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Family Business Dispute Resolution: Mediation

Article

The Business Advisor

Winter 2018

By: Judy Wolf Weiker, CIRA, Principal, Manewitz Weiker Associates, LLC

Family business disputes tend to be ugly, drawn out, and damaging to both families and businesses. Deteriorating family dynamics can impede management’s focus and lead to poor business decisions. An early intervention, where parties can voice their dissatisfaction and bridge gaps through discussion in a nonjudgmental setting, is paramount to salvaging family relationships and maintaining a profitable business enterprise. This article focuses on mediation in family business disputes, a tool that is underutilized. In particular, utilizing a mediator who has restructuring/bankruptcy expertise may be the critical component in ensuring that a successful resolution of the family business dispute is achieved.

Scenario: Patriarch family business dispute

1st Generation: A well-known department store, Catalyst, was founded in the early 20th century, with the flagship store located in Midtown Manhattan. Under John Patriarch’s leadership, the store’s brand and reputation were established. Catalyst utilized advertising early, with clever campaigns that led to high customer demand and loyalty.

2nd Generation: John’s two sons, Bob and Tom, joined the business in the 1960s, and, upon their father’s death, each received a 50 percent ownership of the store. The second generation expanded to 20 stores in large cities throughout the United States. This expansion was funded by private bond financing, so that all financial information remained private. Bob and Tom modernized the stores and were quite attuned to the public’s changing fashion trends. The stores were highly profitable. The brothers continued to reinvest profits into the stores and took modest salaries to support their growing families.

3rd Generation: Bob Patriarch has two sons, Mark and Jeff. Mark, who joined the business in 1990, is currently the CEO of Catalyst. Mark draws his salary from Catalyst and receives various perks befitting his position with the firm. Jeff opted not to join the family business, although he holds a board seat. Each brother inherited 25 percent interest. Tom Patriarch has two daughters, Kate and Tina. Kate joined the firm and developed the company’s internet platform and is credited with saving the family business. Kate is now Catalyst’s CFO. Tina opted not to join the family business. Tom recently passed away and left his children equal interest in the business.

Catalyst’s business by-laws require a majority vote (51 percent) for all major transactions, such as debt financing, store expansion, salaries of officers, annual dividend payout, and acceptance of offers to sell all or part of the company. At the latest board meeting, the family members had a number of disagreements that broke down into heated arguments. These disagreements include:

    • Salary, perks, and benefit packages for Mark and Kate
    • Store proposed reinvestment program
    • Size of future dividend
    • Offer from private equity firm to purchase all or majority interest in business
    • Value of business and distribution of proceeds, if sale is approved
  • Questions related to misappropriation of company funds

Family members questioned Mark’s “customer jaunts” to Aspen for ski trips and to Milan for fashion week, among others. Family expressed dissatisfaction related to poor explanations for inventory shrinkage, exponential growth in expenses, and dwindling cash position. Mark was accused of misusing Catalysts funds for his own benefit, and Kate was accused of sloppy accounting oversight. In turn, Tina and Jeff were accused of not knowing how the business works and wanting only to cash out, to the detriment of the business operations, current employees, and going concern value.

Family members left the board meeting, and each retained counsel to advocate his or her respective position. The family has been very private to date, but one family member plans to go to the press. The attorneys have prepared complaints alleging fraud, misuse of funds, self-dealing, and violation of fiduciary duties. To the extent such lawsuits are commenced, the filing of such suits may result in a violation of bond covenants and could trigger a default on Catalyst’s debt. Further, any such lawsuit will result in significant publicity damage to the Catalyst brand and image.

Issues raised suitable for mediation as a dispute resolution mechanism

Much is at stake for the Patriarch family, both on a personal relationship and financial level. The chart below highlights the overlapping issues which arise in a family business dispute and those addressed in an out-of-court restructuring/bankruptcy. Many of the issues raised in the above scenario would be most expeditiously resolved in mediation.

Chart: Family Business Disputes – Hybrid of Legal and Financial Issues

 

Dispute Issues

 

Matrimonial Law

 

Patriarch Family Business

 

Bankruptcy Law
Corporate Restructuring

 

Parties

 

Family members

 

Family members

 

Equity, management, creditors

 

Financial Review

 

Family income, expenses, and net worth

 

Audited financial statements

 

Financial statements (historic review, projections, and cash flow)

 

Business Review

 

Under-reporting income/hiding assets

 

Fraudulent transfers/misuse of funds

 

Fraudulent transfers/misuse of funds/preferences

 

Compensation

 

Compensation and other income sources

 

Executive compensation

 

Executive compensation, professional fees

 

Breach of Fiduciary Duties

 

Grounds for divorce

 

Breach of duty of care and duty of loyalty

 

Directors and Officers breach of fiduciary duties

 

Valuation

 

Marital assets

 

Business valuation

 

Estate Valuation (going concern, liquidation, sale)

 

Allocation of Ownership

 

Split of marital property and quantification of future payments for alimony, support payments

 

Allocation of ownership/sale proceeds

 

Distribution under plan of reorganization

Benefits of mediation

Privacy: Unlike court proceedings, which are public, mediation is a private matter between parties.

