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.

Selling Minority Equity Interests for What They’re Really Worth - The Lessons of Pappas v. Tzolis

At first glance it might appear as if the New York Court of Appeals struck a major blow to LLC minority member rights in their November 2012 ruling Pappas v. Tzolis. After all, the New York high court held that a majority member owed no duty to disclose to his fellow members that upon buying out their equity interests, he planned to immediately flip for $17.5 million the interests he had acquired from them for $1.5 million. 

However, implicit in the opinion is the recognition that if business partners have a relationship based on mutual trust, a partner may not be free to cheat his partner out of financial gains by failing to disclose material facts.

            Pappas v. Tzolis involved a Limited Liability Corporation (“LLC”) formed by three parties in January 2006 to acquire a long-term leasehold interest in a Lower Manhattan building. Steve Pappas and Steve Tzolis each contributed $50,000 to this project with Constantine Ifantopoulos contributing another $25,000. Trouble plagued this LLC from the start. Tzolis sought to sublease the property to another company he owned, and according to Pappas and Ifantopoulos, they had to go along with this because Tzolis had blocked efforts to sublease to other entities. Further, Tzolis would not cooperate in the development of the property and his company neglected to pay the $20,000 monthly rent on the sublease.

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.  

New Jersey Legislature Creates Oppression Remedy Applicable to LLCs

The Revised Uniform Limited Liability Company Act (RULLCA), signed into law by Governor Christie on September 19, 2012, creates an oppression remedy for New Jersey limited liability companies.  Until now, New Jersey courts have held that the oppression remedy contained in the New Jersey Corporation Law, N.J. Stat. § 14A:12-7, did not extend to LLCs – because this remedy did not appear in the LLC Act.  See, e.g., Hopkins v. Duckett, 2012 N.J. Super. Unpub. LEXIS 93, at *33 (App. Div. Jan. 17, 2012).

The RULLCA added the following provision:

A limited liability company is dissolved, and its activities shall be wound up, . . . on application by a member, the entry by the Superior Court of an order dissolving the company on the grounds that the managers or those members in control of the company . . . have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant.

2012 Bill Text NJ A.B. 1543, Art. 7, par. 48(5)(b) (Dissolution and Winding Up).  This formulation is different from the one in the Corporation Law, which provides:

The Superior Court, in an action brought under this section, may appoint a custodian, appoint a provisional director, order a sale of the corporation’s stock as provided below, or enter a judgment dissolving the corporation, upon proof that[, in] the case of a corporation having 25 or less shareholders, the directors or those in control 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.

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:

The Attorney-Client Privilege and the “Common Interest” Doctrine

Most individuals assume that all of their communications with their attorneys are privileged.  But, this is not always the case.

First, the privilege applies only to communications made in the context of an attorney-client relationship for the primary purpose of securing either a legal opinion or legal services. Only such communications are protected. 

Second, since the purpose of the privilege is to encourage open communication between a client and attorney, the privilege also protects communications if they would tend to disclose the client's confidential communications. Thus, if there was an expectation of confidentiality the attorney-client privilege would apply.

Third, for anyone considering seeking counsel from an attorney, it is important to know that not all communications made between a client and his or her attorney are protected under the attorney-client privilege.

“The implied covenant of good faith and fair dealing is not a license for a court to make stuff up” - Delaware Court of Chancery in Winshall v. Viacom:

Delaware Court of Chancery in Winshall v. Viacom:

The implied covenant of good faith and fair dealing is inherent to every contract. It “requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.” Dunlap v. State Farm Fire & Cas. Co., 878 A.2d 434, 442 (Del. 2005). A party is liable for breaching the covenant when its conduct “frustrates the overarching purpose of the contract by taking advantage of [its] position to control implementation of the agreement’s terms.” Id. While it may be unclear as to when courts should implement implied covenant analysis, a recent Delaware decision, Winshall v. Viacom Int’l Inc., No. 6074-CS (November 10, 2011), sheds some light on the issue.

 In Winshall, defendant Viacom had acquired defendant Harmonix Music Systems, Inc., creator of the music-oriented video games Rock Band and Guitar Hero, in a 2006 merger. Under the merger agreement, Viacom promised the Selling Stockholders an up-front payment of $175 million for their shares, as well as the contingent right to receive uncapped earn-out payments based on Harmonix’s financial performance in the two years following the Merger, 2007 and 2008.

“The implied covenant of good faith and fair dealing is not a license for a court to make stuff up”

- Delaware Court of Chancery in Winshall v. Viacom:

 

The implied covenant of good faith and fair dealing is inherent to every contract. It “requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.” Dunlap v. State Farm Fire & Cas. Co., 878 A.2d 434, 442 (Del. 2005). A party is liable for breaching the covenant when its conduct “frustrates the overarching purpose of the contract by taking advantage of [its] position to control implementation of the agreement’s terms.” Id. While it may be unclear as to when courts should implement implied covenant analysis, a recent Delaware decision, Winshall v. Viacom Int’l Inc., No. 6074-CS (November 10, 2011), sheds some light on the issue.

