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INSIGHT: Business Divorces—Preparing for the Worst During Covid-19

Aug. 28, 2020, 8:00 AM

Personal marriages end in divorce about 50% of the time, and involve money, pain, and suffering. Business divorces relating to stockholders, investors and partners of closely-held corporations, LLCs and partnerships take place at an even greater rate, and also involve money, pain, and suffering.

Knowing how to help your clients minimize their risk of a business divorce starts with knowing the factors that typically lead a partnership to dissolve.

Factors Leading to Business Divorce

So, what are the main issues that can lead to a business divorce? They are often caused by one or more of the following factors:

  1. When cashflow drops, blood pressure increases. When there are one or more outside stressors on the financial and/or operational success of the business. This can be caused by a shift in the market for a business’ products or services, a general downturn in the economy, or, as we are seeing in 2020, a rather specific economic spasm caused by a worldwide pandemic.
  2. Goals of the partners diverge. When one individual or faction wants to “go in another direction”—whether it is a significant change of the company’s main product line, parties wanting a different split of the profits, illness or disability, moving to a new city, “slowing down” or retirement, plans for succession, taking care of family matters, or wanting to have a different role in the business. In 2020, Covid-19 and fear of the virus are a source of personal matters taking precedence over business, sometimes to the unhappiness of other partners.
  3. Self-serving actions of a party. When one party (i) uses company funds for personal benefits (purchasing an automobile via the company for use by one of the partners, e.g.), or hires his or her own family members or businesses, (ii) performs services for or buys into a competing business, or (iii) takes a corporate opportunity that belongs to all, these self-serving actions may not only be violations of agreements and common law, they will really upset other stockholders, investors and/or partners.
  4. Investor unhappiness. An investor either needs or wants liquidity or better performance; or business owners would like to buy-out or otherwise get away from one or more of their investors.

Once you identify some of the factors that could spur a business divorce, it is also important to know how you can minimize the likelihood of a business divorce for your client, or at least increase the chances that the process will be one that is relatively orderly and peaceful.

Precise Documentation

As with personal marriages and divorces, a solid prenuptial agreement can be valuable. In the business context, this means careful (and preferably early) documentation of the roles and expected performance of the stockholders/partners, including as employees and as board members, with plans for illness, voluntary and involuntary separation, retirement and death. In the case of death and disability, this is often as simple has putting in place a “buy-sell” agreement based on life and/or disability insurance. In the case of parties who are employees of the enterprise, articulating how and when they are to be compensated for their personal efforts, or terminated, can also avoid later disputes.

As most practitioners advising closely-held businesses know, however, documentation is often client-created, subject to dispute, or nonexistent. Something as simple as a missing integration clause can make a simple situation contemplated, as oral agreements and course of dealing arguments enter the mix. And this leads to a much higher likelihood of stress on relationships and sometimes to acrimony and litigation.

Who Does the Lawyer Represent?

A large part of successfully navigating a business divorce as an attorney is knowing who the client is. For example, may a lawyer represent the company and still represent the interests of one party over another?

The position of the lawyer with a client involved directly or tangentially in a situation headed for a business divorce will vary greatly with the circumstances. It is tempting to try and act as a mediator between competing factions. As attorneys, however, we usually have to “pick a side” to represent.

If a lawyer represents an individual party to the potential or actual dispute, then, absent some conflict (such as representing another partner in the dispute on related matters or where confidential information about such other partner has been garnered by the lawyer), the situation is clear. If, however, the lawyer represents both an individual (perhaps on multiple matters) and the business entity, things can get murky.

For example, when there is a clear control party (such as where a majority owner of a single manager managed LLC cannot be terminated), the lawyer may sometimes represent the company at such individual client’s direction. In such cases, even though the company may take positions that fit perfectly with the desires of the controlling party, it is possible for company counsel to represent the company against the “divergent” party or parties and to be paid legal fees by the company. In other cases, however, where the disputing parties each have some ability to control or direct the actions of the company, company counsel may be stuck in the middle and not be able to participate directly in the dispute. In such cases, company counsel will have to advise the parties in discussions or dispute to retain their own separate counsel and guide only the company through any resolution process.

Tools to Accomplish the Goal

Any client facing a business divorce has a great need for creative and experienced counsel. Lawyers who focus on business divorces must have a solid grip on the details of the laws and statutes governing corporations, partnerships and limited liability companies. In addition, they must have an understanding of, and experience with, certain pathways to success in disputes involving closely-held businesses.

There are many tools for a lawyer to apply depending on the position of the lawyer’s client, the facts, and the applicable law. These include the withholding of distributions, termination of employment, removal from the board of directors or managers, statutory merger, work stoppage, exercise of options, reviews of books and records, and many more. Whether the situation resolves itself in a re-jiggering of relationships, reorganization of the company, a buy-out, or a sale of the business, experience and creativity matter.

In the current business environment, including the wide-ranging effects of Covid-19, lawyers should anticipate the rise in potential and actual disputes leading to business divorces and prepare clients for the same.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Lee Weinberg is a partner in the Los Angeles office of Weinberg Gonser LLP. He regularly handles partnership disputes and Business Divorces associated with privately held companies.