How to Deal With a Disloyal Business Partner

Did your partner draw out all of the money from your company’s bank account, or conduct a side business with your company’s customers or equipment? Did your partner take control of your intellectual property?  A disloyal business partner can wreak havoc on your business, but there are ways to minimize the fallout or avert any loss. Having a plan of action before you act can save time, money, and effort. Conversely, making accusations without having a full grasp of the facts and the legal issues involved can lead to significant legal headaches.

A Sound Strategy Is Essential

To start, your approach depends on whether you suspect your partner is engaging in improper behavior or if your relationship has simply run its course. If you believe your business partner is no longer invested in the success of the business or the relationship has turned sour, a frank conversation may be a good start. Communicating your concerns and giving your partner the opportunity to explain what’s going on can often lead to an amicable resolution. This can work if your partner is not a sneak or a snake.

If your relationship has simply run its course, it is possible for the business to survive unscathed. Your operating agreement or partnership agreement should dictate what happens when one party wants to exit the business. For instance, the agreement may outline a process for retirement and buying your partner’s share of the business and/or a process for dissolving the business altogether.

Of course, the situation is far more delicate if you suspect that your business partner is up to something nefarious. In most cases, making accusations without having a strategy and evidence in place doesn’t work out. If your suspicions are correct, tipping off your business partner could lead him or her to destroy evidence of wrongdoing. If you are wrong, the relationship with your business partner will certainly be damaged just by the discussion, unless you have good communication skills. So, it is good to do a little sleuthing yourself, to determine the true facts and to gather the needed evidence. My experience has been that the initial gathering of the evidence before having any confrontation can be determinative of the outcome of the discussion.

Understanding the Duty of Loyalty

So, what happens if you suspect that your business partner is acting unfaithfully by embezzling money from your business, secretly competing or using your business for fraudulent purposes? If discussion does not work, or settlement is not yet in the cards, an application to the courts (or arbitration, if company agreements so require) is your best remedy. Filing a complaint for breach of fiduciary duty can often lead to a quick and satisfactory resolution.

Business owners, including partners, members of a limited liability company (LLC), and shareholders of a closely held corporation, owe certain fiduciary duties to the business and to their co-owners. Fiduciary duties were initially established under common law, and a substantial body of New York and New Jersey case law developed.  Many fiduciary duties have now been memorialized under statutes, such as the New Jersey Revised Uniform Limited Liability Company Act (RULLCA) and the New Jersey Revised Uniform Partnership Act (RUPA).

As relevant to this article, the duty of loyalty requires business owners to put the success of the business above any personal advantages. This includes refraining from any activity which harms or competes with the company’s interests, such as diverting profits from the company’s commercial activities; competing with the company; usurping or diverting a business opportunity for personal gain; and using confidential financial, client, or other confidential information to the detriment of other partners.  Dipping improperly into the company till is a tort in its own right: conversion, and is grounds for a criminal complaint.

Bringing a Lawsuit for Breach of Fiduciary Duty

A breach of fiduciary duty occurs when a fiduciary breaches any of the responsibilities, obligations, or duties that he or she owes the business or its co-owners. Recovery of damages can be sought by co-owners, but also by investors, creditors or employees on a showing of required reliance on the perpetrator. To successfully bring a breach of fiduciary duty claim, the plaintiff must generally show that:

• A fiduciary relationship existed between the plaintiff and the defendant;
• The defendant breached a fiduciary duty owed to the plaintiff; and
• The breach of duty entitles the party to a remedy.

In the context of the duty of loyalty, a breach is often supported by evidence that the fiduciary failed to properly act for the benefit of the business; diverted corporate assets; failed to disclose all relevant facts to co-owners; or used confidential information for the fiduciary’s own benefit. Some of the most common breaches include self-dealing, usurpation of a corporate opportunity, misappropriation of funds, failure to disclose, and misrepresentation.

When business partners intentionally breach their fiduciary duties, liability is often clear. However, if they negligently breach their duties, liability may be limited by the “business judgment rule.” Under the business judgment rule, if a partner has acted in good faith, has not put his or her own interests first, and has remained knowledgeable and informed about the business’s operations, the partner may be shielded from liability for acts that damaged the company.

Remedies Available When a Partner is Disloyal

When a fiduciary breach does occur, plaintiffs may have several legal remedies available. The most common is compensatory damages, which are damages awarded to a party as compensation for harm sustained by the party, which may be a non-breaching owner or the business itself that was damaged. The goal is to place a party “in a position substantially equivalent in a pecuniary way to that which he would have occupied had no tort been committed.” 

Equitable remedies are also available. For instance, an injunction may be available in cases where the fiduciary has improperly used confidential information and you want to take action to prevent further disclosure. An injunction can be obtained to prevent the fiduciary from wrongfully competing with the company in violation of the fiduciary duty (or of a non-compete provision). In some cases, the court may even remove the breaching owner from the business or, in a deadlock circumstance, order the business dissolved.

Key Takeaway

Business breakups and disputes between partners can put tremendous pressure on businesses and their owners. Consulting with an attorney before taking action can be extremely beneficial in reaching a successful resolution. Of course, the best route is to plan ahead by creating effective ownership and management agreements when the business relationship is formed.

Our attorneys understand the legal and business issues underlying these disputes and have successfully represented numerous business clients in state, federal, and appellate courts across the country. We write formation and working relationship agreements for our clients on a regular basis. And, when disputes arise and are not resolved, or when litigation is inevitable, our trial attorneys aggressively pursue our clients’ interests, and have obtained successful results in both the prosecution and defense of claims.

If you have questions, please contact us

If you have questions or if you would like to discuss the matter further, please contact me, Dan Brecher, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.