Owners of Parent Corporations Should Have Remedies Against Officers of Subsidiary Businesses

Posted by Jay McDaniel on September 30, 2010

Businesses often create additional new businesses, whether as joint ventures or subsidiaries. The flexibility and favorable tax treatment given to the limited liability company have made it fairly common that an LLC has other business entities as its owners.  For the individual owner, however, this situation can present problems.  The requirement that the members act at the company level often means less individual control and less ability to address acts of wrongdoing in the subsidiary or joint venture.

The individual owner’s recourse is the double derivative action, a complicated device in which the individual owner. asserts the rights of the parent to assert a claim as an owner of the subsidiary. It’s confusing, but the principle is generally well accepted.

 

An Example

An example that came up recently in our practice recently may help illustrate.  Two corporations formed a joint venture, each owning 50 percent.  The two corporations, lets call them A Corp. and B Corp., were each owned by two partners, 50 percent each. There were four individuals each with a 25 percent interest.  However, the members could only act at the entity level, meaning that A Corp. had one vote and B Corp. had one vote.  And, because both corporations needed the approval of both of its shareholders, the result was that all decisions had to be unanimous.

In addition, as is common, the principals were all appointed managers and had jobs in the business.The managers were elected and could be removed by a vote of the members.  So when one of the managers became a problem, that manager could not be removed by a vote of the members because the problem manager could block the affirmative vote of one of the parent entities.  

Consider the alternative as well.  If one of the individual owners has a real grievance at the level of the subsidiary or joint venture – mismanagement of the joint venture or exclusion from management, for example – there is no easy way to address the grievance if the majority is in disagreement.  The individual member is not an owner of the subsidiary.

 

Nature of Derivative Litigation

We hear most often about derivative suits in the context of large public corporations, but the same principles apply to the closely held corporation and they are commonly asserted in litigation among the owners.  A derivative suit is a claim brought by one of the owners of a business (shareholder or LLC member) that asserts a right owned by the business itself.

For example, when the president of a corporation wastes money using the corporate jet for personal vacations, an individual shareholder may sue derivatively on behalf of the corporation. The recovery, if any, belongs to the corporation and the shareholder benefits only indirectly to the extent that the business recovers.  But derivative actions are intended to prevent and deter wrongdoing by corporate insiders and the successful plaintiff in a derivative action can recover costs and legal fees.

 

Double Derivatives

In the double derivative, the individual seeks to enforce a right owned by the subsidiary (which the plaintiff does not own directly).  A recent case in the Delaware Supreme Court (Opinion here in Lambrecht v. Oneal.pdf) provides a good example.  In that case, Merrill Lynch was purchased by Bank of America for sto ck and all of ML’s stockholders received Bank of America stock for their ML shares.  ML became a subsidiary of Bank of America.  One of the former ML shareholders, now a Bank of America shareholder, brought a derivative claim alleging that the former ML management had damaged the corporation by, among other thins, paying huge bonuses to executives.

The plaintiff brought a claim that alleged that:

1)      ML had a claim against its former management.

2)      Bank of America, as a shareholder of ML, had a right to assert that claim derivatively against the managers.

3)      Plaintiff as a shareholder of Bank of America had the right to assert Bank of America’s claim derivatively against the managers because both Bank of America and ML had failed to sue themselves.

Put another way, the plaintiff sought to assert Bank of America’s right to stand in the shoes of Merrill Lynch and sue the allegedly liable managers.  The defendants attempt to dismiss the claim by arguing that the plaintiff did not have standing failed.

In the close corporation, individuals may have similar structural problems.  They are affected as individuals, but the structure of the business presents an obstacle.  Double derivatives are often their only real remedy.

Limited Liability Company Subject to Claims By Former Managers Holding Membership Interests

Posted by Jay McDaniel on June 11, 2010

I often find myself counseling caution to business owners that want to use equity to reward or attract key employees.  The reason, quite simply, is that if the relationship sours, the employee not only has to be fired but you then have to deal -- at best -- with a disgruntled former employee as owner or, more likely, he or she likely will have to be bought out. 

