Business Divorce of Closely Held Corporations – An Overview

No one gets married expecting to get divorced.  And no one forms a business expecting that it will fall apart.  Just as people get divorced, many businesses come to the point at which a business divorce is the best alternative because the partners cannot, or will not, continue to work together.  When that happens, the parties need to restructure, and often separate, their business interests.

Business Divorce Defined

We use the term business divorce to describe a series of different types of lawsuits that involve the owners of a closely held business. The defining character of the business divorce is that co-owners of a business must separate their business interests.  There are typically two alternatives. In this article, we focus on the closely held corporation.  Some of the principles are similar with other types of businesses, which we address in other articles, but the application of the principles are often quite different.

The law varies from state to state and much of this discussion is general.  To the extent that we discuss specific state laws that apply to business divorce, we focus on New York, New Jersey and Delaware law.

A business divorce, like the human divorce, involves the termination of the existing relationship between the owners of a business.  In most cases, one of the owners will exit from the business and there will be a purchase of his or her shares at fair value.  The cases are rarely simple, however.  Many business divorce cases involve the removal of officers or directors, the termination of shareholder employees as employees and a variety of claims involving wrongful conduct in which money damages are also the remedy.  In addition, a business divorce often will involve thorny issues concerning intellectual property, such as trademarks, copyrights, patents, proprietary information and restrictions on competition.

Most business divorce lawsuits incorporate a claim of shareholder oppression, that is unfair, oppressive, dishonest or other wrongful conduct by the majority.  The minority shareholder is typically the plaintiff in these cases and the remedy is a forced repurchase of the minority shareholder’s interest.

Oppressed Minority Shareholder Statutes and the Close Corporation

Corporate affairs are governed by the law of the state in which they were incorporated.  (There are a handful of exceptions, but the application of another state is so rare, it’s not worth much discussion.)  A corporation organized in New Jersey will be governed in its “internal affairs” by the laws of the State of New Jersey, for example.  A Delaware corporation is likewise governed by Delaware law.  This is true, in most cases, no matter where a lawsuit is brought.  The nature of the remedy will be determined by what is in the relevant statute.

It is important to distinguish between corporations in general and the close corporation.  Some states have a statutory definition of what is a closely held corporation (such as with less than 25 shareholders), but many do not.  A close corporation is one in which the equity interests (the shares) are held by a closed group of people.  Frequently the corporation is the livelihood of the owners, who are also employees, officers or directors.  The businesses often are formed a core of business associates and partners.  There is a relationship among the shareholders that is greater than the relationship that shareholders have with the corporation.

It becomes clearer when one looks at how close corporation is distinguished from the public corporation.  In a public corporation, anyone can buy shares.  The public corporation’s shares may be traded and the corporation may file public disclosure documents.  Public corporations have a “by the book” relationship with their shareholders.  The shareholders own the equity in a public corporation.  They usually have duties of loyalty or care (known as fiduciary duties) toward the corporation and can buy, sell and otherwise protect their own interests without considering the effect on the corporation or the other shareholders.

The directors of a corporation are elected by the shareholders and manage the business of the corporation for the benefit of the shareholders.  Their job is to run the business so that it turns a profit, and to build the business.  Directors set policy and appoint the officers like the president or vice presidents.  The officers, in turn, manage the business on a day-to-day basis and hire employees.

Fiduciary Duties in the Closely Held Corporation

Directors and officers do have fiduciary duties of loyalty and care to the corporation and its shareholders.  That means as a practical matter that the directors and shareholders in most cases have to put the interests of the business and the other shareholders ahead of their own.

In a close corporation, these roles are meshed together.  The shareholders are often directors, usually officers and employees.  The shareholders often form the business in order to secure their own livelihood.  A typical example is three brothers who start a restaurant together.  One is the cook, the other the maitre’d and the third the business manager.  They might be President, Vice President and Secretary-Treasurer, and all have seats on the board of directors.  In this case, they have fiduciary duties to each other and cannot simply pursue their own interests.

Close corporations usually are much less formal than a public corporation and, in some states, the shareholders can do away with the board of directors entirely.  The result of all of this is that shareholders owe fiduciary duties to other shareholders, meaning that they cannot act in their own self interest, even as shareholders.  In short, because each of the shareholder/owners have some ability to take actions that affect the welfare of others, they must consider the other members’ interest.

