Tough love: court refuses to give family-owned businesses a pass on corporate formalities

The Delaware Court of Chancery, one of the premiere enforcers of corporate law in the country, recently struck down several actions of Rainbow Mountain, Inc., a family-owned Delaware corporation for failing to follow its own bylaws. See Rainbow Mountain, Inc. v. Begeman, 2017 WL 1097143, at *1 (Del. Ch. Mar. 23, 2017).

Rainbow Mountain, Inc., owns 97 acres of land in Virginia and is primarily operated by Sheridan and Barbara and their six children: Terry, Mark, Laurie, Cindy, Jeffrey and Todd. The family adopted corporate bylaws in 2005 which, among other things, required a 2/3 vote of all members to remove a member. The removal could only be for cause.

A few months after the bylaws were adopted, the family came together and authored a unanimous resolution removing Mark and Cindy from the corporation without cause. Despite the bylaw mandate that removal be for cause, the resolution stated that membership in the corporation could be “terminated by the Board of Directors at any time without cause.” After family relations soured further, the family met again and removed Terry from the corporation without cause and replaced him with Eric, a relative by marriage. Based on the presence of other family members and the resolution, the voting members presumably believed all these actions were taken during a quorum, in compliance with the bylaws’ provisions for removal.

In 2014, Rainbow Mountain sought a declaratory judgment that Terry was properly removed as a director. Terry countersued, claiming that because Mark and Cindy were never properly removed as members, the members’ removal of Terry and appointment of Eric were invalid actions.

Terry won. At the outset, the court agreed with Terry that Mark and Cindy were not properly removed because the bylaws only allowed removal “for cause,” regardless of what the unanimous resolution stated. Rainbow Mountain then argued that since Terry voted to remove Mark and Cindy, he could not now argue that their removal was invalid. Not so, the court held – bylaws are the rules of the road, and any action inconsistent with those bylaws is void, even if the action is challenged by an assenting director nine years later.

After the court found Mark and Cindy were still Rainbow Mountain members, it invalidated subsequent actions because they were taken without a quorum and without compliance with the bylaws – including Terry’s removal. At the end of the day, it turned out that Terry, Mark and Cindy were all Rainbow Mountain members and Eric was out.

The Rainbow Mountain facts are complex but the lesson is simple: in the eyes of the law, bylaws are a contract and closely-held, family-owned businesses don’t get a pass for failing to follow their formalities. What does that mean for you? Don’t just draft your bylaws to fit your business, draft them to fit your family, too. Consider your family’s characteristics and decision-making processes and provide a means for your family to accomplish tasks and accommodate change consistent with those characteristics. Bylaws are not one-size-fits-all and they don’t have to be. Heed the Rainbow Mountain court’s caution: if your bylaws are not working for you, don’t ignore them, change them.

For more information about corporate bylaws and closely-held companies, contact Laura Wasson.  

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed.

- Laura Wasson