with compliance and conservation activities abroad. It is also intended to level the playing field for U.S. producers so they aren’t undersold by suppliers of illegal wood.  Under the Act, importers are prohibited from buying or selling of wood in violation of national forestry laws anywhere in the world, and must electronically submit an import declaration listing the scientific name of the wood, quantity, value and country of origin.

The Gibson raid offers a lesson: companies should be diligent about ensuring their entire supply chain is sourcing wood legally.  Guitar makers would be wise to retain local counsel in the countries where they purchase tonewoods to make sure that the wood is not exported in violation of local law.

The Allegations

On Aug. 24, agents from the FWS and Department of Homeland Security raided Gibson’s executive headquarters, as well as two factories in Nashville and Memphis, Tenn., where they confiscated several pallets of wood, guitars and electronic files, according to the company and news reports. The investigation centers on Gibson’s acquisition of two fingerboard woods, partially finished ebony and Madagascar rosewood, from an Indian supplier. Ebony and rosewood are endangered trees.
It took almost a week for Gibson to get back to full operations. The one-day shutdown and the materials taken cost more than $1 million, according to Henry Juszkiewicz, Gibson’s chairman and chief executive officer.  FWS made two allegationin its affidavit to obtain a search warrant for the raids. The first was that the woods in question were “exported from India by Atheena Exports under an incorrect tariff code (HS 9209), allegedly to avoid the Indian government’s prohibition on export of sawn wood products (HS 4407), and was declared upon import as finished veneer (HS 4408).”  The second was that Gibson Guitar was not identified as the end user. The importer of record, Luthier Mercantile International, listed itself as the end user. The Lacey Act imposes strict liability on a company for those in its supply chain.

An affidavit filed by the Fish and Wildlife Service to obtain the search warrant alleges Gibson falsely labeled the wood import to make it sound legal and omitted the company’s name as the recipient. The sawn wood in question was exported from India by Atheena Exports under an incorrect tariff code (HS 9209), allegedly to avoid the Indian government’s prohibition on export of sawn wood products (HS 4407), and was declared upon import as finished veneer (HS 4408). According to the affidavit, discrepancies among the paperwork accompanying 11 shipments over two years suggest the recipients knew they were purchasing sawn wood.

The most recent shipment, with 1,250 pieces of ebony, arrived in Dallas June 27 from Germany on American Airlines. The shipment was detained by Customs officers for suspected violations of the Lacey Act and referred to Fish and Wildlife, according to the affidavit. The importer was Luthier Mercantile International, a Windsor, Calif.-based wood supplier, which told investigators the ultimate consignee was Gibson. The customs entry listed Luthier as the end user.

Gibson responded unsurprisingly in a statement on its web site: “Gibson has complied with foreign laws and believes it is innocent of any wrongdoing. We will fight aggressively to prove our innocence.”  The statement further contends the Justice Department misinterpreted Indian law, that Indian officials did not consent to the enforcement action, and that if wood from the same tree was finished by Indian workers the material would be legal under the Lacey Act.  Indian law requires that all finishing work on ebony and rosewood be done in India before they are exported, an attempt to add value to diminishing natural resources.
Juszkiewicz has mounted an aggressive media campaign to discredit the government’s position.  He says that Gibson has been sourcing fingerboard wood for 17 years and that it is being bullied by the Justice Department. To wit, at a press conference outside Gibson’s Nashville factory on Aug. 25:

The issue here is not about whether this wood is legally logged. This is not about conservation. This is not           about the environment. This is specifically about a law in India that requires domestic labor content that we       (the United States) are enforcing.

The executive disputed the government’s interpretation of the Indian law in a radio interview, saying he has affidavits from government officials that it is legal to export fingerboard blanks.  He told the Wall Street Journal that a customs broker probably made a mistake in labeling the goods. His affidavit identifies the broker as a Memphis company called V Alexander & Co. Inc. Gibson has been warned that any guitar with infringing materials that it sells and transports will be considered a separate violation of the Lacey Act.  “I’ve instructed our staff to continue building the product and I’m taking personal responsibility for that action,” Juszkiewicz said.

