When fifty/fifty co-owners get embroiled in litigation over the fate of the company, can the company survive the litigation? For many prospective clients, this is the first question they ask when they come in for a consultation.
When one fifty percent shareholder wants to sue the other, the company is already in at least some form of trouble. Sometimes litigation commences because nothing can get done, which is known as a “deadlock.” More often, though, one shareholder sits back and, for the good of the company, allows his business partner more leeway than he deserves. For example, if your partner is the one taking more money out of the company than he should, he already has shown little regard for the company’s finances. If you react and push back, a deadlock could be the result, paralyzing the company. When one 50/50 owner digs in his heels, the company could come to a grinding halt.
What can be done, short of simply “taking it?” One client last year was concerned that if he sued his business partner, his partner would stop making sales or stop doing the other things that were his responsibility. This would have been catastrophic for the company, so my client (before he became my client) did — absolutely nothing. For three years, he sat back in fear of what would happen if he confronted his partner. He knew he had no way to overrule him, since they were both fifty percent owners. After all, the partner who really cares about the best interest of the company is always at a disadvantage, since his business partner is not confined by the same ethical limitations.
We decided that the best strategy was to seek the appointment by the court of a Provisional Director to act as a referee. This is someone appointed by the court to break a tie on a directors’ vote. If one owner stopped making sales, the directors could vote to replace him as head of sales. If the Provisional Director agreed that your partner’s salary was too high, you would now have the votes needed to cut his salary. Just knowing that such a remedy existed was a godsend to my client.
In order to determine whether such a “tiebreaker” could help you and your company, ask yourself what I asked my client. If a neutral third party arbitrated the arguments you typically have with your business partner, who do you really, deep down, think would win? If you are the reasonable one, and your business partner is a selfish bully, chances are you would win most of the arguments if they were impartially refereed.
Many small to medium-sized business owners have no idea that such a court-appointed “referee” is even an option. If you have been contemplating litigation against your business partner, but are concerned with how the company could possibly be run when two shareholders are suing each other, you should seek legal advice from someone experienced in litigating shareholder disputes. You may come to realize that your company is not the first company to face such issues, and that the law has set up a system to deal with them.
In a shareholder oppression lawsuit, clients often think that if they have ever done something “wrong,” they have somehow lost their legal rights to complain about fraud or unfairness by the majority. While a skeleton in one’s closet can be problematic, it is rarely bad enough to cause a minority shareholder to lose the ability to sue his business partners who are treating him improperly.
For example, one client confessed to me that he had actually taken money from the company. It was a relatively small amount, and he justified it by arguing that the majority shareholders had been inflating their salaries and bonuses for years. When he was able, one time, to steer client monies into a personal account, he did.
Once the majority owners learned of this, they took the money out of his pay and redoubled their own cheating ways. Salaries and bonuses to themselves went through the roof, family members were added to payroll, and family vacations began being paid for by the company. Whenever the 15% shareholder complained, he was told that there was nothing he could do about it, because no judge would want to help a “thief.”
When he came to me, he assumed there was nothing he could do, but his wife made him keep the appointment. Together we concluded that there was nothing further that the majority shareholders could do to him, since the act had already been reported to the police, with no charges filed. We also came up with a creative way to explain away the alleged “theft.” The majority shareholders remained steadfast in their insistence that my client deserved no money, and they refused to pay him a penny for his shares in the company. However, once they retained their own attorney, she told them the same thing that I had told my client – whatever mistakes the minority shareholder may have made, that does not give the majority shareholders license to oppress him – at least not in New Jersey.
My client’s past had been dealt with. It was the majority shareholders who became afraid of having to explain their actions to a judge. This was especially the case when I reminded their attorney that the judge would have an obligation to report to the IRS all the additional income the majority shareholders had been receiving (paid personal expenses) and not reporting.
Please don’t assume that you have no rights because you have done something untoward. Speak with an experienced shareholder dispute attorney to see if you have options. You usually do.
