In advising family businesses, a lawyer’s most important resource is usually contract. The choice of entity form matters, but no existing type of business association contains default rules that smoothly reconcile business values and family values. The available business forms – chiefly, partnerships, corporations, and LLCs – do not presume any preexisting relationships among the investors. Moreover, given the variety of objectives that any family might have in operating a business, it is not clear what rules would best suit the majority of family businesses. Therefore, private ordering through contract is crucial to ensure that all participants are treated fairly and their expectations are taken into consideration.
Consider the example of marital divorce. Since nearly half of all marriages fail, divorce litigation should be seen as a regular, recurring feature of family business ownership. Proper planning is essential. In some cases, shareholder agreements can help to ensure that business assets stay in family hands, for instance, by providing a right of repurchase should stock end up with an ex-spouse. But shareholder agreements aren’t enough to get the job done; as noted previously, the equitable division of marital assets in a divorce takes precedence. Marital agreements, however, can state whether business assets count as marital property and, if so, how those assets should be allocated. The point is that the shareholder agreement and the marital agreement are, in fact, two pieces of the same puzzle.
In a contested divorce, the enforceability of a marital agreement may determine the fate of the family business. To return again to the McCourts’ dispute over the Dodgers, Jaime’s claim to 50 percent was valid under the default rules governing divorce in California. The Dodgers were acquired during the marriage and there was no question that Jamie had contributed substantially to the effort. However, shortly after acquiring the Dodgers, the couple had entered into a marital property agreement. Apparently, in order to limit exposure to creditors, the agreement put their several houses and personal property in Jamie’s name, and the businesses in Frank’s name. Jamie claimed that she never read the agreement and failed to understand that it would affect her rights in a divorce. In the end, Jamie convinced the judge to throw out the agreement – otherwise, the divorce settlement would have looked very different, and Frank McCourt would probably still own the Dodgers.
Marital agreements are not the only device available to protect family business assets from intra-family dissension. As mentioned earlier, parents often use trust instruments to give children a stake in the business without relinquishing control. Because the trust owns the stock, trust agreements may protect family assets should a child (or grandchild) divorce. Also, the trust structure can be used in some cases as part of a plan to minimize taxes. Indeed, many family businesses are structured in substantial part to achieve estate planning and related tax objectives, so that trusts, wills, and other testamentary documents may be as much a part of the business as articles of incorporation, bylaws, and shareholder agreements.
Although the parties to a prospective business venture, family owned or not, should clarify key points before investing – for instance, when capital contributions may be required, how business decisions will be made, how earnings (or losses) will be distributed, and what types of opportunities belong to the business – the resources of contract are limited. The parties cannot anticipate every contingency that might arise in a long-term business relationship. Also, because bargaining is expensive, the costs of negotiating a more complete contract will eventually outweigh the benefits. Moreover, the participants in a closely held business may rely upon trust, even as to matters that could have been specified in advance.
Family businesses present distinctive challenges for private ordering because they combine the values and expectations of the workplace with more intimate family bonds. Even if it were realistic to suppose that the parties would engage in arm’s-length contracting to define their mutual expectations, those expectations are complex and difficult to specify within the four corners of an operating agreement. Moreover, to the extent that arm’s-length negotiation reflects the values of the workplace and may be an affront to the informal norms that characterize family life, it cannot provide a neutral method for finding an appropriate reconciliation between the two sets of values.
In the corporate context, most jurisdictions recognize a need for judicial monitoring of the parties’ relationship to prevent the opportunistic exploitation of gaps in the contractual bargain. This is true for family businesses and non-family businesses alike. For instance, even when they have not negotiated specific protections, minority shareholders can seek relief for oppression, often premised on the notion that controlling shareholders owe fiduciary duties and must honor the minority’s reasonable expectations. While courts will not rescue investors from the consequences of entering a one-sided bargain, neither will courts stand by and allow controlling shareholders to deprive minority shareholders of any return on their investment.
