The Business Divorce Law Report

December 20, 2010

Derivative Claim in Dispute Between Owners May Require Independent Counsel

by Jay R. McDaniel, Esq.

A derivative claim is an action brought by an individual, but to enforce a right owned by the company. Any remedy or recovery belongs to the company.
An individual claim is brought to vindicate the rights of an individual owner. The recovery or remedy belongs to the individual owner.
Although the business is often considered a nominal party in derivative litigation — one without a significant stake in the outcome — it may be necessary to have a separate attorney represent the corporation or limited liability company to avoid conflicts of interest with the lawyers representing individual owners.

September 30, 2010

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

by Jay R. McDaniel, Esq.

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

August 16, 2010

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

by Jay R. McDaniel, Esq.

The last-minute motion of a 50-percent shareholder to prevent the sale of a business 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.

August 13, 2010

An Early Cost-Benefit Analysis in Business Breakups Will Keep Dispute in Perspective

by Jay R. McDaniel, Esq.

When one or more of the owners of a business think it is time to get divorced, the decision in invariably accompanied by hard feelings. As most clients ultimately learn, the courts are incapable of resolving emotional issues. But they deal pretty well with money – which is why it makes sense to find out how much is at stake in the fight that is likely to ensue. Save the emotions for therapy; money is what the case is about.

The Pitfalls of Misinformation

My experience is that most clients are pretty thoroughly misinformed about the “fair value” of their business as well as their individual interests. Not infrequently, clients will presume that the high price-to-earnings ratio that one may find in the market of publicly traded stocks will apply equally to their closely held business. Not so. Others will fail to recognize the effect that the unusually high salaries paid to the owners will likely have in inflating the value of the business.

August 11, 2010

Lawyer Confidence May Be Poor Indicator of Results

by Jay R. McDaniel, Esq.

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 will 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 case. In our next post, we’ll take a look at predicting the outcome in a business dispute case.

June 11, 2010

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

by Jay R. McDaniel, Esq.

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.

June 11, 2010

Fiduciary Duties to Minority Interests in Operating Agreement Amendments

by Jay R. McDaniel, Esq.

Limited liability companies are creatures of contract, and the Operating Agreement is the Magna Carta of the business. Because it is a contract, however, all of the members must consent to any changes to the Operating Agreement, which means that the holdout member has a veto. In short, the minority rules on major changes.

The Minority Rule Problem

All of the members, save one, may agree that a change to an operating agreement is in the best interests of the business. Yet that one holdout, for whatever reason, can veto the change because a contract cannot be changed unless all of the parties’ to the original agreement consent.

May 28, 2010

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

by Jay R. McDaniel, Esq.

Without John Murray, the former CEO of Crystex Composites, LLC, the Clifton manufacturer 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 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 of 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.

May 27, 2010

Exercise Care in Valuing Interests in New Jersey Business Breakups

by Jay R. McDaniel, Esq.

A court orders a business valuation in a matter involving an oppressed shareholder claim. The appraiser, carefully applying the standards of his profession, sends an engagement letter describing a fair market value determination. The appraisal will value the enterprise as a whole, then apply minority and marketability discounts. The selling shareholder is going to argue for discounts – they always do – but the report will have all the information necessary for a determination either way.

For the minority shareholder, this can be a trap. And it may be the wrong move to wait for the trial to fight out the discount issue and the battle over the definition of fair value should be fought as early in the case as possible. Here are a few reasons why.

The appraiser is going to prepare a report based on the standards of the valuation industry and that standard is fair market value – what a willing buyer would pay a willing seller. He is going to try to avoid the tough issue of whether any discounts should apply. The AICPA’s Statement on Standards for Valuation Services No. 1 relegates the definition of “fair value” to a single paragraph in an appendix as a matter determined by state law in judicial proceedings.

May 26, 2010

Expelling a Member of a NJ Limited Liability Company

by Jay R. McDaniel, Esq.

Time was that the expulsion of a troublesome individual from a limited liability company or partnership generally meant that the business entity would have to be dissolved and either start over or be sold off. Changes to partnership laws — and the adoption of similar provisions in New Jersey’s limited liability company — make it possible to remove an LLC member without dissolution of the entity.

Unlike Delaware law — on which New Jersey’s LLC Act was modeled — or New York law, New Jersey law includes a provision borrowed from partnership statutes that permits the involuntary dissociation of a member for wrongful conduct or when it is simply no longer reasonably practicable to stay in business together. The statutory provision comes from uniform limited liability company and partnership laws. This departure from Delaware law is a substantial consideration when organizing an LLC or when a dispute arises between the owners.

What that means in practical terms is that for LLCs organized under New York or Delaware Law, the aggrieved parties must often establish that the business cannot go on in pursuit of its original purpose if they are to immediately recoup their investment or, in similar fashion, that the behavior of the offending party is so egregious that the business cannot continue.

A derivative claim is an action brought by an individual, but to enforce a right owned by the company. Any remedy or recovery belongs to the company.

An individual claim is brought to vindicate the rights of an individual owner. The recovery or remedy belongs to the individual owner.

An Example

The Pitfalls of Misinformation

It’s Not Easy to Fire the Owner-Employee

The Minority Rule Problem