ABA Section of Business Law
ABA Section of Business Law
Business Law Today
July/August 1998
Breaking up is hard to do What are your rights when business partners decide to split?
By NEAL A. JACOBS
Jacobs is a lawyer with Blank Rome Comisky & McCauley in Philadelphia.
Business divorces can be just as emotionally wrenching and financially disruptive as a marital divorce. Business divorces between business principals can leave one in possession of the entire business, the customers and profits and the other considering bankruptcy and looking for work. Curiously, many business divorces occur once the business has become successful, the principals are taking home real money and there is significant equity in the business. With success come the difficult, acrimonious issues and decisions that the partners failed to face early on or dealt with only partially. It is these issues that often lead to an acrimonious business divorce.
These issues, or resentments, come to the fore in the nature of arguments over the division of profits, the time spent by the respective partners in the business, outside business interests, outside family and social obligations, the relative value of the respective partner's contributions, management and ownership succession, nepotism and the like.
Of course at this point, one or more of the partners may seek advice from the law firm that had previously represented the business. This may create a conflict of interest for that law firm disqualifying the firm from representing the business and any of the partners in that dispute. See Rosman v. Shapiro, 653 F. Supp. 1441 (S.D.N.Y. 1987). Counsel, as well as accountants, should be aware that beyond the ethical implications, in some circumstances giving advice and representing one of the partners in the business divorce may result in civil liability for damages in favor of the other partner and even the business. Being a lawyer or a CPA does not bestow any immunity from suit for breach of fiduciary duty, negligence, tortious interference with prospective business advantage, aiding and abetting the commission of a tort, civil conspiracy, and on and on.
The principals' rights and obligations vary depending on, among other things, whether they structured their business entity as a partnership, corporation, close corporation, limited liability company or limited liability partnership and the rights and obligations set forth in their partnership, shareholder or member agreement — if any was signed. Many of these rights and obligations are similar regardless of the nature of the business structure. For the purposes of this discussion, we will assume that the business has been structured as a partnership under the Uniform Partnership Act (1914), 6 Uniform Laws Annotated, pg. 238 et. seq. (adopted by 38 states); see also Uniform Partnership Act (1994), 6 Uniform Laws Annotated, pg. 8 et. seq. (adopted by 12 states).
These rights and obligations usually only crop up when a business partner begins to recognize that disputes are leading to a business divorce. Then each partner must act immediately to begin to protect his or her own interest and livelihood, or risk losing all.
By way of example, let us assume that Sheila, Chris and John with the best of intentions and trusting each other "implicitly" formed a marketing/advertising company "OLDCO" on a handshake deal; each taking an equal one-third share of the company. Sheila is the star sales person, Chris the creative director and John the back office administrator.
After five long years, OLDCO is a financial success generating enough business for each partner to take home a significant six-figure income and for the partners to build up substantial equity in the business. Unfortunately for the partners, this success has brought to the fore resentments and disputes that had been lying just below the surface. Sheila has resented for years the fact that she brings in 65 percent of the business through her contacts but is getting only one-third of the profits. Sheila plainly and bluntly tells Chris and John that she is not being adequately compensated as the firm's rainmaker and demands that her partnership interest be doubled. John and Chris are extremely upset with Sheila. John feels that Sheila is completely failing to recognize his contribution for managing their business and Chris feels that it is his creativity that has brought in the clients for which Sheila is now taking credit.
Sheila's, Chris' and John's respective resentment leads to major league battles in the office with both Chris and John refusing to renegotiate their deal with Sheila. The animosity in the office becomes palpable with the morale of all employees plummeting like a stone dropped off of a cliff. The open warfare in the OLDCO office scares Sheila into thinking that her partners might try and lock her out of the business and "fire" her; which, in truth, John and Chris have considered. John and Chris have thought about kicking Sheila out and hiring one or more salespersons to replace her. Sheila realizes that she can't go on like this and she feels that she has only two choices to preserve her income, equity and future.
First, Sheila secretly explores forming her own firm, conducting a midnight raid on her office to get "her" clients' files and hiring the talent she needs to support her clients; all at a fraction of the cost of what Chris and John are taking out of the business. Second, Sheila has been considering joining a competitor who has been soliciting her to come on board as a partner at a significant increase in her profits, of course, with the understanding that she brings "her" clients to the new firm. What happens next depends, in large part, on whether Sheila, Chris and John obtain good legal advice as to their respective rights, duties and obligations under the laws of their state and properly evaluate the relative risks and rewards of each choice. Sheila, Chris and John will all soon learn that their potential business divorce is very complicated and that each course of conduct involves both business and legal risks. Each of the following basic legal principles must be taken into account by Sheila, Chris and John in deciding what action to take.
