The Corporate Divorce: Breaking Up (in Business) is Hard to Do

business attorney

Untangling business disputes between owners (a corporate divorce) is often harder than an actual divorce. In a divorce, the law imposes some order on the process. Without a written agreement from a business attorney, you might not be able to end the business relationship with your partner without ending the business. Unfortunately, business owners don’t often go to a business attorney for advice and the necessary contracts. After all, they don’t know if the business will work, so why spend the money? 

You should spend the time and money with a reputable business attorney in Fairfax, VA to set up the business right because of what happens when you don’t. 

Suppose a dispute arises between the business owners. What the dispute is about doesn’t matter. I’ve seen businesses pulled apart because the business is doing well; the business is doing poorly; one owner thinks the relationship is no longer fair; one owner stops showing up to work; or the owners, who are also husband and wife, separate or get a divorce. The reason for the dispute can be positive or negative. At its heart, an owner dispute that blows up a business will be something the owners can’t resolve between themselves. Without a written agreement, options for breaking this deadlock and keeping the business running are fairly limited.

Most states have provisions to dissolve (end) a company or disassociate (kick out) a member if certain conditions exist. State law allows for appointment of a receiver (third party) to wind up (end) the company’s affairs. All these court-driven solutions end with the company no longer existing and are difficult and costly. It is much better for the livelihood of your business that your business partner and you agree on certain procedures and dispute resolution processes before problems arise. 

Let’s look at an example. A husband, Chin, and wife, Dara, owned a business. Chin was the majority shareholder. He also had mental health issues, which caused him to abandon his business and Dara. Dara filed for divorce. The divorce judge allowed Dara, the minority shareholder, to replace the company’s board of directors and appoint a new board of her choosing. Now, there were lots of problems with this from a legal standpoint. First, as a minority shareholder Dara didn’t have the authority to appoint a board of directors. Second, the company wasn’t part of the divorce, so the divorce judge didn’t have jurisdiction over the company, that is, he didn’t have the authority to order the company to do anything. 

Still, sometimes weird things happen in court, and this judge was determined to enter an order affecting the company. To save the company from the divorce court, Chin, who was undergoing treatment once again, filed the very profitable company for a Chapter 11 bankruptcy—also known as a reorganizing bankruptcy. Chin immediately fired the wife’s board of directors. This story had a happy ending. Ultimately, Chin and Dara reconciled, and the business thrived. However, many businesses die when disputes between the owners occur. 

You should have these three types of agreement with your business partner:

  • a shareholder’s or operating agreement (the type you need depends on whether the company is a corporation or a limited liability company),
  • a buy-sell agreement, and 
  • an employment agreement with non-competition provisions. 

Though I say these are three agreements, the relevant terms can, and probably should wherever possible, be included in one written contract. If you opt to make each type of agreement a separate document, be careful to ensure you don’t have contradicting terms. Again, I find it easier to have all the important agreements in one document. Essentially, you want an agreement that sets out who handles what, how decisions get made and how you get out of the relationship if things aren’t going well. The outline below gives you some of the major terms to have in any agreement between business owners.

Considerations for Shareholders’ or Operating Agreements

  1. Governance
  2. Election of specific people to specific positions
  3. Number and allocation of shares
  4. Day-to-day operations:
  5. Who manages?
  6. Who sets the corporate vision/ direction? 
  7. If there is an equal number of managers, how is a tie addressed?
  8. Requirements—majority or supermajority—to alter corporate documents
  9. Shareholder/member rights
  10. Powers
  11. Waiver of partition rights 

 (legal mumbo jumbo that means the right to have property divided into individual portions for the owners)

  1. Duties
  2. Employment
  3. Compensation and benefits 
  4. Termination 
  5. for cause
  6. without cause
  7. Stock issues 
  8. How additional stock is issued
  9. Is dilution possible?
  10. Restrictions on transfer of stock
  11. Sale of stock
  12. Right of first refusal
  13. Inter-member voluntary sale
  14. Compelled sale
  15. Disability sales
  16. Death sales
  17. Termination of employment 
  18. Effect of owner’s bankruptcy or divorce
  19. Effect of creditor’s enforcement against interest
  20. Payment Terms
  21. Contingencies affecting payments
  22. Key man insurance

