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Case in Point: The Case of the Ménage a ‘Deux’

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Our Case in Point series is a monthly blog written by David Shlagbaum, Senior Counsel/Facilitator and the Head of Pallett Valo’s Family Business Law Group. His series presents case studies focused on real life challenges faced by Family Businesses and Private Enterprises. While David regularly deals with these types of issues in his practice, all names, businesses, events and incidents are used in a fictitious manner. Any resemblance to actual persons, living or dead, or actual events is purely coincidental.

The Enterprise

Northern Comfort Inc. (“Northern”) is a business that was established in the early 1990s by two sisters, Paula and Christine. It has grown to 30 retail stores, specializing in fine linens and bath accessories, located in major malls across Canada.

Going Caj Inc. (“Caj”) is a business that was established in 2010 by Christine and her husband, Felix. Caj specializes in fine lounge wear and has nine retail locations, including in some of the same malls as Northern.

Both companies cater to the mid-level, quality-focused but price-conscious consumer and have engaged in complementary advertising and promotional campaigns.

The Players

Paula is married with two daughters. Christine met and married Felix in 2010.  They have a daughter and a son. Paula and Christine are equal partners in Northern. Caj was Felix’s brainchild and Christine convinced Paula to take a minority interest in the company, with the result that Christine and Felix each own 40% of Caj and Paula owns the remaining 20% minority interest.

The Challenge

Three years ago, Felix committed Caj to a luxury line of lounge wear that is out of step with Northern’s and Caj’s mid-tier market appeal, resulting in stockpiles of unsold inventory, costly license fees to Caj’s distributors and significant operating losses.

Northern has been financing Caj’s operations, relying on its own banking facilities for funding, with the result that the carrying costs of Northern’s bank loans are eating up Northern’s profits.

Paula is fit to be tied. Paula was a reluctant investor in Caj to begin with and only agreed to come aboard because it was important to her sister. Paula had told Christine that she ‘checked Felix out’ and apparently he had gone through two business failures before he met Christine. Her advice to Christine was ‘Stay away!’. Paula blames Felix for the current jeopardy faced by both companies and claims he convinced Christine to commit Caj to the disastrous new product line without consulting Paula.

Paula is threatening to demand immediate payment of Northern’s loans to Caj and to call in a receiver. As a condition of not ‘pulling the plug’, Paula has demanded that Caj abandon the new line, that Felix be terminated and that he give up his shares of Caj. Felix has refused and Christine is standing by her husband. In the alternative, Paula has asked for Christine’s shares in Northern in exchange for a release of Northern’s loan to Caj. Christine has refused.

Paula has consulted a lawyer and has discovered that getting Northern to put Caj into receivership could be an uphill battle because of Paula and Christine’s shared ownership of Northern. Christine is torn between her sister and her husband and has started to see a therapist. Cynthia, Northern’s long-time banker has raised concerns with Paula, as she has watched Northern’s fortunes take a dangerous downward slide. She suggests Paula speak to Perry, a lawyer specializing in dispute resolution and business restructuring.

A Resolution

Perry meets with Paula, who starts to share her sad story. Perry says to Paula, “Before I can help you, we first need to agree on my role. I can be your gladiator and go into the arena for you, in which case, your sister will do the same and there will be a cost and there will be a winner and a loser, but the biggest loser will be your families – yours and your sister’s. The other alternative is I don’t represent you and I don’t represent your sister, I represent both of you and we work towards a resolution.” Paula says she likes the sound of the second alternative. However, Perry goes on to say, “If we are going this route, I need to know that Christine is on board and I also need her to know that I have only met briefly with you so she should not look at me as being ‘Paula’s guy’.  Perry meets with Christine and Christine agrees to work through the process with him and Paula.

Perry meets separately with Paula and with Christine and Felix, in each case on a confidential basis. Paula tells Perry she wants nothing further to do with Felix and doesn’t understand what Christine sees in him. As distasteful as it is for her to think of splitting with her sister after all these years building up their business, Paula thinks it would be best if there was a way to engineer a clean beak where she walks away with Northern and Christine and Felix can do whatever they want with Caj. However, Northern is owed a lot of money by Caj and Paula is not ready to just give that up. Christine tells Perry she’s not about to throw Felix under the bus.  It would destroy their marriage and, despite what Paula thinks, Felix has great ideas, even though this last one didn’t work out so well. As far as Northern is concerned, Christine says it would kill her to walk away from her investment in Northern and she’s just not prepared to do it.

Perry meets with Northern’s accountant and they develop a plan that tries to take into account the concerns expressed by Paula and Christine and is also designed to be as tax-efficient as possible. They call Paula, Christine and Felix to a meeting and, although the plan has a fair amount of detail and complexity, Perry takes them through the basics of the plan:

  • Caj will buy back Paula’s shares in Caj. Paula’s shares will only have nominal value, given that Caj is essentially insolvent.
  • A valuator will be hired to value Northern’s business. It is anticipated that, notwithstanding Northern’s future value, its falling profits over the past number of years, largely attributable to the cost of its loans to Caj, will likely be reflected in a depressed valuation.
  • Northern will buy Christine’s equity shares in Northern at the value determined by the valuator. The purchase price will be paid in part by a promissory note and the balance by issuing special shares in Northern, frozen at the value determined by the valuator. The special shares will be non-voting, leaving control of Northern with Paula, but will provide for a modest annual dividend, to the extent that Paula takes out any dividends for herself. The share value will be paid to Christine if and when Northern is sold, along with a small premium that will be tied to the sale price. Christine will agree that any decision to sell Northern will be completely up to Paula. In addition, Felix will enter into an agreement with Christine and Northern in which he releases any claim he might otherwise have under family law to Christine’s shares in Northern.
  • Perry goes back to the promissory note that forms part of the consideration for Christine’s shares of Northern and advises that, through a series of steps, that promissory note will wind up in Caj’s hands and Caj will use it to offset its loan obligations to Northern. Northern will then forgive the balance of the loan. Northern and Caj will both be able to take advantage of tax deductions associated with the exchange and the loan forgiveness.
  • Paula will resign as an officer, director and employee of Caj.
  • Christine will resign as an officer, director and employee of Northern.

It takes a few sessions to iron out the details and make some adjustments, but in the end, everyone approved the plan.

So why did the plan work? Paula took a significant hit by forgiving Northern’s loans to Caj but wound up owning Northern outright at a discounted price and controlling her own destiny – and getting Felix out of her hair. Christine gave up a significant share of Northern’s future growth but kept a modest stake in the company she helped to grow. She also got to keep Caj, now with a clean balance sheet, and, by closing a few stores and convincing Felix to drop the new product line (which he did, reluctantly), Caj could have a fresh start – and Christine could preserve her marriage.

What effect will the ‘divorce’ have on Paula and Christine’s future relationship and the relationship among all the cousins, their children? It will take time for wounds to heal but this was a negotiated settlement that didn’t deteriorate into a nasty court battle so there are good prospects.

So what can we say about how events turned out? Perhaps the Rolling Stones said it best: ‘You can’t always get what you want, but if you try sometimes, you just might find, you get what you need’. In many cases, that’s not a bad Plan B.

Tune in next month when the Case in Point will be The Case of the Day of Reckoning.

Pallett Valo LLP has earned my trust and loyalty based on their extensive legal knowledge and expertise, further enhanced by their prompt service and attention to detail.
Mark Hallink