The Business Divorce Law Report

June 11, 2010

Fiduciary Duties to Minority Interests in Operating Agreement Amendments

Limited liability companies are creatures of contract, and the Operating Agreement is the Magna Carta of the business. Because it is a contract, however, all of the members must consent to any changes to the Operating Agreement, which means that the holdout member has a veto. In short, the minority rules on major changes.

The Minority Rule Problem

All of the members, save one, may agree that a change to an operating agreement is in the best interests of the business. Yet that one holdout, for whatever reason, can veto the change because a contract cannot be changed unless all of the parties’ to the original agreement consent.

May 28, 2010

NJ Entire Controversy Doctrine Bars Claim That Former LLC Member Owns Factory

by Jay R. McDaniel, Esq.

Without John Murray, the former CEO of Crystex Composites, LLC, the Clifton manufacturer of composite materials would likely not exist. It was Murray who bought the plant in a bankruptcy sale and ultimately ended up with nothing for his efforts. Murray’s failure, however, to assert that he was the rightful owner of the Crystex plant was cut off by application of New Jersey’s Entire Controversy Doctrine, which requires that any claim between the parties to a lawsuit be resolved in one action.

This case has a long history. Murray put together a management team, investors, and arranged financing for the reborn of Crystex in 2003, but he was ousted by the other members of the LLC in May 2004 after failing to make a capital contribution of $200,000. Murray sued, alleging that his pledge of stock to secure a line of credit satisfied his obligation to the business and challenging his removal from the business.

The case went to trial in state court in 2006, with claims of misconduct by both sides. Ultimately, the case turned the issue of whether a Memorandum of Understanding, by which Murray agreed to make his contribution by March 2004 or forfeit his interest, was enforceable. Murray lost, with the court finding that he had “never acquired an interest in Crystex.” Murray appealed, but was unable to reverse the trial court’s decision on the core issue of his ownership. Opinion here.

May 27, 2010

Exercise Care in Valuing Interests in New Jersey Business Breakups

by Jay R. McDaniel, Esq.

A court orders a business valuation in a matter involving an oppressed shareholder claim. The appraiser, carefully applying the standards of his profession, sends an engagement letter describing a fair market value determination. The appraisal will value the enterprise as a whole, then apply minority and marketability discounts. The selling shareholder is going to argue for discounts – they always do – but the report will have all the information necessary for a determination either way.

For the minority shareholder, this can be a trap. And it may be the wrong move to wait for the trial to fight out the discount issue and the battle over the definition of fair value should be fought as early in the case as possible. Here are a few reasons why.

The appraiser is going to prepare a report based on the standards of the valuation industry and that standard is fair market value – what a willing buyer would pay a willing seller. He is going to try to avoid the tough issue of whether any discounts should apply. The AICPA’s Statement on Standards for Valuation Services No. 1 relegates the definition of “fair value” to a single paragraph in an appendix as a matter determined by state law in judicial proceedings.

May 26, 2010

Expelling a Member of a NJ Limited Liability Company

by Jay R. McDaniel, Esq.

Time was that the expulsion of a troublesome individual from a limited liability company or partnership generally meant that the business entity would have to be dissolved and either start over or be sold off. Changes to partnership laws — and the adoption of similar provisions in New Jersey’s limited liability company — make it possible to remove an LLC member without dissolution of the entity.

Unlike Delaware law — on which New Jersey’s LLC Act was modeled — or New York law, New Jersey law includes a provision borrowed from partnership statutes that permits the involuntary dissociation of a member for wrongful conduct or when it is simply no longer reasonably practicable to stay in business together. The statutory provision comes from uniform limited liability company and partnership laws. This departure from Delaware law is a substantial consideration when organizing an LLC or when a dispute arises between the owners.

What that means in practical terms is that for LLCs organized under New York or Delaware Law, the aggrieved parties must often establish that the business cannot go on in pursuit of its original purpose if they are to immediately recoup their investment or, in similar fashion, that the behavior of the offending party is so egregious that the business cannot continue.

May 5, 2010

Operating Agreement Determines When New York LLC May Dissolve

by Jay R. McDaniel, Esq.

The romance of the new business venture has waned. There are disputes between the principals. Emotions are clearly running high. In short, this business marriage, consummated as a limited liability company, no longer works the way at least one of the parties intended. Is that enough under New York for the members of the LLC to get divorced? The answer from the New York Appellate Division, Second Department, is a resounding “No.”

The decision In re 1545 Ocean Avenue (opinion here), which involved a limited liability company formed for purpose of redeveloping property in Bohemia, NY. The LLC’s two members were business entities, Crown Royal and Ocean Suffolk Properties, both in the construction business, and the managers were the principals of those two business entities. Various disputes arose between the managers, including the price charged by one of the members for work on the project and the selection of an architect, and ultimately one of the members asked for a divorce and walked out on the project. The other member continued on, however, and with only a few weeks Crown Royal sought to dissolve the LLC.

Crown Royal claimed deadlock and the trial court granted the petition for dissolution. The Appellate Division reversed, holding that Crown Royal had failed to establish that the LLC had been prevented from continuing in accordance with the terms of its operating agreements. (New York law, you may recall, does not provide for the expulsion of individual members.)