New Jersey Business Dissolution Journal

The Little Big Breach - Restrictive Covenants

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Wed, 15 May 2013 15:10:24 -0500

Most of the cases that we handle – like any other litigation – get settled before trial. One of the incentives to settle is that invariably the departing owner will agree to some sort of restrictive covenant against competing against his former company.

The case that goes to trial, or which is resolved on a substantive motion, leaves this issue wide open. In fact, there is no statutory basis to deter the ousted business owner from setting up a competitor and trying to lure away the business of his former company, and one would suppose with a bankroll secured by the purchase of his or her interest.

Since most business divorce litigation ends with a deal, and restrictive covenants are critical aspects of those transaction, I thought it worthwhile to write about a recent decision of the Appellate Division that gives a stern warning that the restrictive covenant had better be honored.

In that decision, the appeals court affirmed a trial judge’s holding that the seller of a business had breached a covenant not to compete, even if the amount at issue was just a few hundred dollars, and that the purchaser would therefore be relieved from any obligation to pay the balance of the purchase price.

The Court, in Peek v. Johl & Col, Inc., Docket No. A-0499-10T4 (December 11, 2012) (see opinion below) affirmed the trial court hold that by secretly diverting shared insurance premium commissions from another broker, the seller had committed a material breach that was not excused by the small amount at issue.

The plaintiff Peek sold his brokerage to the defendants and received a note in return, along with an agreement to pay a portion of new premiums received by the firm. The buyers also agreed to rent the office in which the business was located from the seller.

Peek had long had an arrangment with another brokerage to write insurance that his own firm did not handle and after the sale continued to refer business to the other broker and receive a share of the commission – which it appears he was entitled to do. Under the terms of the sale, he would have continued to receive his share of the referral payments.

However, Peek had the payments directed to him instead of to the buyer. And when the seller found out, he stopped paying either the note or the office rent. Peek filed suit and the buyer counterclaimed alleging a breach of the restrictive covenant contained in the sale agreement.

The trial judge rejected the agreements and awarded defendants their half of the withheld payments in the amount of $614.30. Te trial court also found that there had been a material breach of the parties’ contract and that further performance by the buyer was excused.

The Court relied on a pair of decisions, Ross Sys. V. Linde Dari-Delite, 35 N.J. 329 (1961) and Nolan v. Lee Ho, 120 N.J. 465 (1990) holding that the material breach of a contract by one party relieves the non-breaching party of further performance.

We appreciate that the amount in commissions that … plaintiffs wrongfully retained was much less than what defendants were obligated to pay under the contract terms. Even so, a breach of a restrictive covenant, which often can be a key bargaining term when a small business is sold to a new owner, was reasonably found here to constitute a material breach that excused defendants from making those additional payments. Because the material breach prevents a claim of substantial performance, the trial court made no legal error in granting defendants relief on their counterclaim.

The appellate court also rejected the argument that excusing further performance of the contract was a windfall to the buyers who, even if there was a breach, should be liable under the theory of unjust enrichment. Rather, the wrongful conduct made the trial cour’ts rejection of the claim “appropriate, even thought that results in defendants reaping the benefits of the transaction for a lesser sum than the amount originally bargained for under the contract.”

Opinion in Peek v. Johl, New Jersey Appellate Division by Jay McDaniel

Expelled LLC Members: No Right to Force Purchase

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Mon, 25 Feb 2013 13:26:55 -0500

Removal of LLC Member May Be 'Prospective' Conduct

In what is probably the most significant appellate decision involving New Jersey limited liability companies in a decade, the Appellate Division held that wrongful conduct is not required to expel a member from the LLC, nor is the member entitled to be paid for the value of the interests.

On the contrary, the opinion in All Saints University of Medicine Aruba v. Chilana, Docket No. A-2628-09T1, App. Div Dec. 24, 2012 (see below), makes clear the standard can be much lower: conduct that makes it not reasonably practicable to continue the business with the member. The former member, moreover, cannot compel purchase of their interests. They are relegated to the status of assignee, forfeiting all of their management rights but still retaining their financial interest in the business.

Removal of Members in Business Divorce Cases

Expelling a member from a New Jersey limited liability company requires a judicial order, unless the LLC's operating agreement contains specific provisions that permit for the expulsion of members. Litigation over the expulsion of members, referred to in the New Jersey Limited Liability Company Act as involuntary dissociation, typically focuses on wrongful conduct by the member whose ouster is sought.

Wrongful Conduct is Not a Requirement

The frequent assumption that wrongful conduct is required to remove a member from a limited liability company. The Appellate Division decision in All Saints is a major opinion clarifying the application of the provisions in the New Jersey Limited Liability Company Act that govern the removal of LLC members. The opinion is important for two reasons.

The court applies a lower standard for involuntary dissociation, simply that the member has engaged in conduct "relating to" the business of the LLC makes it not reasonably practicable to continue with him or her as a member.
The Court makes clear that the fact that a member has been dissociated from the limited liability company does not automatically mean that he or she is entitled to be paid the fair value of their shares.

The factual background of the case involved an LLC formed in New Jersey to operate a medical school in Aruba. The project ran into trouble and disputes broke out between the four members of the LLC. One of the key issues in the case was that the LLC was desperately short of cash and one of the members was willing to put money into the business, but only if other members were dissociated.

The case went to trial and the judge found that two of the members should be expelled based both on the existence of prior wrongful conduct and also because it was no longer reasonably practicable to continue the LLC with their participation. The lower court then proceeded to make a valuation determination under the assumption that the expelled members had a right to be paid for the fair value of their shares. It turned out that the business had no value, but the Appellate Division found that the assumption itself was in error.

