Previously on this website, I wrote about how a recession can help an unscrupulous business partner hide his fraud (Nov. 2008). For example, I explained that “tough economic times” can be used as an excuse to stop paying dividends or providing other financial benefits to minority shareholders. However, it can be equally true that a stronger economy, like we may be experiencing at the moment, can also be used to mask fraud.
While this may seem counterintuitive at first, it makes perfect sense. In a scenario where the majority shareholders are running the company – and, more importantly, the finances, as is often the case – it is easy to disguise self-dealing if the self-dealer masks his own greed. For instance, a business partner who wants to pay himself an exorbitant sum, pay for his wife’s car, his child’s car insurance, and bonuses that he didn’t earn, has a choice. He can also declare at least some dividend so that his out-of-the-loop business partner does not become suspicious. Or, he can double down on his greed, and make sure that his business partner sees nothing out of this company other than his meager salary.
Many shrewd self-dealers are adept enough to realize that a business partner who is kept in the dark about finances is less likely to get suspicious if a modest dividend is paid at the end of the year. After all, any voiced suspicion can then be met with a statement reminding him that a dividend was paid, which did not have to be paid. If I was stealing from the company and was a thief – the thinking goes – why would I have declared a dividend?
Of course, the best way to defend oneself against fraud or self-dealing by your business partner is to inspect the books and records with some frequency. However, that is not always possible since New Jersey law severely circumscribes one’s right to inspect the books and records of the company. In fact, there are few documents to which a minority owner is entitled, which will be the topic of an upcoming article. Thus, it is far better to write into the Shareholders Agreement (or Operating Agreement, in the case of an LLC) a right of inspection.
For many reading this article, it is too late to add such a provision, as the agreement was written years ago. However, there are various points in time when you hold certain leverage even as a minority owner. If the company is borrowing money, and you are asked to sign a personal guaranty, it might be reasonable to condition your signature on a binding, written agreement allowing you full access to the books and records of the company. After all, if you are being asked to put your personal assets at risk, why should you not get full disclosure about the company’s finances now and in the future?
Often employees sign non-compete and non-solicitation agreements that spell out what an employee can and cannot do after employment is terminated. Usually, if an employee never signed such an agreement, he or she is free to compete post-employment, provided confidential information is not involved. However, when the employee is also a shareholder, as is often the case in closely held corporations, there is a twist. Despite the fact that you never signed a non-compete, you may be held by a court to have a fiduciary duty not to compete with the company that you partially own, even if you were fired.
Somewhat surprisingly, there is no New Jersey case law relating to the precise duties owed to a company you partly own not to compete with it. However, it is likely enough for a court to conclude that you cannot compete with a company that you own. The issue will be whether that duty still applies if you have been terminated. After all, if the majority shareholders have just fired you, they are taking the position that they do not want you working for them anymore. How, then, can they argue that you should not be able to work for someone else? They can make this argument, but whether it is successful or not is likely to be dependent upon the particular circumstances of your case.
As readers of this web site well know, when an employee or shareholder is terminated, it may constitute shareholder oppression, resulting in judicial remedies including a forced buyout of your shares. If you file such a suit, announcing that you no longer wish to remain a shareholder and are seeking a buyout, your argument to legally compete is likely strengthened. Conversely, if you sit on your rights and do not sue for a buyout, you may be indicating (in the Court’s eyes) that you are content with being a “passive shareholder”, and may be prevented from competing more readily than if you had sued.
As with many issues involving an oppressed minority shareholder involved in a dispute with a business partner, your rights in such an instance are likely to be very fact specific. You should consult an attorney conversant in such issues before deciding to take a job with a competitor, even if you hadn’t signed a non-compete agreement. A brief legal consultation can make the difference between being sued and knowing that you are operating within the law.
The difference between owning 50% of your company and owning 51% is great. But the difference between owning 50% and owning 49% could be catastrophic, despite the significant remedies available to oppressed minority shareholders in New Jersey.
After reading the other articles on this site, one comes away knowing that minority owners have significant rights in New Jersey (at least, that was my goal). A shareholder who is taken advantage of by majority owners can file an action for damages and various other remedies, including a potential buyout of his shares. However, such an action is expensive, time consuming, disruptive to the business, and should only be resorted to when all other options have been exhausted. There is simply no substitute for retaining a majority, or at least a 50% interest, in your own company.
This advice may seem obvious, but it is amazing how many business owners bring in investors, giving up shares in their company (sometimes even a controlling interest), without thoroughly exploring whether there was any way they could arrange for bank financing. Whether it’s because the owners do not want to pay anything other than the lowest interest rate available, or because they don’t want a bank to know all of their business, the reasons behind this reticence to become beholden to a bank is not uncommon. Sometimes, a company truly cannot get a bank loan. However, resorting to alternate methods to raise capital can have dire consequences.
