When two new clients recently came in to have an Operating Agreement prepared for their newly created LLC, they indicated that they had read my website. Since I had experience in litigating shareholder disputes, they wanted to know how to make a “bulletproof” Operating Agreement, so that there would never be litigation if they disagreed over an issue.
We spent a considerable amount of time trying to come up with a dispute resolution mechanism, but they could not agree on a third party to decide any significant disputes if they ever had one. The only person they both trusted was a minister, but they did not want him making business decisions on their behalf.
After going several rounds trying to figure out how to contract against every possible contingency, they finally realized that what I told them in the first meeting we had was correct – you can’t possibly guard against, and contract around, every single contingency. The best you can do is limit the odds of such litigation by making the agreement as fair to everyone as possible.
We came up with the idea of creating spheres of expertise for both of them and ensuring that the other was comfortable ceding control over such area. For example, at the end of their negotiation, one of them had the final word on all matters relating to sales and marketing, while the other had final say on personnel, staffing and salary issues. They also agreed that, if they could not agree on something truly major – like whether they should construct a new facility instead of leasing, or whether to expand the company – the business partnership likely would not work in the long run if a solution were forced upon them from the outside.
The compromise reached was, if one of them wanted to undertake a major change (like expansion) and the other did not, the one who wanted to take action had the right to buy out the other at fair market value.
As a shareholder dispute litigator, I found it truly refreshing that these two business owners found a way to contractually limit, as much as possible, the risk of costly litigation in the future. By taking the time to really think through these issues at the outset, and spending just a few thousand dollars in legal fees, they went a long way toward ensuring that they would not some day have to spend hundreds of thousands of dollars on shareholder dispute litigation.
If everyone thought through these issues as carefully as these clients at the outset, shareholder dispute litigators would be all but out of business.
Many times, two 50% owners possess different areas of expertise and separate spheres of influence. For example, it is not uncommon for one business partner to be in charge of sales, with the other in charge of finances. Because of this, one person often has more contacts than the other. Presumably, but not necessarily, the shareholder in charge of sales will have more customer contacts than the one who runs the front office.
This often leads to a misunderstanding about what happens in the event of business divorce litigation, or even voluntary separation. For example, in one recent case, a 50% shareholder who was in charge of sales believed the customer contacts were “his,” and that he could take them with him to a new, competing company. While he might have been able to do so after tendering his shares (and thus no longer owing a fiduciary duty to the company, or his co-owner), he did not realize that doing so would substantially impact the value of his shares.
For example, if he were bought out, his 50% interest in the company would have been worth $X. However, by taking “his” clients to a new company, he took a substantial portion of that value with him. As a result, he was entitled to substantially less than $X for his shares.
In another case, one shareholder left the business and simply started soliciting “his” customers (again), not realizing that doing so violated 1) his fiduciary duty (since he was still a shareholder), and 2) the restrictive covenant contained in his Shareholder Agreement.
It is one thing to believe that you have certain rights if you have confirmed your belief with an attorney. But these owners both put themselves in bad positions by acting on their faulty beliefs, then seeking legal counsel after the fact. Please save yourself tens of thousands in legal fees and ask for business divorce advice up front. If it’s too late, and you are already in shareholder dispute litigation, seek counsel from someone who handles such matters routinely.
As many of you have read here before, the New Jersey Limited Liability Company Act now includes recovery for minority member oppression. Those remedies cannot be waived, as a matter of law. However, the parties to an LLC’s operating agreement (or a corporation’s shareholder agreement) can agree to an alternate dispute resolution (“ADR”) mechanism in advance, impacting the forum in which these issues will be decided.
Many people are familiar with the most common form of ADR – arbitration. However, even this familiar procedure has different permutations. Many clauses say that disputes will be resolved in arbitration, but if you specify that the rules of a certain organization will apply (such as the Arbitration Association of America), you may get more than you bargained for. Many people do not realize that a clause that says nothing more than “arbitration under the AAA” may mean a panel of three arbitrators, not one. So, while a New Jersey court provides plenty of judges – for free (well, at least paid for by the taxpayers) – an arbitration election could require that you pay a proportionate share of three paid arbitrators.
People often use another remedy to resolve disputes and break deadlocks in closely-held businesses, namely agreeing to appoint a trusted third party who will make such decisions. However, I have yet to see such a provision actually work. If you do not agree in advance on who the person should be that makes such decisions, it usually means that you could not identify such a person when you drafted the agreement. What makes you think things will be different now? Can you really find someone qualified to make decisions in your industry that does not already work in it? (If he already works in it, it could mean that you just appointed a competitor to resolve all disputes over how your business should operate.) What happens when you and your business partner cannot agree on the identity of such a third party? Will a fourth party help you pick such a third party?
