Family Business Insights: Derivative Actions & Liquidation – Issue #10

We discuss how shareholder disputes can be managed, and when derivative actions and liquidation are appropriate tools to resolve issues in this edition.

Causes and Claims

In family businesses, shareholder disputes can often stem from the personal relationships among the shareholders, who are typically family members. Shareholder disputes in family businesses can arise from a variety of issues, such as diverging visions for the company's future, disagreements over financial policies, governance practices, or tensions regarding succession planning.

A particular challenge in resolving these disputes is the emotional investment and personal histories that can complicate negotiations and legal proceedings. This is exacerbated in scenarios involving derivative actions, where a shareholder sues on behalf of the corporation to address wrongs done to the company.

Such actions can be brought by any shareholder but are particularly contentious in family businesses where personal and business relationships are deeply intertwined. The close-knit nature of family businesses can make these disputes more intense and resolution more complex due to overlapping family and business roles.

Derivative actions

Derivative actions are a form of litigation brought by shareholders on behalf of the company against parties typically within the company, such as directors or officers, who are alleged to have harmed the company. These actions are particularly important in enforcing internal corporate governance. Common types of derivative actions include:

1. Breach of Fiduciary Duty: This is the most common derivative claim. It arises when directors or officers breach their duties of care, loyalty, or obedience to the corporation. Examples include making decisions that benefit themselves at the expense of the corporation, engaging in self-dealing, or failing to act in the company’s best interests.
2. Misappropriation of Company Assets: Shareholders may bring a derivative action if they believe that corporate assets are being misused or stolen. This could involve outright theft or more subtle forms of diverting corporate opportunities for personal gain.
3. Fraud: Actions can be brought against directors or officers who commit fraud against the corporation, whether by misleading shareholders about the company’s financial status or engaging in deceptive practices that harm the company.
4. Negligence: If a director or officer's negligence leads to significant financial loss for the company, shareholders might initiate a derivative lawsuit. An example would be a failure to insure the company adequately, resulting in substantial losses from an event that could have been covered.
5. Excessive Compensation: Shareholders may use derivative suits to challenge what they perceive as excessive or unjustified compensation packages awarded to executives, especially if such compensation is deemed harmful to the company’s financial health.
6. Violation of Shareholder Agreements or the Company’s Bylaws: If directors or officers act in violation of the explicit terms set out in shareholder agreements or corporate bylaws, shareholders can file a derivative suit to enforce compliance.

Derivative actions are an essential tool for shareholders, especially in situations where the usual methods of corporate governance fail to address misconduct by those in control of the company. In family businesses, these actions can be particularly sensitive due to the personal relationships involved, which can complicate the pursuit and resolution of such claims.

Understanding and managing these disputes effectively is therefore critical. Legal frameworks like shareholder agreements can play a key role in preventing and resolving disputes by clearly defining rights, responsibilities, and procedures for dispute resolution. These agreements, along with mechanisms such as mediation are necessary for maintaining business health and family harmony. Regardless, litigation via derivative actions remains a potent means to ensure that family businesses are well-governed.

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Case Studies

This article first published in The Law Society Gazette discusses shareholder disputes in family businesses, focusing on unfair prejudice petitions (UPPs) and derivative actions (DAs). It uses two key cases, Dinglis v Dinglis [2019] and Tonstate Group Ltd v Edward Wojakovski [2019], to illustrate the evolution of the law in this area.

The key takeaways from these cases are set out below:

1. Unfair Prejudice Petitions (UPPs): UPPs address situations where the company's affairs are conducted in a manner prejudicial to the interests of the members. A successful UPP must show that the actions or omissions of the company are unfairly prejudicial to the interests of the members. The case of Dinglis v Dinglis highlights the challenge in family-run businesses where informal trust and mutual expectations may not be sufficient to establish a quasi-partnership unless there is an explicit agreement or understanding that limits the majority shareholder's rights.
2. Derivative Actions (DAs): DAs are brought by shareholders on behalf of the company to address wrongs done to the company itself. These actions can be particularly complex in family businesses due to the overlapping personal and corporate relations. The Tonstate case shows the complexities involved when derivative claims involve companies in multiple jurisdictions and controlled by family members. The court allowed the continuation of derivative claims as double derivative claims, indicating that legal structures and jurisdictions do not inhibit the ability to bring successful claims.
3. Family Business Challenges: In family businesses, distinguishing between personal expectations and legal rights can be difficult. The Dinglis case underscores that even longstanding familial arrangements may not meet the legal criteria for a quasi-partnership without clear, formal agreements. The involvement of family members in management without clear legal backing can lead to disputes if one member is excluded from management, as seen in the Dinglis case.
4. Complex Structures and Legal Claims: The Tonstate case illustrates that even with a complex structure involving multiple companies and jurisdictions, shareholders can still pursue derivative claims effectively, although it may require significant personal investment.

These cases highlight the importance of formalising agreements and understanding the legal frameworks governing shareholder rights and duties in family businesses. The need for clear contractual or legal arrangements to avoid disputes and ensure governance structures are respected is especially important, particularly in the context of quasi-partnerships and derivative actions.

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Company Liquidation

Sometimes disputes, even in family-run companies, cannot be resolved through traditional negotiations or legal remedies often lead to the consideration of liquidation.

Winding up a company on just and equitable grounds, offers a solution, used primarily as a last resort. This drastic measure is typically used in scenarios where shareholders are unable to manage or agree on the company's direction, leading to potential paralysis of the business's operations.

Liquidation on these grounds may be necessary when the company no longer meets its founding objectives - or when there is an intractable deadlock among the directors or shareholders. Other serious issues warranting this approach include significant mismanagement damaging to the company and situations where an individual or a group is excluded from management roles despite reasonable expectations of involvement. These conditions make the continuation of business operations untenable, prompting the need for a just and equitable dissolution.

The process of winding up a company requires filing a petition with the court, which then assesses the necessity and appropriateness of dissolving the company. The court evaluates whether alternative remedies, such as derivative claims or claims of unfair prejudice, might provide a suitable resolution. If other remedies are available and reasonable, the court may opt against winding up. However, the decision to proceed with liquidation hinges on whether it would offer a tangible benefit in addressing the core grievances.

For stakeholders in a family business, the decision to wind up the company is profound. Liquidation leads to the cessation of all business operations, with assets being liquidated to pay off creditors and, if possible, shareholders.

This entire process is managed by a court-appointed liquidator and can often serve as a powerful negotiating tool among shareholders to prompt the resolution of underlying issues or lead to restructuring arrangements that might prevent the actual dissolution of the company. In essence, liquidation on just and equitable grounds provides a final recourse for stakeholders to resolve intractable issues within a company when other measures fail.

For family businesses, this means a clear, albeit final, pathway to address disputes that impact the personal and professional, ensuring actions are taken fairly and equitably. Understanding when and how to pursue this drastic step can safeguard the long-term interests of both the family and the business, providing a structured exit or transition strategy that might otherwise be unattainable.

My goal is to provide practical advice and solutions to help your family enterprise thrive. If you have questions on any of the topics discussed in this newsletter, please feel free to contact me.