New Jersey Business Dissolution Journal

Lease Renewals Save Otherwise Time-Barred Breach of Fiduciary Duty Claims in a Partnership

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Tue, 13 Mar 2012 12:35:51 -0500

The New Jersey Appellate Division affirmed a trial court decision holding that lease renewals would revive stale claims in a partnership dispute. In Munoz v. Perla, et al., A-5922-08T3, the Munoz brought claims, among others, for breach of fiduciary duty for his partners' failure to charge fair market rates in connection with the lease of the partnership's property. Despite that the rents were calculated and leases drawn up in 1994, the partnerships acts of renewing the leases in 2003 were found to be separate acts that revived the otherwise time-barred claims.

Formation of the Partnership

Munoz was one of three partners in a real estate venture called The Heritage Partnership. The three partners for started their business relationship in 1983 as principals of a professional engineering firm. Munoz was an inactive partner of Heritage and was not involved in the partnership's day-to-day operations. The purpose in forming Heritage was to "maintain, operate, manage, sell and/or lease" a commercial building. Each partner contributed capital to the venture and held a one-third ownership interest. The parties' partnership agreement provided that their rights and obligations were governed by the Uniform Partnership Act, N.J.S.A. 42:1A-1 to -56.

In 1992, Heritage purchased a three-story office building and the parties decided to move the business operations of their engineering firm into the space. The parties did not consider a calculation of fair market value for rent for the engineering firm, but decided that the rent should cover the building's expenses. The engineering firm would also manage the building for Heritage a charge for the service. In 1993, the parties incorporated a new business, which would also rent office space from Heritage. In 1994, Munoz received a letter from his partners outlining the rent calculations.

Munoz did not visit the building until 2005 and never requested to inspect the partnership's books and records during that time. Munoz did receive partnership tax returns and K-1 forms, but never read them thoroughly. The question of the fair market value of the rents that Heritage charged did not arise until Munoz sought to withdraw from Heritage in 2005. At that time, the rejection of Munoz's buyout offer led to the appraisal of the property and litigation ensued in 2007.

Statute of Limitations Defense

Munoz alleged in the complaint that his two partners breached their fiduciary duty to him in entering into leases that charge below fair market value rates. Defendants countered, as is expected, with the statute of limitations defense – stating that Munoz's claims expired 6 years after the leases were first executed. While both the trial court and Appellate Division agreed that Munoz possessed sufficient information that would prevent tolling of the statute of limitations, the claims were saved by lease renewals in 2003. The court found that the lease renewals, about which the partners failed to provide notice to Munoz, constituted separate acts and could be the basis for a breach of fiduciary duty. The court further found that the equitable defenses of estoppel, laches, and waiver also lacked merit.

The lesson in this case is that breaches of fiduciary duties may be continuous depending upon the parties' interactions. A prior breach may be revived by a later act long after the statute of limitations has passed. Despite Munoz's failure to keep himself informed about the partnership, the lease renewals created a new cause of action for breach of fiduciary duties for which the partners were found liable.

Bonnie C. Park, a principal of the firm, helped in the preparation of this post.

Oppressed Shareholder Claim is Arbitratable

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Mon, 16 Jan 2012 10:00:00 -0500

Disputes Between Shareholders Not Exempt from Arbration Act

An oppressed shareholder claim is not outside the reach of the New Jersey Arbitration Act, the Appellate Division of Superior Court held in litigation that appears to arise in significant part from a broken promise over the lease of a BMW.

The oppressed shareholder action was filed by dentist David Edenbaum, one of the two owners of State of the Art Smiles, P.A., alleging wrongful conduct under the New Jersey Business Coporation Act’s oppressed shareholder provision. N.J.S.A. 14A:12-7.

Arbitration Clause in Shareholder Agreement

The allegation of shareholder oppression was made in an action filed in Chancery Division as well is an a counterclaim to a lawsuit filed by the other owner, Teresa Addeiego-Moore, claiming that Edenbuam had breached a separate agreement requiring him to transfer to her a portion of his interest in the practice equal to the leased vehicle in the event that he default on the payments.

The shareholder agreement contained an arbitration provision; the agreement concerning the leased BMW did not.

