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Business Divorce: Sources of the Law

The law of business organizations is a creature of state law, and disputes among owners in a business divorce involve the application of the law where the business was formed. More often than not that means the law of the state in which the dispute is being heard, but not always. And significantly, at least for our present purposes, it does not mean that we will find the answer to a business divorce issue in the state in which the litigation is pending, even among the binding decisions of the state law where the enterprise was formed.

Here’s an example: a New York court is called upon to determine whether a managing member of a limited liability company breached his or her duty in negotiating a sale of a substantial asset to a third party that the manager negligently believed was an objectively fair price. The plaintiff seeks to expel the manager or to force a dissolution and sale of the business as a going concern. Does the Court apply New Jersey law? If there is no New Jersey case on point – and there is no binding decision on all of the points in this scenario – does the Court apply New York law, and to which issues?

Even if this case is litigated in New Jersey, and there is no law on point, where does the trial court look to guidance. The nearly automatic response is Delaware, because the courts of Delaware have by far the most developed body of law applicable to corporate governance disputes. However, Delaware may be the wrong choice if the limited liability company statute needs interpretation. A well-reasoned decision from an Appellate Court in Illinois, for example, should be much more persuasive to a court construing New Jersey’s limited liability company statute because of the similarity between the two states’ laws.

Business Divorce Law is Determined by the States

There is no federal corporations law, and instead every state has some statutory framework that governs the business enterprise. In addition to state statutes, there also are principles of common law that both govern the interpretation of statutes and also provide rules of decision when there is no applicable statutory law. Add to this the fact that the docket of corporate governance litigation in many states is not as full as in other types of litigation, leaving many questions unanswered on a state-by-state basis.

The internal affairs doctrine requires that the law of the state where the entity was formed will govern its internal operations and corporate governance. But the applicable law from many jurisdictions is sparse and litigators often have no choice but to add to the gaps that commonly exist in many state laws. The notable exceptions are Delaware and the largest states such as New York, California and Illinois. But in many circumstances there is no authority from the state of organization and litigators look to the best example as some persuasive (as opposed to binding) authority of how an issue should be resolved.

Understanding the source of the applicable law and being able to apply the rationale and holdings from decisions from another state can be of critical importance in corporate governance disputes. This involves more than simply relying on Delaware law as a model. Sometimes we should look at Delaware law, other times not.

Using Delaware Law as a Model in Business Divorce Cases Not Always the Best Approach

I principally practice in New Jersey, which has relatively well-developed jurisprudence on many corporate issues, but no all. The New Jersey statute governing corporate director indemnification, for example, is modeled after Delaware’s analagous provisions in its corporations code and it makes sense to look to Delaware for guidance when New Jersey law is lacking on this particular issue.

New Jersey’s statutory law on limited liability companies, however, is based on the Revised Uniform Limited Liability Company Act (RULLCA) promulgated by the Uniform Law Commission. Decisions from other RULLCA states — such as California, Illinois or Florida — may provide better guidance for decisions.

Uniform laws are model statutes recommended by the Uniform Law Commission, an organization of attorneys and legal scholars, that try to promote uniformity in the law among individual states in a number of legal ares. State legislatures frequently use uniform laws as models and adopt some or all of the uniform laws as the statutes in their states.

It seems like an academic exercise, but in most corporate governance disputes, it is often important to know the source of any statute that is in play. And, of course, in all statutory schemes, one must consider the often over-riding effect of contractual agreements among the affected parties. Not every issue can be decided by a prior agreement between the parties, but the modern trend is that most of the statutory provisions existing under a relevant state statute can be supplanted by a contract. Courts will often look to the commentary of the Uniform Law Commission and to the courts of other states applying a uniform law for guidance to resolve disputes on which there is no established answer.

Shareholder Disputes – Principal Sources of Law

Corporate statutory law falls into two classes: the independents, many of which are largely modeled on the Delaware General Corporations Law (DGCL), and those states that have adopted the American Bar Association’s Model Business Corporations Act (MBCA), which has undergone major revisions in 1969, 1984 and most recently 2016. (Most recent version here.) The MBCA has been adopted in about half the states in the United States and many states have incorporated provisions of the MBCA into their statutory codes.

Among the states that have not adopted the MBCA, Delaware is the dominant source of statutory and common law. The majority of publicly held companies are organized under Delaware Law and the Delaware Courts, in particular the Chancery Division, has developed a large body of case law. (Browse the DCGA here.)Delaware corporate law is persuasive and considered by many to have persuasive impact. Among the independent states, Delaware law may provide a statutory model and its court’s decisions will be seen as persuasive authority.

Even when a state’s corporations code is not modeled on Delaware law, the expertise of the Delaware legislature and its courts, particularly its chancery judges and Supreme Court, will be given wide deference with regard to corporate policy and law.

The independent states with more broadly recognized corporations law include Delaware, New York, California, Nevada, New Jersey, Texas, Illinois, Michigan and Massachussets.

The MBCA is a project of the Business Law Section of the ABA is frequently revised. Its adoption is more prevalent in states in the Northwest, Southeast and New England. For those practicing in an MBCA state, or called upon to consider a statutory provision based on the MBCA, the ABA publishes annotated versions of the model code.

A final source of law to consider is the Principles of Corporate Governance: Analysis and Recommendations (Principles) published by the American Law Institute. It is a mixed format source that includes restatements of the law as well as procedural and statutory recommendations. (See An overview of the Principles of Governance at the Berkeley Law Scholarship Repository here.)

Partnership Disputes – Principle Sources of Law

Partnerships are loosely defined as two or more persons undertaking a business for profit. They were created by the common law, but all states except Louisiana have now adopted some form of the Uniform Partnership Act (UPA) of 1914. The Revised Uniform Partnership (RUPA) has been adopted in 39 states. Notable states that have not adopted the RUPA as of this writing include New York and Massachusetts. (RUPA with commentary here.)

Many states have adopted limited liability partnership (LLP) statutes. The LLP functions as a general partnership, but provides the partners with limited liability. Because the LLP shields the partners from personal liability for the debts of the corporation, they function very much like the limited liability company. Nonetheless, they are most often seen in professional practices that previously operated primarily as partnerships. In many states, a general partnership, in which the partners are personally liable for the debts of the partnership, is converted into a limited liability partnership with the relatively simple act of filing a certificate and adding “LLP” to any use of the partnership’s name.

In those states that have adopted the Uniform Limited Liability Company Act, the distinction between a partnership and a limited liability company are much less pronounced. The uniform LLC laws are largely modelled on RUPA, and thus many issues that arise in governance disputes are treated the same way.

Limited Liability Company Disputes – Principal Sources of Law

Limited liability companies are the newest of the forms of business entity. The first state to authorize limited liability companies was Wyoming in 1977. The concept behind the limited liability company was relatively simple: a business organization principally governed by contract, taxed as a partnership and providing limited liability for its members. Over the next 20 years, all of the states adopted a limited liability company statute.

The tax treatment of an LLC, however, remained murky until 1997, when the IRS adopted “check-the-box” regulations that permitted owners to elect to have their limited liability company treated as either a corporation or a partnership for tax purposes. The use of the limited liability company as the preferred form of organization for news businesses has increased drastically, and new business owners overwhelmingly choose the limited liability company as the form of business organization.

Limited liability statutes can be traced to two sources. The first are those states with a limited liability company statute that adheres to the Delaware model. Examples are Delaware, New York and Nevada. These statutes provide limited remedies and presume that the parties will contract among themselves in the way that best protects their interests. The enforceability of these contractual provisions are key, and the courts are slow to provide a remedy that is not found in an operating agreement or a statutory provisions. (Browse the New Yok Limited Liability Company Law here.)

The other source of limited liability company law is the 1996 Uniform Limited Liability Company Act (ULLCA) and the Revised Uniform Limited Liability Company Act (RULLCA) promulgated the by Uniform Law Commission (last revised in 2013). The ULLCA has been adopted in at 25 states and its adoption is under consideration in two more. Among the more populated states that have adopted the statutory frame work are California, Illinois, Pennsylvania , Florida and New Jersey. Many states — even those who follow Delaware’s model — have borrowed heavily from the RULLCA or its prior iterations. (RULLCA with commentary here.)

The uniform law incorporates concepts and provisions from partnership law, in particular the Revised Uniform Partnership Act (RUPA), and both carry over into the Uniform Limited Partnership Act. (The Uniform Law Commission has prepared a comparison of the three acts available here.) The latest amendments seek, among other things, to “harmonize” the law of unincorporated associations.

The uniform law is characterized in many respects by the breadth of the remedies afforded to courts to fashion remedies in equity, even as it seeks to preserve the rights of parties to order their affairs by contract. The RULLCA is more comprehensive in scope, and provides express authorization for remedies that exist at the fringes, if at all, of more established law. These include the broad right — some might say the unrestrained right — of a court to order a sale of a member’s interest in a dispute or to expel a member. The gaps that exist under the RULLCA are fewer, but for our purposes the most notable distinction between the RULLCA and statutes found in such places as Delaware and New York is the express authorization of the courts to provide remedies that are short of a judicially ordered dissolution.

Limited Partnership Disputes – Principal Sources of Law

The limited partnership is worth mentioning here. A limited partnership, like the limited liability company, is a hybrid entity with aspects of corporations and partnership. The limited partnership in many states functions like a general partnership except that the partnership is divided into general and limited partners. General partners are responsible for the management of the partnership and are subject to personal liability. Limited partners may not participate in management and their personal liability is limited to their partnership interests.

