April 17, 2020

Directed Trust: Use with Challenging Family Business Matter

Holland & Knight's Shareholder Rights Blog
Michael J. Zdeb
Shareholder Rights Blog

A trustee recently was presented with a challenging decision. The trust held shares of stock in a privately held family business. The shares represented a significant minority position in the corporation and the bulk of the value of the assets in the trust.

The shares were carried on the trust accounting at what represented more of an estimate of the fair market value than one from a current appraisal.

The board of the family business proposed a restructuring to satisfy the lender and facilitate the expansion of the business. The restructuring required the approval of a majority of the shareholders. In accordance with good governance, the corporation sent notice of the vote, a description of the restructuring, the reasons and the right of dissent.

The trustee was independent of the family and not involved in the governance or management of the business. In advance of the proposed shareholder vote, the trustee consulted legal counsel about the decision. The trustee was seeking advice regarding the authority to approve the proposed action. However, the legal counsel gave the trustee advice that the trustee had not anticipated.

The right of dissent, if exercised, would bring with it the right to have the shares redeemed at "fair value" in an appraisal proceeding. The trustee was told that the redemption would result in the trust holding liquid assets and would allow for diversification of the investments. Aside from the conversion of the illiquid shares to cash, the trustee learned that the valuation would not be at "fair market value." Rather, the appraised value in a proceeding would be "fair value." Counsel explained to the trustee the relevant primary differences between "fair value" and "fair market value." Those differences were that unlike "fair market value," "fair value" would not include a discount for lack of control or a discount for lack of marketability. Instead, the result would be a proportionate value of the business as an ongoing enterprise.

The impact of those two discounts being eliminated was in the range of a 50 percent-plus increase in value of the shares over the "fair market value."

So, the trustee was presented with a decision: vote to approve the transaction and remain a shareholder with an illiquid asset being held at a lower value, or dissent and obtain liquidity for the trust at a value considerably higher than the carrying and "fair market value."

When the board and other family member shareholders were informed of the prospect of a dissent, something just short of "outrage" occurred. Several family member shareholders also were beneficiaries and interested in the shares remaining in the trust. The corporation realized that purchase at the appraisal value would not be possible under the covenants proposed by the lender. Not surprisingly, some beneficiaries who were not shareholders were interested in the idea of a greater value, liquid result and distributions to them.

After the matter was resolved (the trustee did not dissent), we discussed with the trustee and the beneficiaries about the modification of the trust to a "directed trust." The idea was to have the trustee in future decisions regarding the shares be directed by a "directing party." (Other terms for such a "directing party" frequently used are "investment advisor" or "trust protector.")

A "council" of an independent advisor and two family members (two branches of the family) would be created to direct the trustee on the voting, sale, pledging, etc. of the shares. Under the law of the jurisdiction, the trustee would act pursuant to the "council" direction and be excluded from personal liability for any loss resulting directly or indirectly from the directed action (or inaction).

The use of a "directed trustee" is not new. It is particularly useful for long-term trusts holding interests in family-controlled or family-owned businesses. It can allow for flexibility in decision-making and the potential for changes in the nature of the business overtime.

The drafting of provisions providing for a "directing party" has to consider the type of decisions over which the "directing party" will have authority (voting, holding, reinvestment, changes in fundamental structure, etc.); the question of whether the directing party is a fiduciary; and state law regarding the exculpation of the "directed trustee." Considering the terms for such a trust provision will potentially raise fundamental questions about the relationship of the family members to the business, such as the involvement of family members in the governance and operations of the business; dispute resolution of issues; and the ongoing accomplishment of the goals related to the ownership of the business.

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