New Jersey Business Dissolution Journal - Jay McDaniel

It’s the Wednesday afternoon before Thanksgiving and the phone rings with a new client.  The situation in the office has become an emergency.  Either someone has been locked out or someone needs to be locked out, or someone is walking out the door with a key client. Many of our cases begin as emergencies.

The dispute between LLC members, shareholders or partners erupts into a lawsuit without warning, or so it seems, and without planning.  Here are five considerations that are important to success in a litigated business divorce.

1.         Understand the Statutory Framework.

Different types of businesses may be treated the same for taxes – partnerships, S Corporations and limited liability companies – but they are very different creatures when it comes to disputes between the principal owners.  The “default rules” for issues that have not been addressed in the business organization documents are very different, and the liability of individuals can be widely different.

A couple of examples should give you an idea.  The limited liability company and partnership statutes in many states contain provisions that permit the expulsion of a troublesome member or partner.  There are standards that have to be met, and they are significant, but the member or partner who makes it nearly impossible to continue the business with their participation can be tossed out.

Not so with the close corporation.  Most statutes permit the minority to demand the purchase of his or her shares if the majority has acted oppressively, but not the other way around.  If the majority doesn’t have the votes to fire or remove a shareholder, they may be stuck with that person.

Most partnerships and limited liability statutes have a minority veto built into their structure.  Unless it was previously agreed, you cannot change the basic operating documents – the partnership agreement or the operating agreement – without the consent of all of the members or partners.  Corporations on the other hand can usually operate with a majority vote and can change their by-laws or certificate of incorporation.

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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.

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.

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.