Under the Uniform Partnership Act, business partners are fiduciaries to each other and owe a duty of their utmost loyalty to each other and to their combined business venture. UPA (1914) §21; UPA (1994) §404. As such, the respective partners' actions must be to advance the interest of the business and to act loyally to each other. Id. State court decisions reinforce this notion defining the term "fiduciary duty" to mean "joint adventurers, like co-partners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a work-a-day world for those acting at arm's length are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this, there has developed a tradition that is unbending and inveterate." . . . See Clement v. Clement, 436 Pa. 466, 468, 260 A.2d 728, 729 (1970), citing to Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545 (1928).
This means that if Sheila plans, takes steps to start and actually starts a competing business while still a partner in OLDCO, her partners may claim that Sheila breached her fiduciary duty to her them and to OLDCO. See Woodruff v. Bryant, 558 S.W.2d 535 (Tex. Civ. App. 1977). This places Sheila in a type of "Catch 22." If she decides to leave to form her own business, the law appears to impose the requirement that Sheila first completely withdraw from the partnership prior to taking any steps to start her own business. But if she gives Chris and John that kind of notice of her intentions, and withdraws from the business, Chris and John may raid and scavenge "her business" to the point of ruin. Sheila will have to weigh the cost to her business of taking this step and the business reality that once she withdraws Chris and John may change the locks and begin consolidating their hold on what Sheila perceives to be "her clients."
Of course, conversely, John and Chris must also recognize that since they also owe a fiduciary obligation to Sheila, they may have exposure to her for damages if they violate their fiduciary obligations owing to Sheila by trying to kick her out of the business, by locking her out, or if they decide to form their own business without her. See Notch View Associates v. Smith, 260 N.J. Super. 190, 615 A.2d 676 (1992) (partners who misappropriate business opportunities are liable to other partners for all profits therefrom). In general, unless specified to the contrary in a partnership, shareholder, member or some other agreement, holders of equity in a business have no unilateral right to lifetime employment with the business. It's important to note, however, that where the sole benefit obtained by the partner's equity ownership of a partnership interest is the right to work in and share the profits of the business and if this expectation is clearly spelled out in the agreement, the partner may have a right to continued "employment" with the business. Plainly put, a partner's rights are extremely fact dependent.
In our hypothetical, Chris and John could lock Sheila out of the business and "fire" her as their sales person. But if they do, Chris and John may have exposed themselves to liability to Sheila for a claim of breach of fiduciary duty. Sheila's chances of success on that claim will depend in part on her interest and activity in the business. Under the law of most states, OLDCO's client list developed by or contributed to OLDCO by its constituent partners belongs to OLDCO and may be a trade secret of the business. If the business treated the client list and information on the clients as confidential and took steps to protect it as confidential and proprietary to the business, then most states will treat that as a protected trade secret belonging to OLDCO. This information routinely has been held to include customer lists, customer information, product knowledge, specialized formulas or products or similar information important to the business. However, if OLDCO took no steps to safeguard this information or if this information is publicly available or if Sheila, Chris and John had developed this information prior to forming OLDCO, then the information may not be protected at all. If the client list was contributed by Sheila to the business but with the express understanding that on her departure from or the dissolution of OLDCO the client list would revert back to her and she could recover such clients, then Sheila could have a claim to the use of that information. In general however, unless spelled out to the contrary in an agreement, the customer list always belongs to the business and not to the constituent partners. Again, this is an area that is fact dependent.
In general, a business partner without a noncompete agreement has the right after leaving the old partnership to take a job, or start a business competing with the old business. However, there is a split of authority on the scope of this right. See Leff v. Gunter, 33 C.3d 508, 658 P.2d 740, 189 Cal. Rptr. 377, (1983) (post-partnership competition in the same project or field not allowed); but see Langer v. Becker, 240 Ill. App. 3d 823, 608 N.E.2d 468, 181 Ill. Dec. 395 (1992) (partners are free to do business and compete post partnership). Moreover, even when a partner is able to compete, there may be serious limits on this right imposed by the intertwined concepts of fiduciary duty and trade secrets.
For example, because of the position of trust that the partner may have had with the old partnership, it may be that the partner may have been trained in the business and given access to confidential information (trade secrets) of the business of which she had no knowledge before the partnership started. As such, it may be unfair to allow her to take advantage of such information to compete with the old employer/partnership and to contact former clients. Thus, the ex-partner could be held liable for any damage to the old business for her misuse of its confidential and trade secret business of the old partnership.
