Navigating Shareholder Litigation

April 3, 2012Articles

As seen in Business Lexington.

Even the best relationships can sour, and business relationships are no exception. Indeed, the longer a business lasts and the more changes it experiences over its lifetime, the greater the possibility that mere disagreements can turn into full-blown legal disputes. If you hold a majority stake in a business, how can you minimize the harm to yourself and your business as a result of the dispute? We suggest the following best practices:

  1. Contact your attorney and your insurer. Take the time once you receive a demand to call your lawyer, and ask if he or she can represent you – or find someone else who can. Next, call your insurance carrier and put it on notice of the claim (and if you don’t have D&O coverage, then you need to acquire it ASAP). Shareholder litigation can be expensive, and you do not want to foot the bill. Plus, if you do not advise of the claim when it first arises, the insurer may disclaim coverage. 
  2. Implement a “litigation hold.” Shareholder litigation is document-intensive. In past decades, a business could meet its obligation to preserve relevant documents by not disposing of any records. Today, this kind of passive compliance is insufficient. A corporation sued must actively preserve all documents that may be relevant to a pending litigation, including ceasing the automatic deletion of electronic records. Proper implementation of this "litigation hold" requires communication and cooperation among counsel, executives, and your IT personnel. Failure to preserve all such potentially relevant evidence, however, can be used against you. 
  3. Consider an investigation by an independent board committee. If the shareholder's complaint is at the board level, consider having it investigated by an independent committee appointed by the board. Such an action could stave off a lawsuit or at least constitute evidence of the reasonableness of the challenged board action. 
  4. Re-consider the value of the challenged action. It is difficult to change course due to a shareholder complaint, but take a moment to reflect on the action you are planning and the shareholder's complaint. Try to see things from the complaining shareholder's point of view, and think about whether the challenged action is truly worth the costs of a lawsuit. 
  5. Explain the reasons for the decision. After you have re-thought your decision, and if you still decide to implement it, then you should have identified some justifications for the decision. Share them with your fellow shareholder. Doing so may defuse the situation from the beginning. 
  6. Discuss oppression with your board and avoid its hallmarks. Disgruntled minority shareholders often claim in lawsuits that the majority shareholders have oppressed them. “Oppression” is a vague cause of action, and is better identified by its “hallmarks,” or characteristics: (1) a reduction in the number of shares a minority shareholder owns, or dilution of the minority shareholder’s interest through the issuance of additional shares; (2) the award of benefits to the majority shareholders or parties related to them (e.g., favorable contracts with businesses owned by majority shareholders); (3) the discontinuance of dividends, especially when the business can pay them; (4) low buy-out offers to the minority shareholders by the corporation; (5) a lack of marketability of the minority shareholder’s interest; and (6) any factor which effectively minimizes the value of the minority shareholder’s investment. The corporation’s management should be educated about these hallmarks, and cautioned to avoid them. 
  7. Keep your cool and consider your audience. If you have ever been criticized, then you know it is tempting to fire off an angry letter to whoever is coming after you. In this case, resist the temptation. A shareholder will be seeking to prove that he is being oppressed. Sending an angry letter may help him prove his point. 
  8. Know your end-game. When involved in a lawsuit, it is easy to mistake the forest for the trees. Consider whether a simple dismissal of the action is what you truly want to achieve. For example, a superior result in the long run may be to buy the complaining shareholder out – indeed, that may be what that shareholder wants, too. Except in rare circumstances, however, a court cannot simply order a buy-out. A negotiated settlement is often in everyone’s best interests. 
  9. Consider derivative claims and liability for attorney's fees. A derivative lawsuit is a common means of attacking corporate management’s decisions. In a derivative suit, a shareholder sues a corporation’s management in the name of the corporation to recover for harm to the corporation. Derivative suits are dangerous in and of themselves, but in many states, a prevailing shareholder also can recover his or her attorney’s fees from the corporation. Since these fees can be significant, it is important to consider them in assessing the value of a derivative action.

Shareholder litigation is legally complicated and fact-intensive, and is marked by hurt feelings and bad blood. These cases can be exhausting and expensive. But by following these best practices, you can minimize your exposure in shareholder litigation and increase the likelihood of a desirable resolution.