(life insurance policies designed to pay the company if an owner or other key employee dies to make up for the loss of that individual in the corporate structure)

  1. How to resolve differences
  2. Meet and confer
  3. Mediate
  4. Arbitrate or litigate
  5. Combination of above
  6. Distributions including allocations of profit and loss
  7. When?
  8. Who makes the decision?
  9. Guidelines on what may be distributed
  10. Participation in other ventures
  11. Duty of loyalty 
  12. Liability and indemnification 
  13. Capital contribution calls

(legalese for when a company has the right to request loans or other funds from its owners; failure to pay a capital call can result in a loss of some percentage of ownership) 

III. Restrictions on trade (where allowable)

  1. Non-competition
  2. Non-solicitation 
  3. General Issues
  4. Name rights
  5. Continuation of business after an owner leaves
  6. Major decisions – procedure and definition
  7. Dissolution 

(legal mumbo jumbo for ending the company’s existence)

Still, sometimes weird things happen in court, and this judge was determined to enter an order affecting the company. To save the company from the divorce court, Chin, who was undergoing treatment once again, filed the very profitable company for a Chapter 11 bankruptcy—also known as a reorganizing bankruptcy. Chin immediately fired the wife’s board of directors. This story had a happy ending. Ultimately, Chin and Dara reconciled, and the business thrived. However, many businesses die when disputes between the owners occur. 

You should have these three types of agreement with your business partner:

  • a shareholder’s or operating agreement (the type you need depends on whether the company is a corporation or a limited liability company),
  • a buy-sell agreement, and 
  • an employment agreement with non-competition provisions. 

Though I say these are three agreements, the relevant terms can, and probably should wherever possible, be included in one written contract. If you opt to make each type of agreement a separate document, be careful to ensure you don’t have contradicting terms. Again, I find it easier to have all the important agreements in one document. Essentially, you want an agreement that sets out who handles what, how decisions get made and how you get out of the relationship if things aren’t going well. The outline below gives you some of the major terms to have in any agreement between business owners.

Considerations for Shareholders’ or Operating Agreements

  1. Governance
  2. Election of specific people to specific positions
  3. Number and allocation of shares
  4. Day-to-day operations:
  5. Who manages?
  6. Who sets the corporate vision/ direction? 
  7. If there is an equal number of managers, how is a tie addressed?
  8. Requirements—majority or supermajority—to alter corporate documents
  9. Shareholder/member rights
  10. Powers
  11. Waiver of partition rights 

(legal mumbo jumbo that means the right to have property divided into individual portions for the owners)

  1. Duties
  2. Employment
  3. Compensation and benefits 
  4. Termination 
  5. for cause
  6. without cause
  7. Stock issues 
  8. How additional stock is issued
  9. Is dilution possible?
  10. Restrictions on transfer of stock
  11. Sale of stock
  12. Right of first refusal
  13. Inter-member voluntary sale
  14. Compelled sale
  15. Disability sales
  16. Death sales
  17. Termination of employment 
  18. Effect of owner’s bankruptcy or divorce
  19. Effect of creditor’s enforcement against interest
  20. Payment Terms
  21. Contingencies affecting payments
  22. Key man insurance

(life insurance policies designed to pay the company if an owner or other key employee dies to make up for the loss of that individual in the corporate structure)

  1. How to resolve differences
  2. Meet and confer
  3. Mediate
  4. Arbitrate or litigate
  5. Combination of above
  6. Distributions including allocations of profit and loss
  7. When?
  8. Who makes the decision?
  9. Guidelines on what may be distributed
  10. Participation in other ventures
  11. Duty of loyalty 
  12. Liability and indemnification 
  13. Capital contribution calls

(legalese for when a company has the right to request loans or other funds from its owners; failure to pay a capital call can result in a loss of some percentage of ownership) 

III. Restrictions on trade (where allowable)

  1. Non-competition
  2. Non-solicitation 
  3. General Issues
  4. Name rights
  5. Continuation of business after an owner leaves
  6. Major decisions – procedure and definition
  7. Dissolution 

(legal mumbo jumbo for ending the company’s existence)

Still, sometimes weird things happen in court, and this judge was determined to enter an order affecting the company. To save the company from the divorce court, Chin, who was undergoing treatment once again, filed the very profitable company for a Chapter 11 bankruptcy—also known as a reorganizing bankruptcy. Chin immediately fired the wife’s board of directors. This story had a happy ending. Ultimately, Chin and Dara reconciled, and the business thrived. However, many businesses die when disputes between the owners occur. 