The case involves construction of N.J.S.A. 42:2B-24, which provides the circumstances under which an LLC member can be involuntarily dissociated, that is, expelled, from a limited liability company by judicial order for the following reasons:

(a) the member engaged in wrongful conduct that adversely and materially affected the limited liability company's business;

(b) the member willfully or persistently committed a material breach of the operating agreement; or

(c) the member engaged in conduct relating to the limited liability company business which makes it not reasonably practicable to carry on the business with the member as a member of the limited liability company[.]

N.J.S.A. 42:2B-24(b)(3)

The Appellate Division held that the statute is to be read in the disjunctive, in other words any one of the three reasons provided for in the statute will be sufficient to expel a member. The evidence at trial of wrongful conduct in the opinion was not compelling, but the appellate court found that ultimately it was not necessary to make that determination because it was clear that the LLC could not be reasonably expected to continue with all of the members of him and.

As the court noted, under subsection N.J.S.A. 42:2B-24(b)(3)(a), the plaintiff must establish that another member has committed wrongs that have "adversely and materially affected" the business of the LLC. In other words, the court reasoned, the requirement is for wrongful conduct that actually harms the business.

Subsection 3(c) of that statutory provision, however, has a "prospective orientation." It is sufficient to show simply that the conduct concerned the operations of the LLC and was such that it was unreasonable to continue with that person as a member.

The only issue therefore was whether the defendant's conduct, which admittedly related to the business' operations, was such as to make it not reasonably practicable to continue with him as a member. This standard, the court held, had been established.

The mere fact that a member has been expelled, however, does not automatically entitle that member to be paid fair value for his or her interest. Rather, the court held, the effect of a dissociation is that the former member now becomes an "assignee" of the membership interest. An assignee is entitled to receive the financial benefits associated with that membership interest, such as distributions of cash, profits or losses that might be passed through to an individual tax returns.

Assignees have no right to participate in the management of the business, however. Thus, the result of an expulsion is that the former member forfeits any management rights, but can continue to receive all of the economic benefits of ownership.

Because New Jersey's Limited liability Company Act contains a provision that permits members to resign from an LLC at any time and be paid the fair value of their interests, the Appellate Division opinion does not leave the house to member with no remedy. As the Court notes, the member can always resign, which triggers the obligation of the LLC to repurchase the former member's interest.

An interesting issue that this opinion raises is that under the new law that takes effect March 18, the Revised Uniform Limited liability Company Act, the statutory right to resign from an LLC at any time has been eliminated. Another court might interpret the dissociation provisions of the RULLC are likely to be a significant issue in future limited liability company litigation. Like the current act, the RULLC does not contain any language mandating the buyout of a dissociated member's shares. But the absence of a statutory right to resign could leave members without any remedy.

All Saints University v. Yusuf | Wrongful conduct is not required to expel New Jersey LLC member | McDaniel... by Jay McDaniel

NJ Limited Liability Company Law Effective March 18

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Tue, 05 Feb 2013 09:09:18 -0500

Revised Uniform Limited Liabilty Company Act Changes Legal Landscape

The effective date of New Jersey’s Revised Uniform Limited Liability Company Act is approaching. The law will be effective on March 18, 2013 for newly formed LLCs and will be applied to all LLCs effective March 1, 2014.

There is a laundry list of changes in the new statute. Our view in the firm is that it’s a significant improvement over New Jersey’s current statute, modeled under Delaware law with some fairly significant additions. But the statute is also more complicated, and for those accustomed to drafting under the old law, it’s time get started revising those model clauses.

It’s also time to start warning the owners of existing LLCs about the impending change. The differences are significant enough that some LLCs may have problems with Operating Agreements drafted under the old statute that will have significant problems under the new act.

Although the law does not apply to a new LLC until March 18, we are incorporating the new statute in the LLCs that we are forming. It will apply in just over a year anyway so it makes sense to include a clear choice of law selection, at least until next month.

New LLC Law, New Operating Agreement Language

We find that we have had come up with some new model language in a number of areas including such things as distributions, member’s rights and duties, withdrawals and expulsions. We also find ourselves having to address some new concepts. Some of the issues that we are seeing, and drafting for, include the following:

The new law provides that any written or oral agreement, or any course of dealing, can be an operating agreement. That is a big change from the current law and presents an issue with unwanted oral modifications and waiver. We have drafted some provisions that specifically deal with this problem by including a contractual bar on the presentation of evidence.
The change in the law on voluntary withdrawal of members, what the law calls dissociation by express will, is very significant. Under the old statute, any member could quit and be paid fair value. Not so anymore, and you have to have meaningful discussions about exits from the business.
The oppressed member and involuntary dissociation provisions are much changed and, significantly provide neither a right to the compelled purchase or sale of shares or any mention of “fair value.” We are valuation provisions more carefully with clients.
Under the new law, distributions are assumed to be in equal shares, as opposed to the current presumption that they are proportionate to the capital contributed to the limited liability company. We have tweaked our distribution provisions.
Members do not automatically have the right to act for the LLC, which can create an interest issue when not all of the members are managers. The members of a manager managed LLC do not have fiduciary duties and one needs to review this issue with clients and draft accordingly. The members of an LLC might be surprised to know that that the non-manager members are free to set up a competing business.
Fiduciary duties need to be reviewed with the clients more carefully, and care taken that the provisions for waiver of fiduciary duties are not going to fail the manifestly unreasonable standard. We see this with some frequency in single purpose LLCs and its probably best dealt with in the management structure.

As always, we welcome questions and comments

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Sun, 13 Jan 2013 09:18:45 -0500

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Five Expensive Mistakes When Forming a New Jersey LLC

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Mon, 31 Dec 2012 09:40:58 -0500

New Jersey Limited Liability Company Attorneys

Imagine that the limited liability company you and your partners started five years ago is involved in a nasty corporate governance lawsuit. Perhaps one of the partners needs to be expelled, or maybe one of the owners is involved in a competing business. Imagine that you are spending tens of thousands of dollars every month on legal fees, that the business is in a state of constant disruption and that you haven't had a good night’s sleep in weeks.

