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In my last post I looked at the decision of whether to create a corporation or an LLC from a minority shareholder’s point of view, and explained that minority owners may want to use an LLC. In this article, I will explain that, from a majority shareholder’s vantage point, the exact opposite often may be the case.
Before I explain how the corporate form may be better suited for majority shareholders, a caveat is in order. Using the LLC form may be better for everyone if the parties can agree on most everything at the outset. LLC’s are “creatures of contract,” and courts will usually respect whatever the parties themselves have agreed to. If the Operating Agreement says that a member may withdraw and be paid for his shares only if the Managing Member is convicted of a crime, that is likely exactly what a New Jersey court will enforce. The court will not rewrite the agreement for the parties. However, when not everyone can agree on such terms, the parties unfortunately either a) ignore the controversial issues, assuming they will be dealt with later (they never are); or b) never get around to signing any agreement at all.
With that said, let’s examine how to “get rid of” an unruly minority shareholder. It’s not always the majority owners that are the “bad guys.” What if a 33% owner is the one who runs the office, deals with the money, and is keeping everyone else in the company in the dark? Or awarding himself excessive bonuses? Yes, the majority owners can team up and make certain changes. But what if the minority owner is the only one who knows the critical end of the business? Or, worse, what if the minority owner is involved in a scandal that is hurting the company, and merely firing him as an employee is not a sufficient remedy? The majority owners cannot imagine staying in business with someone who did what he did, but what should the remedy be?
In an LLC, of course, a situation like this could have been specifically taken into account in the drafting process. However, if yours is one of the huge numbers of LLC’s that have no operating agreement, or at least one that does not address this, what is the remedy in an LLC?
In New Jersey, the LLC statute provides that, under certain circumstances, if “fault” can be proven on the minority owner’s part, he can be “dissociated” from the LLC. This means that he can be removed from management and all decision making. However, it does not mean that his shares may be purchased from him. He is still an owner, and still has the right to share in profits. In fact, there is a recent case in New Jersey that affirms just this result.
In a corporation, however, the result may be different. In New Jersey, courts have interpreted the oppression statute as permitting majority shareholders to sue minority shareholders, on the theory that minority shareholders may be just as oppressive as those in the majority. One New Jersey court even coined the phrase “tyranny of the minority” to describe it. If such “reverse oppression” can be established, then the majority shareholders may be able to force a buyout of the minority owner’s shares. This may be critical in a case where a minority owner has stolen from the company, and the company’s customers, vendors, and even its bank no longer wants that person to be an owner.
When trying to determine how to deal with an unruly minority owner, or even in planning for such an eventuality in the future, be careful what form (corporation or LLC) you select. It could make all the difference in the world.
When starting a new company, your first decision is often whether to create a corporation, or an LLC. Unfortunately, this election is frequently made without fully understanding how this decision impacts the rights of minority owners, either positively or negatively. And without knowing what this impact means, it is impossible to realize why this issue is even important.
Taking this lack of information one step further, new business owners many times elect not to spend the money on having a qualified attorney draft a shareholders’ agreement (corporation) or operating agreement (LLC) once the company is actually formed. Or, worse, they find a form on the internet to use. (These forms are often well written for their intended purpose, but are simply not a one-size-fits-all solution.)
In both instances, there exists a failure to appreciate the ramifications of not making a fully informed decision, which is then put into effect by a well-written agreement.
What do I mean? For starters, the difference between creating a corporation versus an LLC is different for majority and minority owners. From the viewpoint of a minority owner, the difference can be critical. In a corporation, if you decide you “want out” of the company, a shareholders’ agreement typically addresses whether, and to whom, you may sell your shares. But what if there is no buyer, and you simply do not want to be an owner any more? In that case, you must essentially prove fault, or what’s known as shareholder oppression. In such an instance in New Jersey, if “oppression” (mistreatment) can be proven, a minority shareholder often has the right to be bought out of the corporation at fair market value. However, this right is not automatic, and a shareholder cannot simply seek to be bought out without some compelling reason, usually fault on the part of the majority shareholders.
In a New Jersey LLC, however, the ability to be bought out of the company depends entirely on what the operating agreement says or does not say. If there is no operating agreement, or if there is one that does not prohibit withdrawal, then any member may withdraw and be paid for his shares without having to prove oppression or any type of mistreatment. An apt analogy is the difference between a no-fault divorce (in an LLC), and one where you have to prove some type of fault (in a corporation). But, if the operating agreement says no member may withdraw, then the right does not exist.