The limited partnership today has largely been supplanted by the limited liability company and exists primarily in specific sectors of the economy in which a partnership with centralized control is desirable, including private investment funds, real estate and film production. In the United States, the limited partnership has existed in various forms since the early 1800. The Uniform Law Commission adopted Uniform Limited Partnership Act in 1976, which was last revised in 2013. (ULPA here with comments.)

#Delaware general corporations law #Model Business Corporations Act #New York Limited Liability Company Law #Revised Uniform Limited :iability Act #Revised Uniform Partnership Act

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mcdaniellaw-blog · 8 years ago

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Minority Shareholder's Silence Waives Oppression Claim

It was the stuff of which a good minority oppression claim is easily cooked up. The party in control of the corporation had used the corporate bank accounts as his personal piggy bank while operating a competing business, paid himself inflated office rents and bankrolled an extra-marital affair with money taken from the business.

None of that, however, could carry the day in a lawsuit brought by the minority shareholders of a New Jersey corporation because they waited years to complain.

Minority Shareholder Oppression Alleged by Ousted Officer of Closely Held Corporation

In a suit heard in the Eastern District of New York, but applying New Jersey law, the trial judge dismissed all of the minority oppression claims, finding that the lawsuit was too late. Digital Camera International, Ltd. V. Antebi, et al., 11-cv-182 (E.D.N.Y. July 13, 2017).

The lawsuit is ample warning that the minority shareholders who waive their rights when things seem to be going well are not going to be heard to complain later. The acquiescence by minority owners to wrongful conduct by the majority is likely to be a complete defense to a lawsuit based on those claims.

Plaintiff Digital Camera International Inc. was a New Jersey corporation that sold cameras at wholesale. The protagonists to the shareholder oppression were Barry Antebi, his wife, Marlene, and Ely Eddi. Antebi was removed from operations in a dispute with Eddi.

After the falling out and Antebi was removed from management, the corporation brought suit alleging a variety of misconduct by Antebi, alleging breach of fiduciary duty and fraud. Antebi counter-claimed, alleging that he was the subject of oppressive conduct by the majority

Trial Court Makes Findings of Officer Misconduct

At trial, the court made findings of fact that included the following:

Eddi and another of the shareholders operated a competing company, Digital Data Devices, which received loans from Digital Camera.

The shareholders made a practice of paying personal expenses with corporate charge cards and maintained a ledger for those expenses. Personal expenses were intended to be deducted from profits otherwise due, but those purchases were never repaid.

The accuracy of the ledger could not be established.

Personal expenses were listed as business expenses on tax returns.

Antebi used corporate assets to fund an extra marital affair.

The competing business, Digital Data Devices, rented space to Digital Camera at inflated prices.

Antebi paid his personal taxes with

The Court proceeded to examine each of the allegations made by the litigants, both as claims of wrongdoing and in connection with the counterclaim filed by Mr. Antebi to address his alleged oppression as a minority shareholder.

On each issue, the Curt held that the acts were indeed wrongful, but that they were well known and could not be pursued.

For example, the Court held that although the shareholders had indeed breached their fiduciary duties by paying personal expenses with corporate assets, the company had ratified the transactions by a keeping a ledger for the express purpose of alllowing employees to use the corporation’s credit cards, “as opposed to proscribing the practice.”

In like fashion, the plaintiff had signed a check that was used to pay Antebi’s personal tax bill and therefore knew of the practice. He could not now claim a breach of duty, the Court held.

On the issue of whether antebi was an oppressed schareholder, the trial court held that the claim was barred by the doctrine of acquiescence, which “precludes shareholders from sitting by or acquiescing in the wrong conduct of the corporatio then seeking a remedy for that coduct long after the conduct has occurred.”

If nothing else, this case has shown, again and again, why a knowing waiver of wrongful conduct cannot be conveniently withdrawn.

Ultimately, the court could only award the amounts that Antebi admitted were a debt to the corporation, as offset by an unpaid load to the corporation.

The fact that the owners of this closely held corporation ignored conduct that was not only in violation of the rights of the other shareholders, and it appears quite questionable as to the ultimate justification of business expenses to the taxing authorities, would not come as much of a surprise to anyone who works with small businesses.

Many, many principals of closely held businesses view the concept of business expense broadly and the books are kept to minimize profits and maximize colorable expenses. In valuing a business, the process of restating perquisites and expenses as income is often a significant chore. What the court is saying here, however, is that shareholders cannot participate or ignore conduct and then try to sue on the same behaviors.

It was offensive to the court on two levels. First, parties are bound in litigation by their conduct in the real world through such doctrines as laches (unreasonable delay) and estoppel (prohibition against unfairly changing positionss). Second, as a matter of accepted principles of business law, corporations have a right to ratify actions. Having ratified objectionable conduct, the shareholders cannot fairly expect to complain later.

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mcdaniellaw-blog · 8 years ago

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Oral Agreement to Transfer Shares Is Enforceable

The prior owner of a woman-owned business will be required to pay upwards of $500,000 to an oppressed shareholder after a trial court found — and the Appellate Division confirmed — that she had entered into a valid agreement to transfer her shares in return for an agreement that allowed her to continue collecting her husband’s salary while he was in prison.

Opressed Shareholder Sues to Enforce Transfer Agreement

The unreported decision in Dilworth v. DiSalvatore, Docket No. A-4492-14T2 (N.J. App. Div. March 16, 2017) is interesting in a number of respects. First, it presents a case in which we see the results of failing to commit agreements among the owners of a closely held business to writing. It’s great for the litigators but no so fortunate for the owners that failed to get it in writing.

The opinion also rejects outright the concept that the Defendants in an oppressed shareholder litigation are prohibited from using corporate funds to pay for for defense counsel. The corporation has a right and obligation to be represented by counsel, the Appellate Division held, although there may ultimately be an allocation between the corporation and the individual defendants.

Limited Liability Company Owners Seek to Preserve Status as Female-Owned Business.

At issue in the litigation was Municipal Codes Inspections, Inc. (MCI), a business that contracted to provide building inspections to municipalities. Because of the competitive advantages that may be available to a business in which the majority owners are women, the corporation was owned by Debra DiSalvatore, while her husband Louis provided the inspections. Debra was officially the president, but earned a modest income of just more than $10,000.

The Defendants (the legal owner and her husband) wanted to hire the another building inspector who was already contracting with a half-dozen municipalities. The inspector, Jay Dilworth, wanted equity. To keep the business’ status as woman-owned, however, a 50 percent interest was transferred to Dilworth’s wife, Debra, in his place.

Louis and Jay continued to provide the inspection services and Marie earned a bit more than $10,000 as the office manager. The business was quite successful, having sales of $1.2 million in 2010. Until, that is, Louis was convicted of tax evasion and sentenced to prison.

The Dilworths agreed that because of Louis conviction, he would pay his salary to his wife Marie for a period of two years after which Marie would transfer her shares to Debra and the DiSalvatore family would be out of the business. As a result, Marie’s salary jumped from about $10,000 to $180,000.

When the two years was up, however, the DiSalvatores declined to transfer the shares, and Marie denied that any such agreement was every made. Jay Dilworth quit and the revenue of the business dropped by 75 percent. Debra and Jay filed suit alleging several theories, including that Debra was an oppressed minority shareholder.

Shareholder Oppression by 50 Percent Owner

The trial court had initially rejected the assertion that Debra had a right to participate in management. Her role was to hold the shares and not to be involved in the day-to-day operations. Nonetheless, the Court held that Debra and her husband had a right to be treated “fairly,” and that Marie — who held onto control of the business — had engaged in a number of oppressive acts.

Among the oppressive acts, the trial court had held, was the failure to make a planned transfer of Marie’s shares to Debra. The Defendants has argued that the trial court’s finding that there was a valid contract for the transfer of the outstanding shares was in error. The appellate division, however, affirmed the trial court.

The appellate court held that there was sufficient evidence in the record that a binding contract had been formed and that a writing was not required. “The record contains ample credible evidence to support the judge’s conclusion that the parties entered into an enforceable oral agreement in 2009.

Fifty Percent Owner is Minority Shareholder

The appellate division left undisturbed the trial court’s holding that Debra, as a 50 percent shareholder, was a minority because she lacked a controlling interest and that the behavior that followed the oral agreement was oppressive. Debra had a reasonable expectation after that agreement was made to receive financial information, to receive dividend income and to not have Marie misapply corporate funds.

The Court affirmed an award of $410,469 to Debra in compensatory damages and $12,508 to Jay.

Corporation’s Payment of Defense Counsel Fees Was Proper

The second major issue decided by the Appellate Division was its holding that the trial court had committed reversible error in holding that it was improper for the corporation to pay the defense attorneys with corporate funds. This is a recurring question in business divorce litigation. Defendants that control the company invariably would prefer to pay defense costs from the company’s revenue. Oppressed minority plaintiffs invariably object.

The summary determination that the corporation’s payment of legal fees was improper was an error, the appeals court noted. The defendants in the case included both the corporation and Marie in her corporate capacity.

First, the Court noted that the corporation was a defendant and under New Jersey law has the power to bring and defend suits, to make contracts and incur liabilities, citing N.J.S.A. 14A:3-1. In addition, the corporation had the right under N.J.S.A. 14A:3-5 to indemnify the Marie as a defendant corporate agent.

