Succession planning and litigation between owners

Gerard V. Mantese is a trial lawyer at Mantese Honigman PC, with a national practice in complex business litigation. He focuses his practice on business owner disputes. He is the CEO at Mantese Honigman PC, with offices in Michigan, New York, Missouri, and Florida. Gerard Mantese was awarded the Champion of Justice Award by the Michigan State Bar in 2010 for advocating for the rights of vulnerable individuals, including children with autism spectrum disorder seeking to access mental health coverage from insurers. He is a graduate of the University of Missouri – St. Louis and the Saint Louis University School of Law. 

Theresamarie Mantese is a partner at Mantese Honigman PC, where she concentrates her practice on health care and business litigation. Her clients include licensed health care professionals, physicians, and health care and business entities. She is a frequent author on health law topics, and her articles appear in compliance journals, health law publications, and legal journals. She is licensed to practice law in Missouri and Michigan and is a graduate of the Saint Louis University School of Law.

Paul J. Tahan is a trial lawyer who concentrates his practice in the areas of business and intellectual property litigation. Over the course of his career, Tahan has tried complex cases in state and federal courts throughout the country, as well as in front of the United States Patent Trial and Appeal Board. He has been recognized by Best Lawyers, “Super Lawyers,” and St. Louis Small Business Monthly. Tahan is a graduate of Rockhurst University and Saint Louis University School of Law.

Business owners start their companies hoping to build something enduring. Yet, few owners engage in formalized succession planning early on. According to the National Association of Corporate Directors, fewer than one in four private companies have a formal business succession plan.¹ Perhaps business owners feel they are too busy with the day-to-day challenges of running the business. They may not want to think about their eventual retirement or death, and some may be overwhelmed by the complexity of succession planning. However, early comprehensive succession planning increases the chances of the company’s long-term survival, may preserve harmony among the owners, can reduce taxes, and provides greater control over who takes over future ownership. 

Indeed, succession planning is critical given the approaching massive transfer of wealth and the disputes that will undoubtedly accompany this wealth transfer. The Wall Street Journal recently reported that “[m]ore than $84 trillion in wealth has been, or is set to be, transferred by estates big and small between 2021 and 2045. That wave of inheritance has brought a rise in lawsuits and other conflicts over family assets.”²

Among the assets transferred will be ownership interests in private companies, which will inevitably lead to intergenerational disputes among shareholders or limited liability company members. These conflicts over control, fortunes, and fame, in addition to long-simmering emotions, are often bruising, protracted, and expensive — and pose significant risks to the business. To avoid calamity, business lawyers need to be knowledgeable, creative, and proactive in planning for the succession of business clients. 

The instructive cases below will demonstrate what can go wrong when business owners and their lawyers do not engage in careful succession planning. Lawyers will then learn more about key contractual provisions and considerations business planners should address to facilitate a smooth succession and reduce the risk of power struggles and litigation. 

Consequences of inadequate business succession planning: Uncertainty, power struggles, and court battles 

Robinson v. Langenbach³ 

In the Supreme Court of Missouri’s Robinson case, the control group in a closely held corporation removed the minority owner from the business, and the minority owner brought claims for breach of fiduciary duty and oppression against the control group.

George Langenbach founded Perma-Jack in 1975. George Langenbach retired in 1985, and his three children succeeded him, becoming equal shareholders and directors on the board. Plaintiff Joan L. Robinson served as president and treasurer from 1985-2012, while her brother, defendant John F. Langenbach, was the vice president and secretary. Their sister, the other defendant, was not involved in the company’s day-to-day operations. 

Over the years, the defendants became dissatisfied with Robinson’s performance and management, as she only spent about two hours per day at the office, and the company began to lose money. The defendants never discussed their dissatisfaction directly with Robinson but rather secretly communicated with one another about removing Robinson from the company. The defendants called a special board meeting where they voted to remove Robinson as president and treasurer. Robinson was then denied access to the company’s offices, her salary and benefits were cut off, and her son was fired from the company. Soon after, John F. Langenbach assumed the role of president, increased his and his daughter’s salaries, and paid himself a bonus. Robinson sued for breach of fiduciary duty and oppression and prevailed at trial.