This is not the first time that the FWS has targeted Gibson. In November 2009, more than a dozen agents raided the Nashville factory in search of illegally harvested ebony and rosewood from Madagascar, marking the first major enforcement action of the 2008 Lacey Act.  Gibson claims that most of the wood it procures is certified by the Forest Stewardship Council, an international organization of timber users, traders and environmental groups that sets standards for forest management. It offers voluntary certification, through accredited third parties, that wood products are made from responsibly harvested and verified sources.

The wood confiscated from Gibson is actually not FSC certified.  It is what the FSC considers “controlled wood.”  Controlled wood is wood from small areas which fail the requirements for certification, but which are exempted by the FSC so that the entire forest area can be certified.  “Gibson has a long history of supporting sustainable and responsible sources of wood and has worked diligently with entities such as the Rainforest Alliance and Greenpeace to secure FSC-certified supplies,” the company said in the statement.

After the 2009 raids Gibson said it takes the subject of responsible wood sourcing “very seriously” and that it was working to increase the amount of wood purchased from certified sources. The guitar maker has tried to make sure, to the extent possible, that it is dealing with reputable suppliers, Juszkiewicz said.  A statement to The Tennessean newspaper from the Rainforest Alliance said Gibson has made a good effort to locate and import legal woods since the earlier raid, but added the effort “also must be accompanied by a clear commitment to eliminating any volume, no matter how small, of illegal wood that may contaminate its supply chain.”
No charges have been filed so far in either case, although internal e-mails and other information released in court documents related to the first case indicate that Gibson decided to buy illegal wood knowing the risks involved. Federal prosecutors have filed motions stating that Gibson was not allowed to obtain the wood from Madagascar because it was unfinished wood and the in-country supplier was not authorized to sell it.
Gibson sourced the ebony in the form of blank strips from a German company, which obtained it from a supplier in Madagascar. The country prohibits the harvest of ebony wood as well as the exportation of unfinished ebony, according to the current civil case in the District Court of Tennessee, where Gibson has sued for return of its confiscated materials.
Gibson maintains the wood seized in 2009 was legally exported and that it violated no law in Madagascar.

“We feel totally abused. We believe the arrogance of federal power is impacting me personally, our company and the employees here in Tennessee,” Juszkiewicz told reporters at the press briefing, a video of which is posted on the Gibson Web site. He said Gibson feels singled out because all guitar manufacturers use Indian ebony and rosewood for their products. The company also hasn’t been afforded due process as the government drags its feet trying to postpone the civil proceedings or filing any charges, he complained, adding that investigators won’t explain what Gibson allegedly did wrong.  “We’re guilty of something they can’t tell us what it is yet” so the company can’t defend its reputation, Juszkiewicz said.

A troubling aspect of the Lacey Act is that it imposes strict criminal liability on any non-compliant company, even a company that didn’t know it was doing anything wrong. There is no mens rea requirement.  Importers are expected to take all reasonable means to comply, but the law doesn’t define the steps a company should take to ensure it doesn’t obtain prohibited wood products.  For Gibson, understandably, this is exasperating.  As Juszkiewicz pointed out

If people wanted to stop us from doing something you would think they’d tell you in advance. ‘Hey, look guys we have a problem with this. You need to do something. Give us a plan. In two cases, we had a SWAT team treat us like drug guys. Come in and shut us down with no notice. That’s just wrong.

After the first raid the manufacturer no longer deals with Madagascar.  Juszkiewicz has conducted a series of interviews, mostly on talk radio shows, in an apparent effort to bring public pressure on the government to back off. In one radio interview he said the raid two weeks ago is an attempt “to intimidate us into copping a plea” in the first case as Gibson prepares to present evidence that it behaved properly.

