Friday, July 16, 2010

Fighting business to business fraud (Part I)

Businesses, professionals, and entrepreneurs often shun lawyers until a business partner lies to them or flees the jurisdiction with all of their money. When something like this happens, the victim has only two choices: surrender or file a business lawsuit. The Patterson Law Firm files a lot of business lawsuits designed to fight business to business fraud, and today’s post considers some causes of business fraud.

Business fraud erupts in these recurring circumstances:

Unequal Bargaining Power, Real or Perceived

Usually you think this only occurs between banks or insurance companies and consumers, but it happens in business too. Venture capitalists drip feed money to an entrepreneur and when he or she needs more money, more control is grabbed, and sometimes the entrepreneur is squeezed out of the business once he or she has completed all the hard work of making the product and preparing to market it. Partnerships between those with money and those who contribute only sweat equity are common and can work, but those with the money often cite the golden rule: “them with the gold rule.”

In one case, the financial partner locked out and purported to fire the President of the company, who had invented the hi-tech product being sold. In another case, one brother locked out the other and vowed not to let him profit from the company of which he was a 50% shareholder. In both these cases, those with the gold thought they had more power than they did. Neither got away with it, although in both cases it took the legal system over a year to fix.

Unequal Experience

A first-time entrepreneur is no match for an experienced investor when it comes to negotiating an agreement, but there are many other less obvious scenarios. Consider a business person with 50 years’ experience in a family business but who has to contemplate turning the business around, liquidating, or going bankrupt. Such a person is ripe for scams from self-proclaimed turnaround specialists and others promising the money to help. This could be the first time the business person faces these decisions, but the specialists make their living at this and know all the tricks.

Communication Ambiguities, Unintentional or Otherwise

Consider this LLC agreement section: “any Member or Manager may engage in or possess an interest in any other business venture, independently or with others, of any nature or description; and neither any other Member or Manager nor the LLC shall have any rights by virtue hereof in and to such other business ventures, or to the income or profits derived there from.” In another section the same agreement stated: “no Manager shall be liable to the LLC or its Members for monetary damages for breach of fiduciary duty as a Manager, except for liability for (i) any breach of the Manager’s duty of loyalty to the LLC or to its Members or (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.”

Can one manager of the LLC secretly invest in a competing business under this agreement? This example comes from an actual case in which one manager secretly competed with the LLC and, when caught, argued that the LLC agreement allowed his competition. (In Illinois, the provision purporting to allow competition should not be enforceable because the LLC Act forbids eliminating the duty of loyalty, which includes the duty to refrain from competition.)

You might argue that this arose from careless and slovenly document preparation, and it is also possible that the parties were not contemplating how to police themselves at the time and were not thinking about potential treachery. They were all friends and business partners at the time the agreement was signed. Perhaps the traitorous party noticed the ambiguity and decided to exploit it. Perhaps he deliberately seeded the agreement with a provision he planned to exploit. Or maybe, in these days of canned form agreements, the issues were never discussed.

My next post will consider some possible remedies for a victim of business to business fraud.