Contract Violation
There is likely no more common legal theory asserted by litigants who are suing their business partner than breach of contract. This broad cause of action can include everything from an express written agreement, to a verbal agreement, or even an implied contract. In fact, in most commercial litigation cases, the plaintiff has just as many causes of action as it has claims against the defendant.
The theory of breach of contract almost always starts with a demand letter/voluntary disclosure request to the potential defendant. Unfortunately, in most cases, the potential defendant has a different view of the facts and circumstances and refuses to settle the matter. Consequently, civil litigation is inevitable.
So, what is a breach of contract? This is essentially a situation where one or both parties have failed to live up to their responsibilities. Every contract contains certain provisions which must be adhered to or a breach can occur . For example, if two businesses decide to form an LLC, and one company fails to pay its proportionate share of the expenses, it is in breach of the LLC agreement. Typically, a party can bring a breach of contract action if it can prove:
Often, an example of a breach of contract will fall under the category of a "minor" breach or a "major" breach. A minor breach is when the breach does not go to the essence of the contract, but is a collateral issue. Whereas, a major breach is a breach that is so substantial that it goes to the essence of the contract. The distinction between the two is largely important when determining the available damages sought. For example, a minor breach might involve the failure to have a quarterly meeting as required by the operating agreement, while a major breach may be the failure of a member to make a capital contribution.
The law provides several defenses to breach of contract claims, which include: (1) fraud, (2) the other party actually prior to entering into the contract, (3) impossibility of performance, and/or (4) mitigated damages.
Breach of Fiduciary Duty
As with partnerships, members of a Limited Liability Company owe a fiduciary duty to one another. In fact, fiduciary duty is the legal basis on which many corporate and LLC disputes are resolved. Fiduciary duty is the fundamental premise that partners, members, officers or directors act in good faith and with fair dealing towards each other. A breach of this duty, among other things, could arise from: (a) an officer or member making a secret profit from the company’s business (dishonest appropriation of company funds or property); (b) a lack of good faith (intentional unfair dealing); (c) unfair competition; (d) misuse of corporate assets; and (e) taking advantage of a business opportunity that should belong to the company. As you can see, there are various ways in which a business owner and/or manager could violate fiduciary duty. Moreover, it is important to note that if fiduciary duty is violated, the potential damages to the offending party may be substantial and even punitive. If you are currently involved in a partnership or contested partnership dispute, feel free to contact our office today.
Fraud and Deceit
The failure of one or more business partners to disclose material information can give rise to opportunities for other, wronged partners, as well as permitting greater freedom of dealings with a third party, as illustrated by these cases.
An action in fraud under California law requires: 1) a misrepresentation of a material fact, 2) knowledge of the falsity of the statement or an insufficient basis for actually believing the statement to be true, 3) intent to induce reliance upon the statement, 4) reasonable reliance by the plaintiff on the misrepresentation and 5) an actual, resulting damage.
In Gottfried v. Hillsman, the managers of a California condominium complex opened a shell company in Nevada to evade a prospective change in California tax law. The managers represented to the plaintiff purchasers that they would have the right of first offer when the complex was eventually sold. Subsequently, a third party desired to acquire the complex, but discovered the shell company. The third party opposed the change of ownership, which was delayed as a result. Because the managers also held a property management company, their interests conflicted with those of their condo owners.
The plaintiff condo owners sued for fraud, but the trial court dismissed the case and denied leave to amend the complaint. The Court of Appeal overturned the dismissal because the complaint adequately alleged that the condo owners had relied on the managers’ omissions.
In Perkins v. Sweeney, a California corporation formed in 1977 entered into business transactions with its lenders based on the corporation’s representations that the company was financially sound. In 1978, the corporation’s directors knew the company had financial problems, but failed to disclose that fact to the lenders. The corporation’s total liabilities exceeded its assets, but the directors followed the corporation’s policy of deferring losses until a later date, despite their knowledge. The corporation made regular interest payments until 1984, when it stopped doing so based on the belief that it could obtain refinancing or gain new investors. However, the corporation’s directors did not disclose to the lenders that additional funding had not been obtained, nor did they inform the lenders of the decision to discontinue making interest payments in favor of management compensation, director loans and other expenses. In 1985, the corporation defaulted on the loans and assigned them to a group of lenders who agreed to pay the directors if a recovery was successful. The government seized the corporation’s assets, ultimately resulting in a judgment for $1.6 million against the corporation over its prior representations. The judgment resulted from the misrepresentations, the failure to disclose material facts and the inequitable conduct of the directors.
