Clearing the Fog of War in Disputes Over Control of Closely Held Entities: What You Should Consider Before the Battle Begins

Serious problems are created when the co-founders or successors of a  successful closely held businesses become disenchanted with each other’s continuing contributions to or goals for the enterprise.  Whether the founders are family or not, it is altogether common for some to slack off, develop different goals and aspirations, have operational differences, or just feel underpaid and under loved.  These circumstances often fester for years until someone reaches their breaking point and seeks to assert control or force changes to remedy their real or perceived grievances.  Regardless of the legal form of the business[1], these circumstances often result in an inability to reach consensus or make important business decisions, which threaten the long term viability  of the business.  While the form of the organization, the dynamics, personalities of the owners and their historical relationship all shape the dispute, some of the worst outcomes result from a lack of planning and strategy once it is apparent that disharmony has become the norm.

The Causes

A wide variety of circumstances can cause business disputes among owners of closely held entities.  Typical situations include:

• The death of a founder;
• A disparity between the personal commitment of the owners to the enterprise;
• The effect of ownership by one faction of ancillary businesses, which compete or contract with a jointly owned entity;
• A belief that someone is not being fairly compensated;
• A difference in opinion or unwillingness to adopt a common plan for the future;
• Different risk profiles;
• An un-willingness to increase or borrow new capital;
• Competition for a dominant internal position;
• A belief in malfeasance.

The Wrong Reaction

Often, the first reaction of the principals to an internal dispute is to employ legal counsel to threaten or bring litigation against the other.  This naturally tends to harden positions and sets the stage for the parties to be convinced that immediate litigation is the only solution.  While this is sometimes the case, any business owner who does not fully exhaust alternative methods to resolve such disputes, or at least carefully plan litigation options, may later conclude that he or she strayed down the wrong path.  This is a time for dispassionate deliberation.  Immediate legal action, without proper analysis, can forestall other resolutions and create cost and emotional barriers to a more elegant or practical solution.

The variations between the types of businesses, the nature of the disputes, the power dynamics between the parties, the amounts in dispute, and the varying contractual rights, duties and conduct means there is no one size fits all methodology.  However, the one most important precursor to any action plan is having a clear-headed analysis completed which considers, not only the factual and legal merits of any dispute, but also how one can best reach a favorable end result.  What are the alternative strategies which should be explored before giving in to the desire to undertake a full frontal attack.

The Initial Skirmish Can Lock in Defeat

The most important step for a business owner who sees a war unfolding is to work with a highly experienced attorney who can reverse engineer the steps necessary to reach the best long term possible resolution of the disputes.  If one finds themselves facing disputes affecting the future of your enterprise, find someone who has the talent and credibility to pursue both consensual resolution and, if necessary, judicial victory.

Many business litigation attorneys will consider this approach to be heresy.  They will argue that being the first to act aggressively is key to demonstrating resolve and instilling fear in the opposition.  A recent exemplar of that philosophy involved a family dispute over control and direction of a $100 million company.  One side filed a complaint which became known by customers, creditors, and employees.  The harm from the public display of disharmony caused difficult problems impacting the value of the enterprise.  A year into the fight and the case was no closer to resolution.  All that was accomplished is that the company in dispute was worth less and the owners had spent a lot of time and money.  Private arbitration could have benefitted all.  Some disputes, where immediate adverse consequences will flow without judicial relief, do require immediate injunctive relief or other equitable intervention.  But the majority of these disputes have festered for years and time allows for a more thoughtful approach.

In another case, one side of a family that owned a half interest in corporations that owned vast amounts of undeveloped agricultural land, became unhappy with the lack of communications from and high salaries paid to favored family members who had operational control.  An attempt to self-mediate at a shareholders’ meeting went badly and shortly thereafter a lawsuit was filed seeking removal and replacement of officers and damages for self-dealing and breaches of fiduciary duty, as well as a claim for corporate dissolution.  The litigation was contentious and discovery and motion practice plodded along for over a year.  During this time, real estate values had improved.  As plaintiffs were pressing on discovery, the defendant made the election to start the statutory appraisal and mandatory buy-out process triggered by the cause of action for dissolution.  The appraisal process itself took another year.  Property values continued to rise.  By not fully considering the ramifications of the claim for dissolution, the plaintiffs made themselves subject to being bought out by the defendant 50% shareholder at a liquidation price set by court appointed appraisers.  The value was measured as of the date of the filing of the original complaint.  Plaintiffs had not considered this result.  They ended up having to sell out at a discounted value below the market.  In essence, the defendant got a free option to buy 50% of the shares based on appraisals valuing the corporations on what they were worth when the litigation commenced.  Plaintiffs also faced potential adverse tax consequences.  This could have been avoided by simply pursuing their claims of impropriety first and, if unsatisfied with the result, bringing a second suit for dissolution.