Any corporation organized for any purpose under any general or special law of this State shall have the power to indemnify a corporate agent against his expenses and liabilities in connection with any proceeding involving the corporate agent by reason of his being or having been such a corporate agent, other than a proceeding by or in the right of the corporation, if …

(a) such corporate agent acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation[.]

It was error, the appellate court held, for the court to summarily determine that the payment of attorney’s fees was improper. The Court had made no determination of whether Marie was entitled to indemnification and, if not, whether the fees paid could be allocated between the corporation and the director.

The opinion leaves open the question of how such a fee award might be approved in a dispute between two 50 percent owners, one of which has already been ordered to transfer shares. Indemnification is permissive on a vote by the non-defendant directors unless the agent has been successful in the defense or indemnification has secured a court order.

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mcdaniellaw-blog · 8 years ago

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Oppressed Shareholder Wins $750,000 Fee Award

An oppressed minority shareholder was awarded approximately $750,000 in attorneys fees and expert expenses — some eight times the amount of the buyout — even though the majority had good reason to fire him from his position as the corporation’s CEO.

Fee Award Under Oppressed Shareholder Statute to Selling Shareholder

This case is a 14-year-old litigation involving a dispute between the family members of a family-owned business, and the outsider executive who was brought in to take over the management of the corporation. The relationship quickly deteriorated amid allegations of misappropriation and sexual harassment in the workplace.

The unreported Appellate Division opinion in Hammer v. Hair Systems, Inc.,Docket No. A-1475-14T1 (App. Div. June 9, 2017) affirmed a trial court’s decision that the former CEO and minority shareholder was justifiably terminated from his employment for the harassment of female employees. Notwithstanding the validity of the termination, the trial court found, and the appellate division affirmed, that the questionable financial practices of the family-owned business constituted minority oppression, and merited an award of fees.

In awarding fees that were, even after a 50 percent reduction by the court, approximately seven times the amount of the purchase price, the trial court rejected a “proportionality” argument that measured the fee award against the amount of the recovey.

Shareholder Dispute Involved Owners of Family Business and CEO

The corporation at the center of the dispute was Hair Systems, Inc. (HSI), owned by members of the Covey and Shah families. The plaintiff in the case was John Hammer, who had retired and was working as a consultant when he was brought in as an outside CEO.

Hammer had first joined the company as a member of the board of advisors and wrote a report suggesting that the company needed to develop an “organizational culture.” When the founder of the company became ill, Hammer joined HSI fulltime and received a two-percent stake in the company.

Hammer’s tenure was controversial. First, he sought to implement policies against the widespread practice of the owners paying personal expenses with company funds. At the same time, Hammer was the subject of allegations of sexual harassment. Hammer was ultimately fired as a consequence of those allegations.

Oppressed Minority Shareholder Statute

Hammer brought suit, alleging that he was an oppressed minority shareholder under N.J.S.A. 14A:12-7(c). The statutes provides a cause of action to minority shareholders of closely held companies with less than 25 shareholders when the corporation’s directors:

have acted fraudulently or illegally, mismanaged the corporation, or abused their authority as officers or directors or have acted oppressively or unfairly toward one or more minority shareholders in their capacities as shareholders, directors, officers, or employees.

The trial judge noted that a court considering a claim of minority oppression must consider whether the behavior complained of frustrates the reasonable expectation of the minority shareholder. (In many cases, shareholders of close corporations expect to be employed.) Hammer claimed that his firing was retaliation and therefore oppression. The trial court disagreed, holding that the termination was justified and therefore not minority oppression.

Majority Shareholders Oppressive Conduct

The other allegations raised by Hammer, however, were held to be minority oppression. The trial judge found that the family members used corporate assets for a variety of personal expenses, ranging to tax preparations to child care. Misappropriation and excessive compensation are widely recognized as oppressive practices. The family members argued, however, that Hammer knew about the business practices before he joined HSI. The trial court rejected that argument, noting that Hammer was hired to change these practices.

Having found that Hammer was an oppressed minority shareholder, the Court ordered the purchase of his two-percent interest for $81,594, but then awarding $758,956 in counsel fees, costs and expert fees.

Fee Shifting in Oppressed Minority Shareholder Litigation

The trial court relied on N.J.S.A. 14A:12-7(8)(d), which provides that court may in its discretion award the selling shareholder “reasonable fees and expenses of counsel and of any experts.” The Court did not, interestingly enough, conduct any analysis of whether it was appropriate to award fees in this case.

The award of fees, the appellate court noted, is subject to a very deferential abuse of discretion standard, that “will be disturbed only on the rarest of occasions.” Only when the trial court did not consider the relevant factors or based its decision on irrelevant or inappropriate facts will the appellate court disturb the trial court’s findings as an abuse of discretion.

Lodestar Analysis in Award of Fees to Oppressed Minority Shareholder

The appellate court then reviewed the traditional “lodestar” analysis generally appropriate for a fee award under a fee shifting statute, in which the hourly charges are reduced or enhanced based on such relevant factors as the results achieved or the statutory objectives.

Hammer requested $1.22 million in fees. Because Hammer had proceeded on a number of contractual claims in addition to the minority oppression cause of action, the trial judge eliminated charges not clearly related to the theory on which he prevailed and expert fees that were not “adequately” explained.

The court noted that the fee was disproportionate to the recovery, but that under the cause of action afforded an oppresed minority shareholder, “a proportionality analysis is not applied to the detriment of a plaintiff seeking the protection of the statute.” The Appellate Division held that it was “constrained to agree given the OMS [oppressed minority shareholder] statute and the judge’s careful and detailed review of the billing records. He did not abuse his discretion.”

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Evidence of LLC Membership by Plaintiff MD is Lacking

EWhat is sufficient evidence of membership in a limited liability company? It is not uncommon that the intentions of the parties in forming a limited liability company are poorly documented and or non-existent.

The plaintiff in this case argued that documents that indicated his initial interest in the LLC were sufficient to establish his membership. These include emails in which he expressed his interest in participating in the LLC, the fact that he was included as a signatory in an early letter of intent with HUMC, the fact that he was initially included in an email group of members and the receipt of meeting notices.

Appellate Court Considers Evidence of LLC Membership in Ownership Dispute Among Critical Care Doctors

The Court rejected the argument, however, granting summary judgment. The appellate division affirmed in Ashtyani v. Critical Care Unit Res., LLC (N.J. Super. App. Div., 2017) in a case that construes what the prior limited liability company act meant by “records” of the company. We look at the case here and consider the limited liability company “entrance” rules under the prior statute N.J.S.A. 42:2B-1 et seq. and its successor, the Revised Uniform Limited Liability Company Act, N.J.S.A. 42:2C-1.

This case was decided under the old statute. We will take a look at how application of the new statute might well have resulted in a different outcome.

Formation of Limited Liability Company

The dispute at issue in this case grew out of the formation of a specialized medical group that was to provide the medical services for the intensive care and coronary care units at Hackensack University Medical Center (HUMC). The plaintiff here, Dr. Ashtyani, was one of the treating doctors at the hospital. Another physician organized a group of the intensive care physicians treating patients at HUMC to take over these services and quickly prepared a “statement of intent” given to the hospital providing that the group of physicians would immediately take over these intensive care services. The plaintiff was one of the doctors signing the letter.

One of the organizers formed a limited liability partnership was formed for the purpose of negotiating with the hospital. The Plaintiff attended several of its meetings and provided his social security number. After these meetings, a limited liability company was then organized, Critical Care Resources, LLC, and another request was circulated requesting names and social security numbers of those who would become members of the llC and requesting $2,000 each for legal fees. The plaintiff did not make his contribution. The other members ultimately decided not to include him in the new company both as a “disruptive” personality and because he did not have a board certification in intensive care..

Plaintiff Doctor Claims he was Wrongfully Expelled from LLC

Dr. Ashtyani brought suit claiming that he had been wrongfully expelled as a member interest in the limited liability company. He claimed that his signature on the original statement of intent and his inclusion on various email and various meeting notices were all company “records” that demonstrated his membership. He contended that the decision made by the other members to exclude him therefore amounted to expulsion The plaintiff relied on N.J.S.A. 42:2B-21(a) under the now-repealed Limited Liability Company Act:

[A] person acquiring a limited liability company interest is admitted as a member of the limited liability company upon the later to occur of

(1) The formation of the limited liability company; or

(2) The time provided in and upon compliance with the operating agreement or, if the operating agreement does not so provide, when the person’s admission is reflected in the records the limited liability company. (emphasis added).]

The court first considered whether the materials claimed by the plaintiff – including the emails, the letter to HUMC and the meeting notices. The trial court had held that these were not records of the LLC. This was an error, the appellate court concluded, relying on the Black’s Law Dictionary definition of record:: “1. [a] documentary account of past events . . . designed to memorialize those events; 2. [information that is inscribed on a tangible medium or that, having been stored in an electronic or other medium, is retrievable in perceivable form.”

The fact that these documents were a “record” did not resolve the issue favorably for the plaintiff, however.