When you are a small business owner, your business partner is often the closest person in your life, besides your spouse. Many would agree that if you suspect your spouse is cheating on you, he or she probably is. At the least, there is a major problem in the marriage. The same rule of thumb applies to your business partner – if you suspect that your business partner is somehow cheating you (as opposed to cheating ON you), he probably is. At the very least, the business relationship is in serious trouble.
One client several years ago exemplified this maxim perfectly. His business partner ran the day-to-day operations and the finances, while my client was constantly out on the road making sales. Predictably, each thought HE was the reason for the company’s success. After years of profitability and large dividends, suddenly there was no money for a year-end distribution. While my client historically had paid no attention to the expense side, as head of sales he was well aware that revenue had not decreased. When he started asking questions, he got the runaround. His suspicion peaked when he realized that his business partner had adopted a practice of making him feel guilty for asking to see the books and records of the company. “What’s the matter, don’t you trust me?” was the usual response.
When he came to see me, he was unsure if anything was wrong, but knew that something just didn’t feel right. He recognized that many business owners don’t like to be second-guessed, and no one wants their honesty questioned. However, there is a huge difference between someone who by nature does not like to be questioned, and someone for whom this is new behavior.
Much like a spouse who suddenly starts staying out late, wearing different underwear, or otherwise changing his or her behavior, a business partner can often be measured the same way. If there was previously openness, with no resistance to sharing critical information, a sudden change may portend something bad.
If your business partner is suddenly keeping you in the dark and denying you critical information, something may be amiss. In New Jersey, as a shareholder (or member of an LLC), you have certain rights to see and obtain critical financial information relating to the company. Even though this right is somewhat limited, there are often ways to get access to more financial information than is set forth in the governing statute. If you find yourself in the dark, starting by seeing an experienced shareholder dispute attorney about getting you access to financial records. If you find yourself suspicious enough, and powerless enough, that you feel forced to go see a shareholder dispute attorney, your gut suspicion that something is amiss is probably right.
A common problem in shareholder dispute litigation is that many companies deal in cash. Shockingly, not every mid-sized, closely held business that generates a substantial amount of cash reports all of it to the various taxing authorities. (I know – you’re shocked, too, right?) How could this impact shareholder dispute litigation?
The first way is rather obvious. When it comes time to value the company, whoever is looking for a higher value – or at least a truthful, accurate value – would want the cash to be counted. If it isn’t, then you aren’t really getting an accurate read on the company’s income, which is the most critical element in an accurate valuation. However, what happens when the court hears that significant cash was unreported?
In New Jersey, judges are duty-bound to report to the appropriate taxing authorities any tax improprieties of which they become aware. This could be catastrophic for the company, and for whoever personally was responsible for the failure to pay the taxes. If you were involved at all in any such decision-making, you must realize that you have potential liability. However, that does not mean that you have to sit back and take unfair, oppressive action from the majority shareholders. Often, they will have more to lose than you do – sometimes much more. This is especially true if they were the ones in charge, and you merely had knowledge. Often in such a situation, a minority shareholder is scared to file suit. However, when this fear is overcome and suit filed, majority shareholders are quite often scared to let the case go before a judge. Many shareholder disputes are settled, because of tax issues, on the eve of the issue coming squarely before the judge.
Although I most often write about representing minority shareholders in business dispute litigation, I represent majority shareholders as well. When I do, and when I represent the company, I often must advise my client against letting a case get to the judge, precisely for tax reasons. It happens all the time.
There is a second way that unreported cash impacts a shareholder oppression action, and this one is a much more difficult issue. Many times, clients say that cash was not only unreported, but split among the shareholders and never even deposited into the corporate account. An in-depth forensic analysis of the company may prove that cash was missing. (If you had no sales, where did all your inventory go??) However, while all the shareholders were getting along, there was no reason for anyone to turn a microscope onto what was transpiring.
