Listen to this post

Arbitration v. Litigation: Pros and Cons of Dispute Resolution

More than two centuries before Hamilton became Broadway’s most successful musical, Alexander Hamilton and his nemesis, Aaron Burr (sir), chose to resolve their disputes by dueling at dawn in Weehawken, New Jersey. This fateful duel, as we all know, mortally wounded Hamilton, one of our nation’s founders and greatest patriots. Fortunately, dueling long ago ceased to be used as a method to resolve disputes, but business partners today continue to have conflicts that require efficient resolution. This post reviews the two options that are available to resolve civil claims — arbitration and litigation — and considers the pros and cons from the perspective of both private company majority owners and minority investors. Neither fits all situations, but the choice could be outcome determinative in some cases, and it is therefore advisable for business partners to decide whether to resolve their future disputes in court or through an arbitration proceeding.

The most common agreement that business owners enter into with each other is a buy-sell agreement (BSA), although the company’s underlying governance documents (whether bylaws, an LLC agreement or LP agreement) will also include dispute resolution provisions. The BSA specifies how a majority owner can trigger the right to redeem the minority investor’s ownership interest in the company, and it also provides the means for the investor to secure a buyout of its minority interest. The specific provisions included in BSAs were discussed in a previous post. Before business partners decide to stick with litigation or choose to arbitrate their disputes under the BSA or company governance documents, they will benefit from considering the factors discussed below: (i) privacy or confidentiality, (ii) the scope of permitted discovery, and (iii) the speed to achieve final resolution and related cost.

The choice of the dispute resolution process is important because conflicts between business partners are common, and a protracted legal battle between co-owners can be very disruptive to the business. If the partners can select a process that enables them to resolve their internal disputes promptly and cost-effectively, they will be saving themselves both time and money, as well as preserving the value of their shared business.

Factor 1: Privacy and Confidentiality

  • Majority Owner Perspective: Values Privacy

Arbitration proceedings are conducted in outside public purview, while all court filings and hearings, as well as trials in litigation, are generally open or available to the public. This is an important factor but may be seen differently by the partners. The majority owner most often desires to maintain privacy regarding the dispute, so the company’s competitors and customers do not become aware of internal disagreements. In addition, the majority owner will want to ensure that sensitive information about the company’s finances and operations are not available to the public. For this reason, the majority owner may want to resolve all disputes with other partners through a private arbitration process.

  • Minority Investor Perspective: Publicity of Litigation May Provide Leverage

By contrast, although litigating claims may be far more expansive and drawn out than in arbitration, minority investors may decide that, for strategic reasons, they do not want to give the majority owner the opportunity to shield their disputes from the public. The minority investor may conclude that significant leverage can be gained in the parties’ later settlement negotiations if the majority owner has a strong desire to keep the minority owner’s claims and disputes away from public disclosure in litigation. 

Factor 2: Scope of Discovery

  • Majority Owner Perspective: Prefers Limited Discovery

The majority owner wants a prompt resolution of the dispute and does not want to allow the minority investor to use discovery to conduct a fishing expedition into areas that might cause discomfort and be distracting for the business. If the minority investor suspects that the majority owner engaged in some type of self-dealing with the company, however, the investor will likely seek discovery about ways the owner benefitted financially from dealings with the company.

Discovery can be restricted in arbitration if the parties each agree to accept limits in the arbitration provision. In litigation, the minority investor is more likely to be permitted to conduct wide-ranging discovery. Thus, the scope of discovery (and the related expense) is generally much greater in litigation than in arbitration, and the restrictions may be even greater if specific limits on discovery are included in the arbitration provision. 

  • Minority Investor Perspective: Broader Discovery Allows for a More Thorough Investigation of the Majority Owner’s Conduct and Financial Dealings

The minority investor may decide to require litigation as the dispute resolution method in order to ensure that sufficient discovery can be obtained to establish that the majority owner abused control over the company to obtain improper financial benefits. Litigation is the clear choice if the minority investor wants to be in a position to conduct thorough discovery regarding the majority owner’s conduct if a dispute between them later arises.

