“Self-dealing” is a legal concept which is applied to a transaction in which a fiduciary (such as a trustee, general partner, controlling shareholder, director, or officer) derives a personal benefit from a transaction with or involving the entity to which he owes the fiduciary duty. In re Nat'l Auto Credit S'Holders Litig., 2003 Del. Ch. LEXIS 5, 30 (Del. Ch. Jan. 10, 2003), (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)).
The Accounting Remedy – II
Statutory Provisions under New York Law
As discussed in our last Blog post, the right to an accounting exists under common law and, in some instances, according to statute
The accounting remedy is codified in New York Partnership Law § 44 and New York Business Corporation Law § 720. Section 44 of the Partnership Law provides that:
Any partner shall have the right to a formal account as to partnership affairs:
1. If he is wrongfully excluded from the partnership business or possession of its property by his copartners,
2. If the right exists under the terms of any agreement,
3. As provided by section forty-three[1],
4. Whenever other circumstances render it just and reasonable.
LLC and Limited Partnership Dissolution: When is it “not reasonably practicable to carry on the business in conformity with the [entity agreement]”?
The New York and Delaware LLC and Limited Partnership Acts both provide that an LLC or limited partnership may be dissolved “whenever it is not reasonably practicable to carry on the business in conformity with the [LLC articles of organization, operating agreement or limited partnership agreement].” [1] This is the standard, but what does it mean?
When can an LLC member or limited partner seek dissolution, with some reasonable basis to believe that he will be successful? These situations arise fairly frequently and there are no clear-cut rules. Many courts have noted the dearth of case law which explicitly define the standard of what it means for it not to be “reasonably practicable” to carry on the business in conformity with the entity’s governing documents.[2]
The starting point for a “reasonably practicable” analysis is always what these documents say. The documents take on great significance and small differences in their language can be decisive. For example, entity documents with broad “purpose” clauses are likely to give the managers much greater latitude as to what they can do and make them more impervious to efforts to cause dissolution. On the other hand, if the entitiy’s stated purpose includes generating “cash flow” or “profits,” a failure to do so is much more likely to lead to dissolution that if the documents are silent on this point.
For Sellers of Minority Interests, the Rule is "Caveat Vendor" – Let the Seller Beware
- New York Court of Appeals rules that seller of minority interest has no remedy when purchasing majority owner immediately flips the interest for twenty times what he paid
Owners of minority interests in companies often have very little say on the most important issues that determine the value of their interests. These issues include:
- whether equity owners will receive distributions and if so, in what amounts; and
- whether the business will be sold and when.
Because of these reasons and others, the only buyers of their interests are typically the majority equity owners and often, because of this, the majority owners can dictate the price.
What happens when the minority owner, who has been waiting for years to realize on the value of his interest finally gets an offer from the majority owner to buy his interest? As several recent New York Court of Appeals decisions illustrate, the offer is often precipitated by the fact that the majority owner has received – or is about to receive - an offer for the entire company that he is ready to accept. He realizes that he can increase his own profit on the sale by buying out the minority owner at less than the pro-rata share of the value for the company that he is entitled to. So, he makes an offer, but neglects to tell the minority owner about the potential transaction or the value that this indicates for the company as a whole. The minority owner accepts the buyout offer, contracts are drawn and the minority interest is sold to the majority owner.
A few weeks later, the minority owner learns that the majority owner has sold the entire company at a value that reflects that the minority position was worth twenty times what he just sold it for. Rightfully indignant, the minority owner sues to collect the amount he believes he was cheated out of. He claims a breach of the majority owner’s fiduciary duties by failing to disclose the offer at the much higher price.
Is a Limited Partnership Forever?
Remedies for Aggrieved Limited Partners in New York
Before the advent of the limited liability company in the mid-1990s, limited partnerships were a preferred vehicle for the organization of pooled investments. Most individuals who invested in limited partnerships did so with certain expectations, such as receiving tax benefits in the early years, profit distributions later on as the partnership assets cash flow increased, and a return of their investment plus a profit when the underlying assets were sold.
But, what if the investor has been a limited partner for many years and he or she has yet to receive any distributions and the general partner has shown no interest in selling the underlying assets? What if the general partner has been able to take out whatever cash flow has been generated over the years in the form of management fees and other distributions? What if the partnership has been managed for the benefit of the general partner, and not the investors?
Under these circumstances, what is a limited partner to do? Without doubt, there will be many obstacles standing in the way of his or her ability to sell the partnership interest, even at a discount. Finding a buyer will be difficult, since there is no public market for the interest. Buyers are usually not looking for investments without a steady return and without any reasonable prospect of an exit. Further, the limited partnership agreement will likely contain restrictions on both the limited’s right to transfer and on the rights of anyone who acquires the interest.