[A]ccepting these writings as “records” does not mean plaintiff was ultimately admitted as a member of CCUR. The emails show that membership in CCUR was an ongoing discussion until September 2010. The emails exchanged between CCUR members reference meetings involving the LLC’s possible corporate structure. Some of the emails requested the requisite financial contributions and information from potential members. It was only in Dr. Ting’s [one of the organizers] September 12, 2010 email that the final request for acceptance of the operating agreement’s terms was offered to those wishing to become members. At this critical point, the record shows plaintiff requested a number of material changes to the terms and withheld his unequivocal acceptance. In fact, it is uncontroverted that plaintiff did not accept the terms agreed upon by a majority who voted to form the company.

Different Membership Rules Under Revised Uniform Limited Liability Company Act

The case demonstrates the necessity of being clear about who is and is not a member, as well as the role of the organizers. It is significant to note that the RULLCA expressly contemplates the activities of promoters. The new statute in effect since 2013, N.J.S.A. 42:C-31, provides for a different set of entry requirements.

In the case of a limited liability company with more than one member, the statute provides that admission is “as agreed by the persons before the formation of the company.” The limited liability company at issue in this case was formed well after the parties were well into the negotiations with the hospital and after the plaintiff had been offered and accepted a membership interest in the new enterprise. It was only after the plaintiff was directly involved in the early steps of the company that the certificate of formation was filed.

The issue under the old statute was whether references in the records trumped the failure to accept the operating agreement. The more interesting issue is whether the pre-formation agreement identifying who would be the members of the company – on this issue, the defendants conceded that the plaintiff was offered and had accepted a membership interest in the new entity – was binding on the company after it was formed. The trial court and the appellate division thought not, but under the language of the RULLCA, the outcome is not so certain. The statute gives effect to those agreements.

Pitfall for Organizers of New Limited Liability Companies

Under the new statute, the issue is what happens if individuals agree to form a limited liability company, organize the entity and then cannot agree on aspects of the operating agreement. Does the failure to agree give the limited liability company the right to move on without the dissenting member? Is the operating agreement formed by the members without the participation of the dissenting member bind the limited liability company?

The answer to both of those questions should be a resounding “no.” The better answer would seem to be that the failure to agree on the terms of the operating agreement has to be dealt with as a deadlock among existing members. On this issue, the statute provides for either a judicial dissolution – and all of the remedies available in such a proceeding – or the involuntary dissociation of the member.

Disputes about who is, or is not, a member are not unusual. Nor are the circumstances in which the parties form the limited liability company and then fail to execute an operating agreement.

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Shareholder Deadlock Grounds to Sell Corporation

Is an intractable deadlock among the shareholders good grounds to force the sale of a large, successful corporation? That was the issue before the Delaware Supreme Court in a case in which the trial court’s decision to sell the business as a going concern – over the objection of one shareholder –was affirmed by the Supreme Court.

In this case, a trial court’s ability to fashion and equitable remedy based on the circumstances of the case ran into direct conflict with the limited remedies that are available to minority shareholders under Delaware law.

Court Orders Sale of Corporation in Shareholder Deadlock

The decision in Shaw v. Elting is without controversy, with one of the justices writing a lengthy dissent arguing that the Court was overstepping its authority and the combatants hiring their own PR firms to spin their positions. Nor was it without its stars, including argument from celebrity Harvard Law Professor Alan Dershowitz and the appearance of various corporate litigation powerhouses to argue for the parties. The result, meanwhile, has resulted in an effort by some to preclude a court from forcing the sale of a solvent business.

The case pitted Philip Shawe and his mother Shirley Shawe against Shawe’s former fiancé and business partner, Liz Elting. Shaw and Elting started the global translation and communications business in a dorm room at a time when they were engaged. They built the business into a wildly successful enterprise, but later became the subject of a juicy, public corporate divorce, full of extraordinary intrigue. Experts testified at trial that the company could fetch $800 million or more at auction. Shaw had offered Elting $300 million for her interest, which she declined.

When mediation failed and the parties continued to be unable to reach any agreement, Chancery Judge Andre Bouchard appointed a custodian to take control of the business, sell it at auction and distribute the assets to the shareholders. Judge Bouchard also sanctioned Shawe for litigation behavior two months later imposing a multi-million fee award to Elting.

Remedy in Shareholder Deadlock Case

The fundamental issue was whether the court could, in a case in which there was no dispute about the nature of the deadlock, order the sale of a solvent company. (Delaware law does not give judges the authority to order one side of a dispute to sell to the other.) The Supreme Court affirmed the trial court’s decision, holding that the trial court did indeed have such a power as a last resort.

[I]n circumstances such as this, when intermediate measures were attempted but failed, the Court of Chancery properly exercised its discretion to sell the company and distribute the proceeds to deadlocked stockholders.

Transperfect is actually a holding company for dozens of subsidiaries. Its bylaws provided for three directors, but the third spot had never been filled. Shaw and his mother owned 50 percent of the shares; Elting owned the other 50 percent.

The Court affirmed the trial court’s finding that a deadlock existed and that the shareholders had been unable to fill the vacant board seat. It also affirmed the trial court’s finding that the deadlock presented the risk of irreparable harm to the company.

Appointment of Custodian in Oppressed Shareholder Cases

The issue, therefore, was whether the Court had exceeded its authority under Delaware G.C.L. § 226(a), which provides that “[t]he Court of Chancery, upon application of any stockholder, may appoint 1 or more persons to be custodians, and, if the corporation is insolvent, to be receivers, of and for any corporation [].”

Custodians, the Supreme Court noted, appointed for solvent corporations and receivers for insolvent corporations. Receivers are intended to marshall the assets of the business and oversee its liquidation. Custodians, normally, are intended to protect the ongoing business from harm.

The appointment of the custodian was not a major source of dispute. While Shawe objected to the appointment of the custodian because the company was not in danger of “imminent corporate paralysis,” the appellate court noted that the inability to elect a director was sufficient and, in any event,

Far from trivializing the irreparable injury requirement, the Court of Chancery accepted the fact that the Company was profitable, but also recognized the extremely dysfunctional relationship between the founders and its effect on all of the Company’s operations. If allowed to persist, the Company was likely to continue on the path of plummeting employee morale, key employee departures, customer uncertainty, damage to the Company’s public reputation and goodwill, and a fundamental inability to grow the Company through acquisitions.

Shawe argued that even if the appointment of the custodian was appropriate, the court erred in ordering him to sell the business. The Supreme Court affirmed the trial court’s interpretation of the statute as permitting such a remedy. The custodian has all of the powers of a receiver, the court noted, but

the authority of the custodian is to continue the business of the corporation, and not to liquidate its affairs and distribute its assets, except when the Court shall otherwise order …

The Supreme Court seized on the language “except when the Court shall otherwise order” to find that the trial court may order the custodian to sell a solvent business. This language, the majority held, was clear and unambiguous.

Rather than read the key language “except when the Court shall otherwise order” as having no significance, we read it consistently with the overall design of the statute, and its intention to allow our Court of Chancery the discretion to deal sensibly with corporations that are unable to move forward with governance because their owners cannot take fundamental action to elect a new board.

Similarly, the Court declined to adopt the argument that the court may have the power to sell assets, but not to compel the auction of the owners’ stock to a third party.

It is also not convincing to characterize the method chosen by the Chancellor as somehow different for purposes of § 226 because it involves a sale of the corporation’s stock, rather than its underlying assets. Stockholders of Delaware corporations are only entitled to the rights that come with their stock, and those rights are subject to the Court of Chancery’s power under statutes like § 226. Many Delaware statutes, including those dealing with certain mergers, subject stockholders to giving up their shares over their objection.

When a stockholder buys stock in a Delaware corporation, it knows that our statute provides the Court of Chancery broad authority to address corporate deadlocks of various kinds, authority that may well affect fundamental ownership interests. Stockholders buy stock in Delaware corporations to gain from the underlying operations of the corporation. It is therefore inconsistent with the practical and efficient design of corporate law in the DGCL, to require asset sales and liquidations, simply to allow stockholders to hold their paper shares and receive a final, and likely lower, liquidating dividend. Nor is it the case that sales of corporate assets or of the entire corporation are somehow unusual when the corporation in managerial deadlock is profitable.

Sale of Stock is Last Resort in Shareholder Dispute

Finally, the majority noted that the sale of the stock was approved only after other remedies had been pursued or eliminated. The appointment of a custodian to mediate had failed. The appointment of the custodian to serve as a third director would required to serve as a constant tie-breaker and monitor without any end. The solution of a sale protected the interests of the business, its shareholders and its employees, the majority held.

The dissent of Justice Valihura, however, focused on the distinction between selling assets in liquidation as a result of judicial dissolution and the sale of stock without shareholder consent. When Delaware law authorizes the court to compel an owner to sell stock, the dissenting justice noted, it does so specifically.

The sale in this case was overly intrusive, the dissent argued, because it forced shareholders to sell personal property without advance notice in the statute. The dissent argued that in every circumstance in which the shareholders may be forced to sell, shareholders have advance warning because the statute provides the specific remedy of a forced sale.

The opinions of the Delaware Supreme Court are persuasive to other states, and it is not uncommon that the liquidation of a corporation will provide the shareholders with much less value than the sale of the entity as a going concern. I would not be surprised to see this opinion cited in other jurisdictions for the proposition that a court’s powers are not limited to the sale of assets.

Oppressed shareholder actions arise under the general remedy of a minority shareholder being able to force a dissolution of the corporation. The rationale behind such a remedy was that it provided the means for the shareholder to secure the value of their investment. Over time courts have developed other remedies that avoid dissolution. The question now is how much the sale of the corporation as a going concern will become an accepted remedy.