The National Association of Music Manufacturers expressed “deep frustration” with the Lacey Act in a Sept. 1 letter to President Obama and members of Congress:

The wide range of interpretation possible in the law and lack of regulatory clarity has resulted in great difficulty in compliance. The confusion is due in large part to the law’s ambitious scope, including enforcement of the laws from all other countries that are the source of these natural materials. . .

The recent high profile raid of Gibson . . . compounded with the slow response on needed guidance for compliance that we have been seeking has created fear and uncertainty for all those involved in the manufacturing, distribution and retailing of instruments and increasingly, artists and owners of musical instruments. We cannot state strongly enough the impact that this confusion, uncertainty and threat of criminality are having on our industry even when intentions of due care and compliance are followed and documented. We have concrete ideas on how to improve the law and are ready to work with members of Congress and federal agencies to make positive changes that will fulfill the intended vision of the Lacey Act and preserve not only the world’s forests, but the vital work of U.S. manufacturing and commerce in the                  music products industry.

Gibson’s public campaign is generating support on the company’s Facebook page from people opposed to big government and outsourcing of U.S. jobs.  And in an interview on KMJ 105.9 in Fresno, Calif., Rep. Thaddeus McCotter, R-Mich., claiming to be a guitar player himself, said, “You‘re looking at American artisans having the federal government come in and tell them they’d be better off if they let people in Madagascar or elsewhere do the work is insane. That’s outsourcing by government fiat from an administration that claims to oppose it.”  What we’re looking at has absolutely nothing to do with outsourced labor.

Compliance Convergence

The Gibson case underscores the importance of having strong internal controls over compliance activities. So how does a company, or an entire industry subject to the Lacey Act, manage all of these risks? I suppose the first thought would be to only buy American, but that thought is probably as unrealistic as a U.S.-based energy company not doing business overseas because of the FCPA. The answer is that a company must first identify the risks it faces and then manage those risks. Here the primary risks would appear to be knowledge of local laws and liability for the acts of those in your supply chain. There are two keys to managing these risks. The first is process, process and process. The second is document, document and document.

Whatever business you are in, the requirement is for you to understand what laws are applicable to your business. If you have to hire local lawyers in the jurisdiction where you are doing business to ascertain if your exports violate local law, don’t whine about it–hire them. If your company has strict liability for those in your supply chain, engage in due diligence, train those vendors in the law and your requirements, and manage those relations going forward. All of the above should be documented so that your company can produce those records in short order if it is investigated . Whining about unfair 111 year-old laws will not get you much sympathy from the U.S. Department of Justice, the U.S. Fish and Wildlife Service or a federal judge.

Small Business, Creditors, and the Good New Corporate Opportunity Doctrine

The so-called corporate opportunity doctrine prohibits a corporate fiduciary from seizing for herself an opportunity in the corporation’s line of business, unless she first offers that opportunity to the corporation. There is no question whether the doctrine applies to small businesses. The more interesting question is how it applies, given the unique characteristics of many small businesses. For example, questions will arise as to whom, if anyone, a corporate opportunity must be disclosed; whether the holder of a distributional interest can challenge the business’ decision to turn down an opportunity; what happens when basic corporate formalities are not followed; and whether the persons taking the opportunity have violated any duty to the business’ creditors. You want to take care of these issues before they arise.  Check it out:

Rule of Disclosure

The officers, directors, and shareholders of a small business owe a fiduciary duty to their company.  This duty includes an obligation to refrain from exploiting so-called corporate opportunities that rightfully belong to the company. What’s a corporate opportunity?  Simple.  When a proposed activity is reasonably related to the company’s present or prospective business and is one in which the company has the capacity to engage, that’s a corporate opportunity.

The corporate opportunity doctrine is actually a rule of disclosure: When a company’s fiduciary wants to take advantage of an opportunity that is in the company’s line of business, “the fiduciary must first disclose and tender the opportunity” to the company. As the Supreme Court of Illinois once explained it, “[I]f the doctrine of business opportunity is to possess any vitality, the corporation or association must be given the opportunity to decide, upon full disclosure of the pertinent facts, whether it wishes to enter into a business that is reasonably incident to its present or prospective operations.” Kerrigan v. Unity Savings Association, 58 Ill. 2d 20 (1974).