Piercing Your Corporate Veil – Part II: An Illustrative Case is Worth a Thousand Words
Starting Up Smarter
It is remarkable to note how many major lawsuits result from a failure to attend to “minor details”—precisely, of the sort of details that many busy entrepreneurs don’t have time for. The recent case of Moras v. Marco Polo Networks, Inc. is just one of many that illustrate this point.
Moras, decided on May 31, 2012, by Federal Judge Paul Engelmayer of the Southern District of New York, illustrates just what can go wrong when individuals don’t attend to corporate formalities and leave themselves open to corporate veil-piercing arguments.
Plaintiff, Moras, after he was fired, sued his employer for breach of an employment agreement, fraud and unjust enrichment. He also sued Ramgopal, the CEO and single largest shareholder of the parent company of his employer, on a veil-piercing theory. In defining the issue on Ramgopal’s motion for summary judgment, the Court asked, “can Ramgopal be held individually liable for the corporate defendants' non-payment of wages by piercing the corporate veil and imposing shareholder liability?”
Expansion of Shareholder Oppression Doctrine in Texas
Reasonable Expectation that Management will Meet with Prospective Purchasers of Shareholder’s Stock
In Ritchie v. Rupe, 339 S.W.3d 275 (Tex.App.-Dallas 2011, pet. filed), the Texas Fifth Court of Appeals held that a minority shareholder in a closely held corporation can have a reasonable expectation that management will meet with prospective purchasers of her stock. Significantly, the Supreme Court of Texas has since granted petition for rehearing and review. If the petition for review is granted, it will be the first shareholder oppression case heard by the Court.
In Ritchie, there was no shareholders’ agreement in place restricting the minority shareholder’s right to sell. Initially, the shareholder, in an effort to sell, offered the stock to the corporation, but rejected the amount that the corporation was willing to pay as substantially below market. The shareholder then began to seek third-party purchasers through a broker, but the broker was informed that company management would not meet with any prospective purchasers. This made the stock virtually unmarketable, since it was unlikely that anyone would buy stock in a closely held corporation without first evaluating and obtaining information from management.
Don’t Let Them Pierce Your Corporate Veil . . . Protecting Against Personal Liability
Starting Up Smarter
One of the main reasons that entrepreneurs incorporate their businesses is to protect against personal liability. By incorporating, they insulate themselves from liability in the event that the business just doesn’t work out, or if there is a catastrophic loss that exceeds the business’ assets.
However, incorporating is just the first step. Those who are not sensitive to what it takes to maintain their personal liability and vigilant in protecting it can be in for a rude and costly awakening. More often than not, this awakening comes at the worst possible moment, when someone is seeking to assert claims beyond the company’s means and “pierce the corporate veil” so that they can reach the assets of the shareholders.
However, incorporating is just the first step. Those who are not sensitive to what it takes to maintain their personal liability and vigilant in protecting it can be in for a rude and costly awakening. More often than not, this awakening comes at the worst possible moment, when someone is seeking to assert claims beyond the company’s means and “pierce the corporate veil” so that they can reach the assets of the shareholders.
New Decision Confirms There is No Oppression Cause of Action Applicable to New Jersey LLC’s
In a recent decision, the New Jersey Appellate Division confirmed that the New Jersey Oppressed Shareholder Statute, N.J.S.A. 14A:12-7(1)(c) does not apply to limited liability companies.[1]
Hopkins v. Duckett (N.J. App. Div. January 17, 2012) involved a long-running dispute between members of an LLC over, among other things, whether the founder could be expelled after he changed his mind on a promise to retire. The founder sued claiming that his ouster constituted “oppression.”
The Court held that the founder could not assert an oppression claim because the LLC, Nightingale & Associates, L.L.C. (N&A) was a Delaware LLC and Delaware did not recognize a claim for oppression (more on this below).
However the Court also ruled that even if N&A had been governed by New Jersey law, the founder’s claim would fail because New Jersey’s oppression cause of action applies only to corporations, and not to LLC’s. The Court was very clear and concise on this point in its January 17, 2012 decision:
Case Law Update: Who decides whether an arbitration clause is rendered unenforceable by an illegal provision – the court or the arbitrator?
In Life Receivables Trust v. Goshawk Syndicate 102 at Lloyd’s, 14 N.Y.3d 850, 901 NY.S.2d 133 (May 4, 2010), the parties included a provision in their arbitration agreement that the parties had the right to challenge an arbitration decision on the grounds that the panel made an error of law. This type of provision appears very logical and at first blush, it is difficult to understand why a provision such as this agreed to by the parties would not be enforceable.
Fraud Claims in the Context of Contract Representations: The Question of Reasonable Reliance
A recent New York Court of Appeals decision provides some guidance of relevance to all transactional lawyers and clients relating to potential causes of action for contractual representations and warrantees, which prove to be untrue.
