/>iConflicts between co-owners in private companies are common, but the vast majority are worked out through dialogue and negotiation. When these internal conflicts cannot be resolved, however, minority investors may file suit against the company’s majority owner. Anecdotally, these investor claims seem to be on the rise, including claims that the majority owner breached fiduciary duties owed to the company. This post therefore reviews strategies for majority owners to consider when they are required to defend investor lawsuits.
Seek Early Settlement of Litigation
Litigation between private company co-owners is not for the faint hearted. Minority investors tend to be passionate about their claims against the business owners, which means the litigation is likely to be protracted and expensive, as well as disruptive to the business. For these reasons, the majority owner is wise to make diligent efforts to resolve the lawsuit at the outset if there is a reasonable path to settlement that avoids a drawn-out legal battle. A prompt settlement will save the majority owner a vast amount of time, dramatically reduce the legal expense that is involved in litigation and avoid a public legal battle that could be harmful to the business.
Achieving a settlement with a disgruntled minority partner makes a lot of sense, but it can be difficult to achieve as investor claims often have an emotional component. Further, investor lawsuits are typically filed only after settlement negotiations between the parties have not been successful. Given this background, the following are several approaches for the majority owner to consider, which may not have been pursued before the lawsuit was filed.
- Mediation – A mediation may not seem productive based on the parties’ impasse in their negotiations before the suit was filed, but this session will require the parties to focus on a potential settlement with assistance from an experienced business mediator. Even if the mediation is not successful, it may provide a settlement framework that can lead to a later resolution. In addition, the mediation may provide information that will be helpful in the majority in the litigation before any discovery takes place in the lawsuit.
- Arbitration – A mandatory arbitration provision may not be included in the LLC company agreement, the bylaws, or shareholder agreement, but the parties can agree voluntarily for their disputes to be resolved through arbitration, which would expedite the outcome in a matter of months rather than after years of litigation. For example, when the primary dispute between the parties concerns the company’s value and the amount to be paid for the purchase of the investor’s interest in the business, the parties may agree to have the value question resolved by a single arbitrator or an arbitration panel.
- Structured Buyout – The impasse that led to the lawsuit being filed may be broken by a settlement in which the minority investor receives a substantial payment for most of the investor’s ownership stake in the business. The settlement will also provide the investor with a carried interest in the company (by contract not ownership equity) that results in a future payment based on the company’s future performance. This type of settlement may work if the investor is looking for short-term liquidity that will monetize a portion of its investment. Further, to provide the investor with some protection regarding the future payment, this amount can be structured with a floor and a ceiling, i.e., the investor receives a guarantee the future payment will be for at least a certain set amount.
- Company Sale – Finally, in some circumstances it may be advisable for the majority owner to sell the business rather than engage in a legal war of attrition with the minority investor. A sale of the company on favorable terms that provides for a cash out of all owners is also likely to result in the resolution of the lawsuit.
Indemnity, Dilution, and Defense of Investor Claims
If the majority owner cannot achieve a prompt settlement of the minority investor’s suit, there are a number of affirmative steps and strategies the owner will want to consider as the case moves forward, which are discussed in the remainder of this post.
Full Indemnity of Majority Owner and Potential Counterclaims
It is not a defense to an investor’s claim, but the benefits of obtaining indemnity should be immediately pursued by the majority owner after the lawsuit is filed. Virtually all company governance documents provide for managers, directors and officers to be indemnified by the business for lawsuits relating to the performance of their duties. The majority owner will be required to make a formal demand for indemnity after which the company is required to pay (reimburse and advance) all of the owner’s legal fees and expenses associated with the lawsuit. Before the payment or the reimbursement of fees and expenses takes place, the majority owner may be required to provide the company with an “undertaking.” This is a promise by the owner to repay the amounts that are advanced by the company if the owner is ultimately found to have engaged in willful misconduct or gross negligence. This would only take place after a final judgment making this finding against the owner, and after all appeals have been exhausted.
The practical effect of the indemnity provision is that the majority owner’s legal fees and expenses in defending against the minority investor’s claims will be fully paid by the company. These are likely to be substantial amounts, and include the fees incurred by financial or other experts retained by the majority owner to testify in defense of the claims made by the investor. By contrast, the investor will be required to pay its own legal fees and expenses, as well as the fees incurred by any expert witnesses who are retained by the investor.
In addition to securing payment (either advancement or reimbursement) of the legal fees incurred by the majority owner in defense of the lawsuit, the owner may also have grounds to file a counterclaim against the investor seeking full recovery of all legal fees that the owner incurs in the lawsuit. This potential recovery exists if the minority investor has breached any provisions of the company’s governance documents, because Texas law authorizes parties to recover their legal fees upon proof of a defendant’s breach of contact(see Section 38.001, of the Texas Civil Practice and Remedies Code).
Examples of conduct by the minority investor that support a counterclaim for breach include all of the following: (1) if the minority investor has failed to pay the full amount of its capital investment to the company, (2) if the investor improperly disclosed the company’s confidential information to the third parties, or (3) if the investor owes any other amounts to the company that have not been timely repaid. However, before bringing this counterclaim against an investor, the majority owner should evaluate whether asserting the claim would trigger the investor’s right to indemnity by the company under the governance documents. The company’s governance documents should make clear that the indemnity only applies to claims that are filed by third parties. Unfortunately, some governance documents include vague language that may provide the investor with a colorable argument that the company’s first-party claim against the investor is subject to indemnification.