New York’s Business Corporations Law, for example, permits the majority in an oppressed shareholder action under BCL 1104-a to purchase the aggrieved minority’s shares at fair value. That election under BCL 1118 can be made within 30 days of the petition.

Similarly, New York courts that have found good cause for a judicially ordered dissolution may order the sale of a party’s shares as a remedy, and it isn’t much of a leap to order the sale of the enterprise when the circumstances exist as an equitable remedy.

New Jersey law permits the court to order the sale of a party’s shares either to the corporation or to any other party. We are aware of one decision in which the Court authorized the sale of the entity as a going concern after the parties did not agree to a sale between themselves. (article here.)

Surprisingly, there is not a lot of guidance on the issue of whether the sale of an entity in its entirety is an appropriate remedy.

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Valuation of Corporation in Oppressed Shareholder Includes Marketability Discount

The general rule is that a court should not apply discounts for marketability or lack of control (the later known as the minority discount) unless there is some unfairness or wrongdoing among the parties. Still, in the world of oppressed minority shareholder litigation, there is always some allegation of wrongdoing, so the question of discounts, or not, is invariably part of the ruling in any court-ordered valuation.

A trial court in Union County recently applied a 25 percent discount in the purchase of a 50% share of a family business after a 35-day trial. The net result was that the defendant in the case took significantly less for the acquisition of his shares in a family owned business than might have been available if there was not a finding of wrongdoing. Parker v. Parker, Docket No. UNN-C-108-13 (Chancery December 22, 2016) The parties involved in a business divorce litigation need to be cognizant that the allegations of bad behavior may have a significant effect on the ultimate determination of value made by a court.

Discounts Reduce Value of Buyout in Family Business Dispute

This case involved two brothers, both of whom were in the plant business. Richard Parker was president of Parker Interior Plantscapes, which installs and services plants in commercial locations. His brother Steven was president of Parker Wholesale Florists, a wholesale plant business that was later transformed into a garden center. Richard and Steven each owned one half of both business and were a vice president in the other business that they did not manage. In addition, each owned 50 percent of the separate companies that owned the land and warehouse where the wholesale distribution center was located.

The Parkers ran their businesses from the same offices in Scotch Plains. Each generally ran their own business, but there were claims of misconduct and ultimately both filed suit to, as the judge commented, have the court “remedy every injustice they perceive has befallen them over the last 25 years.” Both claimed to be oppressed shareholders under N.J.S.A. 14A:12-7. The matter was ultimately tried by Judge Katherine R. Dupuis The trial court opinion is lengthy as it parses through the claims and counterclaims, but the net result is that after the trial the Court found that Steven was the culpable of the two. What is interesting is how that culpability played out in coming to a buyout value.

New Jersey’s corporate code contains an oppressed shareholder provision that permits an action to be brought by a minority shareholder alleging that “the directors or those in control have acted fraudulently or illegally, mismanaged the corporation, or abused their authority as officers or directors or have acted oppressively or unfairly toward one or more minority shareholders in their capacities as shareholders, directors, officers or employees.” The statute is very broad and can be applied to virtually any conduct by the controlling owners of a closely held corporation with less than 25 shareholders.

The remedies available to the oppressed shareholder include the involuntary dissolution of the corporation or the compelled purchase or sale of a shareholder’s interest. Typically, but not always, the oppressed minority shareholder brings an action in court to force the acquisition of his or her shares. It has occurred, however, that the minority has been granted the right to purchase the majority interests.

Oppressive Conduct Frustrates the Shareholder’s Reasonable Expectations

The touchstone of oppressive conduct is that it frustrates the minority shareholder’s reasonable expectation. This includes, of course, fraudulent or illegal behavior, or other types of clear misconduct. It can also extend to a right to hold employment or a deadlock that cannot be broken. In this case, the Court found that Steven’s loss of $500,000 a year for the prior five years and using money from the other business to cover the losses was oppressive conduct toward his brother Richard. The remedy for this oppression, the Court held, was that Steven would be compelled to sell his interest to Richard for fair value. The statute provides in N.J.S.A. § 14A:12-7 that

8) Upon motion of the corporation or any shareholder who is a party to the proceeding, the court may order the sale of all shares of the corporation’s stock held by any other shareholder who is a party to the proceeding to either the corporation or the moving shareholder or shareholders, whichever is specified in the motion, if the court determines in its discretion that such an order would be fair and equitable to all parties under all of the circumstances of the case.

(a) The purchase price of any shares so sold shall be their fair value as of the date of the commencement of the action or such earlier or later date deemed equitable by the court, plus or minus any adjustments deemed equitable by the court if the action was brought in whole or in part under paragraph 14A:12-7(1)(c).

It is important to understand the definition of “fair value,” how “fair value” differs from “fair market value” and how the two may be calculated. Fair value can be defined as fair compensation paid to the selling shareholder as consideration for his or her equity interest. It is different in concept from “fair market value,” which is the price that a willing buyer would pay a willing seller in an unforced transaction. There simply is no ready market for the selling shareholder’s shares. In reality, there can be significant overlap between fair value and fair market value.

Fair Value or Fair Market Value? There is a Difference

The biggest difference between fair value and fair market value is that fair market value will nearly always incorporate discounts for lack of control and lack of marketability. What that means in practical terms is that the valuation is reduced for the fact that it is difficult to sell a closely held company, and that a buyer in an arms’ length transaction will pay less for that interest. This reduction is the marketability discount. Similarly, a buyer will pay less for a minority interest because he or she cannot control the operations of the entity. Likewise, in many transactions, there may be a premium added to the interest of the controlling shareholder.

Fair value is meant to compensate the shareholder fairly. There are any number of techniques that a valuation may incorporate. These include comparable sales, applying a rate of return (known as the discount rate) to the net earnings of the company, valuing its physical assets or applying a multiple to its sales or earnings. It is extremely fact-based and the techniques will vary based on the individual circumstances of the case. It requires an expert analysis and typically the trial of a case involves a battle of the opinions of the competing experts. That was this case in the dispute between the Parker brothers.

Determining the value of a closely held corporation typically begins with the value of enterprise. That determination is case-specific and involves a number of factors, many of which are taken from IRS Revenue Ruling 59-60.

The nature of the business and the history of the enterprise from its inception.

The economic outlook in general and the condition and outlook of the specific industry in particular.

The book value of the stock and the financial condition of the business.

The earning capacity of the company.

The dividend-paying capacity.

Whether or not the enterprise has goodwill or other intangible value.

Sales of the stock and the size of the block of stock to be valued.

The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

Once the enterprise value has been determined, the question is then whether discounts will be applied, in particular the discount for lack of marketability. The general rule is that a marketability discount should not be applied in a fair value determination. The rationale is that a marketability discount unfairly benefits the purchasing shareholder who can buy the oppressed shareholders for less. It is a windfall that in many cases rewards the wrongdoer.

Bad Behavior Reduces the Valuation of a Shareholder Buyout

The application of a marketability discount is reserved for the extraordinary circumstances in which equity demands the application of a discount, and the law gives individual judges wide discretion to make that decision. Here, the court had determined that the defendant was the culpable party.

The court believes a marketability discount should be applied. The actions of defendant were the cause of the lawsuit. He cannot be rewarded by not applying this discount. In cases where the oppressing shareholder instigates the problems, as in this case, fairness dictates that the oppressing shareholder not benefit at the express of the oppressed.

The court then went on to apply a 25 percent marketability discount, reducing the value of the 50 percent interest from $778,000 to $583,000. The court did not apply any minority discount for lack of control, finding that the circumstances did not warrant the discount because neither party could be said to be a minority (both owned 50 percent)

The details of the calculations are beyond the scope of this article. The experts for both parties applied a capitalization rate (the interest rate appropriate for such an investment) but differed on both the earnings to which the rate should be applied and the earnings to be included. (One capitalizes income by dividing the income by the capitalization rate. A 10 percent capitalization rate applied to $10,000 yields a value of $100,000 — $10,000/.1)

Determining the Valuation Date

Much of the valuation differences termed on the date of the valuation. The general rule is that the fair value of a company in an oppressed shareholder action is determined as of the date of the filing of the lawsuit. The court, however may make any adjustments in value – up or down – that it deems equitable. The seller in this case argued that the value of various contracts entered into just two days after the lawsuit was filed should be incorporated in the valuation. The Court rejected this argument.

On the date that the lawsuit was filed, the court reasoned, the only corporate event that had occurred was the development of a money-losing prototype. The court noted that the decisions in which adjustments had been made were tied to the contributions of the parties. On this issue, I don’t think the court gave enough consideration to the fact that the plaintiff filed suit just two days before a major development. A result like this rewards the plaintiff who brings an action knowing that there are positive corporate developments in the works.

This decision is ample warning that there are few guideposts as to what types of conduct are sufficiently serious to merit the application of a discount. The court notes some circumstances in which a discount would not be applicable, e.g., a deadlock, but there is not a great deal of discussion about why or how the conduct rose to the level at which the purchase price should be reduced by a quarter. I see some good arguments as to why the discount was not fair, such as the plaintiff’s apparent acquiescence and the failure to establish that the problems in the wholesale business were not due to other factors.

The presumption is against a discount, but it may not be a particularly strong presumption. If you have any questions of these issues, feel free to contact us.

