Business relationships are similar to marriage and other intimate relationships in many ways. Business partners start with passion for a common goal. They go through ups and downs together. Like any intimate relationship, the business relationship can fall out eventually. When the relationship ends, it can involve much emotional drama, like a divorce between a married couple, and a costly fight in court. Most of all, when the divorce turns ugly, the business itself will suffer, and everyone including employees and customers will lose.
What is business divorce?
Business divorce is the legal separation of the owners of privately held business entities. In most cases, business divorce ends up dissolving the company in the courtroom, but there are other ways to sever the relationship, as we will discuss later.
Business owners might want to part ways for various reasons. The partners might not get along, and may be unable to run a business together. The minority owners may feel excluded from the business operation, and may no longer want to be a part of it. Or, partners may be unable to agree on important decisions, and the operating agreement does not provide a method for resolving the deadlock.
Forms of business divorce
Business owners might find their business is no longer viable, and may decide to end the operation. A court can also order dissolution. It is the most drastic result of business divorce.
A disgruntled shareholder might want to sell his shares and leave the company. The company might already have in place corporate governing documents that allow the buyout, and provide a formula for calculating the value. If governing documents do not provide such guidance, a shareholder can petition the court to order a buyout. Some states have statutes for buyout as an alternative for business dissolution.
When shareholders cannot reach agreement to run their business effectively, and neither side of the dispute wants to be bought out or resign, a court can appoint a receiver to run the business and safeguard the assets. A receiver is a third party who runs the business according to the court’s instructions, and report his actions to the court and all parties. After a specified time, the receiver will present his objective opinions about how to resolve the dispute, and will attempt to mediate an agreement to sell the business or operate it in a better way.
Shareholder derivative action
A disgruntled shareholder might inspect corporate records, such as accounting records or corporate resolutions, and find wrongdoings of managers or directors. In such a case, a shareholder can bring a derivative claim on behalf of the company, and try to enforce the rights of the company against the defendants. Even though the derivative action is not a business divorce itself, it often results in a separation by settlement or by court order.
Breach of contract or fiduciary duty action
A party in a dispute might claim that he suffered harm because another party breached the contract or their fiduciary duty. Common breaches claimed are: failure to contribute required time; exclusion from management; and paying excess compensation to controlling parties. A fiduciary duty is owed to the company by officers and directors to act in good faith to advance the interests of the company. When a manager acts in a way that benefits himself rather than the company, then fiduciary duty is breached. Many breach of contract litigations result in court-ordered dissolution or replacement of an officer or director.
How to avoid an ugly business divorce
As discussed above, most business divorces end up in a courtroom, with parties pointing fingers at each other. Corporate documents like shareholder agreements, partnership agreements and operating agreements are the first places courts will look to determine the validity of claims and decide outcomes. Poorly drafted agreements lead to ambiguity and prolonged litigation.
Well-drafted agreements can not only prevent disputes, but also allow business owners to decide their destiny outside of court when a split is necessary. Here are a few terms business owners can agree upon in advance in order to avoid the cost and effort of business divorce litigations. Once agreements are drafted, it is important they are periodically reviewed and updated to meet changing situations.
When corporate documents set forth management procedures that shareholders can follow, many disagreements can be avoided. For example, the documents can specify when shareholder meetings occur, and how important management decisions are made with a required percentage of shareholder votes.
Even if decision-making processes are well established, there could be a situation where the shareholders disagree and cannot move forward, especially when two partners each own 50% of the shares. Adding a deadlock provision can help by specifying how to get past the situation.
Corporate Records Demands
Shareholders have the right to inspect accounting records, a list of shareholders, meeting minutes and corporate resolutions under common law and state laws. This right is often invoked in business divorce cases where minority shareholders are locked out of management and records. Partnership/shareholder agreements or operating agreements can better define this right to demand records by specifying which documents are available and the time and place of inspection.
Fiduciary duties are one of the most disputed issues in business divorces. A party wanting a divorce will often try to leverage his position by claiming he was harmed by the other party’s breach of fiduciary duties. For example, if one of the partners creates a competing business, does the company and other shareholders have a cause of action against him? It will all depend on what the partnership agreement says about who owes fiduciary duties to whom. If the agreement is absent or does not discuss fiduciary duties in sufficient details, partners have to rely on state laws and courts to resolve their disputes.
Buy-sell provisions specify situations, called triggering events, and processes of dividing business shares. Common buy-sell provisions include triggering events like disability, death, bankruptcy, or divorce of a partner where shares can be sold to the company or other partners, according to a predetermined process. However, they don’t often provide enough detail for triggering events such as termination of employment, failure to perform, deadlock or misconduct that leads to a business divorce. A well-defined buy-sell provision can ease the pain of divorce by facilitating division of shares without prolonged litigation.
One of the reasons a business divorce litigation becomes long and costly comes from the difficulty of purchase price valuation. Each party will bring his own appraiser to the court, but judges are not experts in evaluating businesses. One way to avoid a lengthy valuation dispute is to agree upon a valuation process in advance, and put it in an operating agreement or partnership agreement. Partners can agree on what valuation data to use, what information will be reviewed, appraisal standards and the number of appraisers.
Disagreements happen among business partners, and they cannot always be resolved by trust and empathy alone. Partners benefit if they can reach a settlement before they are forced to meet in the courtroom. Partnership agreements or operating agreements can provide for alternative dispute resolution measures, such as mediation or arbitration.
Questions about Business Divorce? Contact Jiah Kim & Associates
If you are considering Business Divorce, we encourage you to contact us for a confidential consultation. To schedule an appointment at Jiah Kim & Associates, call (646) 389-5065 or inquire online
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.