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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Oppressed Shareholder Settlement Void

Shareholders in New Jersey's Wild West City cannot distribute assets to resolve an oppressed shareholder action due to an unresolved claim involving an employee's accidental shooting. The case is a warning, perhaps, that prudence requires some due diligence before a release is signed to ensure  that there is not a lurking claim that could upset the settlement.

Purchase of Minority Interest

Oppressed shareholder actions almost invariably end with the compelled purchase and sale of the minority shareholder's interest. An unresolved claim, however, that could give a third party an interest in the company's assets may prevent any resolution of the dispute.

Stabile v. Stabile (Stabile v. Stablie.pdf) involved a dispute between the members of several family owned businesses owning a large tract of land in rural Sussex County, New Jersey and operating Wild West City, a western theme park. The businesses also held a liquor license and owned a contiguous restaurant. The litigation among the family members began in September 2005, when James Stabile filed suit alleging various breaches of duties by the directors of the business and minority shareholder oppression. In June 2006, the Court entered an order that the plaintiff was be bought out at fair value. The real estate holdings were appraised at about $11.45 million.

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Most corporations include broad indemnification provisions in their by-laws that are intended to protect directors and officers from the costs of lawsuits claiming wrongdoing. Those corporate provisions, however, as well as the statutory provisions that permit indemnification have an important caveat, an officer or director cannot be indemnified against intentional wrongdoing.

What happens when the officer or director loses a civil case, however, and a judgment is entered finding wrongdoing?  According to a recent decision in New Jersey that finding of wrongdoing does not automatically deprive the officer or director a right to indemnification, nor does it require him or her to repay the costs incurred in the defense or payment of any judgment.

Advancement of Defense Costs

Corporations typically advance the costs of attorneys’ fees to officers and directors that have been sued and, indeed, they are often required to do so by provisions in the by-laws that provide for indemnification unless there is an express finding of intentional wrong.  In Commerce Bancorp, Inc. v. InterArch, Inc., 2010 N.J. (App.Div. Dec. 16, 2010) (Opinion here), the corporation sought to recover those fees. Although the decision is based on a surgical parsing of statutory language, you can’t help but note the court’s pique with the plaintiff. The events underlying the lawsuit occurred more than a decade ago and the plaintiff had approved the indemnity payments, only to change its mind years later with a change in corporate politics.

In any event, when interpreting a statute, the placement of punctuation can mean a great deal. The specific issue on appeal was a lower court’s ruling that an applicable provision of the New Jersey Business Corporation Act barred a corporation from permissively indemnifying its agents under specific factual circumstances, based on its reading of the statute, and the placement of a period in particular. The appellate division, however, disagreed with the interpretation and said that there was no basis in law or equity to support plaintiff’s suit to recoup indemnification payments it knowingly and voluntarily made the defendants.   

The disagreement between the trial and appellate court centered on the statutory interpretation of N.J.S.A. 14A:3-5(2)(a)/(b), mainly because the lower court read a provision as pertaining to only one subsection, where in reality the provision applies to both.

Construction Led to Derivative Litigation

In the dispute, Commerce hired HVAC construction company DiMaria to perform work on a newly constructed office building. Commerce also hired the Defendants, Interarch, to do interior design on the project. Interarch is owned by the wife of Commerce’s founder and chairperson. Commerce terminated DiMaria from the job, but an arbitration hearing on its breach of contract claim resulted in it being awarded damages, which Commerce paid.  

DiMaria then sued Interarch for tortious interference with its construction contract with Commerce and won damages of over $800,000. After a lengthy investigation by outside counsel, Commerce was advised to indemnify Interach to the tune of $1.3 million. Six years later, after a corporate shakeup at Commerce, the bank re-visited the indemnification of Interarch and brought the underlying suit for restitution, asserting that defendants acted in bad faith and outside the scope of agency.  

The trial court granted summary judgment in favor of Commerce, reasoning that the applicable statute barred Commerce from originally indemnifying Interarch because the agent for Interarch did not act in good faith and in the best interest of Commerce.

