Going Rogue: Navigating a Business Through Fraud or Unethical Conduct by a Co-Owner
Part Two of a Series
Payne & Fears’ Business Litigation Group helps businesses and their owners with wide-ranging disputes. In our practice, we’ve noticed that in disputes among business partners there are common issues that often surface. This is part two of a series of articles highlighting some of the most common problems. The articles will cover issues arising at several stages of the business relationship, from inception to ending the business. The topics in these articles are broadly applicable to all types of business entities from general partnerships, to LLCs, and corporations.
Your multiple-owner business is humming along, and while you and your partners do not perfectly agree on everything, you have managed through your differences. Except recently, you have come to suspect that one partner is illegally taking funds from the business. You do not want your business to become a casualty of this partner’s wrongful conduct, so how do you remove your “problem partner,” mitigate harm, recover damages for any harm already caused, and protect company goodwill?
Types of Fraud and Potential Responses
Fraud and unethical conduct in businesses is more prevalent than one might think. The Association of Certified Fraud Examiners (“ACFE”) estimates that organizations lose roughly 5 percent of revenue per year to fraud. Fraudulent conduct may take many forms—common schemes include the creation of, and payments to, phony “vendor” shell corporations, obtaining kickbacks from legitimate vendors via invoice markups, or misappropriating a business’s cash receipts through illegitimate, expenses run through the business, write-offs or refunds. Also, a fraudulent scheme may go undiscovered for a significant period—up to 12 months by ACFE estimates. So when fraud by a business partner is suspected or uncovered, it is important to act quickly and strategically to gather evidence and prevent further harm to the business.
Importantly, because every business is different, and details of rights and obligations may be buried in your partnership agreement or operating agreement, you should consult counsel to understand available legal options. Below are some avenues to consider to protect your business.
Inspect Books and Records
A frequent first step to vet concerns of wrongful conduct is to make a demand to inspect to books and records of the business. This is especially useful for partners not involved in the day-to-day management of the business.While most standard business governing documents—such as partnership or operating agreements—will contain language permitting the inspection of the books and records of the company, state law generally provides this right to business partners as well. Assistance from counsel with your books and records request can be an effective way to ensure complete and timely compliance, especially if your relationship with the suspected partner already is contentious.
Investigate the Suspected Fraud
Depending on your business’s structure and the nature of the suspected conduct, it may be advisable to formally investigate the partner’s suspected fraud. Counsel can advise you whether performing a formal investigation, and documenting the results, would be an effective step to mitigate risk to the company and its other partners.
Remove or Expel the Partner
If your suspicions are substantiated, you may need to take measures to remove the wrongdoing partner from the business. Again, you will want to check your governing agreements to determine if they contain procedures to remove or expel a partner—if you have the votes to do so, this is likely a good option. If your governing documents do not provide for removal, or you are deadlocked with the suspected wrongdoer, alternatives exist, including removal rights appearing in the law, such as through Section 17706.02 of the California Corporations Code (or your state-law equivalent), amendment of the governing documents, or negotiating the voluntary removal of the partner.
If you are unable to remove the problematic partner—for example, you are a minority or non-managing member of an LLC—legal action to remedy the partner’s past wrongs may be appropriate. It is likely that the suspected wrongdoer—whether a partner, member or manager of your business—owes fiduciary duties of loyalty and care to the business and its other partners/members. E.g., Cal. Corp. Code § 17704.09. When those duties are breached, the business and/or its members may have legal claims, along with other potential causes of action including business torts and/or breach of contract. In addition to damages, you can seek a full accounting of the activities of the business to uncover the full extent of the wrongful conduct. And in the case of intentional diversion of money or assets from a partnership, limited liability company, or other business, you may even be able to seek treble damages and attorneys’ fees for criminal theft pursuant to the California Supreme Court decision, Siry Investments, L.P. v. Farkhondehpour, et al.
While addressing partnership disputes may feel daunting, experienced counsel can help you navigate business risk, obtain recovery, and help you to reach a practical, cost-effective, outcome with your business objectives in mind. If you need assistance navigating a partnership dispute, please contact Payne & Fears LLP.