These issues may apply to any litigation, but business disputes in closely held businesses are particularly ripe for being decided by way of ADR. Shareholder dispute litigation is vastly different than a fight with a vendor over payment terms. If the business partners are fighting over the very manner in which the company should be run, delays and a lack of a clear company direction could be fatal, as more than one business has died before a shareholder dispute trial could be scheduled. At the outset of a business relationship, the business partners should sit down with an attorney well-versed in ways to avoid business dispute litigation, and discuss ways to streamline the process that make sense in the event a serious dispute becomes wholly unavoidable.
When majority shareholders want to force a minority owner out of the company, there are a variety of means for doing so. One of the most popular methods is the unnecessary capital call.
One recent case involved a client who was a part owner of a corporation that seemed, on the surface, to be in need of money. In reality, the majority owner was “in need” of “getting rid” of the minority shareholder (my client) to solidify his control over the company. The majority shareholder engineered a capital call, knowing full well that my client would be unable to raise enough cash to increase his already hefty investment in the company. As a result, my client was diluted from a one-third owner to a nine percent shareholder. He was ready to accept a meager payment for his shares when he came in for a consultation.
A forensic accountant discovered in his review of the company’s books and records that the majority owner was siphoning money out of the company. As a result, he essentially met the capital call with money taken in the form of substantial overpayments to himself, and illegal reimbursement of hundreds of thousands of dollars worth of purely personal expenses.
When it became apparent to the majority owner’s counsel what his client had done, the settlement offer increased several multiples, and a lengthy and expensive litigation was largely avoided.
The most amazing part of this case is that my client started out believing that he had no rights whatsoever. The majority shareholder had issued a capital call, which my client knew to be a perfectly legitimate mechanism to raise money, but he had no money to contribute. Having an experienced business divorce attorney review the facts before he made a fateful decision made all the difference in the world to him.
In my last post, I wrote about the fact that your right to simply withdraw from a New Jersey LLC and be paid fair market value for your shares – provided the Operating Agreement does not prohibit this – is being eliminated on March 1, 2014. Many readers of that post have contacted me, hoping there was a way to extend that deadline. Unfortunately, it cannot be extended. The amendment to the LLC Act is already “on the books,” and takes effect on March 1st. There is simply no way around this.
What many of these clients have in common is that they believe they MAY be being taken advantage of by the majority owners, but they are not sure. What if you find yourself in this situation? What is the best course of action? Should you withdraw from the LLC while you can, and just be paid for your interest? Or should you hold out and see how things go, and whether things get any better?
Obviously, that is a very personal and individual decision that each client must make on his or her own. But there is one thing everyone making this decision needs to keep in mind. If you are reading this post, you have already decided that there is a significant enough issue to cause you to explore legal representation. If you have only suspicion that the majority owners are engaged in wrongdoing – but don’t yet have the proof – the trust relationship has already been eroded, if not completely destroyed. While I obviously cannot know what an investigation will uncover – whether on your own or with the aid of an attorney or a forensic accountant – there is one thing that is known. If you wind up suing your business partners after March 1st for oppression under the amended LLC Act, the action will cost much, much more than if you had taken advantage of the expiring right to simply withdraw and be paid.
If you own an interest in a New Jersey LLC and are even contemplating “getting out,” you should seek legal counsel immediately, before your options dramatically change.
If you are a member of a New Jersey Limited Liability Company (LLC), and you are not happy with the way the company is being run, you can simply withdraw and be paid fair market value for your shares – provided the LLC’s Operating Agreement does not prohibit this. However, this right expires on March 1, 2014, because of an amendment to the law.
If you read my previous posts on this blog, you are aware that, to date in New Jersey, there has been a marked difference in the rights of shareholders of corporations, and the rights of LLC members. The difference is easy to understand if you think of the issue in terms of getting a business divorce. In a New Jersey corporation (with fewer than 25 shareholders), you can get a “divorce” from your fellow shareholders only if you can prove some sort of wrongdoing or fault (called “oppression” under the law). There is no such thing as a “no-fault divorce” when it comes to corporations. Oppression must be proved, and then you have the right to a remedy, most often a buy-out.