You should have these three types of agreement with your business partner:

  • a shareholder’s or operating agreement (the type you need depends on whether the company is a corporation or a limited liability company),
  • a buy-sell agreement, and 
  • an employment agreement with non-competition provisions. 

Though I say these are three agreements, the relevant terms can, and probably should wherever possible, be included in one written contract. If you opt to make each type of agreement a separate document, be careful to ensure you don’t have contradicting terms. Again, I find it easier to have all the important agreements in one document. Essentially, you want an agreement that sets out who handles what, how decisions get made and how you get out of the relationship if things aren’t going well. The outline below gives you some of the major terms to have in any agreement between business owners.

Foundation documents set the baseline for what everyone believes is a “fair” resolution of specific anticipatable events while everyone gets along. If the parties separate amicably, they can always agree to do more than the agreements require. In the event that the parting is less friendly, everyone knows the minimum result in advance. Having these critical foundation agreements can save not only the business if a later dispute arises but also the relationship between the owners. It’s important to have these discussions with your business partner when you start the company and to document any agreements reached to avoid later landmines.

What is the Duty of Loyalty?

employment attorneys

The duty of loyalty arises out of the common law (the law made by courts rather than a legislative body like the Senate or Congress) regarding the master-servant relationship, or whenever someone acts as an “agent” for someone else. The employee must act solely for the benefit of her employer in all matters connected with her employment. 

What’s that mean? 

Since at least Biblical times, we’ve heard the phrase “No man can serve two masters.” Essentially, this quote embodies the duty of loyalty in its most basic form. 

The employee must give loyal, diligent, and faithful service to his employer even when no written agreement exists between them. An employee must act with the utmost good faith in the furtherance and advancement of the employer’s interests. An employee can’t benefit at her employer’s expense. While this sounds like a simple concept, it’s complicated and more prone to litigation with the help of an employment attorney than you might think. Besides the common law, certain statutory laws also prevent an employee from benefitting at his employer’s expense. 

 

What Can an Employee Do Without Violating the Duty of Loyalty? 

An employee can take preliminary steps to start her business while still employed. Preliminary steps can include forming a new company and even securing a lease if the employee isn’t on her employer’s time when she does these things. Essentially, an employee can do just about everything she needs to do to set up her new company, but can’t start operations or look for work. 

So, when does an employee cross from preliminary steps to walking in a minefield?

 

What Does an Employee Do to Violate the Duty of Loyalty?

The second an employee puts his interests in front of his employer’s, that employee violates his duty of loyalty. 

Unfortunately, many companies have fallen prey to disloyal employees over the last two decades and have needed the assistance of employment attorneys. In one Virginia case, critical company employees approached a competitor and asked if it wanted to acquire the entire division of the employees’ current employer. Not surprisingly, the competitor said yes. The employees crossed the line between preliminary steps and disloyalty. 

Once the competitor agreed to defend and “indemnify” (legal mumbo jumbo for “protect from legal fees and damage claims”) the employees of the old company, the secret meetings started. The employees made a list of which other company employees to approach and when to approach each of them based on whether they thought that person might “blab.” They orchestrated a mass resignation designed to cripple their current employer. They moved copies of the company’s trade secrets and confidential information to client sites so the information would be available to the competitor after they quit.

The employees resigned en masse and went to work with the competitor. The clients moved to the competitor. The old company sued with the help of employment attorneys. When the dust settled, the employees were found to have breached their duty of loyalty and violated the Virginia Trade Secrets Act and the new employer owed over $1.2 million dollars in damages to the old company. 

