What to Do When Your Business Partner Is Defrauding the Business

By Muhammed T. Hussain, Esq.

When individuals agree to join forces to start a business (or purchase an existing one), there is usually trust amongst the owners at least in the beginning.  However, in a small number of cases, one or more of the owners begin to suspect the other of fraud or stealing, also known as embezzlement.  Discovering the embezzlement early is important, as sometimes the theft of funds or assets can be so extensive that by the time it is discovered, the business is irreparably harmed and must be dissolved.  In the case of a minority owner, the situation can be particularly problematic if a majority owner is suspected of the fraud or embezzlement, and the minority owner is not able to oust the majority owner who may continue to embezzle funds from the business.  

In this article, I will discuss the things owners can do to prevent or minimize fraud or embezzlement by a co-owner. 

How to prevent or minimize the potential for fraud or embezzlement by a co-owner.

The first step that owners of a business should take is to enter into an agreement that lays out how the business should be run and how to deal with the various issues that may arise.  These agreements go by different names depending on the type of business, but all generally accomplish the same objective (for example, a partnership agreement for a partnership, an operating agreement for a limited liability company, and bylaws and shareholders’ agreement for a corporation). 

This business agreement should at least cover the following situations:

  • Identify the person(s) who are to run the day-to-day operations of the business;
  • Indicate the percentage of ownership interest required to approve certain actions (i.e., a sale or purchase of assets or entry into a lease);
  • Indicate the percentage of ownership interest required to approve any spending over a particular threshold;
  • Provide for access to owners of the company’s books and records;
  • Provide for the circumstances under which the company or other owners can buy out an owner;
  • Provide for drag-along and tag-along rights; and 
  • Provide for the dissolution of the company.

The above provisions would allow all owners to keep an eye on the business accounts, prevent any one owner from being able to steal funds or assets, as well as provide a procedure for dissolution, buyout of a partner, or sale of the business. 

If the existing business agreement does not cover these issues, owners most likely will resort to court to resolve these issues with a judge and sometimes a jury, or alternatively, they may resort to mediation and/or arbitration.  A clear business agreement may make the lawsuit more likely to resolve a dispute quicker and at a much smaller cost, as the court would just order the implementation of the procedures in the business agreement. 

In the case that a co-owner is unable to prevent the embezzlement, there are two options for the innocent owner:

  1. Sue the embezzling owner, attempt to recoup the stolen funds/assets and oust them from the business; or
  2. Dissolve the business. 

I will discuss the first option below.  I will discuss the second option to dissolve the business in my next article.

Suing a co-owner for fraud or embezzlement.

Corporate fraud (or business fraud) can be described as an illegal activity undertaken by an individual, company or business partner, in an unethical or deceitful manner, for personal or financial benefits.  These schemes usually appear under the pretext of legitimate business practices.

Above, I discussed how a good business contract (such as an LLC operating agreement), along with provisions that allow owners to keep an eye on the finances and the business bank accounts, could prevent an owner from committing fraud or stealing.  

However, if the other owners were unable to prevent fraud or embezzlement by the bad owner, one of the only options is to sue the bad owner with the goal of forcing him or her to disgorge the embezzled funds and further ousting him or her from the business.

The bad owner can be sued for: 

  • breach of fiduciary duty for misappropriation of funds (embezzlement or conversion); 
  • misrepresentation of financial or other material information from the other owners; 
  • not acting in the best interest of clients; 
  • making the business engage in illegal or fraudulent activities; and 
  • breach of the business agreement. 

A favorable outcome in the lawsuit usually results in the bad owner disgorging the funds that he or she stole (or this amount being used to offset the value of his or her ownership interest when bought back by the company or the other owners), being ousted from the business, and the possibility of the other owners collecting punitive damages. 

Encore Law has been engaged in numerous such disputes representing owners and/or the business suing other owners, executives and/or employees for fraud and embezzlement. 

To discuss the above topic, please contact Muhammed Hussain at muhammed@encorelaw.com or any other Encore Law attorney.