Confidentiality: In a mediation setting, only the parties, their legal counsel, and the mediator will be privy to matters discussed in the mediation. The mediator’s retention letter will address the confidentiality of the proceeding. The mediator will not disclose a party’s information without permission, so as to encourage free flow of information and candid and meaningful discussion among the parties.

Judge vs. Mediator: The family members may opt to pursue litigation, which is a formal process. If litigation is commenced, the parties will file court pleadings, take discovery, and may have a trial where a judge or jury will ultimately decide the outcome based on evidence presented and application of rule of law. During the course of the litigation, it is possible that certain family members will be called to testify in court; however, their respective cases will be argued solely by counsel. The decision of the judge or jury will be binding on all parties to the lawsuit, unless overturned on appeal, which appeal will prolong the litigation. The process is public, lengthy, and expensive, and there is never a guaranteed outcome.

When the parties opt to pursue mediation, they will have the benefit of counsel; however, at the end of the day, the family members will decide the terms of a settlement. The parties will select the mediator and split the costs, so that each participant has a vested interest in a successful outcome. It is important that the parties consider the experience, knowledge of underlying issues, and style of the mediator when making their selection. The mediation is a more informal process. The mediator will likely request documents, position statements, and supporting information that will be helpful to facilitate a settlement or narrowing of the issues. If the parties subsequently pursue litigation, information provided to the mediator or exchanged among the parties will remain confidential.

Parties’ Position Statements and Advocacy: Mediation provides a private forum to vent emotions before resentment is hardened and the family relationship is irreversibly ruptured. The parties prepare position statements prior to meeting with the mediator, wherein they outline their understanding of the relevant facts and what they want in terms of settlement (i.e., money range, an apology, recognition of their importance). The mediator will have discussions with each party, so that the mediator can better understand the issues to be resolved during the mediation process.

Facilitative Process: At the beginning of the in-person mediation, with all decisionmakers and their respective counsel present, the mediator will set the tone for the negotiations, setting parameters and rules of engagement. As part of the mediation process, it is important that the mediator’s neutral status is understood and respected, and parties understand that they will look solely to their respective counsel for any required legal advice. It is the mediator’s job to facilitate negotiations by asking probative questions that may reveal the weaknesses and strengths of positions. The mediator has the option of conducting the negotiations with all parties present in the room or meeting with each party separately, going back and forth, to facilitate continued discussions. The mediator will seek to establish agreed facts and understanding of issues by all parties, all in an effort to narrow the differences and reach settlement. Once the parties agree to terms, a settlement statement is drafted, which all parties must sign to be binding. Litigation Is Expensive: Where the parties are set to litigate, mediation may be used to establish agreed facts and narrow issues to be litigated before the court. Limiting the scope of the litigation claims likely will reduce discovery requests, proposed time at trial, and legal fees.

Timing Is Everything: Mediation may be utilized any time during the litigation process. Where family disputes are concerned, early dispute resolution is critical to preserve the familial relationships.

Selection of professionals

Many of the issues in a family financial dispute occur in bankruptcy as well, where mediation is used as the primary dispute resolution mechanism.

Legal Counsel: Including counsel with restructuring expertise will likely be essential to a successful resolution.

Mediator(s): Including on the mediation team a professional with bankruptcy and restructuring experience may be critically important to achieving a successful outcome. A trained mediator who comes with a restructuring background will have the expertise and understanding of the underlying legal and financial issues, which may include:

    • Valuation
    • Financial reporting
    • Forensic accounting
    • Future structure of the business
    • Buyout of family members no longer actively involved in the business
    • Structuring of success incentives
  • Long-term success of the business

In addition, restructuring professionals focus on a regular basis on resolving complex disputes. In a typical chapter 11 case, there are many different stakeholders, many of whom have competing interests. Restructuring professionals are used to dealing with these dynamics and know how to reach settlements that both benefit their clients and preserve the value of the underlying business. A mediator with a restructuring background who is used to resolving complex financial situations is likely the best person to resolve a family business dispute.

Conclusion

Family disputes can lead to irreparable harm to the underlying relationships and business enterprises. Before these disputes adversely affect the corporate governance and impede business decisions, mediation should be considered as an early intervention dispute resolution. Mediation has been successfully utilized in divorce proceedings and in corporate restructuring disputes and, given the overlap of issues, should be used for family business disputes. When selecting a mediator, the parties should consider a trained bankruptcy mediator who is experienced and knowledgeable about the underlying issues and who will be better suited to facilitate a consensual resolution by the parties.