Norris, McLaughlin & Marcus

Pros & Cons of Alternative Dispute Resolution in Shareholder Dispute Litigation

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.

Unnecessary Capital Call as Means of Dilution Can Be Shareholder Oppression

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.

Get out of That New Jersey LLC before the Law Changes?

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.

The Right to Be Paid Fair Value for Your NJ LLC Interest without Showing Fault Expires Soon

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!

Termination of LLC Member Employee Could Soon Be Considered “Oppression”

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.

New Jersey LLC Minority Members Can Look Forward to More Protection

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 Business Divorce Litigation, Who Gets Custody of the Company’s Lawyer?

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.

Discovering Fraud By Your Business Partner: Act Now or Forever Hold Your Peace?

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.

Make Sure Majority Shareholders Never Feel As If They Are Not Being Watched

Minority shareholders often do not work at the company, and are not involved in management, making them, for lack of a better word, “passive investors.”  While no broad rule can ever be applied to everyone, it is these types of minority shareholders who are the most vulnerable to abuse by the majority shareholders.

The easiest way for a passive minority shareholder to be abused is for the majority shareholders to keep increasing their salaries and bonuses to the point that they are significantly above market rates.  Instead of paying out distributions to shareholders – which, of course, are paid proportionately to share ownership – the money is sucked out of the company and paid to the majority only.

This and other forms of minority shareholder oppression can sometime be prevented by nothing more than vigilance by the minority shareholder.  Ask to see financial records.  Insist that annual shareholder meetings take place, even if there are only three of you.  In other words, let the majority shareholder know that, at the very least, you are watching them.  This does not mean that the relationship should or must be confrontational.  But being someone who keeps an eye on his or her investment is always a good idea.

For example, majority shareholders often start with a car being paid for by the company.  Then, the company pays for his car insurance.  Then, his wife’s insurance, followed by his wife’s car payments, followed by his kids’ cars.  It happens all the time.  By the time a truly passive minority shareholder comes to my office complaining about such abuses, the path to shareholder dispute litigation has already been paved.  Most minority shareholders in that situation wish they had a time machine so they can nip such behavior in the bud.  Abuses like this are much less likely to occur if the majority shareholders know they are being watched.

Stated differently, whether it is an employee in a store, a manager, or a majority shareholder of a small to medium-sized company, people are more likely to abuse their power if they know no one is watching them.  So, even if you are a passive investor, watch the majority shareholders.  Politely, without interfering in the business.  But watch them.

Ability to Access Financial Info Is Broader in Practice than Law Technically Provides

Shareholder disputes often arise because of a lack of information being disclosed by the majority to the minority shareholders.  In New Jersey, there are limitations as to what financial documents must be shared with minority shareholders.  However, most of the time business owners believe that their business partners should share more information than the bare minimum dictated by law.

A common tactic employed by majority shareholders who do not want to disclose any more financial information than required, yet want to stave off a minority shareholder lawsuit, is to provide a “slow drip” of information.  For example, when five years of tax returns, financial statements, and general ledgers are requested, the majority shareholders will start by providing two years of financial statements and nothing else.  Then, they will supplement with last year’s tax return.  Then two years’ worth of returns.  Then, after much back-and-forth and several weeks (or even months), they will give you everything you asked for, except, of course, for the general ledger, which is the main thing you really wanted.

The purpose of this strategy is to create the appearance of providing financial information.  The majority shareholders’ lawyer will be able to point to four or five letters where they gave you information, and argue to the court (when the inevitable shareholder dispute litigation arises) that you are never satisfied, and that they have been extremely cooperative.  Then, they will fall back on the argument that they have already given you more than you are legally entitled to under the law, anyway.

Do not fall for it.  When I represent majority shareholders, I advise them to go above-and-beyond what the statute requires, and you should settle for nothing less.  After all, if shareholder dispute litigation is filed, the minority shareholder will be entitled to every financial document under the sun as part of the discovery process.  Better to provide the documents the easy way than the hard way.

If you want an explanation as to why things are occurring a certain way, or why a certain expense keeps recurring, you should be entitled to know, even if the statute does not specifically say so.  The relationship between you and your business partner should be an “open book,” based upon trust and cooperation.  If you suddenly want to see documents that you never historically looked at, chances are there is already at least the start of a schism in the relationship.  A refusal to provide even the most basic financial information, or to answer certain fundamental questions about business operations, can only make that schism worse.

If you are being completely shut out from financial information and seem to have hit a wall, contact an experienced shareholder dispute litigation attorney.  Chances are, he or she will be able to get you the documents you want to see – either the easy way or the hard way.