Business partner disputes are normal. But what happens when you believe your business partner has engaged in wrongdoing? What are your rights and what can be done about it?
I’m an attorney first and foremost, but I’m also a business owner. I served as general counsel for two startups, and am an investor in several others. I have business partners to manage, and I represent clients who themselves have shareholders and partners.
In other words, I have been on the inside as a shareholder, and on the outside providing counsel. I understand that shareholder disputes can cause chaos and destroy value. So this post is intended to outline the types of disputes that can arise, what the law condemns, and what can be done about it.
Business Partner Disputes Share Common Themes
Of course there are distinctions between various types of business arrangements. There are corporations, limited liability companies, partnerships, and even handshake agreements. While the rules governing each arrangement vary, there are basic principles of corporate law that every shareholder should understand.
A substantial amount of nuance is omitted, so please do not rely on this blog as legal advice. To keep it simple, I will refer to officers, directors, partners, LLC members and managers all as “business partners” and “shareholders.”
There are several sources of law that govern business partners. The first is the corporate law in the state where the company is incorporated, and also the state where it has its principal place of business. The law of both these states can apply. For example, in California, there is the Uniform Partnership Act, Uniform Limited Liability Company Act, and the General Corporation Law.
State corporate law is often supplemented with a contract between the business partners. This contract is called a partnership agreement, shareholder agreement, or operating agreement. These agreements can enlarge or restrict the rights and obligations under state law.
Finally, there are state and federal securities laws. Securities laws generally cover the sale of equity or debt to third parties, and might be the subject of another post. But for the purposes of this article, securities laws prohibit providing false or misleading information to investors.
Since the primary rules governing business disputes can be found in state corporate law, that will be the focus of this post.
The Business Judgment Rule
One of the most basic concepts of corporate law is a doctrine called the “Business Judgment Rule.” In a nutshell, it means that business partners are insulated from liability for losses that arise from dumb decisions. Put another way, if your business partner is simply incompetent, you probably have no recourse when they mess up.
I think the Business Judgement Rule makes sense. As a society, we want entrepreneurs to take risks. Taking risks creates profits. But the potential for profits comes with the possibility of losses. So the practical lesson of the Business Judgment Rule is to conduct rigorous due diligence before going into business with anyone because their mistakes will be your mistakes.
The Duties Of “Care” “Good Faith” and “Loyalty”
The Business Judgment Rule is not without limits. It is constrained by the fiduciary duties of “care” “good faith,” and “loyalty.”
Duty of Care
In a nutshell, the duty of care requires business partners to make reasonable efforts to act in the best interests of the company. They need to stay informed. Business partners should conduct whatever due diligence is necessary to make informed decisions. Making decisions by throwing darts at a dartboard is improper.
One frequently recurring duty of care violation is overpaying for corporate assets. Perhaps your business partner was poorly informed. Perhaps they were just lazy. This could be a duty of care violation. However, duty of care violations are often difficult to remedy because they overlap with the business judgment rule. The violation needs to be fairly egregious before the duty of care kicks in.
Duty of Good Faith
The duty of good faith requires that business partners do their best to advance corporate interests. They need to be honest with business partners and sincere in their motives. They can’t intentionally violate laws that apply to the business. Knowingly making decisions that can cause harm to the company is a no-no.
Duty of Loyalty
The duty of loyalty carries the most teeth, and requires business partners to be completely faithful to the company. In practice, this means that business partners cannot act with conflicts of interest, engage in self-dealing, or abscond corporate opportunities. The duty of loyalty also prohibits using company secrets for selfish purposes, or disclosing them to competitors.
Business partners have conflicts of interest when they stand to personally benefit from a corporate decision in a way other shareholders do not. For example, if a corporate officer does company business with his brother, he is conflicted.
Self-dealing is a specific type of conflict where a shareholder does company business while standing on both sides of the transaction. For example, if a corporate officer grants herself a preferential loan with company money, she is self-dealing. If she causes the company to do business with her other company on preferential terms, that is self dealing.
Finally, the duty of loyalty prohibits business partners from misusing company opportunities or trade secrets. For example, if the company is bidding for a big contract, it is improper for one of the business partners to try to win that contract for himself.
Conflicted transactions must withstand the doctrine of “entire fairness.” The entire fairness doctrine permits conflicted transactions so long as the transaction was procedurally fair, and so was the price. For example, a business partner may award a company contract to his brother if multiple bids were taken from the market, and the brother’s company had the best bid. If the conflicted transaction cannot satisfy both requirements, it probably won’t withstand scrutiny.
Minority Shareholder Oppression
Business partners can also take advantage of each other by abusing positions of corporate control. Shareholders with less than 50% of a company’s stock do not have the ability to control company decisions. In the simplest example of a two shareholder company, the stockholder with 51% has complete control over all decisions. Because there is often no market for company stock, minority shareholders can become trapped.
Under this power structure, majority shareholders can abuse their control. When times are good, the majority may try to appropriate a greater portion of the economic benefits. When times are bad, they may want to capture a greater piece of a shrinking pie. The majority may even wish to get rid of minority owners altogether.
Such oppressive conduct can “squeeze out” a stockholder, forcing them to sell their shares at an unfairly low price. Majority shareholders can also “freeze out” the minority through corporate governance structures and by diverting funds away from the minority. In this situation, the minority’s shares are essentially irrelevant because they are cut off from information, participation in management, and disbursement of funds.
What Are Shareholder Rights?
The above was a basic overview of how business partners can take advantage of each other. But what can be done to remedy the situation?
If a shareholder has been frozen out by company management, they can make a demand to inspect corporate records. This is a formal demand on the company to inspect items like financial statements, minutes of meetings, and other company records. These demands have procedural requirements and limitations, so it is a good idea to have a business partnership lawyer work with you on this.
Shareholders can also make motions for the company to take action. These motions can remove a person from their position, limit their authority, or change the rules for how decisions are made. The aggrieved shareholder can notice a meeting, and propose items to be voted on. This is a good opportunity to seek corporate reforms that may resolve the dispute.
Records demands and shareholder motions are a good way to get the attention of business partners. For example, in most situations, shareholders are required to bring their grievances to the company before they sue. This gives the company the opportunity to resolve the problem, but also lets business partners know you have serious concerns and may be contemplating litigation.
Another way to address a dispute is to wind down the company, or sell your shares. But what happens if your business partner tries to sell the company at an unfair price? Minority shareholders can seek to have an independent third party establish the shares’ fair market value. In this situation, there is usually a very limited time to pursue “dissenters rights”. So it is wise to seek help from a shareholder dispute lawyer if the company is being sold for too little.
When all else fails, there is shareholder litigation. If business partners have violated their duties of care, good faith or loyalty, shareholders can sue. Courts can order the bad actor to pay-back funds taken from the company, or damages caused to the company from their wrongdoing. Courts can also halt bad conduct if it would cause “irreparable harm.”
Shareholder lawsuits are tricky because they often involve a procedure known as “derivative litigation.” Derivative lawsuits are brought by the aggrieved shareholder in the name of the company. The rationale is that an officer or director owes duties to the company, not its shareholders. Shareholders are injured because the company is injured.
Where minority shareholders are being specifically oppressed, the derivative rules may not apply. Because minority shareholders are being specifically targeted, it is not the company that is being injured.
Special rules apply, so be sure to consult a knowledgable shareholder rights attorney.
If you are in a dispute with your business partners, The Restis Law Firm, P.C. is here to help.
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I am not your attorney, and this is not legal or investment advice.