In the corporate setting, it has long been the case that a shareholder can assert a claim on behalf of the corporation when management of the entity refuses to do so – a so called derivative action. Under Pennsylvania’s limited partner statute, a partner (general or limited) can now do the same. A derivative action is one brought by a partner to assert a claim on behalf of the partnership where the general partner refuses to do so.
To bring a derivative action, unless the requirement to do so is excused, the limited partner must first make a demand that the general partner take steps to assert the partnership’s right. The demand must be in “record form” and “give notice with reasonable specificity of the essential facts relied upon to support each of the claims made in the demand.” As will be seen, it is important to carefully craft the demand, since the scope of the derivative claims that can be asserted is limited to those claims identified in the demand and because making the demand also temporarily tolls the statute of limitations on such claims.
After receipt of the demand, the general partner may choose to appoint a special litigation committee (SLC) to investigate the claims asserted in the demand and determine whether pursuing any of them is in the best interests of the partnership. The statute gives the general partner wide discretion to appoint members of the committee, so long as they are not interested in the claims and can exercise objective judgment. Indeed, other limited or general partners may be committee members.
The SLC is then charged with conducting an investigation. The scope of that investigation is limited by the claims set forth in the demand letter and is subject to the good faith requirements of the statute. Within these limitations, the investigation conducted is left to the committee.
Upon conclusion of the investigation, the SLC can make one of several recommendations authorized by the statute. These range from recommending that the claims not be brought (and if brought, discontinued) to recommending that the limited partnership itself assert them. The SLC has ultimate power over the claims as Court is bound to enforce its decision with judicial review limited to whether the members of the committee met the qualifications required under the statute and whether the committee “conducted its investigation and made its recommendation in good faith, independently and with reasonable care.”
I recently used the SLC procedure in a case involving a limited partner who owed a large sum of money to the limited partnership. The general partner authorized a claim against the limited partner to collect the balance due. The limited partner defended the case by asserting that the general partner was improperly appointed and therefore did not have authority to commence the collection action. The limited partner issued a demand for removal of the general partner under the act. I suggested that a special litigation committee be appointed. In this instance, I suggested that one committee member be a retired judge from the county in which the action was pending to defuse any argument that the SLC was not qualified or that it did not act in good faith and independently. As I represented the limited partnership, separate counsel was engaged to represent the general partner before the SLC.
In proceedings before the SLC, the limited partner’s counsel sought to expand the claims to include mismanagement and breaches of fiduciary duty alleged to have been committed by the general partner. Illustrating the importance of properly crafting the demand, the SLC refused to consider any of these expanded claims, holding that its review was limited to the issue raised in the demand – whether the general partner was validly appointed. .
Ultimately the SLC found that the general partner was validly appointed and directed that no claim be brought on this issue. As this claim had already been asserted, the limited partnership was preparing a motion to be filed with the Court to enforce the SLC’s determination when settlement negotiations, which had stalled over a year before, resumed, leading to a prompt settlement. The entire SLC process, from demand letter to decision, took four and one half months – a much quicker resolution, and at less cost, than fully litigating the issue.
The SLC procedure allows an independent review of the merits of derivative claims. If appropriate, such claims can be asserted on the partnership’s behalf or by the partnership itself. However, where such claims are found to be without merit, they can be summarily dismissed. The SLC is a powerful tool to address the merits of derivative claims on an expedited and reduced cost basis.
Many of our previous posts delve into the benefits of resolution of a commercial or shareholder dispute without litigation. Cost, uncertainty and business distraction are factors which often weigh in favor of settlement even at a price which seems unfair. But making a deal necessitates a desire to do so from both sides. As they say, it takes two to tango. If one party is simply not so inclined or the final best offer is simply unacceptable, litigation may be inevitable, and the only mechanism available to bring about resolution.
In a corporate setting, that litigation may take several forms. Choosing the right path is fact intensive and dependent on the relative positions of the parties. Of course, the terms of agreement between business owners may either provide mechanisms for resolution or limit potential alternatives. Regardless, every course of action comes with significant consequences which must be carefully considered prior to embarking on what can be both emotionally taxing and expensive.
Minority Shareholder Strategies
A minority shareholder who is not actively involved in the business has limited options. Unless a shareholders’ agreement provide a mechanism for redemption or transfer, it may be difficult for a minority shareholder to compel a purchase. That minority shareholder would be left to argue that he or she has been “frozen out” from the business, i.e. excluded from information relating to management, oppressed or treated inequitably in terms of distributions of profits so as to trigger an obligation that the company redeem their shares at “fair value”. An action for the appointment of a custodian or receiver is the minority shareholders weapon of choice in that instance. Majority and controlling shareholders are loathe to lose control of what is often their economic life blood.