Dilution of Minority Interest
If a buy-sell agreement exists when the minority investor asserts a claim, the majority owner can exercise the right to redeem (purchase) the investor’s interest in the business. In most cases where lawsuits are filed, however, no buy-sell agreement exists, or the minority owner would have already triggered the agreement to require that its ownership interest be purchased by the majority owner. In the absence of a buy-sell agreement, a strategy that may be available for the majority owner to consider exists if the company’s governance document (LLC agreement or bylaws) does not require unanimous consent to amend the governance agreement.
If a simple majority ownership is all that is required to amend the governance document, the majority owner can amend the document to adopt a new buy-sell agreement. This type of amendment is an after-the-fact adoption of a buy-sell agreement, and the majority owner can then apply the terms of the amendment to redeem the ownership interest held by the minority investor. This after-the-fact amendment procedure has not been addressed directly by Texas case law, but the Texas Supreme Court has shown considerable deference to the majority owner’s exercise of powers that are authorized by the company’s governance documents. This deference should include the owner’s power to amend the governance documents in accordance with their terms(see Ritchie v. Rupe, 443 S.W.3d 856 (Tex. 2014)).
Litigation Defenses
In most lawsuits that minority investors file against their majority owners, the investors allege that the owner has breached fiduciary duties owed to the company. Before evaluating any defenses that are available to fiduciary duty claims filed by the investor, majority owners should first examine the company’s governance document to determine whether they include any exculpatory provisions. Some bylaws and LLC company agreements limit the scope of fiduciary duties owed by governing persons. For Texas LLCs, Texas statutes indicate that members may completely eliminate all fiduciary duties owed by managers and officers.
Specifically, while the Texas Business Organizations Code (TBOC) prohibits the exculpation of corporate officers and directors for breaches of the duty of loyalty (see TBOC § 7.001(c)), it expressly allows exculpation for limited liability companies “to the additional extent permitted under Section 101.401” (emphasis added). But Section 101.401, which applies to LLCs, expressly allows for the restriction of any fiduciary duties, without limitation:
The company agreement of a limited liability company may expand or restrict any duties, including fiduciary duties, and related liabilities that a member, manager, officer, or other person has to the company or to a member or manager of the company (emphasis added).
If the company’s governance documents do not eliminate the fiduciary duties owed by governance persons, majority owners who act as governing persons have statutory defenses to these claims. Under Sections 21.418 and 101.255 of the TBOC, known as the Interested Director Rule, governing persons in corporations and LLCs — under certain conditions — are granted a “safe harbor” immunity when they engage in interested party transactions with the business. This safe harbor applies when:
- The transaction was approved by a majority of disinterested directors with knowledge of material facts;
- The transaction was approved by a vote of shareholders with knowledge of material facts; or
- The transaction was objectively fair to the corporation when the contract or transaction was authorized, approved or ratified.
The safe harbor statue effectively requires the majority owner (the governing person) to obtain approval for the transaction from disinterested parties. Therefore, if no vote is held by disinterested parties before the transaction takes place, the governing person has the burden to establish that the transaction was fair to the company. When no vote is taken by disinterested parties to approve the transaction, the question of whether it was fair to the company will likely require a trial on this issue, i.e., this question will require a fact finder to determine the issue of fairness, and the court cannot decide the matter on a pre-trial motion.
In addition to the safe harbor provision, a governing person can also assert the business judgment rule as a defense, which protects officers, directors and managers from claims for breach of their fiduciary duties if the minority investor contends they were negligent, unwise or imprudent. This defense applies when the actions of the governing person were “within the exercise of their discretion and judgment in the development or prosecution of the enterprise in which their interests are involved” (see Sneed v. Webre, 465 S.W.3d 169, 178 (Tex. 2015)). To overcome this defense, the minority owners need to show that the governing person engaged in some type of self-dealing that provided the governing person with a direct personal benefit.
If the investor alleges in the lawsuit that the majority owner misappropriated a corporate opportunity, the governing person has several factual defenses available. These include the defense that the alleged corporate opportunity was not in the company’s line of business; that the company lacked the funds, personnel or other means necessary to pursue the opportunity; and that the opportunity was not available to the company and could only be pursued by another party. These defenses are fact-intensive, which will require a trial to determine the outcome. To avoid having to prevail at trial in this type of dispute, the majority owner can seek approval from minority partners to confirm that the new opportunity falls outside the company’s line of business, or that it is not available to the company for other reasons.
Conclusion
As private company investors appear to be filing suit more often when disputes arise with the company’s majority owners, there are a number of legal and other strategies for owners to consider when faced with these claims. Based on the substantial expense and distraction of civil litigation, majority owners will benefit if they can work out a prompt resolution of these claims, which may include a structured settlement. When an early settlement is not possible, owners should take the steps necessary to secure indemnification to ensure payment of their legal fees and expenses by the business. Finally, when a reasonable settlement is not achievable with the investor at the outset, the majority owner should evaluate all legal defenses available, as well as potential counterclaims that would allow the owner to take the offensive in the litigation.
