The Business Break-up Part II: The Messy Divorce

There are many ways a “partnership” can go awry. In the article Now You’re Buying Out Your Business Partner, I discuss a scenario where a business-separation is amicable. But the fact remains most splits, especially in the context of closely held businesses or family owned businesses, are rarely amicable. Preventing a business-separation is probably hard to do as relationships are unpredictable. However, preventing a messy business-divorce is certainly preventable…. with the right legal advice and the right corporate governance contracts in place. Before understanding the “fixes” however, it is important we understand what the situation looks like when things go wrong. The best way to do that is to quickly review some common litigated issues and causes of action.

Breach of Contract: Breach of contract can take many forms. It can mean the breach of an operating agreement, partnership agreement, or shareholder agreement. It can also mean a breach of a management agreement or employment agreement. These claims can and often do co-exist. Understanding these contracts inside and out can make the difference between a strong lawsuit and a frivolous lawsuit. Consulting with a knowledgeable business attorney can help you and your business partner discuss and envision potential issues. When those issues are identified you can then work with your business attorney and business partner to craft ways of mitigating the risks associated with litigating those issues. You can’t predict or prevent everything but you can certainly spend the time and money now to ensure you won’t have to spend 10 times the time or money later.

Derivative Claims: A shareholder derivative suit is a lawsuit brought by a shareholder  (or partner or member depending on the legal form of the entity) on behalf of a corporation against a third party. Often, the third party is an insider of the corporation, such as an executive officer or director.  These claims take shape in the form of claims brought on behalf of the company against your business partner (who is often a manager, executive, or director) alleging that he/she committed some act or acts which have damaged the company’s profitability, reputation or good standing. As such your claims “derive from” (hence derivative) the harm caused to the company as a result of said business partner’s unlawful conduct. These claims often take the form of “breach of fiduciary duty”, “embezzlement”, or “waste” just to name a few.  Under New York law there are very specific procedural requirements for commencing a derivative action including demanding that management cause the company to sue the member whose conduct is unlawful.

Oppressed Shareholder:  “Although the term ‘oppressive actions’ is not statutorily defined, the Court of Appeals has held that ‘oppression should be deemed to arise when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner’s decision to join the venture.” In re Dissolution of Upstate Medical Assoc. P.C., 739 N.Y.S.2d at 767. Oppression is analytically distinct from illegality and is subject to a “reasonable expectations” test. As the Courts have explained, “oppression should be deemed to arise only when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner’s decision to join the venture”. Given the broad “reasonable expectations” test, there is no all-encompassing list of acts that can be deemed oppressive, nor will the same acts be considered oppressive in every circumstance. Nonetheless, the most common and recurring forms of oppression include:

  1. The failure to declare dividends;
  2. Termination of a minority shareholder’s employment;
  3. Removal of a minority shareholder from management;
  4. Excessive compensation to the majority shareholders;
  5. Diversion of opportunities to other corporations and mergers under unfair terms;
  6. A change of policy concerning the distribution of corporate income, designed to offer no return on the oppressed shareholder’s investment in an attempted “squeeze-out.”;
  7. A shareholder who reasonably expected that ownership in the corporation would entitle him or her to … a share of corporate earnings, …, or some other form of security, would be oppressed in a very real sense when others in the corporation seek to defeat those expectations and there exists no effective means of salvaging the investment.
  8. Efforts of majority shareholders to void a minority shareholder’s shares, falsify corporate documents, and prevent minority shareholder access to corporate records;
  9. The actions of a majority shareholder group in eliminating the petitioner and associated persons from participation in the active operation of a corporation in which they had previously participated, and in which have included they had every reasonable expectation of being able to continue to participate.

As you can imagine the analysis is fact sensitive and law sensitive and particularly messy especially where the parties’ expectations are not sufficiently laid out in well drafted corporate governance agreements.

Embezzlement or Misappropriation: This refers to theft or misappropriation of funds placed in one’s trust. Often these allegations rear their ugly heads when the money gets tight and paranoia sets in.  Again, having the right business structure can further a quicker resolution to these types of disputes.

Self Dealing: Self-dealing is the conduct of a fiduciary or trustee that consists of taking advantage of his position in a transaction and acting for his own interests rather than for the interests of the company, shareholders or other beneficiaries.

Breach of Fiduciary Duty: A claim for breach of fiduciary duties can take many forms including allegations of: (1) waste of company assets, (2) self-dealing, (3) breach of duty of loyalty, (4) breach of duty of confidentiality, (5) breach of implied covenants (6) oppression, etc., but those claims are not absolute. Again, one would have to turn to the corporate governance agreement to determine the extent of those duties, whether the accused has a managing interest in the company, the expectations of the parties, whether the statutory body of law provides certain exceptions, and the available defenses under statute or case law such as the “business judgment rule” or Section 409 of the NY LLC Law. Breach of fiduciary duty claims are highly complex and often involve analysis and research by attorney, CPA’s and perhaps forensic accountants in order to understand the extent of one’s breach and the damages to the company or its shareholders.

Shareholder Status Disputes: In order to bring a dissolution proceeding for the variety of reasons that may be permitted under the Business Corporation Law, Partnership Law, or LLC Law, a threshold matter is proving your status as a shareholder/partner/member of the Company. In theory one could rely on tax documents such as K-1’s and the like. However, these are not absolute arguments. That is why it is critical that if you are going to establish any kind of partnership or be compensated by becoming a “part owner” of a company in any respect whatsoever, you have to have your agreement and status properly documented. The last thing you need is to spend $15,000.00 litigating a threshold issue.

Demand for an Accounting or Access to the Books and Records: Fiduciaries have a responsibility to account for the assets and liabilities of the company they manage. As such demanding an accounting from a fiduciary who has allegedly breached his duties to the company or its shareholders is a common sense cause of action in most shareholder disputes or business-breakups.

The “Fixes”

Some of the above causes of action are based in statute, some on contract theory. But they all can be prevented or mitigated by well drafted corporate governance agreements such as a “partnership” agreements, employment agreements, or buy-sell agreements. Having the right corporate governance agreement accomplishes one critical thing. It manages and sets forth the expectations of the parties which when looking to the “breach of fiduciary duty” claim or “oppressed shareholder” claim, is a critical part of the analysis. In doing so, issues regarding management of the company, compensation, special duties, shareholder status, and company purpose are all (hopefully) clarified and explained at length.  The buy-sell agreement is of particular import. The buy-sell agreement sets an objective valuation mechanism which can substantially mitigate against the extraordinary costs of a shareholder valuation dispute.

 I find that these issues are most common in the closely held business or family owned business where good friends or family work together in a casual manner under the illusion that the relationships that bind them are unbreakable.  Let’s set the record straight. Business is the most personal thing there is for the startup, entrepreneur or investor.  Bringing personal relationships into a highly personal venture without setting proper boundaries and expectations is nothing short of a recipe for disaster.

Spend the money now so you don’t have to spend 10 times the money later, or worse, lose the hard earned fruits of your labor.

The Law Office of Jeffrey K. Davis, Esq. is a full service business-law firm dedicated to providing business owners with resourceful counsel at all stages of the business life-cycle. Providing Practical Legal Solutions. Call for a free consultation.