United States: Litigation Lessons: When Closely Held Business Owners Disagree

Have you seen the latest?" Mike, the fifty percent owner of a real estate investment firm asked his administrative assistant. "That son-of-a-gun is charging the company for his 'administrative services,' work he agreed to do as part of his general contribution to the business. He refuses to approve payments for needed repairs, and he won't even talk about selling the McDonald Building now that the market has peaked. I can't out-vote him, and I won't allow him to sink my investment. Is there anything we can do?" Mary responded, "You know, I think you had better call Attorney Jones and talk to him about filing to dissolve the company. It looks to me as though Billy Bob is driving the company into the ground, and we don't need to be part of that mess. Let's see what Mr. Jones has to say."

The owners of closely held corporations sometimes disagree as to the plans for the company's future, the relative worth of their contributions and a host of other matters large and small. When those disagreements result in an irretrievable break-down in communication, and no owner can out-vote the other(s), things can go badly for the company. The law in most states attempts to address these difficult dynamics in a way that preserves both the ownership stakes of the disputing parties and the underlying business of the company. This is not a perfect process, however, and it behooves business partners to anticipate the potential for disagreement and plan accordingly.

The law allows one or more of the deadlocked parties to petition the court to dissolve the company. Before a court will let an owner or ownership group "pick up their marbles and go home," however, the owner(s) seeking dissolution must establish: 1. the directors are deadlocked in the management of the company's affairs; 2. the shareholders are unable to break the deadlock; and, 3. the company is threatened with irreparable harm. The court can also order dissolution where the company's affairs can no longer be conducted to the advantage of the shareholders. Finally, a court can order dissolution where it finds that the directors or those in control of the corporation acted, are acting, or will act in a manner that is illegal or fraudulent.
Even where the court determines that the company can be dissolved, there is still room for one or more of the shareholders who want to perpetuate the company to do so. To be exact, those who wish to continue the business can agree to buy out the dissenter. This election must be made within ninety days of the request for dissolution. The law makes an election to purchase the dissenter's shares irrevocable unless the court determines there is some good reason to set aside or modify the election. The parties have sixty days after the election to purchase to agree on a price for the departing shareholder's shares. By electing to purchase the dissenter's shares instead of dissolving, the company's operations are preserved.
If the parties cannot reach agreement on the price to be paid to the dissenter, the court can determine the fair value of the petitioner's shares as of the day before the date on which the petition was filed or as of such other date as the court deems appropriate. Fair value does not mean "fair market value," but rather means what the dissenter's shares are fairly worth---a determination potentially subject to significant debate. Once the court determines the fair value of shares, it orders their purchase for that price, upon such terms and conditions it deems appropriate. The terms of purchase can include provisions such as installment payments and/or security for installment payments. The court can also allocate the fees and costs associated with the valuation proceeding.
The problem with the law is that the parties can wrangle over the fair value of a dissenter's shares only to have the result unwound if within 10 days of the court's final determination of the terms of purchase, the company votes to dissolve rather than buy the dissenter's shares according to the terms established by the court. The vote to dissolve puts the company right back where it was when the petitioning shareholder first went to court seeking dissolution. The only difference is that by the time the court valuation process is completed, the litigation has usually gone on for years, with all the costs associated with that process.
While it is helpful that the law allows the owners of a dead-locked corporation to get their investment back, there is lots of room for controversy. For example, the meaning of "fair value" is not fixed by the "market" as is "fair market value."  Even "fair market value" is debatable when applied to the valuation of an asset without a ready market. Of course, where there is ambiguity, the time and money it costs to reach resolution can escalate. Likewise, finding capital or diverting operating income to buy-out a significant stakeholder can be challenging in the best circumstances. It is also unnerving for the petitioning shareholder to know that the company could vote to dissolve after a costly valuation process and the passage of time that may further erode the company's value.
Owners in closely held business may therefore want to anticipate the potential for disagreement in fashioning their business agreements. They should, for instance, have a clear understanding on issues like how and when they will be called upon to contribute additional capital, the expectations for the ongoing commitment of time and attention to the business, and how leadership of the company will change over time. Second, they can agree to procedures for resolution in the event of a deadlock. For example, they might agree to a mechanism for valuing their interests such as by using a multiple of the company's revenue averaged out over the prior three years. They might also stipulate that in the event of litigation over the value of a dissenting shareholder's interest in the company, the loser will pay the attorneys' fees and costs of the winner---a powerful incentive to be reasonable and avoid litigation.

Scott Harris, is a director in the Litigation Department of  McLane, Graf, Raulerson & Middleton, Professional Association.

Published in the New Hampshire Business Review

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