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Realizing Value out of Business Conflict By Mark S. Furman, Esq. and William R. Rodgers, Esq.

Monday, December 16, 2002 - By: Mark S. Furman and William R. Rodgers

By Mark S. Furman, Esq. and William R. Rodgers, Esq.

For as long as there has been business, there has been conflict between owners. While a robust conflict of ideas can lead to constant improvement, systemic conflict can be destructive to an operating business.

Conflict can result from greed, ego, or a need for control. In some family businesses it can be rooted in historical family antagonisms. In other cases it arises from a sense of being under-appreciated, being taken for granted or from bearing disproportionate burdens. In mild cases, conflict can manifest itself in quarreling and missed opportunities. In serious cases, it can result in business failure, soured friendships or family schisms.

Many conflicts can be abated by simple measures such as opening up the books and sharing information. Others require the thoughtful use of consultants and management experts who can bring industry norms to bear on contentious issues such as compensation and competency. When properly selected, the sense of objectivity and fairness these professionals can bring to the table is often enough to set the business on track.

However, when it isn't, many turn to lawyers for help. Different approaches are required to maximize value in different circumstances. No two situations are the same and win-win outcomes aren't always available to eliminate deadlock, to stop self-dealing, to remove obstacles to growth, or to find a way to realize on an illiquid ownership interest.

The starting point for a lawyer is to identify the client's desired goal and tolerance for risk and to then evaluate the various tools that can be used to that end. These can include reason, negotiation, mediation, arbitration, and litigation. Sometimes unique leverage is available and can be exploited. Nevertheless, the key is to marry the right tool to the right strategy and to exploit them within the confines of the fiduciary duties which the law imposes on corporate dealings.

Fiduciary Duty Obligations

Privately owned business owners owe each other fiduciary duties. These fiduciary duties require that the owners act with the "utmost good faith and loyalty" to each other and the Company. Oppressive measures taken by the majority at the expense of the minority which have the effect of freezing out the minority are prohibited. A breach of fiduciary duty may occur by the majority terminating minority shareholders, taking excessive salaries or refusing to declare dividends.

Problem: A brother owns 75% and his sister owns 25% of the family business founded by their now deceased parents. Only the brother is involved in the business. The sister receives a small dividend each year. As the business becomes increasingly profitable, the brother increases his salary driven by a sense of entitlement because the profits result from his efforts. The sister's eventual reaction is a request for increased dividends or to be bought out. Brother buys her shares, but fails to disclose that he is about to receive an offer to buy the company from a third party for substantially more per share than he is paying his sister. He then promptly sells all of his shares to the third party.

Solution: The sister brings a claim against her brother for breaching his fiduciary duty in failing to disclose the offer from the third party. The sister realizes additional compensation for her shares consistent with the company's actual value.

In Massachusetts, minority owners also owe fiduciary duties to the majority. For example, the minority may not use a veto right to prevent a company from taking action in the best interests of the company.

Problem: 30% minority shareholder has veto right over the sale of a technology business at a price less than $10 million. The Company, running out of money despite receiving over $2 million in short term loans by the majority owner, must be sold. Minority shareholder refuses to consent to any sale below $10 million unless he is paid the amount he'd receive from a $10 million sale.

Solution: Company grants an exclusive license to its proprietary technology to a third party without the consent of the minority shareholder. The minority shareholder sues. The majority shareholder defends on the grounds that there was no "sale" and counter sues the minority shareholder for breach of fiduciary duty in unreasonably withholding consent to the sale. Minority shareholder tries to enjoin the license agreement. The Court denies the injunction, and the license agreement goes forward.

Firing Business Owners

Where the controlling group fires an officer who is also a minority shareholder, a claim for breach of fiduciary duty may arise. When such a termination constitutes a breach of fiduciary duty is not always clear. In one leading case, the Court held that the majority breached its fiduciary duties to the minority shareholder because there was no legitimate business purpose for terminating the minority shareholder, and the majority disregarded the long-standing policy that employment in the corporation would go hand in hand with stock ownership. However, in another case, where there was no general policy tying stock ownership to a right to employment, an owner termination was allowed even in the absence of a legitimate business purpose for the termination.

Problem: One of several founding shareholders of a company becomes disruptive and unproductive. He blocks strategic initiatives, undermines his colleagues and alienates most of the employees.

Solution: On advice of counsel, the Board of Directors compiled a paper trail evidencing a pattern of unsatisfactory performance, the repeated opportunities extended to the founder to mend his ways, and then fired the unproductive shareholder. To minimize the effectiveness of an anticipated charge of wrongful "freeze out", the Company offered him a generous severance package which forced him to choose between accepting the severance and giving a release to the company, or suing the company for freezing him out. He took the severance.

Ensuring Business Opportunities

The fiduciary duties of directors and shareholders of a closely held corporation also prohibit the diversion of business opportunities to the director or shareholder or their affiliated parties.

Problem: Two brothers each own 50% of a business. One brother dies. The surviving brother controls the business and was named the executor of the estate of the deceased brother for the benefit of the deceased brother's children to whom the deceased brother's shares were left. The surviving brother grows and expands the business, but all new opportunities are exploited in the name of a new entity owned exclusively by the surviving brother's side of the family.

Solution: On learning of the surviving brother's self dealing, a child of the deceased brother brought suit to recover damages arising out of wrongful diversion of corporate opportunities. The Court ordered damages, a transfer of assets to the original entity.

Disputes between business owners risk the value those owners spent years, and sometimes decades, creating. They also impair the future growth of that value. While non-litigation solutions are desirable, all means to effectively resolve the dispute must be considered. Clients and their advisors, including their lawyers, must identify the goal and carefully evaluate the risks and rewards of each potential action available to solve the problem. The desired strategy varies depending on the unique circumstances of the situation, the leverage available, the external influences, the situation of the business owners, the percentage ownership and a multitude of other factors. Advisors must think creatively to tailor their advice and their strategies to each situation. The goal, however, is almost always to preserve or realize on the highest possible value of the business.