What many potential litigants fail realize is, that there may be more than missing cash at issue. In more than one case, I have seen majority shareholders, who were receiving their “fair share” of the cash over the years, suddenly feign shock and outrage at “discovering” that cash is missing. Guess who they point the finger at?
In one case, the minority shareholder was also an employee, responsible for collecting cash and distributing it among the shareholders. He kept no records and could prove nothing. The majority shareholders realized that they could blame this minority shareholder for “missing cash.” When he questioned why the company was paying over $200,000 for the wedding of the majority shareholder’s daughter, the employee/shareholder was fired and accused of stealing cash.
Fortunately, we were able to come up with witnesses who saw the majority shareholders with enormous sums of cash which could not otherwise be explained. As a result, we were able to favorably settle the case. But the minority shareholder, for too many years, had no idea how vulnerable he was making himself. And the majority shareholder was his brother – as is so often the case.
The lesson is, be very careful about how you conduct yourself and what position you are putting yourself in. You do not want to be vulnerable to someone else’s easily concocted lie. If you are concerned that what you are doing may impact your rights in the future, talk to a lawyer now, in a conversation that would be protected by the attorney-client privilege. But if you think you are being defrauded or oppressed by your business partners, don’t give up, even if there may be some “cash skeletons” in everyone’s closet. At least seek legal advice to see if you have options.
I should probably end by saying that, of course, it’s always better to just pay all applicable taxes in the first place. But you may not be in control of that decision.
In my last post I looked at the decision of whether to create a corporation or an LLC from a minority shareholder’s point of view, and explained that minority owners may want to use an LLC. In this article, I will explain that, from a majority shareholder’s vantage point, the exact opposite often may be the case.
Before I explain how the corporate form may be better suited for majority shareholders, a caveat is in order. Using the LLC form may be better for everyone if the parties can agree on most everything at the outset. LLC’s are “creatures of contract,” and courts will usually respect whatever the parties themselves have agreed to. If the Operating Agreement says that a member may withdraw and be paid for his shares only if the Managing Member is convicted of a crime, that is likely exactly what a New Jersey court will enforce. The court will not rewrite the agreement for the parties. However, when not everyone can agree on such terms, the parties unfortunately either a) ignore the controversial issues, assuming they will be dealt with later (they never are); or b) never get around to signing any agreement at all.
With that said, let’s examine how to “get rid of” an unruly minority shareholder. It’s not always the majority owners that are the “bad guys.” What if a 33% owner is the one who runs the office, deals with the money, and is keeping everyone else in the company in the dark? Or awarding himself excessive bonuses? Yes, the majority owners can team up and make certain changes. But what if the minority owner is the only one who knows the critical end of the business? Or, worse, what if the minority owner is involved in a scandal that is hurting the company, and merely firing him as an employee is not a sufficient remedy? The majority owners cannot imagine staying in business with someone who did what he did, but what should the remedy be?
In an LLC, of course, a situation like this could have been specifically taken into account in the drafting process. However, if yours is one of the huge numbers of LLC’s that have no operating agreement, or at least one that does not address this, what is the remedy in an LLC?
In New Jersey, the LLC statute provides that, under certain circumstances, if “fault” can be proven on the minority owner’s part, he can be “dissociated” from the LLC. This means that he can be removed from management and all decision making. However, it does not mean that his shares may be purchased from him. He is still an owner, and still has the right to share in profits. In fact, there is a recent case in New Jersey that affirms just this result.
In a corporation, however, the result may be different. In New Jersey, courts have interpreted the oppression statute as permitting majority shareholders to sue minority shareholders, on the theory that minority shareholders may be just as oppressive as those in the majority. One New Jersey court even coined the phrase “tyranny of the minority” to describe it. If such “reverse oppression” can be established, then the majority shareholders may be able to force a buyout of the minority owner’s shares. This may be critical in a case where a minority owner has stolen from the company, and the company’s customers, vendors, and even its bank no longer wants that person to be an owner.