Given that litigation is so expensive, the minority investor may ultimately agree to accept arbitration to resolve disputes, but still include specific provisions in the BSA that will permit the investor to conduct the discovery necessary to ferret out fraud or other types of misconduct by the majority owner. For example, while it is common for arbitration provisions to limit the total number of depositions to just two or three and to restrict the number of document requests to 10 or 15, the minority investor may insist on obtaining a broader scope of discovery. In this regard, the investor may insist that the arbitration provision permit 30 or more document requests to be served, as well provide for the opportunity for each party to conduct five or six depositions. In this manner, the minority investor preserves the right to conduct enough discovery in the arbitration proceeding to be able to support future claims that are made against the majority owner.

Factor 3: Speed of Resolution and Cost

            These final factors often provide the greatest consensus between the majority owner and the minority investor. Both parties typically want to resolve their disputes promptly and in a cost-effective manner. One variable, however, may be if the majority owner has substantially greater assets and the minority investor has limited resources. In this situation, the majority owner may believe the investor would be hard-pressed to engage in a drawn-out legal dispute, and the owner therefore may decide to select litigation as the dispute resolution mechanism. 

            One important note here is that for the parties to achieve the prompt resolution they both desire, they need to specify in the arbitration provision that the final hearing will take place in a short timeframe, perhaps 90 days after all arbitrators have been selected. The arbitrators who are appointed will enforce this timetable in the contract, and it assures the parties that they will not become involved in a lengthy arbitration proceeding that drags on for months.  

Conclusion

Business partners today can choose non-fatal ways to resolve their disputes. But before they select either litigation or arbitration as the dispute resolution process to include in a BSA or in the company’s governance documents, they need to consider how factors like privacy, the scope of permitted discovery. and the speed and expense of the resolution process may help them achieve their strategic goals. 

Majority owners who want to preserve confidentiality about the business and promptly resolve disputes with a minority investor are likely to conclude that arbitration proceedings meet their objectives. The selection of arbitration will avoid a long and public court battle that could expose the company’s sensitive business information and publicly reveal the investor’s claims. On the other side, minority investors may conclude that resolving disputes in litigation will provide them with broad access to discovery and a public forum for their claims, giving them some advantages and leverage in litigation that they would forego in an arbitration proceeding. 

The bottom line is that majority owners and minority investors need to decide how they want to resolve any potential future disputes between them at the outset — and long before they have conflicts that arise in their business relationship.

Listen to this post

In the final quarter of the year, many private companies will accept new investments that accelerate their growth. But new investments are not guaranteed to create lasting relationships, and that may be the case when new investors join the company. Here, if the majority owner’s relationship with the new investor sours in the future, both parties will want to have an exit plan available. To secure this contractual exit right, the parties will need to negotiate and sign a buy-sell agreement or similar provision, which we refer to as a business prenup. 

For the majority owner, a buy-sell agreement (or BSA) enables the owner to purchase the ownership interest held by a minority investor who becomes disruptive to the business. For the minority investor, the BSA assures the investor of the right to a future buyout if the owner takes the business in a direction opposed by the investor. In light of the importance of the BSA, this post reviews the key terms the owner and the investor need to include in the agreement.

Who Can Trigger the Buy-Sell Agreement and How

Most BSAs include provisions known as the “4 Ds” that permit the majority owner to trigger a buyout of the minority investor, which all come into play when the investor leaves the business. The right to trigger the BSA in these circumstances exists because the majority owner does not want to allow former shareholders to remain owners in the company after they are no longer present and active in the business. The 4 Ds are:

  1. Death – Death of the minority investor
  2. Disability – Permanent incapacity of the minority investor
  3. Departure – Resignation or retirement of the investor from the business
  4. Default – Breach of agreement terms or company policies by the investor

There is also a fifth “D” provision in the BSA — disruption. When the majority owner believes that the minority investor is causing discord in the business, the owner will want to be able to remove the investor from the company who has become a thorn in the owner’s side.