This distinction is often surprising to clients who have never had it explained to them before. While a member with a twenty percent interest may be thrilled to find out that he merely has to write a withdrawal letter, to create a right to be paid for his shares, the LLC itself is often not quite so happy to find this out. What if a member wants to exercise his or her right to withdraw, but the LLC cannot afford to pay for his interest? If it is ordered to do so by a court, what happens? How can the company find itself in this situation?
If the founders had sought legal counsel about these and other issues when forming the company, these issues could have been dealt with, taking into account the interests of all the owners. Crisis-induced decisions are usually less than ideal in almost all situations.
In my next post, I will discuss the distinction between corporations and LLC’s from the point of view of majority owners, as opposed to minority owners. As explained above, without a written agreement of any kind, a minority owner may benefit from using an LLC, since his right to withdraw will exist intact. However, in my next post, I will explain how, with majority owners, the opposite may be true. Without a written agreement of any kind, majority owners just may be better off using the form of a corporation, rather than that of an LLC.
Listen to the Little Voice Telling You Your Business Partner is Treating You Unfairly and Seek Advice Sooner Rather Than Later
It is fascinating how many clients come in to discuss potential shareholder litigation against their business partner, completely unable to explain why it took so long for them to see a lawyer. Most perplexing are the ones who believe their business partners have been stealing from them for years. When asked to explain where they’ve been, the excuse is often that they “didn’t have proof.”
One client in particular (who agreed to let me mention him in this article as a cautionary tale to others), a 50% shareholder, noticed that there was never as much money in the bank as he thought there should be. However, he said he “could never be sure,” so he did nothing about it. Finally, after he got married, his wife convinced him he should at least talk to a lawyer, just to see if anything could be done.
Of course something could be done. Even a minority shareholder is entitled to inspect certain books and records of the company, and a 50% owner should have full access to everything. If your business partner won’t provide you with full access to all financial information, especially to a co-equal 50% shareholder, then every red flag should be raised as high as they can go. In fact, the Court will often force such disclosure, and will almost always side with disclosure over secrecy.
Another client, a 25% shareholder, also waited years to see a lawyer, thinking that the 75% majority shareholder could essentially do what he wanted because it was “his company.” Fortunately, he read one of the articles on this blog explaining that even minority shareholders have rights that must be respected, and which can be enforced.
Waiting is not simply an issue of timing. The majority shareholder defendant will almost always argue that you didn’t wait just because you were unsure what to do. Instead, he will argue that you waited because you knew and approved of everything that was going on – the acquiescence defense. While you may think it absurd for your business partner to argue that you actually approved of him using company money to fix the roof at his house, or pay for his kid’s car, that is exactly the type of argument that is made in defending shareholder oppression cases. He will argue that you had full access to all books and records, whether that is true or not, and then he will attempt to charge you with knowledge of everything. Since you didn’t object for so long, you must have approved. And it will be your word against his regarding whether you truly had access to the financial records.
Avoid this trap. While you should not institute unwarranted litigation against your business partner, since such a suit could tear the company apart, you also should not just sit back passively while your suspicions mount. See a lawyer and take action. More importantly, seek to keep yourself apprised of what is going on in the company from the outset. Tell your business partner at the start of your business relationship that you intend to be fully informed, that you intend to hold him accountable, and that you expect to be held accountable, as well.
Or, just stop by in a few years and tell me that you “always had this suspicion, but never acted on it because …”
Hiring a Business Valuation Expert in Potential Shareholder Dispute Litigation is Not a Do-It-Yourself Proposition
In my last post, I discussed several ways an experienced shareholder dispute attorney can help assess a pre-litigation offer for your shares, including helping you retain a business valuation expert. One critical reason never to retain such an expert on your own is to maintain communications with such an expert as privileged and non-discoverable.
In New Jersey, if an attorney hires the business valuation expert, communications with the expert usually become privileged and non-discoverable. However, if a litigant hires the expert directly, the same privilege may not apply. The privilege also extends to draft reports, which are not discoverable if provided to an attorney first.
The quest to maintain such communications as privileged should not be misinterpreted as in any way improper. There is simply no reason to make communications with one’s expert discoverable. And draft reports are critical to ensure that the expert properly understood the scope of the assignment, not to make changes that an attorney does not like.
In addition, the valuation date is often critical, and often not the date you may presume it to be. It would certainly be disheartening to come to an attorney’s office, proud you have already learned from an “expert” how much your shares are worth, only to discover that 1) your emails with that expert are discoverable by your co-shareholder, 2) the expert has no experience testifying in a courtroom setting, making you the “guinea pig” for testing his abilities, and 3) the expert used the wrong valuation date, meaning that a substantial part of the report must be redone.