Still, some states do not require the formal presentation of a potential opportunity the company has no interest in or cannot afford to pursue. In Broz v. Cellular Information Systems., Inc., 673 A.2d 148 (Del. 1996), for example, the Supreme Court of Delaware held that presentation is a form of safe harbor, “which removes the specter of a post hoc judicial determination that the director or officer has improperly usurped a corporate opportunity.”  Other states, including Georgia, Rhode Island, and Connecticut have adopted similar approaches.

But this “safe harbor” is not universal. Illinois courts, for instance, view the failure to disclose a corporate opportunity as undermining the “prophylactic purpose” of the rule. In such circumstances, the failure to disclose “forecloses” the interested fiduciary from exploiting the opportunity, even in cases where he or she reasonably believes the company is incapable of claiming the opportunity. Thus, in Kerrigan, the directors’ belief that their savings and loan association was precluded by law from capitalizing on an opportunity in the insurance business could not “operate as a substitute for [their] duty to present the question” to the corporation for independent evaluation.

Application to Small Businesses

In theory, disclosure is simple process: The interested fiduciary sadly tenders the opportunity to the company, fully discloses all pertinent information, and watches from the bleachers as disinterested fiduciaries then evaluate whether the company should engage in the opportunity. The problem, however, is that this process does not always neatly apply in the context of a small business, where (1) each fiduciary may want to pursue the opportunity for himself; (2) distributional interests may be held by someone other than an owner; (3) corporate formalities are not always observed; and (4) the company may be insolvent or nearly insolvent.

Absence of Disinterested Fiduciaries

Here’s an interesting practical question. The smaller the business, the more likely it is that every owner knows about or is personally interested in the corporate opportunity. What happens when there are no disinterested officers, directors, or owners to evaluate an opportunity on behalf of the business? Must the opportunity be served up to a disinterested third party for independent evaluation?

The classic In re Tufts Electronics, Inc., 746 F.2d 915 (1st Cir. 1984) (Mass. law), considered this issue in detail. There, the former president, director, and sole shareholder (Martin) of a bankrupt corporation challenged the imposition of a constructive trust on property he personally owned. Martin had acquired the property in part with corporate funds, and then leased the property back to his corporation. The bankruptcy and district courts, applying the corporate opportunity doctrine, decided that Martin had breached his duty to the corporation by using corporate funds to help purchase the property for himself rather than for the corporation. If that reasoning seems kind of stupid to you, given that the sole owner of the corporation was Martin, you’re right.  But formalism was cool back then.

The First Circuit reversed. Emphasizing that Martin was the sole shareholder, director, and president of the company, the court held that the corporate opportunity doctrine was inapplicable because Martin’s actions “necessarily involve[d] the knowledge and assent of the corporation.” The court further recognized that even though Martin and the corporation were separate persons, “absent some element of defrauding, Martin was not obliged, in every action he took, to prefer the corporation’s interests to his own. No one could operate a corporation solely on such a basis.”

Other jurisdictions have applied similar reasoning to reach the same conclusions. For example, in L.R. Schmaus Co. v. Commissioner of Internal Revenue, 406 F.2d 1044 (7th Cir. 1969) (Wisconsin law), the court found that “if an officer of the company owns all the stock, he may use the corporate assets as he sees fit and there can be no misappropriation of corporate assets by him.” Likewise, in Mediators, Inc. v. Manney, Adv. 93 Civ. 2304 (CSH), 1996 WL 297086, at *10 (S.D.N.Y. June 4, 1996) (New York law), the court dismissed a corporate opportunity claim because the corporation had “necessarily consented” to diversion of its assets through the acts of its sole owners and officers, who were accused of usurping opportunity. In In Committee of Unsecured Creditors of Specialty Plastic v. Doemling, 127 B.R. 945, 952 (Bankr. W.D. Pa. 1991), the court found the corporate opportunity doctrine was “difficult to apply” to a small business where “there were no other shareholders to whom [the sole fiduciary] owed a duty of disclosure and loyalty.” And in Pittman v. American Metal Forming Corp., 649 A.2d 356 (Md. 1994), the court held that the sole shareholder could not be liable for usurpation of a corporate opportunity in the absence of any harm to creditors.