For the majority owner, the right to trigger the BSA to redeem (buy out) the interest held by the minority investor is referred to as a “call right,” and it authorizes the majority owner to call/purchase the investor’s interest. The minority investor wants to be able to demand a buyout of its interest, which is referred to as a “put right,” and it authorizes the investor to exercise the right to require the majority owner to purchase the minority interest.

The timing of the ability to trigger the BSA is a critical part of the agreement. The majority owner may not want to permit the minority investor to cash out of the investment a fairly short time after it was made, because this can create a capital crunch. Similarly, the minority investor may not want to be forced out of the business too quickly — just when things are starting to take off for the company. Given this alignment of interests, the parties can mutually agree to include a “delayed trigger,” which prevents either side from exercising the buyout right for some period of years after the investment (but this provision would not trump the 4 Ds reviewed above). 

The Look Back Provision – A Trap to Be Avoided for Minority Investors

A final important point regarding the BSA concerns the minority investor’s need to secure a look-back provision that will protect the value of its investment. This provision will prevent the majority owner from purchasing the minority investor’s interest in the company for a modest value and then selling the company for a much higher value just a few months later. As a result, this provision kicks in when the majority owner triggers the BSA, purchases the minority investor’s interest and then, during an agreed time period after the purchase, the owner sells the company or brings in a new investor within that specific time period for a higher value than the minority investor received. In these circumstances, the minority investor will receive a true-up payment from the majority owner.

In other words, if the price the majority owner paid to the minority investor for the purchase of its interest is less than the value the company received when it was sold during the look-back period or less than the amount paid by a new investor within the look-back period, the minority investor will receive another payment to true up the payment to the investor to the level of the company sale price or the value paid by the new investor. The look-back period is often one year, but the parties can select a shorter or longer time frame.

Determining the Value: The Make-or-Break Element

Determining the value of the minority investor’s interest in the business is one of the most challenging issues that owners and investors will confront in a business divorce. The BSA tackles this issue head on as it sets forth a defined procedure that the parties have agreed to adopt to determine the value of the investor’s interest in the business. The valuation approach we have found that leads to the least amount of conflict is described below. 

Once the BSA is triggered, the company (at the direction of the majority owner) will retain a business valuation expert at the company’s expense to determine the value of the interest held by the minority investor. The BSA must state clearly whether the valuation expert retained by the company will apply minority discounts to the interest to be valued. The majority owner may want the expert to apply discounts for both lack of marketability and lack of control to the minority interest, because these discounts will dramatically reduce its value. For this reason, the minority investor will be strongly opposed to applying any minority discounts and will insist on the expert presenting an undiscounted value. Therefore, the parties must decide at the outset and specify in the BSA whether or not to apply minority discounts to the valuation, which will avoid major conflicts between the parties once the BSA is triggered.

After the company-retained expert has issued the valuation report, if the minority investor is dissatisfied with the conclusions in the report, the investor will then be permitted to retain his or her own valuation expert to provide a competing valuation at the investor’s expense. Once both valuation reports are issued, if the resulting values are too far apart (the parties will have to decide the specific percentage of difference and state it in the BSA), the BSA will provide that the two different valuation experts themselves (and not the parties) will appoint a third expert to conduct another valuation. At that point, the parties will have three different valuation reports, and they will have the following options to consider to reach a final determination of value:   

  • Average all three reports to achieve one final value
    • Adopting the valuation amount (company or minority investor) closest to the third valuation expert’s reported value will be the value that controls
  • Average the two closest reports to determine the final value
  • Allow the third valuation expert’s report to determine the final value

            The parties will choose this option to include in the BSA, which ensures that they will secure a final value that determines the purchase price for the investor interest. 

