It is a well-worn expression that small businesses are the backbone of America’s economy. The truth is that most small businesses are started by individuals to give themselves a means of employment. And employment lasts as long as the business is profitable. However, too often entrepreneurs do not put in place the necessary legal mechanisms to deal effectively with the day when the profit ends or when one or more of the business partners want to leave.
Thirty years ago, a good friend informed me that he was forming a business with four other partners in a bucolic New England town. I recommended he make sure that they had a proper shareholders agreement for the new corporation to address disputes among the owners and other matters, e.g. buyout and dissolution. My friend, who had the touch of the iconoclast in him at the time, rejected that advice, saying he did not want to go into any business if they first had to get all wound up with prescriptive legal matters and legal expenses. In other words, he wanted to trust the business to each participant’s word and handshake.
Several years later, internal disputes grew out of control, despite the business being profitable. In the end the business was shuttered in the wake of several bitter law suits among the shareholders. So much for their handshake agreement.
Often times, an internal dispute is a matter of one partner shareholder having had enough of the business, for whatever reason, and wants to close it to cash out his investment, while the other partner shareholder wants to keep the business going. Without a shareholder agreement in place (or an operating agreement for a limited liability company [ an “LLC” company]), disputing shareholders are thrown back on what the law or a court will permit. Under New York’s Business Corporation Law, § 1104(a), a court can grant dissolution of a corporation if the company’s owners are deadlocked and cannot make operational decisions. One might assume that where one shareholder wants to close the company and the other wants to keep it operating creates a deadlocked situation. Well, that’s not necessarily the case, according to the recent decision in: Matter of Ades v. A&E Stores, Inc., New York Supreme Court, New York County, Index No. 650267/2017, decided January 23, 2018.
A&E Stores was formed in 1973 by Alan Ades, who is a 50% shareholder, and the brothers Albert and Dennis Erani, who each own 25% of the company. Apparently, the partners had no shareholders agreement, nor did the company’s bylaws provide any mechanism to avoid a deadlock or to deal with a dissolution situation. By 2015, Alan Ades had enough of operating the business because he said it was less profitable. The Erani brothers, however, disputed Ades’ lack of profitability claim.
Ades filed a petition with the court seeking the judicial dissolution of the company. He asserted that the company was deadlocked because the other shareholders disagreed with him, and therefore it should be liquidated so that he could get the best return on his investment. The Erani brothers responded that Ades’ petition should be denied because Ades had acted in bad faith by intentionally taking positions and taking unilateral actions (e.g. cancelling a store lease without the others’ consent) that manufactured the deadlock. Furthermore, argued the Eranis, the business was still fully functional because they had hired three senior executives to manage it. Therefore, according to the Eranis, the shareholders’ presence was not necessary for the business’ day-to-day operations.
The Business Corporation Law §1104(a) provides that a shareholder who owns at least 50% of the voting shares is entitled to petition the court for dissolution of the business if:
- The owners/directors are so divided regarding management that it is impossible to vote for any required action;
- The owners/directors are so divided that it is impossible to vote on new directors; or
- Internal disputes are so significant that dissolution of the company would be more beneficial to the shareholders.
Often, internal disputes pose irreconcilable barriers among the shareholders and thus create the deadlock that can only be resolved by dissolving the company. But a court can and will deny dissolution when the petitioning shareholder is the one who created the underlying dispute or deadlock for the purpose of justifying dissolution, as the Erani brothers argued about Mr. Ades. The court in the Ades v. A&E Stores stated: “manufactured creation of dissension is the sine qua non of bad faith.” Furthermore, the court noted that Mr. Ades’ desire to sell or liquidate the business while it is still profitable so that he could recoup his investment and avoid loss, “is not a basis for dissolution under §1104.” In the end, the court decided that the Erani brothers sufficiently stated a factual dispute of Ades’ petition. The court then set the matter down for an evidentiary hearing to sort out the facts and determine whether dissolution would be recommended. And so, these parties are to undergo some further, and very expensive judicial procedures and legal maneuvers.
Like my friend’s business ending up in expensive litigation among its owners, all this mishigas between A&E Stores’ shareholders could have been completely avoided if they had in place a proper shareholders agreement. That agreement could have provided the mechanism for a buyout of Mr. Ades’ interests while allowing the Erani brothers to continue operating the business. At the very least, they should have had bylaws in place that addressed issues of company deadlock and internal disputes on the operation of the business.
If the court finally determines that Mr. Ades himself created the deadlock so that he could get a dissolution of the company, then Ades may be left holding the bag. In the end, the court could deny dissolution and since there is no other mechanism to have Erani brothers buy him out, Mr. Ades could be stuck with a company in which he longer wants any involvement.
When it comes to protecting one’s business interests, a handshake is never enough.