And now, accept the fact that this could have been avoided.

The chances are that if a closely held business is involved in this type of litigation it is because the owners did not plan well when they started the business. How do I know? Having litigated many of these matters over the years, I see the same mistakes made early in the life of the business surfacing again and again as the source of litigation.

New Jersey Limited Liability Company Operating Agreement

This is my non-exclusive list of what I think are the most expensive mistakes that I see people make in their business. There are others, to be sure, but these are the ones that I see as the source of litigation among the members.

No Operating Agreement: Actually, I am not going to count not having an operating agreement as one of the five “mistakes.” It is not really a mistake, it is a colossal blunder, kind of like drunk driving – you may get away with it for a while, but you know how it’s going to end.

If you have more than one member of a limited liability company and you don’t have a written operating agreement, please keep my number handy. (New Jersey does not require a written operating agreement.) If a business does not have one, sooner or later, it will have problems and without any point of reference whatsoever, the probability of litigation is high. When that happens and the business is successful, the chances are that you will spend the price of a college education – at a nice private school – on the lawsuit.

Mistakes to Avoid When Starting an LLC

For those companies that at least have an operating agreement, here are the five of the costliest areas in which limited liability company owners make the mistake of not planning carefully.

No Operation Planning: Many operating agreements don’t try to distinguish between what is day-to-day management and what are “members” matters requiring approval of a majority or all of the members. There is a difference between leasing a new copier and acquiring a competitor or buying a building. Companies that devote the same attention to both types of issues are headed for trouble. And it only gets worse when one person can veto the decisions of the rest of the owners. Often people come to a business with specific skill sets and expect autonomy, but just how much autonomy will the individual members be given? How will you manage the day-to-day? How will you manage the really big issues?
No contingency Planning: The owners of limited liability companies often don’t plan adequately for the unexpected. Life happens and the time to think about the contingencies of life is before they occur. One of the members may die or become disabled. Some may have children that they want to bring in the business. Sometimes the members are, or will get married, and then get divorced. What happens if a member develops financial or personal problems and has to be removed? What happens when one quits to start a competing business? Suppose that one of the members gets divorced and must pay half of his or her interest to an ex-spouse. How will you manage these issues? If they aren’t planned for, they likely will become the source of expensive litigation.
No valuation planning: Despite the best efforts of all involved, a divorce is inevitable. Sooner or later, someone is going to leave even the most successful business. Sometimes, it is simply because one of the members wants to retire. Other times it is because of poor planning or personality confilicts. For whatever reason, the members need to go their separate ways, and this happens for an infinite of reasons, many of which are unforseeable. Still companies often fail to build into their operating agreements a way to value the interests of those involved. Will the company hire an appraiser or build a formula for valuation into its operating agreements, put the method in its operating agreement or just leave the issue to a judge to decide? Many operating agreements taken out of a form book use a book value system to value the interests of its members, which are usually unfair to the departing member because they do not adequately include the value of the company’s good will, or because they fail to consider the above-market income distributed to most owners of successful businesses. Litigating the value of a business is expensive and uncertain. How does your business plan to make these difficult valuation decisions? Leaving it to a court to decide is the worst possible alternative.
No succession planning: We all hope when we start a business that it going to last a lifetime and beyond. In every successful business there will come a day when the founders will no longer part of the business. What I mean by succession planning is more than simple retirement planning. It is how the business will carry on when the founders are gone. And yet, even though most business owners hope their work will endure for more than one generation, they fail to plan for the succession of their interests. Will the business admit new remembers to replace the outgoing members? Will the family members of the business be permitted to acquire the founders’ interests? Can those interests be passed by will or intestate succession? These issues can be fertile ground for disputes.
No planning for amendments to the Operating Agreement: An operating agreement is a contract and, like any other contract, it requires everyone to agree to any changes before they can become effective. And because you cannot change a contract over the objection of the parties, it gives each of the members a minority veto. Imagine that all but one of the members wants to admit another member or merge with another business? The minority member may veto actions that are for the good of the business for any or no reason. An effective operating agreement contains mechanisms for amendment that are planned for in advance.

The central point here is that it is a bad idea not to plan the operations of a business before there is a vested interest in the outcome – that is before a dispute develops. Formbook operating agreements or contracts drafted by non-lawyers may serve some purpose, but they are rarely adequate.

The beauty of a limited liability company is that it can be almost anything that you want, but that takes thought, a bit of effort and is not something that should not be left to chance. And remember, the money that you save later will more than justify the expense of doing it right in the first place.

Please fee free to contact us if you have any questions or comments.

Operating Agreements That Modify Fiduciary Duties

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Mon, 17 Dec 2012 09:29:07 -0500

Statutory Fiduciary Duties May Be Limited or Eliminated – Sometimes

A Series on New Jersey's Adoption of the Revised Uniform Limited Liability Company Act

The revised limited liability company law that takes effect in March 2013 creates a new statutory structure of fiduciary duties for LLC members and managers. As we noted in our recent post, the statutory standards are floor, not a ceiling, and courts are still able to find a duty based on the circumstances at issue. Limited liability companies may alter or amend those duties by statute – or ratify a breach after it has occurred – but not without limits.

The new law is a significant improvement over the existing law, which is largely silent on the precise duties owed by members and managers to an LLC. The current law seems to presume that the members will define these duties for themselves; an assumption that in practice is often not true. It also opens the door to business practices that may be oppressive and assumes that all have an equal say in the terms under which an agreement is organized. The new law adopts a “manifestly unreasonable” standard that limits the ability of LLC members to create businesses under contracts that include oppressive provisions.

