Thorough pre-litigation preparation is essential to any lawsuit, but it is particularly so in a case contesting conduct of those who manage corporations and limited-liability companies. Such entities can be closely held, meaning their stock or membership interests are not freely traded and are held by relatively few individuals. In a perfect world, those in charge have the expertise and integrity to manage operations and finances.
It’s safe to say that some conflict is endemic to most business relationships. The question is whether the conflict pertains to benign day-to-day decisions, or whether it threatens the very existence of the business. Lawyers are often retained to litigate over the latter situation, and their preparation begins as soon as they meet a prospective client.
A litigated business dispute is complicated, time-consuming, expensive and messy. It requires a lawyer’s understanding of the business’s structure and governance, and the nature of the specific conflict at hand. To achieve that understanding, the lawyer must rely on facts and documents provided by the prospective client. Ideally, our prospective client has sufficient documentation and information to focus the issues in dispute. A thorough examination of all formation and organizational documents is indispensable.
Knowing the business structure and form is essential. Is the business a corporation, limited liability company, partnership, or joint venture? Is the business a professional entity, such as a medical practice or law practice? Each type of business structure presents different hurdles to protecting ownership interests, and affords our prospective client different rights and remedies.
The rights and obligations of the owners of corporations and limited liability companies (namely, shareholders and members, respectively) are usually embedded within corporate documents. So too, the powers of those who govern these entities are defined in such documents. As few of these documents are available to the public, the lawyer must rely on the prospective client for disclosure. In the case of a corporation, there will be a certificate of incorporation, and likely a shareholder’s agreement, by-laws, and stock ledger. A limited liability company will have articles of organization, and likely an operating agreement. These documents typically provide limits on the power of management, voting rights of shareholders or members, and for sale of ownership interests.
We may learn, for example, that the prospective client owns a minority membership interest in a limited liability company. We may learn further that the problem or dispute is with a business associate who controls the management of the company, and has allegedly been self-dealing, withholding distributions, denying access to the company’s books and records, and misappropriating corporate opportunities.
Fundamentally, those who manage corporate affairs are fiduciaries, and as such must act for the benefit of the company and its members on all corporate matters. Identifying the alleged misconduct is one thing. But how to deal with it is another. Whether to seek a litigated, rather than a corporate, solution depends on understanding how the company’s management is supposed to work. Governing documents usually detail the authority and role of management: how long is the term of office, what types of agreements can and cannot be entered into on the company’s behalf, what oversight rights do shareholders and members have, when and under what circumstances must membership approval be sought, and procedure for removal.
Regrettably, in many instances, even if the company’s governing documents provide a mechanism for taking action, it may not solve the problem. For example, the governing documents may permit owners to band their corporate interests, call a special meeting, and remove a dishonest director. The person aggrieved, however, may not have sufficient support to take inter-corporate action. Litigation may be the only option.
Before commencing litigation, it should be clear that the alleged misconduct is likely to rise to the level of fraud on the company, discrimination against a particular member or members, self-dealing or other serious misconduct, rather than simply poor judgment. Once the decision to litigate becomes evident, a decision must be made on the type of claim or claims to assert. Generally, an aggrieved member or shareholder may bring personal claims to vindicate personal rights, or derivative claims on behalf of the company for wrongs committed against the company.
Identifying a claim as derivative presents another hurdle. The person bringing a derivative action must first demand that the company’s management initiate the lawsuit. If the action is brought without making such a demand, the plaintiff must demonstrate that a demand would have been futile. A demand is only futile, and therefore excusable, when the management is incapable of making any impartial decision, as where each member of the board either has an interest in the challenged transaction or is controlled by a self-interested director.
The most common derivative claim against a dishonest or self-dealing director or manager is a breach-of-fiduciary-duty claim, often based on frauds committed against the company, self-dealing, and misappropriation of corporate assets. Personal claims include recovering withheld distributions, or enforcing rights or benefits provided to the individual shareholder by law or governing documents.
Disputes of the sort described here are not uncommon. Aggrieved business owners who have invested in the enterprise are often blind-sided by misdeeds of those in control.
Providing one’s attorney with as much information about the business and issues in dispute as possible is necessary for thorough and effective representation. A prudent shareholder or member should, therefore, always keep abreast of corporate activity, insist upon corporate formality, attend meetings, review corporate tax returns, scrutinize the conduct of directors or managers, and if improper or unlawful activity is discovered or suspected, proceed quickly to avoid irreparable harm to the business and to his or her investment.