When trying to determine how to deal with an unruly minority owner, or even in planning for such an eventuality in the future, be careful what form (corporation or LLC) you select. It could make all the difference in the world.
When starting a new company, your first decision is often whether to create a corporation, or an LLC. Unfortunately, this election is frequently made without fully understanding how this decision impacts the rights of minority owners, either positively or negatively. And without knowing what this impact means, it is impossible to realize why this issue is even important.
Taking this lack of information one step further, new business owners many times elect not to spend the money on having a qualified attorney draft a shareholders’ agreement (corporation) or operating agreement (LLC) once the company is actually formed. Or, worse, they find a form on the internet to use. (These forms are often well written for their intended purpose, but are simply not a one-size-fits-all solution.)
In both instances, there exists a failure to appreciate the ramifications of not making a fully informed decision, which is then put into effect by a well-written agreement.
What do I mean? For starters, the difference between creating a corporation versus an LLC is different for majority and minority owners. From the viewpoint of a minority owner, the difference can be critical. In a corporation, if you decide you “want out” of the company, a shareholders’ agreement typically addresses whether, and to whom, you may sell your shares. But what if there is no buyer, and you simply do not want to be an owner any more? In that case, you must essentially prove fault, or what’s known as shareholder oppression. In such an instance in New Jersey, if “oppression” (mistreatment) can be proven, a minority shareholder often has the right to be bought out of the corporation at fair market value. However, this right is not automatic, and a shareholder cannot simply seek to be bought out without some compelling reason, usually fault on the part of the majority shareholders.
In a New Jersey LLC, however, the ability to be bought out of the company depends entirely on what the operating agreement says or does not say. If there is no operating agreement, or if there is one that does not prohibit withdrawal, then any member may withdraw and be paid for his shares without having to prove oppression or any type of mistreatment. An apt analogy is the difference between a no-fault divorce (in an LLC), and one where you have to prove some type of fault (in a corporation). But, if the operating agreement says no member may withdraw, then the right does not exist.
This distinction is often surprising to clients who have never had it explained to them before. While a member with a twenty percent interest may be thrilled to find out that he merely has to write a withdrawal letter, to create a right to be paid for his shares, the LLC itself is often not quite so happy to find this out. What if a member wants to exercise his or her right to withdraw, but the LLC cannot afford to pay for his interest? If it is ordered to do so by a court, what happens? How can the company find itself in this situation?
If the founders had sought legal counsel about these and other issues when forming the company, these issues could have been dealt with, taking into account the interests of all the owners. Crisis-induced decisions are usually less than ideal in almost all situations.
In my next post, I will discuss the distinction between corporations and LLC’s from the point of view of majority owners, as opposed to minority owners. As explained above, without a written agreement of any kind, a minority owner may benefit from using an LLC, since his right to withdraw will exist intact. However, in my next post, I will explain how, with majority owners, the opposite may be true. Without a written agreement of any kind, majority owners just may be better off using the form of a corporation, rather than that of an LLC.
Listen to the Little Voice Telling You Your Business Partner is Treating You Unfairly and Seek Advice Sooner Rather Than Later
It is fascinating how many clients come in to discuss potential shareholder litigation against their business partner, completely unable to explain why it took so long for them to see a lawyer. Most perplexing are the ones who believe their business partners have been stealing from them for years. When asked to explain where they’ve been, the excuse is often that they “didn’t have proof.”
One client in particular (who agreed to let me mention him in this article as a cautionary tale to others), a 50% shareholder, noticed that there was never as much money in the bank as he thought there should be. However, he said he “could never be sure,” so he did nothing about it. Finally, after he got married, his wife convinced him he should at least talk to a lawyer, just to see if anything could be done.
Of course something could be done. Even a minority shareholder is entitled to inspect certain books and records of the company, and a 50% owner should have full access to everything. If your business partner won’t provide you with full access to all financial information, especially to a co-equal 50% shareholder, then every red flag should be raised as high as they can go. In fact, the Court will often force such disclosure, and will almost always side with disclosure over secrecy.