            A relatively small number of parties will opt to dispense with using valuation experts at all, and instead, they will select and include a specific formula in the BSA that determines the value of the departing investor’s minority interest. This formula is usually tied to the total revenue of the business as it is harder for the owner to manipulate revenue than earnings.

Payment Structure

Once the value of the minority investor’s interest is determined, the parties will need to specify for the payment structure in the BSA, because the purchase price is almost always paid to the investor over time rather than in a single lump sum. This installment payment plan raises the possibility that the majority owner will need to provide some form of collateral to protect the investor if there is a payment default. The collateral could be the stock in the company, but that will complicate things as it would bring the investor back into the company. Alternatively, the majority owner may be willing to personally guaranty the company’s payment obligation.

Conclusion

The excitement the majority owner and the minority investor share in ending the year with a new investment may tarnish over time, which is why they both need to hammer out and sign off on a BSA that governs this investment. The adoption of a BSA ensures that each of the new business partners has an exit plan available if their new relationship runs into problems. The BSA therefore reflects the type of careful, advance planning that both parties will appreciate if they ever need to seek a business divorce in the future.

Listen to this post

In a real-life case of adding insult to financial injury, companies harmed by the disloyal actions of their former partners, officers, managers or employees (the “former insiders”) may also have to pay their legal fees when the company sues them to recover for their misconduct. In this situation, if the company’s governance documents (and specific indemnity provisions) have not been carefully drafted, the company may have to pay the legal fees the insiders incur when they defend claims filed against them by the company. 

This situation arises because almost all corporate bylaws, company agreements for LLCs, and partnership agreements for limited partnerships contain indemnity provisions protecting current or former insiders if they are named in a lawsuit because of their position with the company. Frequently, the governing documents will provide these insiders with the right to receive current payment of their legal fees during the litigation and before the lawsuit is ever resolved. And in some instances, the governing documents grant these rights to every company employee rather than to just partners, officers, directors and managers of the company.

Companies include these indemnity provisions in their governance documents because they encourage business leaders to serve in management roles without fear of sustaining personal loss from lawsuits, regulatory actions, or other legal proceedings related to their services for the company. These assurances also support sound decision-making and responsible risk taking by managing leaders that benefit the company. But, as noted, if the indemnity provisions in the company’s governing documents are not carefully drafted, these often-overlooked terms can result in some costly unintended consequences for the company. More specifically, the company could be forced to fund the legal fees incurred by both sides of the company’s lawsuit against a disloyal former insider. This post provides an overview of well-drafted indemnification and advancement rights and how they should be used by companies to achieve their best effect.

Indemnification and Advancement Defined

Typically, a company’s obligation to indemnify will arise from a contract (i.e., a company agreement), a statute, or a combination of the two. When a company provides indemnity, it usually covers legal fees, settlements, and judgments that are incurred or entered against an individual who was sued because of his or her services for the company. Generally, a company’s indemnity obligation will either indemnify insiders against liabilities or damages, or indemnify them against both liabilities and damages. When a company indemnifies against liabilities, the indemnification is owed when the liabilities become “fixed and certain,” such as when a judgment becomes final. But when a company indemnifies against damages, the indemnity becomes due when the indemnitee is compelled to pay the judgment or debt.

Although the right to indemnification and advancement are related, they are separate and distinct rights with notable differences. When a company provides the right of advancement, this enables the insider to receive advance payment of the legal expenses the insider incurs in defending against any claims that relate to that person’s services for the company. In other words, the advancement provision provides insiders with immediate interim relief from the burden of paying for the defense of a claim rather than waiting until the point at which the litigation concludes. Further, because the right to receive advanced payment of legal fees is not dependent on the right to receive indemnification, whether the company insider actually engaged in the misconduct alleged in the lawsuit is irrelevant to the insider’s right to receive advancement of legal fees.

