The Course of Shareholder Dispute Litigation Can Be Affected By The Way Your Shareholder Agreement is Drafted
Many business owners involved in shareholder dispute litigation wish they could go back in time and rewrite their shareholder agreement. Unfortunately, it is often during expensive, protracted litigation with your business partner that you learn how your shareholder agreement could have been drafted to save you a costly lawsuit, or at least alter the course of that lawsuit.
For example, in one recent case, the Court wound up appointing what is called a “Provisional Director” to break ties between two fifty/fifty owners of a subchapter S corporation. Unfortunately, the Provisional Director began making all sorts of decisions that went against my client’s interests. The decisions may have made some business sense, but they were clearly not what my client wanted to occur.
With better planning up front, this situation could have been avoided. A Provisional Director is a court-appointed member of the board of directors of a corporation, and has all the powers to act as a director, essentially breaking any tie. However, in New Jersey, he or she is not a shareholder and cannot act as a shareholder. Of course, in a small, closely-held business, the shareholders are almost always the directors. But on this point, the distinction is critical. If the shareholder agreement provides that certain decisions can be made only by the shareholders, and takes certain issues out of the hands of the directors, a tie between shareholders in a shareholder vote cannot be broken by a court-appointed Provisional Director, at least in New Jersey.
In my case, the client desperately did not want raises to be given out, fearing that the increased pay would only be used by his co-owner to pay his attorneys’ fees, further fueling the litigation the client thought should not have been started in the first place. Had the attorney who drafted the shareholder agreement thought about possible future shareholder dispute litigation, he could have drafted the document to require unanimous shareholder approval for salary increases and the award of bonuses. But no such foresight was present at drafting, and the fifty percent owner’s fate was decided by a court-appointed stranger who knew very little about this – or any – company.
Many of the articles I write on this blog have a common theme: attempting to help the reader avoid problems before they occur. Once again, steps taken at the outset can make a huge difference should shareholder dispute litigation become necessary. And if your shareholder agreement – assuming you can find it – does not contain such a provision, it’s never too late to amend it; provided, of course, that all shareholders agree to the changes.
New Case Reaffirms the Difference Between Corporations and LLC’s When It Comes to Rights of Minority Owners
I have written extensively about the difference between the law in New Jersey protecting a minority shareholder in a corporation, and the law protecting a minority member in a limited liability company (LLC). Most lawyers practicing extensively in this area of law have long argued, and believed, that the statute protecting minority shareholders in a corporation from what is considered “shareholder oppression” does not apply to LLC’s (much as we may want it to). The New Jersey Appellate Division reaffirmed this principle in a recent, unreported decision, Hopkins v. Duckett.
The importance of this legal distinction cannot be stressed enough. Actions such as the failure to give dividends to shareholders (in certain circumstances), termination of a shareholder as an employee, and excess payments to themselves by the majority shareholders have all been held to constitute shareholder oppression, often giving rise to the right to be bought out of a NJ corporation. However, these same acts may not give rise to the right to be bought out of an LLC. Instead, the rights of a minority member of an LLC may be much more complicated, and the remedy may not include a buyout of the minority member’s interest.
Of course, the rights and obligations under an LLC in New Jersey may also be much simpler, assuming the LLC’s Operating Agreement does not prohibit withdrawal. If it does not, in NJ, a member may simply withdraw from the LLC and have the statutory right to be paid for his membership interest a much less expensive, procedure than a shareholder oppression lawsuit. However, the Operating Agreement often bars such withdrawal, and then a very careful analysis of the facts is necessary to determine a minority member’s rights.
A minority member of an LLC may still protect himself, even if the majority members insist on prohibiting withdrawal at the time the Operating Agreement is drafted. Absolutely nothing prevents the members of an LLC from adopting the rights and remedies set forth in the shareholder oppression statute, thus making them applicable to an LLC by contract. This could be a fair compromise between simply permitting withdrawal, and providing no relief at all. What is absolutely critical, though, is to utilize the services of an attorney who is well-versed in this area of law. Lawsuits brought by minority members against my corporate clients have been thrown out because the attorney on the other side based his entire case on the shareholder oppression statute, when the company at issue was an LLC. Those clients learned the hard way that this area of law can be complicated and wished they had done more due diligence in hiring their attorney.
Email as Evidence – The Difficulty of Email Between Business Partners
You and your business partner are having a serious dispute, and litigation may be inevitable. How do you communicate with each other prior to the suit being filed?
In some cases, you and your business partner both work in the same building, while in others one of you works from home or does not actually work for the company. When disputes about how to run the business appear serious enough that they may result in litigation, how you communicate with each other may be critical regardless of your respective roles in the company.
