Background
“Business Divorce” is the emerging title for the practice area dealing with shareholder, partnership, membership and other internal disputes in closely-held or family-owned companies.
“The acute vulnerability of minority shareholders in the closely-held corporation is well recognized. It stems principally from two factors. Because of its controlling interest, the majority is able to dictate to the minority the manner in which the corporation shall be run. In addition, shares in closed corporations are not publicly traded and a fair market for these shares is seldom available.” Orchard v. Covelli, 590 F. Supp. 1548, 1557 (W. D. Pa. 1984)
How the issues arise:
- The forces that built the business are now pulling it apart
- Often sudden and unexpected
- Highly emotional and stressful
- Frequently leads to economically irrational behavior
- Clients are implicated
- And, employees are implicated
What are the common complaints?
The majority owner(s) or the owner(s) running the daily operations is(are):
- Withholding distributions of company profits creating taxable “phantom” income
- Majority is withholding salary from the client
- Issuing unnecessary cash calls to put unnecessary financial pressure on one or more owners
- Terminating, restricting or precluding the client from employment in the company
- Taking excessive salaries, expenses, or fringe benefits and eliminating the profits
- Withholding information about the operation of the company
- Misappropriating company assets
- Failing or refusing to hold company/board/management meetings
- Preventing participation in the company decision-making
- Operating a competitive side business
- Setting up an exit plan and recruiting clients and key employees
What are some of the legal claims and rights that can be asserted?
Breach of Contract
- Violation of Restrictive Covenants
- Violation of Confidentiality Provisions
Breach of Fiduciary Duties
- Usurpation of Corporate Opportunities
- Oppression
Statutory Books and Records Inspection Accounting
- Compelling the controlling owner to account for revenue and expense
Trade Secrets
Who may assert the claims – The shareholder or the corporation?
The duty of the board of directors, committees of the board and individual directors under section 1712 (relating to standard of care and justifiable reliance) is solely to the business corporation and may be enforced directly by the corporation or may be enforced by a shareholder, as such, by an action in the right of the corporation, and may not be enforced directly by a shareholder or by any other person or group.
15 Pa.C.S.A. § 1717, Limitation on standing
To have standing to sue individually, the shareholder must allege a direct, personal injury—that is independent of any injury to the corporation—and the shareholder must be entitled to receive the benefit of any recovery.
Hill v. Ofalt, 85 A.3d 540, 548 (Pa.Super.,2014)
Breach of contract
Every business venture between two or more owners is the product of an agreement. Somewhere a decision was made to go into business together so there IS some agreement even if the parties neglected to reduce it to writing.
The first task is to determine “what was the agreement:”
If there is a writing, what does the agreement say about the issues in dispute?
What if there is no writing or the writing ambiguous on a point of contention?
- If ambiguous, we analyze the language under the rules of contract construction.
- Parol evidence (oral testimony) will be admissible to explain the ambiguity.
- Look at the course of dealing for indicia of the parties understanding of the agreement
Fiduciary duties among business owners
Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions. * * * Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court.’
- Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545 (1928) as quoted in Seaboard Industries, Inc. v. Monaco, 276 A.2d 305, 310, 442 Pa. 256, 264 (Pa. 1971)
The Standards of Review a Court uses to review the actions of the officers and directors
Business Judgment Rule . . .
- The “business judgment rule” insulates an officer or director of a corporation from liability for business decisions made: (1) in good faith; (2) where the director or officer is not interested in the subject of the business judgment; (3) is informed with respect to the subject of the business judgment to the extent he reasonably believes to be appropriate under the circumstances; and (4) rationally believes that the business judgment in question is in the best interests of the corporation.
- Viener v. Jacobs, 834 A.2d 546, 557 (Pa. Super. 2003)
Or “Intrinsic fairness”
Where a majority shareholder stands to benefit from his decisions as a controlling stockholder, the law requires that the majority’s action be “intrinsically fair” to the minority interest.
Minority Oppression
A policy of corporate governance which has as its objective the denial of benefits to the minority interest runs afoul of this fairness standard and calls to question the majority’s fulfillment of its fiduciary duty to the other shareholders.
Orchard v. Covelli, 590 F. Supp. 1548, 1556 (W.D. Pa. 1984)(Internal cite omitted)
Statutory duties of officers and directors of a corporation
- (a) Directors.–A director of a business corporation shall stand in a fiduciary relation to the corporation and shall perform his duties as a director, including his duties as a member of any committee of the board upon which he may serve, in good faith, in a manner he reasonably believes to be in the best interests of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances.
- (c) Officers.–Except as otherwise provided in the bylaws, an officer shall perform his duties as an officer in good faith, in a manner he reasonably believes to be in the best interests of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances. A person who so performs his duties shall not be liable by reason of having been an officer of the corporation.
- 15 Pa.C.S.A. § 1712. Standard of care and justifiable reliance (See also, 15 Pa.C.S.A. § 512)
Usurpation of Corporate Opportunity
The Corporate Opportunity Doctrine precludes an officer or director “from appropriating to himself a business opportunity which in fairness should belong to the corporation, and subjects any property or profit he so acquires to a constructive trust in favor of the corporation.”
74 Harv. L. Rev. 765
In Pennsylvania, “if there is presented to [an officer or director] a business opportunity which is within the scope of its own activities and of present or potential advantage to it, the law will not permit him to seize the opportunity for himself; if he does so, the corporation may elect to claim all of the benefits of the transaction. Nor is it material that his dealings may not have caused a loss or been harmful to the corporation; the test of his liability is whether he has unjustly gained enrichment.”