On appeal, the defendants argued that Robinson’s breach of fiduciary duty claim was a disguised wrongful termination claim and the termination was valid because she was an at-will employee. They also asserted that the lower court should have applied the business judgment rule when it analyzed the oppression claim. The Supreme Court of Missouri rejected these arguments. The Court emphasized that Robinson’s claim was not an “employment claim” but rather a claim against the controlling shareholders for ousting her from the company, freezing her out of participation, and depriving her of the financial benefits from her minority interest. The Court also affirmed the finding of oppression and held that the business judgment rule was inapplicable because the lower court determined the defendants acted in bad faith. The business judgment rule protects certain actions of directors when they act in good faith and have no self-interest at stake.⁴ 

Here, visionary succession planning on how future management would be decided after the founder’s retirement might have assisted the parties. 

Coster v. UIP Companies, Inc.⁵ 

When Wout Coster, a 50% owner of a real estate services company, developed leukemia, he began negotiations with his co-equal owner, Steven Schwat, and two other executives for a buyout of Wout’s shares. After a year of failed negotiations, Coster died and his shares passed to his widow, Marion Coster. The parties deadlocked over electing directors, and Marion Coster sued to appoint a custodian to resolve the impasse. Schwat then sold a one-third ownership interest to one of the executives, which resolved the deadlock and mooted the custodian action. However, the stock sale diluted Marion Coster’s ownership, and she sued to cancel the sale.

The Supreme Court of Delaware held that the sale met Delaware’s strict entire fairness standard⁶ and was not undertaken for inequitable purposes. Rather, the sale was a justified response to the “existential crisis” of the custodian action and implemented the succession plan Wout Coster favored in the first place. Ultimately, nearly a decade of fraught negotiations and litigation passed between Wout Coster’s diagnosis and the final decision, with Marion Coster no closer to receiving the financial security her husband had desired for her. 

Unanue v. Unanue⁷ 

The Unanue case involved an intergenerational family dispute over control of Goya Foods, Inc., a highly successful multinational food company. Goya was founded in 1936 by Spanish immigrants who built the company with their four sons. By the early 2000s, Goya was the fourth-largest Hispanic-owned company in the United States. The Unanue family exclusively owned the company’s voting stock. 

One of the founders’ sons, Joseph A. Unanue, was involved in the company’s management for several decades and served as its president, chairman, and CEO. While the company achieved remarkable success under Unanue’s leadership, he progressively became more domineering and autocratic, making numerous unilateral decisions without board approval (e.g., positioning his son to become his successor and naming him chief operating officer, installing his daughter as the president of a subsidiary). There was significant dissension within the board of directors, which was comprised of Unanue and his two nephews. The situation reached a breaking point in 2003 when Unanue refused to carry out board resolutions and secretly issued severance agreements to multiple employees. 

Fearing that Unanue’s obstinate, unilateral approach could jeopardize the company’s future, the nephew directors procured written consent from a majority of the shareholders to remove Unanue as a director. The next day, the nephews issued resolutions terminating the executive employment of Unanue and his son with the company, and the nephews promptly filed a declaratory suit to confirm the validity of their actions. 

The Delaware Court of Chancery held that the nephews’ actions to remove Unanue and his son were valid, holding that because a majority of shareholders can remove a director, the only question was whether the decision to remove Unanue was fully informed. The court found that the shareholders who approved the removal were sufficiently informed because Unanue’s autocratic leadership style was well known within the family. 

Federico v. Brancato⁸ 

Family dynamics can pose unique challenges to succession plans in family businesses. This was exemplified in the New York case Frederico v. Brancato. In 1976, Anthony and Roseann Brancato founded a commercial printing company and grew it into a successful business with 40 employees over several decades. As part of their estate plan, Anthony and Roseann Brancato entered into a shareholders agreement with their two children, Joseph Brancato and Theresa Federico, that allocated equity in the business among the four family members, solidified the parents’ control, and gave each shareholder a right to continued executive employment with the company. 

When Anthony and Roseann Brancato became elderly and ill, they decided Joseph Brancato should take over the company because he had worked there since its inception and was most knowledgeable. Federico had joined the company two decades later and had a more limited role. Also, due to events outside the workplace, Federico and Joseph Brancato were not on speaking terms, so the parents decided it would be best for the company if Federico left. 

