Finding the right structure for a family business can help avoid significant problems later. Family members often love and trust one another. That means that few families enter into, or grow, a business imagining that there will be a falling out further down the line. As a result, agreements may be less formal than they would be between purely commercial partners, and few people go into a family business expecting or preparing for it to fail.
This article discusses the extent to which the chosen structure of a family business impacts on a dispute, and how the status and nature of any governing documents plays into that. This is intended to help family business owners to consider what structures they currently have, and whether that is really the best choice for their business, in the (hopefully unlikely!) event that they fall out with their fellow owners.
What are the options?
Broadly, a family business might be structured as a:
A. traditional partnership; or
B. limited company; or
C. limited company run as a quasi-partnership; or
D. limited liability partnership (LLP) – although perhaps less frequently for this last one.
The mechanisms for dealing with disputes will vary depending on which structure has been used and we summarise the position below. Contractual joint venture arrangements are not covered in this article.
A Partnership
A traditional Partnership can arise even if there is no written agreement in place. The question of whether one exists is based on whether parties are carrying on business together with a view to making profit.
Partners have very wide-ranging abilities to set out their own terms of agreement as between themselves. They are free to determine their own split of profit share and capital and are free to implement their own decision-making processes and dispute resolution mechanisms. Broadly, where a written agreement has been entered into by the Partners which set out such processes, those mechanisms will apply. However, if the parties have consistently varied any written mechanisms in practice or somebody new has joined the Partnership in the intervening period, it may be possible to assert that the terms originally agreed should be varied or dis-applied.
Where Partners have not set out written terms which deal with the specific scenario or dispute they are facing, the default position is that the terms of the Partnership Act 1890 will apply:
- This starts from a position that all Partners are equal, taking an equal share of income profits, capital profits and losses, regardless of how much capital they have brought into the business.
- It also otherwise determines issues such as the retirement of partners, circumstances in which dissolution and winding up of the Partnership take effect, payment out of a Partner’s share on their departure and sets out rules about ownership of assets.
The default position under the Partnership Act may not be what the Partners would wish for or are expecting, so it is important to ensure that Partners consider the consequences which will arise if they do not cover off certain scenarios in a written agreement, and that they regularly check the position to ensure that the terms they are operating under are fit for purpose, particularly where new Partners have joined after written terms have been agreed.
It should also be noted that one or more Partners may be able to assert a claim against another Partner based on behaviour that amounts to a breach of their ‘fiduciary’ duties. Partners owe a duty to each other to act with utmost good faith, meaning they must act honestly towards the other Partners, act for the benefit of the Partners as a whole, not to put themselves into a position where their duty to the Partnership and their own interests conflict, to make full disclosure of any fact relevant to the partners and not to make an unauthorised personal profit. This is an overriding implied duty in all Partnerships but Partners are also free to agree the specific scope of that duty in any written agreement they enter into.
B Limited company
Parties who incorporate a limited company operate under comprehensive rules set out in legislation and standard articles and memorandum of association will apply in default of shareholders agreeing alternative terms. Shareholders do, however, have some freedom to agree their own mechanisms for decision making at Board level and to allocate varying voting powers for different classes of shares. Shareholders can also enter into a ‘shareholders agreement’ which may set out certain governance terms and understandings as between them.
Broadly, without agreed terms which vary the position, the starting point with a company is:
- That decisions are made based on a majority, whether ‘simple’ (being more than 50%), or ‘special’ for certain decisions (being not less than 75%).
- Directors are appointed to run the company and (again broadly) decisions that they make are passed on a majority basis.
- If shareholders do not like decisions being made by directors they can call the directors to account and make decisions based on the shareholding of those members.
If a dispute arises between shareholders about the running of the company there are some options available to a member, even if that member does not have a majority shareholding.
One way of achieving this is to petition the court for relief from unfair prejudice under section 994 of the Companies Act 2006. An ‘unfair prejudice’ petition may be possible where a member can show that the affairs and/or an act of the company are being, or have been, conducted in a manner that is unfairly prejudicial to the interests of members generally, or some part of its members (including, at least, the petitioning shareholder).
The court has wide-ranging powers in relation to remedies following a successful unfair prejudice petition. These range from making orders around governance of the company, for example calling a specific meeting, ordering certain acts to be carried out/not carried out, ordering the purchase of shares (which might be at market value without applying a minority shareholder discount, or otherwise) or granting remedies against specific directors or shareholders.
If members have entered into a shareholder agreement and the terms of that are being breached, their remedy would be to bring a claim for damages for breach of contract. However, it may be difficult to establish what value to place on those damages, particularly if the member concerned has a minority shareholding. The situation may also be complicated if shareholders or other circumstances have changed after the date of the shareholder agreement – it is important to ensure that any such agreement (along with any articles of association) are reviewed periodically to ensure they remain fit for purpose. It is also worth noting in the context of family businesses that the family court also has certain powers to consider company shares as marital assets, even where their transfer/ownership may be specifically dealt with in some otherwise conflicting way under a shareholder agreement.
In the event that a director acts in breach of his or her duties it may also be possible for a member to bring a derivative action on behalf of the company.
C Quasi partnership
In some circumstances, it may be possible to argue that the parties have been running a limited company as a ‘quasi-partnership’, on principles akin to those of a Partnership. This requires one or more of the following to be established:
i) there is a relationship of mutual confidence between shareholders;
ii) there is an understanding that all or some of the shareholders will participate in the conduct of the business; and/or
iii) there are restrictions on the transfer of shares (for example in a shareholder agreement).
Under this doctrine, parties may run the argument that shareholders in the company are bound by an understanding (by words or conduct) which it would be unfair to allow members to act inconsistently with, and the court may give effect to informal agreements and understandings which have been relied upon even if they would not otherwise have binding legal force. Similarly, it may also be possible to assert that a relationship of trust and confidence exists, despite the existence of formal agreements governing the relationship between the parties which set out different terms (eg. articles of association or other express written terms).
D LLP
LLPs are a hybrid, sitting somewhere between traditional Partnerships and limited companies:
- Like companies they differ from traditional Partnerships in limiting liability of members as against the outside world. LLPs, like companies and unlike traditional Partnerships, are a legal entity on their own right and must be registered at Companies House. This means it is possible to objectively establish whether an LLP exists.
- Like Partnerships, however, there is greater organisational flexibility for members to agree how to share profits, who is responsible for management and how decisions are made, when and how new members are appointed, and when and how members retire.
- Like Partnerships, there are default provisions (under the Limited Liability Partnerships Act 2006 and some additional regulations) which apply to the extent that they are not dealt with by written terms agreed by the members, so members must take care to ensure they have covered things off which may be important to them or may become an issue in due course. Members are free to make changes to their agreements and should make sure such agreements are reviewed to ensure they remain fit for purpose, especially as members join and leave.
- Unlike traditional Partnerships, there is no automatic duty of good faith as between members of an LLP, so if members wish to include such an obligation, or hold LLP members to account on a similar basis, they must ensure that appropriate provisions are included in the written terms of agreement.
Summary
Finding the structure at the outset that is best for family members is clearly very important, and the most suitable structure in any given case will depend on a range of factors specific to the business and individuals concerned. However, if parties wish to avoid unnecessary pain, expense and difficulty later, it is also important to ensure that (i) careful thought is given to how things might be dealt with if disagreements arise; and (ii) agreements are regularly reviewed to check that they remain appropriate and fit for purpose as the business, the family members involved and the world around them evolve over time.
If you would like to discuss your family business structure, please contact Maddie Dunn or your usual Burges Salmon contact.