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Are Dividends A Mask For Financial Fraud?

Previously on this website, I wrote about how a recession can help an unscrupulous business partner hide his fraud (Nov. 2008). For example, I explained that “tough economic times” can be used as an excuse to stop paying dividends or providing other financial benefits to minority shareholders.  However, it can be equally true that a stronger economy, like we may be experiencing at the moment, can also be used to mask fraud.

While this may seem counterintuitive at first, it makes perfect sense. In a scenario where the majority shareholders are running the company – and, more importantly, the finances, as is often the case – it is easy to disguise self-dealing if the self-dealer masks his own greed. For instance, a business partner who wants to pay himself an exorbitant sum, pay for his wife’s car, his child’s car insurance, and bonuses that he didn’t earn, has a choice. He can also declare at least some dividend so that his out-of-the-loop business partner does not become suspicious. Or, he can double down on his greed, and make sure that his business partner sees nothing out of this company other than his meager salary.

Many shrewd self-dealers are adept enough to realize that a business partner who is kept in the dark about finances is less likely to get suspicious if a modest dividend is paid at the end of the year. After all, any voiced suspicion can then be met with a statement reminding him that a dividend was paid, which did not have to be paid. If I was stealing from the company and was a thief – the thinking goes – why would I have declared a dividend?

Of course, the best way to defend oneself against fraud or self-dealing by your business partner is to inspect the books and records with some frequency.  However, that is not always possible since New Jersey law severely circumscribes one’s right to inspect the books and records of the company. In fact, there are few documents to which a minority owner is entitled, which will be the topic of an upcoming article. Thus, it is far better to write into the Shareholders Agreement (or Operating Agreement, in the case of an LLC) a right of inspection.

For many reading this article, it is too late to add such a provision, as the agreement was written years ago. However, there are various points in time when you hold certain leverage even as a minority owner. If the company is borrowing money, and you are asked to sign a personal guaranty, it might be reasonable to condition your signature on a binding, written agreement allowing you full access to the books and records of the company. After all, if you are being asked to put your personal assets at risk, why should you not get full disclosure about the company’s finances now and in the future?