Another client, a 25% shareholder, also waited years to see a lawyer, thinking that the 75% majority shareholder could essentially do what he wanted because it was “his company.” Fortunately, he read one of the articles on this blog explaining that even minority shareholders have rights that must be respected, and which can be enforced.
Waiting is not simply an issue of timing. The majority shareholder defendant will almost always argue that you didn’t wait just because you were unsure what to do. Instead, he will argue that you waited because you knew and approved of everything that was going on – the acquiescence defense. While you may think it absurd for your business partner to argue that you actually approved of him using company money to fix the roof at his house, or pay for his kid’s car, that is exactly the type of argument that is made in defending shareholder oppression cases. He will argue that you had full access to all books and records, whether that is true or not, and then he will attempt to charge you with knowledge of everything. Since you didn’t object for so long, you must have approved. And it will be your word against his regarding whether you truly had access to the financial records.
Avoid this trap. While you should not institute unwarranted litigation against your business partner, since such a suit could tear the company apart, you also should not just sit back passively while your suspicions mount. See a lawyer and take action. More importantly, seek to keep yourself apprised of what is going on in the company from the outset. Tell your business partner at the start of your business relationship that you intend to be fully informed, that you intend to hold him accountable, and that you expect to be held accountable, as well.
Or, just stop by in a few years and tell me that you “always had this suspicion, but never acted on it because …”
Hiring a Business Valuation Expert in Potential Shareholder Dispute Litigation is Not a Do-It-Yourself Proposition
In my last post, I discussed several ways an experienced shareholder dispute attorney can help assess a pre-litigation offer for your shares, including helping you retain a business valuation expert. One critical reason never to retain such an expert on your own is to maintain communications with such an expert as privileged and non-discoverable.
In New Jersey, if an attorney hires the business valuation expert, communications with the expert usually become privileged and non-discoverable. However, if a litigant hires the expert directly, the same privilege may not apply. The privilege also extends to draft reports, which are not discoverable if provided to an attorney first.
The quest to maintain such communications as privileged should not be misinterpreted as in any way improper. There is simply no reason to make communications with one’s expert discoverable. And draft reports are critical to ensure that the expert properly understood the scope of the assignment, not to make changes that an attorney does not like.
In addition, the valuation date is often critical, and often not the date you may presume it to be. It would certainly be disheartening to come to an attorney’s office, proud you have already learned from an “expert” how much your shares are worth, only to discover that 1) your emails with that expert are discoverable by your co-shareholder, 2) the expert has no experience testifying in a courtroom setting, making you the “guinea pig” for testing his abilities, and 3) the expert used the wrong valuation date, meaning that a substantial part of the report must be redone.
If you can see the handwriting on the wall and know that a lawsuit with your business partner is looking more and more inevitable, consult a shareholder dispute attorney earlier in the process, rather than later. At the very least, you should ensure that the path you are headed down is the right one.
Things To Consider In Assessing a Pre-Litigation Offer to Buy Your Shares in Shareholder Dispute Litigation
Making a low-ball offer to buy your corporate stock is probably the most common tactic used by one owner against the other in disputes between business partners. But how do you know when it’s worth the money to fight for more?
I hear it all the time. “I’ve been frozen (or squeezed) out of the company, and my business partner has offered me only X for my shares.” In a vacuum, of course, such an offer is hard to analyze. Is X a good offer? Are your shares worth 5X? 10X? Or is the offer on the table really not so far off from reality?
It is easy to see why this is such a common tactic. Often (but not always) the business partner in charge of the books and records, who is presumably the one in the best position to determine the value of the company, is the one who makes such a proposal. He is in a better position than you to know that his offer to purchase your shares is low; just how low it is may be known only to him. Since you do not have access to the same information that he does, it is very difficult for you to assess the offer, other than to suspect that it can’t possibly be fair.