Arbitration not Precluded by Statutory Relief

Edenbaum argued that numerous references in the Oppressed Shareholder Act providing for relief from the Superior Court indicated that the legislature intended that such actions must be litigated in court and that agreements to arbitrate are therefore unenforceable in oppressed shareholder lawsuits.

The trial court rejected that argument and the appeals panel affirmed that decision. The appeals court noted that there is a strong public policy favoring arbitration as a means of resolving disputes and that the courts have compelled arbitration of a number of statuory claims.

We, thus, reject reject Edenbaum's argument that the Legislature's choice of language in N.J.S.A. 14A:12-7 manifests an intent to exclude arbitration and to require that only a court may impose the reliefv to which an oppressed shareholder might be entitled.

Edenbaum also argued that enforcement of the arbitration act would require two actions: a court litigation over the lease agreement and an arbitration of the oppressed shareholder agreement. Two actions arising out of a single set of facts violates the Entire Controversy Doctrine and creates the potential for conflicting decisions, Edenbaum argued.

The appellate court agreed that the agreement to arbitrate did not cover the lease agreement and that conflicting decisions were possible, but ruled that the trial court could simply require the disposition of one action before the other. The decision in the first action would then be binding upon the tribunal in the second action.

DAVID R. EDENBAUM, D.M.D., Plaintiff-Appellant, v. TERESA ADDIEGO-MOORE, D.M.D., Defendant-Respondent. TERESA ADDIEGO-MOORE, D.M.D., Plaintiff-Respondent, v. DAVID R. EDENBAUM, D.M.D., Defendant-Appellant.; DOCKET NO. A-4682-10T2, A-4683-10T2, SUPERIOR COURT OF NEW JERSEY, APPELLATE DIVISION, January 9, 2012, Decided

COUNSEL: Steven E. Angstreich argued the cause for appellant (Weir & Partners, attorneys; Mr. Angstreich, on the briefs).

Karen M. Murray argued the cause for respondent (Caplan, Valenti & Murray, attorneys; Ms. Murray, on the briefs)

Business Divorce: Five Considerations You Should Consider

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Fri, 06 Jan 2012 09:18:55 -0500

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.

2. Who Controls the Office?

If there is going to be a protracted fight for control of the company, then control of the office is going to be a key consideration. The office is where the documents, computer systems, records and checkbook are located. The party without access to the office is at a disadvantage in securing information about the business, which may be critical if that party is trying to gain control of the operation.

In a similar fashion, whoever controls the office is also likely to control the loyalty of the employees. Employees want to keep their jobs and are more likely to cast their lots with those who appear to be in control. As witnesses, they can be manipulated.

The party that is likely to be ousted is usually well advised to secure whatever evidence they can before the lockout occurs, but to be careful to do so lawfully.

3. Who Owns the Intellectual Property?

Many businesses have some intellectual property or proprietary process that was contributed by one or more of the principal owners and, unfortunately, the company has never documented the ownership of that intellectual property. The ousted party may have a right to use that property without the consent of the business.

Consider the company that was built on the idea of a new business process and one or more of the owners contributed intellectual property that is protected by a copyright or patent. If there has not been an assignment, the company cannot be assured either of its continued exclusive right to use that intellectual property or that it will not have to pay a royalty.

4. Are There Restrictive Covenants in Place?

Most business divorces settle and, in most cases, the settlement includes some type of agreement not to compete. Those restrictive covenants, having been bought and paid for, are generally enforceable according to their terms. If the case goes all the way to judgment, however, the circumstances in which the ousted principal cannot compete with the business are extremely limited.

If there are no restrictive covenants in place, the parties need to be careful about the rainmaker, even if he or she was impossible to work with, taking sales to a new business after they are fired. Again, the ability to compete without restriction depends on both the form of the business entity and the agreements of the principals, but many majority owners are surprised to learn that they can be forced to buy the shares of a recalcitrant minority who simply uses the money to set up a competing business.

5. Who Will Control the Checkbook?

A frequent issue in business divorce litigation is the payment of attorney’s fees and litigation expenses. Those in control of the checkbook would obviously prefer to use money from the company accounts. Courts, however, usually will require equal treatment.