In DDJ Management, LLC, et al., v. Rhone Group L.L.C., et al., 15 N.Y.3d 147___N.Y.S.2d___ (June 24, 2010), the New York Court of Appeals addressed the following questions in its decision to allow Plaintiff DDJ Management’s $40 million fraud claim to proceed to a jury:
- When can a recipient of written representations from a company, which prove to be untrue, sue third parties, such as shareholders and officers of the company making the representations?
- In what circumstances does neglecting to conduct a due diligence investigation impede the recipient of contract representations from bringing a fraud claim?
The basic facts, in a nutshell, are as follows:
LLC Withdrawal and Dissolution: Why Explicit Provisions in the Operating Agreement are Necessary
Over the past decade, the Limited Liability Company (“LLC”) has become one of the most favored forms of a closely held business organization in New York. As an unincorporated business entity, the LLC is favored because of its pass-through tax treatment coupled with maximum operating flexibility. However, an LLC also demands a well-written and comprehensive operation agreement - especially with regard to withdrawal and dissolution - because it may create the only chance for a member to exit the company.
Under Limited Liability Company Law (“LLCL”) §606, for example, unless the operating agreement specifically provides for the right of withdrawal, a member is not allowed to withdraw prior to dissolution of the LLC. Thus, where there is no such provision, if a member wants to withdraw, he must try to force a dissolution under LLCL §702, which provides:
Protection of Minority Shareholder Rights and Shareholder Oppression Doctrine in Texas
What can minority shareholders do in under Texas law to protect themselves against unfair treatment, including “squeeze-outs”, “freeze-outs” and the taking of disproportionate benefits by the majority?
Texas recognizes both the shareholder oppression doctrine and “breach of fiduciary duty” theories in close corporations to protect the rights of minority shareholders.
The Dissolution Statute:
The Texas corporate dissolution statute, Article 7.05 of the Texas Business Corporation Act, provides for the appointment of a receiver and the possibility of dissolution when an aggrieved shareholder establishes “illegal, oppressive, or fraudulent” conduct by directors or those in control.
Of significance, Texas Courts have used this statute as a basis to fashion a broad range of remedies less harsh than dissolution, where they find that minority shareholder rights have been abused.
What is Oppressive Conduct?
Though illegal and fraudulent conduct is fairly easy to identify, oppressive conduct is less readily definable. One of the leading cases in Texas, Davis v. Sheerin, adopts the language of New York’s Matter of Kemp for oppression, and defines “oppressive conduct” as follows:
Shareholder Oppression in Delaware
Delaware does not have a cause of action for oppression per se, but it does offer relief for minority shareholder oppression-like claims applying other legal principles. Thus, oppression-like claims must be carefully pleaded in Delaware.
Since court’s in other states are likely to apply Delaware law to oppression-like claims to companies organized in Delaware, vigilance must also be exercised in pleading claims relating to Delaware corporations in non-Delaware courts. Some courts outside of Delaware, such as the Southern District of New York and the Northern District of Illinois, have upheld causes of action for shareholder oppression under Delaware law, while others, such as the District of New Jersey, have dismissed oppression claims for failure to state a claim under Delaware law.
Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993), is a Delaware case that often cited for the proposition that Delaware does have a shareholder oppression remedy, and also for the proposition that it does not. The case states that “[t]he entire fairness test, correctly applied and articulated, is the proper judicial approach” to deciding claims brought by minority shareholders against those in control of the corporation. Thus, some conclude that oppression claims may be pursued under the entire fairness doctrine.
However, Nixon v. Blackwell also, contains language that seems to indicate otherwise:
Shareholder Oppression in New Jersey
Applicable Statue:
The New Jersey Shareholder Oppression Statute, N.J.S.A. § 14A:12-7, provides that when those in control of a corporation having 25 or fewer shareholders “have acted fraudulently or illegally, mismanaged the corporation, or abused their authority as officers or directors or have acted oppressively or unfairly toward one or more minority shareholders in their capacities as shareholders, directors, officers, or employees,” the Court can impose a wide variety of equitable remedies, including ordering a buy-out at “fair value.” (emphasis supplied).
The buyout that the Court can order does not necessarily have to be of the minority shareholders’ interest. It can order a buyout of the majority’s interest. The purchaser can be the corporation or the other shareholders.
What is Oppressive Conduct?
Oppressive conduct is defined in New Jersey as conduct that frustrates the “reasonable expectations” of the minority as of when they joined the enterprise.
In Brenner v. Berkovitz (1993), the New Jersey Supreme Court stated that the special circumstances, arrangements and personal relationships that frequently underlie the formation of close corporations generate certain expectations among the shareholders concerning their respective roles in corporate affairs, including management and earnings. A court, then, must determine initially the understanding of the parties in this regard. Generally, the court noted that any increase in benefits to the majority shareholders without corresponding benefit to minority may provide a claim of oppression.