One of the most frequent phone calls I get as a corporate attorney is a variation on the following question:
“My business partner is dreadful and I should never have gone into business with him. How can I get rid of him so I can just run the business?!”
My first question is, “Do you have a good Shareholder Agreement or Operating Agreement (or Buy-Sell Agreement) that might give us some contract remedies?” Usually, my second questions is, “When can you come in to talk about statutory fixes?”
All corporations should have a Shareholder Agreement and all and limited liability companies (or LLCs) should have an Operating Agreement. Either of those documents is likely to have a section on transfers or “Buy-Sell” provisions. These documents are contracts among the owners (shareholders or members) and sometimes the company (the corporation or the LLC), where the parties agree on some ground rules for the management and ownership of the company. For example, the owners can agree that no one can sell that ownership without first getting approval from the other shareholders or offering it to them first. Some of these issues are easy, and some are not.
I always recommend that a Shareholder Agreement or Operating Agreement (I’ll use the term Shareholder Agreement going forward, but it is true for both types of agreements) contain a provision where a shareholder can be removed as a shareholder – an Expulsion Provision. Usually I make the Expulsion Provision very difficult to achieve – for example, you need to have committed a “Serious Act” and then if all the other shareholders agree, the “bad actor shareholder” will be required to sell its ownership back to the Company. “Serious Act” is usually defined as material harm to the Company, embezzlement, conviction of a felony, or serious drug or alcohol use that affects the Company. This way, if something very serious occurs, the Company can rid itself of the bad actor and move forward. Alternatively, a Company could make the provision less strict. If you have shareholders that are expected to work for the Company, you could make the provision require a certain level of performance, certain number of working hours, or some other metric. In this case, if the shareholder does not meet the expectation, he or she could be expelled without going to court.
While Companies should have a Shareholder Agreement in place, many Companies never realized they needed another Agreement, delayed entering into an Agreement or have a defective agreement that doesn’t reflect their needs. In that case, the only remedy when an owner commits a back act, is to look to the Corporate or LLC Acts.
For LLCs, Section 1040.1 of the Virginia LLC Act allows for judicial dissociation (or removal) of a Member if that Member “engaged in wrongful conduct that adversely and materially affected the business of the limited liability company, … or the member engaged in conduct relating to the business of the limited liability company which makes it not reasonably practicable to carry on the business with the member.”
This judicial remedy, would require another member or the LLC itself to file a petition with the local circuit court asking for the judicial remedy to dissociate the member. The member or the LLC would need to put on evidence that the Member’s conduct rose to the level described above. Not something you want to do publicly, but it is a remedy if you have no other options – likely to arise only if such individual’s specific bad actions implicates the business going forward. For example, if your business is to operate a security company and your partner was just convicted of taking your client’s secure assets.
Contrasting with Corporations, there is no effective way to judicially remove another shareholder for such shareholder’s bad actions. If the shareholder serves as a director or officer, there are ways to bring actions against just the individual on a breach of fiduciary duty, but just being a bad actor does not equal a breach of fiduciary duties.
If you have a serious enough situation that you are not able to work with someone anymore because of the bad action, the only remedy is to petition the court for a judicial dissolution of the entire Corporation. You choose that you would rather end the business, than continue with the bad actor. In a dissolution, the Corporation’s assets would be sold and the proceeds, less any liabilities, would be distributed to the Shareholders, pro rata. In the request for dissolution, a shareholder would need to establish that “the directors or those in control of the corporation have acted, are acting, or will act in a manner that is illegal, oppressive, or fraudulent…” Note that the provision only applies to directors’ actions, not those of a mere shareholder, however, for a close corporation, it is likely the directors are shareholders themselves.
There are many ways to protect yourself when you go into business with someone else, but the reality is that you need to plan for these situations in the beginning. Without proper planning, you may need to file a lawsuit and dissolve the business just to pull yourself out of a bad situation.