It started with a great vision and path to success together. This partner was going to be an asset to the business. And perhaps at some point, they were. But for whatever reason, the relationship soured, and now your differences are irreconcilable. The partner may be absent, and the other members are left carrying all the weight. They may be making decisions that are detrimental to the company or engaging in conduct that breaches their fiduciary duty. Simply put, the partnership is no longer in the best interest of the business and you found yourself in the middle of a partnership dispute.
There are several mechanisms that can be employed. One of the more aggressive ones is a “freeze-out” merger a “squeeze-out merger” or a “midnight merger.” In New York, minority members of a limited liability company or a corporation can sometimes be involuntarily bought out of the company in a freeze-out merger. These mergers are not the first mechanism that could or should be employed when it comes to a partner dispute.
Sample Business Partner Dispute Scenario A
Jane suspects that John is using his ownership interest in Smith LLC to get intellectual property and trade secrets to form a side company to Smith LLC’s detriment. Jane wants to terminate the partnership with John and offers to buy him out for what Jane thinks is a reasonable price considering John’s bad faith actions. John isn’t willing to sell his shares, and Jane didn’t have the provision in the LLC operating agreement to force John out of the business and sell his shares.
Sample Business Partner Dispute Scenario B
A minority shareholder may die and leave his shares to a family member. Now a spouse, that does not know the business, has obtained your former partner’s shares. Your business will suffer if you don’t buy the spouse out, but she doesn’t want to sell.
Sample Business Partner Dispute Scenario C
A minority shareholder is not contributing to the business’s success. They are just not pulling their weight. They may not be showing up to work, or they are just phoning it in. Perhaps they are even having behavioral issues, and it’s affecting your staff. Sometimes, these issues are a result of the minority shareholder’s personal life, such a going through a divorce.
In all the above scenarios a freeze-out merger may be a good solution.
Who Has the Upper Hand in a Business Divorce?
In partnership disputes, the majority owner is in the driver’s seat, but there are some limits on their ability to steer the course of the company. In your ideal situation, you had your business lawyer draft an operating agreement or shareholder agreement that allows you to buy out or force out the minority owners based on a formula. If you don’t have a force-out provision, then the freeze-out merger may be the best way forward.
Forcing a Partner Out of the Business
When there are irreconcilable differences with a business partner, majority shareholders can legally do a freeze-out merger. This is a strategic merger transaction done to remove minority shareholders that refuse to be bought out at a reasonable price. In this situation, the other business partners would squeeze out a problematic individual.
How Does a Freeze-Out Merger Work?
When a partnership dispute cannot be resolved, one owner may proceed against the other owner under state laws to end their relationship without the consent of the minority owner. The majority owner(s) create a new entity, as well as a written agreement and plan of merger to merge the existing entity into the new entity. The majority members force the minority member to accept cash for his or her membership interest in the original company instead of getting equity in the new surviving company. The minority interest owner then has no ownership interest in the new entity.
This process effectively ends the minority owner’s interest in exchange for cash. A freeze-out of a business partner can be done quickly and without the consent of the problematic minority owner if done according to the exact steps set forth under the state law governing freeze-out mergers.
The result is that the remaining shareholders own the surviving entity and the problematic former partner no longer has ownership. The new company is vested with all of the assets and is subject to all of the liabilities of the merged company. The business partner that was forced out receives fair value in exchange for his previous ownership stake.
The Minority Shareholder’s Protection in A Freeze-Out Merger
The freeze-out statutes protect the frozen-out member to the level of providing them with the right to dissent from the merger and to demand a fair market value appraisal by the court of their shares. Section 623 (k) of the Business Corporation Law states that a shareholder’s right to dissent from a merger coupled with the exclusive remedy to get cashed out with a “fair value” via an appraisal proceeding. It has to be an unbiased third-party appraiser who determines if the frozen-out business partner received fair value of his or her former ownership interest in the business.
While a minority shareholder cannot prevent a freeze-out merger from taking place under most state’s dissenters’ rights statute, the statutes are generally designed to allow them to maximize the price that he or she gets in exchange for his or her shares.
Avoiding Litigation: Ensure No Fraud or Bad Faith!
The key to freeze-out mergers to be legal is for the majority of partners to not have dealt in bad faith, committed fraud, or otherwise breached their fiduciary duties against the business partner who is being forced out. It is critical for the majority owners to tender a fair market cash-out, and a failure to do so could expose them to unwanted and costly litigation. Each state has its set of laws that govern business disputes. New York law, as an example, acknowledges the validity of freeze-out mergers while other states may not. Working with a business attorney will ensure everything is done legally in the state where your business was formed.
You don’t have to continue working with a business partner or shareholder who is not pulling their weight. You have rights, and they can be enforced quickly and legally. If done right, the freeze-out merger can be an effective remedy in a partnership dispute for majority owners faced with a problem shareholder. The freeze-out, however, must be done very carefully and in accordance with state statutory procedures, as well as under the laws of an operating agreement, if one is in place.
To avoid any undesirable legal or tax consequences, partners should seek the advice of a business attorney to ensure the freeze-out merger is executed correctly. Gouchev Law can evaluate your business to ascertain whether this option is available to you and a prudent choice for your partnership dispute.
Disclaimer: The information in this article is for general information purposes only. Nothing in this article should be taken as legal advice for any individual case or situation. This information is not intended to create and viewing it does not constitute an attorney-client relationship.