Documentation of facts is always important, and the lead-up to shareholder litigation is no different. Obviously, most written communication today occurs via email. How you word these emails matters. For example, no matter how much your co-owner’s conduct has annoyed you, or even harmed you, the tone and tenor of your written communications may matter in court. They are likely to be evidence of relevant issues. In fact, their use as evidence is, in some instances, the main reason that they are being written. So it is critical to keep in mind that it is very likely that a judge will be reading these emails at some point in the future.
Why is this important? In most shareholder dispute litigation, the judge is going to decide the case, not a jury (at least inNew Jersey). Therefore, his or her opinion of you is critical. If your emails to your business partner (and future litigation adversary) seem overly harsh, or are written in a way that inadvertently puts you in a bad light, unintended repercussions down may result. While documenting the facts, you must appear reasonable at all times. When you are involved in shareholder dispute litigation, you want to be the one in the white hat while your adversary is the perceived outlaw.
In one case, a 1/3 shareholder let his frustrations boil over at the female majority owner who was using the company as her personal piggy bank, and in his anger used a slur that should not be used against a woman. Although he was totally justified in all of the allegations that he made in the email, the female judge did not appreciate his choice of words when the document wound up as an exhibit in court three years later.
To protect yourself in such a situation, follow these two rules:
- First, when attempting to document the facts, imagine that the email (or letter) is being copied to the judge who will preside over your likely future lawsuit against your partner.
- Second, make sure you are accurately documenting what you want to memorialize, and that what you are attempting to say comes across clearly. More than once I have had to tell a client that the email he thought confirmed a date or an event was not written clearly enough to ensure that the other side was not left any “wiggle room” to weasel out of the issue. A client who was sure his email instructed his business partner not to do something was sickened when I had to tell him that the email was not strong enough because it said only that he “didn’t think” his partner should do it. That’s a far cry from directing him not to.
Although no one likes to spend money on legal fees, the best approach is to consult with an attorney well versed in shareholder dispute litigation as soon as you suspect there may be an issue. Having an attorney trained to handle business partner litigation review critical emails before they are sent just may prove invaluable down the road.
Is the Next Generation Ready to Take Over Your Business?
Having your child work in the family business that you helped grow from the ground up may be the thing you are most proud of, possibly in your entire life. Knowing your business will not die with you can be a truly liberating feeling. But when you do not own 100% of the company, and you have a business partner to answer to, that means that your child has to answer to him, as well. Of course, the same goes equally for your business partner’s child, who has to answer to you. But if neither of you sees everything that the other’s child does, how do you evaluate their performance?
For example, suppose your business partner’s child works on the plant floor, learning the business from the ground up. How do you know if he is doing a good job? Even if your supervisor tells you that he is, is it true? Or, does the supervisor believe that your business partner’s son is his future boss? If he does, can you trust that you are getting an independent assessment of his skills and talents? Or do your current employees simply want to curry favor, leading them to give favorable reviews out of a sense of self-preservation?
The question goes both ways, of course. If your child is receiving “rave reviews” from your supervisory staff, is your staff just sucking up to you?
The ability to accurately assess the talents of the next generation may not be important to you, especially if it’s your own child being discussed. Not surprisingly, many small-to-medium-sized businesses think this is a greater issue when it’s their partner’s child under the microscope. But this issue may be more critical than you realize.
The abilities of those who will take over from you will directly affect whether the company remains a success while you are supposed to be enjoying retirement. One set of clients learned the hard way that their own children were incompetent. The clients decided to sell the business to the children over time, rather than to an independent purchaser for cash up front. Within two years, it was apparent that both of the founders would have to come out of retirement to save their business, as well as their retirement income, from ruination.
Ensuring quality management into the future can also avoid ruinous shareholder dispute litigation. Allotting equal pay and responsibility to both succeeding children, when one is a superstar, and the other is incompetent, is a recipe for disaster; resentment and expensive litigation between business partners often results from such a situation. Sometimes, it is far better for one child to manage the company, while the other has a lesser role equal to his talents. As long as both have an equal ownership stake, they would be serving the company’s best interests.
Obviously, if there were a way for you to determine for yourself how well your respective children are performing, that would be ideal. But this often is not possible for a variety of reasons. Or one partner may think that his child is fantastic, but that his partner’s child has much room for improvement – while the other partner sees it exactly the opposite way. Then what?