Statutory Interpretation of NJ Business Corporations Act

The trial court based its interpretation on the language of N.J.S.A. 14A:3-5(2)(a)/(b) and the so called “anti-presumption” provision which states that “[t]he termination of any proceeding by judgment, order, settlement, conviction . . . shall not of itself create a presumption that such corporate agent did not meet the applicable standards of conduct set forth in paragraphs 14A:3-5(2)(a) and 14A:3-5(2)(b).” The trial court read this provision as only applicable to criminal proceedings based on the way the provision was structured.  

On appeal, the Court engaged in an interesting grammatical interpretation of the statute by parsing the structure of the language in order to properly unearth what the legislative intent was. The relevant statutory section in context reads:

(2) Any corporation organized for any purpose under any general or special law of this State shall have the power to indemnify a corporate agent against his expenses and liabilities in connection with any proceeding involving the corporate agent by reason of his being or having been such a corporate agent, other than a proceeding by or in the right of the corporation, if

(a) such corporate agent acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation; and

(b) with respect to any criminal proceeding, such corporate agent had no reasonable cause to believe his conduct was unlawful. The termination of any proceeding by judgment, order, settlement, conviction or upon a plea of nolo contendere or its equivalent, shall not of itself create a presumption that such corporate agent did not meet the applicable standards of conduct set forth in paragraphs 14A:3-5(2)(a) and 14A:3-5(2)(b). (emphasis added).

The trial court viewed the “anti-presumption” provision, underlined above, as only pertaining to criminal proceedings, and therefore found the original suit against Interarch for tortious interference with DiMaria’s contract as creating a presumption that Interarch did not act in good faith, or with Commerce’s best interest in mind. This resulted in a favorable ruling for Commerce, allowing for their suit for restitution to proceed. 

The Appellate Division disagreed with this analysis, finding that the second sentence, although in close structural proximity and connected with clause (b), is actually a modification of the first sentence and specifically and expressly references both clauses.

The result: that the “anti-presumption” provision applies to both clauses (both civil and criminal).  This effectively meant that the judgment against Interarch shall not of itself raise any presumption of bad faith, and the mere fact that now some six years later there may exist “a different legal gloss on a known and undisputed state of facts possibly suggesting an erroneous conclusion as to its legal effect does not alter the equities of the situation, excuse the delay, or itself justify a belated cause of action for recoupment.”

Disputes between the owners of a business often involve derivative claims; specifically that one of the parties has breached his or her duty to the business or done something to damage the business.  In the closely held business the interests of the owners are more likely to be the same as the business.  Nonetheless, a derivative claim raises the thorny question of whether the entity must now engage independent counsel to represent the business itself.  

The Role of Independent Counsel in Derivative Actions

The role of independent counsel in a derivative action is to avoid potential conflicts of interest between the controlling owners and the business entity, whether it is a corporation, a limited liability company or a limited partnership. (Claims by a partner in a general partnership are similar, but do not fall under the concept of a derivative action.)  A derivative action is a claim that belongs to the business entity, but which the controlling owners refuse to pursue.  

A derivative action must be brought by an owner (shareholder, member or limited partner) who was an owner at the time that the cause of action arose and at the time that the claim is brought.  The statute requires that the minority owner first make demand (demand that the majority pursue the claim) unless to do so would be futile.  In a closely held business, in which the majority owners would have to vote to sue themselves, futility is usually presumed.

Derivative Claims in Closely Held Businesses

Derivative actions provide for an award of attorneys fees, and we invariably include a derivative claim when representing a minority owner in which there are claims of conduct detrimental to the business entity.  Typical derivative claims include conduct that depleted corporate assets, breaches of the duty of care or loyalty, basic self dealing, excessive compensation, or misappropriating a business opportunity that belongs to the business.

The defendants in such a derivative action are the other owners, officers, directors, members or general partner, and the corporation is named as a nominal plaintiff.  The potential for the conflict of interest is that the majority owners cannot be expected to act on behalf of the corporation in a way that is detrimental to their interest – particularly when they are also defendants.  In addition, there is also the likelihood that the majority owners will contend that the minority owner is liable to the business for some wrongdoing.