Thus if those in control of the company wrote a check from the operating account to hire a lawyer to defend an oppressed shareholder suit, they may well find themselves having to write a check to the plaintiff’s lawyer in an equal amount. In a similar fashion, the minority member who does not control the business should make sure that the court is requiring equal treatment and demand the financial documents to make sure that the business is not funding the litigation.

Indemnity agreements are another related issue. On occasion the corporate governance documents may contain unconditional agreements to indemnify some of the parties for some of the allegations at issue. At other times, the indemnity obligations of the company may be discretionary and require a vote of disinterested directors. Given the cost of business divorce litigation, these are important considerations.

This short list is not intended to exhaust all of the considerations that arise when a business divorce is in the works, but to point out some of the key issues in the early stages of litigation.

If you have any questions about these issues, please feel free to contact me by telephone or send an e-mail to jrmcdaniel@mcdlawpc.com.

Fiduciary Duties Change With Time

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Tue, 03 Jan 2012 09:37:42 -0500

Partnership Failed to Keep Inactive Partner Informed

The fiduciary duties owed among partners can change with time and circumstances, and the disclosures that were appropriate when all of the partners worked together in the business may become inadequate when one of the partners has ceased to take an active role.

This is the lesson of Munoz v. Perla, Docket No. A-5922-08T3 (App. Div. Dec. 20, 2011) in which the Appellate Division affirmed a trial court decision holding that the members of a partnership had failed to make adequate disclosure of the terms of the leases held by the engineering firm, of which the parties had all once been partners.

Although the case involved the now-repealed Uniform Partnership Act, and thus not all of the holdings may be applicable to partnerships formed under later law, the decision is instructive as to how the fiduciary relationships between partners my evolve as time passes and circumstances change. (For another reason decision involving fiduciary duties among partners, see our blog post here.)

Partners Purchase Office Building

The dispute grew out of a 1992 decision by the members of the engineering firm, RPMS Consulting Engineers, to buy a vacant building in which they would locate their business and also lease space to other businesses. The three individual owners of RPMS, Plaintiff Orlando Munoz and defendants Robert Perla and Robert Steiger, formed a new partnership, The Heritage Partnership. Heritage then paid $1.55 million for a property in Monroe Township. RPMS leased the third floor from Heritage for its office space.

Initially, Heritage set the rent for RPMS based only on the cost to carry the building, not the fair value of the space the firm occupied. RPMS also invoiced Heritage for the cost of RPMS personnel providing management services.

Partner's Withdrawal From Business

Plaintiff Munoz withdrew from RPMS in 1993. From 1993 to 2005, although he retained his interest in Heritage, he took no part in the day-to-day operations of the business. Munoz received K-1s from Heritage but never made any inquiries about its operations.

Munoz asked to be bought out from Heritage in 2005 and his partners offered $200,000 for that interest. As part of that process, the building was appraised and other documents apparently exchanged. Plaintiff filed suit alleging, among other claims, minority oppression, breach of fiduciary duty, unjust enrichment and an accounting.

At trial, the principal issues were the application of the statute of limitations – the trial court only considered events within six years of the complaint – and whether the allegedly wrongful acts of the defendants justified reformation of the leases under which RPMS occupied the third floor.

The trial court had found that the defendants had a fiduciary duty to inform plaintiff about the renewal of leases between Heritage and RPMS. Significantly the court found that the nature of the fiduciary duties had changed after plaintiff withdrew from RPMS. An arrangement that made sense when all three partners were still involved in the engineering business – rent equal to the cost of carrying the building – changed after plaintiff left the engineering practice.

Fiduciary Duties to Non-Active Partner

The trial court denied Munoz' claim for dissoution of the partnership. It found, however -- and the appeals court affirmed -- that it was a breach of fiduciary duty not to inform the plaintiff about renewals of RPMS' lease arrangement; that plaintiff likely would have objected; and that the rates paid by the engineering firm were below market rates. The trial judge ordered the leases reformed to market rates and, one would infer from the opinion, that the defendants compensate plaintiff for his share in the difference from years past.

The Appellate Division affirmed the trial court’s finding that the conduct of the majority partners constituted a breach of fiduciary duty and equitable fraud (that is fraud without any bad intent or scienter requirement). In affirming, the appellate court deferred to the discretion given to the trial court’s fact finding.