Anthony and Roseann Brancato proposed to buy out their daughter’s equity interest at a purchase price 50% higher than an amount determined by an independent valuation expert. But Federico refused to negotiate or speak to her parents. Anthony and Roseann Brancato responded by canceling Federico’s check-signing authority at the company, reducing her salary by 90%, withholding tax distributions, terminating her access to the company’s records, and then terminating her employment. Federico sued for breach of the shareholders’ agreement, breach of fiduciary duties, and oppression.

The court found that Anthony and Roseann Brancato had breached the shareholders’ agreement and the covenant of good faith and fair dealing by terminating Federico’s employment, as the agreement gave her a continued right to employment. The court rejected the breach of fiduciary duty and oppression claims, emphasizing that Anthony and Roseann Brancato had acted out of concern for the company’s continued viability and had attempted to give their daughter a generous buyout package to facilitate their desired succession plan. 

Armentano v. Armentano⁹ 

This case from New York highlights the problems that may arise when a controlling owner implements a succession plan without regard for existing procedures. Pat Armentano founded a large propane gas provider in 1968, and his three sons received equity in the company in 1991. When they received their shares, the brothers entered into a stock redemption agreement and a cross-purchase agreement, which gave the company and its shareholders rights of first refusal on stock transfers. 

By 2017, one of Pat Armentano’s sons, Joseph Armentano, had become the sole owner of the company’s voting stock and its CEO, while he and his two brothers held the company’s nonvoting stock. Two years later, the board of directors asked Joseph Armentano to create a corporate succession plan, and he began positioning his daughter to succeed him as CEO. Attempting to sidestep the rights of first refusal contained in the corporate agreements he signed, Joseph Armentano unilaterally terminated the stock redemption agreement, had the board ratify that act, and then transferred voting stock to his daughter. His brothers subsequently sued for breach of the agreements. 

Joseph Armentano argued, in part, that because the claims concerned succession planning — “a quintessential business judgment issue” — the business judgment rule applied. The trial court disagreed. The stock redemption agreement was unambiguous and did not permit unilateral termination by the CEO. Thus, the board had no authority to ratify the improper termination of the agreement, and the business judgment rule did not apply. 

Digeser v. Flach¹⁰ 

When family members or friends go into business together, the parties often fail to plan for the possibility of dissension. In Digeser, Henry Digeser and John Flach were family friends who co-owned and co-managed a New York construction business their fathers had previously operated together. Through the parties’ combined efforts over two decades, the business achieved significant success. Though Flach was the majority owner, the parties had agreed to draw an equal amount of compensation from the business. By 2007, the co-owners’ sons had become involved in the business, and the parties had developed a succession plan to pass equity and control to the younger generation. The situation changed in 2012, when Flach’s oldest son died in an accident, and the parties’ relationship rapidly deteriorated.

Flach quickly began efforts to “divorce” Digeser from the business by removing him as a corporate director, denying him access to his work computer and email, restricting his interactions with customers and employees, proposing to buy out his minority equity interest, and paying himself a large bonus while declining to make any distribution to Digeser. When Digeser refused to accept Flach’s buyout offer, Flach terminated Digeser’s employment. Digeser then sued for dissolution. 

The court found that Flach had committed shareholder oppression. By terminating Digeser’s employment, removing him from the management of the business, and denying him a proportionate share of the profits that were distributed as a “bonus,” Flach had defeated the reasonable expectations Digeser had acquired over the decades of participation in the business. The court thus found that Digeser had established grounds for dissolution. 

Planning for succession: Key considerations and contractual provisions 

Buy-sell agreements 

Buy-sell agreements are contracts between business owners, or between owners and the company, which provide for the purchase of an owner’s shares when some specified event occurs (often death or total disability or other severance from the company). 

A buy-sell agreement is a critical succession planning tool for multiple reasons. First, a buy-sell agreement gives owners more control over the future ownership of the company. Consider, for example, a grocery store owned by two co-equal owners who are active in its operation. In the absence of a buy-sell agreement, if one of those owners dies, their ownership interest would pass in accordance with their estate plan, likely to their surviving spouse or children, who may have no interest in running the business. With a buy-sell agreement, this situation can be avoided, as the remaining owner or the business itself can purchase the deceased owner’s interest. Another important function of a buy-sell agreement is to give deceased or withdrawing owners a guaranteed market for their ownership interest (i.e., the owner or their heirs can exit the business with liquidity). Additionally, buy-sell agreements can help peg the value of a deceased owner’s interest for purposes of estate taxes. 