In recent years, the LLC has overtaken the corporation as the entity form of choice for most small business owners. Notably, the LLC combines the flexibility of a traditional partnership and flow-through taxation with the stability and limited liability benefits of incorporation. Also, for tax reasons, families may use LLCs to hold real property for personal use. Thus, the continued vigor of judicial monitoring may depend upon whether well-established shareholder protections apply in disputes involving LLC members.
In some respects, the difference in organizational form between a corporation and an LLC does not matter because the fundamental problem – an overreliance on trust and a failure to document basic understandings among co-owners – is identical. Regardless of formalities, the family members may view themselves as partners in a common enterprise. However, in corporations and LLCs alike, controlling family members can abuse their power when informal consensus evaporates; the majority has the formal right to control business decisions, and there is no default exit right for a minority owner frozen out of any return on her investment. Therefore, to the extent the law has already developed an approach for protecting minority shareholders in corporations, it would seem counterproductive to insist upon new, possibly less effective tools for dealing with a shared problem.
However, while the contours of the problem may be familiar, one cannot assume that the available legal recourse is the same. Corporate law and LLC statutes in a jurisdiction may provide different standards for relief and offer different remedies. Also, to the extent LLC law places greater emphasis on private ordering, courts may be reluctant to imply equitable obligations not set forth in an operating agreement, and they may defer to waivers of fiduciary protections that would otherwise have applied. As a policy matter, one could argue that it would undermine the LLC’s value as a distinctive legal form if courts simply imported corporate law principles and failed to respect the difference between LLCs and corporations. The salience of this objection, in turn, might depend upon whether one can distinguish intelligent borrowing from blind copying. (It does not instill confidence when courts persist in using corporate-law terminology when addressing LLC disputes).
Yet, even if LLCs follow a more explicitly contractual approach, perceiving a family business in contractual terms should not entail a narrow approach to the interpretation and enforcement of relevant bargains. That is, a contractual approach does not require courts to abandon minority investors, family or otherwise, to the explicit terms of their bargain, regardless of whether those terms are consistent with the parties’ reasonable expectations. If the business is a contract, it is a relational contract intended to endure over time and not a discrete, bargained-for exchange. Judicial protection of vulnerable minority investors conflicts with private ordering only if we assume the artificially rational world of neoclassical economics. But LLC members and corporate shareholders live in the real world, not in the pages of a game theory treatise, and the ties of family and friendship, the social norms of business, and the constraints imposed by transaction costs all affect the likelihood that the parties will negotiate adequate protections against possible future discord.
For better or worse, so long as family ownership remains a prominent feature of the business landscape, courts will be called upon to adjudicate business disputes among family members. Although unfortunate, the family grievances that tore apart the Demoulas family and caused the Market Basket fiasco are not uncommon. In this regard, perhaps we can supply a lawyerly caveat to Tolstoy’s famous dictum that “each unhappy family is unhappy in its own way.” Where the novelist might observe an infinite variety of miseries, the experienced lawyer will perceive repetitions of a relatively small number of themes: sibling rivalries motivated by competition for parental affection; aging patriarchs who cannot let go; parents who invite disaster by distributing business assets to children without regard for their ability or interest; active participants who resent uninvolved family members for expecting to profit from a business that they do not contribute to building; and, in what some might characterize as the central problem of business law, the ever-present temptation for those who control a resource to use it, disproportionately, for their own benefit.
This article relates to a panel discussion regarding Family Business Disputes that the author moderated at the ABA LLC Institute on October 16, 2014, and he is grateful to Thomas Rutledge for organizing the event and to the panelists, Eric Chiappinelli, Peter Mahler, Douglas Moll, and Robert Thompson for their participation. Readers interested in a fuller treatment of the matters discussed herein may wish to consult Benjamin Means, A Contractual Foundation for Family-Business Law, 75 Ohio St. L.J. 675 (2014) and Benjamin Means, Nonmarket Values in Family Businesses, 54 Wm. & Mary L. Rev. 1185 (2013).