When there is a business divorce, it most often arises out of some breach of the fiduciary duties of one or more of the members, but on occasion will be the result of an intractable difference of opinion that deadlocks the company.  Often these claims are labelled as “minority shareholder oppression.”

MInority Shareholder Oppression Claims

Most states have adopted the reasonable expectations test as a guiding principal in disputes among the owners of a closely held corporation.  The idea is this: the owners formed or joined the business with a reasonable expectation of the benefits that they would receive.  In most cases, this was the opportunity to work in and run a business, to receive a salary or benefits, and to have the other members respect those rights.

In oppression cases, the majority might have “frozen out” a minority from the management (also referred to as a “squeeze out”), may have removed them from their employment or stopped payment of dividends, or may be involved in wrongful conduct that affects the business or the other shareholders.  Examples include misappropriation or waste of corporate assets, competition with the business or even mismanagement.

These claims, and others, all fall into what is generally described as oppression.  And oppression is ground for a court to take action in a lawsuit among the owners of the business.

In addition, there are cases in which the directors or shareholders are just stuck.  There is a deadlock among the owners that cannot be broken.  An example might be that the two equal owners of a company cannot agree on whether to buy out a competitor’s business.  A deadlock that has a material effect on the business can be grounds for a court to get involved.

STATUTORY Remedies: Buyouts and Judicial Dissolution

Most states have an oppressed shareholder statute of some type.  Quite frequently, the oppressed shareholder remedy is incorporated into statutes that permit a court to judicially dissolve a corporation.  The statutes often provide relief for a minority shareholder that has been oppressed through the conduct of the majority in the form of a forced purchase of their interests.

Repurchase of Shares

New Jersey, for example, provides that in a corporation with fewer than 25 shareholders, a Court may grant a remedy if “the directors or those in control have acted fraudulently or illegally, mismanaged the corporation, or abused their authority as officers or directors or have acted oppressively or unfairly toward one or more minority shareholders in their capacities as shareholders, directors, officers, or employees.”  N.J.S.A. §14A:12-7.

New Jersey courts have broad discretion to order the sale of shares:

Upon motion of the corporation or any shareholder who is a party to the proceeding, the court may order the sale of all shares of the corporation’s stock held by any other shareholder who is a party to the proceeding to either the corporation or the moving shareholder or shareholders, whichever is specified in the motion, if the court determines in its discretion that such an order would be fair and equitable to all parties under all of the circumstances of the case.  N.J.S.A. § 14A:12-7(c)(7).

New York’s corporation statutes,under B.C.L. §1104-a,permit the holder of 20 percent or more of a corporation to file a petition for judicial dissolution if

(1) The directors or those in control of the corporation have been guilty of illegal, fraudulent or oppressive actions toward the complaining shareholders;

(2) The property or assets of the corporation are being looted, wasted, or diverted for non-corporate purposes by its directors, officers or those in control of the corporation.

Under New York law, the corporation or any of its shareholders may make an irrevocable election to purchase the shares of the shareholder who sued for dissolution.  If the parties cannot agree on the price, the court will conduct a valuation proceeding.  See B.C.L. §1118.  The Court may also order a sale or purchase of the interests of one of the shareholders if the equities so require.  The 20 percent limitation, however, is a significant impediment in many cases.

New Jersey law is less straightforward, but more flexible.  The minority shareholder has to establish good cause, but the statute does not presume that dissolution is the only remedy.  New Jersey courts have also, in rare circumstances, forced the majority to sell to the minority.

Many corporations organize under Delaware law because it is widely believed to have the most well-developed body of case law about corporate governance and because the state is generally friendly to corporations.  Delaware does not, however, have an oppressed shareholder statute.  It relies on judicially created common law and will consider  very limited remedies in oppressed shareholder actions only when the parties have bargained for the remedy in their by-laws or articles of incorporation, or in a narrow set of circumstances in which there is a clear breach of a fiduciary duty.  Significantly there is no right of a minority shareholder to force the majority to repurchase his or her shares.

Dissolution and other remedies

Courts have broad authority to grant non-monetary relief in business divorce cases.  These remedies can be temporary to preserve the interests of the parties pending a final dissolution.  Or they can be a permanent aspect of the ultimate disposition of the case.  They may be financial or relate to the structure of the business.

