Shareholder Wars

Like a marriage strained by the loss of a job, shareholder relations at closely-held businesses have become strained as sales decline and financial and management agendas diverge.

Fred Mendelsohn

Like a marriage strained by the loss of a job, shareholder relations at closely-held businesses have become strained as sales decline and financial and management agendas diverge.

Recent case law from across the 50 states shows the following trends in the law of shareholder and ownership governance disputes:

  • For closely-held business entities, courts are increasingly ignoring traditional judicial deference to management decisions, absent obvious conflicts of interests. Courts now frequently review not only the substance of the decision, but also the process of decision-making in the particular business. Bottom line: Companies in potentially contentious situations should document significant business decisions. This includes more detailed minutes of decisions by shareholders, partners, LLC members, directors, officers, and others, as well as documenting the financial and strategic justification for significant or contentious business decisions.
  • Rather than reviewing how controlling shareholders unfairly harmed the non-controlling group, courts have more frequently examined the “reasonable expectations” of the non-controlling shareholders in their ownership of shares of the company. Bottom line: Management should document the expectations of owners and other interested persons. Documents can include employment agreements, management agreements, and/or shareholder agreements (depending on the type of business entity), with clear provisions relating to the subject matter – grounds for employment termination, circumstances under which ownership is bought and sold, and how corporate governance is handled. In the case of payment of fees or dividends to related companies, appropriate documents can effectively evidence the expectations of the parties and substantially limit risk.
  • Courts have more frequently allowed terminated employees to claim that their salary is a de facto dividend from the company, and one that is not easily terminated. The theory: cut off the salary, and the controlling shareholders have effectively hoarded the dividends (i.e., the terminated owner’s salary). Bottom line: Document, document, document. Execute employment agreements that describe anticipated compensation and responsibilities. Shareholder agreements can demonstrate whether the parties anticipated dividends, or provided a means to sell shares to the controlling shareholders. Operating agreements in limited liability companies (LLCs) can address these issues and more, again to avoid claims based on unwarranted or unreasonable expectations.
  • Increasingly, the law applicable to “closely-held” businesses diverges from court cases establishing the law applicable to publicly-held corporations, especially as to control by the board of directors. Delaware corporate case law, which occupy the bulk of legal textbooks on the subject, have become increasingly irrelevant to courts reviewing claims of shareholder oppression and other wrongful conduct by those in control of business entities vis-Ă -vis the minority (who are of course not in control). Bottom line:Th e obscure cases rule the day. Consult with advisors with knowledge of these buried judicial bombshells.
  • As LLCs have become widely accepted, courts have become more comfortable applying the letter of the operating agreements to owner disputes. Courts will rely less on the judge-made legal principals such as duties of fairness, due care and loyalty, and oppression claims. Thus, owners of interests in LLCs can rely far less on the general common law standards than on the precise words of their agreements. Bottom line: The more likely disputes among LLC owners, the more value exists in carefully crafted LLC operating and other related agreements. Given the interpretation of the LLC acts versus corporation statutes or age-old partnership law, courts often defer to LLC agreements and governing document.

Unfortunately, if a dispute of this nature heats up to litigation, there are various courtroom tactics and strategies that can be used to resolve a “business divorce,” including the applicability of derivative claims. In some circumstances, particularly in entities (primarily corporations) that have several managers (directors), an owner may need to make a demand on the business entity to file suit against an owner, manager, or officer who has harmed the company (such as an owner engaged in self-dealing). In some circumstances, a disgruntled owner may seek to “dissolve” the business entity. These claims can be very effective to secure a buyout of the owner or to achieve other dispute resolution objectives, and can often set the stage for alternative dispute resolution such as mediation, as would occur in a marital dissolution. Ultimately, a focus on these additional legal remedies that can have major strategic and tactical impact on bringing, defending or resolving claims among owners in dispute in privately-held businesses.

In short, with a slumping economy, having and maintaining appropriate documents and adhering to corporate and other business formalities has become increasingly important to reduce the chance, or intensity, of business ownership and related disputes. With owners more likely to fight amidst a corporate downturn with competing ownership goals, management should review documents and practices to avoid inside disputes and preserve resources to fight outside competitors.