Infighting: Is your closely held business at risk because people don’t get along?
“This case is one of the many disturbingly common lawsuits in which family members turn on each other in fighting for control of a close corporation.”
Del Borello v. Del Borello, 62 Pa. D. & C.4th 417, 418 (Phila. Com. Pl. 2001)
When you started your business all those years ago, you and your co-founder—perhaps it was a relative, a close friend, or just a colleague ready to join your new venture—were probably more concerned with getting the business off the ground (or out of your garage) than with the intricacies of corporate governance. Or perhaps you and your siblings took over the family business, and you all were occupied with filling your parents’ shoes, not succession planning.
Years have passed, and the business has grown significantly. But other things may have changed, too. Maybe you and your partner (or sibling) don’t see eye to eye about the company’s direction. Or one of you feels like you’ve contributed more than your fair share. Or one partner is seriously ill and fears that another partner will take advantage of his absence from the business. Or you just can’t stand each other anymore, even though such a thing would have been unthinkable even a few years ago.
As the Del Borello quote above makes clear, disputes among the leadership in small businesses are far more common, serious, and costly than many people realize. It’s an unfortunate problem, too, since it can often be prevented. As I have seen in my own practice, no one involved in such a dispute is happy about the situation, and most everyone wishes they had taken precautionary steps that could help avoid a drawn-out conflict.
So what does the law say about dealing with corporate infighting, particularly in closely held businesses, and how can you protect yourself?
When does a principal in a small business need legal help?
While any number of circumstances might give rise to legal proceedings between shareholders in a closely held corporation (or, as noted in the next section, partnerships and limited liability corporations), including fraudulent or illegal acts by one shareholder, one of the most common issues is the oppression of a minority shareholder by the majority shareholder(s). Oppression is the “unjust or cruel exercise of authority or power.” In considering whether conduct is oppressive, both Pennsylvania and New Jersey courts ask whether the conduct “frust[rates] . . . the reasonable expectations of the shareholders.”
Oppression often takes the form of a “freeze out,” in which the minority shareholder is deprived of certain rights or benefits attendant to his interest in the closely held corporation. In Adler v. Tauberg, for example, several partners in a medical practice attempted: to force Dr. Adler, a shareholder, to retire; to force Dr. Adler to reduce his salary; and to steal his patients. They also manipulated the composition of
1. Both New Jersey and Pennsylvania define what constitutes a “closely held corporation” based on the number of shareholders. See N.J. Stat. Ann. § 14A:12-7(1)(c) (describing remedies available to shareholder in corporation with 25 or fewer shareholders); 15 Pa. C.S. § 1103(a) (defining a closely held corporation as (1) having 30 or fewer shareholders or (2) a statutory close corporation).
2. Adler v. Tauberg, 881 A.2d 1267, 1269 (Pa. Super. Ct. 2005) (internal quotation marks and citation omitted).
3. Id. (internal quotation marks and citation omitted); see also Brenner v. Berkowitz, 134 N.J. 488, 506 (1993) (citing 2 O’Neal’s Close Corporations § 9.29 at 132 (Callaghan & Co., 3rd ed. 1988)).
the company’s board of directors, raised their own salaries, and paid their attorneys’ fees with corporate funds, among other misconduct. A trial court concluded that this misconduct, as well as the defendants’ improper issuance of additional company stock, warranted granting Dr. Adler’s request for appointment of a custodian to run the affairs of the business. The Pennsylvania Superior Court agreed. Other examples of “freeze out” behavior may include depriving a shareholder of access to corporate records, withholding salary or shareholder distributions, or even physically barring the shareholder from the corporate offices. Under these circumstances, the oppressed business owner should seek counsel.
What legal remedies do Pennsylvania and New Jersey offer?
When corporate infighting gets so bad that the rights of shareholders, directors, or the corporation itself are threatened, shareholders have various options.
The law governing internal corporate disputes is similar in Pennsylvania and New Jersey. Regardless of the size of a corporation, a shareholder or director of a Pennsylvania or New Jersey corporation can file a derivative action—a lawsuit on behalf of a corporation—to remove directors who act fraudulently or dishonestly, or who abuse their authority, and cause harm to the corporation. In the same circumstances, or when those in control of a company are deadlocked to the point of irreparable injury to the corporation, a court can even order involuntary dissolution of the company. Importantly, the remedy of dissolution is also available to principals in partnerships and limited liability corporations. Notably, courts are not required to exercise this “nuclear option,” and may craft less drastic remedies.
