Resolution of Disputes Among Business Partners in Closely Held Businesses
This article summarizes possible outcomes from a business divorce. In our last article on business divorces, we discussed why small business owners should have an agreement with their business partners to help guide them when a disagreement inevitably arises. We identified some of the major causes of disagreements between small business partners. When small business partners are unable to resolve their disagreements, one partner may proceed against the other partners under various legal theories. In this article, we discuss what are some of the likely outcomes of a business divorce. Remember, when we refer generally to “partners,” we mean members in a LLC, a shareholder in a corporation, or partners in a partnership.
Related article: Business Divorces and Small Businesses
Who has the edge in a business divorce?
It has come to this and the partners in a small business have decided to file for divorce. There are rarely good options in a business divorce, only ways to minimize the risk and uncertainty. It is not unlikely that the partners will engage in a self-defeating street fight with only losers and no winners. There are several issues that may affect the partners’ respective negotiating positions. We discuss those issues in this section.
In a business divorce, you want to be in the top position on the pecking order. There are three different positions in a small business. You can be the majority partner. That is of course where you want to be. You can be an equal partner, which may increase the risk of a deadlock. Or finally, you can be in the unenviable position of a minority partner, but as discussed below, all hope is not lost.
The majority partner is always in the driver’s seat, but there are some limits on the partner’s ability to steer the course of the company. We don’t want to belabor the point, but if you are the majority partner, you should have used your negotiating power to craft an operating agreement or shareholder agreement under which you can buy-out the minority partners based on a formula. If you did not, then you may have some challenges. The majority partners may have to achieve a supermajority or garner unanimous consent for certain decisions, and this may pose an additional challenge.
In closely-held companies, the most common stalemate is between two equal partners or blocks of partners. When you have equal partners and they cannot agree, they end up in a deadlock. If they had previously agreed on how any deadlocks would be resolved, then they can simply resort to those procedures.
Related article: Negotiating LLC Operating Agreements
When equal partners are at loggerheads, unless they have agreed in advance what happens in the event of an impasse, the resolution may be the dissolution of the company. All of the choices are not good ones and can result in the dissolution of the company. That seems like a harsh remedy but that may be the only viable option. Indeed, one sure way to resolve the dispute is for all of the partners to proceed with a voluntary dissolution of the business.
The minority shareholders in a corporation or those who control less than a majority of the membership rights in a LLC have a tough row to hoe. The majority can dictate to the minority and the minority partner has nowhere to run. There is not a market for minority shares in a small business and even if there were a market, often times there is a restriction on the partner’s ability to transfer the partner’s shares to a third party. The minority partner does have some rights in certain circumstances as discussed below such as when the majority partner has been guilty of “minority oppression.”
The results may hinge on in which state the business was formed. The law governing LLCs or corporations differs from state to state and the resolution of inter-partner disputes may depend on where your business was formed. Even if you have in your agreement with your partners a provision requiring all disputes to be resolved in the state in which you are doing business, if you originally formed the company in Delaware, which is the case in many corporations and limited liability companies, you may be required to litigate in Delaware. For example, a New York court refused to hear a dispute, holding that it did not have jurisdiction to dissolve a foreign business entity. The court stated that, “the decision as to whether dissolution is appropriate lies with the courts of the state in which the entity was created.” Raharney Capital, LLC v. Capital Stack LLC, 25 N.Y.S.3d 217 (N.Y. App. Div., 2016).
Kind of entity
There are some differences between the treatment of LLC operating agreements and corporate bylaws in some states. Consequently, how a business divorce will be resolved may turn on the kind of entity that is involved, whether a corporation, partnership or LLC.
Level of scrutiny
Even if you are the majority partner and you control the board of directors or board of managers, you still have duties to minority partners. Courts may examine the corporate decisions of the board of directors or board of managers, using various levels of scrutiny based on a number of factors, such as whether there is an unbiased board of directors or whether there was a “legitimate business purpose.” There are various levels of deference and the jurisdiction may dictate how the issue will be resolved. In general, there are at least three various levels of scrutiny: 1) business judgment: defer to the reasonable judgement of an independent board; 2) enhanced scrutiny for certain significant events such as an acquisition or takeover; and 3) entire fairness: if the board is not independent, then a court may require the board to prove that the decision was fair.
