7 Ways to Avoid the Feuds that Destroy Family Businesses:
A Litigator’s Perspective
Family and other closely-held businesses typically start off as ventures between relatives or close friends who trust each other. They often operate informally without following, or even without creating governing documents or agreements. This may work well for a time, but when ownership or control shifts, company performance spikes or plummets, or less involved owners feel (or are) unfairly treated, the situation can change very quickly.
No matter how close family or friends are at the start, certain events or frustrations will spark disputes that may devolve into litigation.
Changes in ownership or control due to death, divorce or lifetime transfers. As time passes, the original owners may pass on their interests to family through inheritance, as the result of divorce, or to bring grown children or others into the business. The second and third generations may not be close and may not even know each other well, and the trust that kept the business in balance at the start is gone, leading to fights over control and strategy.
Changes in company performance and dissatisfaction (warranted or not) with distributions. Poor company performance may result in decreased distributions to owners, motivating particularly those owners less involved in the day-to-day business to seek to sell their ownership interest or to suspect wrongdoing by those managing the business. The same may happen if a company’s performance skyrockets, but distributions remain relatively flat.
Unfairness (perceived or actual) among the owners. When minority or outside owners suspect (rightly or wrongly) owners involved in management of using the business to benefit themselves at the others owners expense, this may give rise shareholder “oppression” or “freeze out” claims. This includes may include owners drawing unfairly large salaries, benefits and perks, hiring immediate family for desirable positions in the business, engaging in related party transactions, or usurping corporate opportunities. It may also involve direct actions, such as unfairly terminating a minority owner’s employment, voting a minority owner off the governing board, voting to prevent dividend payments or interference with other owners’ voting or access to information.
While it is impossible to eliminate completely the risk of a lawsuit, with careful planning, the risk can be significantly reduced. If a lawsuit is unavoidable, however, the same planning will help narrow the issues and put the company and shareholders in a better position to litigate more efficiently and to resolve their differences more effectively. Here are just a few ways to plan ahead....
1. Create and adhere to strong and clear governance documents.
In Massachusetts, G.L. chapter 156C governs LLCs, but LLCs are creatures of contract and so the LLC’s Operating Agreement may modify and trumps the provisions of the statute. G.L. c. 156D governs corporations, but some exceptions, may be modified by the corporation’s governing documents. In either type of entity, the governing documents are critical and must be carefully considered and crafted for each new business. Form or boilerplate governance documents and agreements should not be used to save time or money.
A non-exhaustive list of important areas for the governing documents to address includes:
Classes of ownership and shareholder/member voting rights, powers, limitations
Who will manage the business (Directors/Managers) and their powers, duties and limitations
How directors or managers are selected, how they may be removed or replaced
How and for what purpose capital calls may be made, any limitations, and a procedure for making and fulfilling them, as well as consequences to owners who do not participate
An agreement on when and a formula for how much will be paid out in distributions
A process for valuing, buying and selling ownership interests and restrictions on transfer of ownership interests
Provisions for indemnification and advancement
Inspection and copying of documents
Definitions of and policies for engaging in related party transactions
Policies for presenting and pursuing corporate opportunities
Employment of owners and hiring of family members
Limitations and amendments to the documents
Of course, it is not enough to create thorough governance documents. The business and all involved must follow them. Otherwise, decisions made and actions taken will be vulnerable to challenge. Failure to follow formalities may also jeopardize the corporate or LLC form and expose owners to liabilities for the entity's debts. But that is an article for another day.
2. Agree on a bullet proof buy/sell agreement.
Many disputes arise when a minority owner wishes to divest itself of its ownership interest and either there is no provision for the owner to do so, or there is significant disagreement about the value of the minority owner's interest (and the application of discounts for lack of marketability/minority interest). Or both.
The best way to avoid or decrease the risk of this type of dispute becoming the impetus for a lawsuit is for the company and its owners to have a clear buy/sell agreement that anticipates a sale of a minority interest, as well as other transfers. It should spell out, among other things, the requirements for and any restrictions on transfer, provisions for the entity or other owners to purchase a selling owner's interest, a timetable for such purchases, a method for valuing the interest, including any discounts that will applied and how they will be figured, a dispute resolution procedure that is not too onerous, expensive or lengthy, a time, place and location for a closing on the purchase and sale, and terms for payment, and if the payment is by the entity over time, any interest to be paid, any required personal guaranties and any necessary subordination.
3. Be as transparent as possible and get owner buy-in for all major decisions.
Owners are often unpleasantly surprised to learn they do not have unfettered access to the company's records and information.
Unless the governing documents provide for broader access, Massachusetts shareholders’ rights to inspect corporate records are limited to two, specific categories of documents, some of which are only available if the shareholder articulates a “proper purpose” for requesting them. Even then, the corporation may refuse if it determines in good faith that disclosure presents a risk to the corporation. <<Read our article about Massachusetts shareholders' inspection rights>>
LLC members have ostensibly broader rights under chapter 156C, but the Operating Agreement controls overall access.
In both situations, it is a good idea to have policies in place for owners to seek and obtain information and to stick to those policies. While the company must provide the statutorily-required information at a minimum, it may also adopt a policy to provide more and to marshal all requests for inspection.
Whatever the governing documents or the statutes require, transparency and inclusiveness will go a long way to avoiding unwarranted suspicions and mistrust from outside owners. If owners are kept apprised of financial performance, business plans and strategy, significant hurdles and opportunities and are included in major decision-making (to the extent possible without jeopardizing the business), management and the company are less likely to be accused of keeping owners in the dark, operating for the management-owners' benefit and to the detriment of outside owners, or other wrongdoing. It also allows managing owners to learn of and address any objections to the extent possible before proceeding.
