Written By: Eric D. Dean
Small business is the backbone of America. When the business is operated by a small group of individuals it can also be a significant source of disputes and litigation. Whether the business is operated as a partnership, limited liability company or corporation, to often the participants in the venture are during the start up and building years view themselves as being in alignment and are focused on protecting themselves from third party claims and building their business. However, many events can arise resulting in a dispute between the co-venturers. Such disputes can have a wide range of causes such as a dispute between the co-venturers over the direction of the business, a fragmentation resulting from a diversity in work ethic, talent or style, the death or incapacity of one of the venturers resulting in family members or an administrator of an estate assuming a role in the business or one of the co-venturers desiring to retire or be bought out. Regardless of the cause, such a dispute if not contained can be as confrontational and emotionally charged as any divorce. These disputes can be manifested in such actions as a diversion of business assets or opportunities, the exclusion of co-venturers from information and management decisions, a disruption of employee and customer relationships and a diversion of energy and resources from business activities to in fighting.
To often co-venturers when forming their business venture, rely on verbal understandings or canned boilerplate documents. The more focus placed by co-venturers on issues when forming and during the course of their business relationship, the less likely that there will be an out of control dispute as the venture progresses. For example, the co-venturers operating as a corporation may form their business as a “close corporation”. As a close corporation, the co-venturers can enter into a “shareholder agreement” under which the shareholder can define their relationship in a wide range of areas including designating their respective authority, duties and responsibilities, make provision for the buyout of a co-ventuerer on his/her death or incapacity and agree on the method for resolving disputes. Members of a limited liability company can accomplish similar results by their “operating agreement” and partners by the provisions of their partnership agreement.
While this presentation will focus on corporations, the similar concepts apply to limited liability companies and partnerships.
Avoiding and Limiting Disputes
The time to limit and anticipate disputes is when the venture is in the formation stage. The more comprehensive and defined the duties, rights, limitations and responsibilities of directors, shareholders and officers are the better. This can be accomplished through such things as Shareholder Agreements, and the By-Laws. These types of agreements can also set forth a procedure to resolve disputes if and when they arise. Buy Sell Agreements are also extremely effective in defining the rights of the shareholders to either demand a buyout of their shares or the right to buy out other shareholders in the event of a dispute that cannot otherwise be resolved. Buy Sell Agreements are also important in the event of the death or disability of one of the shareholders.
The Duties of The Directors
The business and affairs of a corporation are managed by the Board of Directors of the business. The directors are selected by the shareholders of the corporation. The directors elect the officers of the corporation who are responsible for the day to day operation of the business. The officers report to the Board of Directors. The By Laws of the corporation set forth the duties and responsibilities of the officers. In a small business the shareholders, directors and officers may be the same.
Accepting the position of a director of a corporation creates certain duties and responsibilities which cannot be delegated or waived. A director must act in good faith in the best interest of the corporation and its shareholders. A director must use reasonable care in fulfilling his/her duties, including making reasonable inquiry and investigation. A director may not enter into contracts or transactions with the corporation unless the shareholders other than the director in good faith, after being provided with all relevant information, approve the transaction. Similarly, a director may not make a loan from the corporation or cause the corporation to guaranty a debt or obligation of a director unless the shareholders other than the director in good faith, after being provided with all relevant information approve the loan or guaranty. A director who authorizes or allows for a distribution of liable to the corporation or unpaid creditors to the amount of such wrongful distributions even if the director did not directly benefit from the distribution. The duties of a director to the corporation and to its shareholders are called “fiduciary duties”. Essentially, the director is required to act fairly and put the interest of the other shareholders above his personal interest.