In my last posting (discussing Second Generation Shareholder Litigation), I discussed the wisdom of setting up the successor generation with a mechanism to have compensation set by an outside consultant, to avoid shareholder dispute litigation over salaries taken. A similar thing can be done with performance evaluation, although it may not be easy, depending on the type of business involved. If an outside consultant is impractical, having reviews and assessments performed by your most trusted senior manager, who has no fear of retribution from the next generation, can also lead to a more impartial result. If at all possible, having an assessment performed by someone truly independent, who does not fear reprisal, could save you and your business partner from literally putting the company, and your respective futures, into the wrong hands.
Protecting the Second Generation from Oppressed Shareholder Claims
In my last post, I addressed how you and your business partner, as equal 50% shareholders, can protect yourselves from claims brought by the next generation once you begin to turn over the company reins. This time I want to discuss other difficulties that can be encountered when turning the company over to your children, and how to protect your children from oppressed shareholder claims.
When only one of you has a child who will work in the business, but ownership will still be divided between both your offspring, problems – although not insurmountable once – may arise. The biggest area of dispute is likely to be compensation. The next-generation shareholder who has worked in the business for years, and who knows the finances inside-out, will likely wind up setting his own salary. And every dollar that he gives himself as a bonus is one dollar less that can be paid out as a dividend and split evenly.
How is the shareholder on the outside supposed to know whether he is being treated fairly? If you and your business partner have passed on the company to your children, should you care how they get along in the future?
I don’t have to tell you that you should care, because if you’re reading this article, you probably do care. And why shouldn’t you? You worked for years building up the company. Why would you want to see it torn apart by shareholder dispute litigation between your children?
You can take steps now to prevent such fights, including making sure that mechanisms are in place for transparency, especially with respect to the finances. One client set up a mechanism for an outside consultant to set all salaries for the company, providing in the shareholder agreement that all shareholders had to agree on the choice of consultant. This particular client and his business partner had never had a disagreement in over thirty years in business, so some people thought that having salaries set by a consultant was unnecessary. But he saw that his son and his business partner’s son did not see eye-to-eye on several things, and he knew that only one of them would work in the business.
This approach might be a waste of $5000 per year. Or, it just might be the thing that prevents shareholder dispute litigation from tearing the next generation apart – and with it, the company that the partners spent the better part of their lives building.
Surviving in business is difficult with a business partner, especially when you are both 50% shareholders, with neither of you in total control. Cooperation and trust are critical, and the relationship could have fallen apart at so many different times over the years. Disagreements about the future direction of the company likely have occurred, but you survived them all. As you approach the age where you can begin to see your retirement on the horizon, questions inevitably arise about the future of the company once you are no longer there. When you are a co-owner, you also have to consider whether your business partner has the same vision of the future that you do.
You would be surprised to know just how many savvy business partners have never addressed – or even discussed – a succession plan. Do you both want to sell at some point? If so, when? Do you both want the next generation to run the business? What if one of you wants to sell, but the other wants the children to take over? If your children run the business, will you give away all your shares first, or will and your partner continue to maintain ownership control?
It is critical that these issues be decided as early as possible, certainly before it’s time to implement a succession plan, whatever that plan may be. Although these are corporate planning issues, the statute (at least in New Jersey) governing shareholder oppression and minority shareholder rights has a large impact on how these issues should be addressed.
If the plan is to leave the business to the next generation, it is quite common to gift shares over a period of years as an estate planning tool. To protect the founding generation, shares are often gifted as non-voting shares, so that control is maintained. But, in New Jersey, those new minority shareholders now have certain rights – even if they are your children. They may sue for shareholder oppression, which is defined in a variety of ways, and, under the statute, includes the broad category of “unfairness” towards the minority.
One recent client gifted his shares to his son, while his business partner did the same with his daughter. Instead of being grateful for the windfall, both children (in their 30’s) felt entitled, and complained about the large salaries being taken by the majority shareholders who had not only gifted them their shares in the first place, but still ran the company, as they had for three decades. Those complaints turned into a lawsuit, and the majority shareholders soon wished that there had been some way to address this issue up front, rather than through expensive shareholder litigation.
Even if you are correct in your belief that your child would never sue you, are you as confident that your business partner’s child would never sue him? Or you?
Although it is unavoidable that a minority shareholder would have certain statutory rights in New Jersey that cannot be waived, there are ways to craft a new shareholders’ agreement that can limit the exposure to such a suit. For example, the new shareholder, when he receives his shares, could acknowledge in a new shareholder agreement that he is aware of everyone’s salaries, recognizes such salaries to be fair and justified, and concedes that he is to have no role in the future in setting salaries. This one precaution would protect, to a certain degree, one generation against the claims brought by the next. But, what of the second generation itself?
