This year is the 40th anniversary of the release of the Oscar-winning movie Kramer vs. Kramer. Kramer vs. Kramer which starred Dustin Hoffman and Meryl Streep was one of the first movies to depict the turmoil that ensues when the dissolution of a marriage and the battle for custody of a child makes its way into the courtroom. By now these custody fights are ingrained in our pop culture and can be witnessed on an almost daily basis on television. There is another type of divorce that can be just as emotional and bitterly fought as the custody fight in Kramer vs. Kramer: that is the business divorce.
Business divorces involve the break-up of a small closely-held business. Although these cases are at times referred to colloquially as “business divorces” they are more appropriately referred to as shareholder (or member in an LLC) oppression suits or minority shareholder (member) freeze-out cases. These cases arise because unlike publicly traded corporations, the ability of minority shareholders to sell their shares of a small business is extremely limited. As such, Pennsylvania law has established procedures to protect minority shareholders which are balanced against a natural reluctance to interfere in the operations of businesses.
Pennsylvania Courts define shareholder oppression as conduct that substantially defeats the reasonable expectations of a minority shareholder. A freeze-out happens when a minority shareholder is removed from office, or his power or compensation is substantially diminished. The majority shareholder or member’s conduct is measured against the business judgment rule. The question that courts require to be answered is whether the majority shareholder had a rationale belief that he was acting in the best interest of the company. If the majority shareholder is acting in accordance with the business judgment rule, then the owner has nothing to worry about. If she is not, then the consequences may be significantly more severe than those suffered by Dustin Hoffman in Kramer vs. Kramer.
In Kramer vs. Kramer, Dustin Hoffman’s character ended up in court because he was spending too much time at work and not enough time with his family. Just like in marital divorce cases, there are certain behaviors that will almost assuredly land a majority owner in court. The most frequent misbehavior is failing to provide the minority with financial information about the business. It is remarkable how frequently majority members take the position that it is their company, and the books are not the minority owner’s business. Not only is that attitude shortsighted, but it is also completely contrary to Pennsylvania law. Minority owners have a statutory right to see necessary financial information so long as the request for information is legitimate. If the minority owner offers a legitimate reason to review the records, a court will compel the inspection of the financial records.
Other behaviors that can lead to a finding of minority oppression include:
- Failing to observe corporate formalities. Refusing to have corporate meetings or not adopting necessary resolutions will be perceived as denying necessary information to the minority shareholder.
- Terminating the employment of a minority owner. Since most owners of a closely held business also work for the business there is nothing that will get a minority shareholder to a courthouse quicker than the majority owner firing a minority owner.
- Paying the majority owner excessive compensation or the corollary, paying the minority owner an inadequate salary.
- Failing to award dividends or distributions. If the business is profitable, minority shareholders have a reasonable expectation that they will reap the benefits. If too much money is tied to the salary of the majority member, it will engender the type of ill-will that leads to litigation.
- Diverting corporate assets for the majority’s personal benefit. Just because you are the majority owner does not allow you to use the company credit card for the first-class vacation to Europe.
- Usurping corporate opportunities. Courts frown when majority owners get involved in competing businesses in their personal capacity, which should have been brought to the corporation for the benefit of the corporation and all of its shareholders to enjoy.
Just like in custody cases where courts have broad authority to fashion an award, courts have a number of tools at their disposal to remedy shareholder oppression. The most significant and detrimental tool for the majority owner to be aware of is that the court can award both compensatory and potentially punitive damages to the oppressed shareholder. Courts can also appoint a receiver to run the business on a temporary basis while the parties are litigating their dispute. Courts can always order the dissolution of a business if the owners are not able to work with each other. Dissolution is most appropriate when the shares of the company are equally owned, and the owners can no longer run the business together.
The key to avoiding a business divorce is the same as avoiding a marital divorce: communication. The majority owner has a fiduciary duty both to the corporation and to the minority owners. Keeping all of the owners informed about day to day decisions will go a long way to keeping the business and its owners away from the turmoil that Dustin Hoffman and Meryl Streep’s characters endured.