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June 1, 2011

When the Family Business Fails

by Dana J. Nelko

The Smith Industries Inc. case discussed below is not real. Rather, the scenario presented is a combination of facts taken from a number of different decisions with the names and industry referred to being changed (what is a widget anyway?). However, the law applied in the Smith case is real and should give everyone involved in a family business cause to reflect on what safety net is in place for their particular enterprise. A version of this article was presented to the Estate Planning Council of Winnipeg on November the 1st 2010 by Dana J. Nelko and Derek Cumming.

Smith Industries Inc. had been in the Smith family since 1928. The company manufactured widgets and had enjoyed much success for many years. The current Smith brothers, Dave and John, inherited the business from their father. Dave and his wife held a 50% stake in the company and were officers and directors, as were John and his wife.

Dave took an active role in the business with respect to the day to day management and arguably was its driving force. John was involved to a lesser extent. For years, business decisions were made on a consensus basis. Because Dave was more actively involved, however, John often simply took his brother’s advice and the business prospered.

At some point, John’s wife began to question some of the decisions Dave had made. She had a bit of an accounting background and decided to become more actively involved in the business. Six months later, she concluded that Dave had been using the business for personal financial gain.

As the friction between the two families began to intensify, it was suggested that the parties enter into a Unanimous Shareholders Agreement which would more clearly set out everyone’s role in the business and put in place a template to assist them in resolving disputes. John’s family refused to sign. Both sides retained legal counsel.

The families learned that a company was in fact a distinct legal entity that had, for lack of a better expression, a “life of its own”. That life was governed by the provisions of The Corporations Act. This legislation, which exists at both the provincial and federal level, contains provisions permitting the court to intervene in appropriate circumstances to resolve disputes among directors and shareholders where the dispute threatens the viability of the corporation.

The so-called “oppression remedy” is triggered by misconduct on the part of a shareholder or director that is construed by the court as oppressive or unfairly prejudicial, or that unfairly disregards the interest of another shareholder, director or officer of the company.

Both the Manitoba courts and the courts across the country have wide powers to remedy virtually any corporate governance problem that may arise in the context of a corporate dispute, be it family-related or otherwise. In order to remedy any deadlock or alleged misconduct, the court can (a) grant injunctive relief or appoint a receiver; (b) amend by-laws of the corporation or amend the unanimous shareholders agreement; (c) order a buy-out by one group of shareholders over another; or (d) if all else fails, order the liquidation or dissolution of the company.

In the Smith Industries case, the judge noted that a once harmonious family business have suffered a complete breakdown of trust, with the very honesty and integrity of its most important manager and employee called into question. The prospect of mending this relationship was unlikely. The court commented that, in the context of a family business, the reasonable expectations of the parties as to how that , enterprise is to be conducted must be viewed and measured against the backdrop of the entire relationship between the parties. It was clear that the distrust and suspicion introduced into the relationship by John’s wife was unsubstantiated but , had nonetheless damaged the “partnership”.

The court was left to come up with a solution. Neither side had sought liquidation of the company. John and his wife proposed that the court impose a “shotgun” solution whereby John and his family or Dave and his family could offer to purchase the other shares at a certain price. The party on the receiving end of the offer could then either take the price proposed or, alternatively, elect to become the buyer at that price.

It is not uncommon to have a buy sell agreement featuring a “shotgun” clause incorporated into a unanimous shareholders agreement. The purpose of the clause is to ensure that the playing field is level and that a fair and reasonable price will be arrived at with respect to any buy-out.

The advantage of having a unanimous shareholders agreement drafted “up front” is that the parties can entertain a number of different creative options with respect to dispute resolution. For example, they can opt for mediation and/or arbitration clauses. The advantage here is that any family dispute will be kept private, unlike court proceedings which are a matter of public record. As well, arbitrations are often less expensive then court proceedings and can be more collaborative and informal.

In the Smith Industries case, the court concluded that it would be unfair to place the two families on the same footing. The dispute was not the making of Dave’s family but resulted from the insistence of John’s wife’s that Dave had been guilty of misconduct. Fairness required that Dave’s family be committed to buy John’s family’s interest in the company at a fair and reasonable price. It was left that, if the parties could not agree on what was fair and reasonable, a further hearing would be held to determine the fair value of John’s family’s shares.

What can we learn from the Smith Industries case? Not all family businesses fail but, when they do, it is often with a spectacular “splash” and with a ripple effect that does more than financial damage to the parties involved. Whether the company is a “mom and pop” operation or a sophisticated enterprise, a balance between the special interests of family members and corporate strategic planning is often difficult to achieve.

When lawyers and accountants are consulted at the start of any business enterprise, the discussion all too often focuses solely on adopting a corporate model to maximize tax planning. While the model may address such matters as income splitting and family trusts, very little time is spent on worst-case scenarios which might befall the corporation. What if Dad passes away or Uncle Ed is caught stealing from the company? What if Cousin Dave goes bankrupt or simply refuses to come into work? What if Mom and Dad divorce?

Lawyers live in a worst-case scenario world. We are constantly building lifeboats long before the ship leaves the dock. Unfortunately, it can be difficult to counsel clients who are hoping for the best but need to plan for the worst. Suggesting to a client that he or she enter into a shareholders agreement that deals with contingencies of a corporate breakdown may seem like asking the client to “bet” against him or herself. Clients often resist allocating scarce resources to a “fancy” agreement that, once executed, may not see the light of day again. Adding to the problem is the fact that, at the start of a business, the need to address potential failure is not considered a priority.

In fact, the value of a well-crafted unanimous shareholders agreement cannot be overstated. It is the safety net that will ensure adherence to proper corporate governance and that, in the event of a fracturing of trust between the shareholders, the rights of all shareholders will be properly protected. While family members might resist paying the upfront cost associated with preparation of such an agreement, the costs will be much greater if a breakdown does occur and litigation results.

Unanimous shareholders agreements can reflect the specific needs and concerns of each specific group of shareholders. There is no “standard” form of agreement although each agreement should address certain corporate themes such as management, responsibility and succession issues. A unanimous shareholders agreement should also operate to ensure that the sale and purchase of shares is controlled within the family. If the business is to be “handed off” to the kids, it is important to have a good succession plan in place long before it becomes apparent that the children are going to continue on with the family’s legacy.

While unanimous shareholder agreements are best crafted when disputes between family members have not yet begun to fester, parties should recognize that it is never too late to properly organize their corporate affairs. Doing so will ensure that, in the event the family business fails, the interests of all parties are given proper voice and protected.

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