In one company, the founding shareholders owned 60% and 40%, respectively. The majority owner gave away a 5% interest to three separate investors (15% in total), reducing his interest to 45%, but raising almost $1 million for the company in the process. He thought that he had a responsibility to “his company” to do this, even though the 40% shareholder refused to give up a single share. The former majority shareholder believed he was protected because he remained the single largest shareholder. Plus, he took a long-term note back for the value of the shares that he “sold,” so that he would be repaid years down the road, when the company was sold.
Of course, it is obvious where this story is going – at least on this website. Once the new shareholders “ganged up” on him with the 40% owner, and he was outvoted 55%-45%, his world had changed. He could no longer dictate the direction of the company that he had run for years. Nor could he set his own compensation. At first, he was a minority shareholder without a remedy, because not everything that majority shareholders do that the minority disagrees with is actionable. And when the new majority coalition finally went too far and engaged in action that he could sue over, it was hardly a day to celebrate. An unceremonious firing, followed by two years of litigation, led to a multi-million dollar buyout that certainly did not leave him destitute. However, while he may be a rich man today, he would much rather have remained in charge of his “own” company, with the opportunity to see what it could have achieved under his stewardship.
The worst part is, when I asked him why he didn’t just borrow the money the company needed from the bank, he confided that the interest rate was too high. Well, at least he saved that.
The point is, while minority shareholders (and now, LLC members) do have significant rights in New Jersey, those rights are no substitute for control. So, if you ever find yourself on Shark Tank, don’t take the money, unless you deparately need it and have no other alternative, if the “Shark” is asking for 51% of your company. It will probably turn out worse than you can imagine.
When two new clients recently came in to have an Operating Agreement prepared for their newly created LLC, they indicated that they had read my website. Since I had experience in litigating shareholder disputes, they wanted to know how to make a “bulletproof” Operating Agreement, so that there would never be litigation if they disagreed over an issue.
We spent a considerable amount of time trying to come up with a dispute resolution mechanism, but they could not agree on a third party to decide any significant disputes if they ever had one. The only person they both trusted was a minister, but they did not want him making business decisions on their behalf.
After going several rounds trying to figure out how to contract against every possible contingency, they finally realized that what I told them in the first meeting we had was correct – you can’t possibly guard against, and contract around, every single contingency. The best you can do is limit the odds of such litigation by making the agreement as fair to everyone as possible.
We came up with the idea of creating spheres of expertise for both of them and ensuring that the other was comfortable ceding control over such area. For example, at the end of their negotiation, one of them had the final word on all matters relating to sales and marketing, while the other had final say on personnel, staffing and salary issues. They also agreed that, if they could not agree on something truly major – like whether they should construct a new facility instead of leasing, or whether to expand the company – the business partnership likely would not work in the long run if a solution were forced upon them from the outside.
The compromise reached was, if one of them wanted to undertake a major change (like expansion) and the other did not, the one who wanted to take action had the right to buy out the other at fair market value.
As a shareholder dispute litigator, I found it truly refreshing that these two business owners found a way to contractually limit, as much as possible, the risk of costly litigation in the future. By taking the time to really think through these issues at the outset, and spending just a few thousand dollars in legal fees, they went a long way toward ensuring that they would not some day have to spend hundreds of thousands of dollars on shareholder dispute litigation.
If everyone thought through these issues as carefully as these clients at the outset, shareholder dispute litigators would be all but out of business.
Many times, two 50% owners possess different areas of expertise and separate spheres of influence. For example, it is not uncommon for one business partner to be in charge of sales, with the other in charge of finances. Because of this, one person often has more contacts than the other. Presumably, but not necessarily, the shareholder in charge of sales will have more customer contacts than the one who runs the front office.
This often leads to a misunderstanding about what happens in the event of business divorce litigation, or even voluntary separation. For example, in one recent case, a 50% shareholder who was in charge of sales believed the customer contacts were “his,” and that he could take them with him to a new, competing company. While he might have been able to do so after tendering his shares (and thus no longer owing a fiduciary duty to the company, or his co-owner), he did not realize that doing so would substantially impact the value of his shares.
For example, if he were bought out, his 50% interest in the company would have been worth $X. However, by taking “his” clients to a new company, he took a substantial portion of that value with him. As a result, he was entitled to substantially less than $X for his shares.
In another case, one shareholder left the business and simply started soliciting “his” customers (again), not realizing that doing so violated 1) his fiduciary duty (since he was still a shareholder), and 2) the restrictive covenant contained in his Shareholder Agreement.
