New Jersey Business Dissolution Journal - Jay McDaniel

Most of the cases that we handle – like any other litigation – get settled before trial. One of the incentives to settle is that invariably the departing owner will agree to some sort of restrictive covenant against competing against his former company.

The case that goes to trial, or which is resolved on a substantive motion, leaves this issue wide open.  In fact, there is no statutory basis to deter the ousted business owner from setting up a competitor and trying to lure away the business of his former company, and one would suppose with a bankroll secured by the purchase of his or her interest.

Since most business divorce litigation ends with a deal, and restrictive covenants are critical aspects of those transaction, I thought it worthwhile to write about a recent decision of the Appellate Division that gives a stern warning that the restrictive covenant had better be honored.

In that decision, the appeals court affirmed a trial judge’s holding that the seller of a business had breached a covenant not to compete, even if the amount at issue was just a few hundred dollars, and that the purchaser would therefore be relieved from any obligation to pay the balance of the purchase price.

The Court, in Peek v. Johl & Col, Inc., Docket No. A-0499-10T4 (December 11, 2012) (see opinion below) affirmed the trial court hold that by secretly diverting shared insurance premium commissions from another broker, the seller had committed a material breach that was not excused by the small amount at issue.

The plaintiff Peek sold his brokerage to the defendants and received a note in return, along with an agreement to pay a portion of new premiums received by the firm.  The buyers also agreed to rent the office in which the business was located from the seller.

Peek had long had an arrangment with another brokerage to write insurance that his own firm did not handle and after the sale continued to refer business to the other broker and receive a share of the commission – which it appears he was entitled to do.  Under the terms of the sale, he would have continued to receive his share of the referral payments.

However, Peek had the payments directed to him instead of to the buyer.  And when the seller found out, he stopped paying either the note or the office rent.  Peek filed suit and the buyer counterclaimed alleging a breach of the restrictive covenant contained in the sale agreement.

The trial judge rejected the agreements and awarded defendants their half of the withheld payments in the amount of $614.30.  Te trial court also found that there had been a material breach of the parties’ contract and that further performance by the buyer was excused.

The Court relied on a pair of decisions, Ross Sys. V. Linde Dari-Delite, 35 N.J. 329 (1961) and Nolan v. Lee Ho, 120 N.J. 465 (1990) holding that the material breach of a contract by one party relieves the non-breaching party of further performance.

We appreciate that the amount in commissions that … plaintiffs wrongfully retained was much less than what defendants were obligated to pay under the contract terms. Even so, a breach of a restrictive covenant, which often can be a key bargaining term when a small business is sold to a new owner, was reasonably found here to constitute a material breach that excused defendants from making those additional payments. Because the material breach prevents a claim of substantial performance, the trial court made no legal error in granting defendants relief on their counterclaim. 

The appellate court also rejected the argument that excusing further performance of the contract was a windfall to the buyers who, even if there was a breach, should be liable under the theory of unjust enrichment.  Rather, the wrongful conduct made the trial cour’ts rejection of the claim “appropriate, even thought that results in defendants reaping the benefits of the transaction for a lesser sum than the amount originally bargained for under the contract.”

Opinion in Peek v. Johl, New Jersey Appellate Division by Jay McDaniel

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Revised Uniform Limited Liabilty Company Act Changes Legal Landscape

The effective date of New Jersey’s Revised Uniform Limited Liability Company Act is approaching.  The law will be effective on March 18, 2013 for newly formed LLCs and will be applied to all LLCs effective March 1, 2014.

There is a laundry list of changes in the new statute.  Our view in the firm is that it’s a significant improvement over New Jersey’s current statute, modeled under Delaware law with some fairly significant additions.  But the statute is also more complicated, and for those accustomed to drafting under the old law, it’s time get started revising those model clauses.

It’s also time to start warning the owners of existing LLCs about the impending change.  The differences are significant enough that some LLCs may have problems with Operating Agreements drafted under the old statute that will have significant problems under the new act.

Although the law does not apply to a new LLC until March 18, we are incorporating the new statute in the LLCs that we are forming.  It will apply in just over a year anyway so it makes sense to include a clear choice of law selection, at least until next month.

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New Jersey Limited Liability Company Attorneys

Imagine that the limited liability company you and your partners started five years ago is involved in a nasty corporate governance lawsuit.  Perhaps one of the partners needs to be expelled, or maybe one of the owners is involved in a competing business.  Imagine that you are spending tens of thousands of dollars every month on legal fees, that the business is in a state of constant disruption and that you haven't had a good night’s sleep in weeks.

And now, accept the fact that this could have been avoided.

The chances are that if a closely held business is involved in this type of litigation it is because the owners did not plan well when they started the business.  How do I know?  Having litigated many of these matters over the years, I see the same mistakes made early in the life of the business surfacing again and again as the source of litigation.

New Jersey Limited Liability Company Operating Agreement

This is my non-exclusive list of what I think  are the most expensive mistakes that I see people make in their business.  There are others, to be sure, but these are the ones that I see as the source of litigation among the members.