The drafters of the Revised Uniform Limited Liability Company Act (RULLC) noted that the model statute

rejects the ultra-contractarian notion that fiduciary within a business organization is merely a set of default rules and seeks instead to balance the virtues of “freedom of contract” against the dangers that inescapably exist when some have power over the interest of others.

No Limits Under Current LLC Law to Eliminate Member Duties

The current law does not seem to impose any limits on the ability to eliminate or modify fiduciary duties. N.J.S.A. 42:2B-66. We often see special-purpose LLCs in which the relationship of the members is an arms-length contract; they are free to compete and owe no duties of care or loyalty. These agreements will be problematic under the new law because the waiver may be ineffective.

Another word of warning that current operators of LLCs should consider is that the definition of operating agreement is much broader under the new law than under current law which provides that an operating agreement, if it exists, must be written. Members can expect that the courts will look at the actual practices of the LLC, not just what has been included in the operating agreement. N.J.S.A 42:2C-2. Under the RULLC, there is no such thing as an LLC without an operating agreement because just about anything can be an operating agreement. It is any agreement – written, oral or implied – that governs any aspect of the LLC’s business.

The RULLC defines the fiduciary duties created by default under the statute, and prescribes a duty of good faith and fair dealing. (We discussed these in more detail in a previous post.) Those duties may be eliminated or restricted when to do so is not “manifestly unreasonable.”

Fiduciary Duties May Be Restricted or Eliminated

The statute provides that the operating agreement may restrict or eliminate the duties

to hold any property of benefit derived from the LLC,
to refrain from dealing with the LLC on behalf of someone with an adverse interest,
to refrain from competing with the LLC, or
to exercise due care, except to permit intentional misconduct or knowing violation of the law.

Because the statute foresees other fiduciary duties that may arise out of particular circumstances, it also permits the LLC to “identify specific types or categories of activities that do no violate the duty of loyalty” and to “alter any other duty, including eliminating the particular aspects of that duty.” The RULLC also permits the operating agreement to provide explicit standards by which to “measure the contractual obligation of good faith and fair dealing.”

There are some areas of law that are off limits. The operating agreement may not alter the law applied to the internal affairs of the limited liability company, restrict the court’s power to judicially dissolve the LLC, unreasonably restrict the right of the members to bring an action under the LLC act or to void the veto power of any member over a business combination that would result in that member having personal liability.

The Manifestly Unreasonable Standard

The new statute in N.J.S.A. 42:2C-11 contains specific guidelines for applying the “manifestly unreasonable standard” that in the event of a dispute appears to make the application of the standard a threshold question for a judge:

h. The court shall decide any claim … that a term of an operating agreement is manifestly unreasonable. The court:

(1) shall make its determination as of the time the challenged term became part of the operating agreement and by considering only circumstances existing at that time; and

(2) may invalidate the term only if, in light of the purposes and activities of the limited liability company, it is readily apparent that:

(a) the objective of the term is unreasonable; or

(b) the term is an unreasonable means to achieve the provision's objective.

There is one perhaps significant distinction between the model act drafted by the National Conference of Commission Uniform State Laws and the act adopted in New Jersey, which is the tip of the hat given to freedom on contract in a rule of construction not found in the model statute.

“This act is to be liberally construed to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.”

It seems unlikely that a rule of construction is likely to have much affect on the individual application of the manifestly unreasonable standard, but one can see the scales tipped ever so slightly in favor of freedom of contract in a close case.

The changes to the law, which will take effect for existing LLCs in 2014, are such that many operating agreements should be reviewed and revised. The new statute is a clear improvement over existing law, but likely will be problematic for LLCs with operating agreements drafted under the existing statute.

We welcome questions and comments.

N.J.S.A 42:2C-2 provides that

"Operating agreement" means the agreement, whether or not referred to as an operating agreement and whether oral, in a record, implied, or in any combination thereof, of all the members of a limited liability company, including a sole member, concerning the matters described in subsection a. of section 11 of this act. The term includes the agreement as amended or restated.

§ 42:2C-11. Operating agreement; scope, function, and limitations [Effective March 18, 2013]

a. Except as provided in subsections b. and c. of this section, the operating agreement governs:

(1) relations among the members as members and between the members and the limited liability company;

(2) the rights and duties under this act of a person in the capacity of manager;

(3) the activities of the company and the conduct of those activities; and

(4) the means and conditions for amending the operating agreement.

b. To the extent the operating agreement does not otherwise provide for a matter described in subsection a. of this section, this act governs the matter.

c. An operating agreement may not:

(1) vary a limited liability company's capacity under section 5 of this act to sue and be sued in its own name;

(2) vary the law applicable under section 6 of this act;

(3) vary the power of the court under section 21 of this act;

(4) subject to subsections d. through g. of this section, eliminate the duty of loyalty, the duty of care, or any other fiduciary duty;

(5) subject to subsections d. through g. of this section, eliminate the contractual obligation of good faith and fair dealing under subsection d. of section 39 of this act;

(6) unreasonably restrict the duties and rights stated in section 40 of this act;

(7) vary the power of a court to decree dissolution in the circumstances specified in paragraphs (4) and (5) of subsection a. of section 48 of this act;

(8) vary the requirement to wind up a limited liability company's business as specified in subsection a. and paragraph (1) of subsection b. of section 49 of this act;

(9) unreasonably restrict the right of a member to maintain an action under Article 9 (sections 67 through 72 of this act);

(10) restrict the right to approve a merger, conversion, or domestication under section 86 of this act to a member that will have personal liability with respect to a surviving, converted, or domesticated organization; or

(11) except as otherwise provided in subsection b. of section 13 of this act, restrict the rights under this act of a person other than a member or manager.

d. If not manifestly unreasonable, the operating agreement may:

(1) restrict or eliminate the duty:

(a) as required in paragraph (1) of subsection b. and subsection g. of section 39 of this act, to account to the limited liability company and to hold as trustee for it any property, profit, or benefit derived by the member in the conduct or winding up of the company's business, from a use by the member of the company's property, or from the appropriation of a limited liability company opportunity;

(b) as required in paragraph (2) of subsection b. and subsection g. of section 39 of this act, to refrain from dealing with the company in the conduct or winding up of the company's business as or on behalf of a party having an interest adverse to the company; and

(c) as required by paragraph (3) of subsection b. and subsection g. of section 39 of this act, to refrain from competing with the company in the conduct of the company's business before the dissolution of the company;

(2) identify specific types or categories of activities that do not violate the duty of loyalty;

(3) alter the duty of care, except to authorize intentional misconduct or knowing violation of law;

(4) alter any other fiduciary duty, including eliminating particular aspects of that duty; and

(5) prescribe the standards by which to measure the performance of the contractual obligation of good faith and fair dealing under subsection d. and subsection g. of section 39 of this act.

e. The operating agreement may specify the method by which a specific act or transaction that would otherwise violate the duty of loyalty may be authorized or ratified by one or more disinterested and independent persons after full disclosure of all material facts.

f. To the extent the operating agreement of a member-managed limited liability company expressly relieves a member of a responsibility that the member would otherwise have under this act and imposes the responsibility on one or more other members, the operating agreement may, to the benefit of the member that the operating agreement relieves of the responsibility, also eliminate or limit any fiduciary duty that would have pertained to the responsibility.

g. The operating agreement may alter or eliminate the indemnification for a member or manager provided by section 38 of this act and may eliminate or limit a member or manager's liability to the limited liability company and members for money damages, except for:

(1) breach of the duty of loyalty;

(2) a financial benefit received by the member or manager to which the member or manager is not entitled;

(3) a breach of a duty under section 36 of this act;

(4) intentional infliction of harm on the company or a member; or

(5) an intentional violation of criminal law.

h. The court shall decide any claim under paragraph (1) of subsection d. of this section that a term of an operating agreement is manifestly unreasonable. The court:

(1) shall make its determination as of the time the challenged term became part of the operating agreement and by considering only circumstances existing at that time; and

(2) may invalidate the term only if, in light of the purposes and activities of the limited liability company, it is readily apparent that:

(a) the objective of the term is unreasonable; or

(b) the term is an unreasonable means to achieve the provision's objective.

i. This act is to be liberally construed to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.

§ 42:2B-66. Liberal construction [Repealed effective March 1, 2014]

a. This act is to be liberally construed to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.

b. To the extent that, at law or in equity, a member or manager has duties (including fiduciary duties) and liabilities relating to a limited liability company or to another member or manager: (1) any member or manager acting under an operating agreement shall not be liable to the limited liability company or to any other member or manager of the limited liability company for the member's or manager's good faith reliance on the provisions of the operating agreement; and (2) the member's or manager's duties and liabilities may be expanded or restricted by provisions in an operating agreement.

Fiduciary Duties Change In New Jersey LLC Law

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Tue, 04 Dec 2012 11:51:06 -0500

Law Specifies Fiduciary Duties for Members and Managers

of New Jersey LLCs

A Series on New Jersey's Adoption of the Revised Uniform Limited Liability Company Act

The fiduciary duties imposed on a member or manager of a New Jersey LLC are at present elusively and poorly defined in the statute. While the current act contains several provisions limiting the personal liability of members, nowhere does it clearly define the duties that are inherent in the relationship of the members. Attempts to impose the fiduciary obligations that have traditionally been thought to be a fundamental aspect of the relationship of partners in a partnership, or the officers and directors in a corporation, have met with uneven results.

As we noted in our recent blog post (Fiduciary Duties Murky Under Delaware Law), reviewing a decision from the Delaware Supreme Court, the issue is still undecided in the most influential jurisdiction in the country on issues of business governance, and there is little guidance in the form of controlling authority in New Jersey.

Uncertain Responsibilites of LLC Members

That uncertainty should change significantly when the revisions to New Jersey’s limited liability company law take effect in March 2013 for newly formed companies, and in March 2014 for existing LLCs. In adopting the RULLC, the legislature put in place a new set of standards for the conduct of members and managers of LLCs organized under New Jersey law. While some of the changes reflect much of the judge-made law applying equitable principles to the conduct of small business owners, there are some significant differences in the way those duties will now work, and anyone involved with a New Jersey limited liability company needs to have a firm grasp of the structure.

This definition of fiducIary duties is significant because courts are often hesitant to create new rules of law by analogizing to the law of corporations or partnerships. A particularly contentious issue in New Jersey, for example, was whether a minority member of an LLC who was treated unfairly could bring an action for oppression and obtain the remedies available under corporate law. These efforts have uniformly had anything but uniform results -- in New Jersey and other states with similar limited liability company statutes.

The RULLC is more comprehensive that the present New Jersey Liability Company Act. Under the current act, there is no explicit definition of the duties. The current law simply provides that to the extent that “at law or in equity” a member or manager has any duties, including fiduciary duties, those duties can be varied by the operating agreement and that the member or manager can rely on the operating agreement. N.J.S.A. 42:2B-66. The current act also provides that where the statute is silent, the “rules of law and equity” govern. N.J.S.A. 42:2B-67. Many commentators see this as the express understanding that fiduciary duties are created by the equitable principles that are widely accepted as governing the relationships between members of business enterprises. Others think not.

NJ Revised Uniform Limited Liability Company Act

In any event, when the RULLC takes effect in March 2014 for newly formed companies, and in March 2015 for existing companies, the statute lists specific duties owed by the members or managers then provides the opportunity to limit or eliminate most of those duties through the contractual terms of the operating agreement. It’s complicated, however.