It is one thing to believe that you have certain rights if you have confirmed your belief with an attorney. But these owners both put themselves in bad positions by acting on their faulty beliefs, then seeking legal counsel after the fact. Please save yourself tens of thousands in legal fees and ask for business divorce advice up front. If it’s too late, and you are already in shareholder dispute litigation, seek counsel from someone who handles such matters routinely.
As many of you have read here before, the New Jersey Limited Liability Company Act now includes recovery for minority member oppression. Those remedies cannot be waived, as a matter of law. However, the parties to an LLC’s operating agreement (or a corporation’s shareholder agreement) can agree to an alternate dispute resolution (“ADR”) mechanism in advance, impacting the forum in which these issues will be decided.
Many people are familiar with the most common form of ADR – arbitration. However, even this familiar procedure has different permutations. Many clauses say that disputes will be resolved in arbitration, but if you specify that the rules of a certain organization will apply (such as the Arbitration Association of America), you may get more than you bargained for. Many people do not realize that a clause that says nothing more than “arbitration under the AAA” may mean a panel of three arbitrators, not one. So, while a New Jersey court provides plenty of judges – for free (well, at least paid for by the taxpayers) – an arbitration election could require that you pay a proportionate share of three paid arbitrators.
People often use another remedy to resolve disputes and break deadlocks in closely-held businesses, namely agreeing to appoint a trusted third party who will make such decisions. However, I have yet to see such a provision actually work. If you do not agree in advance on who the person should be that makes such decisions, it usually means that you could not identify such a person when you drafted the agreement. What makes you think things will be different now? Can you really find someone qualified to make decisions in your industry that does not already work in it? (If he already works in it, it could mean that you just appointed a competitor to resolve all disputes over how your business should operate.) What happens when you and your business partner cannot agree on the identity of such a third party? Will a fourth party help you pick such a third party?
These issues may apply to any litigation, but business disputes in closely held businesses are particularly ripe for being decided by way of ADR. Shareholder dispute litigation is vastly different than a fight with a vendor over payment terms. If the business partners are fighting over the very manner in which the company should be run, delays and a lack of a clear company direction could be fatal, as more than one business has died before a shareholder dispute trial could be scheduled. At the outset of a business relationship, the business partners should sit down with an attorney well-versed in ways to avoid business dispute litigation, and discuss ways to streamline the process that make sense in the event a serious dispute becomes wholly unavoidable.
When majority shareholders want to force a minority owner out of the company, there are a variety of means for doing so. One of the most popular methods is the unnecessary capital call.
One recent case involved a client who was a part owner of a corporation that seemed, on the surface, to be in need of money. In reality, the majority owner was “in need” of “getting rid” of the minority shareholder (my client) to solidify his control over the company. The majority shareholder engineered a capital call, knowing full well that my client would be unable to raise enough cash to increase his already hefty investment in the company. As a result, my client was diluted from a one-third owner to a nine percent shareholder. He was ready to accept a meager payment for his shares when he came in for a consultation.
A forensic accountant discovered in his review of the company’s books and records that the majority owner was siphoning money out of the company. As a result, he essentially met the capital call with money taken in the form of substantial overpayments to himself, and illegal reimbursement of hundreds of thousands of dollars worth of purely personal expenses.
When it became apparent to the majority owner’s counsel what his client had done, the settlement offer increased several multiples, and a lengthy and expensive litigation was largely avoided.
The most amazing part of this case is that my client started out believing that he had no rights whatsoever. The majority shareholder had issued a capital call, which my client knew to be a perfectly legitimate mechanism to raise money, but he had no money to contribute. Having an experienced business divorce attorney review the facts before he made a fateful decision made all the difference in the world to him.
In my last post, I wrote about the fact that your right to simply withdraw from a New Jersey LLC and be paid fair market value for your shares – provided the Operating Agreement does not prohibit this – is being eliminated on March 1, 2014. Many readers of that post have contacted me, hoping there was a way to extend that deadline. Unfortunately, it cannot be extended. The amendment to the LLC Act is already “on the books,” and takes effect on March 1st. There is simply no way around this.
What many of these clients have in common is that they believe they MAY be being taken advantage of by the majority owners, but they are not sure. What if you find yourself in this situation? What is the best course of action? Should you withdraw from the LLC while you can, and just be paid for your interest? Or should you hold out and see how things go, and whether things get any better?