LLCs, until now, have been treated much differently. There was never any such thing as a “fault divorce.” If wrongdoing occurred, it could constitute a breach of the Operating Agreement, or of one’s fiduciary duty, and an aggrieved minority member could be compensated for damages actually suffered. But that is far different than actually being paid fair value for your shares in the LLC.
However, the law of New Jersey LLC’s did recognize a “no-fault divorce” – provided the Operating Agreement did not prohibit such a thing. If you simply gave written notice that you were withdrawing from the LLC, you would have to be paid fair market value within six months; no questions asked. Of course, that does not mean the majority members will always agree to do this, so a lawsuit to compel compliance, or regarding what constitutes fair value, could always be necessary. But the right to be paid for your LLC interest, without proving oppression by the majority, did exist.
But, it is critical to understand that that right disappears in New Jersey on March 1, 2014. Any withdrawal that occurs after February 28, 2014, will be ineffective as a matter of law.
This issue is critical because I have had three clients approach me in the past month who thought they had to file a hugely expensive lawsuit against the majority LLC members, only to learn that they had a very simple, and relatively inexpensive, remedy available to them. But they had no idea this right existed, and, obviously, no idea that it would only be available to them for a very short time.
I will be writing about this issue more in the next month-and-a-half. But if you are in this situation, you should give serious thought to whether you want to avail yourself of the “no fault business divorce” from the co-members of your New Jersey LLC. Quickly!
Recently, a defendant testified in a deposition that I was conducting that there was no reason that he could not fire my client, who was a 28% minority shareholder in a New Jersey corporation. Since the defendant was the majority (51%) owner, he believed he could fire whomever he wanted.
Of course, he is right. He could fire whomever he wants. Most employees in New Jersey are employees at will and everyone knows that they can be fired at any point with or without reason (as long as the termination is not discriminatory, of course). So, yes, I had to admit that he had the right to fire my client. But that does not mean that there can be no consequences that flow from the termination.
Since my client had always been a valued employee and was one of the founding members of the company, he had a “reasonable expectation” that he would continue to be an employee as long as he was a shareholder (or so I argued, backed by New Jersey law). In other words, the status of shareholder and employee were inexorably intertwined with him, and rightfully so.
Because of this, my adversary’s attorney knew full well what his client did not – that the law in New Jersey protects minority shareholders in closely held corporations from termination. So, while the majority shareholder had every right to fire him as an employee, my client also had the right to be paid fair value for his shares. As a policy, New Jersey courts believe that majority shareholders should not be permitted to terminate a shareholder as an employee, but keep his capital captive. If not for this remedy, the shareholder would not only no longer be working as an employee, but he may also be precluded from getting any return on his investment.
Courts know that, while the law requires distributions to be made pro-rata to all shareholders, it is very easy for business owners to play games with salary and bonuses and overcompensate themselves, leaving little money left over for shareholder distribution.
This protection has been afforded to shareholders in New Jersey corporations for many years. As of March 2014, the LLC statute in New Jersey is being amended to apply the concept of “oppression” to New Jersey LLCs. While there is nothing specific in the amended statute detailing exactly what this means, there is every reason to believe that a New Jersey LLC member who is terminated as an employee, frustrating his or her reasonable expectations, will soon have the full weight of law in their corner. Finally, LLC owners will be afforded the same relief that is available to owners of corporations.
I have written many times over the years about the differences between a corporation and an LLC when it comes to minority owner rights in New Jersey. On many occasions, I have written about the fact that shareholder rights are much more expansive in a corporation, and much more restrictive in an LLC. That all changes of March 1, 2014.
On that date, the existing LLC statute is being repealed, and the oppressed minority shareholder statute is effectively being incorporated into the LLC statute.
Those rights, and the rest of the new LLC statute, are already in effect for LLC’s created after March of this year, as well as LLC’s that have specifically adopted the new statute. But as of March 1st of next year, every LLC member in the state of New Jersey will be protected under the new oppression section of the statute.
What protections will be afforded? Since the LLC statute will now read almost exactly the same as the corporate statute, it is likely safe to assume that many of the same protections will be found to apply, and that the body of case law relating to corporations will be applied to LLC’s. (Of course, there are no guarantees until judges start applying the new provisions.)