Ciampa v. Conversion Sciences, Inc., 2015 WL 8196712, at *10 (Pa.Super.,2015) (quoting Lutherland, Inc. v. Dahlen, 53 A.2d 143, 147 (Pa.1947)).
Judicial Dissolution of a Limited Liability Company
Old rule: 15 Pa.C.S.A. § 8972, Judicial dissolution
- On application by or for a member, the court may order dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with the operating agreement.
New rule: 15 Pa.C.S.A. §8871, Events Causing Dissolution
- (4) On application by a member, the entry by the court of an order dissolving the company on the grounds that:
- (i) the conduct of all or substantially all the company’s activities and affairs is unlawful;
- (ii) it is not reasonably practicable to carry on the company’s activities and affairs in conformity with the certificate of organization and the operating agreement; or
- (iii) the managers or those members in control of the company:
- (A) have acted, are acting, or will act in a manner that is illegal or fraudulent; or
- (B) have acted or are acting in a manner that is oppressive and was, is or will be directly harmful to the applicant.
- (b) Other remedies.–In a proceeding brought under subsection (a)(4)(iii)(B), the court may order a remedy other than dissolution.
Judicial Dissolution Of a General Partnership
Old Rule: § 8354. Dissolution by decree of court, PA ST 15 Pa.C.S.A. § 8354
- (a) General rule.–On application by or for a partner, the court shall decree a dissolution whenever:
- (1) A partner has been declared a lunatic in any judicial proceeding or is shown to be of unsound mind.
- (2) A partner becomes in any other way incapable of performing his part of the partnership contract.
- (3) A partner has been guilty of such conduct as tends to affect prejudicially the carrying on of the business.
- (4) A partner willfully or persistently commits a breach of the partnership agreement or otherwise so conducts himself in matters relating to the partnership business that it is not reasonably practicable to carry on the business in partnership with him.
- (5) The business of the partnership can only be carried on at a loss.
- (6) Other circumstances render a dissolution equitable.
New Rule: § 8481. Events causing dissolution, PA ST 15 Pa.C.S.A. § 8481
- (4) On application by a partner, the entry by the court of an order dissolving the partnership on the grounds that:
- (i) the conduct of all or substantially all the partnership’s business is unlawful;
- (ii) the economic purpose of the partnership is likely to be unreasonably frustrated;
- (iii) another partner has engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with that partner; or
- (iv) it is otherwise not reasonably practicable to carry on the partnership business in conformity with the partnership agreement.
Judicial dissolution of a limited partnership
Old Rule: 15 Pa.C.S.A. § 8572, Judicial dissolution
- On application by or for a partner, the court may order dissolution of a limited partnership whenever it is not reasonably practicable to carry on the business in conformity with the partnership agreement.
New Rule: 15 Pa.C.S.A. 8681, Events Causing Dissolution
- (6) on application by a partner, the entry by the court of an order dissolving the partnership on the grounds that:
- (i) the conduct of all or substantially all the partnership’s activities and affairs is unlawful;
- (ii) it is not reasonably practicable to carry on the partnership’s activities and affairs in conformity with the certificate of limited partnership and partnership agreement; or
- (iii) the general partners have acted, are acting or will act in a manner that is illegal or fraudulent.
Judicial Dissolution Burden of Proof, or fait accompli?
“the equity court should remember that involuntary dissolution is a drastic remedy to be employed cautiously and only in clear cases.”
O’Farrell v. Steel City Piping Co., 403 A.2d 1319, 1325, 266 Pa. Super. 219, 232 (1978)
In a recent Pa case, one of two 50/50 LLC members complained that the other was operating the company to his exclusion. The Court found that the failure to operate in accordance with the operating agreement justified an involuntary dissolution notwithstanding that the company was operating profitably. Staiger v. Hollohan, 100 A.3d 622 (Pa. Super. 2014). There, the party seeking the dissolution was deemed the oppressed rather than oppressor.
What if the party seeking dissolution is the oppressor – does the Doctrine of Unclean Hands protect the victim of the oppressive majority/controlling shareholder?
- Except to the extent otherwise provided in this title in cases where a statutory remedy is provided by this title, the court shall have the powers of a court of equity or chancery insofar as those powers relate to the supervision and control of corporations and other associations.
- 15 Pa.C.S.A. § 104.
Books and records inspection
(b) Right of inspection by a shareholder.–Every shareholder shall, upon written verified demand stating the purpose thereof, have a right to examine, in person or by agent or attorney, during the usual hours for business for any proper purpose, the share register, books and records of account, and records of the proceedings of the incorporators, shareholders and directors and to make copies or extracts therefrom. A proper purpose shall mean a purpose reasonably related to the interest of the person as a shareholder. In every instance where an attorney or other agent is the person who seeks the right of inspection, the demand shall be accompanied by a verified power of attorney or other writing that authorizes the attorney or other agent to so act on behalf of the shareholder. 15 Pa.C.S.A. § 1508. Corporate records; inspection by shareholders
What are the possible remedies?
- Money damages
- lost profits
- punitive damages
- Specific Performance
- Injunctive relief
- Books and Records Inspection 15 Pa.C.S. § 1508 (Corp), 5508 (Nonprofit) , __08 (LLC), __08 (LP)
- Appointment of a Receiver 15 Pa. C.S. A. § 1984, (Compare Delaware “Custodian”)
- Constructive Trust
- and, anything the Court desires???
- See 15 Pa.C.S.A § 104
- See 15 Pa.C.S.A. §8871(b)