It's Not Easy to Fire the Owner-Employee

To get a sense of how difficult these circumstances can be, let's look at Ross Holding and Management Co. v. Advance Realty Group (Ross Holding v. Advance Realty (Del).pdf), a case recently decided in Delaware construing New Jersey law.  Advance Realty Group managed real estate properties on the East Coast and awarded membership interests to key managers.  The managers received "Class A" general ownership units and "Class B" units reserved for management.  Reading between the lines of the opinion, it seems that a new investor came into the business and the old management team got their walking papers.

The departing managers redeemed their "B" units for cash and also signed general releases of any employment related claims.  The "A" units were carved out for later redemption.  When the redemption failed to happen, the former managers brought suit alleging various claims of wrongdoing and mismanagement.

Release Did Not Cover Claims Brought As Owners

Construing New Jersey law, the Court held that most of the claims would survive a motion to dismiss because they were brought not as former employees, but as holders of "A" units, including acts that allegedly occurred before the managers were let go.  The releases given by the former management team simply did not extend to their claims as equity holders.

Thus the current management of Advance Realty found itself subject to claims concerning the sale of properties, alleged self-dealing and the like.  Moreover, it likely discovered that the former management team knew far more about the business than would a passive investor, which would certainly make it more difficult to prevail.

Pitfalls of Equity Awards

When dealing with a small limited liability company, or a corporation for that matter, in which employment is bound up with ownership, you don't simply fire one of the owner-employees.  In many corporate oppressed shareholder cases, that termination amounts to per se oppression unless there are reqular dividend payments.  In limited liability companies, the rights may be less clear, but former employees can be well motivated and the litigation costs may be substantial.

There are a couple of approaches that one might take, none of them very satisfactory.  One is the use of a tiered equity structure - the so-called limited equity owners.  These un-owners are have some of the rights of owners (voting, ability to bind the business, etc.) but no right to participate in the upside of the business through equity.  The other way is to set the equity for the employee-owner in advance at a modest amount.  (I was once a limited equity owner of a law firm and my interest was worth the princely sum of $100.)

The better view is simply to beware.  You don't want to grant anyone equity unless you are willing to take on the burdens, and hopefully rewards, of having them as a full owner of the business.  In many cases, if it doesn't work out, the business will have the same headaches as it would if they were one of the founders.

 

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

Posted by Jay McDaniel on May 28, 2010

Without John Murray, the former CEO of Crystex Composites, LLC, the Clifton manufactuer 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 (Photo of Crystex Composites) 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 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.

Murray then filed suit in federal court, arguing that if he never had an interest in Crystex, as determined in the state court litigation, then the assets that he acquired personally in the backruptcy proceeding, belonged to him, not Crystex.  Copy of Complaint here.  Defendants successfully moved the federal court for summary judgment, arguing that New Jersey's Entire Controversy Doctrine, which requires litigation of all claims between the parties in one action, barred Murray's attempt to claim ownership of the property.  Opinion here.

In what is likely to be the end of this litigation, Murray's appeal to the Third Circuit Court of Appeals was rejected.  Murray argued that his claim to be the owner of the Crystex factory did not arise until the state trial court held that he had never acquired an interest in the business and that it was simply unfair to prevent him from purusing those claims now.  The Third Circuit disagreed (opinion here) holding that the wrongful act of possessing the property began in 2003 and that Murray was not an "uniformed litigant."  Murray's interest was in dispute at the time of the state court lawsuit and that as the plaintiff he had to know that that the lawsuit implicated his rights in the Crystex factory.  Because the same parties and factual allegations were involved, the Third Circuit held that Murray was obligated to raise his claim to ownership in the first state court action. 

It was a creative theory, but unfortunately for the plaintiff too late to be of use. 

A final note in the interest of full disclosure.  I represented John Murray in the earliest days of this case.  With the meeting scheduled to oust Murray, and the outcome already written on the wall, I had the brilliant, but unsuccessful idea, to bring a claim on behalf of Crystex itself seeking a TRO to enjoin the meeting.  As I was making my typically compelling arguments, adversary counsel's cell phone rang and he took the unusual step of answering it during oral argument.  It was a majority of the members calling, and I was fired.  The client came to the same conclusion some weeks later.