When the remaining owners are the purchasers, the buy-sell agreement is typically referred to as a “cross-purchase” buy-sell agreement. When the entity is the purchaser, the buy-sell agreement is generally referred to as a “stock redemption agreement.” Another type of buy-sell agreement is a “wait-and-see” agreement that first gives the entity an option to purchase the deceased or withdrawing owner’s shares. If the company does not purchase all the shares, the remaining owners have the option to purchase the remaining shares pro rata. If there are still “leftover” shares at this point, then the entity would be required to purchase those shares. 

When drafting and implementing a buy-sell agreement or provision, key considerations include: what the triggering events are, how the purchase price will be determined, what the payment terms are, and how the buyout will be funded.

Triggering events

Owners can specify what events will trigger a buyout under the buy-sell agreement, and a robust buy-sell agreement should include a variety of triggering events. Common triggering events include death, disability, termination of employment, retirement, and deadlock. The buy-sell agreement should clearly define the specified events. For example, if disability is a triggering event, the agreement should specifically define a “total and permanent disability,” if that is the language used. If termination of employment is a triggering event, the buy-sell agreement should specify what types of termination activate the buyout (e.g., voluntary, involuntary, for cause, without cause). For example:

– Termination of employment: In LaRue v. Alcorn,¹¹ the 50% shareholder and president fired the plaintiff, the other 50%owner, for competing with the company. This activated a buy-sell agreement provision in the shareholders agreement, as termination of employment was a triggering event, thus defeating the plaintiff’s petition claiming deadlock and seeking dissolution. 

– Dissolution: In Estate of Collins v. Tabs Motors of Valley Stream Corp.,¹² a shareholders agreement contained a buy-sell agreement that included filing a dissolution petition as a triggering event. The court found that this was enforceable and that the corporation validly purchased the shares of two shareholders who filed for dissolution of the company. 

Purchase price/valuation

When business owners plan for future buyout of ownership interests, valuation is critically important, as an appropriate and agreed-upon valuation can mean the difference between a fair transaction and an abusive one that sets the stage for likely litigation. For example, in Franks v. Franks,¹³ the control group’s redemption proposal at a fraction of the value calculated by professionals, coupled with withholding of dividends, was found to be evidence of shareholder oppression. Business owners can minimize the risk of litigation by memorializing accepted valuation methodologies in their buy-sell agreements. 

A variety of valuation methodologies may be used. One option is to specify a fixed purchase price that is subject to periodic revaluations. The more common method, however, is to use a valuation formula. Typical valuation formulas include:
– net book value (total assets minus total liabilities) — does not account for goodwill and might be appropriate for a relatively new business; 
– adjusted book value (start with net book value and adjust to reflect the fair market value of tangible assets like equipment and inventory);
– multiple of earnings (multiply earnings by an industry-specific multiplier) — earnings are often based on a three- to five-year average and may be subject to normalizing adjustments (e.g., subtracting nonrecurring expenses); or 
– fair market value or fair value (to be determined by the company’s accountant or an outside, independent appraiser) — the appraiser may use multiple valuation methods and use weighted averaging to arrive at the FMV. Owners can outline an appraisal process whereby both the seller and purchaser of the ownership interest select their own appraisers to value the interest. For example, the buy-sell agreement could provide that, upon a triggering event, the seller and purchaser will each select an appraiser to value the seller’s equity and then each side would exchange their appraisals. If the variance in the appraisals exceeds a certain percentage (e.g., 10%), then the buy-sell agreement might provide that the parties must jointly choose a third appraiser to resolve the disagreement.¹⁴

Along with the specific methodology to be used, an important consideration to address is the valuation date (i.e., the date on which the company is being valued). Failure to identify such date can lead to uncertainty and litigation. For example, in Mintz v. Pazer,¹⁵ the parties disputed the valuation date where the buyout provision was silent on this point. The court considered the shareholders’ agreement, emails between the parties, and the surrounding circumstances to determine the appropriate date. Other case law examples include:

– No methodology provided in agreement: In Nicolazzi v. Bone,¹⁶ the plaintiff may have withdrawn from the limited liability company by initiating a lawsuit against the other member, but the operating agreement was silent on how to value a withdrawing member’s interest. The lower court was directed to determine whether the plaintiff withdrew, and if so, ascertain the fair value of his ownership interest.

