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The Accounting Remedy – II

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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.

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Fiduciary Duties in LLCs and Limited Partnerships

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It has long been a truism that partners in joint endeavors owe each other certain responsibilities to look out for one another. Justice Benjamin N. Cardozo stated the proposition as follows:

Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.

Meinhard v Salmon, 249 NY 458 (1928). Although Justice Cardozo elucidated this rule over 90 years ago, it still rings true today. In Birnbaum v Birnbaum, the court reaffirmed this strong duty stating:

This is a sensitive and ‘inflexible’ rule of fidelity, barring not only blatant self-dealing, but also requiring avoidance of situations in which a fiduciary's personal interest possibly conflicts with the interest of those owed a fiduciary duty (Matter of Ryan, 291 N.Y. 376, 407). Included within this rule's broad scope is every situation in which a fiduciary, who is bound to single-mindedly pursue the interests of those to whom a duty of loyalty is owed, deals with a person "in such close relation [to the fiduciary] * * * that possible advantage to such other person might * * * consciously or unconsciously" influence the fiduciary's judgment.

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LLC and Limited Partnership Dissolution: When is it “not reasonably practicable to carry on the business in conformity with the [entity agreement]”?

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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.

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Is a Limited Partnership Forever?

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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.  

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LLC Withdrawal and Dissolution: Why Explicit Provisions in the Operating Agreement are Necessary

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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:

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Shareholder Oppression in Delaware

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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:  

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Case Law Update: What are Acts of Shareholder Oppression?

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In Stephanie (Younger) Waters v. G&B Feeds, Inc. and Wiliam Younger, No. SD29745, March 4, 2010, the Missouri Court of Appeals upheld the trial court's finding of shareholder oppression, showing that a pattern of oppressive acts is key to the cause of action.  The trial court recited a medley of actions taken by Appellant-Defendant which the trial court considered to be acts of shareholder oppression:


[h]e assumed control of the corporation and the operation of its business without lawful authority and in complete disregard for the rights of [Respondent]. He borrowed money and refinanced debts on his own without consultation with [Respondent]. He testified that throughout the term of the business he purchased livestock feed at cost for [his] herd of 500-600 head of livestock, a substantial savings over a period of six years. However, the court has no evidence, other than [Bill’s] testimony, as to any such amounts paid for feed. He declined the opportunity to pay [Respondent] $70,000[.00] for her stock, the amount she had paid for it, and thus be in a position to have complete ownership of the corporation and the lawful right to operate the corporation business as he was doing without lawful right. He refused to cooperate in the sale of the business property to the ultimate financial detriment of both shareholders. He retained all rental receipts from the storage units and gave no accounting therefore. He has totally failed to give a proper accounting of his stewardship of the business affairs.

 

The Court of Appeals went on to hold that there was "sufficent evidence supporting the trial court's determination that [Appellant-Defendant] breached his fiduciary duty to Respondent in his dealings with her and in his operation of the affairs of [the company]"  and upheld the trial court's finding of minority shareholder oppression.

For the entire decision, click here.

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Limitations on Majority Rule in the Management of Business Entities

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The general rule in the corporate governance of business entities -- including corporations, limited liability companies and partnerships -- is that absent an agreement or statutory requirement to the contrary, majority rule governs.  Indeed, majority equity owners often assume that they can do pretty much anything they want with regard to the business entity. 

However, this is an erroneous assumption.  Over the years, many legal principles have evolved which limit the freedom of the majority  to do as they wish.