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How to Prevent Shareholder Litigation in a Closely Held Corporation

January 17, 2023

A closely held corporation is a private corporation with typically five or less owners (shareholders). There are millions of such businesses in the U.S. and many face unique challenges because of their size. One of those challenges is the potential for internal disputes which can result in expensive and time-consuming litigation among the shareholders. If you are a shareholder of a closely held corporation, you can minimize the potential for shareholder litigation by consulting with an attorney and putting in place proper safeguards. 

What Are the Benefits of a Closely Held Corporation? 

Many closely held corporations are family owned and run. However, regardless of whether the owners are family, the small number of shareholders can make these companies easier to manage. There are fewer people with control of the business, and they can easily communicate with each other. Such businesses can also be extremely profitable because payroll costs tend to be lower if shareholders are also employees.

What Are the Disadvantages of a Closely Held Corporation?

The fact that there are only a few owners can easily result in conflicts over the running of the business. For example, if there are only two shareholders, who each own 50% of the business, it is likely that both owners will need to agree on all business decisions (unless the shareholder agreement and by-laws state otherwise). In the event the owners disagree, there may be no way to break the tie. This can lead to deadlock which can significantly impact the running of the corporation. 

Unfortunately, many small, especially family-owned corporations tend to operate without clear guidelines in place. This can be extremely problematic. For instance, the shareholders may not have clear governing documents concerning annual financial statements and the exchange of information amongst shareholders. The shareholders may be fine with this for some period of time, but what happens if one shareholder starts to withhold information? The remaining shareholders may question what information they are entitled to and may begin to distrust one another. This can directly impact the running of the business.      

How Will Shareholder Litigation Affect Your Closely Held Corporation? 

Unfortunately, shareholder litigation can easily lead to the demise of a closely held corporation. Lawsuits are expensive and time-consuming. Further, when shareholders are involved in litigation against each other, they are unable to focus on their business causing the business to suffer. 

If the issues cannot be resolved, it could also lead to the dissolution of a company. In many states, a shareholder can seek the dissolution of a corporation if the directors are deadlocked, or one shareholder is being oppressed. This is a costly process that unnecessarily involves the court in your corporation’s affairs. 

What Are the Best Ways to Minimize or Prevent Shareholder Litigation? 

You cannot prevent all litigation, but a few proactive steps can minimize your risks substantially. 

  1. Have well-written governing documents. Your by-laws, operating agreement, and shareholder agreement should include all terms and conditions necessary for the running of your business. There should be clear guidelines as to each shareholder’s role and responsibilities within the company, as well as procedures regarding shareholder meetings.
  2. Comply with applicable statutes. Many state laws have specific provisions pertaining to corporations. It is imperative that your business, especially a closely held corporation, abides by those laws. For example, in some states, corporations must provide their shareholders with certain financial documents annually. Failure to do this can easily result in shareholder litigation. 
  3. Communicate regularly. It is common in closely held businesses for one shareholder to be more involved in the day-to-day running of the business than the others. This creates a perfect breeding ground for distrust. There should always be honest and open communication between shareholders. All information about the business, such as bank statements, profit and loss statements, and balance sheets should be readily accessible to all shareholders. 
  4. Consult an attorney. If you are a shareholder of a closely held corporation, you can preempt costly litigation by speaking with an experienced attorney who can review your current practices and help to make impactful changes. 

Our legal team can conduct a comprehensive legal risk assessment for your business to identify and correct issues that could lead to shareholder litigation. We provide clients with assessments as part of our General Counsel services as well as on a standalone basis to help your business succeed. Contact our firm today to learn more.

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