In a similar case, an employee accepted a position with a competitive company. Before he resigned, he copied all of the company’s information and planned to walk out of the building with it. Fortunately, the company had planned to fire him that same day. When the company went into the employee’s office to change his passwords, a coworker phoned him to let him know he was about to be fired. He begged her to get his briefcase and keep it from the company. Well, she got the briefcase and turned it over to the Human Resources Department. The matter ended up in court. The now-former employee was barred from accepting his new job and using the company’s information to benefit someone else. He was likely going to have to pay significant damages to his former employer. Instead of going to trial to determine how much he owed, our employment attorneys settled the case. 

Most employees who violate their duties of loyalty aren’t malicious. They often act because they feel the company is in a financial crisis and they are doing what they need to do to survive. The simple truth is that, while he’s still employed, an employee can’t take work that his employer could perform, offer to work for his employer’s client, or offer employment to other employees without the company’s permission.

According to the Small Business Survey, over 13 million, or nearly 60%, of all small businesses have experienced significant legal events in the past two years. You wouldn’t believe the things employees have done. In another case, an employee tendered her resignation and gave a month’s notice.  After resigning, but before she left the company, she forwarded hundreds of company emails, many of which contained company financial information and other sensitive data, to many accounts at her new employer, to many personal accounts of her current coworkers, their spouses and family members, and to her personal account. A coworker who was not in on the conspiracy saw her printing and hiding company documents and reported her to the company. The company then checked its email backup files. In this business, when an employee “deleted” a document, the system saved a copy of that email to a “vault” file to ensure that no important data was lost. Can you guess what happened next? Yeah, that. With the assistance of employment attorneys, the company sued her and the other employees who were in on the conspiracy.

Courts have found that employees violated their duties of loyalty when they: 

  • Diverted work from their employer to the new company or employer. 
  • Asked the employer’s customers to give work to their new business.
  • Hired or tried to hire their employer’s other employees or contractors. 
  • Planned a mass resignation. 
  • Took copies of customer lists. 
  • Took copies of the company’s business plans or “secret sauce.” 
  • Deleted the employer’s information from its own systems. 
  • Used time paid for by the employer to support the new business. 
  • Used company assets, like copiers, computers, software, cars, and funds, without paying for them. 
  • Used the company’s office space for the new business without permission. 
  • Used an employer’s confidential information, such as credit, billing, or other financial information of the company or company’s business records, for the benefit of the new venture. 
  • Used the employer’s trade secrets to benefit the employee’s business. 
  • Voted, as an executive officer, for a bonus he and others would receive when he knew he was quitting. 

This list isn’t exhaustive; there are other things employees can do to breach their duty of loyalty to their employers. 

Did some items on that list surprise you? 

Working on the Great American Novel while you’re supposed to be operating the company’s business breaches your duty of loyalty. Worse, since the employer paid you for the time to write the novel, or even if you used your employer’s computer, the employer might have an ownership interest in the work.

Does the Duty of Loyalty End When the Employee Leaves?

An employee’s duty of loyalty generally ends when the employment does. But not always. Sometimes that duty may continue after the employee quits. 

What does that mean? 

If a post-employment act can be traced to a pre-employment breach of the duty of loyalty and the issue goes to court, the employee will probably be prevented from obtaining the benefit of the breach after he leaves. In a criminal law context, this concept is called “fruit of the poisonous tree,” which means that law enforcement can’t benefit from evidence it discovered through unlawful means (for example, an improper search or a coerced confession). The same idea applies to employees. The former employee can’t benefit from his breach of his duty of loyalty while employed, even if the benefit occurs after he resigns. 

Let me give you an example. 

While employed, a CEO directed a client, who wanted a high-end custom home, away from his employer and to his new business. The CEO was fired. Then the former employer sued the CEO and his new business for breach of the duty of loyalty. Even though work on the client’s house didn’t start until after the CEO was fired, he was not allowed to benefit from the stolen contract and paid his former employer the profit it would have received on the contract. 

How does an ex-employee end up paying his profit to his former employer? Well, the answer relates to an employer’s remedies for the employee’s breach of the duty of loyalty. 

What Can an Employer Do About a Breach of the Duty of Loyalty? 

