Business Divorce In The Time Of Covid

Stephen Brodsky, Partner, Mazzola Lindstrom LLP

The coronavirus pandemic has impacted private companies so severely that many owners of general partnership companies may decide they have no choice but to part ways. In response to the many issues buffeting their businesses, owners may have legitimate yet intractable disputes about how to proceed forward. In addition, each may have vastly different personal and financial circumstances that may influence, or even dictate, their business decisions.

This article discusses how the COVID-19 crisis may cause more disputes among the owners of private companies and how owners may attempt to resolve them. Nevertheless, a number of them will likely be unable to do so. In such cases, some will seek to sell their shares and member interests, others will invoke dispute resolution procedures, and still others may pursue relief under a governing state statute.

Sometimes, business “divorce” is the only option.

Current Conditions

Regardless of their organizational form and industry, nearly all privately-owned companies face the same extreme market conditions, including the following.

Decreased Demand

Demand for a company’s goods or services may have fallen drastically, whether due to curtailed spending or state-mandated safety measures. Regardless of the cause, consumers are not buying what the company is selling. So how can the company adjust, both in the short and long term? Should it lower its prices? Can it change its business model?

Disruptions in the Supply Chain

Supply shortages and delays are likewise affecting companies, often resulting in scarcity and higher costs. Should the company pass costs to customers or absorb them in the hope of retaining goodwill?

Employment Issues

Employment matters of various kinds abound. For example, it is simply not feasible for some businesses to have employees work remotely while shelter in place orders are in effect. Without question, owners may disagree about employees that are presently not needed and salaries that are no longer affordable.

Nonperformance of Agreements

Many businesses will be unable to perform their contracts or find that others will fail to perform. Purchase orders may be canceled. Supply agreements will not be honored. Defaults will occur. Each event may give rise to potential liability. So when is nonperformance the best alternative?

Fixed Costs

Every company will have certain costs that will remain due and owing, such as mortgages, rent, utilities, and insurance premiums. Companies must decide which it should continue to pay. Perhaps for some, defaulting is the better, or only, option.

Liquidity and Financing

Cash and financing needs may have changed drastically. Events may have triggered a default or material adverse change in a financing agreement. Is restructuring debt possible, and if so, can the owners agree to new obligations?

Increased Potential for Disputes

Responding to each of these challenges will require business owners to make difficult, even critical decisions. The potential for legitimate, good faith disputes is undeniable. Each owner may weigh legal, operational, and practical considerations differently.

While one may seek to preserve sales, another may focus on cost. Disagreements may arise over the same issue. One owner may favor targeted layoffs, while another may prefer across-the-board salary cuts.

The company’s shareholder or operating agreement may require that certain decisions be decided only by unanimous owner agreement. While this provision may have been thoughtfully included at the time of the company’s formation, how will that provision play out now? Will it result in a deadlock?

The life circumstances that each owner is experiencing may also give rise to disputes. The influence of each owner’s personal financial condition cannot be ignored. For example, one owner with a nest egg may demand that all owners refrain from taking a distribution, while another without such resources may seek a distribution and demand other cost-cutting measures.

Perceived or actual differences in owner performance or contributions to the business may cause still other disputes. Personal matters, perhaps exacerbated by the current pandemic, may be affecting an owner. Examples are marital discord, family obligations, and medical issues. Each may understandably result in underperformance.

If the owners’ agreement does not adequately address underperformance or inequities, resentment and discord among the owners may build.

Resolving Disputes

Direct Negotiations

Ideally, if all owners desire to continue their business, they should attempt to resolve their disagreements among themselves. It is undoubtedly the least costly route. Trust, open-mindedness, and compromise will be critical. Such discussions may be either with or without reference to the operative terms of their agreement. If their agreement does not sufficiently address the issues at hand, renegotiations among the owners may be necessary.

Owners’ Agreement

Regardless of the nature of a private company (e.g., a corporation, partnership, or limited liability company), it is best practice for the owners to have a carefully drafted, clear, and comprehensive executed written agreement that sets forth the rights and responsibilities of the owners. This agreement should address, among other things:

  • How company decisions are to be made
  • Officer or manager roles
  • Transfers or sales of shares or member interests, whether through voluntary dispositions or in the event of an owner’s disability, incapacity, or death, to third parties, including first-refusal rights of company owners
  • Involuntary automatic sell back provisions given certain triggering events, such as breach of one or more contractual or other duties by an owner
  • How shares or interests are to be valued in each circumstance
  • When and how profit and other distributions are to be made
  • Matters concerning operations of the company and the rights and obligations of the owners.

Such additional terms may include restrictive covenants, confidentiality agreements, and indemnity provisions.

Relevant to this discussion is how company decisions are to be made. The owners may agree that decisions are to be made by a majority of the votes of owners with voting rights. Or they may vest managers with discretionary authority. Importantly, the owners may decide that certain significant decisions require a supermajority vote or unanimous agreement. The agreement will typically define what constitutes a significant decision.

Examples are:

  • Hiring or termination of key officers and employees
  • Execution of contracts of a specific type or above a particular dollar amount
  • Entering into contracts or taking actions that are not in the ordinary course of business
  • Any other matter that the owners consider to be sufficiently important to require more than a mere majority vote.

It is reasonable that the companies’ decisions during the COVID-19 pandemic and the accompanying financial turmoil may be significant decisions and/or decisions not in the ordinary course of business for the company. If the shareholder, operating, or partnership agreement includes a unanimous consent rule, the owners may take action if all agree. Certainly, the possibility of deadlock looms.

The agreement will likely include a dispute resolution provision that operates in certain circumstances. It may cover disputes concerning particular matters, or it may be triggered upon the occurrence of certain asserted events, such as a contractual, fiduciary, or other breach by an owner.

These provisions commonly require arbitration to be used. Some may even specify the arbitral forum to oversee the process and procedures that will govern.

Resorting to Statutory Relief

If there is no agreement among the owners or the agreement does not address the issue at hand, an owner may need to seek relief under relevant state statutes. For example, if there is a deadlock among management such that the affairs of the company cannot be continued, a shareholder or LLC member may petition a court for dissolution.

For example, as to New York corporations, Business Corporation Law Section 1104 enables shareholders who own one-half of all votes of outstanding shares to petition for dissolution if (1) the directors are so divided respecting the management of the corporation’s affairs that the votes for action required by the board cannot be obtained; (2) the shareholders are so divided that the votes required for the election of directors cannot be obtained; and/or (3) there is internal dissent, and two or more factions of the shareholders are so divided that dissolution will be beneficial to the shareholders.

Business Corporation Law Section 1104-a is available to holders of shares representing 20% or more of all outstanding shares. It allows for dissolution in the event of illegal, fraudulent, or oppressive actions toward the complaining shareholders or property or other assets of the corporation or being looted, wasted, or diverted for non-corporate purposes.

Similarly, for a New York limited liability company, LLC Section 702 allows a member to petition for dissolution if it is not reasonably practicable to carry on the business of the LLC in conformity with the articles of organization or operating agreement.

It is possible but not assured that an owner in personal financial distress will be able to use such statutory mechanisms to force a dissolution of the company.

Conclusion

To respond in the current pandemic and financial turmoil, companies will need to make difficult decisions. While some owners may seek to continue with their company’s business, others may desire to leave it for personal or other reasons. But, hopefully, all who seek to weather the storm will see their businesses survive.

 This article was previously published in Law 360