Under the new statute, N.J.S.A. 42:2C-39, LLC members owe to the company and to each other the fiduciary duties of loyalty and care.

The fiduciary duty of loyalty is defined to include the duties:

To account to the company and hold as trustee any property, profit or benefit derived by the member from the company’s activities, its property or the taking of any opportunity that belongs to the company;
To refrain from dealing with the company on behalf of anyone having an interest adverse to the company; and
To refrain from competing with the company.

The fiduciary duty of care is defined as to refrain from from engaging in:

grossly negligent or reckless conduct;
intentional misconduct; or
a knowing violation of law.;

The revised statute also codifies the obligation of good faith and fair dealing in performing the obligations of the operating agreement and provides that there is no violation of a duty merely because the member’s conduct furthers their own interest. The RULLC also provides that the members may by unanimous action ratify conduct that would otherwise be a breach of the duty of loyalty. It also creates a defense in the event that the member acted on behalf of someone with a conflict that the transation was fair to the LLC.

All of that assumes that the Members manage the LLC. If the company is a manager-managed LLC (the members elect or agree to managers to run the business), then only the managers and not the Members .owe the company the fiduciary duties of loyalty and care. The duties of the non-managing members are limited to the contractual obligation of good faith and fair dealing.

No Fiduciary Duties for Non-Managers

While the revised statute contains a list of fairly detailed duties, it also expressly states that a member does not have duties to the company or to any other members solely by virtue of the fact that they are members. To many currently involved with a New Jersey limited liability company, that would likely come as a surprise.

It is generally presumed that the people who own a closely-held business have a special relationship with each other and that fiduciary duties apply. Consider the case of the small business with principals that don’t work in the business. It would come as a surprise that they are free to compete or misappropriate opportunities from the business.

A few additional comments are worth noting. Although the RULLC borrowed heavily from the Revised Uniform Partnership Act (RUPA), the question of fiduciary duties is one where the Uniform Law Commission, which drafts model acts for the states to consider adopting, took a different approach.

The standards of conduct provided in the RULLC are considered a floor not a ceiling. The RUPA, from which the New Jersey legislature adopted its definition of partners’ fiduciary duty, uses what the Law Commission describes as the “cabining” approach: the duties defined in the statute are the only duties owed by the partners unless they agree otherwise in a partnership agreement. N.J.S.A. reads that the “only” fiduciary duties defined a partner owes to the partnership are the duties of loyalty and care defined in the statutes as they may be “clarified or limited” (but not eliminated) in the partnership agreement.

The Uniform Law Commissioners, however, eschewed the attempt to corral fiduciary duties to those listed in the statute, noting that “ït is impracticable to cabin in all LLC-related fiduciary duties within a statutory formulation.” Judges will still be free to find, and of course the parties may contract for, other fiduciary duties that are not in the statute. A likely example might be the duty to secure the best possible price in a sale of the company or its assets.

The trade off, it seems, is that although the duties of a limited liability may be broader than those of a partnership, the LLCs members have much greater leeway to limit or eliminate those fiduciary duties in the operating agreement. I will take a look at the ways in which the duties of LLC members or managers may be limited in our next blog post will

As always, we welcome your questions or comments.

§ 42:2B-66. Liberal construction [Repealed effective March 1, 2014]

a. This act is to be liberally construed to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.

§ 42:2B-67. Rules of law and equity govern [Repealed effective March 1, 2014]

In any case not provided for in this act, the rules of law and equity, including the law merchant, shall govern.

§ 42:2C-39. Standards of conduct for members and managers [Effective March 18, 2013]

a. A member of a member-managed limited liability company owes to the company and, subject to subsection b. of section 67 of this act, the other members, the duties of loyalty and care stated in subsections b. and c. of this section.

b. The fiduciary duty of loyalty of a member in a member-managed limited liability company includes the duties:

(1) to account to the company and to hold as trustee for it any property, profit, or benefit derived by the member:

(a) in the conduct or winding up of the company's activities;

(b) from a use by the member of the company's property; or

(2) to refrain from dealing with the company in the conduct or winding up of the company's activities as or on behalf of a person having an interest adverse to the company; and

(3) to refrain from competing with the company in the conduct of the company's activities before the dissolution of the company.

c. The duty of care of a member of a member-managed limited liability company in the conduct and winding up of the company's activities is to refrain from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.

d. A member shall discharge the duties under this act or under the operating agreement and exercise any rights consistently with the contractual obligation of good faith and fair dealing.

e. A member does not violate a duty or obligation under this act or under the operating agreement merely because the member's conduct furthers the member's own interest.

f. All of the members of a member-managed limited liability company or a manager-managed limited liability company may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty.

g. It is a defense to a claim under paragraph (2) of subsection b. of this section and any comparable claim in equity or at common law that the transaction was fair to the limited liability company.

h. If, as permitted by subsection f. of this section or the operating agreement, a member enters into a transaction with the company that would otherwise be prohibited by paragraph (2) of subsection b. of this section, the member's rights and obligations are the same as those of a person not a member.

i. In a manager-managed limited liability company, the following rules apply:

(1) Subsections a., b., c. and g. of this section apply to the manager or managers and not the members, and the duty stated under paragraph (3) of subsection b. of this section continues until winding up is completed.

(2) Subsections d. and e. of this section apply to the managers as well as the members and, subject to subsection d. of this section, a member does not have any duty to the company or any other member solely by reason of being a member.

(3) The power to ratify stated in subsection f. of this section pertains only to the members.

