Shareholder Disputes: How to Prevent a Corporate Divorce

March 22, 2012Articles
As seen in Business Lexington.

Small and medium-sized businesses provide valuable goods, services, and jobs. Often, they are run as corporations in which the controlling officers and directors also are the major shareholders. Frequently, friends and family found these businesses together. But even successful businesses owned by friends and family aren’t immune to problems resulting from circumstances and relationships that change over time.

Shareholders may start the business together, but wish to leave at different times based on life events. New, valuable employees might want to be owners, too. Business deals may be made with companies in which some, but not all, of the directors or shareholders overlap. In situations like these, interests can collide.

Successful businesses last a long time, and change is inevitable. But preparation on the front end may eliminate big problems that could arise down the road. While there are few “one size fits all” rules, we suggest some best practices to consider when forming a business.
  1. Put your agreement in writing. Business relationships founded on a handshake may begin with good intentions, but are unlikely to stand the test of time. Businesspeople who spell out their expectations in written agreements obtain greater security about what their understandings really are – and have a contract to look to if problems arise. Shareholders’ agreements also let you address how to handle major events – like adding shareholders, or an owner’s retirement – before they happen.
  2. Pick your partners wisely. Closely-held corporations are like marriages. When personalities mesh and goals are aligned, the family can prosper. When they don’t, you may end up in a nasty divorce. And when you have a very different idea from your partners in the beginning about what’s fair, or what everyone’s role should be, or what the business will look like in ten years, a divorce is inevitable.
  3. Hold formal meetings and keep good records. Important decisions are made when a business is formed, as well as when it is established and thriving. Your fellow shareholders may seem happy with those decisions, but looks can be deceiving. A good corporate secretary, keeping records of votes and discussion on important decisions in corporate minutes, may prove invaluable later on if someone wasn’t as happy as you thought they were. Good minutes are more than a mere formality.
  4. Know what you signed up for. Board membership is a serious responsibility. Directors owe special duties to the corporation and its shareholders. This fiduciary relationship is sacred in the law, and you are held to a higher standard of conduct as a result. Consider training your board members on their responsibilities so that they know how to discharge them faithfully.
  5. Consider outside voices. Once your corporation is established, hiring an outside director (someone uninvolved in your business) to serve on your board may be advisable. Outside directors with open minds will consider board proposals from a fresh perspective. They also may insulate management’s proposals to the board from second-guessing.
  6. Counseling in-house. In-house attorneys are tremendous resources. With business minds and legal backgrounds, they can help members of your management team navigate through decisions big and small. But business advice can be closely related to legal advice, and only legal advice is protected under the attorney-client privilege. Consider carefully what you ask your in-house lawyers to do.
  7. Keep shareholders informed. Information is power, and it is expected to be imparted to the shareholders, particularly in a closely-held business. Informing shareholders of a major corporate action only after it’s been taken may lead to arguments about the action’s propriety.
  8. Full disclosure. Closely scrutinize transactions between a director or major shareholder (or another business they own) and your corporation. A failure to ensure that a deal is fair to all, and especially to the corporation, invites a claim that the director involved in the transaction breached his fiduciary duty. It also may result in a claim that the other directors let their colleague take advantage of the corporation, and by doing so breached their own fiduciary duties.
  9. Good policies are a good policy. Business records take all forms – monthly accounting data circulated on spreadsheets; emails on a server; individual files in drawers throughout the office. Having a well-thought-out policy on document retention, email usage, and documents that simply shouldn’t be removed from the building helps you manage risk. If a problem arises, you don’t want to have to explain why you have some records dating to your company’s inception, but you’ve permanently purged an email sent ninety days ago, unless you have a written policy on point.
  10. Insure your risks: Internal disagreements may result in claims against directors or officers when they make a decision that a shareholder doesn’t like. While courts afford deference to a board’s decisions under the “business judgment rule,” directors may face personal liability on these claims, and the costs to defend themselves, in the absence of commonly-acquired Director & Officer (“D&O”) insurance. D&O coverage is simply a must.

Avoid the corporate divorce before it happens. A little advance planning can go a long way.