In short, the conduct that Munoz once knew of, and approved of, as a member of the related engineering firm ceased to be reasonable as the years passed and the relationship between the parties changed. More complete disclosure was required and terms of the engineering firm’s relationship with the real estate partnership also should have changed to reflect the fact that the parties now had different interests.

Limited Liability Co Founders May Have Disclosure Duties

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Tue, 27 Dec 2011 19:26:12 -0500

Promoters of LLC Subject to Breach of Fiduciary Duty Claims

Limited liability companies are clearly the vehicle of choice for new, closely held businesses. That means that more often than not the principals have some existing relationship before they take up their new business together. Can that prior relationship create fiduciary duties even before the company has begun operations?

A decision out of the New York Court of Appeals indicates that there may be fiduciary duties in such a relationship, in particular duties of full disclosure and fair dealing. Moreover it appears that these duties may exist before the limited liability company is formed or membership interests are acquired. In Roni LLC v. Arfa, 2011 N.Y. Slip Op. 09163 (Dec. 20, 2011), The court held that the existence, or not, of a fiduciary relationship depends up the relationship of the parties and whether it meets the traditional criteria necessary to create fiduciary obligations.

Real Estate Investments by LLC

This case involved the conduct of promoters, the individuals who organize a new business and seek out other participants or investors. The defendant promoters organized seven limited liability companies under New York law for the purpose of buying and renovating buildings in the Bronx and Harlem for resale. The plaintiffs were a number of Israeli investors who acquired interests in the LLCs.

The plaintiffs alleged that the promoters deliberately concealed the fact that they had received commissions from the property sellers and mortgage brokers that inflated the prices of the properties by millions of dollars. The defendants moved to dismiss, arguing that no fiduciary duty existed between them, as promoters, and the investors.

Creation of Fiduciary Duties

A fiduciary relationship creates a duty to act or give advice within the scope of the relationship for the benefit of another. The plaintiffs alleged that the promoters planned the business, organized the companies and controlled the investment of funds. In addition, according to plaintiffs, the promoters assumed a position of trust and confidence by “playing upon the cultural identities and friendship.”

The circumstances alleged by the plaintiffs, the court held, were sufficient to allege a fiduciary relationship. Significantly the Court did not reach the issue of whether promoters by virtue of their status as organizers of the LLC are fiduciaries to those who later join the business.

Peter Mahler, who has covered this case on his blog at www.nybusinessdivorce.com, notes that the personal relationships described by the plaintiffs were rejected by the the intermediate appellate court as the basis for creating fiduciary duties, and that the Court of Appeals opinion makes no mention of the appellate divisions ruling. The open question, he notes, is how the court will deal with cases alleging a fiduciary duty created by one’s status as promoter.

Fiduciary Duty Under New Jersey’s LLC Act

The New York Court of Appeals decision was reached without relying on any statutory authority and, indeed, promoter liability is not addressed by any of the major limited liability company statutes. The New Jersey Limited Liability Company Act speaks only of the right of LLC members to expand or contract the rights and obligations through the Operating Agreement to rely on the Operating Agreement as the basis for conduct.

There are two ways to look at this dispute. Prior to the formation of an LLC with third parties, promoters are likely to have invested time, effort and capital to create the business. One could argue that they have their own rights to seek the best return possible for their efforts and that the participation of third parties is a voluntary arms-length transaction.

The other view, which appears to have accepted by the Court of Appeals, is that when the investors look to the promoters as the knowledgeable parties and place their trust and confidence in them, the promoters at a minimum have a duty of full disclosure. The later view is messy and determined by the specific facts of the relationship. Yet, since many LLCs are formed among friends and family, with one person having more knowledge and influence that the others, these are not issues that should be overlooked. A more prudent approach is to make full disclosure at the outset and avoid later claims of wrongful conduct.

Canyon Creek Development LLC Member Fails to Meet the Capital Call

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Tue, 22 Nov 2011 10:40:34 -0500

Small business owners sometimes run into difficulties with their business partners after much time has passed since they first set up the business. They come to discover that the operating agreement either does not address their problem or the result is not what they intended. Small business owners should take care to draft their controlling documents by considering as many scenarios as possible.

