Judge, Jury and...Shareholder?

Judges have the power to control companies and manage disputes such that they can override traditional shareholder agreements and corporate rules. Courts are far more reluctant to intrude upon large widely-held companies, but for the closely held firm, beware the judge bearing good intentions! Closely-held companies must recognize the risks and manage their affairs to ensure predictability and control.

Traditionally, companies are governed by statutes and by their own governing documents, such as articles of incorporation, bylaws and shareholder agreements. These laws and documents can establish a clear route for owners managing companies and anticipating procedures, should ownership disputes arise.

The problem is that in many states, including Illinois, judges ruling on ownership disputes may override traditional laws and documents. This can create uncertainty for the owners and require attorneys to anticipate judicial criticism or overriding of governance structures for entities. Similar to a divorce, when owners go to war with one another, the disputing parties fight over the custody of their prized corporate baby. As with divorce cases, judges in ownership disputes will use extraordinary discretion to decide which party is more honorable, trustworthy, and worthy of controlling the entity. Judges can also be inconsistent. Some will follow the letter of the law and an agreement — to a fault. Others, sensing inequity in the documents or procedures, will cast them aside and casually re-write the rules of engagement. Business owners may hope for a judge who will faithfully follow the rules — but prepare for one who will not.

The problem begins with the nature of ownership disputes, which tend to become he-said / she-said matters. Judges must sift through varying facts and accusations, often presented with a side order of financial and business crisis. In some states and counties, such cases are automatically routed to judges responsible for ruling on “equitable” matters such as injunctions. In such “equity” cases, judges focus on “fairness” and “efficiency,” with much less regard for the niceties of legal formality.

Shock 1: Company Procedures Ignored

The first rude awakening for the scrupulous owner is that corporate formalities are often ignored. Details concerning shareholder or director meeting notices, waivers, quorums, and resolutions may fall victim to “the bigger picture.” Procedural errors (for example, whether a company provided ten day notice, instead of twenty) are rarely fatal to an argument — to your loss or gain. Judges often ignore failure to comply with procedural deadlines, and more seriously consider the actions taken by the parties.

Shock 2: Majority May Not Be Controlling

The second surprise is that majority holders of shares may not actually control the company. Judges can rule that the majority abused its control, squeezed out the minority holders, and/or oppressed shareholder-employees. Judges can overrule corporate actions, grant minority shareholders rights to damages, or, in extreme cases, appoint a receiver to operate the company. Effectively, the closely-held firm becomes a ward of the state.

Shock 3: Buy-Sell Prices Ignored

Often closely-held firms are governed by buy-sell agreements establishing buyout prices — whether fixed or set according to a formula. However, when bickering shareholders come before a judge, at least one of the parties may be shocked to learn that the judge deems the formula or price unfair. The judge may ignore the price and set a hearing for the parties to present arguments on the company’s value. So much for the pre-existing buy-sell agreement.

Shock 4: In Some States, the Law Allows Judges to Do Nearly Anything

In some states (including Illinois), the law provides judges with a 10- to 12-point list of options for resolving ownership disputes and managing a company from the bench. These include cancelling or altering bylaws or articles of incorporation, removing any director or officer from office, appointing directors, mandating dividends, dissolving the company, or overruling any act of the company or its owners, directors or officers.

Shock 5: LLCs – The All or Nothing Entities

Unlike corporations, courts tend to approach limited liability companies from either of two extremes. On the one hand, they can honor and uphold the detailed and professionally drafted operating agreement as if it were sacred text. On the other hand, they can completely manufacture new rules, especially for entities using thin or poorly drafted agreements. If the limited liability company operating agreement is detailed and tailored for the situation before the court, judges often respect it. But if it’s a long but ill-suited document or a short, vague skeleton, the judge will rule the day.

Craig McCrohon is a corporate and securities attorney specializing in equity offerings, venture capital and mergers and acquisitions. You may contact him at cmccrohon@burkelaw.com or 312-840-7006.

Fred Mendelsohn is a litigation attorney specializing in complex commercial litigation, shareholder disputes and fiduciary litigation. You may contact him at fmendelsohn@burkelaw.com or 312-840-7004.