Obviously, that is a very personal and individual decision that each client must make on his or her own. But there is one thing everyone making this decision needs to keep in mind. If you are reading this post, you have already decided that there is a significant enough issue to cause you to explore legal representation. If you have only suspicion that the majority owners are engaged in wrongdoing – but don’t yet have the proof – the trust relationship has already been eroded, if not completely destroyed. While I obviously cannot know what an investigation will uncover – whether on your own or with the aid of an attorney or a forensic accountant – there is one thing that is known. If you wind up suing your business partners after March 1st for oppression under the amended LLC Act, the action will cost much, much more than if you had taken advantage of the expiring right to simply withdraw and be paid.
If you own an interest in a New Jersey LLC and are even contemplating “getting out,” you should seek legal counsel immediately, before your options dramatically change.
If you are a member of a New Jersey Limited Liability Company (LLC), and you are not happy with the way the company is being run, you can simply withdraw and be paid fair market value for your shares – provided the LLC’s Operating Agreement does not prohibit this. However, this right expires on March 1, 2014, because of an amendment to the law.
If you read my previous posts on this blog, you are aware that, to date in New Jersey, there has been a marked difference in the rights of shareholders of corporations, and the rights of LLC members. The difference is easy to understand if you think of the issue in terms of getting a business divorce. In a New Jersey corporation (with fewer than 25 shareholders), you can get a “divorce” from your fellow shareholders only if you can prove some sort of wrongdoing or fault (called “oppression” under the law). There is no such thing as a “no-fault divorce” when it comes to corporations. Oppression must be proved, and then you have the right to a remedy, most often a buy-out.
LLCs, until now, have been treated much differently. There was never any such thing as a “fault divorce.” If wrongdoing occurred, it could constitute a breach of the Operating Agreement, or of one’s fiduciary duty, and an aggrieved minority member could be compensated for damages actually suffered. But that is far different than actually being paid fair value for your shares in the LLC.
However, the law of New Jersey LLC’s did recognize a “no-fault divorce” – provided the Operating Agreement did not prohibit such a thing. If you simply gave written notice that you were withdrawing from the LLC, you would have to be paid fair market value within six months; no questions asked. Of course, that does not mean the majority members will always agree to do this, so a lawsuit to compel compliance, or regarding what constitutes fair value, could always be necessary. But the right to be paid for your LLC interest, without proving oppression by the majority, did exist.
But, it is critical to understand that that right disappears in New Jersey on March 1, 2014. Any withdrawal that occurs after February 28, 2014, will be ineffective as a matter of law.
This issue is critical because I have had three clients approach me in the past month who thought they had to file a hugely expensive lawsuit against the majority LLC members, only to learn that they had a very simple, and relatively inexpensive, remedy available to them. But they had no idea this right existed, and, obviously, no idea that it would only be available to them for a very short time.
I will be writing about this issue more in the next month-and-a-half. But if you are in this situation, you should give serious thought to whether you want to avail yourself of the “no fault business divorce” from the co-members of your New Jersey LLC. Quickly!
Recently, a defendant testified in a deposition that I was conducting that there was no reason that he could not fire my client, who was a 28% minority shareholder in a New Jersey corporation. Since the defendant was the majority (51%) owner, he believed he could fire whomever he wanted.
Of course, he is right. He could fire whomever he wants. Most employees in New Jersey are employees at will and everyone knows that they can be fired at any point with or without reason (as long as the termination is not discriminatory, of course). So, yes, I had to admit that he had the right to fire my client. But that does not mean that there can be no consequences that flow from the termination.
Since my client had always been a valued employee and was one of the founding members of the company, he had a “reasonable expectation” that he would continue to be an employee as long as he was a shareholder (or so I argued, backed by New Jersey law). In other words, the status of shareholder and employee were inexorably intertwined with him, and rightfully so.
Because of this, my adversary’s attorney knew full well what his client did not – that the law in New Jersey protects minority shareholders in closely held corporations from termination. So, while the majority shareholder had every right to fire him as an employee, my client also had the right to be paid fair value for his shares. As a policy, New Jersey courts believe that majority shareholders should not be permitted to terminate a shareholder as an employee, but keep his capital captive. If not for this remedy, the shareholder would not only no longer be working as an employee, but he may also be precluded from getting any return on his investment.
Courts know that, while the law requires distributions to be made pro-rata to all shareholders, it is very easy for business owners to play games with salary and bonuses and overcompensate themselves, leaving little money left over for shareholder distribution.
This protection has been afforded to shareholders in New Jersey corporations for many years. As of March 2014, the LLC statute in New Jersey is being amended to apply the concept of “oppression” to New Jersey LLCs. While there is nothing specific in the amended statute detailing exactly what this means, there is every reason to believe that a New Jersey LLC member who is terminated as an employee, frustrating his or her reasonable expectations, will soon have the full weight of law in their corner. Finally, LLC owners will be afforded the same relief that is available to owners of corporations.