Of course, common sense dictates and unreasonable objections or delay tactics by non-managerial minority owners should not be allowed to harm the business.
4. Institute and follow policies for nepotism, related party transactions and corporate opportunities.
Three areas of fertile ground for lawsuits are nepotism in hiring and promotion, related party transactions and usurpation of corporate opportunities. To reduce the risk of disputes that turn into lawsuits, the entity's governing documents can spell out policies and procedures related to each and require strict adherence to them.
Nepotism. Nepotism in hiring and promotion is not unusual in closely-held businesses. Often the founders started the business with the hope of bringing one of more children into the company when they were older. When owners involved in management hire, promote or increase the pay of their children, other relatives or friends, "outside" owners often view these acts as unfair either because their own children, relatives or friends are not treated equally, or because they believe the person hired or promoted is not qualified for their position. Many questions and fights can be avoided or at least narrowed if the governing documents include clear policies for hiring friends and relatives of owners and other insiders, and if owners and management follow the policies. The policy may include specific requirements for certain management positions, a procedure for obtaining outside candidates and comparing credentials, and/or owner approval of hiring of related parties or friends for certain positions.
Related party transactions. In family and other closely-held businesses, related party transactions, and even owner involvement in competitive businesses are not uncommon. This comes up, for example, if an owner holds real estate that it leases to the business, or when related companies (affiliates or other companies the owners have an interest in) provide goods or services to the company. Sometimes these relationships are beneficial to the company. Sometimes they are examples of certain owners benefiting to the detriment of the company and other owners.
Related party transactions or relationships may lead to claims of breach of fiduciary duty. To provide clarity and avoid unnecessary litigation, related party transactions can be defined and insulated from liability by inclusion in the governing documents or policies adopted by the directors/manager. It may be advisable to insulate transactions that meet certain criteria as opposed to insulating them entirely, and such transactions should always be fully disclosed and subject to approval by the directors/managers .
Corporate opportunities. Corporate opportunities come in many forms and in Massachusetts are defined broadly, giving the entity a significant interest in pursuing business opportunities that its fiduciaries (officers, directors, managers, owners) learn of. Alleged usurpation of corporate opportunities spawns much litigation. The law provides protection to the entity, and requires full and fair disclosure and presentment of all opportunities to the entity before a fiduciary takes the opportunity for itself, but there is still uncertainty in many situations about whether an opportunity fell within the scope of the entity's business, or otherwise would have been of interest to the entity, and whether a fiduciary fully disclosed all material facts about the opportunity.
The entity's governing documents can do more, however, to clarify what opportunities are of interest and must be presented to the entity, the process and criteria for presentment and a threshold and method for the entity to accept or reject the opportunity. This gives everyone involved more guidance and less wiggle room and, therefore, reduces the likelihood of litigation over whether a business opportunity should have been or was properly presented.
5. Keep business and personal expenses separate.
Managerial owners who utilize the company like their personal bank or checking account are likely to get sued by other owners. They are also jeopardizing the entity's form (corporation or LLC etc.) by co-mingling business and personal funds and expenses. It should go without saying that the business should pay business expenses and the individual owners should pay their own personal expenses. Legitimate business reimbursements are one thing, but having the company pay for living expenses unrelated to the business is another. The company and the owners should with their accountants to determine what is permissible.
Also, owners should not lend money to the corporation or borrow from it without giving the same terms and opportunity to all owners and without having and following a clear policy for doing so.
6. Have employment agreements with owners who work in the business.
To avoid amorphous claims of owner's right to continued employment, the company may wish to memorialize terms of employment of owners in an agreement, even if it is an agreement for at-will employment. Expectations for performance and conditions of continued employment, advancement, compensation, bonuses, discipline and termination should be clearly addressed.
One claim minority owners often make is that continued employment is part of their reasonable expectation as an owner. When the company is not making distributions or the owner is not benefiting in other ways, the argument may have teeth. It is important, however, that all expectations be reduced to writing to avoid such a claim when it is not warranted and to define it when it is.
7. Avoid deadlock or plan for how to deal with it.
If a company is deadlocked - meaning, decision-making is impossible because the decision-makers are tied 50/50 or otherwise unable to meet the required voting threshold to make a decision or take action, the business suffers.
In Massachusetts, the only statutory fix for a deadlock in a corporation is judicial dissolution if certain criteria are met. Chapter 156C provides for court-ordered dissolution of an LLC upon application of an LLC member "whenever it is not reasonably practicable to carry on its business in conformity with the certificate of organization or the operating agreement."
But dissolution is unlikely to be desired in most cases. If a company is profitable or the owners otherwise wish to carry on the business, the remedies available in the event of a deadlock will be left to the court's equitable powers (in litigation) or the agreements made in the governing documents.
Uncertainty and harm to the corporation can be avoided by including a method to break deadlocks in the governing documents. While owners may sometimes break a deadlock at the director/manager level, if they are unable to do so, other alternatives should be available. This may include agreement on or a process for appointment of a provisional director/manager - a neutral third party who participates in deadlocked decision-making to break the tie.
Other ways to deal with a deadlock include providing for a buy-out by one owner of another, removal and replacement of officers or directors/managers, and/or requiring an accounting with respect to any matter in dispute.
Whatever method is chosen, this should not be left until there is mistrust or bad blood. All involved are best served by dealing with it up front when there is trust and optimism.
Consult an attorney
Shareholder and other family and closely-held business disputes are very fact-specific and are often complicated. If you or your business is involved in an owners' dispute, you should confer with an attorney with experience handling these difficult matters. An attorney can help you minimize the damage to your company and protect your business interests.
If you have questions or need advice or representation in connection with a potential or ongoing family or closely held company dispute, please call me at 617-716-4303 or email me at firstname.lastname@example.org or contact Cross Nadel LLC here.
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