Members of limited liability companies are given considerable leeway to craft a management and business structure as they see fit. This control is one of the reasons why the LLC form is attractive to those engaged in new business ventures. The LLC’s operating agreement is the contractual means by which the members will determine the business structure – and courts continuously warn parties that failure to craft the operating agreement carefully will sometimes force unintended results.

The Case

We are reminded of this situation by a recent case from the Kansas Court of Appeals in Canyon Creek Development, LLC v. Fox. Doug Batey fully describes this case on the LLC Law Monitor (available here). Mike Fox and three other members formed two LLCs for the purpose of developing residential real estate. Fox owned 50% of each LLC and the other members owned the other 50% interest.

When the LLCs struggled to meet costs due to economic downturn in 2008, a member demanded that Fox contribute capital to each LLC. When Fox failed to do so, two of the members contributed additional capital, which gave them a majority interest in each LLC and removed Fox from management. They then brought suit against Fox to recover the amount of capital that he failed to contribute. The trial court found for Canyon Creek’s breach of contract claim, but Fox appealed the decision.

After determining that Fox had breached the operating agreement by failing to meet the capital call, the Court had to turn to the more problematic issue of the proper remedy for this breach. To make this determination, the Court depended on the terms of the LLC’s operating agreement.

The operating agreement held that the other members could adjust the relative interest ownership of a member that failed to meet a capital call by adding the additional sum to their own capital accounts. While this was allowed, but not required, by the operating agreement, this was the course taken by the other members against Fox. The Court ultimately found that a lack of clear statutory language and lack of additional remedies beyond those already used in the operating agreement prevented the imposition of personal liability against Fox.

NJ LLC Act

Under normal contract rules, breaching parties are typically not subject to additional penalties or forfeitures. This is why, at first glance, the Court seems correct in preventing personal liability on Fox for breach of contract when the members already used the remedy of reducing his membership interest and removing him from management. While New Jersey courts appear not to have dealt with this issue directly, both the Kansas and New Jersey statues governing LLCs allow for broad penalties and consequences for a member’s failure to make a required contribution.

The New Jersey Limited Liability Company Act states:

An operating agreement may provide that the limited liability company interest of any member who fails to make any contribution that he is obligated to make shall be subject to specified penalties for, or specified consequences of, such failure. Such penalty or consequence may take the form of reducing or eliminating the defaulting member's proportionate interest in a limited liability company, subordinating his limited liability company interest to that of nondefaulting members, a forced sale of his limited liability company interest, forfeiture of his limited liability company interest, the lending by other members of the amount necessary to meet his commitment, a fixing of the value of his limited liability company interest by appraisal or by formula and redemption or sale of his limited liability company interest at such value, or other penalty or consequence.

N.J.S.A. § 42:2B-33(c)

While this statute grants the ability of an LLC to impose penalties outside of those normally allowed in contracts, one thing is clear – such penalties must be provided for in the operating agreement. Courts can only enforce contracts as written and operating agreements are no exception. While N.J.S.A. § 42:2B-33(c) grants broader remedies, the statute specifically states that these must be contained in the operating agreement itself and the statute declines to grant these penalties independently. LLC members should take care to craft their operating agreements in a manner that provides as many remedies as possible in the event of such a breach.

We welcome questions and comments about operating agreements, LLC member expulsion, and any other business dispute you may need assistance with.

Chancery Court Rejects 'Inconceivable' Value in Shareholder Buyout

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Tue, 01 Nov 2011 12:10:12 -0500

Sometimes an expert valuation opinion, however well documented, leads to a conclusion that just doesn’t square with reality. That was the case with an expert opinion in Rughani-Shah v. Noaz, Docket No. A-4943-08T2 (Sept. 16, 2011) that valued a one-third interest in a medical practice at just $25,000. The trial court’s decision was affirmed by the Appellate Division of New Jersey Superior Court.

The trial judge didn’t buy it – not when the practice was grossing $1.7 million a year and not when the buy-in for the shareholder seeking the buyout had been eight times that amount. Common sense said the number was just too low, and the expert’s opinion was rejected.

Advanced Valuation?

We see this happen with some frequency. The valuation advanced by one of the parties’ in a case simply doesn’t make sense in light of the economic reality. Simply put, if the value in the opinion strays too far from what ordinary common sense would tell you – in this case that the buyer cannot expect to sell a minority shareholder’s interest for more than a fraction of her annual profits and capital contributions – then the opinion will not get much consideration. A chancery judge is not likely to do handsprings to reject an opinion that just seems out of line. Nor is the Appellate Division likely to reverse.