Remedies: Ongoing operations
In terms of the company, there are a limited number of possibilities: the company will continue to exist or it will be dissolved. There are of course other variants such as the assets of the company may be purchased or the company may be merged into a different company. In terms of damages or other remedies to the aggrieved party, courts try to fashion a remedy depending on the alleged harm.
Dissolution is generally viewed as an extreme remedy, but sometimes there is no choice but to dissolve the business especially when there is a deadlock between partners or blocks of partners with equal ownership interests. In other cases, courts have not been inclined to dissolve a business, except for gross mismanagement, positive misconduct, breast of trust or extreme circumstances showing imminent danger of great loss to the company, which, otherwise, cannot be prevented. State statutes may allow a more lenient standard for dissolution, such as if the business is making a profit but the two shareholders, each of whom owns an equal share are having a dispute about control of operations.
When there is equal ownership between business partners, without an agreement in place, it is a challenge to decide who would get to buy out whom. There are some but very few cases in which one of the equal partners may be required to sell to the other in lieu of dissolution. Fulk v. Washington Service Assoc., Inc., 2002 WL 1402273 (Del. Ch. June 21, 2002). As the court in Fulk noted, the “core of the problem is that the . . . two 50% stockholders . . . never agreed to an ‘exit strategy.’” In the case of a deadlock, certainly it is much more likely that the business will be dissolved. Haley v. Talcott, 864 A 2d 86 (Del. Ch, 2004). Of course, the dissolution of the company may be in neither party’s interests but that may be the inescapable the result of the partners’ intractable disputes.
When one partner has a majority stake in the company, the majority partner may try to “squeeze out” the minority shareholder but this is subject to various conditions and may not be available in some states for LLCs. A squeeze out merger, also known as a freeze out merger, may allow two entities to merge and the minority shareholder is forced to sell stock for a cash buyout as part of the transaction. There are other mechanisms for majority partners to buy out minority partners through a reverse stock split or a cash out merger. The minority partner may resort to court proceedings, based on the terms of the transactions. Some of the major issues that are likely to cause concern are the employment status of the minority partner, payment of dividends or distributions, and of course the big one, valuation, how much money will the minority partners get if the partner is cashed out. For example, in evaluating a reverse stock split, the Court in Reis v. Hazelett Strip-Casting Corp., 28 A. 3d 442 (Del. Ch. 2011), applied an entire fairness analysis and held that the attempt to cash out minority shareholders by way of a reverse split was not fair and did not result in a fair price. The court awarded damages to the minority shareholders.
Damages and other remedies
Regardless of whether the business continues in existence or not, a disgruntled partner may request the court to award damages or provide another remedies. The nature of the remedy may depend on the theory of recovery or the nature of the alleged misconduct. As we have discussed, the misconduct may assume many forms, such as minority oppression, breach of contract, breach of fiduciary duty, and misappropriation of trade secrets. Where the damage is difficult to measure, the court may award damages as measured by the gain accruing to the defendant as a result of the misconduct. In the case where a partner has used confidential information, a court may award compensatory damages to the victim of the misappropriation, typically measured by lost profits.
An injunction is an extraordinary remedy and a partner needs to show the possibility of irreparable harm. An injunction may be imposed particularly in the extraordinary circumstances of a partner misappropriating a trade secret or breaching a confidentiality agreement. Confidentiality claims are often directed at preventing a partner from using company secrets to compete unfairly with the business. Trade secret claims are usually based on the law of the jurisdiction in which the business is located. Confidentiality claims are usually contract based or based on the breach of fiduciary duty.
If you have a confidentiality agreement or a non-competition agreement, and you are the partner who wants to set up business across the street and your partner objects, you may have to obtain an involuntary or judicial dissolution to terminate the agreements before setting off on your own. In some cases, minority partners want a buyout, but the majority partner objects. The minority partner may have only limited protections and options such as filing an action for accounting, or access to books and records.
Nasty small business divorces are preventable
Whatever the outcome in a business divorce, usually none of the parties is particularly happy. The best medicine is to preventive medicine. You should only go into business only with those whom you trust and those with whom you can manage a long term relationship. And before you go forward with that partner, even the most compatible partner, make sure you speak with your small business attorney to craft an agreement for what you and your partner should do when you disagree.