If you can see the handwriting on the wall and know that a lawsuit with your business partner is looking more and more inevitable, consult a shareholder dispute attorney earlier in the process, rather than later. At the very least, you should ensure that the path you are headed down is the right one.
Things To Consider In Assessing a Pre-Litigation Offer to Buy Your Shares in Shareholder Dispute Litigation
Making a low-ball offer to buy your corporate stock is probably the most common tactic used by one owner against the other in disputes between business partners. But how do you know when it’s worth the money to fight for more?
I hear it all the time. “I’ve been frozen (or squeezed) out of the company, and my business partner has offered me only X for my shares.” In a vacuum, of course, such an offer is hard to analyze. Is X a good offer? Are your shares worth 5X? 10X? Or is the offer on the table really not so far off from reality?
It is easy to see why this is such a common tactic. Often (but not always) the business partner in charge of the books and records, who is presumably the one in the best position to determine the value of the company, is the one who makes such a proposal. He is in a better position than you to know that his offer to purchase your shares is low; just how low it is may be known only to him. Since you do not have access to the same information that he does, it is very difficult for you to assess the offer, other than to suspect that it can’t possibly be fair.
But shareholders who feel they are being oppressed or squeezed out need to consider several things about pre-litigation offers for their shares. First, it is critical not to assume that the shareholder who controls the finances actually knows what he is talking about. Valuing a business is no easy task. Many things should be taken into account, and you need an experienced business valuation expert (not an attorney) to tell you what the true value is. Second, you must realize that it is highly unlikely that your business partner actually spent the money to hire a valuation expert to value your shares. In other words, there is a high likelihood that his offer bears little relationship to the actual value of your interest, and may be pulled completely from his you-know-what.
If you are in dispute with your business partner, considering litigation, and have to weigh a pre-litigation offer for your shares, don’t do it alone. You should consult with an attorney experienced in handling shareholder dispute litigation. The first thing any such attorney will tell you is that you should first see if there is any underlying basis to the offer on the table. If the majority shareholder or your 50/50 partner, as the case may be, obtained an appraisal for your shares, your attorney should ask to see it. If no appraisal was obtained, he will likely ask for the basis for the number. When no basis is forthcoming, the offer will be exposed for what it is.
An experienced shareholder dispute attorney will also be able to obtain for you the documents that you need to have an expert value your shares. In New Jersey, a corporation must give any shareholder certain financial records, as a matter of law. For the rest of the documents your expert would likely want to see, a threatening letter will often get the documents produced. After all, if you sue, you should get every financial document under the sun.
Lastly, an experienced shareholder dispute attorney should know a good business valuation expert who can do well testifying in court, hopefully at a (relatively) reasonable price. Next time, I will discuss a critical reason why a potential litigant should never hire his own expert – protecting communications as privileged.
In New Jersey Shareholder Dispute Litigation, Your Concern Must be Your Own Interests, Not the Interests of Other Minority Shareholders, or Even Family Members
When a new client comes in complaining that he is being treated unfairly by his business partners and hears that he may have the right to be paid for his shares, that potential remedy is often appealing. After all, it frequently takes years for a business relationship to fall apart, and in those years, the company’s value may be building up. Your shares are often worth more than you think. However, it is fascinating to me that so many clients say they want to be bought out, but don’t necessarily want to sue their business partners for other than cost reasons.
A strong letter writing campaign, with pointed correspondence from an attorney well-versed in shareholder rights and shareholder dispute litigation, may be attempted first, and could possibly work. If it does, significant legal fees may be avoided. But letters usually get you only so far. When it sinks in that filing suit is really the only viable option, clients often restrict the allegations they want made in the suit. Sometimes a client who believes his business partners are committing fraud – literally stealing from the company – actually does not want to use buzzwords like “theft” or “embezzlement,” because he doesn’t want to anger other family members (in a family-owned company). Or, he may not want to alienate the other minority shareholders, with whom he still has a relationship, or at least believes he does.
The reason for this hesitancy is often that the business partners are family members or close friends, or at least people who at one point were close friends. However, when I remind the client that these are the same people engaging in the acts he just spent an hour and a half complaining about, the message usually sinks in.
A minority shareholder who believes he is being oppressed by the majority, but does not want his lawsuit to alienate others involved in the company, including other minority shareholders, needs to ask himself two critical questions. First, how do you expect to protect your own rights when you are more concerned with the impact your lawsuit may have on others than you are with what is being done to your shares in the business?
