We have recently seen an increase in partner disputes and shareholder disputes in the age of COVID-19. The disruptions of 2020 are taking a toll on closely-held businesses.
Why now? A few sets of stressors seem to be uncovering or exacerbating conflicts. Remote work and the need to adjust headcounts raise social and managerial concerns. Social distancing, social unrest and the trauma to the overall economy are contributing to financial distress. Internal business systems designed for another time no longer work well. Renewed scrutiny of financial resources is revealing once-hidden past actions. On the more intangible side, the pressures of today’s world are leading to the emergence of deferred conflict from mismatched expectations and simmering distrust.
What We Are Seeing. We are seeing friction among co-owners in a few specific areas:
Fraud and Conversion. Business owners looking more closely into shrinking financial resources have been discovering partners who have been dipping more from the well than they should have. Some of the problems are recent, but some have gone on for years and are only now coming to light. These range from padded expense reports to related party transactions and even outright cash transfers.
At the same time, we are also seeing accusations of fraud and conversion (the civil law equivalent of theft) where none exists. Some arise because partners find it hard to contemplate that their company can be so unprofitable even in the current economic climate. However, some arise from personality conflicts or when partners seek to use legal process to grab a larger piece of a smaller pie.
Breaches of Fiduciary Duty. A corporate fraud investigator we work with says there is nothing new under the sun, that when nefarious business action happens it generally follows familiar patterns. Two of these patterns fall under the legal concept of “breach of fiduciary duty.” Fiduciary duties can be broadly divided into two categories, the duty of care and the duty of loyalty.
Breach of the duty of care, which is sometimes interpreted as extreme mismanagement, is often alleged but rarely proved. Most management activities are protected by the business judgment rule; and, especially in the context of a closely-held business in which ownership and management overlap, it is not always clear which members of management actually contributed to alleged mismanagement. Many duty of care allegations we are seeing relate to pre-coronavirus activities. Post-coronavirus activities are a different matter. In the context of a pandemic that is unprecedented in our working lifetimes, it would be surprising if many current management issues were egregious enough to be actionable. It is possible that a manager who escapes to a country home and stops responding to communications would violate the duty of care.
A more common allegation is breach of the duty of loyalty – basically, self-dealing of one sort or another. We are still seeing typical allegations: unapproved dealings with entities related to one of the parties (typically at an overcharge), unapproved ownership of competing businesses and even surprise relatives on the payroll. Many of these relate to pre-coronavirus activities that come to light once partners start to scrutinize the financial statements more carefully. If evidence exists (as opposed to suppositions), they are easier to prove in court or arbitration than duty of care claims. However, suspicions are not actionable: we are advising concerned partners to find out as much as they can before confronting alleged wrongdoers. Certain claims must be “pleaded with particularity,” meaning that they must allege specific actions rather than general patterns. One of my favorite lines from a barebones complaint in a partnership litigation is, “Plaintiff has been defrauded. When he completes discovery, the record will be replete with multiple instances of fraud, conversion and breach of fiduciary duty.” The court was not impressed.
Disagreements Over Control. Some industries have found their revenues to be particularly hard hit recently, and the capital markets have not been kind to small businesses seeking growth capital. These factors can lead to struggles for control, particularly for companies with documentation that does not contemplate current conditions. While these cases have often arisen in businesses that are owned 50-50 by two shareholders or partners or in publicly-held companies, we are now seeing more minority owners in private companies banding together to confront larger owners.
Retirement. Some closely-held company documents contemplate that one or more owners will one day retire (for instance, we urge law firm clients to contemplate the likelihood up front). When the documents are silent but an owner decides to make a change, the buyout negotiations can be difficult even in the best of circumstances. The challenges of 2020 are not the best of circumstances, but they have invited some owners who are approaching retirement to wonder if this should be their year. The difficulties are that valuations may be down, capital may be short and remaining owners may be reluctant to take on future obligations. Many business owners are deferring retirement dates, but we are suggesting that co-owners consider planning for the future to avoid future conflict.
Our Recommendations Vary to Match the Situation. In normal times, we encourage clients to seek out of court resolution of partner disputes and shareholder disputes. It is generally a faster and more cost-effective route than litigation; although it can be a useful tool, once a complaint is filed, clients lose control of the process, the outcome and the extent of the bills. Since these are not normal times, we have doubled down on this advice. The court system has been largely unavailable; most courts have been closed except for emergency motions. It is rare that partner disputes and shareholder disputes can take advantage of the limited kinds of relief that the courts have been providing. Looking forward, we anticipate the courts facing months of backlog even though they may technically be opening, so any judicial relief being sought may be slow to materialize. Parties who use the clogged judicial system to try to extract an advantage may even find themselves facing abuse of process counterclaims unless their process is well-managed.
The pressures of today’s world have caused us and our clients to be particularly thoughtful in seeking creative and flexible solutions. Tools like early stage mediation and jointly retained neutral accounting experts have become more useful. We have adopted other tools from the collaborative law playbook that are more commonly used in contexts like divorce. We have even considered submitting issues to arbitration, since an arbitrator’s availability does not depend on the court system. The most difficult situation is when one party is satisfied with the circumstances or afraid of liability and therefore slow to come to the table. In other times, the implicit threat of filing a civil complaint may have been enough to coax a reluctant party to begin serious discussions. Now, even more than in the world before COVID-19, we are working with corporate governance tools, subtle reminders of liability and other ways to get all parties to consider the advantages of a good faith attempt at resolution. These tools can work. All in all, while partner disputes and shareholder disputes will be with us as long as there are partners and shareholders, there are still ways to resolve their conflicts.
Jeffrey Fink is a business lawyer with deep transactional corporate roots. He provides clients with sophisticated general business services that range from starting up a business to disposition or business divorce. His clients include individuals, local Massachusetts companies, multi-million-dollar enterprises and multinational organizations. An experienced business lawyer, Jeff is also a trained mediator and collaborative attorney who handles a limited range of family law matters arising out of his interest in creative uses of dispute resolution techniques. He can be reached at (781) 997-1587 or jfink@kcl-law.com.