When the American Dream Becomes a Family Nightmare
 
April 19, 2006
 

Family businesses often demand that owners manage disgruntled relatives as well as difficult employees or combative competition. The volatile mix of a lifetime of emotions, together with pressures to turn a profit, can explode into courtroom confrontation. Thus, the company that was the family’s crown jewel of accomplishment becomes more a source of personal pain than financial gain.

These family feuds arise from the constantly evolving legal theory of corporate fiduciary duty. The concept of a fiduciary duty imposes significant and subtle responsibilities on controlling managers and stockholders that few owners contemplate. These duties include thorough director oversight and board procedures to approve significant deals. Courts might also give minority stockholders the legal weapons of fiduciary duty claims to attack insider transactions.

A lawsuit can survive several rounds in the judicial process even if the facts fail to support the case strongly. The defense of a legal action can divert hundreds of hours from the active management of the business and result in significant added costs for legal representation.

Unfortunately, the standards of managerial fiduciary duty are often vague and difficult to apply in the context of day-to-day management decisions. Courts have considered to whom the duty is owed: is it the stockholders, employees, creditors, or the community? Other cases have addressed the question of who owes the duty: is it the directors, controlling stockholders, minority stockholders, or professional management? Consequently, advisors to family businesses must carefully execute decisions in the event that a wary family member stands ready to strike with a lawsuit.

In general, the controlling stockholder owes a duty to avoid conflict of interest, maintain loyalty to the company and exercise due care in making decisions. Most commonly, courts allow plaintiff stockholders to levy complaints concerning management decisions that personally benefit management at the expense of the minority owners. In addition, firms have found themselves in litigation purgatory in cases accusing management of carelessly and casually making decisions. Evidence of insufficient homework or failure to consult the appropriate expert have resulted in months or years of courtroom maneuvering.

Decisions that appear reasonable to management can be seen as shoddy and self-serving when a judge views a deal through the lens of a hostile attorney. Courts tend to review transactions and decisions that are either significant or inherently self-dealing.

Family management should take extraordinary caution when making the following decisions:

• Selling the company. Just as the sale of a family home can aggravate a long-festering marital argument, selling a family business can trigger disputes among related stockholders. Given the many side deals that often accompany such a sale, minority stockholders have a wide array of potential causes of action against management and the directors.

• Equity repurchases. Directors must manage the balance sheet as much as the workforce. Often stock buybacks create a more efficient firm. Holders of a tiny number of shares distract management and inflate legal and accounting costs. Also, potential investors and business partners may avoid the firm due to the needlessly crowded stockholder pool.

• Executive compensation. Next to the sale of the family business, bonuses and salaries to senior management are the most common source of complaints.

• Insider deals. These include leases or supply agreements with affiliated companies. These deals may be legitimately motivated by keeping control over quality and profit, or reasonable reduction of tax liabilities. Nevertheless, courts have consistently held that self-dealing is a dangerous game and must be managed to avoid even the appearance of a conflict of interest.

The Solution

While fiduciary duties remain difficult to define in the context of each and every business organization, years of court cases have revealed methods to minimize lawsuits. While these cases do not provide a simple checklist, they highlight best practices that minimize stockholder claims.

• Appoint a board. If the company is sufficiently large and the stockholders numerous or hostile, the board of directors will significantly reduce the risk of litigation. Without a board – preferably of outsiders – the company will appear more like a personal piggy bank than a going concern for the benefit of all owners.

• Give directors homework. Quiet boards make for loud lawsuits. In the now infamous cases such as Enron, the board of directors was outrageously complacent to corporate looting. However, in cases such as In re Walt Disney Co., which approved a generous $140 million bonus to a single executive, plaintiffs argued that the board did not do its homework. When approving one of the contentious corporate decisions enumerated above, directors should ensure that they have received and reviewed all relevant background material. This includes a full financial analysis of a proposal – be it a lease, executive bonus or offer to buy the company. Boards should meet more than once to review an insider deal or significant transaction.

• Ask the tough questions. Boards should ask the hard questions of management, especially regarding comparable opportunities. What are the alternatives to renting space, selling the company, or providing that generous bonus?

• Leave the room. Independent directors must discuss a decision without the presence of the executive or relative who will personally benefit.

• Appoint an independent board committee. In addition to an active board, a subcommittee of independent directors should review transactions that are potential conflicts of interest and require arm’s-length terms.

• Don’t be greedy. The board or the independent committee should ensure that terms are fair and reflect the market – whether the rent on a lease, the amount of annual compensation or the valuation of the firm for purposes of a stock repurchase plan.

• Hire experts. Often an independent internal review is not enough. In many cases, the board will need to support its argument by seeking the opinion of a third-party appraiser or other expert. This could include a valuation expert to value the company in the case of sale of certain assets, or the repurchase of stock, or the granting of equity options to management. In some cases, independent outside counsel should review the procedures contemplated and advise on how to minimize threats of litigation. In the case of executive compensation, this could include hiring an executive compensation consultant well known in the field who can benchmark the fairness of the compensation package.

The Bottom Line

Caution cannot guarantee that stockholders will not sue, but it often serves to deter an angry and emotional relative from charging vengefully into court. Adherence to court-mandated duties may not only reduce risk, but also promote responsible and profitable oversight of the family enterprise.

For more information, e-mail Craig McCrohon at craig.mccrohon@hklaw.com or call toll free, 1-888-688-8500.