January 1, 1900

by Francis J. Sullivan

According to the U.S. Chamber of Commerce, small businesses (companies with less than 500 employees) represent 99.7% of all employer firms in the United States and employ one-half of all private workers. It is estimated that there are over 5.7 million employer firms operating in excess of 7.1 million business establishments in the United States in all industry categories. Small businesses account for over 50% of the private sector output and generate 60-80% of new jobs annually. The substantial majority of small businesses are legally formed as corporations. Moreover, as these statistics demonstrate, most small business corporations are entities which generally have less than 30 owners or shareholders and typically the owners are often family members or are close friends who have decided to become business partners. Often, the ownership of the small business and the personal life of the owners are inextricably entwined. Thus, the hallmark of most American small businesses is a strong interpersonal relationship, familial or otherwise, upon which the business is based. Therefore, there is no surprise that when the strong, interpersonal relationship shatters, the effect upon the business can likewise be catastrophic.

Causes of Business Divorce

The business divorce is often the culmination of internal business conflicts such as financial problems as well as financial successes, using the business to pay for personal expenses, personality conflicts, nepotism, marital problems, drugs and substance abuse problems, embezzlement of funds, arguments over control, sexual harassment lawsuits, managerial incompetence, wasted assets or just general disagreement on day to day business issues argued in an environment where all trust has been lost. When the survival of a small business is tied to the continuing vitality of intimate personal relationships, and the parties are unable to separate the business and personal aspects of their relationships, then, like the disintegration of a marriage, unless + the parties have entered into a carefully drafted “pre-nuptial” agreement, the parties inevitably contact their lawyers and the business divorce war erupts and litigation commences.

Typically in a small business, there is a diversity or separation of labors between the owners. Often there is the inside person who handles the business operations while the outside, or sales function, is the responsibility of another owner. There are numerous variations on this theme, especially if there are different or distinct lines of business but the common thread is that one owner has decided that the other owner has to go. This decision is manifested generally in one of two ways. One shareholder engages in a course of action to “squeeze out” or “freeze out” the other or sets up a new business operation and diverts business opportunities and assets from the commonly owned business to the newly created business. Frequently, a difference in ownership percentage among owners dictates what scenario occurs. However even when the ownership is on a 50/50 basis, where there is a stronger, more powerful personality and “runs” the business (sound familiar), these scenarios remain the same. Other less frequent scenarios involve the majority owner deciding to sell his interest, which causes the minority owners to scramble to protect their investment. Usually, this scenario occurs when the majority owner is an investor or has now decided that it is time to cash out. Thus, absent a well drafted owner or shareholder agreement (covering buyout issues and valuations, employment issues, put-call rights, drag along or tag along provisions) made while the owners still liked each other and which contemplated and determined how shareholders will deal with each other in these situations, the seeds for the business divorce are sown.

Impact of Fiduciary Obligations

In most small businesses, an owner/shareholder often times is also a director or officer of the company. Directors and officers owe fiduciary obligations to the corporation and its shareholders. Moreover, even if a majority shareholder is not officially nominated as a director or officer, the fiduciary relationship still exists. Thus, one standing in a fiduciary relationship with another is subject to liability for harm resulting from a breach of duty imposed by that relationship. A fiduciary relationship exists between persons when one of them is under a duty to act for or to give advice for the benefit of another upon matters within the scope of the relationship.

In Pennsylvania, the fiduciary obligation carries with it both the duty of care and the duty of loyalty. An officer or director of the corporation must perform his duties as an officer in good faith, in the best interest of the corporation and with such care, skill and diligence, as a person of ordinary prudence would use under similar circumstances. Pennsylvania Law provides that a fiduciary cannot directly or indirectly make a profit at the expense of the corporation. Accordingly, diverting assets (including confidential or proprietary information) or business opportunities from the corporation to another entity which benefits the shareholder /director/officer is prohibited. Similarly, a “squeeze out” or “freeze out” of a shareholder is a breach of fiduciary duty.

It is obvious that when owners of a small business decide to divorce, the declarations of breach of fiduciary duty will sound loudly and often. Secrets shared and confidences given will become weapons wielded by the owners against each other, often spelled out in embarrassing, lurid detail in the lawsuits and counterclaims that inevitably follow after the decision to divorce is made. These allegations, all based on the principal of breach of fiduciary duty, may and most likely will encompass claims for (1) interference with contractual relationships; (2) misappropriation of trade secrets and confidential information; (3) unfair competition; (4) usurpation of corporate opportunities; and (5) conversion of corporate assets. Preemptive actions in the nature of injunctions are also often employed. In summary, a business divorce can quickly become hostile, deeply acrimonious and extraordinarily expensive especially when, in addition to the claims for damages, the shareholder, who is not in control of the business, seeks the further remedy of dissolution of the entity and/or the appointment of a custodian over the operations of the business.

