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Begin with the End in Mind – A primer on Small Business Dispute Resolution

How should small business owners prepare to resolve disputes between themselves before they arise?Historically, small businesses were either sole proprietorships or partnerships. While a sole proprietor may experience internal conflict, the law deals only with conflict when more than one person is involved.  As a result, partnership disputes, as opposed to shareholder, limited partnership, or member disputes, dominated the courts over the last century. While partnerships remain the default, i.e.if you go into business with someone else and you don’t agree otherwise you are likely in a partnership, the trend in the past few decades has been away from partnerships to corporations, limited liability companies, and limited partnerships.  This trend has two primary implications.  It changes the obligations people in business together owe each other and it changes the rights of the parties when they are in a dispute and especially when they want to end their business relationship.

In a partnership, partners owe each other the highest duty recognized by law.  The duty, called a fiduciary duty, includes the duty of loyalty, duty of candor, duty to avoid self-dealing, duty to act with the highest integrity, and duty of fair and honest dealing.  In addition to these duties, partners have a statutory right to exit the business if their partner is not living up to these responsibilities.  This right, called a right of redemption, generally allowed partners (even a minority partner) to require the partnership to buy-out his or her interest in the partnership at fair market value.

The move away from partnerships has eroded both the duties business partners owe to each other and the rights of minority owners to exit the business.  In closely held corporations, limited liability companies, and limited partnerships, the duties of those that invest in the business and who manage a business day-to-day can be significantly modified by agreement and they are generally owed to the business itself rather than to the other shareholders, members, or partners.  For example, a director in a corporation owes a fiduciary duty to the company, but he or she does not owe a fiduciary duty to the shareholders directly.  This shift from partner to partner duty to partner to entity duty has major implications when disputes arise and this shift needs to be addressed in the beginning when the parties are forming the business.

For years, while the shift from partnerships to corporations and limited partnerships was taking place, Texas appellate courts recognized a cause of action for shareholder oppression.  Although difficult to prove, a minority shareholder that proved shareholder oppression could force the majority owner to buyout their interest in the company. In a case called Ritchie v. Rupe, the Texas Supreme Court held that the buyout remedy would no longer be available. The remedy left to minority owners after Ritchie v. Rupeis the right to bring a derivative suit.  This is a fancy way of saying the minority owner can sue for the corporation, but not for him or herself directly.

The successful result of a derivative action can be an award of money directly to the minority owner, but often even a successful result will be the recovery of money by a company that the minority owner does not control.  So if the majority owner has been overcompensated, the company recovers the excess compensation and then the majority owner will still be left in control of whether the business distributes that recovery to shareholders or makes some other use of the recovery.

Given that almost everyone who invests his or her time and/or money in a business does so with the hope of a return on that investment, it may be surprising to learn that Texas law provides no clear guidance on when or if a corporation is required to pay a dividend or make an owner distribution. Further, Texas Courts and other states generally are reluctant to second guess the decisions of business owners. In one notable example, a Delaware court refused to hold a corporate board of directors liable even for galactic stupidity.

So if the Courts will not hold businesses responsible for galactic stupidity, how can anyone invest as a minority owner in any business with any confidence?  The answer is solid dispute resolution provisions in the company agreement.  These provisions should be both broad and specific. The provisions should be broad enough to resolve a wide range of disputes and specific about how those disputes are resolved.

A good dispute resolution procedure must define the dispute broadly.  For example, if the dispute is defined in a way that limits “disputes” to breaches of legal duties, e.g.the fiduciary duties that are owed to the corporation and not the minority owner, the procedure may not be triggered by the most common minority owner complaint – the failure of the company to pay a dividend or make a distribution.  Further, especially when a business’ management responsibility is divided evenly, the dispute resolution procedure should clearly include situations where management is deadlocked.  If the dispute resolution procedure does not include the deadlock situation, the remedies available through the courts include the appointment of a director, custodian, or receiver – – in layman’s terms, a stranger running your business.

The second feature of a good dispute resolution provision in a company agreement is an obligation to mediate.  Mediation is simply a process where the parties meet with a neutral third-party and attempt to work out their differences.  While parties often approach mediation with skepticism, the process forces parties to focus on the problem and at least hear (and hopefully consider) the point of view of their business partner.  And, even when mediation is not completely successful, it can result in narrowing the parties’ differences or disputes.

The third, and most important, feature of a good dispute resolution procedure is a buyout provision.  A buyout provision is essential in my opinion.  This is true because the solutions available through litigation when business partners cannot resolve their differences are usually not solutions at all and the litigation process itself is usually harmful even to a healthy business and can result in the failure of a marginal business.

When considering the terms of the buyout provision, know that the terms being offered or in the form you are using may not fit well with the business or situation you are entering and that the buyout provisions you agree to will be strictly enforced, even if those provisions result in a buyout at what you consider a grossly inadequate value.  For example, if your buyout agreement sets the price on the book value of the company as opposed to the fair market value, your interest will be valued on the book value of assets that may have been aggressively depreciated for tax purposes. The best solution, if the parties are both similarly capitalized (have the same available cash), is commonly referred to as a push-pull buyout.  In a push-pull buyout, basically, one party offers to purchase the other party’s interest at a price per share of stock or unit of ownership. Then the party who receives that offer has the right to either sell their interest in the business at the offered price or purchase the offering party’s interest for that same price per share. In this situation, the costs and gamesmanship involved in various methods of valuation are avoided altogether.

With solid dispute resolution provisions in your company agreement, you will be better positioned for your business to succeed and be better off if it fails.  All business ventures are entered into optimistically.  But, even all good things come to an end.  Plan accordingly by beginning with the end in mind.

Sam Burke is board certified in Civil Trial Law and can be reached at sburke@dentonlaw.com.