The second question I tell clients to ask themselves has to do with those whose opinions of his suit the client is so concerned about. It is simply, “Where have they been?” When you discovered that the majority shareholder was using the company as his personal piggy bank, did the other family members rally around you and against the majority shareholder? Or were you left in the wilderness to complain on your own? When you, a 15% shareholder, were denied access to the books and records of the company, did the two other 15% shareholders assist you in any way? Did they give you the documents you were looking for? If they were truly your friends, and their opinions worthy of your concern, would they not have assisted you in standing up for your rights?
A reckless lawsuit brought without legitimate purpose could tear a company apart. But if your concerns are legitimate, and you have a valid shareholder oppression lawsuit, your focus should be on your own rights, not on what your suit may do to your company.
In my last posting, I started discussing the difficulty involved in simply “getting before the judge” so that he can “hear my story,” and the fact that it’s usually not that easy in a shareholder dispute litigation. This time, I want to elaborate on such requests, including real life examples in shareholder disputes of when a judge is likely to intervene early, and when she is not.
At the outset, although no one reading this is likely interested in all of the nuances, a simple primer on the standard for granting what courts refer to as “injunctive relief” is in order. Generally speaking, a court will not grant an injunction unless you are trying to prevent harm that is both imminent and which could not easily have a dollar value placed on it (“irreparable harm”).
(At this point, I must comment on something that has been plaguing me since law school. Many lawyers I know have never understood the concept of something that cannot be remedied by money damages. The classic example given in law school is land, which is unique. If you lose your land, no money could ever get you THAT land back. However, our court system puts a price tag on a lost arm, or even a lost life. So, when you try to explain the concept to a client, the quizzical looks are perfectly understandable. But I digress …)
In shareholder disputes, clients often are forced to seek the same relief in nearly every case. Access to the company’s books and records is often something a minority shareholder is denied, and is quite possibly the easiest thing to get a Court to order at the start of a case. Additionally, countless clients have asked to have their termination (as an employee) stopped by the Court. However, this is often an easy one for the Court, as money damages can almost always compensate one wrongfully terminated. As a result, few judges in New Jersey will intervene to stop a termination and order that a shareholder/employee may go back to work.
Even more common is the client who wants the Court to enjoin his business partner from stealing from the company. This is a tricky one, since the threshold of “irreparable harm” is likely met. After all, stealing could literally end a company’s existence, which most courts deem irreparable harm despite the fact that the business can be valued and have a dollar figure attached to it. However, you also have to prove that stealing is very likely occurring, which is often not terribly easy prior to taking discovery. Proving such an allegation will be extremely fact and case sensitive. However, I have yet to see the case where a clear-cut, open-and-shut case can be made on day one that stealing is occurring. Usually, your unscrupulous business partner does a better job than that of covering his tracks and hiding improper transactions. He will always have an excuse for all of his dealings, whether fabricated or not.
An experienced shareholder dispute litigator will know how to uncover what really has happened, and make the best possible presentation to the Court. However, getting the judge to act quickly is no easy task.
When clients first come in for a consultation regarding potential shareholder dispute litigation, they are normally upset over some recent, often traumatic, event. Some have just been fired, while others have recently discovered that their business partner, whom they trusted, has been stealing from the company. Whatever the particular issue is, many clients want to get right to the end of the case and have the judge award them whatever relief they are seeking. Prospective clients often say they want to get before a judge, NOW, and tell the judge what their business partner has done. Surely, after hearing what happened, the judge will put a stop to it.
Nothing would be better for clients, and the system generally, than if it were this easy. But often it’s not. Usually, there are numerous steps that simply cannot be avoided before you can tell your story to a judge and expect relief.
The usual discovery process normally cannot be bypassed. As much as you know in your very soul that you are right, and that your business partner is a snake, you simply cannot assume that the judge, who has never met either one of you, will take what you say at face value and discount the lies that your business partner is sure to tell. There is no substitute for evidence, and you are paying your lawyer to win, not just to get you an audience with the judge.
In order to put you in the best possible position to win, your lawyer will have to go through a careful analysis of what evidence you will need and how you will go about getting it. You must exchange documents with the other side and obtain certain other information, like the identity of any expert that either side will retain. Deposing witnesses is within your attorney’s discretion, but it is a tremendous risk to skip this crucial step simply to save time and money. Moreover, you will not be able to get around the fact that the other side will likely want to depose you.
