Norris, McLaughlin & Marcus

Posts Tagged ‘Shareholder agreement’

We Are Getting a “Business Divorce.” Who Gets “Custody” of the Customers?

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.

Pros & Cons of Alternative Dispute Resolution in Shareholder Dispute Litigation

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.

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.