Chadwick v. Huntoon¹⁷ upheld the trial court’s $900,000 valuation of the company, despite an average net worth of less than $186,000, because net worth and value are distinct concepts, and the court made credibility determinations to arrive at the valuation. 

In Garcia v. Garcia,¹⁸ a divorce case, the ex-husband owned interest in a medical practice pursuant to an agreement with a buy-sell clause that provided a $45,000 total buyout upon a shareholder’s death, disability, or termination of employment. The trial court did not err in disregarding this amount and adopting the valuation figure calculated by the ex-wife’s expert under a net-asset approach.

– Methodology specified in agreement: In Cadd Centers of Florida, Inc. v. Strickland,¹⁹ the court reversed a judgment valuing the defendant’s stock at $214,500 and reduced that valuation to $429 total because the parties’ shareholders agreement required the shares to be valued based on par value, which was essentially zero dollars per share.

Some buy-sell agreements include a mechanism called a “shotgun” clause, also known as a “Russian Roulette” or “Texas Shootout” provision. These provisions are intended to resolve deadlocks between business owners. If a deadlock occurs, one party would specify a purchase price, and the other party could then sell their ownership interest at that price or buy the first party’s ownership interest at that price.

Payment terms

Most buy-sell agreements provide that the purchase price will be paid in installment payments, because paying in full at closing usually presents cash flow issues. Payment periods typically range from three to 10 years, but the exact length will depend on the circumstances underlying the buyout. The down payment amount and interest rate should also be specified. When determining specific payment terms to include in the buy-sell agreement, business owners should consult with their tax professionals to reduce potential tax liability in connection with the buyout.

Funding

A common way to fund a future buyout under a buy-sell agreement is to take out life insurance policies on the business owners. This way, if one of the owners passes away, the remaining owners or the business entity can collect on the policy and use the money to fund the purchase of the deceased owner’s interest. When funding a buy-sell agreement with insurance, business owners and their lawyers should carefully review the terms of the insurance policy to ensure the contemplated triggering events (i.e., death or long-term disability) would be covered. 

Management: Who are the top executives and can they be removed?

A company’s high-level executives and managers play an integral role in the operation of the business. The top officers make marketing and expansion decisions and have influence over profitability. A robust business succession plan should address the company’s eventual need to replace current members of management (e.g., upon retirement, death, or disability). This is especially important in closely held family businesses, where the younger generation may not be prepared for or interested in taking over management from the older generation. 

Another key issue is whether and how executives may be dismissed from the company. Consider if a company’s owner, who was also an officer, assaulted the company’s president and argued that despite his no contest plea, he could not be discharged under the shareholder agreement. While the contractual duty of good faith and the law of oppression could provide potential remedies, it is best to clearly outline in the company’s governance documents the process for terminating top executives’ employment. Other examples:

– In A. Cappione, Inc. v. Cappione,²⁰ the defendant, a minority owner and officer of a family-owned beer distributor, was required to sell his shares to the company after he was convicted and incarcerated for committing a felony. Even though the corporation may have failed to timely exercise its purchase option under the shareholders’ agreement, the court held that allowing the defendant to retain his shares would have placed the corporation at risk of losing its distributor’s license, which would render its stock worthless. 

– R & R Capital LLC v. Merritt²¹ upheld for-cause removal of a limited liability company manager where the manager was removed for committing fraud, which was one of the grounds for for-cause removal under the operating agreement.

– In Schmitz v. Schmitz,²² a shareholders’ agreement provided that its three owners would be the company’s sole directors for life, with rights of survivorship in their spouses. The two deceased owners’ spouses could bring direct claims against the remaining original shareholder for unilaterally engaging in unauthorized transactions, despite a provision in the shareholders’ agreement requiring unanimous approval by the three directors.

Employment: Do owners have the right to be employed? 

