What do business owners owe one another?

There was an interesting storyline for small and mid-sized businesses in the National Federation of Independent Business’s optimism index for January. While the outlook from small business owners was guarded, the actual activities undertaken by those businesses showed continued momentum.

“Most of the January decline was due to waning optimism over future business conditions and expected sales,” wrote the Wall Street Journal. “Still, hiring and overall spending among small businesses remained solid [and] newly hired workers were better compensated.”

Such mixed messages are par for the course for business owners, and the uncertainty underscores an age-old truth: business ownership is a long journey, with plenty of turns along the way.

Companies that have multiple owners may find rifts appearing between them as they discuss strategic direction — or they may simply battle over staying afloat during down times. However daunting the challenges, shareholders and partners should understand that when they entered into shared ownership, they agreed to a set of legal obligations to each other that are designed to protect the business.

There are three principles that business owners should keep in mind to avoid legal missteps as the business evolves.  In certain states, these duties may be more extensive than in others — those discussed here are specific to Massachusetts, but every region has guidelines that are worth a look.

  • Exercise caution in firing shareholders

In small businesses, owners often serve dual roles as management and as employees. Just as with other staff, there may come a time when a majority shareholder wants to fire another owner based on the quality of his or her work as an employee. There may be circumstances under which the move makes sense, but it can be a breach of fiduciary duty if the end result deprives the employee of the benefits of being a shareholder.

For example, consider four shareholders that founded a business together, each drawing a salary based on their ownership percentages.  If three of the team together decide to fire the fourth as an employee, could they split the additional draw or re-invest it in the business?

The reason behind the firing may be valid, but because the terminated partner was an owner, disassociation is not so simple inasmuch as the shareholders owe each other fiduciary duties, and a court will closely scrutinize whether the situation could have been handled in a different way.  Preserving the anticipated benefits of ownership is an important obligation in the court’s eyes.

  • Shareholders get equal treatment

Controlling shareholders cannot favor themselves or certain shareholders over others – the rights and privileges of ownership are generally not subject to the whims of owners in power.

If, for example, a corporation’s founder built her business over a number of decades and is now retiring, the remaining shareholders may cause the corporation to purchase her stock back at favorable but fair terms. While she may have close relationships with the remaining controlling shareholders, those shareholders must make the same terms of repurchase available to all shareholders, including minority shareholders.   

  • Stay away from self-dealing

Shareholders may have any number of activities outside the office, and networks of trusted allies. Their reputation is likely to lead to new opportunities, but they must take care before pursuing them outside the structure of the business they own.

An owner’s business obligation includes a duty of loyalty to fellow shareholders, which prevents them from favoring their individual interests. There is plenty of gray area, though.  Some agreements among partners may specify the business scope, and opportunities that fall outside of that scope may not present an issue. Without such specifics, courts may view the business scope more broadly and restrict an owner’s ability to engage in outside activities.

In the real estate arena, for example, agreements will often state explicitly that an entity was established for the purpose of buying a specific property.  Buying other properties without involving partners may not violate the agreement.  But in an entity established to purchase residential properties in general, an opportunity to buy a commercially zoned building in the same neighborhood could raise more complex questions about the goals of the business.

Closely held corporations and partnerships can be complicated arrangements – especially when companies face challenges that require owners to truly share the burden.  When the going gets tough, shareholders must be certain that their actions further the interest of the business and fulfill their obligations to other shareholders. No matter how contentious a relationship may become, every owner has an obligation to uphold their fiduciary duties.

Frederic Marx  is partner and former chair of the Business Law Group at Hemenway & Barnes LLP.