The parties in this litigation were the principal owners of a medical practice in Monmouth County. Over time, the relationship deteriorated and ultimately the other shareholders terminated her, triggering the right to have her shares purchased. The plaintiff was the last physician to join the practice as a partner, paying approximately $275,000 for her equity share.

The shareholder agreement required the purchase of the shares of a terminated member at book value, using an assets minus liabilities formula. In calculating assets, however, the agreement required a 15 percent discount to accounts receivable to account for uncollectable debts.

The value of the accounts receivable was the central issue in determining the value of the plaintiff’s shares. The plaintiff’s expert calculated a net book value of $656,000, most of which was accounts receivables, and that the plaintiff’s one-third interest was $218,685.

Appellate Division States

The defendant’s expert, however, testified that the accounts receivable was overstated by approximately $550,000, in that it included improper credit balances, failed to include discounts given to insurance carriers. She came up with a value of $41, 804 for the plaintiff’s interest. The Appellate Division, quoting from the trial transcript, does not try to find a technical error in the report, other than the fact that the shareholder agreement requires only 15 percent. The Appellate Division quoted the trial court:

. . Except for the year 2007, the growth of this business is essentially stagnant. But the [c]ourt cannot conceive that the book value is only $134,657, and [plaintiff's] share is only $44,886. . . .

* * *

It seems inconceivable that a one quarter interest in a business grossing approximately $1.7 million consistently over five years, and generating net income of over $600,000, to be divided among the principals, could be bought for only a $25,000 note. . . .

* * *

Based on this analysis . . . , the [c]ourt concludes that the fair market value of [Ocean] as of December [31, 2007,] is $656,056.

The defendants moved for reconsideration and they explained, again as quoted by the Appellate Division, that that they had relied “not only on the analysis by the accountants, but looked at other factors including [plaintiff’s] buy in, the gross receipts and the net profits to get a feel as to whether or not … [the] calculation of fair market value was correct.”

The defendants asserted on appeal that the trial court had unfairly considered extrinsic evidence in reaching its valuation, an argument that the appellate court found to be “without sufficient merit to warrant discussion in this opinion.”

The lesson here is that few judges are going to accept a valuation that renders a minority shareholder’s interest of almost trivial value or one that is out of proportion to what the minority shareholder paid for their equity or the profits that were distributed to the principal owners. Technical analysis is unlikely to trump common sense.

We welcome questions and comments. Feel free to contact me or post your remarks.

Partnership Accounting Not Available from Deceased Partner's Heirs

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Wed, 26 Oct 2011 14:21:28 -0500

Uniform Partnership Act Limits Remedy

If a partner dies after having allegedly misappropriated partnership funds, do the other partners have a right to pursue his estate? The answer appears to be no, according to a recent Chancery Court decision.

The decision in In re Genet, Docket No.: ESX-C-44-11 (Oct. 13, 2011) was decided under the now repealed Uniform Partnership Act – yet another warning to partnerships formed before December 2000 that if they want the newer law to apply, they should amend the partnership agreement to say so.

In granting a motion to dismiss the claim of the surviving partner seeking to require his nieces to account for the misappropriations of their father, Chancery Judge Walter Koprowski held that the statutory language that created an obligation of the partnership to account to the estate of a deceased partner was not reciprocal. It did not create a similar obligation of the estate to account to the partnership for the wrongful acts of the deceased partner.

Real Estate Partnership

Gerald and Leon Genet were brothers and equal business partners in Genet Realty from the early 1980s. Leon died in 2005 and his wife died a week later. All of Leon’s assets passed to his three daughters in equal shares. At that time, Leon Genet Realty was still earning commissions on lease transactions.

Gerald initially agreed that he would pay Leon’s share of the incoming commissions to his heirs “so that the partnership could be wound up and … [the] Estate closed in a timely fashion.” In the next two years, payments of $330,000 were made to each of the daughters and, in 2007, Leon’s estate was closed.

