A business divorce is the process by which the owners of a business separate their business interests. The process involves negotiation and may also require litigation.
These cases can be divided into four phases: the emergent phase, the examination phase, the valuation phase and the resolution phase.
Most owner lawsuits end in a negotiated transaction because it gives the parties more flexibility over the manner in which the case is resolved.
We’re going to look at business divorce in terms of the four phases that the typical case goes through from its start to the time that is resolved, either through settlement or trial.We should start with the most basic definition of what is a business divorce. I use the term to describe the process by which people who were in a business together disentangle themselves.
It’s a pretty broad class of cases and it could range from two people who were in a partnership together, to the textbook oppressed minority shareholder action to the enforcement of restrictive covenant, or an agreement not to compete. What we’ll focus on today is litigation between people who own a business together. That’s the most typical type of case that comes into the office, followed by agreements not to compete and disputes about the use of confidential and proprietary information.
At the risk of being overly simplistic, I’m going to identify four stages to business divorce, and I’m going to use a hospitalization to illustrate how those stages work. Now, the first stage is the emergent phase.
It’s the race to the court to try to get restraining orders, or injunctions, or other kinds of emergent relief. The second stage is the examination. It’s when the parties delve into the merits of the underlying claim, specifically, does the plaintiff have a case — whether it’s a claim for judicial dissolution, expulsion of a member, an accounting for profits or any of the other kinds of relief that is often involved in business divorce disputes.
The third stage is the valuation stage. The last stage is the resolution of the matter. You could say it’s like a patient undergoing the knife in an operating room, in a business divorce. That’s the procedure by which the case gets resolved on its merits. It’s important to remember that business divorce cases, like virtually all other litigation, ends in a settlement.
Our discussion is geared towards a resolution that ends in an agreement between the parties, and cases usually ends in a transaction. Only two, three, four or five percent of cases actually go to trial and business divorce is no different. Let’s start with the emergent phase. This is like the emergency room doctor trying to stabilize the patient. The goal in this phase is to find some acceptable status quo that is going to remain in place during the litigation.
Many, if not most, business divorce cases start as an emergency application for some type of immediate relief. In those cases, an expedited hearing is held to determine what safeguards are necessary to protect the interests of the parties and to assure that the case is decided on its merits. The issues in this preliminary phase can be far reaching. Here are some that are relatively common. Lockouts. Is someone being barred from the business?
Or should someone be barred from the business? This is often the first step in a contested business divorce. The majority may change the locks and alarm codes. They may change passwords or change bank accounts, or take any number of steps to literally and figuratively lock one of the owners out of the business. Interim reporting , documents records — this is another area that’s often addressed in an emergency hearing.
If one of the parties is out of the business, they will want to exercise their rights and know the status of the business. Can they ask the other party to get monthly reports, copies of tax returns, copies of bank statements? Should the ousted party be given access to sales reports? These are some of the issues that a court will often determine at the very start of the matter.
Interim distributions can also be a major battleground, and the outcome here is pretty uncertain. It’s not unusual that a party that has been locked out of the business will also be cut off from the distribution of profits. The ousted party invariably tries to compel continued distributions, but success in these applications is pretty uncertain. A judge may find that the claim for distribution is just a claim for money and make the party wait until the end of the case to recover on the judgment.
Or the court may step in and require a continuation of distributions. It really depends on the circumstances and the judge who’s hearing the case. Appointments of a custodian, a receiver, special fiscal agent. Judges have a lot of discretion in the remedy that is imposed in some business. Business divorce cases can include the appointment of a receiver or custodian or an independent director or special fiscal agent.
These are people who can get involved in breaking a deadlock and helping the company keep operating. In New Jersey., the courts recognize the special fiscal agent, someone whose job it is is simply to monitor and report to the court. The goal in the preliminary stage is to get an injunction and try to preserve the status quo. And we should briefly discuss what the standards are for emergent relief.
An injunction can be positive, such as ordering a party in control of the entity to provide periodic reports or it can be a negative injunction, one that prohibits some type of action, such as the use of disputed information or the dissipation of assets. It can prevent the parties from taking actions outside the ordinary course of business, or any other remedy that’s necessary to preserve the case itself for litigation.
The touchstone for many of these applications is the preservation of the status quo. What a party needs to show to get an injunction is first a reasonable likelihood of success on the merits. That means they have to put in their case and show that there are facts that support the positions that they’re taking. Second, they have to show that there is no adequate remedy in law.
It’s a technical term, but what it means is that there is no remedy for money damages., that money won’t make the party whole. Finally, the court is going to engage in a balancing of the equities. In other words, what does justice require? What’s more equitable as between the two parties and generally speaking, the party that is seeking an injunction has to show that the equities are balanced in their favor.