Taking Business Property
Misappropriation of company assets by a partner can also provide grounds for breach of fiduciary duty suit brought by the other partner(s), or alternatively for the appointment of a receiver over the partnership business. For example, if a partner uses the partnership company’s property or assets for his or her own purposes, without the consent of the other partners, this is a wrongful taking and conversion of the assets of the partnership and may lead to personal liability on the part of the partner who converted the assets. The "conversion" may be wrongful, even if it is done for the benefit of the partnership itself, if it is done without the consent of the other partners or otherwise contrary to the provisions of the Company’s operating agreement. If a partner takes money out of the company hand to which he or she is not entitled, and spends it, this is also a wrongfully taking a property for which the partner can be held accountable for an awarded sum of damages to the company for the value of the misrepresented property.
Breach of Confidentiality
In the context of a business partnership, parties may end up sharing sensitive information that affects the success and profitability of the business. For example, in the course of a partnership running an accounting firm, partners may share information about accounting fraud they find or get their clients’ tax information. Testimony, documents, and other information that is exchanged in the course of operating the business are sometimes referred to as "trade secrets" and confidences and can be extremely sensitive. Because they can literally make or break a business, courts regularly enjoin a business partner from using or disclosing such information for its own profit.
Under the general rule, there is no intellectual property protection for confidential information that is not registered with the Patent Office or the Trademark Office, i.e. has not been "copied." However, a court may nevertheless provide protection where the information is proprietary to the partnership. Duplicating information for a legitimate purpose is not therefore a violation of the law. The legal theory supporting the "trade secrets" designation is the idea that information acquired by or generated in the course of doing business is generally considered confidential.
Not every piece of information is protected by trade secrecy. Generally, where the information is not confidential, it can be used by a partner for any purpose, including fair competition or marketing . But confidential information such as customer lists (for example) could be used by a partner to compete if it contains the names of the businesses’ customers. A customer list of a retailer which contains the names of individual consumers, on the other hand, may not be protected because the list may have been acquired through notice and is available to the general public. Trade secrets can include, but are not limited to: business plans, manufacturing processes, software code, customer lists and proprietary algorithms.
Business partnerships possibly have the most extensive duties of confidentiality. Partners share information without concern for who might overhear them. For example, in the course of agreement deployment, a partner might mention their customer base on the phone, at a dinner or cocktail party, a trade event, conference or seminar. Any disclosure of information that undermines a business’s advantages is regarded as a breach of its ethical duty of confidentiality.
An action for breach of the duty of confidentiality may arise in several ways:
The elements that must be proved to establish a breach of confidentiality are as follows:
A breach of duty of confidentiality is subject to the same defenses as liability for breach of contract, i.e. illegality, impossibility, unconscionability, mistake and frustration of purpose.
Intellectual Property Disagreements
Of course, disputes over intellectual property between partners are most easily resolved when they occur in writing, such as a license or option agreement for the patent. In such cases, the Court will usually determine whether a statutory breach occurred by analyzing the allegations under a rubric of contract law. For example, in Bolide Technology, Inc. v. Comm. ES Corp., 2002 WL 1585093 (Del. Ch.), the Court was faced with a dispute between two partners over which of them owned rights to patent and patent applications which had been assigned to a third agent, but for the benefit of one of the two partners. Bolide brought suit against Comm. ES, alleging unfair use of their intellectual property after Comm. ES made and sold products covered under the patents in question. Here, the documents between the parties reflected no intent to assign rights to the agency or Comm. ES. The Court, therefore, ruled in favor of Bolide.
Dispute Resolution and Legal Action
The path forward then might involve attempting to broker a solution with your partner. You can start with informal discussions. There might be a misunderstanding or issue that is easily resolved through dialogue. Or you might be able to arrive at a compromise that satisfies all parties involved.
If informal dialogue does not bear fruit, you may wish to try mediation. You and your business partner will each need legal representation. Then, a third-party mediator will attempt to help you both find common ground. This can work if the dispute has arisen from interpersonal issues, such as a lack of communication, respect, or trust. Be aware, however, that mediation is not legally binding. If you agree to the terms but either side fails to meet their obligations later, they can be held to account only through a court action anyway.
As the name suggests, a court action is a lawsuit. Your attorney can file a complaint with a local court. There are filing fees associated with such a process. Depending on the complexity of the matter, it may take some time for the presiding judge to review the case and pass judgment . If the judge agrees with your position, the plaintiff may be awarded economic damages (at times referred to as "restitution"). For example, a partner who has forced a company to make a poor business investment that has resulted in lost revenue could be asked to compensate for losses suffered because of that investment.
Alternatively, the judge may grant equitable compensation. This is especially likely when the business as a whole was somehow harmed but the dangers posed by the partner’s misconduct still exist. For instance, this may include an order that the offending partner meet certain legal or ethical standards to protect the business they helped found. In extreme cases, the judge may also order the partner to relinquish any profits earned in the interim period, as this is a type of fraud.
Much like mediation, lawsuits can be costly and time-consuming endeavors. They can also create bad blood between business partners, thus jeopardizing the future of the company. Before pursuing this route, therefore, consider alternative conflict resolution options.