An employer can seek several forms of relief when an employee breaches his duty to his employer, including:

  • Repayment of the wages, bonuses, and benefits paid to the disloyal employee.
  • A money judgment equal to the damage done to the business or its lost profits. 
  • Imposition of a constructive trust on the funds the employee received because of the breach, which means the former employee must hold in trust all or some of the money received by his new venture for the benefit of his former employer. 
  • Recovery of punitive damages, which are payments imposed by the court to deter wrongful conduct and are in addition to payments covering the employer’s actual losses. Some states have caps on the amounts of punitive damages that can be awarded. 
  • Recovery of liquidated or other statutory damages. For example, when an employee has taken her employer’s trade secrets, the employer can recover triple damages. In other words, if the employee’s conduct caused the employer to lose a hundred thousand dollars, the employer can recover three hundred thousand dollars! 
  • Recovery of legal fees and costs. Most courts follow the “American rule,” by which each side to a legal dispute pays for its own employment attorneys and related expenses. However, in some cases the winning party can also recover these expenses. Some statutes, like the Trade Secrets Act, specifically allow for the recovery of legal fees. Outside of a specific written law, some types of claims like fraud—where the defendant lies about something important, the plaintiff believes him and suffers as a result—allow for the recovery of legal fees. Make no mistake. Litigation is very expensive. The legal fees to prove a case can sometimes be greater than the actual damages from the bad action. Employees who breach their duties of loyalty risk paying these additional expenses for the employment attorneys they need. 
  • Obtaining an injunction. Employers often have grounds in these cases to ask the court to stop the former employee from engaging in some conduct or to take affirmative action to stop the harm to the employer by, for example, returning the information they took. Under the right circumstance, an injunction can even require you to put funds in trust for your former employer’s benefit until the end of the case.

What Other Claims May Exist?

When an employer sues for breach of the employee’s duty of loyalty, the company is also likely to sue under several related theories. In the right cases, these additional claims can include fraud, tortious interference with contracts, violation of the Trade Secrets Act, violation of the Computer Crimes Act, and conspiracy.

How Do You Avoid This Landmine? 

As an employee starting a new business, there are some do’s and don’ts to follow:

  • Do set up your new business on your own time.
  • Don’t take any of your employer’s documents with you when you leave the company. 
  • Don’t delete company information off the company’s system before you leave. 
  • Don’t download the company’s information. 
  • After giving the company a copy of any of its information on your personal systems, do delete this information from those systems.
  • Don’t use any of the company’s documents or financial information, including price lists, in your new business. 
  • Don’t use any of the company’s assets, like meeting rooms or vendor accounts, in setting up your business. 
  • If the company’s documents were online templates, don’t use the modified version from your employer. Go back to the source and start fresh with the base template. 
  • Don’t offer competing services until after you leave.
  • Don’t talk to your co-workers about hiring them and don’t hire them for your new company before you leave the old one. 
  • Don’t talk to your employer’s customers or vendors, even ones where you have a personal relationships, about your new venture until you’ve left your old position. 
  • Do make a clean break so that, if there is any question about a breach of your duties, you can show an unrelated source for the information. As an example: Your former employer accuses you of taking the company’s customer list. However, you deleted those contacts from your personal cell phone and turned in the company phone. You can then show that either the customer contacted you— after all, nothing forced them to delete your contact information—or you received the customer information through other legitimate means like searching LinkedIn, Facebook, or other social media sites.

Starting your new business is an exciting time, but there’s a need for extra care when you start your business while working for someone else. If you try to take a shortcut by using the former company’s documents or taking its workforce or clients, you are wandering in a minefield. The question isn’t if your former employer will figure out what you’ve done, but when and how much your “shortcut” will cost you. I’ve given you some tips on ways to minimize your chances of winding up in this minefield and needing to invest in employment attorneys, but no book can cover every possible scenario. Consult with small business attorneys to determine which steps might later be determined to have breached your duty of loyalty and exposed your new business, and you, to claims by your former employer. 

This is an excerpt of attorney Nancy Greene’s book, Navigating Legal Landmines, a runaway number one bestseller. Buy it now at amazon.com.