Fiduciary Duties of Limited Liability Principals Undecided

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Mon, 26 Nov 2012 16:24:18 -0500

Court Rejects as Unnecesary Statutory Interpretation Finding Fiduciary Duties in LLC Act

One of the burning issues in limited liability company law is the existence and scope ofthe fiduciary duties that are the core of the business relationship between the owners and managers of the business. Our discussion of a recent decision from Delaware is intended to emphasize the unsettled nature of the question in much of the country and to provide a good starting point for an ongoing discussion of just how deep are the changes in the recently enacted changes to New Jersey’s limited liability company statute.

The decision, Gatz Properties, LLC v. Auriga Capital Corp., C.A. No. 4390 (Nov. 7, 2012), is significant to the members and managers of New Jersey LLCs not just because of the influence of the Delaware courts, but because the New Jersey statute – for a short while longer – contains an identical provision. We don’t discuss the case at length here because our point is somewhat different – the the different way fiduciary duties are addressed by the Revised Uniform Limited Liability Company Act adopted in September. There are some excellent discussions of the case and its impact can be found on the blogs of Francis Pileggi’s blog (post here), Stoel Rives LLP (post here) and Peter Mahler (post here.)

There are those that argue that an LLC is at its core is a creature of contract, and that the relationship between the members or managers carries with it no inherent fiduciary obligations. Thus, the argument goes, the members and managers owe each other no greater obligations that they do in any other contractual relationship and the only fiduciary duties that exist are those that are created by the LLC’s operating agreement.

Others, meanwhile, argue that a limited liability is a business enterprise and that the fiduciary relationships that one finds in other forms of business organization, such as corporations or partnerships, should apply. In many states, including New Jersey, it is an open issue. So when a Delaware Chancery Court judge went out of its way to find that the Delaware limited liability company statute itself creates fiduciary duties akin to those widely accepted in the context of corporate governance, people paid attention. Delaware is still considered the fatherland of corporate governance and its decisions, even those of trial judges, carry a great deal of influence.

Any certainty, however, disappeared with the holding of the Delaware Supreme Court that the finding of the trial court concerning any fiduciary duties under the statute was dicta not necessary to the final outcome of the case, and expressly stating that the question of the fiduciary duties of limited liability company managers is still an open issue under Delaware law.

Breach of Fiduciary Duty Alleged in Property Sale

Gatz involved a limited liability company that owned the land where the Long Island Natinal Golf Club is located, and leased the property to the golf course's operators. The plaintiffs alleged that the manager of the LLC had breached its fiduciary duty in not seeking the highest price in a sale of the property and purchasing the tract for himself. Among the allegations were that the property was purchased by the manager at auction, even though third parties had already expressed their willingness to pay a significantly higher price.

The Supreme Court held the Operating Agreement, which prohibited deals with affiliated parties that were less favorable than those available from other third parties, unless approved by a 2/3 disinterested majority, covered all of the issues in dispute. The interpretation of the statute, the Supreme Court held, was unnecessary and should be “regarded as dictum without any precedential value.”

The court then explicity stated that it declined to express any views regarding default fiduciary liabilities existing as a matter of statutory construction. Whether any such duties are created by the statute is “one about which reasonable minds could differ” and that the statute seemed “consciously ambiguous.”

The trial court relied on Sections 1101 and 1104 of Delaware LLC, 6 Del. C. §§ 18-1101 and 18-104(c), which provide first that the members may expand, restrict or eliminate any duty, including fiduciary duties and that in the absence of any statutory provision the rules of law and equity “shall govern.” These provisions, from which the trial court found the existence of fiduciary duties as a matter of statutory interpretation, are substantially indentical to provisions found in N.J.S.A. § 42:2B-66 and § 42:2B-67.

Uncertainty for LLC Members

What does this mean to the owners or managers of a New Jersey LLC? If you follow the reasoning of the Delaware Supreme Court -- and many judges will – then it is risky to assume that there are any fiduciary duties governing the relationships of the members and managers that are not specified in the operating agreement.

There is no controlling authority about the nature and scope of fiduciary duties among members and mangers in New Jersey and my own experience is that there is rarely a willingness to specify the duties of members or managers when drafting an operating agreement. Provisions that restrict common fiduciary duties are relatively commonplace, but it remains to be seen how the courts will construe the ambiguous language.

One can certainly argue that a court asked to consider whether a duty exists should reason by analogy from the corporations statute. Courts are often reluctant, however, to reach into another statute to create new rights, as was seen in decisions declining to find an implied caused of action for opression from the fact that the corporations code contains such a right.

New Jersey’s new LLC statute will take an entirely different approach. N.J.S.A. § 42:2C-1 et seq. The statute sets out specific duties of loyalty and care, but gives members the ability to adopt an operating agreement that either eliminates those rights (with certain limits) or identify others. The statute also expressly provides for an obligation of good faith and fair dealing and, subject to the business judgment rule, what appears to subject members and managers to liability under an ordinary negligence standard subject to the business judgment rule and a right to rely on expert opinions (both of which are sizable safe harbors.)

Thus the new statutory framework in New Jersey contains a clear enumeration of rights that the organizers must affirmatively, if they can, disavow. The new statute’s creation of fiduciary duties is comprehensive and will be the subject of an upcoming post.

The new statute does not take effect for existing limited liability companies until March 2014 and it could be a costly error to assume too much from an operating agreement that is silent about fiduciary duties. A close look at existing operating agreements and consideration of the changes brought about by statutory revisions may be in order.

And of course the time to look at these corporate governance issues is always now, before there is a dispute between the members. Once that happens, it is invariably too late to make these decisions in a business-like fashion.

As always, we welcome your questions and comments.

N.J.S.A. § 42:2B-66. Liberal construction [Repealed effective March 1, 2014]

a. This act is to be liberally construed to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.
b. To the extent that, at law or in equity, a member or manager has duties (including fiduciary duties) and liabilities relating to a limited liability company or to another member or manager: (1) any member or manager acting under an operating agreement shall not be liable to the limited liability company or to any other member or manager of the limited liability company for the member's or manager's good faith reliance on the provisions of the operating agreement; and (2) the member's or manager's duties and liabilities may be expanded or restricted by provisions in an operating agreement.