The Scope of the Indemnity Provision Is Critical to Understand

Majority business owners who direct their companies to file suit against disloyal former insiders often assume that their company won’t be required to indemnify or advance legal expenses for the insider’s egregious or even blatant misconduct — regardless of what the company’s governing documents may say. But if the company is an LLC or GP, that assumption can be both incorrect and very costly.

This common misunderstanding may stem from the statutory scheme for indemnification and advancement for corporations. Specifically, the Texas Business Organizations Code (TBOC) codifies certain “default” rules applicable to corporations (and other Texas entities other than LLCs and GPs). For example, the TBOC specifies the circumstances under which a Texas corporation is required to indemnify a governing person, permitted to indemnify a governing person, and prohibited from indemnifying a governing person:

  • Mandatory Indemnification – First, Texas corporations are required to indemnify their current or former governing persons if they are wholly successful in defending a lawsuit to which they were a defendant because of their position in the company.
  • Permissive Indemnification – Second, a corporation is permitted, without the necessity of any enabling provision in its governing documents, to indemnify a governing person who meets certain standards. In civil proceedings, this standard requires that the governing person (1) acted in good faith and (2) reasonably believed the conduct was in the best interest of the corporation (or was not opposed to the corporation’s best interest if the conduct was outside the person’s official capacity).
  • Prohibited Indemnification – And third, corporations are statutorily prohibited from providing indemnification to a person “in relation to a proceeding in which the person has been liable for (A) [willful] or intentional misconduct in the performance of the person’s duty to the enterprise; (B) breach of the person’s duty of loyalty owed to the enterprise; or (C) an act or omission not committed in good faith that constitutes a breach of a duty owed by the person to the enterprise.”

TBOC also permits corporations to advance legal fees and other litigation-related expenses to individuals, either through their governing documents or on a case-by-case basis, as long as the individual provides the company with (1) a written affirmation that they believe they have met the standard of conduct necessary for indemnification, and (2) an undertaking, which is a promise to repay the amount advanced if there is a final determination that the person has not met the standard for indemnification.

But LLCs and GPs enjoy significantly more leeway than corporations in permitting the owners to grant or completely omit indemnification and advancement rights for managers and others. That is because, in contrast to corporations, TBOC’s indemnification and advancement provisions are not applicable to LLCs and general partnerships by default. Instead, as it relates to indemnification and advancement, the owners of LLCs and GPs may either expressly adopt the Texas statute applicable to corporations or “may contain other provisions, which will be enforceable.” In most cases, LLCs and general partnerships will choose the second option, which restricts the company’s advancement and indemnification obligations solely to those that are listed in the governing documents. If these standards and restrictions are broad (e.g., any proceeding that the individual is made a party to because of his or her employment), then the company will likely be required to indemnify and advance expenses to a former employee, regardless of how wrongful the former insider’s conduct may have been. 

In sum, owners of LLCs and general partnerships need to decide whether the indemnity provisions that protect insiders in their governance documents will protect them solely from third-party claims brought by third parties or whether they will also apply to first-party claims that are brought against them by the company. In almost all cases, the owner will want to limit the scope and protection of indemnity provisions solely to third-party claims that are filed against former insiders. 

Conclusion

Companies need to provide indemnification and advancement rights to attract and retain talented managers and employees, but the company’s governance documents need to set forth these rights in a manner that is no more expansive than the company intended. In almost all cases, the scope of the indemnity protection should be limited solely to claims made by third parties; these are claims filed against company insiders by third parties based solely on the fact that the insiders are affiliated with the company. If the company’s governance documents properly limit the scope of the indemnity provision, then, in any future suit by the company against disloyal former insiders, they will not be able to obtain any indemnity protection or advancement of their legal fees from the company. This careful drafting of indemnity provisions avoids a situation where the company is required to foot the fees for legal counsel on both sides of the lawsuit.