And, quite often you will need an expert, often a forensic accountant, to prove your allegations. For example, I had one case where my client insisted that his business partner was stealing from the company, but the books and records reflected that the monies taken were documented as “officer loans.” A forensic accountant was able to determine that the “loan” documentation did not appear until after my client first complained about the missing cash. It did not take very long to settle that case, once the other side saw what our forensic accountant had uncovered.
It is crucial to hire an attorney experienced in shareholder dispute litigation, who knows how to focus the discovery so that precious resources are not wasted.
These steps all may seem obvious, but I cannot stress enough how many clients simply want to get in front of a judge and don’t see why it will take so long to get there. It is the attorney’s job to explain all of this to the client. In my next posting, I will discuss those rare instances in which an oppressed minority shareholder MAY be able to get in front of a judge right away, at least to obtain some limited relief.
Can You Buy Out a Majority Business Partner?
A minority shareholder will most often seek a buyout as a judicial remedy. However, in some instances, the minority shareholder may want to be the purchaser instead of the seller. Although this is never easy, it is possible, depending upon the particular facts.
If you have a chance of being the purchaser of the majority’s interest, by definition you have been successful in demonstrating that the majority shareholders engaged in wrongful conduct. Often the question becomes, just how wrongful was the conduct?
A skilled attorney should focus the court on how improper, non-business expenditures robbed the company of various opportunities. For example, it’s easy to say the majority shareholder should not have spent $500,000 on an addition to his Aspen vacation house. But, if the focus is placed on the fact that YOU would have spent the $500,000 on a particular investment that would have grown the company and created more jobs, you can position yourself as more deserving of owning the company, even though you are currently a minority shareholder.
The manner in which employees are treated can be critical, too. Showing that employees prefer you to the majority shareholder and are more likely to remain employed if you take over can be a factor in your favor. This is especially effective if they so testify, since the judge will know that they are taking risk by doing so.
It is of course easier to present yourself as the person who deserves to own the company if you have been an active participant for years, while the majority shareholder has been winding down his involvement. Anything you can do to facilitate this process, and make the transition more readily apparent, will help. The more responsibilities you have, the stronger your claim to wind up with the company. I have seen at least one majority owner who was satisfied to force the minority owner to do the lion’s share of the work for a fraction of the majority owner’s inflated salary. After we consulted, the client decided that, instead of filing suit right away, he would do the extra work for a year to bolster his claim that he, not the majority stockholders, was the one vital to the success of the company.
It worked, and the client wound up owning the company, much to the majority shareholder’s chagrin.
You have decided that the problems you are having with your business partner are so bad that you have to file litigation against him. As discussed in prior postings, the remedy in such a case is often a buy-out. Either the court will order that you will buy out your business partner, or that he will buy you out. (This is also often the remedy when minority shareholders sue for shareholder oppression, or when one 50/50 shareholder sues the other.) When a new client hears that these are the potential outcomes, the inevitable question is – how can I make sure of one outcome over the other?
In other words, one business partner may want to be the purchaser, and another may want to be the seller, but very few have no preference at all. More often than not, when business owners feud, the preference is to remain in control of the company and not be the one forced to sell. In such a case, strategizing how to become the one who gets to keep the company becomes critical.
Certain things are fairly obvious. For example, shareholder oppression cases in New Jersey are almost always decided by a judge rather than a jury. Therefore, the more you position yourself as the “good guy” in front of the judge, the more likely the judge is to like you and see you as deserving of whatever relief you are seeking. Maybe. But there is much more to it than this.
What will influence the Court far more is whatever the court considers to be in the best interest of the company. For a company with only two shareholders and no other employees, there are fewer considerations. But for a company with several employees depending on the company for their livelihood, the court will often look to whichever owner is in the best position to keep the company in business and succeeding.
By the time you see a lawyer, it may be too late to change anything, and whatever has happened up to that point is already etched in stone. For example, if you have allowed your business partner to make most of the decisions while you sat by passively, there is very little time to change this once litigation commences. Therefore, seeing an attorney as early in the process as possible is key.
All too often, a new client comes to me stating that he has been having issues with his business partner for years, but that some recent action was the “last straw.” By that point, it is too late to strategize and put yourself in the best position to try to obtain the result you seek in the eventual litigation. The earlier you identify problems in your business relationship and seek legal counsel, the greater your ability to affect the outcome. Such a strategy requires foresight, and may cause you to see a lawyer before you would prefer. But it may be better than effectively rolling the dice to see which one of you winds up with the business that you both created.
In my next posting, I’ll examine how a minority shareholder (as opposed to a 50% shareholder) can position himself or herself to be the purchaser in a forced buy-out, rather than the one forced to sell.