Sheila's, John's and Chris' previous background and work experience, their prior knowledge of the industry and the partnership's clientele, their access to confidential information, and their activities during their term as partner may all affect their ability to compete with OLDCO or each other in the future.
In general, the law states that the assets of the business belong to the business and not to the constituent partners, even if they originally owned the asset before contributing it to the start of the business. UPA (1994) §203; UPA (1914) §24 (cannot possess property to exclusion of other partners); Buell Cabinet Co. Inc. v. Sudduth, 608 F.2d 431 (10th Cir. 1979) (property belongs to partnership not individual partners). Thus, OLDCO could potentially assert a claim for significant damages for the unlawful "theft" of OLDCO's property against Sheila if she conducted a raid on the business offices to take what she perceives to be "her" files, but which in reality are owned by the business. A further consideration in some regulated or licensed businesses or professions is that the clients may actually own the files and the taking of such files may expose the partner to disciplinary action and damages.
The law has long recognized that the partners in a closely held business must generally present to that business all business opportunities that they may generate or come across that are in the field of endeavor of their closely held business.
Thus, if Sheila planned her new venture and starts soliciting for new business while still a partner in OLDCO, OLDCO could charge Sheila with wrongfully seizing corporate/business opportunities rightfully belonging to OLDCO.
Another option frequently used by warring business partners is to seize the business bank accounts, remittances from clients and any other business funds that may be available. Some warring partners even attempt to divert the mail and receivables of the business to a new P.O. box controlled only by that partner. While these actions may arise in the context of a battle for control of the old business' assets, doing so will implicate the partners' respective fiduciary duties owing to each other as well as their potential liability for breaches of that duty and for actions in seizing the accounts.
The diversion of U.S. mail may also implicate portions of the U.S. Criminal Code and the diversion of the business funds may implicate the criminal code of the state with jurisdiction over the business and its assets. See 18 U.S.C. §§1701, 1702, 1708 (diversion of mail and interference in mail is a federal crime); The People of the State of Colorado v. Fullop, 837 P.2d 215, (Colo. Ct. App. 1992) (director and officer convicted for theft of corporate assets). Of course, money is the life blood of any business and it is ammunition in a battle between divorcing business partners. As such, there may be significant strategic reasons for attempting to gain control of the mail containing remittances from clients, bank accounts and funds. Of course there are significant risks to such a strategy as well.
Under the UPA, Sheila or Chris or John can dissolve the partnership at any time by notifying their partners of their withdrawal from the partnership. UPA (1914) §31. This will trigger the winding up of the business affairs of the partnership. UPA (1914) §37. Thus, if their affairs have truly reached the breaking point, Sheila could simply deliver a letter to Chris and John dissolving the partnership.
At that point, while the partners can start planning their respective business ventures, the affairs of the old business still have to be wound up. After termination, the partners are required to wind up the business affairs of the old partnership, collecting the accounts receivable, paying the old accounts payable, filing the final tax returns and distributing any remaining net profits. Of course included in this will be the distribution of the assets of the partnership, assets that will include the client lists and client information, over which disposition the partners invariably strongly disagree.
In our hypothetical, Sheila will assert ownership of her client accounts, while Chris and John will likely contest that position. That may result in litigation if the parties are unable to resolve their disputes. Any of the partners could ask the court to order the other partners to account for and explain the disposition of any assets or collections of receivables.
Of course, the foregoing only discusses certain legal precepts and legal theories. In reality, Chris, John and Sheila will be scrambling to protect their own business interests and livelihood. In so doing, each of them may have to take on the risk of exposure to potential legal claims in order to protect their business interests. For example, Sheila will insist that she has to be contacting each of her clients, referral sources and customers and notifying them of her intention to leave OLDCO all while still an OLDCO partner in order to preserve as much of her business as possible. John and Chris may well feel that in order to protect OLDCO's business, they have to lock Sheila out of the office and transfer their bank accounts.
Each of these "business" requirements of Sheila, Chris and John may entail risk of exposing each of them to potential damages down the road. But the imperative of protecting their present livelihood and business may require acceptance of that risk. Moreover, the former partners must be cognizant of the risks of going too far in their competitive efforts. If the former partners conspire in their efforts to raid the others' business and if they show an intention to drive the other partner out of business, they may be open to claims of anti-competitive behavior in violation of the Sherman Antitrust Act and thus be exposing themselves to potential treble damages. See Antitrust Law Developments (Fourth), Restraints of Trade, pg. 122-124 (Conspiracies to Eliminate A Competitor By Unfair Business Conduct) (discussion of Albert Pick-Barth Co. v. Mitchell Woodbury Corp., 57 F.2d 96 (1st Cir.), cert. denied, 286 U.S. 552 (1932) and its progeny). These same sorts of activities can also give rise to potential claims of violations of the Racketeer Influenced and Corrupt Organizations Act (RICO) 18 U.S.C. §1961 et. seq.