N.J.S.A. § 42:2B-67. Rules of law and equity govern [Repealed effective March 1, 2014]

In any case not provided for in this act, the rules of law and equity, including the law merchant, shall govern.

LLC Mortgage May Be Challenged

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Fri, 09 Nov 2012 11:05:04 -0500

Purchaser Alleges Mortgage Was Not Approved by All LLC Members

A mortgage given by a New Jersey limited liability company to one of its members can be challenged by the purchaser in a court-approved sale of the business, the Appellate Division holds, reversing the trial court.

This case arises out of the estate planning undertaken by John Best and his wife, defendant Patricia Ann Best, after Mr. Best learned that he was terminally ill. The couple owned Sea Village Marina in Northfield (across the bay from Margate). They had transferred 25 percent of the business to their son, John, in 1994.

Succession Plan for LLC Only Partially Completed

John Best became ill in 2003 and an estate plan was put together that assumed that he was the sole owner of the marina. He would acquire the interests of his wife and son and they would receive mortgages back for $1.6 million and $200,000 respectively. As it turned out, the plan was never fully completed and John never acquired the 25 percent interests of his son.

Mark Best refused to transfer his interest and later said that he would never have approved the mortgage because it didn’t represent a valid debt. His mother did transfer her interest and received the mortgage. The result was that at the time that John Best died, the business was owned 75 percent by his wife and 25 percent by his son.

Mortgage Given by Limited Liability Company

Most of the value of the business was in the property, according to the court, but the property was encumbered by a mortgage. That mortgage, however, was not approved by all of the members or the managers.

It later developed that none of the children nor the wife wanted the business. They tried to sell the property but the offers were much lower than would be necessary to pay the secured debts of the business totaling $2.267 million. Ultimately the court approved the sale of the business to a third party that took the property while reserving the right to challenge the mortgage.

LLC Challenges Mortgage Given to Former Owner

Patricia Best opposed the sale. After the transaction was completed, the purchaser filed a complaint seeking to invalidate the mortgage. On motions for summary judgment, the trial court held that the mortgage was valid and that the failure to enforce its terms would grant the purchaser a windfall.

The Appellate Division reversed, finding that the purchaser had expressly reserved its right to challenge the mortgage and that the court had approved the sale under those terms.

Because the court had previously entered an order requiring those interested in the will of John Best to bring any claims challenging the mortgage and no one had made such a challenge, Patricia argued that the purchaser of the LLC was barred as well. The Appellate Division also rejected this claim. The fact that the prior owners of the LLC might be barred from asserting the claim did not prevent the same claim from being brought directly by the LLC.

Stock Certificate Transfer Claim Rejected

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Fri, 09 Nov 2012 10:17:18 -0500

Ownership Transfer Rejected When Stock Certificate Note Endorsed

One of the principles of corporate law that comes up with some frequency in shareholder disputes is that a share certificate is not an interest in a company, but only evidence of ownership. That does not mean, however, that the formalities for issuing and transferring shares can be ignored.

As a recent case from the Appellate Division of the New Jersey Superior Court demonstrates, a court may refuse to recognize what the plaintiff claimed had been a transfer of shares in a closely held corporation when the alleged transferee could not produce the endorsed stock certificate.

Elements of Transfer of Share Certificate

In that case, Acquaviva v. Estate of DiMisa, Docket No. A-5741-10T4 (App. Div. October 18, 2012), the plaintiff claimed that his father had transferred his interest in a businesses not by endorsing the certificate, but by way of a letter, and that those shares had subsequently been transferred to him. The details of the case are convoluted and involve an action to collect on a judgment entered as a result of a partnership’s default on a loan.

The case is instructive, however, as a warning to closely held businesses that issue stock certificates and then fail to observe the formalities of the Uniform Commercial Code or accurately record the ownership of the shareholders. It is not unusual that shares are passed around without being endorsed or that, after the initial shares are issued, no one pays much attention to the stock ledger or the certificates.

Share Certificate Transfers Poorly Documented

One of the first issues that we often face when there is a dispute among the owners of a business is who owns what, and it is not unusual that the answer is not well-documented. Moreover, it is common that a number of years have passed since the incident, a factor that was also present in the Acquaviva opinion, as the supposed transfer had occurred a decade before the dispute initially arose and 20 years before the case was ultimately decided.

Plaintiff’s basic claim was that his father signed a letter directed to the corporation in 1991 transferring his interest to plaintiff’s sister. This letter was purportedly sent to the corporation with the share certificates, but they were not endorsed. Plaintiff claimed that in 1997, his sister transferred the shares to him.

Share Certificate Must Be Signed and Delivered to Transferee

The trial court held, however, that no transfer had occurred because N.J.S.A. 12A:8-304(c) requires that a share certificate be endorsed and delivered to the transferee before the transfer of the certificate. The Court also recited the principal that an individual cannot become a stockholder without their knowledge - the plaintiff’s sister said she was unaware of the transfer when it occurred. Finally, the court noted that the transfer, if it had occurred, would have violated the terms of a buy-sell agreement between the parties.

The plaintiff’s claim seems a little farfetched unless, of course, you work in this area of the law. I have opened stock ledgers to find all of the shares neatly filled out and unissued. I have been presented with unsigned share certificates and, in another matter, the shares purported to have been cancelled were never returned. The owners of small businesses have other matters to attend to and years will pass in which documents and formalities were ignored or forgotten.

The plaintiff’s father may have intended to transfer the shares and the other shareholders may or may not have known at the time. The point is that if the formalities aren’t observed, it may not matter.