LLC Does Not Distribute Clients on Dissolution

Posted by Jay McDaniel on April 12, 2011


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When a limited liability company dissolves, it pays its creditors and distributes the remaining assets in the winding-down process. Many professional practices are organized as LLCs, and their principal assets are the clients they serve.  That does not mean, however, that the professional limited liability company in dissolution has to divide up the clients.

This is an important holding for lawyers, accountants, doctors and other professionals that are practicing in New Jersey as a limited liability company. According to a New Jersey appeals court, the clients that the professionals, such as an accountant, bring to the LLC represent personal goodwill that belongs to the individual professional, rather than goodwill belonging to the enterprise.  Thus, clients of professional limited liability companies are not considered assets of the LLC and on dissolution are not subject to distribution.

Accountants Seek Dissolution of Firm

The decision, Michael Gaines v. John Luongo (copy of opinion here) involved an accounting firm that was formed under the New Jersey Limited Liability Company Act, N.J.S.A. 42:2B-1. The Operating Agreement of the limited liability company gave Gaines a 70 percent majority but provided that the two members would share profits and losses equally.The Operating Agreement provided for dissolution of the limited liability company under various conditions, including any event that made it "impossible, unlawful or impractical" to continue operating the business of the limited liability company. The Operating Agreement also provided that in distributing assets to members at the time of dissolution, if the LLC's assets could not be sold, they were to be valued on the company's books for the purpose of distribution to the owners.

The Operating Agreement of the limited liability company also contained a restrictive covenant that prohibited Luongo, the defendant, from competing with the firm for one year and within a 10-mile radius. The relationship between the partners deteriorated within a few years of the formation of the LLC. The litigation arose out of the fact that the partners disagreed about whether they had agreed to dissolve or whether the majority had locked the plaintiff out of the business.

Dissolution of LLC Subject of Dispute

Defendant Luongo claimed that the two partners had decided that the LLC would be dissolved and that each would keep their own clients. Luongo claimed that he arranged for new office space and they divided up the furniture and agreed that each would keep their clients. Gaines denied any agreement to dissolve, said he had continued to operate the firm and that his partner had cleaned out the bank account and frozen him out of the business.

Although the firm was organized as a limited liability company, Gaines filed suit as an oppressed minority shareholder under N.J.S.A. 14A:2-7, seeking an injunction, appointment of a fiscal manager and an order determining the fair value of his interest - including the value of the clients of the firm as assets to be distributed on dissolution of the limited liability company. He sought to compel judicial resolution. (See our prior post on court-ordered distributions of assets in an involuntary dissolution here.) He also sought to enforce the restrictive covenant.

The trial court held that the parties had, in fact, agreed to dissolve and that the clients were not part of the assets to be distributed. In affirming the lower court's decision, the Appellate Division agreed with the trial court's finding that the company's clients were never carried on the books as an asset, no value was ever assigned to them on the company's balance sheets, and that they were free to remain as clients of either partner, or neither.

Clients of Profession Are Personal Goodwill Not a Business Asset

Each of the accountants simply took their clients with them after the LLC had been dissolved. An in-kind distribution when the LLC was dissolved was "inconsitent wit the nature of professional clients, whose value is found in personal goodwill." The court used the "working definition of personal goodwill" as the "part of increased earning capacity that results from the reputation, knowledge and skills of an individual person and is not transferrable or marketable." Which is simply to say that clients hire accountants (or lawyers or doctors) not firms.

 

 

 

 

MICHAEL GAINES, Individually and as a Shareholder of Gaines, Goldenfarb and Luongo,LLC, Plaintiff-Appellant, v. JOHN LUONGO, Defendant-Respondent. Docket No. A-3600-09T3f, from Superior Court of New Jersey, Chancery Division, Middlesex County, Docket No. C-276-08. Tobia& Sorger, LLC, attorneys for appellant (Ronald L. Tobia and JillTobia Sorger, on the brief). HarwoodLloyd, LLC, attorneys for respondent (Michael B. Oropollo, of counseland on the brief).

Flickr Credits: Independent Picture Service

Alessandro Bianchi, an associate of the firm, helped with the preparation of this post.

Appellate Division Affirms Sale of Business as a Going Concern in Shareholder Dispute

Posted by Jay McDaniel on August 16, 2010

The last-minute motion of a 50-percent shareholder to prevent the sale of a business as part as part of an oppressed shareholder lawsuit was insufficient to block the receiver from proceeding with the transaction, according to a New Jersey appellate court.

The opinion in Georgiadis v. Georgiadis, Docket No.: A-4018-08 (App. Div. June 21, 2010) demonstrates the ability of a chancery judge to manage a business divorce and fashion an equitable remedy based on the facts of the case, and the deference that the appellate courts give to those decisions.

The lawsuit arose between two brothers who owned equal shares in a diner in Mountainside.  One of the brothers left the business to run another diner in Connecticut.  When that diner closed, his brother refused to let him return to the business in Mountainside and an oppressed shareholder action followed.  The defendant brother filed a counter claim and the case was tried in 2007.

The remedy provided the defendant – who still controlled the business – could purchase his brother’s shares within 90 days of the order, otherwise the business would be dissolved, the assets sold by a receiver and distributed in equal shares to the parties.

When the defendant failed to buy his brother’s interest, a receiver was appointed and an offer of $1.35 million was received.  The defendant then offered to buy the plaintiff’s interest for $412,255, and when that was rejected moved to compel the purchase for the amount that the plaintiff would receive less deductions claimed by the defendant.

The trial court denied the motion, holding that the time to make such a purchase of the defendant’s interest had long since passed.  Defendant appealed, arguing that the trial judge had failed to fashion a remedy that would permit the defendant to retain the business.  Although courts are hesitant to force the sale of a going concern when one of the parties wants to continue to operate the business, in this case the application came too late.

In affirming the trial court's decision, the appellate division concluded that equity did not require the trial judge to provide the defendant to buy out his brother’s interest.

Operating Agreement Determines When New York LLC May Dissolve

Posted by Jay McDaniel on May 05, 2010

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.)

The dissolution of an LLC organized under New York law is "initially a contract-based analysis," the Second Department wrote. Limitied Liability Company Law 702 permits judicial dissolution "whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement." Thus, the court reasoned, it is not proper to consider standards developed in similar disputes involving corporations or partnerships.

Rather, a court considering dissolution of an LLC must determine whether the manager's agreement is such that the LLC cannot continue to function as envisioned by the terms of the written agreements between the members. The touchstone of the analysis, according to the court, is whether the the management of the entity "is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved or the entity is financially unstable."

Now the interesting gem in this decision is the fact that because the Operating Agreement did not limit the authority of its managing members, and because in the absence of such a limitation either one could act unilaterally on behalf of the LLC, there could be no deadlock preventing the company from pursuing its stated objectives. Simply put, because the company was still operating and pursuing the real estate projects for which it was organized, it mattered not that one of the members was so unhappy as to seek a dissolution of this business marriage.