Owners of closely held businesses commonly work for the companies they own. A terminated owner may have legal recourse against their co-owners if a termination was part of an effort to squeeze them out of an ownership interest in the company.²³ 

While the law may offer protection for terminated owners in appropriate circumstances, business owners are wise to avoid the uncertainty by explicitly addressing owners’ employment rights, if any, in the governance documents. Some key points to address include:
– Which owners, if any, have a right to employment? 
– What are the owner’s responsibilities as an employee? 
– How will compensation be determined? 
– Under what circumstances may the owner be terminated?

– In LaRue v. Alcorn,²⁴ the defendant, the corporation’s 50% owner and president, legitimately terminated her co-owner’s employment because he was an at-will employee and had competed against the company by loaning money and gifting equipment to a competing business while he was still employed. 

– Federico v. Brancato²⁵ found that the parties’ shareholders’ agreement conferred a right to continued employment on a minority shareholder for as long as she continued performing her duties and that the controlling shareholders breached this agreement by terminating her employment. 

– The Stavroulakis v. Pelakanos²⁶ court chastised the defendants for attempting to justify a fraudulent squeeze-out of the plaintiff on the grounds that he did not work for the company: “Neither [New York’s corporations statute] nor any executed shareholders’ agreement contains any requirement for plaintiff to work for the Company … Many businesses have passive investors … If investors intend to condition an equity grant on the requirement of further contribution (either labor or capital), they must expressly agree to such a condition.”

Distributions: What are owners’ rights to profit distributions?

Owners’ rights to dividends and other distributions have been litigated as long ago as the famous Dodge v. Ford Motor Co.²⁷ in 1919. In the absence of clear contractual language addressing distributions, minority owners of a company may be at risk of the controlling owners attempting to squeeze out the minority by refusing to issue dividends or other distributions (e.g., tax distributions for owners of a pass-through entity). For example, in Franks v. Franks,²⁸ the control group’s refusal to declare dividends and low buyout offers were evidence of oppressive conduct. Business owners would be wise to address distribution rights at the outset to avoid contentious disputes. Other examples include:

– In Chadwick v. Huntoon,²⁹ a limited liability company’s control group expelled the minority member without cause and asserted that he was not entitled to further distributions. Distinguishing “participation rights” and “distribution rights,” the court found that the expelled member’s participation rights had been extinguished but not his distribution rights. Because the operating agreement was silent on an expelled member’s rights to distributions, under Missouri’s Limited Liability Company Act, the member was still entitled to receive his distribution percentage. 

– Runco v. Francis³⁰ rejected the plaintiff’s claim that the operating agreement required the company to make profit distributions where the language governing distributions was permissive rather than mandatory. The provision stated that the company “may make distributions” and that the, “Members shall endeavor to make distributions.” 

– World Ambulette Transportation, Inc. v. Kwan Haeng Lee³¹ rejected the defendant’s claim against the company for breach of shareholders’ agreement, finding that the agreement did not provide the defendant with any right to dividends or distributions.

Liquidity: Do owners have put rights? 

Often, owners of closely held companies have no easy ability to sell their ownership interests to third parties and lack redemption rights. This may particularly occur in the context of family-owned companies where the owners do not negotiate for their equity interests. In these circumstances, the owners’ locked-in equity interests may simply be “paper wealth.” Business owners and their lawyers should address liquidity rights when the company’s governance documents are being drafted. Without any contractual language addressing these rights, the owners in control of the company may try to financially exploit the minority owners, knowing they have no recourse to exit the company other than by abusive, low-ball stock redemptions. 

One type of redemption right is a put right, the right to require the company to buy the owners’ shares at a specified value. This can be a valuable tool for minority shareholders to obtain liquidity from their otherwise illiquid investment. Case law examples include: 

– In Allen v. Plummer,³² the minority shareholders in a close corporation exercised a put option under the shareholders’ agreement, but the control group never followed the formal buyout procedures outlined in the agreement. A year-and-a-half later, the control group sold most of the company’s assets and issued a check to the minority shareholders as a purported buyout payment related to the exercised put option. The court held that the exercise of the put option, by itself, had not divested the minority shareholders of their ownership interest. Because the control group failed to purchase the shares as required under the agreement, the minority shareholders retained ownership in the company.