If that turns out to be the case, many of the things that I have written about over the years that constitute “shareholder oppression” in a corporation will likely constitute “member oppression” in an LLC. The failure to pay dividends when the company can afford it; overcompensation of majority members at the expense of member distributions; termination of employment when there was a reasonable expectation of continued employment; embezzlement; freezing a member out of management; concealment of financial information; and conducting improper, self-interested transactions, are all now likely to constitute minority oppression in the context of an LLC. As a refresher for those interested, I will be writing a series of articles discussing many of the things that could be considered minority shareholder oppression in an LLC. I will also be discussing what steps, if any, may be taken by majority owners to protect against an oppression claim in an LLC.
For now, though, minority members of New Jersey LLCs should at least take heart that, as of the spring, they will no longer take a back seat to corporation shareholders when it comes to having their interests protected by New Jersey courts.
In a divorce, an obvious issue to be resolved is who gets custody of the children. In a business divorce, an issue that often arises is who gets custody of the company’s lawyer.
Many New Jersey corporations and LLC’s have a long-standing lawyer, who has often represented one or more of the shareholders in their individual capacity, as well. What happens when one of the owners discovers that his business partner has been defrauding him, or stealing from the company, or committing some other form of shareholder oppression? Who will the lawyer represent? Who CAN the lawyer represent?
Of course, an attorney may decline to represent anyone, on the grounds that he is too close to everyone. Or, as is often the case, the lawyer who has represented the company for years does not have expertise in shareholder dispute litigation. In such a case, the attorney will probably refer you to someone who routinely handles such matters. But can the lawyer choose sides, and represent one of the shareholders while being adverse to the other[s]?
This may seem like an unimportant issue at first blush. After all, it is not as if the attorney for the company is the only lawyer in New Jersey. But it does become an issue when the attorney on the other side of the case is someone who not only represents the company you partially own, but who personally represented you in your real estate closing, speeding ticket, or some other situation in which you found yourself over the years.
The easy answer, as is so often the case, is that it depends on the particular circumstances of both the prior and current representations. In New Jersey, the company lawyer is not prohibited per se from representing one shareholder against the other, or even from representing the company in a suit against a shareholder. But, if the matter in which the lawyer previously represented the shareholder personally is either the same as, or substantially similar to, the new matter, then a conflict exists, and the representation is not allowed.
If you find yourself embroiled in shareholder dispute litigation and find yourself in a similar situation, the first question you ask your attorney may involve whether or not the lawyer on the other side has a conflict or not.
When you catch your partner in a breach of trust, can you ever trust him again? And even if you can, are you better off just moving on separately, or can the relationship ever really be repaired?
It may sound like this article is discussing a marriage, but that is what a business partnership is like in some cases. In fact, one judge in New Jersey often refers to business separation litigation as a “corporate divorce.”
A breach of trust with your business partner can occur in many ways, from finding out that he or she has opened a competing business to discovering that he has been reimbursing himself for wildly expensive and purely personal expenses for years, always hiding the evidence from you. In some cases, it might have been extremely difficult to know (competing business), while in other cases, perhaps you were a little lax in reviewing corporate records (expense reimbursement abuse). But now that you know, what do you do?
To a large degree, this is a purely personal choice and will be affected by a variety of different factors, including various measurements of both the costs and benefits of each competing option. Staying together might seem impossible, but separating the company might seem too costly and cumbersome to undertake or even to contemplate.
Here is where one of the true differences between a marriage and a business partnership comes into play. In a marriage, if you try to work it out, you can always file for divorce later if things don’t get any better. Most states, New Jersey included, are “no fault” divorce states where you do not need much of a reason at all to divorce.
But in a corporate divorce, a much different result could take place. The court could apply the doctrine of waiver, or other equitable principles, to determine that you waived a perfectly viable claim when you failed to act after you discovered what your business partner had been doing. For example, a court could determine that if you really had a problem with the expenses your partner was paying himself, you would have taken affirmative steps once you learned of it. In one case, a fifty percent shareholder had it held against him by the court that he failed to take any steps whatsoever to amend tax returns once he discovered that improper expenses, not really business-related, had been both reimbursed and deducted from the corporation’s taxes.
The court did not mean to imply that the complaining shareholder actually knew and did not dispute the fact that he objected – in writing – when he learned of it. However, the court found that he would have been willing to live with it if other things in the business relationship had worked out, so he can not be heard to complain that his fellow shareholder’s actions were so outrageous as to amount to shareholder oppression.
Instead of self-diagnosing, speak to an attorney experienced in shareholder disputes when faced with a significant problem with your business partner. A good, reputable attorney will point out not only what to expect if you do want to take action, but also what might happen if you fail to act.