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How to Expel an LLC Member

Probably the most litigated issue in my practice involves the expulsion of a member of a limited liability in response to some wrongful conduct or breach of the operating agreement. We represent majority owners when they are trying to remove a member and we represent the minority member who is fighting removal. Not all states permit removal or expulsion – known as involuntary dissociation – for misconduct and some recent decisions indicate that in the states that do, it may be harder than once thought.

Involuntary Dissocation of a Limited Liability Company Member

There was a belief, perhaps unreasonably so, that Courts were unwilling to keep people in business together when plainly the owners were no longer capable of maintaining a working relationship. The New Jersey Supreme Court, in the first decision by any state supreme court on the topic, held that the concept of “not reasonably practicable” to stay in business together means more than personality conflict. It requires a structural inability to act, including deadlock or significant wrongful conduct.

In fact, the circumstances in which a court will intervene to remove a member or, in perhaps a more extreme circumstance, to dissolve the entity cover fall into a number of categories. First, it is important to note that the owners of a limited liability company can incorporate standards for the removal of members in their own operating agreement. These standards should govern except in the most extreme circumstances. Members can also voluntarily dissociate themselves by giving “notice of the person’s express will” to withdraw as a member. Usually, this is a written notice of withdrawal, but it can take other forms such as the approval of an amendment to the LLC’s certificate of formation.

Even without an express provision in the operating agreement, a member may be dissociated from the limited liability company if there is a change in its status. These status-based changes vary by state and will include the bankruptcy or other actions seeking protection from creditors, receivership, transfer of all of the member’s interest to a third party (other than as security or under a court’s charging order), death, merger or the dissolution of a trust that holds the membership interest. Some states permit the dissociation of a member by vote of the members when it has become unlawful to continue the LLC with that person as a member.

Courts May Order Expulsion of LLC Member

These status-based criteria for dissociation generate less controversy than the cases involving the bad behavior of members. Events like bankruptcy or dissolution of a trust are circumstances for which it is relatively easy to plan. Operating agreements also typically include boilerplate provisions that give the members little discretion about how to respond.

The conduct-based grounds for dissociation, which commonly involve some claim of a breach of duty, wrongful conduct or a deadlock that prevents the LLC from continuing normal operations, tend to be far more controversial. These are the circumstances that will pit family members against family members, disrupt long-time business relationship and often make it difficult, if not impossible, to continue the status quo.

Assuming that there is no express language in an operating agreement governing the standards for dissociation based on alleged misconduct – and there rarely are – the parties must be guided by statutory standards.

Standards for Involuntary Dissociation from a Limited Liability Company

These standards come from the Uniform Limited Liability Company Act. For example, New Jersey’s statutory criteria are set out in in N.J.S.A. 42:2C-46 provide three circumstances in which the court, on application by the LLC, may order the expulsion of the LLC member.

Wrongful conduct. The individual’s wrongful conduct has “adversely and materially” affected, or will adversely and materially affect, the company’s activities;

Breach of contract. The individual has “willfully and persistently” or is willfully and persistently committing, a material breach of the operating agreement or their duties or obligations as a manager or member of the LLC;

Not reasonably practicable. The individual has engaged, or is engaging, in conduct relating to the company’s activities which makes it not reasonably practicable to carry on the activities with the person as a member.

The New Jersey statute adopts the criteria of the Revised Uniform Limited Liability Company Act (RULLC) § 601. The RULLC has been adopted in 17 state jurisdictions and the District of Columbia.

Other limited liability company statutes do not provide for the expulsion of individual members. These statutes, Delaware and New York being the best-known examples, provide for the dissolution of the LLC as the sole remedy when it has reached a level of dysfunction that impairs its operations. New Yok courts, however, have found that if there are grounds to dissolve the entity, then the court has the option, if circumstances merit, of ordering the sale of a membership interest.

There are similarities and differences in both approaches. New York and Delaware do not provide an oppression remedy (By oppression, I include the broad category of wrongful conduct that majority owners may inflict on minority owners.)

On the other hand, all of the other statutory schemes permit a Court to intervene when the company has ceased to function in an acceptable manner. The difference is that the limited remedy states permit Court to compel the company to dissolve, i.e., to cease normal operations, and to begin winding up its affairs. (The general topic of judicial dissolution is beyond the scope of this article.)

The states applying the Uniform Limited Liability Company Act are modeled on partnership law and permit the removal of one of the members in the right circumstances. They also grant the courts very broad discretion to find a remedy that suits the circumstances of the case.

Wrongful Conduct as Grounds for Dissociation

The Revised Uniform Limited Liability Company Act (RULLCA) provides that a persona may be dissociated if they have engaged in wrongful conduct that has adversely and materially affected, or will adversely and materially affect the company’s activities. The scope of conduct that has been included in the purview of the act has included such things as misappropriation of assets or opportunities, competition with the company, or generally a breach of the duties of loyalty. It could involve, for example, a one-sided transaction favoring a controlling member or manager. Or it might involve the misuse of proprietary information.

The key issue in considering the “wrongful conduct” that would constitute grounds for dissociation is that the offending member or manager had some control over the interests or welfare of others. Members in a manager-managed limited liability company, like shareholders in a corporation, have now inherent right to participate in the decisions or day-to-day activities of the business. It is only when management is vested in the owners, whether managers or shareholders, that they are required to look after the interests of others. In other words, when a member (or member acting as a manger) has a fiduciary duty to the company or the other members, his wrongful conduct may be grounds for dismissal.

The reason for this is that the modern presumption for a limited liability company is that if the company has managers who have responsibility for the business decisions, then the members as members have a legal right not to trouble themselves with the interests. A limited liability company is, after all, a creature of contract and we do not presume that the parties to a contract owe each other any duty other than to fulfill their obligations under the contract according to the letter of the agreement.

Breach of Contract as Grounds for Dissociation

A limited liability company is, as we often write, a creature of contract. One of the fundamental principles underlying the law of LLCs is that the members of a limited liability company should be free to order their own affairs as they see fit, and that whatever agreement they may reach should be put into writing. That being the case, it should not be too surprising that a past or present breach of the agreement of the parties may well be grounds to expel the offending member.

In many jurisdictions, the agreement has been defined by the written agreement that the parties themselves have executed. In New Jersey, for example, there was good authority that a claimed oral agreement between the parties was of no effect; only written agreements mattered. That model went out the window with the RULLCA’s acceptance of any agreement or course of conduct as binding the parties.\

We have litigated persistent breach cases that involved a failure to repay loans, not honoring capital requirements and not honoring commitments to segregate responsibilities among the members. Here again, a court will look at the materiality threshold and the effect on the other members.

Not Reasonably Practicable

The final statutory grounds for expulsion is what is arguably a catch-all provision, but which in fact seems to encompass much of the messy, human behavior that can bring an end to a working relationship among the co-owners of a business. The RULLCA, for example, provides that past or present conduct that makes it not “reasonably practicable” for the LLC to continue with that person as a member is grounds for involuntary dissociation.

Courts have been relatively uniform in holding that the “not reasonably practicable to stay in business together any longer” criteria does not require culpable conduct. Deadlock for example, may be the result of two competent, well-meaning owners who are at loggerheads over some issue. We have seen it when one side refuses to participate in a capital call, or to honor an agreement, or to participate in management.

But what is not reasonable practicable? Does it mean that the parties don’t speak anymore, that they no longer rule by consensus? Does it apply, for example, to a refusal to accept – or share – management authority? Does it require more.

Not Reasonable Practicable is a Structural Impediment

We generally will see the not reasonably practicable standard invoked in two circumstances. The first is in connection with the potential judicial dissolution. The second is in connection with the removal of a member. I thought they were different, but it is turning that not reasonable practicable has a more uniform interpretation that I thought.

Delaware and New York, for example, allow a court to order the dissolution of a limited liability company when it is “not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” Del. Limited Liab. Co. Act. § 18-802. New York law is similar. In the seminal case under New York law, In re 1545 Ocean Ave., LLC, 72 A.D.3d 121 (2d Dep’t 2010), the court held that judicial dissolution was an extreme remedy that was not triggered by the exclusion of one member from the management of the company – at least not as long as the company continued to operate successfully.

The standard is that the limited liability company is either unable to function – as in the case of deadlock – or it is failing financially. The Ocean Avenue court articulated the standard as “for dissolution of a limited liability company pursuant to Limited Liability Company Law § 702, the petitioning member must establish, in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.”

Some courts saw it as a looser standard when it came the dissociation of a member. The two decisions that have considered the issue have looked at the reasonably practicable as meaning not feasible despite reasonable efforts. Disagreements, disputes and even deadlock that does not prevent decision making on key issues were sufficient. See Supreme Court Sets Standard to Expel Member from Limited Liability Company.

Equitable Dissociation of an LLC Member

New York courts have fashioned a hybrid remedy under which a court may, in its equitable discretion, force out a member of the limited liability company. It is a two-step process. When the plaintiff has established grounds for judicial dissolution, the court may order the sale by a minority to the majority members.

Exactly what circumstances would justify a sale are not clear, but it is likely that the threshold issue is whether there is otherwise good ground to dissolve the company. Such sales are referred to as being in aid of dissolution or a means of dissolution.

After Dissociation, what are the Former Member’s Rights?

Dissociation as a member does not automatically entitle a member to sell his or her shares. On the contrary, unless a court orders otherwise, under the RULLCA, the member becomes a transferee. What that means is that the former member still has a right to maintain their economic interest and receive distributions when they are made.