– Celauro v. 4C Foods Corp.³³ upheld the validity of an amendment to a shareholders’ agreement that eliminated a put option for shareholders. Though the plaintiffs claimed it would be impossible for minority shareholders to sell their stock in the close corporation without put rights, the court disagreed and noted that the plaintiffs did not have any vested right or future entitlement to “retention of shareholder ‘put’ benefits.” 

– In Darby Emerging Markets Fund, L.P. v. Ryan,³⁴ the shareholders’ agreement conferred a put right on the minority shareholder plaintiff in the event of a “fundamental dispute” within the company. The plaintiff stated a claim for anticipatory breach of that provision when there was an alleged deadlock over the terms of a potential sale of the company, and the controlling shareholders refused to recognize the plaintiff’s put right.

Can owners be diluted? 

Business owners should always be aware of whether their ownership interests can be diluted. Those in control, by virtue of their voting power, can sometimes require additional capital infusions or pursue outside investors’ capital, and existing owners who don’t contribute may be diluted by these transactions. These capital events frequently incur at inflection points where the business’s current financial situation or growth potential is uncertain, leading to outsized impacts — positive or negative — on valuation, which drives the amount of dilution. 

This is exemplified in the film, “The Social Network,” in which the protagonist procured the chief financial officer’s signature (who was promised 30% ownership of Facebook) on seemingly standard corporate documents that then allowed the protagonist to dilute the CFO’s stake to below 1%. These types of dilution events often give rise to contentious litigation. To avoid such an outcome, business lawyers must ensure their clients understand when and how owners may be diluted.

Other case law examples include:

– HCI Investors, LLC v. Fox³⁵ upheld under the entire fairness standard a corporate transaction involving the issuance of warrants that would dilute nonparticipating shareholders’ stock by 25%.

– Sheppard v. Advanced Acoustic Concepts, Inc.³⁶ rejected the plaintiff’s claim that the board’s issuance of class B shares — which diluted her ownership interest by almost 50%— breached the company’s shareholders’ agreement. Though the agreement prohibited issuance of new stock without written shareholder consent, the new class of shares did not fall under the agreement’s definition of the term “stock.” The plaintiff’s authorized proxy had consented to the new issuance, and the plaintiff’s claim was not timely. 

– Coster v UIP Companies, Inc.³⁷ affirmed the lower court’s finding that the dilutive issuance of stock — which reduced the plaintiff’s ownership interest from one-half to one-third — satisfied the entire fairness standard and was not undertaken for inequitable purposes because, among other things, it was designed to resolve the company’s “existential crisis” of a deadlock.

Estate planning 

In the absence of careful planning, business owners’ plans for succession can be complicated by an estate plan. If a company’s governance documents do not properly address succession of ownership interests upon an owner’s death, then a deceased owner’s interest may pass according to their estate plan, or through intestacy, in the absence of any estate planning. The beneficiaries may have no interest in owning a (possibly illiquid) closely held business, and the remaining co-owners may not want to do business with the new owner(s). To prevent this outcome, business lawyers should consider including in governance documents language that expressly overrides attempted bequests of ownership interests. Additionally, incorporating a robust buy-sell provision that includes death as a triggering event can also help mitigate the risk of owners’ estate plans interfering with the business’s succession plan.

Case law examples include:

– In Coven v Neptune Equities, Inc.,³⁸ the decedent’s interest in the corporation passed according to multiple estate plans, creating confusion years later as to which individuals held ownership interests. The court looked to whom the corporation had previously reported as shareholders on its tax returns and found the original owner’s son’s ex-wife had standing to bring dissolution action. 

– The Tita v. Tita³⁹ court found that the decedent’s membership interest in the company passed to his children pursuant to his will, rather than back to the company via a “death buy out” provision in the operating agreement, because that provision did not specify who would receive the interest upon the decedent’s passing, nor did it state that the interest would immediately vest in another member upon death. Because the operating agreement was silent as to the actual disposition of the interest, the decedent’s will controlled.

Conclusion 

Fights over succession can be contentious, time-consuming, and costly — threatening the continued viability of successful businesses. With the help of lawyers, business owners can avoid or mitigate the risks of significant ownership disputes by creating and implementing a comprehensive succession plan. Tax and estate planning experts should also be intimately involved in the process to ensure a smooth and successful succession.

