To Sue or Not To Sue: Determining Whether Filing a Lawsuit Is Appropriate in a Business Dispute
When two or more people form a business, they usually share similar goals in the beginning. But, as the business develops, the owners’ shared vision may begin to differ. Normally, these differences do not lead to a lawsuit. However, if these differences lead to one or more of the business owners sustaining some form of liability or loss, they may want to sue the other party, or parties, for their share of the liability or loss.
Because not all business disputes give rise to a lawsuit, it first must be determined if there are grounds for filing a lawsuit, as not all business disputes are created the same. To help with this process, we have compiled a non-exhaustive list of the typical legal issues raised in court in connection with a business dispute.
1. Breach of Agreement or Violation of Bylaws
State laws give shareholders and directors the ability to bring a civil action in state court against the corporation and the board of directors for violating the corporation’s bylaws. In some situations, creditors can even point to a corporation’s noncompliance with basic corporate formalities, such as adopting and complying with bylaw requirements in order to make a case in court that the individual shareholders of the corporation should be held liable for business debts. This process is called “piercing the corporate veil” and can affect small business owners who run their corporations as a personal alias instead of an independent entity that complies with the laws that govern its management. Similarly, a member of a limited liability company (LLC) or a partner in a partnership could also be personally liable if the member or partner is operating the business as if it was a personal alias for the individual.
Additionally, many partnerships will have a formal partnership agreement that describes the business duties and obligations of each partner. Similarly to partnership agreements, LLCs have an operating agreement that sets out how the LLC’s members can take legal action against one another.
If you pursue legal action, it is important to show that you or the business suffered harm as a result of your partner’s breaches and/or violations.
2. Breach of Fiduciary Duty
Once an entity is formed (such as an LLC, partnership or corporation), a fiduciary relationship is formed when someone acts on behalf of the entity and/or owners of the business. The members of an LLC, partners in a partnership, and the shareholders and directors in a corporation often owe each other and the entity a fiduciary duty to act in the best interests of the business. They must place the interest of the business above their individual interests. The fiduciary duties owed include duty of good faith and fair dealing, duty of care, duty of loyalty and duty of disclosure.
Even though a breach of fiduciary duty is commonly also a violation of a partnership agreement or operating agreement, a claim for breach of fiduciary duty can exist outside of a formal partnership and operating agreement. So, even without a written partnership or operating agreement, you may be able to pursue legal action if a member, partner, director or shareholder has engaged in any form of self-dealing where they have placed their individual interests over the interests of the entity.
For example, an individual engages in fraud when they knowingly misrepresent themselves to you or when they supply inaccurate information to clients for the sake of gaining some type of favorable outcome (a) for the business, such as adding extra numbers to figures to make it seem like profits have increased, or (b) for the individual, such as using for personal gain the funds that were meant for business purposes. If an individual commits a fraudulent act, they have breached their fiduciary duty and can be subject to legal action.
For corporations, the board of directors must act in the best interest of the corporation and its shareholders. Once a director takes a seat on the board, they have various duties as the representative of the shareholders, including the duty of care and loyalty which determine if they are doing their job properly. Although directors are generally not be responsible for the corporation’s debts, they owe a duty of care to the corporation and can incur personal liabilities if they neglect this duty.
A breach of one specific fiduciary duty can also support a negligence claim. A member of an LLC, a partner in a partnership or a director of a corporation typically owes a duty of care to the owners of the business and to the business to make decisions in good faith. A failure to do so can support a negligence claim. Should a member, partner or director have acted negligently in any way that has harmed the business, you may have a valid legal claim if you show that:
- The member, partner or director did not act as a reasonable person would have under the same or similar circumstances; and
- The business suffered harm as a result of the member, partner or director’s actions.
A member, partner or director is only expected to act in a reasonably prudent manner. Under the business judgment rule, they are not normally held liable for business decisions made in good faith and with reasonable care but which turn out to be erroneous.
A breach of another specific fiduciary duty can support a claim for abandonment. The duty of loyalty includes a duty to refrain from doing anything during the dissolution, or “winding up,” of the business in a way that is adverse to the business. Abandonment occurs when a shareholder, partner or director leaves the business prior to proper dissolution.
If you think you have a claim, please contact one of the Encore Law attorneys for further assistance.
To discuss the above topic, please contact Patty Chen at email@example.com or any other Encore Law attorney.
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