The logic of these cases is compelling. After all, as the Seventh Circuit recognized in In re Doctors Hospital of Hyde Park, 474 F.3d 421 (7th Cir. 2007), a sole shareholder can “hardly . . . defraud himself or breach a fiduciary duty to himself.” Other courts have reached the same conclusion, as in In re Hearthside Baking Co., Inc., 402 B.R. 233 (Bankr. N.D. Ill. 2009) (a “sole shareholder does not owe a fiduciary duty against its own corporation and cannot breach a fiduciary duty to itself”); and In re Gordon Car & Truck Rental, Inc., 65 B.R. 371, 376 (Bankr. N.D.N.Y. 1986) (corporate opportunity doctrine inapplicable where sole stockholders and officers “cannot be accused of withholding information from themselves“).

A minority of courts have reached the same result through a different-but-related doctrine–ratification. For example, in In re Safety International, 775 F.2d 660 (5th Cir. 1984), the Fifth Circuit held that “even when [a] transaction is detrimental to the corporation, no cause of action will lie if all of the [interested] shareholders have ratified the transaction.” According to the court, “[e]ven if [the directors/shareholders] breached their duty to [the corporation] by taking the purchase option in their own names, no party to this action can complain of the breach. There are no non-consenting shareholders.”

In short, where the usurpation of a corporate opportunity from a small business necessarily involves the “knowledge and assent” of the corporation ( Tufts) or ratification by the shareholders (Safety International), there can be no claim under the corporate opportunity doctrine. With the exception of insolvency, explained below, this rule is true even where the consenting or ratifying fiduciaries are personally interested in the opportunity.

Transfer of Distributional Interests

Many small businesses are structured as limited liability companies. Because a distributional interest in an LLC ordinarily is a transferable asset, it is not uncommon for a member of an LLC to transfer her distributional interest to a person who has no ownership interest in the business, like a creditor. That raises the question of how, if at all, such a transfer affects a fiduciary’s disclosure obligations under the corporate opportunity doctrine.

The transfer of a distributional interest does not confer an ownership interest or a fiduciary relationship with the company’s other members. The consequences of this are twofold. First, the transferee of a distributional interest is not entitled to exercise the rights of a member, which include challenging–either directly on its own behalf or derivatively on behalf of the company–the supposed usurpation of a corporate opportunity. Second, as a corollary, corporate fiduciaries are not obligated to disclose the opportunity to some independent third party for evaluation merely because a non-owner holds a distributional interest in the company.

Consider a recent Virginia case.  The sole members of a limited liability company, a husband and wife, faced a claim that the husband had usurped an opportunity of the LLC in precisely this situation. The usurpation claim was brought by a judgment creditor of the wife who had used part of its judgment to acquire her distributional interest in the company. The creditor argued that the husband could not take a corporate opportunity without first formally tendering the opportunity to the company and having it evaluated by some independent person. According to the creditor, if the husband had not taken the corporate opportunity for himself, the company would have profited from the opportunity and would have had assets to distribute, which would have benefitted the creditor. The trial court rejected the creditor’s argument. It found that the husband had no fiduciary duty to a creditor holding his wife’s distributional interest in the LLC and, further, that the husband and wife, both of whom knew of the corporate opportunity, had no obligation to formally present the opportunity to the corporation or to submit it to an independent third party for evaluation. Accordingly, the court dismissed the claim.

Failure to Adhere to Corporate Formalities

The failure to adhere to basic corporate formalities, like documenting board meetings or recording shareholder votes, unfortunately is commonplace among many small businesses.  This oversight is often a product of the cost of compliance, the casual approach to operations taken by many small business owners, or simple ignorance of proper procedure. Whatever its cause, a lack of documentation can lead to significant problems where corporate opportunities are concerned.