Endnotes
1 “Business Succession Planning for Private Companies,” QUIST INSIGHTS, 2015, https://www.quistvaluation.com/wp-content/uploads/2015/08/Quist-Insights-Business-Succession-Planning-for-Private-Companies.pdf.
2 Ashlea Ebeling, Hash Out the Inheritance Now, or Fight your Family Later, THE WALL STREET JOURNAL (Apr. 6, 2024), https://www.wsj.com/personal-finance/hash-out-the-inheritance-now-or-fight-your-family-later-5fd836b9.
3 599 S.W.3d 167 (Mo. 2020).
4 See, e.g., G. Mantese, P. Louis, The Verdict on the Business Judgment Rule, 76 MO. BAR J. (March-April 2020).
5 300 A.3d 656 (Del. 2023).
6 The entire fairness doctrine occupies a central place in Delaware law on corporate director duties. It requires directors to establish that the transaction was the product of both fair dealing and fair price.
7 2004 WL 2521292 (Del. Ch. Nov. 3, 2004).
8 43 Misc. 3d 1231(A), 993 N.Y.S.2d 644 (Sup. Ct. 2014).
9 70 Misc. 3d 1215(A), 139 N.Y.S.3d 520 (2021).
10 49 Misc. 3d 1213(A), 29 N.Y.S.3d 846 (N.Y. Sup. 2015).
11 389 S.W.3d 215 (Mo. Ct. App. 2012).
12 156 N.Y.S.3d 711 (2021).
13 330 Mich. App. 69, 944 N.W.2d 388 (2019).
14 See e.g., Mintz v. Pazer, 152 A.D.3d 761, 60 N.Y.S.3d 74 (2017); Walsh v. White House Post Prods., LLC, 2020 WL 1492543 (Del. Ch. Mar. 25, 2020).
15 152 A.D.3d 761, 60 N.Y.S.3d 74 (2017).
16 564 S.W.3d 364, 375 (Mo. Ct. App. 2018).
17 634 S.W.3d 832 (Mo. Ct. App. 2021).
18 25 So. 3d 687 (Fla. Dist. Ct. App. 2010).
19 851 So. 2d 756, 757 (Fla. Dist. Ct. App. 2003).
20 119 A.D.3d 1121, 990 N.Y.S.2d 297 (2014).
21 No. CIV. A. 3989-CC, 2009 WL 2937101, at *4 (Del. Ch. Sept. 3, 2009). 22 2024 WL 4137987 (Fla. Dist. Ct. App. Sept. 11, 2024).
23 See Michigan’s shareholder and member oppression statutes, MCL 450.1489 and MCL 450.4515, which include termination of employment as an oppressive act if the termination disproportionately interferes with that shareholder’s or member’s ownership interest; see also Robinson v. Langenbach, 599 S.W.3d 167, 178 (Mo. 2020).
24 389 S.W.3d 215 (Mo. Ct. App. 2012).
25 43 Misc. 3d 1231(A), 993 N.Y.S.2d 644 (Sup. Ct. 2014).
26 58 Misc. 3d 1221(A), 106 N.Y.S.3d 725 (N.Y. Sup. Ct. 2018).
27 204 Mich. 459, 170 N.W. 668 (1919).
28 330 Mich. App. 69, 944 N.W.2d 388 (2019).
29 634 S.W.3d 832 (Mo. Ct. App. 2021).
30 No. 317926, 2015 WL 3796060, at *5 (Mich. Ct. App. June 18, 2015) (underlined emphasis added).
31 161 A.D.3d 1028, 1033, 78 N.Y.S.3d 137, 142 (2018).
32 No. 224500, 2002 WL 652129 (Mich. Ct. App. Apr. 19, 2002).
33 30 Misc. 3d 1204(A), 958 N.Y.S.2d 644 (Sup. Ct. 2010).
34 No. CV 8381-VCP, 2013 WL 6401131, at *12 (Del. Ch. Nov. 27, 2013). 35 412 S.W.3d 424 (Mo. Ct. App. 2013)
36 22 Misc. 3d 1112(A), 880 N.Y.S.2d 227 (Sup. Ct. 2009)
37 300 A.3d 656 (Del. 2023).
38 198 A.D.3d 643, 155 N.Y.S.3d 178 (2021).
39 334 So. 3d 646, 650 (Fla. Dist. Ct. App. 2022).