Although there is always the hope that these disputes can be successfully negotiated and settled before a lawsuit is filed, most of the time the minority shareholder must file a lawsuit and litigate the matter for a significant amount of time in order to create enough leverage to convince the majority shareholder to pay a fair and reasonable amount to buy the minority shareholder out of the business. Many times in these situations, the minority shareholder is at a negotiating disadvantage because the majority shareholder has not disclosed accurate and complete financial and other business information to the minority shareholder. As a result, litigation—and its accompanying powers to compel discovery from parties and nonparties alike—is the only way the minority shareholder can obtain the relevant financial records and other information on the business that are required to determine the value of a fair buyout.
Many times in these types of cases, the minority shareholder will assert that the majority shareholder caused damage not only to the minority shareholder but also to the actual business. As a result, if the evidence bears out that the majority’s wrongdoing has caused damage to the business as well as distinct damage to the minority shareholder, depending on jurisdiction-specific law, the minority shareholder likely has both individual and derivative claims against the majority shareholder. Therefore, in addition to claims of oppression or squeeze-out and breach of fiduciary duty, evidence of fraudulent conduct by the majority shareholder necessitates the assertion of some type of fraud claim, such as misrepresentation or concealment.
Types of Fraud and Related Malfeasance
Fraud can come in many forms in the closely held business context. The most widely known type of fraud is misrepresentation, which occurs when an individual makes a knowingly false representation to another with the intent to deceive. Suppression or concealment, on the other hand, occurs when a party omits a material fact that the party had a duty to disclose. Another type of fraud is promissory fraud, which occurs when a party promises to do something in the future with no intent of actually honoring the promise. Another form of fraud that arises in these types of situations is fraudulent inducement, which occurs when an individual has been tricked into entering into a contract or transaction based on misrepresentations or the concealment of material facts (or both). While fraudulent inducement can be difficult to prove because of the frequent modern usage of merger clauses in contracts, such a claim is often likely to be legally sufficient in the closely held business context as a result of the ongoing transactions among the business’s owners.
Recurring Scenarios
Evidence of a fraudulent misrepresentation or concealment often occurs at the beginning of the business relationship that has led to the dispute. For example, there will be some type of evidence that the majority or founding shareholder made a representation about the business that induced the minority shareholder to invest in the business. The minority shareholder then discovers after the fact that the representation, which was material to the minority shareholder’s decision to enter into the business relationship, was not true. This type of situation can also occur when a closely held business is sold. For example, where evidence demonstrates that the seller of a business made certain material representations regarding the financial condition of the business to the buyer, who relied on it in acquiring the business and discovered after the acquisition that the representations were false, the buyer will likely have a claim for fraudulent misrepresentation.
Another recurring theme in these types of cases that actually manifests itself during the business relationship is a lack of disclosure by the majority to the minority regarding the financial condition of the business, which can support a claim for suppression or concealment. The majority shareholder will often refuse to voluntarily provide the minority shareholder with financial records or other important information about the company, because many times these financial records reveal additional fraud, embezzlement, or other wrongdoing committed by the majority shareholder. The financial records will also reveal the information necessary for determining the fair value of the minority shareholder’s interest, which he or she must know to intelligently negotiate a fair and reasonable buyout. Because controlling shareholders in these situations will withhold information evidencing their fraud or the artificial deflation of the value of the minority shareholder’s interest, litigation is required to compel the majority shareholder to provide the business’s complete financial records.
Similarly, once the minority shareholder is able to obtain the business’s complete financial records, the documents frequently reveal that the majority shareholder has been taking a disproportionate share of benefits to the detriment of the minority. For example, the financials may demonstrate one or more of the following situations:
- The majority shareholder is paying himself or herself an unreasonably high salary or is taking disproportionate distributions.
- The majority shareholder is paying himself or herself additional compensation in some form, such as ambiguous or vague “management fees.”
- The majority shareholder is using the company credit card or company funds to pay for his or her personal expenses.
- The majority shareholder is taking loans from the company with no intent to pay the loan back and the company, controlled by the majority shareholder, fails to accrue interest on the loan, demand repayment, or even designate the loan on the company’s books as an asset.
- The majority shareholder is diverting business assets to another entity solely owned by the majority shareholder.
Fraud of these sorts damages not only the minority shareholder but also the business, substantiating why the case should likely be filed by the minority shareholder both individually and derivatively on behalf of the company.
Preventing or Minimizing Disputes by Putting Safeguards and Protections in Place on the Front End
There are a number of different ways to either prevent or minimize the severity of these types of disputes. First and foremost, before any individual acquires an interest in a closely held business, that individual should retain an attorney to advise him or her and review the necessary documentation for the business valuation and acquisition. All too often, a minority shareholder does not have his or her own attorney review the corporate documents before signing them, or—even worse—the minority shareholder does not review the actual terms of his or her agreement either, or did review the terms but did not truly understand them. Then, when there is a falling out between business partners, the terms turn out to be significantly less favorable to the minority shareholder, who easily could have negotiated more favorable terms just by retaining his or her own attorney before the transaction occurred. Generally, a minority shareholder has no defense in litigation for failing to read the shareholder or governing agreement or not understanding the legal implications of the terms of the agreement. Moreover, a minority shareholder should never simply “trust” the person he or she is entering into the transaction with, even if the parties are family members or close friends. A minority shareholder should never assume that the attorney handling the transaction represents the minority shareholder or will protect the minority shareholder’s interest, because that attorney is generally retained by the majority shareholder. Minority shareholders must always be advised to retain their own independent counsel to advise them appropriately and to represent their interests.
Secondly, the actual terms that will govern the business relationship between the minority and majority shareholders should be completely, accurately, and clearly set forth in writing at the outset of the relationship. A merger or integration clause should also be used in the governing agreement so that there is no uncertainty in a future dispute as to the meaning of a term or the existence of an oral side agreement. Putting the time in at the beginning of the relationship to create a simple and complete agreement between the parties that uses clear and unambiguous language can help to minimize the extent of litigation in the event of a future dispute. A well-drafted, comprehensive agreement could prevent litigation altogether. In addition, if any subsequent agreements are reached between the parties that substantively change the terms of the original governing agreement, those changes should be attached as amendments to the original agreement or otherwise be put in some type of writing signed by the parties, such as shareholder meeting minutes. If a closely held business is bought or sold, the inclusion of thorough and specific representations and warranties in the purchase agreement can protect the buyer and keep the seller accountable.
Third, certain controls and protections can be negotiated into the terms of the governing agreement to help prevent fraud and other types of majority shareholder wrongdoing. For example, the agreement can require loans made from the company to any shareholder to be documented through an enforceable promissory note, accrue interest, be treated as an asset on the books of the company, and enforced in accordance with the terms of the promissory note. Another successful control mechanism is a requirement that audited financial statements by a certified public accountant be completed for the business each year and distributed to all shareholders. Complete transparency helps to keep people honest and accountable, but it can also benefit a majority shareholder by calming the uncertainty of a minority shareholder who otherwise may take more aggressive positions if not regularly provided verifiable financial information on the company.
Conclusion
Fraud and related wrongdoing can arise in many different shapes in closely held business disputes. Some of the underlying facts giving rise to these types of disputes repeat themselves from case to case, while unusual businesses or financial arrangements can give rise to unique legal issues. Regardless, evidence of fraud or related wrongdoing can always provide a negotiating advantage in resolving a dispute through a fair buyout of the minority shareholder’s interest. There are also many ways to try to prevent or minimize fraud if sufficient time and effort are expended at the beginning of the business relationship. As the world changes and technologies evolve, this area of the law will undoubtedly change over time.