Posts Tagged ‘fraud’
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?
When you catch your partner in a breach of trust, can you ever trust him again? And even if you can, are you better off just moving on separately, or can the relationship ever really be repaired?
It may sound like this article is discussing a marriage, but that is what a business partnership is like in some cases. In fact, one judge in New Jersey often refers to business separation litigation as a “corporate divorce.”
A breach of trust with your business partner can occur in many ways, from finding out that he or she has opened a competing business to discovering that he has been reimbursing himself for wildly expensive and purely personal expenses for years, always hiding the evidence from you. In some cases, it might have been extremely difficult to know (competing business), while in other cases, perhaps you were a little lax in reviewing corporate records (expense reimbursement abuse). But now that you know, what do you do?
To a large degree, this is a purely personal choice and will be affected by a variety of different factors, including various measurements of both the costs and benefits of each competing option. Staying together might seem impossible, but separating the company might seem too costly and cumbersome to undertake or even to contemplate.
Here is where one of the true differences between a marriage and a business partnership comes into play. In a marriage, if you try to work it out, you can always file for divorce later if things don’t get any better. Most states, New Jersey included, are “no fault” divorce states where you do not need much of a reason at all to divorce.
But in a corporate divorce, a much different result could take place. The court could apply the doctrine of waiver, or other equitable principles, to determine that you waived a perfectly viable claim when you failed to act after you discovered what your business partner had been doing. For example, a court could determine that if you really had a problem with the expenses your partner was paying himself, you would have taken affirmative steps once you learned of it. In one case, a fifty percent shareholder had it held against him by the court that he failed to take any steps whatsoever to amend tax returns once he discovered that improper expenses, not really business-related, had been both reimbursed and deducted from the corporation’s taxes.
The court did not mean to imply that the complaining shareholder actually knew and did not dispute the fact that he objected – in writing – when he learned of it. However, the court found that he would have been willing to live with it if other things in the business relationship had worked out, so he can not be heard to complain that his fellow shareholder’s actions were so outrageous as to amount to shareholder oppression.
Instead of self-diagnosing, speak to an attorney experienced in shareholder disputes when faced with a significant problem with your business partner. A good, reputable attorney will point out not only what to expect if you do want to take action, but also what might happen if you fail to act.
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.