A Better Way

A more productive approach is illustrated by a matter in which corporate counsel for a large group of family-owned companies, which owned a vertically integrated agricultural business, convinced the owners to take a different approach.  A major dispute had arisen between the second and third generations over the intent of an ancient stock purchase agreement made by the founders.  The family members who worked for the companies had far different perceptions and goals than those who did not.  A lawsuit was filed, but corporate counsel was able to encourage all sides to spend the time and money to seek an agreement which would attempt to compromise a panoply of business issues.  The negotiations took almost three years.  Having a judge willing to allow the parties the ability to delay proceedings, while retaining their respective positions, allowed for detailed due diligence and a series of mediations.  Responsible counsel for each of the parties were able to keep the negotiations ongoing and civil until every business issue was resolved.  Instead of seven law firms each charging a million dollars to complete discovery and try the case, the clients’ resources were focused on tax, leasing, and other business issues.  This was a true success for the enterprise and its shareholders.

The initial selection of an attorney who sees the whole battlefield, is the most important decision an owner will make when war is on the horizon.  It is critical that a cohesive strategy is developed that considers every potential material factor to reach a best case resolution with a full evaluation of the pitfalls of other approaches.  Developing a step by step action plan to give the matter the best chance of favorable resolution is key.

What Should Your Attorney Know Before Deciding on a Strategy?

An effective strategy must be based upon a full knowledge and analysis of the facts.  Some of the most important considerations follow.

• What are the client’s ultimate goals and how realistic are they based on the facts and law?
• How do the parties and their history inform likely future behavior?
• Are there any considerations requiring immediate legal or other actions?
• Are there any persons, aside from the protagonists, whose attitudes or information will be pivotal and what steps can be taken to secure their cooperation? Who has the hearts and minds of any key employees?
• Are there any business actions that can be taken now which will support the chosen strategic plan?
• Are counsel for the entity truly neutral or are they allies or enemies? Should they be replaced?
• Is there any evidence that needs to, and legitimately can, be promptly secured?
• Is there or could there be any insurance available to either side should litigation occur? How do the terms and exclusions of those policies affect proposed pleadings?
• Do you have the economic resources to buy out the opposition if control is a goal? How quickly can these resources be mobilized?
• What duties do the parties have to each other and what actions should be avoided so as to not be accused of violating them? Should there be consideration given to resignation from the board or from the entity?
• Who will benefit from the status quo and are there any compelling time horizons mandating early resolution?
• What are the material facts which support a favorable legal resolution and what will need to be done to establish these facts?
• Are there any issues of law which are dispositive or significant. Are there any actions which can be undertaken now to have such issues be determined favorably?
• Are there circumstances where acquiring the entity could be made less valuable by post resolution competition?
• Is there some third party involved or likely to be benefited or harmed by the outcome?
• Are there any governmental approvals or entanglements that could undercut or assist consensual resolution? Can the tax laws be an ally?
• If a resolution were negotiated, are there any actions which could not be controlled by contractual covenants, which could later harm the economic benefits of resolution?
• How much justice can you afford? Is the likely cost of a protracted dispute too high economically or emotionally?

Once these questions are evaluated, you and your attorney will be able to discuss the merits of different initial strategies.  There are too many variations to list, but some basic considerations are listed below.

What Are The Initial Options?

The first decisions listed below relate to process and resolution possibilities.

• Shall the parties immediately seek to mediate their differences and if so, who would be appropriate as mediator? Would it help to bring expert consultants to any mediation?  Are there contractual provisions mandating a dispute resolution methodology?
• Is it practical for a party to be a buyer or a seller? Is there an auction method which makes sense?  Is it practical or desirable to market and sell the business to a third party?  Do all parties understand the tax consequences of each alternate proposed resolution?
• Is there any ability to make concessions to continue to work together or can all sides delegate operations to independent professional management?
• If litigation is probable, have a complaint or arbitration petition prepared which contains every appropriate legal and equitable claim. Consider providing a draft to opposing counsel to establish the nature and strength of your case and to give the opposition the chance to see what they will be up against before suffering from any adverse publicity.  Determine if some limited consensual discovery could be helpful in having the parties understand their real positions before full blown formal discovery.
• Be certain that legal work anticipated is budgeted for and approved by the client and regularly revisit settlement discussions as the merits become clearer. If the decision is to go to the mat with litigation, then recognize that often no one is a clear-cut winner and the victors can still suffer permanent injury.[2]

Conclusion

Business disputes are best resolved when led by someone who knows to avoid the losses caused by unnecessary skirmishes, rather than an overly aggressive advocate who only seeks to attack, without regard for the post-war world.  Deliberate analysis at the outset of a dispute can go a long way to clear the field of foggy thinking and maximize the ability of owners of closely held entities to win the war or at least live to fight another day.

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[1] General or limited partnerships, corporations, or limited liability companies.

[2] In a matter pending long ago, the two owners of a foreign entity which owned a very successful local tech company sued each other in a knockdown, drag out, litigation.  Neither founder sought, much less would agree to, consensual resolution.  Key employees eventually became disenchanted, left the company, and went to a competitor, which used the public accusations of the founders against each other as a marketing tool and took over much of the entity’s market share.  The owners’ fight became a fight over a carcass.