By Brad Monk
People change, and not always for the better. Which leads to the question: what is the best course of action when a trusted business partner turns out to be a rotten egg? The answer is not easy, but usually the best course of action is to promptly remove an untrustworthy partner from ownership in the business and also from participation in the company’s management.
Removal Provisions Need to be in the Governance Documents
The process of removing a bad business partner is often unpleasant and difficult, but it is likely unavoidable. To prepare for this type of risk, diligent majority owners will want to include “removal rights” in the company’s governing documents (the LLC agreement, the partnership agreement, or corporate bylaws) that provide for the removal of business partners who go off the rails. By the same token, minority investors will want to closely review all “bad boy” provisions to insist on changing these terms if they give the majority owner unbridled power that could be used abusively to harm the minority investor.
While it should not be so difficult to remove a bad partner who has engaged in abusive or other improper conduct, the removal process can be both problematic and exceedingly costly. In addition, the removal of a bad business partner may not be possible if the company’s governing documents do not specifically provide this right. Many business owners do not realize until too late that they have no legal basis to remove a bad business partner, because the default corporate statutes do not provide for this type of removal right.
Therefore, the right to remove a bad business partner exists—if at all—in the company’s governing documents. For majority owners of the company to avoid being stuck with a business partner who is dishonest/disreputable, the governance documents must plainly and clearly authorize the owner to exercise these removal rights when one or more triggering events take place. The removal provisions should also clearly set forth the standard of proof that is required to remove the bad business partner, as well as provide for how the minority investor’s ownership interest will be cashed out at the time of removal. Costly and protracted disputes over these issues are likely to arise if these removal provisions are not clearly stated.
Real World Examples
In one actual case, the owners of a private company were both surprised and frustrated to learn that they could not remove a business partner who had clearly misappropriated company funds—unless they could prove their business partner had committed “actual fraud.” Because proving fraud can be difficult and costly (certainly more costly than proving breach of fiduciary duties), these owners opted not to incur the disruption and substantial cost of seeking to remove the dishonest partner and were effectively required to continue doing business with him. This problem could have been avoided if the governing documents expressly permitted a partner to be removed based on a clear breach of fiduciary duties and/or for the misuse of company funds.
In contrast to the situation above, removal provisions can go too far and make it too easy to remove or expel another owner. These provisions, which are seen often in the “off-the-shelf” company agreements, provide that one owner may remove another owner at any time and for any reason or for no reason at all. To offset this unlimited power of removal, the removal provision requires the majority owner who takes this action to immediately purchase the full ownership interest of the expelled partner. Thus, the only “protection” provided to the expelled partner in these agreements is a buyout that takes place at the time of the expulsion. If the minority partner is fortunate, the buyout will be for “fair value” (as opposed to “fair market value”). This method does reduce the risk of a costly dispute over the removal of a partner, but it also fails to provide minority investors with adequate protection from abusive conduct by majority owners. These over-broad removal provisions are therefore prone to being exploited by a “bad egg” majority owner, who has waited for the opportune time to increase his/her stake in the company.
Take-Aways For Effectively Dealing with Bad Partners
In sum, a company’s governance documents should provide for a balanced approach to dealing with a bad business partner. At a minimum, these documents should include:
- Removal rights triggered by breach of fiduciary duties, misuse of company funds, or other specific acts significant enough to justify the removal of a bad partner (but not too difficult or cumbersome to establish);
- A buyout provision that is tailored to fit the needs of the company;
- A clear, fair removal method that includes an appropriate discount (i.e., not a punitive discount) of the interest held by minority owners who engage in conduct that triggers the removal rights; and
- A limited power to amend the company’s governance documents (so that majority owners cannot unfairly re-write the LLC company agreement or bylaws).
Despite the pitfalls discussed in this post, it is possible to draft provisions for the removal and buyout of bad business partners in the company’s governance documents that meet the needs of the company and its owners. But if these provisions are not included or they are not properly drafted in the company documents, the majority owners may be stuck with a rotten egg business partner who cannot be removed when the bad partner goes astray.