Majority vs Minority Owners

Typically, disputes between owners involve a fight between the “majority” versus the “minority” owner. This majority/minority dichotomy can be based upon a difference in the percentage ownerships but frequently occurs when one owner is no longer actively engaged in the business operations of the corporate entity, and the “majority” owner is in place operating the business. Many times, the out of office owner was also an employee, and his employment has been terminated by the majority or stronger owner. Under either circumstance, the ability of a minority owner to seek redress from the courts under Pennsylvania law is limited by the obligation to prove that the majority owner has been acting “illegally, oppressively or fraudu­lently” against the minority owner.

Generally, Pennsylvania Courts will impose upon the majority owner to act with the utmost good faith and loyalty in transacting corporate affairs. The courts look at actions taken by the majority as they affect the minority owner to make sure that they are “intrinsically fair” to the minority’s interest in the business. A minority owner is acutely vulnerable in the small business setting principally because of two factors. First, there is no market liquidity for his minority interest. Secondly, because the majority owner has controlling interest, he is able to dictate to the minority owner the manner in which the corporation will be operated. As a consequence, the challenge by a minority owner to the conduct of a majority owner places the minority owner on the horns of a dilemma. He cannot profitably leave nor safely stay because, in reality, the only buyer of his minority interest in the business will be the majority owner.

Under Pennsylvania law, a dissatisfied minority owner has a heavy burden enlisting the Courts to craft a remedy which would secure the value of his minority ownership interest. Unless the minority owner can prove that he has essentially been the victim of a “squeeze out” or “freeze out”, with a showing that the majority has acted “illegally, oppressively or fraudulently”, the minority owner may find himself on the outside without any remedy to either recover the value of his ownership interest or regain the ability to participate in the operation of the business.

Litigation Remedies

In litigation between warring owners, the lawsuit will contain the causes of action cited above and most likely will also contain provisions seeking the appointment of a custodian over the business or will seek the court to liquidate the business entity by the appointment of a receiver to wind down and dissolve the entity. Pennsylvania law would authorize the court to appoint a custodian over the business when there is a deadlock on the Board of Directors, the shareholders are unable to elect directors or those in the control of the corporation have acted “illegally, oppressively or fraudulently” toward one or more holders or owners of 5% or more of stock in the business. Dissolution of the entity may also be a remedy brought by the majority. However, dissolution is rarely imposed by the Courts in Pennsylvania even where there has been “illegal, oppressive or fraudulent” conduct against the minority because Section 1981 also requires that the dissolution of the corporation “be beneficial to the interests of the shareholders that the corporation be wound up and dissolved”.

The reasons why most Pennsylvania Courts are loath to order a dissolution of a corporation are both numerous and valid, not the least of which is the loss of jobs and economic benefits to the employees as well as to third parties who deal with the corporation. Moreover, in almost all litigation between shareholders, the ultimate issue, whether statutorily provided or as a result of the Court’s exercise of its equitable powers, will be the buyout of one shareholder by the other. Although Pennsylvania law does not provide for a buyout of a minority shareholder’s interest, as does the business corporation law of other jurisdictions, Pennsylvania Courts have been leaning towards a judicially crafted remedy in the form of a forced buyout of the minority shareholder’s interest in the small business.

Avoiding Litigation

Ultimately, the ability to resolve the business divorce, like a marital divorce, is in the hands of the divorcing parties. Different mechanisms can be utilized to resolve the conflict, either before or after litigation commences. A well drafted Shareholders Agreement (there is a theme here) can outline how the conflict will be resolved but absent an agreement, experienced counsel for both sides know that non-judicial resolutions are favorable over a Court mandated resolution. Mechanisms such as face to face negotiations or mediation through an independent, experienced third party can resolve expensive litigation. Sometimes, dividing the business by product line or geographic area can work.

Finally, if no solution appears satisfactory, the parties can agree to sell the business—assuming the sales price can be agreed upon—or absent a willingness to sell, the parties can agree for one to buy out the other. The buy out by one of the other can also cause the fight to continue interminably. Thus, a frequently used mechanism to avoid the continuation of the fight over the valuation is to employ a “Russian Roulette” theory of setting the price. The “Russian Roulette” theory simply provides that the party offering to sell will state the price at which he wishes to sell while the other third party has the option to be either a buyer or seller at that stated price. Reality, fairness and balance can be the result of this approach provided that the use of the “Russian Roulette” mechanism is not hamstrung by numerous and unreasonable conditions.

In conclusion, a business divorce, like a marital divorce, is an emotional rollercoaster for all involved. When the decision to divorce is made, unless there is an effective, well drafted Shareholders Agreement, the process of resolving all the owners’ interest in the business will be an experience that prudent, small business owners will never, ever wish to repeat.

Francis J. Sullivanis partner-in-charge of the Business & Commercial Law Practice Group of Hill Wallack LLP in the Langhorne, Pennsylvania Office