Emergency Relief in Oppressed Shareholder Cases

Most litigated business divorce cases involve an initial application for an injunction.  To secure an injunction, the party has to show some irreparable harm that must be stopped and, generally, that there is merit to that party’s cases.  An example might be to prevent the removal of assets from the business or to enjoin a specific shareholder vote.  The touchstone for these application for most courts is to preserve the status quo.

There are also cases in which a Court will bring in a third party, either as a receiver, a special fiscal agent or an independent director.  The Court has the authority to appoint a director if necessary to protect the interests of the business.  The Court may also appoint a special fiscal agent or special master to oversee and report on certain aspects of the business. An example might be a special fiscal agent to oversee profit distributions or the collection of cash.

The appointment of a receiver is rare, because such a step often marks the end of a closely held corporation as a going concern.  The receiver’s role is often to collect assets, hold them and it may ultimately be the receiver who sells the assets to a third parties.  The appointment of a receiver is widely seen as an indication that a business is not viable.  In many cases, appointment a receiver puts the corporation in default on its loans and other contracts.  Courts view the appointment of a receiver as the least attractive course of action.

Valuation and Sale of Assets

In the vast majority of cases involving a viable business, one side of the dispute is going to purchase the interests of the other side of the dispute.  Who will be the buyer and who will be the seller is often the core subject of the litigation, along with the price that the purchaser will pay.

Where both sides to the dispute have a competing claim to the management of the business, the issue will turn on whether there has been oppressive conduct.  The exception is New York’s oppressed shareholder statute, which allows for the purchase of the shares of the oppressed shareholder plaintiff.  The Court in these cases will be required to determine the value of the interest that is being sold.  It may often require the court to decide any claims for adjustments — sometimes referred to as surcharges — that the principals may owe back to the business.

Valuation of a close corporation almost always involves the use of expert witnesses.  The one possible exception is when there is a pre-existing agreement to use some value that can be calculated in reference to a non-expert source.  An example might be a shareholder agreement that requires payment of a multiple of taxable income as previously reported on the corporation’s tax returns.

The expert valuation is required because there generally is no ready market for the shares of a closely held company.  Again, there may be rare exceptions, but in the vast majority of cases, the business must be appraised to determine its “fair value.”  In most cases, fair value involves a determination of what a theoretical purchaser might expect as a return of their investment if they were to buy the selling shareholder’s interest.  This concept is called capitalization and it puts a value on the cash generated by the business as a measure of the value of the equity of the shareholders.

The valuation will involve putting a value on the business — the enterprise value — and on the individual shareholder’s value.  The valuation expert will often consider discounts and premiums for control and marketability, and the ultimate fair value is often complicated and the source of significant dispute.

Dissolution and Sale

While you find the oppressed minority statutes in most states under the section for judicially ordered dissolution, this is the least frequently utilized remedy — at least for viable companies.  Courts have the authority to order a company to dissolve (that is to cease operations and ultimately to go out of business) and to “wind up’ their affairs.

Dissolution is a process.  Once a company has officially dissolved by filing a certificate of dissolution, then it collects up what it is owed, sells of what it owns, pays off its creditors and finally distributes what is left to the shareholders.  Dissolution is most often considered when there is no realistic prospect for the continued operation of the corporation, or the purchase of the interests of one side of the dispute by the other side is not possible.

A court can, and often will prefer to, preside over the sale of the business as a going concern, rather than as a simple sale of whatever assets it may have.  Sale of a business as a going concern will generally be worth more than the assets, and most courts recognize that they have an obligation to follow a course that gives the shareholders the greatest return possible.

The Court may also decide on a sale of the business when there is a third party that is willing to pay a premium over what the experts believe is its fair value.  Here again, the issue before the Court is getting the best return for the departing shareholder.  The existence of a premium for the sale of the business over and above fair value may exist because of competitors or other economic circumstances and is not uncommon.

bUSINESS dIVORCE FOR CLOSE CORPORATIONS, A CONCLUSION

Business divorces are not unusual, and in a significant number of cases do not involve misconduct, but rather simply a divergence of interests that cannot be reconciled.  The successful business divorce does not destroy the business in the process, but affords each of the particpants a fair return on the time and money they have invested in the closely held business.