Of course, this "open hunting season" on each other and on OLDCO's customers has more than just theoretical legal implications. This conduct may leave the OLDCO business hemorrhaging as customers depart the battle zone for the peace and quiet of the competition. Simply put, most clients do not like having to be put in the middle of such business divorces and having to choose sides.
In the event that open warfare continues between Chris, John and Sheila, whether before dissolution of the partnership or afterward, one option open to each of the partners is to petition the court for the appointment of a receiver to operate and oversee the business until their disputes have been resolved either in court or in some other forum. The receivership statutes vary from state to state, but in general a receiver can be appointed when the business is in danger of failing and there is a finding by the court that the principals in control have defrauded the business. In general, where the business is a going concern and is operating profitably, a receiver is a difficult remedy to obtain. However, the appointment of the receiver can be fraught with risks as well. The appointment of a receiver is hard to obtain and is frowned on by the courts. Further, even if the court agrees to appoint a receiver, the selection of a receiver will be a further issue. While the parties will each propose their own favored receivers to run the business, it will be up to the court to determine which receiver to select, either one proposed by the parties or one that the court may select from another source. Also, the receiver's obligations will simply be to maintain as much of the business as possible and to run it in a business-like fashion.
There is a great risk that Sheila, Chris or John would not like the way the receiver is running the business or will dispute the way the receiver runs the business. Further, it is often difficult for entrepreneurial individuals to allow a third party to come in and take over the operation and running of their business or even the winding up of the business affairs. Finally, the receiver is entitled to a significant fee for running the business as well as having his or her legal fees paid for by Chris, John and Sheila, all of which comes out of the pockets of the partners. This last item can in some circumstance be enough to force the parties to try and find a way to resolve the situation. A typical solution to many business divorce situations is to have one side buy out the other side's interest in the business. This may be as a result of the exercise of a well-crafted buy-sell provision in an agreement or as a result of an emotional decision to end the problem by throwing money at it.
In either event, the main issue may come down to setting a value for the business as well as agreeing on how to set that value. This may require the use of business-valuation experts and negotiating the inevitable dispute between experts as to the value of the business.
However, once an agreement on value has been reached, the parties must next turn to the often difficult task of raising the funds necessary to finance the purchase. Lawyers familiar with raising funds, investment bankers and financiers are all critical at this stage.
After the initial legal maneuvering, and the expenditure of legal fees, Sheila, Chris and John will usually find that it is far more cost efficient and effective both economically and emotionally to reach an amicable resolution of this dispute or to move their battle to an alternative dispute resolution-type forum. Some businesses are well suited to particular ADR approaches. For example, mediation is well suited in the case where the partners' business is focused on two or more discreet product or service lines, both of which are profitable.
In the event the partners cannot agree on a division of the business, or if the division of the business is impracticable, then a mediator could help the parties craft a mechanism to separate the partners by having one or the other buy out the interest of the remaining partner. There are a myriad of other possible ADR structures and outcomes. If the partners determine that it is in their best mutual interests to have one of the partners or one group of partners buy out the partner or the other group of partners, then a number of key issues come into play including, among other things,
- deciding on which group of partners will buy out the remaining partners;
- the price for the buy-out;
- the terms for payment of the buy-out price;
- whether the selling partners will agree to finance any portion of the purchase price;
- whether the selling partners will agree to a noncompete and, if so, then its length and duration; and
- the parties' obligations in the event of any default.
For example, if the business partners do not trust each other and do not trust in their own respective abilities to value the business, then one favored option is to use the "spinning shotgun" approach to the buyout. In this particular scenario, the partners agree that one set of partners will place a number valuing the entire business on the table — loading the shotgun. The other partners will then have the option of deciding to be a buyer or a seller of the business at the price set by the other partner — spinning the shotgun to decide where it is aimed.
The advantage of this procedure is that the difficulty of precisely valuing the business is resolved. If the price is set too low, the other partner will definitely be a buyer, too high and he will be a seller.
Any business partner or any equity holder considering a business divorce or believing that a business divorce is being thrust on him or her should seek counsel immediately. Otherwise, that person may walk into his or her office one day only to find that the files, computer, telephone, Rolodex and customer account information have all been removed, the bank accounts drained or closed and only a letter left in the now-empty office informing him or her of the name of his or her former partner's lawyer.