How to prevent claims between or among the members of the next generation – claims that could tear apart your business, and your legacy – will be dealt with in my next posting.
When you started your company all those years ago, you were certain you didn’t need a Shareholders’ Agreement (or, in the case of an LLC, an Operating Agreement). An attorney would have charged you more than you wanted to pay at the time to draft one (as they usually do), and after all, you trusted your business partner (back then). If an issue between you ever arose, you were confident in your ability to work it out quickly and easily.
But now, you and your business partner have encountered a dispute that cannot be resolved – a fundamental difference of opinion over the direction of the company. He blames you, and he wants out. A carefully-drafted Shareholders’/Operating Agreement might have contained a buy-sell agreement that spelled out each shareholder’s right to be bought out by the other under certain circumstances. Without such an agreement, though, your partner feels trapped, as if he has no choice but to sue.
So he sues, alleging shareholder oppression and mismanagement, accusing you of failing to undertake numerous actions that were never your responsibility. Had an agreement been in place, you might have been able to point to language showing that the responsibilities you are alleged to have breached never were charged to you. Once again, a written agreement, spelling out the rights and responsibilities of all the owners, would have proven quite useful.
I have seen this situation, where the absence of an agreement between the parties has led directly to shareholder dispute litigation.
Then, to add insult to injury, after your attorney has charged tens of thousands of dollars to defend you against the shareholder oppression claim, your business partner finds a buyer and announces that he intends to sell his 50% interest to him, completing his exit strategy. Without an agreement to protect you, you are now in business with someone you’ve never met, and this stranger owns the other half of your own company. But you saved money by not having to pay for an agreement at the outset. Congratulations.
All of this can be avoided by making sure that you consult with an attorney who is conversant in shareholder dispute issues – not only when you get sued, or when you are ready to sue your business partner – but also when things are going well. As with so many things, a little legal “preventive medicine” can save a fortune down the road.
If you no longer trust your business partner, can your business be saved? This may not seem like an issue for an attorney, and may seem more suited for a psychologist. But an attorney well versed in handling shareholder disputes may be able to help save such a business. At the very least, it may be worth a try, because the alternative may be costly and disruptive shareholder litigation.
In order to determine whether the trust can be rebuilt, it is critical to know why the trust eroded in the first place. Did they have control over setting salaries and exercise their discretion unfairly? Did they inappropriately cause the company to repay themselves for personal expenses, a perq that was either abused, or simply not shared with you? Are their family members on the payroll that shouldn’t be, while they refuse to end the practice?
As bad as some of these things may be, their actions would be even worse if they were done surreptitiously. While it may be difficult to hide a friend or relative who is employed by the company, cash payments to oneself may be easier to conceal.
If you are having a dispute with your business partner that appears headed to court, you may want to consider pre-litigation mediation, which may be the best way to resolve the dispute. If the issues can be addressed before the situation gets ugly, huge dollars may be saved on attorneys’ fees, and tremendous business disruption may be avoided. An accountant, clergy member, or business-savvy family friend (trusted by both parties, of course) could act as a mediator in such a case.
Communication is often the key to salvaging a business relationship. In one recent case, we discovered that the 75% owner was treating the 25% shareholder unfairly (providing large bonuses to themselves, instead of paying dividends pro rata) because they believed the minority shareholder was diverting their efforts to another business. When they finally discussed it and the majority shareholder learned that their business partner’s “side business” was really a charity, the entire business relationship took on a different tone. The business relationship was healed simply with direct communication.
If some sort of mediation is opted for pre-litigation, you actually may achieve a better result if both parties sit in a room together, without attorneys being present. That was a difficult sentence for a lawyer to write, but it’s true – lawyers sometimes get in the way of settlements. A client reading this may think that lawyers have an incentive to keep a case going to “churn” fees. While clearly some lawyers do this, I am referring to the simple fact that lawyers and business owners often see things through a different perspective. Lawyers are paid to look for worst case scenarios, while sometimes focusing on the negatives is not conducive to getting a deal done. Nevertheless, in a shareholder dispute where litigation may be inevitable, seeking at the very least behind-the-scenes advice from an attorney experienced in shareholder litigation is critical.
There may be issues that you aren’t aware of that bear on the strength of your case, which would give you confidence, and possibly the upper hand, during your mediation discussions. For example, in New Jersey, the failure to pay dividends to shareholders, when the company could have done so, may constitute shareholder oppression under the right circumstances. Knowing this may greatly strengthen your negotiating hand. Or, you could learn that your complaints, while valid, are simply not recognized under the law as actionable, leading you to rethink just how far you want to push your particular issue.