After the emerging phase, the next phase is the examination of the merits. Using our hospitalization analogy, this is like the doctors running tests and doing physical examinations. What is the status of the patient? In many cases, the factual basis for the relief is vigorously disputed, particularly when claims of wrongful conduct, such as misappropriation or breach of fiduciary duties. The allegations are the subject of discovery in depositions and exchange of documents.
There are two general classes of actions that you see in most business divorce cases. The first is generally based on some type of deadlock. In those cases, the parties cannot agree on an action that is critical to the continued operations of the business. It could be the approval of a merger, a new lease or a loan, the appointment of a director or the addition of a new member.
Parties are tied up and they cannot do something that is important. The other group of cases involve some kind of claimed wrong that is alleged by the parties. These can include minority oppression, in which the owners with majority stakes treat the minority unfairly. It can involve other types of conduct that are detrimental to the business, ranging from misappropriation of money to breach of a shareholder agreement or breach of an operating agreement.
There is also typically some type of an accounting that is involved in a business divorce, and that is often a focus in the examination stage. One side will contend they didn’t get their share. That claim for an accounting can be its own case. As a general rule, however, a business divorce case will require that the books are trued up, so to speak.
It’s worth noting that some states permit the defendant in an oppressed minority lawsuit to simply elect to purchase the interest of the plaintiff. This election precludes discovery on the merits of a claim of wrongdoing, and turns the action into one that is basically intended only to set the price. The next phase in a business divorce is the valuation phase.
I think of this using our analogy again as the doctors making rounds and reaching some kind of a consensus on the condition of the patient. The vast majority of business divorce cases end in a transaction, frequently the sale — voluntarily or under court order — of an equity interest, or sometimes of the business as a going concern. It’s critical, therefore, particularly in reaching a settlement, that the parties have a consensus on what the business is worth.
The truth is that the valuation phase usually overlaps to a great degree with the examination phase. I always encourage clients to make sure that they have an independent, unbiased view of what their business is worth before they get involved in litigation. The value of a business is often the subject of competing expert opinions, and it’s a very fact specific inquiry and varies significantly from state to state.
There are a few different ways that the parties will go about assessing the value of a business. In a business, divorce case, the method that I think most people would anticipate is, in my view, the least attractive. And that involves each side engaging an expert to prepare an independent valuation and then presenting those independent valuations to a court for decision.
Court can either accept the opinions in whole or in part, reject them, or come up with some combination. My experience is that unless there is some fundamental issue that needs to be resolved, it just doesn’t make sense to have the final valuation determined by the court, not if it can be avoided. One of the approaches that parties in divorce litigation often take is to have an expert appointed by the court or to come to an agreement on the use of an expert.
My personal preference is to have an expert appointed by the court, but to preserve for the parties the right to make additional comments or submit additional expert testimony about that valuation. This approach tends to keep the parties more in check with their expectations of value and provides a more predictable result, whether the final determination is made by trial or settlement.
The last stage of the business divorce is resolution. Here we can look at this as the surgical operation that resolves the matter. Ultimately, the case will get resolved. And as noted, this is often in the sale of an interest of one of the litigants. The resolution may come on a trial at the merits, at which time the court will determine the merits of the claim, as well as the amounts of money that will change hands in order to separate the parties interests.
More often, however, the parties avoid a trial and come to a negotiated purchase and sale. Trials are, after all, shockingly expensive and an order of the court typically leaves the parties with none of the flexibility that accompany a negotiated transaction. Mediation in this resolution phase is common, and sometimes the parties will conduct a separate valuation proceeding. Parties also have to be careful of the consequences of going to a trial at which testimony about unlawful conduct might come out —
In particular, business income that was not declared or other questionable business deductions. A court may have an obligation to report conduct that was illegal to the proper authorities. A court that must fashion a remedy after trial does not have the same business flexibility that the parties can incorporate into a negotiated settlement. Now it may impose terms and penalties, but one should not anticipate that the court will commit itself to continuing oversight.
That’s why mediation at this stage is very common. Now, those who have never been through the process should know that mediation is structured settlement negotiations with the assistance and under the guidance of a neutral. Frequently the mediators that the parties will turn to are themselves, retired judges. Finally, when we think about the anatomy of a business divorce, we also have to bear in mind that most of these cases do end in some type of transaction.
There’s a purchaser and a seller, and there are terms and many items that frequently have to be negotiated. These can include the way that the cash proceeds of the sale are allocated. inclusion of agreements not to compete, terms of the payout, security for the purchase, just to name a few. I often tell my clients it’s important to remember that business divorce is really not about the past, but about the parties coming to some resolution of what
The owners of a business typically invested years of their effort and much if not all of their financial resources into the business. It’s important, however, to remember that whatever the situation may be, life does go on, and it’s always important for the parties to restrain themselves from doing damage to the business in order to earn some sense of self-indication. That vindication is rarely available in the court system.