Independent counsel, when appointed to represent the corporation, will advise the business (the controlling and minority owners) on the issues in which the interests of the corporation are at stake: e.g., compromise of claims, indemnification of officers and directors, disclosure of sensitive records.

Disqualification of the Majority’s Attorney

When an attorney attempts to represent both the controlling owners of a business and the business itself, opposing counsel should file a motion to disqualify as a result of the actual or potential conflict of interest.  The commentary on Rule 1.13 of the Annotated Model Rules of Professional Conduct proves instructive:    

Most derivative actions are a normal incident of an organization's affairs, to be defended by the organization's lawyer like any other suit. However, if the claim involved serious charges of wrongdoing by those in control of the organization, a conflict may arise between the lawyer's duty to the organization and the lawyer's relationship with the board. In those circumstances, Rule 1.7 governs who should represent the directors and the organization.  (Emphasis added).

In many cases, there will not be a sufficient uninterested number of owners to waive any potential conflict of interest, or to consider such controversial conduct as approval of permissive indemnification, much less to determine whether there is merit in the derivative claim.  The duty owed to the corporation to preserve misappropriated funds, or correct an interested transaction, may well be compromised through the representation of the alleged wrongdoers.  

As a general rule, in the absence of a benefit to the corporation from suit, or an injurious threat to the company, a defendant in a derivative action may not use corporate funds for the payment of attorney’s fees.  See Hollander v. Breeze Corporations, 26 A.2d 507 (N.J. Court of Chancery 1941).  If, when the derivative action threatens the health of the corporation, corporate funds may used to pay the defense. Most would agree that a plaintiff should not have to pay for a defendant’s defense.  The same concept applies here.

Derivative Action May be Indistinguishable from Oppression Claims

            Defense counsel, in an attempt to fight opposing counsel’s motion to disqualify for a conflict of interest, may posit some useful arguments.  First, defendant may attempt to prove that the interests of the corporate officer(s) and the corporation are aligned or identical, thereby nullifying a conflict of interest argument.  Often in closely held corporations, the lines separating the corporate entity from the corporate officers are blurred, so an injury to one may be viewed as an injury to all.  To be successful, the defendant must be sure that the alleged misconduct does not rise to the level of serious wrongdoing (See Rule 1.13). 

A second response to a motion to disqualify is to convert the action from derivative to direct, thereby altering the position of the parties which can potentially ameliorate conflicts of interest.

A court has discretion to find a conversion appropriate, and in doing so will circumvent many of the restrictions and defenses applicable to only derivative actions.   Generally courts convert derivative to direct actions in order to permit a plaintiff to pursue a claim that would be barred by the technical requirements of the derivative statute; however, we have seen it argued successfully that the court should convert the derivative action to recognize the reality that the business has no interests distinct from its owners.

New Jersey does not unilaterally treat all closely held derivative actions as direct as some jurisdictions do.  See Brown v. Brown, 323 N.J. Super. 30 (App. Div. 1999).  A court reserves the discretion to deem an action direct even if brought derivatively, in recognition of the realities of the overall circumstances and difficulties differentiating the injury to the corporation, as opposed to the injury to the officer(s).  (The concept of a corporate injury that is distinct from any injury to the shareholders approaches the fictional in the case of a firm with only a handful of shareholders)(Comment (e) to § 7.01. American Law Institute's Principals of Corporate Governance: Analysis and Recommendations (1992)).  

A potential problem to this argument is that despite a conversion to a direct action, conflicts of interest may still exist which would require independent representation if officers in a closely held corporation have differing interests with respect to the particular suit.

Alessandro Bianchi, an associate of the McDaniel Law Firm, PC, assisted in the preparation of this post.

Lawyers must evaluate cases and try to predict the most likely outcome.  To be successful, to attract and win clients, they must do so with confidence. A recent study of the accuracy of those predictions, however, reveals that lawyers are often overconfident and overly optimistic in their assessments of a client's case.