In March 2010, Gerald refused to make payments and claimed that he had discovered that Leon had misappropriated funds from the partnership. He also claimed that the estate owed him for numerous loans made to Leon over the years. The daughters filed suit in New York; Gerald filed suit in New Jersey. Motions to dismiss followed in both actions. Ultimately the New York action was dismissed for lack of standing because the claim, according to the New York Court, belonged to the estate.

We welcome questions and comments about the partnership statute that was construed by the court or other matters involving partnerships, closely held corporations, or limited liability companies.

Contract's Plain Meaning Voids Parties Understanding

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Mon, 24 Oct 2011 01:00:25 -0500

A contract means what it says, even if the two parties who came to the agreement may have understood something different. This can be a trap for the business that is not careful to ensure that the contract that it signs at the end of negotiations accurately reflects exactly what it thinks it has agreed to.

It is not particularly unusual that, at the end of a period of negotiations, the contract that is finally written up does not exactly fit the terms the parties thought they had negotiated or that it does not contain all of the terms that the parties thought were relevant. A court, however, is unlikely to read those terms into the agreement, or even permit one of the parties to argue that they should have been there – at least not when the meaning of the agreement is plain from its terms.

Court Review

The New Jersey Appellate Division opinion in MicroBilt Corp. v. L2C, LLC demonstrates just how difficult it can be to get a court to consider that there were important terms missing from the final document that should have been included.

MicroBilt signed a contract with L2C under which L2C would perform credit evaluations of MicroBilt’s potential customers and provide customer credit scores to MicroBilt. MicroBilt later claimed that L2C was also required to supply the underlying data used to calculate the credit score, which L2C obtained from a third party vendor. L2C claimed it could not provide the underlying data because its contract with its vendor prohibited the release.

Plain Meaning Rule

Relying squarely on what is often referred to as the Plain Meaning Rule, the appellate court rejected MicroBilt’s claim. The Plain Meaning Rule requires a court to enforce a contract as written, without considering any other evidence, if the terms are clear and unambiguous. An ambiguous contract is one that can be interpreted in different ways—that is, the precise meaning of the words cannot be determined from the fact of the contract.

The court found that the contract was clear because L2C’s obligation was to perform the credit evaluation and return a conclusion to MicroBilt, and that “conclusion” was unambiguous because it was limited to “a score, attributes or a combination of the two.” In other words, L2C’s obligation to provide a conclusion did not include the underlying data. Further, because the contract was “unequivocal and lack[ed] any ambiguity,” the court would not consider MicroBilt’s evidence that the parties understood that the data would be supplied.

The MicroBilt case is a good example of why businesses should make certain that the language of the contracts they enter are not only clear and unambiguous, but also include everything expected from the contract. Essentially, the business executive needs to understand that, in many cases, the court will not “rewrite” or “fix” a contract if it is clear and unambiguous and will not provide the product or service desired. The Plain Meaning Rule encourages parties to enter enforceable written contracts by using clear language, but that clarity also draws sharp lines around the obligations of the parties. Those sharp lines can exclude what one party may have wanted to include and leave the disappointed party with no options.

Failure to Disclose Transfer of Partnership Not Wrongful

jrmcdaniel@mcdlawpc.com (Jay McDaniel) — Wed, 19 Oct 2011 16:08:17 -0500

Partnership Interest Secretly Transferred to Family Member

Does a partner have an obligation — separate and apart from the terms of a partnership agreement — to disclose the fact that one of the partners has transferred their interest to another member of the partnership?

The question seems to answer itself. Of course it is. After all, is there anything more material to the business of a partnership than the identities of the partners? But in a case earlier this year involving a secret transfer from a mother to one of her sons, the New Jersey Appellate Division’s came to the contrary conclusion. The narrow reading given by the court to the Uniform Partnership Act and its failure to find that there was a duty to disclose the transfer is troubling.

Fiduciary Duties under the Uniform Partnership Act

The question that is lurking in this decision, Taylor v. Taylor, Docket No. A-4363-09T1 (N.J. App. Div. July 8, 2011), is whether the adoption of the UPA fundamentally altered the relationship between the partners of a partnership, and whether precedent going back to the early 20^th Century is still good law. The Taylor decision suggests it is not.