Consider, for example, the following situation.  Every shareholder knows of a corporate opportunity, and agrees that the business should not pursue it. Some of the shareholders decide to take the opportunity for themselves, but they fail to document any sort of formal presentation of the opportunity to the business or official vote of the officers or directors. Sometime later, maybe because the business opportunity turns out to be better than expected or because the shareholders have a falling out, the shareholders who did not pursue the opportunity bring a lawsuit against those who did, claiming that the opportunity was not fully or properly disclosed to the corporation.

What might have been quickly resolved with proper documentation had corporate formalities been observed now presents a thorny factual issue. Was the opportunity actually tendered to the corporation? Were the material facts fully disclosed? Did the board or shareholders in fact agree that the business should not pursue it? The fact that the answers to these questions cannot be found in board minutes or shareholder ballots could mean the difference between a speedy resolution of the claims on a motion to dismiss and costly, time-consuming discovery. In short, the failure to adhere to corporate formalities that so often plagues small businesses can needlessly complicate  your life in the context of a usurpation claim.

Insolvency

An additional consideration is whether the small business was solvent at the time of the challenged transaction. This is important because, when a company is insolvent, the duties of its fiduciaries–including the duty to disclose corporate opportunities–extend to its creditors. As the Supreme Court of Delaware explained in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007):

It is well settled that directors owe fiduciary duties to the corporation. When a corporation issolvent, those duties may be enforced by its shareholders, who have standing to bring derivativeactions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.

And once an insolvent company files for bankruptcy, its creditors have standing to complain about the usurpation of corporate opportunities, and they often do. A small business is no different than any larger company in this respect.

In re McCook Metals, LLC , 319 B.R. 570 (Bankr. N.D. Ill. 2005), illustrates the point. There, the bankruptcy trustee of a closely-held aluminum processor (McCook) brought suit against McCook’s principal (Lynch) for, among other things, transferring an opportunity to acquire a smelter away from McCook. As part of his defense, Lynch argued that he had breached no duty to McCook because he had disclosed the opportunity to purchase the smelter to McCook’s other members, who agreed that a separate entity should make the acquisition. The bankruptcy court rejected this argument because the duty involved was to McCook’s creditors, not its other members. According to the court, “That the other member owners agreed to transfer the [smelter] opportunity away from McCook makes them jointly and severally liable, with Lynch, for a breach of duty to the creditors; it does not excuse Lynch.”

Similarly, in Brown v. Presbyterian Ministers Fund, 484 F.2d 998 (3d Cir. 1973), the president and majority shareholder (Hoffman) of a family-owned business arranged to personally buy a mortgage at a discount when the opportunity to do so rightfully belonged to his corporation. The corporation filed for bankruptcy hours after the purchase was complete. The district court found that Hoffman had not breached a duty because the acquisition was agreed to with the “knowledge and approval of all of [the corporation’s] officers, directors and shareholders,” i.e., Hoffman and his sons. The Third Circuit rejected this logic, finding that it could not “countenance such a narrow view of the scope of Hoffman’s fiduciary duty. As an officer, director and principal stockholder of an insolvent corporation . . . Hoffman was duty bound to act with absolute fidelity to both creditors and stockholders.” The court explained that because Hoffman had arranged the transaction with knowledge of his corporation’s insolvency, approval by the fiduciaries did not free him to appropriate corporate opportunities to the detriment of the corporation’s creditors. Corporate assent did not, therefore, relieve Hoffman of his fiduciary duties, and the “opportunity should have been disclosed to the receiver as representative of the creditors.”

Conclusion

The corporate opportunity doctrine can pose significant challenges to the owners of small businesses. These problems can be exacerbated by the failure to observe corporate formalities and, in particular, whenever the corporation is insolvent and the rights of creditors are at stake. Still, when insolvency is not an issue, the case law now suggests that small business owners have the right to treat their business as their own, including by taking corporate opportunities for themselves personally.