Are the Director’s Actions An Exercise of Business Judgment or Overreaching
A court in ruling on a dispute between corporate co-venturers will primarily be ruling based on its conclusions as to what is fair or equitable. In ruling on these cases, a court is faced with two competing principles. The first such rule is called “the Business Judgment Rule”. The Business Judgment Rule provides that the Court will defer to the judgment of the directors of the corporation in making business judgments and not impose the court’s business judgment as to the operation and direction of the business affairs of the corporation. The second principal is the right of the outsider (i.e. minority or non managing shareholders) to be protected from overreaching by insiders (i.e. the Board of Directors or majority shareholders). Therefore these cases are very factual in nature. Those defending the lawsuit will argue that the lawsuit brought by the dissenting shareholder is without merit and that the controlling shareholders have done nothing other than exercise their discretion as directors. The insiders will also argue that the dissenting shareholder has delayed in asserting his/her claims, is trying to disrupt the business and/or is attempting to extort a benefit that he/she is not otherwise entitled to by bringing the suit. The dissenting shareholder will attempt to set forth facts demonstrating that the insiders are abusing their position and acting for their own benefit in derogation of their fiduciary duties. Against this backdrop, the dissenting shareholder has multiple courses of action open to him/her when faced with a corporate dispute.
Shareholders May Request Information and Documentation
There are non-litigation remedies that should be considered by the dissenting shareholders before filing litigation. These include a demand for inspection of documents and calling a shareholder meeting. Under the Corporations Code a shareholder holding five (5) or more percent of the outstanding shares may demand an inspection of corporate records including a shareholder list. Any shareholder can demand the right to inspect and copy the accounting books and records and minutes of shareholders and directors. In addition, a director may demand the physical inspection of properties of the corporation. Should insiders fail to comply with such inspection requests by a dissenting shareholder or director, the court may enter an order enforcing the inspection rights and also for good cause shown appoint one or more competent inspectors or accountants to audit the books and records of the corporation and investigate and report to the court as to the property, funds and affairs of a corporation. The corporate insiders cannot take a position that the requested records do not exist. Under the code, these records must be maintained in written form and the corporation at its expense must provide the records in written form. The Court can order the corporation or insiders to pay the reasonable costs incurred in enforcing inspection rights. Exercising the right of inspection therefore becomes a potential early and effective mechanism for the dissenting shareholder to obtain valuable information and if those in control of the corporation refuse to cooperate demonstrate the need for court intervention and to cast the insiders in a bad light with the Court. From the insiders prospective it is best to produce the required records albeit perhaps to insist on a confidentiality and use stipulation as a condition of the production.
Another effective remedy for a dissenting shareholder is to call a shareholder meeting. A holder of ten percent (10%) or more of the outstanding shares of the corporation may call a special meeting of shareholders. Numerous items can be brought up at a shareholder meeting including the removal of directors and making inquiries into the corporate business and its affairs. We typically recommend that a stenographer be retained to prepare a transcript of the special meeting so that this transcript is available for the court. The meeting if properly planner and documented can become a powerful source of evidence in later court proceedings.
A shareholder holding at least ten percent (10%) of the outstanding shares of the corporation may file a suit asking the court to remove a director where fraudulent or dishonest acts or gross abuse of authority or discretion can be demonstrated. The burden is on the shareholder filing the suit to demonstrate bad acts justifying court intervention. Therefore demanding inspection of records and/or calling a shareholder meeting in advance of filing this action may be an important predicate to filing an action.
The Provisional Director
If the corporation has an even number of directors who are equally divided and cannot agree as to the management of its affairs so that business can no longer be conducted in an advantageous manner or there is a danger that property will be impaired or lost, the court may appoint a “provisional director”. A provisional director is a qualified neutral who is appointed by the court and has the full power of a director until the deadlock on the board of directors is broken or the court orders the provisional director removed. The provisional director can serve an important function in maintaining the business and preventing the corporation from being looted pending resolution of a dispute or dissolution proceeding. The provisional director also may be a powerful witness reporting to the court on his/her findings as to the directors’ and officers’ conduct of the business.
The Injunction
Another commonly used tool to maintain the status quo in a corporate dispute pending a judgment is a preliminary injunction. A preliminary injunction is a court order issued pending judgment that prohibits the person against whom the order is directed from engaging in certain activities. Typical preliminary injunction orders will require such things as the maintenance and disclosure of accurate books, maintaining accounts at a certain bank, limiting the diversion of funds etc. Violation of the preliminary injunction order will subject the violator to a possible contempt citation.