Majority Shareholder Strategies
A majority shareholder desirous of consolidation of ownership faced with a minority owner not interested in selling also has limited options to compel a sale. In the absence of an agreement which provides for same, there is no provision at law relating to corporations to simply expel a shareholder. With regard to llc’s, the Pennsylvania Limited Liability Company Act provides a limited number of circumstances where the right of expulsion may apply. In either case, involuntary expulsion of a minority interest is no easy task.
The Nuclear Option
The above being said, the nuclear option available to a controlling interest is dissolution. Blow it up, resign all positions which impose fiduciary obligations at law, liquidate the assets and start something new. While the process may be incredibly disruptive to the continuity of business and the personal finances of all the parties, if the separation of the minority interest holder is imperative dissolution may be the only option. The minority may scream breach of fiduciary duty, but in the absence of an agreement among shareholders that the shareholders would not move to dissolve, the success of such a claim at law is speculative at best.
In the end, the decision of whether to engage in such explosive tactics involves a financial analysis but also other factors such as whether the long term interests of the parties require same. In some cases, such as in professional settings, potential irreparable damage to reputation may demand action regardless of the short term pain such action may cause.
In my many years of practice as a commercial litigator dealing with conflicts between shareholders, it has become clear time and again that one of the best things business owners can do when in business with multiple shareholders or partners is to have a well-defined agreement which governs the operations of the business. Not only can that agreement memorialize the respective rights and obligations of the parties, it can also provide dispute resolution mechanisms which may serve the parties well in the event of material disagreement. Utilizing the powers granted by the Business Corporations Law and granted by the terms of an agreement governing business owners can be complex and risky but can often force an acceptable resolution when the status quo is no longer tenable.
In the case of a corporation, a shareholders agreement or by-laws will often identify the corporate office which holds supreme executive authority subject only to removal of that corporate officer by a vote of the directors. If the officer controls sufficient votes from the board, removal by a disgruntled shareholder may be impossible. The acts of the executive are subject to the business judgment rule and granted a certain amount of deference at law.
A majority shareholder who holds the top executive office is free to wield that power, consistent with the business judgment rule, in many ways - including business dealings with outside parties and, generally, with respect to employment decisions. If the disgruntled shareholder is an employee of the company, which is often the case in small business, that shareholder’s continued employment may be at the discretion of the majority. Termination of employment, if justified, is a use of corporate power which often impacts on the relative negotiating positions.
Of course, a majority shareholder who exercises corporate authority can be faced with claims that the minority has been “frozen” or “squeezed” out of the business. In such cases, it is important that the majority have “clean hands” and has avoided self-dealing, corporate waste or fraud as such allegations, if proven, could result in the appointment of a custodian or receiver and a loss of control. Certainly the majority cannot transfer the assets of the business to a new entity controlled solely by the majority. However, the existing entity can be managed in a way that maximizes benefit to the majority consistent with the exercise of business judgment. The existence of a dispute between shareholders does not in and of itself negate the discretion afforded by the business judgment rule.
AMM counsels clients through the minefield of corporate authority and with regard to available strategies to address disputes which arise between business owners.
By Thomas P. Donnelly, Esquire
Reprinted with permission from the November 23, 2015 issue of The Legal Intelligencer. (c) 2015 ALM Media Properties. Further duplication without permission is prohibited.
A high business “tide” does not necessarily float all boats. Often, when business is good and profits increasing, a business owner’s desire to avoid sharing those increasing profits with an underperforming partner can create an irreconcilable divide; particularly in the case of a partner not intimately involved in the day to day operations of the business. Similarly, more difficult economic times stress cash flow, and may motivate a performing partner to explore options to decrease or eliminate that portion of the business income flowing to those performing at a lower level. Of course, the lesser performing partner generally adopts a contrary perspective. In either case, the divergence between two or more partners can render the status quo unacceptable and threaten the business as a going concern.
In approaching disputes among shareholders several factors must be considered. First, does the attorney represent the company, the majority interest, or the minority interest? The practitioner’s potential strategies must be informed by the relative position of the parties. Second, what are the respective goals of the parties? Certainly, the long term goal of extracting the most gain in income or the value of the investment is the goal of all the parties, but short terms strategies can have a dramatic and sometimes unintended consequence. Third, what is the impact of the potential short term strategies, not only on the business, but also on the individuals? Financing arrangements and personal guarantees must be considered. Finally, the respective rights and obligations of the shareholders post dissolution must guide the process.