But shareholders who feel they are being oppressed or squeezed out need to consider several things about pre-litigation offers for their shares. First, it is critical not to assume that the shareholder who controls the finances actually knows what he is talking about. Valuing a business is no easy task. Many things should be taken into account, and you need an experienced business valuation expert (not an attorney) to tell you what the true value is. Second, you must realize that it is highly unlikely that your business partner actually spent the money to hire a valuation expert to value your shares. In other words, there is a high likelihood that his offer bears little relationship to the actual value of your interest, and may be pulled completely from his you-know-what.
If you are in dispute with your business partner, considering litigation, and have to weigh a pre-litigation offer for your shares, don’t do it alone. You should consult with an attorney experienced in handling shareholder dispute litigation. The first thing any such attorney will tell you is that you should first see if there is any underlying basis to the offer on the table. If the majority shareholder or your 50/50 partner, as the case may be, obtained an appraisal for your shares, your attorney should ask to see it. If no appraisal was obtained, he will likely ask for the basis for the number. When no basis is forthcoming, the offer will be exposed for what it is.
An experienced shareholder dispute attorney will also be able to obtain for you the documents that you need to have an expert value your shares. In New Jersey, a corporation must give any shareholder certain financial records, as a matter of law. For the rest of the documents your expert would likely want to see, a threatening letter will often get the documents produced. After all, if you sue, you should get every financial document under the sun.
Lastly, an experienced shareholder dispute attorney should know a good business valuation expert who can do well testifying in court, hopefully at a (relatively) reasonable price. Next time, I will discuss a critical reason why a potential litigant should never hire his own expert – protecting communications as privileged.
In New Jersey Shareholder Dispute Litigation, Your Concern Must be Your Own Interests, Not the Interests of Other Minority Shareholders, or Even Family Members
When a new client comes in complaining that he is being treated unfairly by his business partners and hears that he may have the right to be paid for his shares, that potential remedy is often appealing. After all, it frequently takes years for a business relationship to fall apart, and in those years, the company’s value may be building up. Your shares are often worth more than you think. However, it is fascinating to me that so many clients say they want to be bought out, but don’t necessarily want to sue their business partners for other than cost reasons.
A strong letter writing campaign, with pointed correspondence from an attorney well-versed in shareholder rights and shareholder dispute litigation, may be attempted first, and could possibly work. If it does, significant legal fees may be avoided. But letters usually get you only so far. When it sinks in that filing suit is really the only viable option, clients often restrict the allegations they want made in the suit. Sometimes a client who believes his business partners are committing fraud – literally stealing from the company – actually does not want to use buzzwords like “theft” or “embezzlement,” because he doesn’t want to anger other family members (in a family-owned company). Or, he may not want to alienate the other minority shareholders, with whom he still has a relationship, or at least believes he does.
The reason for this hesitancy is often that the business partners are family members or close friends, or at least people who at one point were close friends. However, when I remind the client that these are the same people engaging in the acts he just spent an hour and a half complaining about, the message usually sinks in.
A minority shareholder who believes he is being oppressed by the majority, but does not want his lawsuit to alienate others involved in the company, including other minority shareholders, needs to ask himself two critical questions. First, how do you expect to protect your own rights when you are more concerned with the impact your lawsuit may have on others than you are with what is being done to your shares in the business?
The second question I tell clients to ask themselves has to do with those whose opinions of his suit the client is so concerned about. It is simply, “Where have they been?” When you discovered that the majority shareholder was using the company as his personal piggy bank, did the other family members rally around you and against the majority shareholder? Or were you left in the wilderness to complain on your own? When you, a 15% shareholder, were denied access to the books and records of the company, did the two other 15% shareholders assist you in any way? Did they give you the documents you were looking for? If they were truly your friends, and their opinions worthy of your concern, would they not have assisted you in standing up for your rights?
A reckless lawsuit brought without legitimate purpose could tear a company apart. But if your concerns are legitimate, and you have a valid shareholder oppression lawsuit, your focus should be on your own rights, not on what your suit may do to your company.