The importance of having an Operating Agreement in the case of a limited liability company and a Shareholder Agreement in the case of a corporation is very significant. Essential terms include identifying who the shareholders are, what their shareholder interest is, how distributions are decided and what happens if there is a deadlock between the shareholders. Additional essential terms include Buy/Sell Agreements that address what happens if a shareholder decides to leave, becomes incapacitated or dies, and in general how does a company operate if one of the shareholders departs. When all these issues are left open because there is no written agreement, the situation is ripe for litigation.
The problems this situation could cause are best illustrated by a practical example. Let’s assume one of the members decides to divorce their spouse and that member believes walking away from the company is the fair thing to do. What could happen next?
The divorcing spouse could claim that the interest in the company that was left behind had substantial value. How do we find the answer? Nothing is in writing. And if everyone doesn’t agree, what is the next step? If all the members or shareholders cannot agree on the value, then a pre-lawsuit mediation may be effective and resolve the dispute without the time, expense and uncertainty of a lawsuit.
However, in this scenario, we assume that pre-lawsuit mediation fails and the angry ex-spouse to be (“Angry Spouse”) sues the company and all the shareholders of the company. So, the remaining shareholders who are working hard to keep the company going are now faced with a lawsuit because they allegedly obtained a shareholder interest in the business without providing payment. The Angry Spouse says he is entitled to an exorbitant amount of money because the shareholder interest his spouse gave up is a marital asset and it has substantial value. The Angry Spouse claims that the company should have paid for the stock. So, as those shareholders work hard to keep their company going, a lawsuit is filed, they are required to hire an attorney and must file an Answer in the court where the case is brought. This is just step one of the litigation process. At that time, the shareholders in the company may choose to assert affirmative defenses and counterclaims explaining why they have affirmative claims against the resigning shareholder. Was the resigning shareholder distracted from her job as a result of the pending divorce? Because of the stress of the pending divorce, was she was mismanaging the company which caused damage to the company? Assuming that these partners have worked together for years, it is a difficult choice to have to criticize someone who was once a loyal member of the company. But they may have no other choice in order to fight off the allegations made by the Angry Spouse.
Step two of the litigation process is discovery, which may involve extensive depositions and document production. All of this takes away from the operation of the business and the Angry Spouse’s goal is to try to find some mistake that the company or the partners made and also to prove that the company has great value. The Angry Spouse will be entitled to discover the amount of wages, distributions and other benefits the shareholders received and will be entitled to see all the books and records of the company.
Step three is post-litigation mediation which is usually required by the court. This is an opportunity to talk to an unbiased mediator who cannot bind the parties in litigation but will encourage everyone to set aside emotion and come to a solution that is financially prudent. In this scenario, it is likely that the innocent hard working shareholders and the company will have to pay something to put an end to the case. Many times it is a cost /benefit issue and the uncertainty of litigation that causes the parties to settle at mediation. Since there are no written agreements between the shareholders, if the shareholders in the company were actually successful in the lawsuit they would not be entitled to reimbursement of attorneys’ fees and costs. If a Shareholder or Operating Agreement had been drafted, an attorneys’ fees provision would have been in the agreement, requiring the losing party to pay the prevailing parties’ attorneys’ fees and costs. If that was the case, then they may have chosen to take the risk of proceeding to trial.
The fourth step is the trial before either a judge or a jury. No one has control over the outcome. Both parties will have experts which may include certified public accountants and business valuation specialists. All of the books and records of the company will be scrutinized. For instance, the remaining members in the company could argue that all the expenses of the company are valid, that they are still in start-up mode and that the business value is very little; or in the alternative, they may argue it is a service business and therefore the business is the shareholders themselves. In other words, the business itself is not really marketable as an ongoing business. Of course the Angry Spouse will argue to the contrary. In the end, who will win?
The take away: Even if you don’t have an Operating Agreement, Shareholder Agreement, Buy/Sell Agreement, Employment Agreement or other important agreements that govern the rights, duties and liabilities between the shareholders/members and the company, it is never too late to have a “legal checkup”. Please do not hesitate to contact us at Iurillo Law Group, P.A. to answer your questions.
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