The former member, as transferee, has not management rights, however, no right to receive information and quite possibly no right to object to changes to the operating agreement that dilute their interest.

The RULLCA provides that a court may order the dissociated member to sell the interest at a value determined the day before the effective date of the dissociation. The statute also provides that in cases of oppressive conduct, the court may order any party, at any time, to sell to any other party.

The fact is that most serious business divorces end with one side purchasing the interest of the other side, usually at something known as fair value. The question, almost invariably, is what is a fair price.

If you have a question on the expulsion or removal of a member or manager, please feel free to contact us.

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Limited Liability Company Owners Personally Liable to Creditor

We counsel many owners of limited liability companies that the filing of a Certificate of Formation does note automatically protect the owners from person liabilities. There are a number of business practices, often referred to as the “corporate formalities” that should be followed.

A case from Iowa’s Court of Appeals illustrates this principle, in which the court affirmed the finding of a trial court that the owners of a limited liability company were personally liabile for $235,000 owed to a supplier. Keith Smith Co. v. Bushman, 873 N.W.2d 776(Table), 2015 WL 8364910(Table) (Iowa App., 2015).

The supplier claimed that the defendant was essentially a shell company with inadequate capitalization. The trial court agreed and the appeals court affirmed.

In the instant case, neither Duane Bushman nor Shirley Bushman provided any capital whatsoever for the start up of Farmer Grown Poultry. Its only revenue was a $2000 loan from a Bushman-related entity. As debts were incurred, Bushman-related entities would lend money to Farmer Grown Poultry for payment on its debts. Farmer Grown Poultry did not have any assets itself. Duane Bushman entered into a contract with Keith Smith, on behalf of Farmer Grown Poultry, to purchase hatching eggs. He entered into a contract that provided payment would be made to Keith Smith within 21 days of receiving the eggs. However, Farmer Grown Poultry, at best, would not receive any income for at least 10 weeks, when the birds could be processed and sold. Farmer Grown Poultry continued to accept eggs from Keith Smith in spite of the fact Custom Poultry Processing failed to become operational until December 2010. Farmer Grown made no attempt to request Keith Smith stop egg deliveries and seek another purchaser. This could have reduced Keith Smith’s loss.

The Court concludes the “corporate veil” of Farmer Grown Poultry, a limited liability company owned by Duane Bushman and Shirley Bushman, should be pierced and personal liability be imposed on Duane Bushman and Shirley Bushman.

To not hold the individual owners of the limited liability company personally liable, the appellate court held, “would promote an injustice to the creditor.”

Entrepreneurs and business owners often elect to create a formal business entity, such as a limited liability company (“LLC”), to shield themselves from personal liability. In other words, they create such an entity to ensure that if an adverse court judgment is entered in relation to the business’ activities (e.g. breach of contract; slip & fall; infringement, etc.), the judgment is solely collectible against the LLC and not against the individual owner(s) in their personal capacity.

A recent Iowa Court of Appeals case illustrates that limited liability is not an “automatic” benefit conferred upon business owners when creating an LLC. Specifically, the Iowa Court of Appeals determined that while business owners may set up a new entity (e.g. LLC), creation alone is not the only factor a court will assess when determining whether a business owner may be personally liable. In rendering its opinion, the Court identified six different factors a court may consider when determining whether to hold a business owner in an LLC personally liable: Factors that would support such a finding include [whether] (1) the corporation is undercapitalized; (2) it lacks separate books; (3) its finances are not kept separate from individual finances, or individual obligations are paid by the corporation; (4) the corporation is used to promote fraud or illegality; (5) corporate formalities are not followed; and (6) the corporation is a mere sham. Keith Smith Co. v. Bushman , 873 N.W.2d 776 (Iowa Ct. App. 2015)

While no one factor is determinative, these factors illustrate various […]

See When Owners in an LLC Are Personally Liable

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mcdaniellaw-blog · 8 years ago

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Unanimous Consent of LLC Members Not Required to Continue Company

It may take a unanimous action of the members of a limited liability company to dissolve the entity or to change the date on which the company will dissolve according to the terms of its operating agreement. But unless the Operating Agreement specifically requires the members to act unanimous to extend the company, a simple majority may suffice.

That was the holding of the New Hampshire Supreme Court in McDonough v. McDonough, a case in which one of the members of this family business attempted to enforce a dissolution provision in the operating agreement to force the purchase of his shares.

Limited Liability has Limited Term of Existence

The limited liability company’s operating agreement provided that the company would have a term, and that it would dissolve on September 2015. Brother Patrick wanted the company to dissolve, but the other two brothers Matthew and Patrick voted pursuant to a provision in the operating agreement to extend the life of the LLC. The clause at issue provided that “The Company shall have a term beginning on the date the Certificate of Formation is filed . . . and shall continue in full force and effect for a term of twenty (20) years, unless sooner terminated or continued pursuant to the further terms of this Agreement.”

Limited liability companies do not contain a termination date unless the operating agreement or certificate of incorporation so provides. The members in many states can include a specific term as part of the certificate of formation but apparently did not do so in this case.

The minority brother, meanwhile, argued that unanimous consent of the members was required. Because the operating agreement provided for a specific date of dissolution, he contended, any change in that date constituted an amendment to the operating agreement. Both parties moved for summary judgment.

Court Distinguished Operating Agreement from Certificate of Formation

The Court drew the distinction between the Certificate of Formation, which puts the world on notice that the company is operating as an LLC, and the operating agreement, which defines the relationships between the parties. The legislature had not specifically provided that the continuation of a limited liability company beyond its expiration date would require a unanimous vote, so the Court turned to the language of the operating agreement.

The Court reasoned that the statute specifies the decisions that must be made by a majority and those for which a simple majority is sufficient, and held that it did not resolve the dispute. Applying the terms of the operating agreement, the court reasoned, there was no indication that a unanimous vote was required.

The minority brother also argued that he was now bound to his brothers for as long as they continued to extend the life of the company, since there was no way for him to retrieve his investment. The court did not reach the issue of what might be a reasonable remedy for that complaint, if any, because it was not adequately preserved below.

The result might have been different under some other statutes. The Revised Uniform Limited Liability Company Act, as adopted in New Jersey, requires unanimous consent for acts “outside the ordinary course of the company’s activities.” N.J.S.A. 42:2C-37. See Model Act § 40(c)(3)(A). Under New York and Delaware law, meanwhile, permit a dissolution or merger of an entity by a simple majority, but are silent about acts outside ordinary realm of the company’s operations and do not contain language that would appear to prevent a similar result.

Of court the members of a limited liability company can agree on any procedures for dissolution, or for continuing the limited liability company.

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Good Faith and Fair Dealing Required Disclosure of Conflict

The modern trend is business relationships is to allow the owners of an enterprise to contract among themselves in almost any manner they choose and order their own affairs as they see fit. We see this in the law of a number of influential states, particularly Delaware, and in the model partnership and limited liability company acts.

Obligations of Good Faith and Fair Dealing in Partnership Agreements

One of the principles underlying this “contractarian approach” is that the owners of a business can decide for themselves what fiduciary duties they will owe among each other and to the entity. In virtually every case, it is a limitation of those duties, and most often in the context of a limited liability company or a partnership.

The contract between the parties has limits, however, and the majority or controlling interests’ reliance on those contractual limitations must still be consistent with the generally nonwaivable duties of good faith and fair dealing that are a core aspect of contract law.

Duty of Controlling Interests to Disclose Conflict of Interest

That was the case in a decision of the Delaware Supreme Court Dieckman v. Regency GP LLC, et al. , No. 208, 2016 (Del. Jan. 20, 2017) in which the Court held that the manner in which the controlling interests had applied certain “safe harbor” provisions, even if they complied with the letter of a limited partnership agreement nonetheless were actionable because they did not meet the parties’ obligation of good faith and fair dealing.

The case involved a publicly held limited partnership and the essential allegations asserted that the general partner had failed to disclose conflicts of interest. The defendants moved to dismiss, arguing that their conduct fell within the four corners of the safe harbor provisions. These provisions provided for “special approval” by a conflict committee, among other measures.

Delaware Supreme Court: Some Contractual Duties are so Obvious They are not Included in the Agreement

The Supreme Court held, however, that the plaintiffs had at least at the pleading stage stated a claim that the process was manipulated in bad faith and that, regardless of the text of the safe harbor provisions, they had a claim for non-disclosure of the nature of the conflicts.

We find that implied in the language of the LP Agreement’s conflict resolution provision is a requirement that the General Partner not act to undermine the protections afforded unitholders in the safe harbor process. Partnership agreement drafters, whether drafting on their own, or sitting across the table in a competitive negotiation, do not include obvious and provocative conditions in an agreement like “the General Partner will not mislead unitholders when seeking Unaffiliated Unitholder Approval” or “the General Partner will not subvert the Special Approval process by appointing conflicted members to the Conflicts Committee.” But the terms are easily implied because “the parties must have intended them and have only failed to express them because they are too obvious to need expression.” Stated another way, “some aspects of the deal are so obvious to the participants that they never think, or see no need, to address them.”