Derivative vs. Individual Claims
One of the major issues in corporate disputes is whether the claims belong to the individual shareholder bringing the suit or belong to the corporate entity. As a general rule, an individual shareholder does not have individual claims for diversion of corporate assets or opportunities. Such claims belong to the corporation and are asserted by the individual shareholder on behalf of the corporation through “a derivative lawsuit”. The corporation may be named as either a nominal defendant or a plaintiff in a lawsuit brought by a shareholder. Before filing the lawsuit, as a general rule, unless good cause can be shown not to do so, the dissenting shareholder must have requested the Board of Directors to take action and inform the Board of Directors in writing of the predicate facts and issues underlying the claim. This later requirement may be fulfilled by providing the Board of Directors with a copy of the proposed legal complaint that the dissenting shareholder intends to file to commence the lawsuit. A director or officer who has been named in a lawsuit or the Board of Directors of the corporation may in response to the filing of a derivative lawsuit request the court to require the dissenting shareholder who filed the lawsuit to post a bond which in the discretion of the court can be as high as $50,000. The purpose of the bond is to secure the costs of defending the lawsuit. Before requiring a bond the court must make a determination that the derivative lawsuit is without any possible merit.
Dissolution of The Corporation
A shareholder or shareholders owning one third (1/3) or more of the outstanding shares of the corporation or one half (1/2) or more of the members of the Board of Directors may file an action for Involuntary Dissolution of the Corporation if (1) the Board of Directors is deadlocked (2) there is internal dissension among shareholders such that the corporation is deadlocked (3) those in control of the corporation have been guilty of or knowingly permitted persistent and pervasive fraud, mismanagement or abuse of authority or persistent unfairness towards any shareholders or its property is being misapplied or wasted by its directors or officers or (4) in the case of any corporation with 35 or fewer shareholders, liquidation is reasonably necessary for the protection of the rights or interests of the complaining shareholders. If the court determines that the complaining shareholder has met its burden the court will order the winding up and liquidation of the assets of the corporation. The officers and directors of the corporation continue to have a fiduciary responsibility to the corporation and its shareholders during the liquidation proceeding and winding up process.
Protecting The Business Through A Receiver or Referee
If the court determines that assets are being dissipated by management the court may appoint a receiver to take over the management and affairs of the business and preserve assets pending the determination of the complaint for dissolution. If appointed the receiver will assume control of the corporation and its assets and report to and take instructions from the court. The receiver will then retain its own accountants, consultants and lawyers to manage and protect the business and its assets. The receiver may also assert claims against directors, officers and others in the name of the corporation. However, because of the expense involved with a receivership, receivers are viewed as drastic remedies and generally court’s are reluctant to appoint them unless extreme circumstances exist.
Instead, courts are more prone to rely on provisional directors or a preliminary injunction as discussed above. The Court may also appoint a neutral “referee” to gather information and make recommendations to the court which the court can then adopt as its findings. Referees are commonly appointed in dissolution proceedings to engage in fact investigations and report to the court. The court can invest the referee with substantial powers to gather information and require that the parties cooperate with the referee. The referee can save a substantial amount of court time by its investigation. The referee does not have the power to make findings in the case. However, the referee will report to the court and the court will typically adopt portions of the referee’s report as its findings.
In order to protect the corporation from liquidation or a receivership, holders of fifty percent (50%) or more of the outstanding stock of the corporation may elect to purchase the shares of the dissenting shareholder at “fair value”, or the liquidation value of the corporation. If the parties cannot agree on fair value, the court will appoint three disinterested appraisers as referees to determine the fair value. The determination of a majority of the appraisers as to fair value is binding. If the shareholders who desire to continue to operate the business timely pay the amount determined by the appraisers as fair value, then the court shall refrain from entering an order of dissolution. Under certain circumstances, the court may stay the dissolution proceeding in order to allow a fair value determination to be made. In order to stay the proceeding, the court may order the parties seeking to avoid the dissolution to post a bond to cover the costs associated with the fair value determination.
Conclusion
The time to anticipate potential disputes and adopt a method to resolve them is before they arise. If an irreconcilable dispute arises between minority and majority shareholders or between the Board of Directors and passive investors, litigation may be required to resolve these disputes. There are multiple alternatives avenues available to both the controlling parties and the dissenting shareholders to protect their respective positions. Competent counsel is essential to guide the parties through these disputes in a manner that minimizes costs and protects their respective interests.