No Operating Agreement:  Actually, I am not going to count not having an operating agreement as one of the five “mistakes.”  It is not really a mistake, it is a colossal blunder, kind of like drunk driving – you may get away with it for a while, but you know how it’s going to end.  

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Law Specifies Fiduciary Duties for Members and Managers

of New Jersey LLCs

A Series on New Jersey's Adoption of the Revised Uniform Limited Liability Company Act

The fiduciary duties imposed on a member or manager of a New Jersey LLC are at present elusively and poorly defined in the statute.  While the current act contains several provisions limiting the personal liability of members, nowhere does it clearly define the duties that are inherent in the relationship of the members.  Attempts to impose the fiduciary obligations that have traditionally been thought to be a fundamental aspect of the relationship of partners in a partnership, or the officers and directors in a corporation, have met with uneven results.

As we noted in our recent blog post (Fiduciary Duties Murky Under Delaware Law), reviewing a decision from the Delaware Supreme Court, the issue is still undecided in the most influential jurisdiction in the country on issues of business governance, and there is little guidance in the form of controlling authority in New Jersey.

Uncertain Responsibilites of LLC Members

That uncertainty should change significantly when the revisions to New Jersey’s limited liability company law take effect in March 2013 for newly formed companies, and in March 2014 for existing LLCs.  In adopting the RULLC, the legislature put in place a new set of standards for the conduct of members and managers of LLCs organized under New Jersey law.  While some of the changes reflect much of the judge-made law applying equitable principles to the conduct of small business owners, there are some significant differences in the way those duties will now work, and anyone involved with a New Jersey limited liability company needs to have a firm grasp of the structure.

This definition of fiducIary duties is significant because courts are often hesitant to create new rules of law by analogizing to the law of corporations or partnerships.  A particularly contentious issue in New Jersey, for example, was whether a minority member of an LLC who was treated unfairly could bring an action for oppression and obtain the remedies available under corporate law.  These efforts have uniformly had anything but uniform results -- in New Jersey and other states with similar limited liability company statutes.

The RULLC is more comprehensive that the present New Jersey Liability Company Act.  Under the current act, there is no explicit definition of the duties.  The current law simply provides that to the extent that “at law or in equity” a member or manager has any duties, including fiduciary duties, those duties can be varied by the operating agreement and that the member or manager can rely on the operating agreement.  N.J.S.A. 42:2B-66.  The current act also provides that where the statute is silent, the “rules of law and equity” govern. N.J.S.A. 42:2B-67.  Many commentators see this as the express understanding that fiduciary duties are created by the equitable principles that are widely accepted as governing the relationships between members of business enterprises.  Others think not.

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Purchaser Alleges Mortgage Was Not Approved by All LLC Members

A mortgage given by a New Jersey limited liability company to one of its members can be challenged by the purchaser in a court-approved sale of the business, the Appellate Division holds, reversing the trial court.

This case arises out of the estate planning undertaken by John Best and his wife, defendant Patricia Ann Best, after Mr. Best learned that he was terminally ill.  The couple owned Sea Village Marina in Northfield (across the bay from Margate).  They had transferred 25 percent of the business to their son, John, in 1994.

Succession Plan for LLC Only Partially Completed

John Best became ill in 2003 and an estate plan was put together that assumed that he was the sole owner of the marina.  He would acquire the interests of his wife and son and they would receive mortgages back for $1.6 million and $200,000 respectively.  As it turned out, the plan was never fully completed and John never acquired the 25 percent interests of his son.

Mark Best refused to transfer his interest and later said that he would never have approved the mortgage because it didn’t represent a valid debt.  His mother did transfer her interest and received the mortgage.  The result was that at the time that John Best died, the business was owned 75 percent by his wife and 25 percent by his son.

Mortgage Given by Limited Liability Company

Most of the value of the business was in the property, according to the court, but the property was encumbered by a mortgage.  That mortgage, however, was not approved by all of the members or the managers.

It later developed that none of the children nor the wife wanted the business.  They tried to sell the property but the offers were much lower than would be necessary to pay the secured debts of the business totaling $2.267 million.  Ultimately the court approved the sale of the business to a third party that took the property while reserving the right to challenge the mortgage.

LLC Challenges Mortgage Given to Former Owner

Patricia Best opposed the sale.  After the transaction was completed, the purchaser filed a complaint seeking to invalidate the mortgage.  On motions for summary judgment, the trial court held that the mortgage was valid and that the failure to enforce its terms would grant the purchaser a windfall.

The Appellate Division reversed, finding that the purchaser had expressly reserved its right to challenge the mortgage and that the court had approved the sale under those terms.

Because the court had previously entered an order requiring those interested in the will of John Best to bring any claims challenging the mortgage and no one had made such a challenge, Patricia argued that the purchaser of the LLC was barred as well.  The Appellate Division also rejected this claim.  The fact that the prior owners of the LLC might be barred from asserting the claim did not prevent the same claim from being brought directly by the LLC.