The Revised Uniform Liability Company Act (RULLCA) now enacted in 17 states and the District of Colombia takes an approach that is not unlike that adopted by the Delaware Supreme Court with regard to the partnership. The statute permits the Operating Agreement to alter fiduciary duties of loyalty and care in for “manifestly unreasonable.” It also permits parties to the Operating Agreement to set standards for the duty of good faith and fair dealing. (An example of these limitations is found in N.J.S.A. 42:2C-11.)

Similar standards are found in the Uniform Partnership Act § 105 and the Uniform Limited Partnership Act §110. They represent part of the broader trend in business entities (other than corporations) to permit the parties to narrow or in some ways even eliminate the traditional fiduciary duties that have traditionally been a part of our business law.

What the Delaware Supreme Court case identifies are some of the limits of the doctrine, not in the scope of carve-outs from traditional fiduciary duties, but from basic concepts of good faith and fair dealing among parties in business together. The Delaware Court saw it as very significant that the controlling interests had put together an extensive disclosure document, but failed to clearly articulate the conflicts of interest.Carl Neff at Fox

Carl Neff at Fox Rothchilds blog on the Delaware Chancery Court brought this case to our attention.

A recent Delaware Supreme Court decision, Dieckman v. Regency GP LLC, et al. , No. 208, 2016 (Del. Jan. 20, 2017), the High Court reversed the Court of Chancery and upheld claims based upon breach of the implied covenant of good faith and fair dealing. The decision is noteworthy because the limited partnership agreement disclaimed fiduciary duties, and provided for conflict resolution safe harbors which defendants asserted were met. However, the manner in which such safe harbors were obtained doomed defendants’ reliance upon the same.

Background

The plaintiff is a limited partner/unitholder in the publicly-traded master limited partnership (“MLP”). The general partner proposed that the partnership be acquired through merger with another limited partnership in the MLP family. The seller and buyer were indirectly owned by the same entity, creating a conflict of interest.

The general partner sought refuge in two safe harbor conflict resolution provisions contained in the limited partnership agreement: “Special Approval” of the transaction by an independent Conflicts Committee, and “Unaffiliated Unitholder Approval.” The former requires approval by a special committee independent of the sponsor and its affiliates review and make a recommendation to the board whether to approve the transaction. The latter requires approval by a majority of unitholder unaffiliated with the general partner and its affiliates. Under the Limited Partnership Agreement (“LPA”), if either safe harbor is satisfied, then the transaction is not a breach of the agreement.

Plaintiff brought a petition before the Court of Chancery challenging the propriety of the transaction. Plaintiff […]

See Delaware Supreme Court Addresses the Implied Covenant of Good Faith and Fair Dealing

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Employee Termination Without Cause May Limit Enforceability of Non-Compete Agreement

Litigating with a former employee for violation of a restrictive covenant agreement becomes more complicated when the former employee was terminated without good cause. And because we are an at-will employment economy, this becomes an issue more frequently than one might imagine.

As one author notes, it typically is not the underperformer who creates a problem for their former employer. It’s the superstars, of course, that threaten to walk out the door not because they were fired but because they plan on taking a big chunk of business.

Include Poor Performance as Grounds for Termination

Nonetheless, the failure to include poor performance as “cause” for termination might be a fatal error to enforcing a restrictive covenant against a former employer with access to confidential information and the ability to compete unfairly with the former employer. Competitors have been known to hire ex-employees of a competitor less for their skills than for what they know about the other side.

In New Jersey, enforcement of a restrictive covenant involves a balancing of interests, part of which is the hardship brought on the employee if the agreement not to compete is upheld. A termination without cause will likely be a factor in the court’s analysis.

Employers Often Define ‘Cause’ Too Narrowly

“Many employers limit themselves by too narrowly defining ’cause’ in their agreements. In many instances, the definition of “cause” for terminating employment used by the employer focuses on various forms of employee misconduct, e.g., for theft, embezzlement, commission of a criminal offense, violation of a company policy, or conduct harmful to the organization’s reputation,” say Douglas Mishkin and Ronald Taylor is a recent post on enforceability of restrictive covenants.” The failure to include bad performance as cause, they warn, can open the door to competition.

Although the arrival of the new Administration moots the Obama White House’s recent “State Call to Action on Non-Compete Agreements” addressing that administration’s concerns about non-compete agreements in the workplace, the fact remains that non-competes are governed by state law, and that some of the issues raised in the “State Call” will remain with us.

One such issue is the enforcement of non-competes against employees who are terminated without cause. For example, some courts have found that an employer has no legitimate business interest in enforcing a non-compete when the employer terminates an employee without cause. Politics aside, this is a concern that employers can address so as to enhance their odds of enforcing a non-compete.

Many employers limit themselves by too narrowly defining “cause” in their agreements. In many instances, the definition of “cause” for terminating employment used by the employer focuses on various forms of employee misconduct, e.g., for theft, embezzlement, commission of a criminal offense, violation of a company policy, or conduct harmful to the organization’s reputation. “Cause” frequently does not include poor performance. As a result, an employee who is terminated for poor performance is, by definition, terminated without cause within the meaning of the agreement. In states like New York or Montana, that poorly performing employee, who was required to sign a non-compete for the same, legitimate reasons as other employees, would be free to compete upon termination.

Sometimes that’s not a problem, because as a practical matter a poor performer is simply not someone you need […]

See Rethinking “Cause” May Enhance the Enforceability of Your Non-Compete

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mcdaniellaw-blog · 8 years ago

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Company Must Indemnify Former Director for Fees Owed under Oral Agreement

The potential liability of a director for attorney’s fees is what determines whether recoverable litigation expenses are due under the indemnification provisions of Delaware law, the Chancery Court holds.

The expenses at issue were incurred in litigation that wound its way through state and federal courts in Illinois for nearly a decade, including a bankruptcy. The Plaintiff in Dore v. Sweports, Ltd, C.A. No. 10513-VCL (Del. Chancery January 31, 2017) was a former director and investor in Sweports, who was ousted in a dispute with the other directors and locked out of the business. A significant component in the lawsuit involved the services of the law firm that was general counsel and also represented the plaintiff in some of the underlying litigation.

Court Awards Expenses Incurred Under Oral Agreement to Defend Counterclaims by Corporation Against Former Director

The litigation history is tortured, and the court rejected large blocks of fees and expenses sought by the plaintiff as not covered by the company’s indemnity obligation or not reasonably incurred, awarding some $241,000 of approximately $1.2 million that was sought in the case. It also awarded approximately $80,000 for the costs of pursuing the action to secure indemnity.

The case is notable for the manner in which it dealt with the issue of attorneys’ fees that were then unpaid, but for which there was an arguable liability under an oral agreement to pay normal hourly rates in defense of counterclaims made Sweports in lawsuits brought by Dore. It is also noteworth that the court construed language used in the corporations statututes of many other states.

Permissive Rights of Indemnification

Delaware law provides corporations with the power to indemnify individuals in any matter in which the person is brought “by or in the right of the corporation” in matters in which “the person acted in good faith and in a manner the persona reasonably believed to be in or not opposed to the best interests of the corporation.” DCGL § 145(b)

A corporation shall have power to indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the corporation to procure a judgment in its favor by reason of the fact that the person is or was a director, officer, employee or agent of the corporation . . . against expenses (including attorneys’ fees) actually and reasonably incurred by the person in connection with the defense or settlement of such action or suit if the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation

Mandatory Obligation to Indemnify Director

The statute in DGCL § 145(c) makes that indemnification mandatory if a former officer or direct has successfully defended the case.

To the extent that a present or former director or officer of a corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in subsections (a) and (b) of this section, or in defense of any claim, issue or matter therein, such person shall be indemnified against expenses (including attorneys’ fees) actually and reasonably incurred by such person in connection therewith.

The defendants in the action argued that the “actually and reasonably incurred” requirement had not been met because plaintiff’s attorneys were engaged on a contingent fee basis. The defendants argued that based on the Delaware Supreme Court’s opinion in Scion Breckenridge Managing Member LLC v. ASB Allegiance Realty, 63 A3d 665 (Del. 2013) that contingency fee payments were not recoverable. The court held there that the reimburse and incurred requirement “clearly and unambiguously indicate that [the plaintiff] must have been liable for a payment at some point.

Corporation Must Indemnify Director for Obligation Incurred under Oral Agreement

The defendants argued that there was no agreement to pay the plaintiff’s law firm to defend the counterclaims, that “as a practical matter” the law firm would not seek recovery and that it had not invoiced the plaintiff for those costs. Plaintiff countered that he had an oral agreement to pay the law firm’s hourly fees and disbursements if the lawsuit to recover fees was unsuccessful, which is an enforceable contract under Illinois law.

Given this record, the plaintiffs have an enforceable oral contract with the Law Firm. They incurred the amounts for which they seek indemnification in the sense that the Law Firm has a legal right to recover from the plaintiffs the amounts that the plaintiffs sought in this proceeding to the extent Sweports does not pay them. This decision has held that Sweports has no obligation to pay a substantial portion of the amounts that the plaintiffs originally sought. The plaintiffs have a legal obligation to pay those amounts to the Law Firm, just as they would be obligated to pay the amounts that Sweports must indemnify. The fact that the Law Firm has fronted the amounts to date does not prevent the plaintiffs from seeking to recover from Sweports.

The opinion gives some guidance on how to structure a fee arrangement when the law firm has advanced its own time and expenses. A contingent fee arrangement is risky, since it could be a bar to a statutory provision. The concept that indemnity covers expenses “incurred” is not unique to Delaware law.

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