I do need to confess my personal bias. I think the current trend of allowing parties in a business relationship to contract away basic principles of honesty and loyalty, demonstrated by statutory and occasional court approval of agreements that eliminate fiduciary duties, is a bad idea. In my opinion, it’s like the Japanese gangster who willingly cuts off his own fingertip to atone for a mistake. The fact that the Yakuza participated in the wrong done to himself doesn’t make it right. On the other hand, I appear to be in the minority and the drafters of the Uniform Partnership Act, adopted in New Jersey in 2000, and a growing number of courts seem to think otherwise.

Undue Influence Claim

Not that the outcome of the Taylor case is particularly surprising. The court there rejected an undue influence claim asserted by one brother alleging that the other brother had wrongfully coerced their mother into transferring her interest in the family business to him before her death. Moreover, because the business that they owned together had already been sold, the breach probably caused no damages.

The narrow reading given to the Uniform Partnership Act by the Appellate Division, however, is difficult to reconcile with the well-established precedent that partners stand in an elevated fiduciary relationships to one another, obligated to exercise the “utmost good faith.” See, e.g., Stark v. Reingold, 18 N.J. 251 (1955). It is also difficult to square with another Appellate Division opinion earlier this year – also involving a family partnership – describing the relationship of partners as “one of trust and confidence, calling for the utmost good faith, permitting of no secret advantages or benefits … a duty of the finest loyalty.” Pass v. Kirschner, Docket No. A-40002-07T3 (N.J. App. Div. March 9, 2011).

The Taylor family was the owner of a health club and a corporation in which the health club operated. Originally the businesses were owned by the father and two sons, Rick and George. When the father died, his interest passed to their mother. The mother later decided that she wanted to transfer her interest to Ricky, thus eliminating it from the assets that would pass by her will.

Mrs. Taylor, however, insisted that the transfer be kept from George and continued to act as though she were one of the three owners. She executed various documents in connection with the sale of the business and continued to sign checks almost a year after she had performed the transaction.

George sought damages on the basis that Ricky had breached his fiduciary duties to him and also sought to expel him from the partnership (apparently notwithstanding the prior sale of the business.) The court held, however, that the concealment by mother and son of the transfer had not “materially affected the partnership business,” (emphasis in original.) Nor had Ricky breached his fiduciary duties of loyalty and care.

Fiduciary Duties under the UPA

If a partnership agreement does not specify the limits, those duties are specified – and limited – by the UPA. The relevant statutory provisions are:

The only fiduciary duties a partner owes to the partnership and the other partners are the duty of loyalty and the duty of care set forth in subsections b. and c. of this section, as those duties may be clarified or limited in the partnership agreement …

b. A partner’s duty of loyalty to the partnership and the other partners is limited to the following:

(1) to account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct and winding up of the partnership business or derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity;

(2) to refrain from knowingly dealing with the partnership in the conduct or winding up of the partnership business as or on behalf of a party having an interest materially adverse to the partnership; and

(3) to refrain from actions intended to cause material injury to the partnership in the conduct of the partnership business before the dissolution of the partnership.

c. A partner’s duty of care to the partnership and the other partners in the conduct and winding up of the partnership business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.

The Taylor panel read the definition of fiduciary obligations narrowly, perhaps too narrowly, as not falling within one of the clearly articulated duties. One of the principles of a partnership is the ability of the partners to do business with the people they choose. The other is the limitation on transferability. A partner may transfer their right to profits and losses, but not the management rights. The transferee has no right to exercise the partnership rights. A partner who transfers all of his or her interest is subject to expulsion by unanimous vote of the partnership.

The opinion is silent about what the partnership agreement said about transferability of the partners’ interest. Nonetheless the opinion reads as though it purported to be a complete conveyance of the partnership interest, not the mere assignment of the partners interest.

Knowing who the partners are may also have an impact on whether and how the partnership continues. A partner has the right to withdraw, even in breach of the partnership agreement, and be paid the fair value of their interests. Moreover, the transfer of the complete interest could in itself cause the dissolution of the partnership if the transferring partner is withdrawing.

In short, the manner in which the Taylor court construed the breach of fiduciary duty claim as not including any duty of disclosure of matters that are material to the partnership business and the partner should give anyone involved in the partnership a bit of pause. It is probably no longer correct to assume that a partner must disclose material events and that the concept of a “duty of the finest loyalty” may be fading into history.