Death, Disability, Divorce, and Disputes: Know What Your Company’s Governing Documents Dictate in the Event of a Crisis

Now is a good time to review your company’s governing documents and succession plans to ensure the company is prepared to deal with whatever the future brings before it happens.

1. Death of an Owner

The death of an owner of a private business may cause not only grief, but also turmoil for the company. Without a thoughtful succession plan that is formalized in governing documents, an owner’s death may result in unexpected difficulties for the business, the other owners, and the deceased owner’s family, including:

• A fight for control among surviving owners.
• Loss of significant income by the deceased owner’s family.
• Liquidity issues if the company is required or desires to purchase the deceased owner’s shares.
• Significant estate and income tax liabilities for the deceased owner’s estate.

Business owners should review their company’s governing documents to understand what rules apply when an owner dies. Those documents might include operating agreements, shareholder agreements, or other contracts.

Owners should assess how the deceased owner’s shares would transfer and to whom, what transfer terms would apply, whether significant tax liability would be likely, and whether the buyer would be likely to have sufficient cash to purchase the shares (if required). Owners should also consider whether any share transfer provisions in the company’s governing documents conflict with the terms of any trusts that hold shares in the business.

If the owners are dissatisfied with how the governing documents deal with an owner’s death, they should negotiate revisions sooner rather than later. They should also consider whether to make other plans in the event of an owner’s death. For example, if an owner has significant management responsibilities, the company should consider purchasing “key-man” life insurance and documenting a management succession plan.

2. Disability of an Owner

Many of the same considerations that apply to an owner’s death also apply to an owner’s disability. Typically, individuals are considered disabled when they can no longer conduct ordinary business prudently. Without clear rules set forth in the company’s governing documents, an unexpected disability may cause even more turmoil for the business than the unexpected death of an owner.

What happens, for example, when an owner who has significant management responsibilities is no longer able to fulfill them as a result of a disability? That can spur a quarrel over who has the right to manage the business or make decisions for the business.

And without a clear definition of an owner’s “disability” in the company’s governing documents, there may even be a dispute over whether or not an owner is disabled.

Business owners should review their company’s governing documents to understand when an owner may be deemed disabled and what rules apply if that determination is made. Those documents should specify procedures for dealing with a disability, a clear and comprehensive definition of “disability,” and who has the ultimate authority to determine whether an owner is disabled.

3. Divorce of an Owner

The termination of an owner’s marriage can cause problems for a company because the owner’s ex-spouse could have a claim to a portion of the owner’s shares. Consequently, without planning, the divorce may give an outsider (who may lack experience with the business or lack required formal education or training) all of the rights associated with ownership, including voting rights, earnings distributions, and access to confidential information.

Business owners should review their company’s governing documents to determine whether the company and the owners are protected in the event of an owner’s divorce. One common protection for the company is to require a divorcing owner’s shares to be sold to the company. Other protections are to require that the owners’ shares be held in trusts with powers designed to limit a divorcing spouse’s access to the shares or that an owner enter into a prenuptial agreement that protects the ownership interest in the event of divorce.

4. Disputes Among Owners

Disputes among owners are unavoidable and disruptive, and often force other owners and employees to take sides. As a result, the company may incur significant legal expenses. A dispute may even result in public disclosure of sensitive company information.

Business owners should review the company’s governing documents to assess whether appropriate dispute resolution procedures are in place to protect their interests and the company’s interests. Important considerations are whether arbitration is required or if public litigation is allowed, how the company’s confidential information will be protected, and whether the company may be responsible for the litigation expenses of certain owners or managers.

One common way to attempt to avoid protracted ownership disputes is mandated mediation or some other informal, confidential dispute resolution process before an owner can bring a formal claim against another owner or the company.

Action Item: Take a Dry Run

Business owners and management may find it productive to review the company’s current plans and governing documents as if a death, disability, divorce, or dispute were presently occurring. What are the consequences? A “dry run” exercise can be very illuminating and may help the company identify high-priority changes to the status quo. We suggest that business owners start having the tough conversations soon to prevent or mitigate turmoil down the road.