When approached by a client considering business divorce, the attorney must consider potential conflicts of interest. Often, the majority owner’s first call is to corporate counsel. However, Rules of Professional Conduct 1.7, 1.8 and 1.9 bear upon whether corporate counsel can represent the interests of only one shareholder/member. In summary, representation of the “company” in the same or substantially related matter, or receipt of confidential information which may bear upon the representation of the party not seeking to be represented by corporate counsel, would preclude corporate counsel from undertaking the representation of a single shareholder/member. In some circumstances, it may be appropriate for the company to have separate counsel, such as where the company is a potential defendant in litigation commenced by either a third party or a shareholder. However, such representation is complicated by divergence among board members and can present difficult issues in corporate governance and communication between counsel and the corporate client.
Representation of the majority interest provides for the implementation of whatever remedies may be available under the terms of written agreements among the shareholders or by means of corporate action as to a non-performer. Significantly, there is no statutory right or method for the involuntary removal of a shareholder (arguably, such a remedy may be available in a partnership or Limited Liability Company setting). Potential courses of action include severance of employment or reduction in employment benefits for the non-performer, voluntary dissolution if provided and appropriate pursuant to the agreements between the parties, and modification of corporate governance. Of course, such potential courses of action do not come without risk, and the potential for litigation alleging minority oppression should be anticipated. In such a case, documentation of non-performance and job duties is compelling.
Representation of the minority owner is more difficult. Many times, the minority owner is left with litigation alternatives such as actions for the appointment of a custodian or liquidating receiver pursuant to 15 Pa.C.S.A. Sections 1767 or 1985, respectively. While these litigation remedies can be compelling, it should not be expected that litigation would result in continuation of the status quo indefinitely. Litigation rarely restores a broken relationship. Further, as recently noted by the United States District Court in Spina v. Refrigeration Service and Engineering, Inc. 2014 WL 4632427, a shareholder seeking the appointment of a receiver or a custodian bears a heavy burden and such appointment is at the discretion of the Court.
In addition, litigation alternatives necessarily incorporate business risk. Can the company survive the appointment of a custodian? By definition, a custodian is designed to continue the business as opposed to liquidation. The impact of a custodian on customer relationships, the entity’s capacity to contract and the willingness of business partners to engage in long term planning or projects may render liquidation inevitable. Certainly, the appointment of a custodian or receiver results in a loss of control on the part of the shareholders. All policy and management decisions fall within the purview of the court appointee. Such loss of control can be particularly problematic as it pertains to the case of tax reporting.
That same loss of control must be considered in a liquidation scenario. Liquidation contemplates an orderly winding down and distribution of assets which should be anticipated to include intellectual property and customer lists in addition to any fixed or hard assets possessed by the entity. As noted in Spina, liquidation is generally carried out by public auction so as to ensure fairness among shareholders. In the event of a liquidating receiver, a marketing campaign designed to enhance the value of the assets and maximize the selling price should be anticipated. In such circumstance, neither party may be in a position to acquire the liquidated assets or may be forced to over-pay, thereby rendering such acquisition economically unfeasible. Accordingly, while the goal at the outset of a liquidation proceeding may be to force a buy out of a shareholder, the end result may be that no party is in a position to acquire assets and engage in continued business operations.
The impact of a custodian or receivership on the individual business owners must also be considered. Business owners frequently guaranty corporate debt. The commencement of an action for the appointment of a custodian or receiver is almost always defined as an event of default with regard to the entity’s financing arrangements and could also trigger liability under the personal guaranty.
Finally, post liquidation obligations, or the lack thereof, should also be considered. It should be anticipated that former partners would compete post liquidation. The liquidation of the entity by definition precludes any claim for breach of fiduciary duty on the part of the company to the extent based on post liquidation acts or omissions and any right to enforce a post termination of employment restriction against competition. However, arguably, the sale of the entity’s assets, including confidential information such as customer lists, may implicate the Uniform Trade Secrets Act and preclude use of information known to the shareholders in competition with the buyer. While no case decided under Pennsylvania law addresses the application of the Act to such circumstance, the Act appears to be applicable where a shareholder retains possession of information which was subject to transfer in liquidation.
The complexities of business divorce through litigation mandate that the parties consider and pursue all avenues of amicable dissolution and consider all proposals for voluntary consolidation of ownership before pursuing litigation with uncertain results.
Tom Donnelly is a Partner with Antheil, Maslow & MacMinn. His practice focuses primarily on commercial litigation and transactions, employment disputes and personal injury.