Pre-litigation mediation may be advisable in certain circumstances, but you are looking for a successful result – not just a result. Be prepared, and be well-advised by someone who has handled cases like yours before. And don’t be afraid to sit down with your business partner and try to save a fortune on legal fees. Unfortunately, there’s plenty of work out there for us shareholder dispute attorneys.
A business dispute with your co-owner can often be resolved in litigation. But the question remains – if you sued your business partner because of improper action on his part, what remedy would you seek?
Many people assume that, when you sue your business partner, it is like any other case in which you are suing for damages. For example, I have been approached by numerous prospective clients seeking to sue a business partner for damages after finding out that he was being – to put it charitably-“overly generous” in giving himself corporate benefits (cars, bonuses and the like). But a case for damages may not be the best available option.
In most cases, the business partner (often a majority owner, or at least a 50/50 owner) took excess funds from the company. Although this may in effect damage the other owners, the claim (at least under New Jersey law) belongs to the company. In other words, if your 50/50 partner helped himself to $100,000 worth of personal benefits, he effectively stole $50,000 from you, and $50,000 from himself. Usually, the right to seek reimbursement of the funds improperly taken belongs to the company.
However, a better remedy may be available. A co-owner instead may allege shareholder oppression, and seek the right either to buy out his business partner or to be bought out. This may not always be the plaintiff’s option, as it is up to the judge to determine who will be the buyer, and who the seller. Therefore, a business owner must understand that he may file the suit looking to buy out his co-equal shareholder, only to have the judge rule that he must sell, instead.
An attorney experienced in such lawsuits can often help a client assess what the most likely outcome in such a case may be, and how to focus the case to help achieve the desired result. For example, careful attention must be paid to facts showing why you are the one who, deserves to maintain ownership of the company, and why your partner should be judicially compelled to sell to you. Obviously, this will be easier if you can actually show that your business partner was embezzling or stealing from the company, but most cases are not so black-and-white. An experienced attorney can help you determine what facts should be emphasized, and how to obtain the evidence you will need.
Shareholder litigation: Those two words designate an action that can be profoundly disruptive to a business, because the mere existence of such a pitched battle between owners can bring a closely held company to a grinding halt.
When shareholder litigation is pending, the owners obviously have issues with each other severe enough to warrant filing suit. Those cases can involve allegations as nasty as fraud, mismanagement, or even embezzlement. Often, one shareholder has had his or her employment terminated, and is no longer on site, but is on the outside, looking in. Even more often, the shareholders involved in litigation against each other are still working together – or trying to – sometimes in very close quarters. This may be the most difficult type of shareholder litigation of all, especially when the shareholders are family members.
Shareholder litigation where the owners still work together can seem to take over a company. Every decision made, every act undertaken, is viewed through the litigation prism. Why is he asking me to do this? Do we really need it done, or is he somehow trying to make me look bad or set me up? Why is she asking for that document? Does she need it for the business, or is it going to be a trial exhibit? Obviously, such an atmosphere can be poisonous, and sometimes even fatal, to a company.
It goes without saying that, during the pendency of shareholder litigation, decisions should be made with the company’s best interest at heart. Of course, while this may describe your thought process, it may not describe your fellow shareholder’s, leading to confusion and even chaos. For example, when one owner tells the bookkeeper to approve and reimburse for a certain expense, but the other owner directs the payment not to be made, the situation can become very tense, whether the expense is an advertisement, business travel, or a new computer. Or, when one shareholder wants to grow the business, but the other insists on maintaining the status quo until the litigation is over, the impasse can be detrimental and demoralizing to the other employees.
When your business partner does any of the above, and acts in a way that harms the company, the action you take may be based entirely on the judge in your case. In New Jersey, some judges are more receptive to getting involved in business disputes between litigants, and some less so. Some judges will attempt to resolve such disputes on a conference call, while others will require the filing of a formal motion for relief. Often a judge will appoint a “Special Master” to resolve such disputes, either with both parties agreeing to abide by the resulting decision, or with the right to appeal that decision to the judge. However the judge decides to resolve the issues, an attorney with experience in shareholder litigation is critical.
It takes a special touch to present such issues to the court or Special Master, and not sound like your client is a whiner. Often a client will be tempted to complain to the court about every little issue. However, an attorney experienced in such cases will know what issues are important enough to bring to the court’s attention; and which ones should just be ignored – at least for the time being. When interviewing an attorney to represent you in shareholder litigation, ask what creative solutions he has utilized to help his clients deal with a business partner as unbearable as you know yours will become once the Complaint has been filed.