New Podcast: Stay out of Court: Five Causes of Unnecessary Litigation

Stay Out of Court: Five Causes of Unnecessary Litigation
By Philip W. Bledsoe

Printed in the Denver Business Journal on October 13, 2006

It is well-known within the legal profession that business people do not like lawyers – until they need one. Sometimes that need cannot be avoided, as in the case of a nonperforming vendor or  contractual partner. But there are recurring types of business litigation that could have been avoided. They are most commonly seen – but not exclusively so – in closely held companies, even in those with substantial revenues. Indeed, it is in the successful business when the dollars at issue become worth fighting about that these recurring issues arise. This article discusses five
of those categories.

The Closely Held Company Without An Exit Strategy

Very often owners of a smaller business are so focused on getting their business up and running that an insufficient amount of attention is spent on the end game, whether that be sale of  the company or an individual owner wishing to retire or to simply sell to pursue other business opportunities. Perhaps the best way to deal with this is to include a “Buy/Sell” provision in your Shareholder Agreement or Operating Agreement. The failure to have a viable method to separate ownership can be particularly acute when there are minority ownership interests in the company. Whether that minority interest becomes dissident or is being oppressed by the majority, the failure to include a meaningful, yet fair, way to separate business owners who have become disenchanted with one another can paralyze a business or impose transaction costs to the ultimate disadvantage of all of the owners.

The Closely Held Company Without A Real Management Strategy

This recurring issue shows up in two primary ways. The first is the “50/50” problem.
Perhaps the most common variation of this is when two soon to be ex-friends go into business together. On that first happy day when the business opens they are sure they will always agree on important business decisions. When that does not happen, and there is no mechanism to avoid a stalemate, the resulting business divorce can result in the acrimony sometimes associated with a real divorce.

A second problem in this category shows up with limited liability companies that do not properly attend to the duties of members versus managers. While it is a variation on the above theme, if an LLC has a member out transacting business without the authority of being a manager it can expose the company to liability or undermine existing management. This situation can occur when roles within the business change and evolve without the needed followup under the Operating Agreement.

The Business That Just Happened

This seems to occur with some surprising regularity. It arises from the fact that business  people pursue unexpected opportunities and are so interested in that pursuit and achieving success that they do not do things like form an actual company. Another way this happens is because business plans do not always unfold as predicted. Opportunities can surprisingly occur or perhaps a single large customer fundamentally alters the nature of the business. When these things happen and take the actual operation of the business outside what was anticipated under the original company documents trouble can easily follow.

The first cousin to this recurring litigation issue is the business that undertakes a major project with a third party or “business partner” with a generalized intent to “document it later.” Later often ends up simply being too late. And this is true whether a deal has gone bad and the dispute is about who pays or whether a deal has done well and the dispute is about who gets paid. The second cousin to this problem is when the business outgrows the existing governing document. This happens when new owners, or producers in a sales context, are brought into a business without adequate consideration and documentation of their role, responsibility and compensation. It can also occur when someone “recycles” a previously formed business entity without regard for whether there are any lingering liability issues.

Forgetting The Difference Between Individual And The Business

This problem can arise even in a single owner business where, because of that reason, an individual can expose himself to personal liability by failing to ensure that a particular business obligation is actually in the name of the company. When carried to an extreme, it can certainly result in substantial individual exposure or taxation problems.

Another common manifestation of this problem is when one business partner is providing capital while the other is providing sweat equity or industry expertise. Failure to account for the difference between an individual and a company can blur the issue of whether or not advanced monies are considered capital or a loan. That difference can be substantial - because it can effect who gets their money first - and a dispute about the characterization of an advance can easily spill into the courtroom.

The Formation Of A Subsidiary For Protection Without The Follow Through

The protection of an individual’s assets by the use of a corporate shield (whether a
traditional corporation or a LLC) can be lost. This occurs when there is inadequate follow-up in terms of maintaining annual registrations and other corporate formalities. It also occurs when a subsidiary business entity undertakes substantial business obligations without adequate capitalization. In those circumstances, when the subsidiary is plainly acting only for it’s owner, inadequate capitalization can result in the corporate protection being lost.

Nothing said here is truly remarkable. But these problems arise time after time and too often result in a visit with your lawyer. Corporate formation is about allocation of responsibilities as well as risks and rewards. Advance thought about the potential life span of a business at the time it is formed, full consideration of the rights and responsibilities of the principals, along with regular review, is the best vaccination to reduce the chances of unnecessary litigation.

 
To contact Phil Bledsoe, email at pbledsoe@stklaw.com or call 720-931-1172.

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©2006 Shughart Thomson & Kilroy, P.C. All Rights Reserved

Author: G. Stephen (Steve) Long
Firm: Shughart Thomson & Kilroy, P.C.

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