From outstanding tax liability to unearthed financial irregularities, biz breakups can be every bit as emotional and complicated as a marital split
When the economy is in recession, it's a given that many businesses will be sold or go under. And when that happens, it often triggers what attorney Michael A. Gold, of Jeffer Mangels Butler & Marmaro in Los Angeles, calls a "business divorce." From outstanding tax liability to business debt and unearthed financial irregularities, these breakups can be every bit as emotional and complicated as a marital split, Gold says. He spoke recently to Smart Answers columnist Karen E. Klein; edited excerpts of their conversation follow.
You represent developing and entrepreneurial companies across a range of industries. When did you start to see an increase in business dissolutions and partnership splits?
When the economy was really booming there were very few of these. But I noticed in early 2007—and by the end of 2007 it became apparent—that that part of my practice was really picking up. And then 2008 tuned out to be a very busy year, especially after Lehman Brothers tanked.
Business partnerships are often related to marriages; you liken partnership splits to divorces. Why?
Business divorce does have some of the same characteristics of a family divorce, just without the china and silverware. But there are usually substantial assets involved and people often bring a lot of emotion to the table. Many times they want a lot of things that can't be obtained in court.
Why do business partnerships break up?
Soured personal relationships, financial strains, and bad business models can contribute to a decision by the owners of a closely held business to part company. Sometimes the breakup is amicable, although it can often be hostile and litigious. And where there is no pre-existing agreement—like a shareholders' agreement, a limited liability company operating agreement, or a partnership agreement—with a road map that governs the separation, business divorces can quickly become very nasty.
Are you seeing business divorces triggered by situations specific to this recession?
Yes, especially post-Lehman Brothers I'm seeing partners realize that they have different risk profiles. One guy might believe this is the greatest real estate buying opportunity of all time, while the other wants to take his chips off the table because he thinks we haven't yet hit bottom in the commercial real estate market.
I've also seen some near-death financial experiences, where a bank has pulled financing, or there's inadequate capitalization and the bank comes back and wants guarantees from the partners. Suddenly, one partner realizes he doesn't want to guarantee a debt with the other partner, and those personal and credit issues cause them to re-evaluate whether they want to be in business together.
What kinds of unexpected issues arise in business divorces?
Very often we are dealing with banks and other third-party financing. One case I'm working on involves seven different lenders, all with different loan agreements, scattered across the Southwest. One shareholder may want to pay the debt in full, while the other says 'Why do we want to do that? These guys will let us get away with paying 75¢ on the dollar!'
Dealing with employees can also be a significant problem. In California, for instance, as a matter of policy and law the courts take fair treatment and payment to employees very seriously. When companies find themselves in trouble they sometimes short the employees— which can give rise to significant liabilities. We also face a lot of tax issues and competition issues.
Do you see partners who haven't really gotten along for years but have managed to work together while their business is doing well?
Oh yes, all the time. I handled the split up of a surgical center where all three owners, who were doctors, got along well when the money was really loose. But post-Lehman, when things began to get really tight, they realized they not only didn't like each other but they also didn't trust each other. Negotiating the separation agreement was hilarious. We had to get into a level of granularity that included whose name plates would remain on what doors until what dates.
What about post-business divorce? Are there issues about future business opportunities?
Definitely. Typical LLC agreements include standard language that says [a withdrawing partner] is not prohibited from being in another business, but if he gets opportunities that apply to the original business, they have to go through that business. So a partner that is leaving may want to go into the same business elsewhere. Or he may have done something before the split that the former partner claims is a business opportunity the original company should have gotten.
Are there surprises that come up when a partnership is ending?
Often there's an elephant in the room that no one will talk about until an attorney like me says, "Something has to be done about this elephant."
Sometimes one or more partners doesn't have any notion about the taxes or hasn't looked deeply into the finances. When they do, they realize that certain things had been going on that were very unseemly. One of my clients found out that the principal shareholder in her firm had taken a $15 million distribution that she was completely unaware of because she'd never looked at the corporate tax returns.
Are business divorces likely to wind up in court?
There's always the potential for litigation. I've actually tried a few of these cases and found that judges generally don't like them, especially where the parties have a lot of money. They see it as a bunch of rich people squabbling over their fortunes. Judges tend to bring down the hammer fairly quickly and appoint a receiver or referee to work out a settlement.
What happens to companies that don't have formal partnership agreements or LLC operating agreements?
In a business dissolution case they default to their applicable state corporations code. Those codes all have provisions that deal with creditors and other stakeholders and what priorities they get for repayment.
What advice would you give business owners before they get into divorce situations?
Have some kind of written agreement, either an LLC operating agreement or a buy-sell agreement or a shareholders' agreement. Absent an agreement, it very much behooves a business owner to consult with savvy counsel to identify all the issues of a business divorce, including those that may not be immediately apparent to the business owner.