A recent study published in Psychology, Public Policy and Law revealed that the more confidence a lawyer expressed in his or her ability to achieve a possible result, the more likely he or she was to be fail to achieve those results.  You can read the full article here (Insightful or Wishful - Lawyers Ability to Predict Case Outcomes.pdf).

The lesson appears to be that clients might want to maintain some skepticism about the results that the supremely confident lawyer predicts, even as they recognize that the statistics don't tell the whole story.  The lawyer who doesn't believe in a case, or who lacks confidence will have a difficult time being the zealous advocate that is the touchstone of an effective litigator.  We may not meet our lofty goals as often, but that is not to say that we don't do better for our clients when we are confident in the cause.  In our next post, we'll take a look at predicting the outcome in a business dispute case.

How Important Is The Lawyer's Prediction?

When choosing and working with a lawyer, we all look for someone that we believe can achieve the results that we want.  And we are attracted to the lawyer who both exudes and inspires confidence.  (I look for the same thing when I have to hire a lawyer.  The fact that I have a law degree doesn't make much difference when I am the client.)  We aren't likely to be attracted to a lawyer who is equivocal and uncertain about a successful outcome.

We will make decisions based on the lawyer's assessment, important decisions. To sue or not to sue.  To settle.  To pursue the extra deposition or conduct additional discovery.  We want and need to believe in the lawyer's judgment and expertise.  It is difficult to pursue a litigation strategy when the lawyer isn't confident in its success.

Our need to believe, however, might be contrary to reality.  This study indicated that there is a negative correlation between the confidence of the lawyer and his or her ability to predict the outcome.

The Statistical Evidence

In a study taken primarily among civil litigators, the researchers found that the lawyers who were the most confident about the results they expected to achieve were also more likely to fail to achieve those results.  At the same time, those lawyers who were less confident were more to likely to exceed their expectations.  Women were slightly more accurate than men.  And, perhaps most surprisingly, years of experience did not seem to affect the results.

The researchers conducted surveys of lawyers concerning matters that were expected to be tried within 6-12 months.  They asked the lawyers to define the "win situation in terms of your minimum goal for the outcome of the case."  The lawyers where then asked to give the probabily that they would achieve the outcome.  The researchers then went back and determined the actual results of the matters to see how they compared to the lawyers' predictions.

Most of the lawyers said they were 45-65 percent confident of achieving the outcome that they predicted.  These lawyers were generally accurate in their predictions, particularly among those where were 46-55 percent of the outcome.  But as the lawyers "confidence interval" exceeded 65 percent, the accuracy of their predictions deteriorated.  The most confident lawyers as a group failed to achieve their predictions about 20 percent of the time.

The least confident lawyers as a group did significantly better than their estimates, according to the researchers.  In fact those who were less than 50 percent confident underestimated the results as often as they were accurate.

Lawyers Are a Stubborn Lot

The researchers tried to determine whether the lawyers would be influenced by other factors.  The predictions and confidence levels of the lawyers did not change significantly as the case got closer to trial.  Nor were the lawyers likely to revise their predictions - or be significantly less confident - when asked to think through the negative aspects of their cases.

The opinions of the lawyers after the matter had been resolved also were not subject to major revisions.  Sixty-five percent of the more confident lawyers said they were pleased or very pleased with the outcome, although lawyers achieved their goals in only 57 percent of their cases.  When asked why the cases had failed to meet their predictions, the most frequently given response related to factual and evidentiary issues, the next most cited reason was "witness problems," followed by "client problems."  The least cited reason was attorney performance, including the performance of adversary counsel.

The Non-Scientific Assumptions

What is missing from the research is whether the overconfident lawyer does better for his or her clients than the lawyer who lacks confidence.  In other words, on a similar set of facts, will the client achieve a better net result with the confident lawyer or the not-so-confident lawyer.  In my opinion, the lawyer that is confident becomes a leader among the other lawyers or lawyers in the case, with the judge and with the jury.  There is a benefit to the client, however difficult it is to measure.