Of particular interest is that both Pennsylvania and New Jersey afford remedies specifically to minority shareholders in closely held corporations. Under these statutes, a court can afford relief to a minority shareholder when “the directors or those in control of the corporation have acted illegally, oppressively
4. See Adler, 881 A.2d at 1268.
5. See id. at 1267.
6. See id. at 1270-71
7. See, e.g., Del Borello, 62 Pa. D. & C.4th at 427-28 (noting that Pennsylvania’s “oppressed minority shareholder” statute mimics New Jersey law).
8. See 15 Pa. C.S. § 1726(c); N.J. Stat. Ann. §§ 14A:3-6.2, et seq.
9. See 15 Pa. C.S. § 1981(a); N.J. Stat. Ann. § 14A:12-7(1).
10. See N.J. Stat. Ann. § 42:1A-39 (New Jersey partnerships); N.J. Stat. Ann. § 42:2C-48(a)(5), (b) (New Jersey limited liability corporations);15 Pa. C.S. § 8481(a) (Pennsylvania general partnerships); 15 Pa. C.S. § 8681(a) (Pennsylvania limited partnerships); 15 Pa. C.S. § 8871(a)(4), (b) (Pennsylvania LLCs).
11. See Baron v. Pritzker, 52 Pa. D. & C.4th 14, 20 (Phila. Com. Pl. 2001) (“That the [Pennsylvania Business Corporation Law] would authorize the court to grant such drastic relief [(i.e., appointment of a custodian, or receiver and dissolution)], but forbid the court from affording milder equitable remedies, would make no sense.”); N.J. Stat. Ann. § 14A:12-7(1) (court may appoint a custodian or provisional director, order a sale of the corporation’s stock, or dissolve the corporation).
12. The New Jersey statute does not prescribe criteria for determining who counts as a minority shareholder, but Pennsylvania requires that a shareholder own at least 5% of any class of a company’s outstanding stock to invoke the oppressed minority shareholder statute. See 15 Pa. C.S. § 1767(a)(2). In addition, courts in both Pennsylvania and New Jersey have treated 50% shareholders as minority shareholders, provided that the “minority” shareholder lacked power relative to the other 50% shareholder. See, e.g., Baron, 52 Pa. D. & C.4th at 28-29 (plaintiff and defendant were 50-50 shareholders, but defendant had two votes on company’s board, whereas plaintiff had only one); Balsamides v. Protameen Chems., Inc., 734 A.2d 721, 731 n.7 (N.J. 1999) (“Note that for the purposes of this statute, each of two fifty percent shareholders is a ‘minority’ shareholder.”). or fraudulently” towards a minority shareholder in his or her capacity as a shareholder, director, officer, or employee. Such relief can take a variety of forms, including a court order that:
- grants an oppressed shareholder access to a company’s books and records;
· requires payment of dividends or distributions that have been withheld;
· appoints a custodian or provisional director to oversee the company’s affairs;
requires the offending party to either buy the minority’s shares at fair value or sell his own shares, thus ceding control; or
· appoints a receiver and dissolves the company.
As an added measure of protection, a shareholder who brings a successful action under New Jersey’s oppressed minority shareholder statute may also be entitled to attorneys’ fees.
How can I avoid getting dragged into contentious litigation with my (soon to be former) friends and/or relatives?
Unfortunately, there is no surefire way to avoid disagreements with others, which means that, sometimes, legal action is required to determine people’s rights and obligations. That said, there are sound strategies that can limit the scope of disputes, and can help facilitate quicker, less costly resolutions. Two approaches in particular can be helpful, especially when used in combination.
Approach #1: If the hypothetical at the beginning of this article resonates with you at all, it is good business to have an attorney examine and update your corporate governance documents (e.g., bylaws, shareholder agreements, employment agreements). If you got these documents on the cheap when you first started out, chances are that you got what you paid for. Even if you obtained stellar, well-drafted documents, it is unlikely that these documents predicted all the subtle changes to your business, and a tune-up may be in order. Simply put, updated corporate governance documents that clearly set forth the parties’ expectations, rights, and responsibilities are crucial. That is the case whether they become relevant to a dispute later on, or just prescribe a clear path forward for business owners who separate amicably, pass along their ownership interests to other shareholders, or decide to retire and wind down the business.
Approach #2: Follow the Golden Rule. You might be surprised how many crises can be averted by just being nice, even if the disputing parties ultimately cannot agree.
13. 15 Pa. C.S. § 1767(a)(2). New Jersey’s statute is nearly identical.
14. See N.J. Stat. Ann. § 14A:12-7(10). Notably, however, a defendant wrongfully sued under the statute can recover attorneys’ fees, as well. See id.