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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.
I have written many times over the years about the differences between a corporation and an LLC when it comes to minority owner rights in New Jersey. On many occasions, I have written about the fact that shareholder rights are much more expansive in a corporation, and much more restrictive in an LLC. That all changes of March 1, 2014.
On that date, the existing LLC statute is being repealed, and the oppressed minority shareholder statute is effectively being incorporated into the LLC statute.
Those rights, and the rest of the new LLC statute, are already in effect for LLC’s created after March of this year, as well as LLC’s that have specifically adopted the new statute. But as of March 1st of next year, every LLC member in the state of New Jersey will be protected under the new oppression section of the statute.
What protections will be afforded? Since the LLC statute will now read almost exactly the same as the corporate statute, it is likely safe to assume that many of the same protections will be found to apply, and that the body of case law relating to corporations will be applied to LLC’s. (Of course, there are no guarantees until judges start applying the new provisions.)
If that turns out to be the case, many of the things that I have written about over the years that constitute “shareholder oppression” in a corporation will likely constitute “member oppression” in an LLC. The failure to pay dividends when the company can afford it; overcompensation of majority members at the expense of member distributions; termination of employment when there was a reasonable expectation of continued employment; embezzlement; freezing a member out of management; concealment of financial information; and conducting improper, self-interested transactions, are all now likely to constitute minority oppression in the context of an LLC. As a refresher for those interested, I will be writing a series of articles discussing many of the things that could be considered minority shareholder oppression in an LLC. I will also be discussing what steps, if any, may be taken by majority owners to protect against an oppression claim in an LLC.
For now, though, minority members of New Jersey LLCs should at least take heart that, as of the spring, they will no longer take a back seat to corporation shareholders when it comes to having their interests protected by New Jersey courts.
In a divorce, an obvious issue to be resolved is who gets custody of the children. In a business divorce, an issue that often arises is who gets custody of the company’s lawyer.
Many New Jersey corporations and LLC’s have a long-standing lawyer, who has often represented one or more of the shareholders in their individual capacity, as well. What happens when one of the owners discovers that his business partner has been defrauding him, or stealing from the company, or committing some other form of shareholder oppression? Who will the lawyer represent? Who CAN the lawyer represent?
Of course, an attorney may decline to represent anyone, on the grounds that he is too close to everyone. Or, as is often the case, the lawyer who has represented the company for years does not have expertise in shareholder dispute litigation. In such a case, the attorney will probably refer you to someone who routinely handles such matters. But can the lawyer choose sides, and represent one of the shareholders while being adverse to the other[s]?
This may seem like an unimportant issue at first blush. After all, it is not as if the attorney for the company is the only lawyer in New Jersey. But it does become an issue when the attorney on the other side of the case is someone who not only represents the company you partially own, but who personally represented you in your real estate closing, speeding ticket, or some other situation in which you found yourself over the years.
The easy answer, as is so often the case, is that it depends on the particular circumstances of both the prior and current representations. In New Jersey, the company lawyer is not prohibited per se from representing one shareholder against the other, or even from representing the company in a suit against a shareholder. But, if the matter in which the lawyer previously represented the shareholder personally is either the same as, or substantially similar to, the new matter, then a conflict exists, and the representation is not allowed.
If you find yourself embroiled in shareholder dispute litigation and find yourself in a similar situation, the first question you ask your attorney may involve whether or not the lawyer on the other side has a conflict or not.
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.
Minority shareholders often do not work at the company, and are not involved in management, making them, for lack of a better word, “passive investors.” While no broad rule can ever be applied to everyone, it is these types of minority shareholders who are the most vulnerable to abuse by the majority shareholders.
The easiest way for a passive minority shareholder to be abused is for the majority shareholders to keep increasing their salaries and bonuses to the point that they are significantly above market rates. Instead of paying out distributions to shareholders – which, of course, are paid proportionately to share ownership – the money is sucked out of the company and paid to the majority only.
This and other forms of minority shareholder oppression can sometime be prevented by nothing more than vigilance by the minority shareholder. Ask to see financial records. Insist that annual shareholder meetings take place, even if there are only three of you. In other words, let the majority shareholder know that, at the very least, you are watching them. This does not mean that the relationship should or must be confrontational. But being someone who keeps an eye on his or her investment is always a good idea.
For example, majority shareholders often start with a car being paid for by the company. Then, the company pays for his car insurance. Then, his wife’s insurance, followed by his wife’s car payments, followed by his kids’ cars. It happens all the time. By the time a truly passive minority shareholder comes to my office complaining about such abuses, the path to shareholder dispute litigation has already been paved. Most minority shareholders in that situation wish they had a time machine so they can nip such behavior in the bud. Abuses like this are much less likely to occur if the majority shareholders know they are being watched.
Stated differently, whether it is an employee in a store, a manager, or a majority shareholder of a small to medium-sized company, people are more likely to abuse their power if they know no one is watching them. So, even if you are a passive investor, watch the majority shareholders. Politely, without interfering in the business. But watch them.
Shareholder disputes often arise because of a lack of information being disclosed by the majority to the minority shareholders. In New Jersey, there are limitations as to what financial documents must be shared with minority shareholders. However, most of the time business owners believe that their business partners should share more information than the bare minimum dictated by law.
A common tactic employed by majority shareholders who do not want to disclose any more financial information than required, yet want to stave off a minority shareholder lawsuit, is to provide a “slow drip” of information. For example, when five years of tax returns, financial statements, and general ledgers are requested, the majority shareholders will start by providing two years of financial statements and nothing else. Then, they will supplement with last year’s tax return. Then two years’ worth of returns. Then, after much back-and-forth and several weeks (or even months), they will give you everything you asked for, except, of course, for the general ledger, which is the main thing you really wanted.
The purpose of this strategy is to create the appearance of providing financial information. The majority shareholders’ lawyer will be able to point to four or five letters where they gave you information, and argue to the court (when the inevitable shareholder dispute litigation arises) that you are never satisfied, and that they have been extremely cooperative. Then, they will fall back on the argument that they have already given you more than you are legally entitled to under the law, anyway.
Do not fall for it. When I represent majority shareholders, I advise them to go above-and-beyond what the statute requires, and you should settle for nothing less. After all, if shareholder dispute litigation is filed, the minority shareholder will be entitled to every financial document under the sun as part of the discovery process. Better to provide the documents the easy way than the hard way.
If you want an explanation as to why things are occurring a certain way, or why a certain expense keeps recurring, you should be entitled to know, even if the statute does not specifically say so. The relationship between you and your business partner should be an “open book,” based upon trust and cooperation. If you suddenly want to see documents that you never historically looked at, chances are there is already at least the start of a schism in the relationship. A refusal to provide even the most basic financial information, or to answer certain fundamental questions about business operations, can only make that schism worse.
If you are being completely shut out from financial information and seem to have hit a wall, contact an experienced shareholder dispute litigation attorney. Chances are, he or she will be able to get you the documents you want to see – either the easy way or the hard way.
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.