 In Winshall, defendant Viacom had acquired defendant Harmonix Music Systems, Inc., creator of the music-oriented video games Rock Band and Guitar Hero, in a 2006 merger. Under the merger agreement, Viacom promised the Selling Stockholders an up-front payment of $175 million for their shares, as well as the contingent right to receive uncapped earn-out payments based on Harmonix’s financial performance in the two years following the Merger, 2007 and 2008.

 About one year after the Merger closed, Harmonix released a new video game, Rock Band and had already entered into an agreement with Electronic Arts, Inc. (“EA”) for the distribution of Rock Band through March 2010. However, due to the game’s popularity, EA wanted to renegotiate the contract in 2008 to gain a broader scope of rights to Rock Band and its sequels. Because of EA’s interest in amending the distribution agreement, Harmonix and Viacom allegedly had an opportunity to negotiate for an immediate reduction in distribution fees that would have potentially increased the Selling Stockholders’ earn-out payments for 2008. But, at the direction of Viacom, Harmonix did not amend its contract with EA so as to immediately reduce its distribution fees. Rather, Harmonix and EA’s amended agreement involved a reduction in distribution fees in upcoming years, after the expiration of the earn-out period. The revised contract also granted EA a number of important new rights having nothing to do with EA’s already firm right to distribute Rock Band during 2008. On behalf of the Selling Stockholders, Winshall sued Viacom and Harmonix, alleging that Viacom and Harmonix purposefully renegotiated the distribution contract with EA so as to reduce the earn-out payments payable to the Harmonix stockholders, and thus breached the covenant of good faith and fair dealing implied in the merger agreement.

 Winshall’s view of the implied covenant would require that a party to an agreement not simply refrain from upsetting the fundamental expectations of the other party, as implied by the explicit terms of the deal, but actually improve that deal by expanding its contractual counterparty’s expectancy. The Court rejected this view and determined that while Viacom and Harmonix were under an implied duty not to reduce any reasonable contractual expectation of the Selling Stockholders, they were not obligated to take any and all opportunities during the earn-out period to increase the earn-out payment for 2008, regardless of whether that opportunity was offered to Viacom and Harmonix in exchange for granting the counterparty rights to future assets in which the recipients of the earn-outs had no reasonable expectancy interest. In dismissing Winshall’s claim, the Court concluded that the facts do not support an inference that Viacom and Harmonix acted to deprive the Selling Stockholders of their reasonably expected benefits under the Merger Agreement and that the Selling Stockholders had no legitimate expectation that, if Harmonix was offered a chance to renegotiate the amount of distribution fees payable under a distribution agreement that was entered into after the Merger, it would choose a structure that benefited the Selling Stockholders and increased the amount of already unlimited earn-out payments that it was obligated to make under the Merger Agreement.

 In the Winshall decision, the Court also clarified the application of the covenant. “[I]mplied covenant analysis will only be applied when the contract is truly silent with respect to the matter at hand, and only when the court finds that the expectations of the parties were so fundamental that it is clear that they did not feel a need to negotiate about them.” Allied Capital Corp. v. GC-Sun Holdings, L.P., 910 A.2d 1020, 1032-33 (Del. Ch. 2006). Further, the implied covenant is not a license to rewrite contractual language just because the plaintiff failed to negotiate for protections that, in hindsight, would have made the contract a better deal. When conducting an analysis of whether a party breached the implied covenant of good faith and fair dealing, the court “must assess the parties’ reasonable expectations at the time of contracting and not rewrite the contract to appease a party who later wishes to rewrite a contract he now believes to have been a bad deal.” Nemec v. Shrader, 991 A.2d 1120, 1126 (Del. 2010).

Oppression Plaintiff Obtains Injunctive Relief

Recent New York Decision Grants Injunction Pending Litigation of Oppression Claims


In a recently issued opinion in Feinberg v. Silverberg, 2011 NY Slip Op 32299 (Nassau Co. 2011), Nassau County Supreme Court granted injunctive relief preventing Defendant from continuing oppressive acts. The case strongly supports the proposition that when an oppressed shareholder stands to lose his stake in control and management of a corporation, money damages are not sufficient compensation and an injunction provides greater equity as relief.

L&E is a closely held corporation founded by Feinberg, Plaintiff, and Silverberg, Defendant, who are both 50% shareholders. Feinberg is the President and Treasurer; Silverberg is the Vice President and Secretary. Victor Hecht, another named Defendant, is the Chief Financial Officer of L&E, and Brian Barney is an employee with responsibilities involving the business of L&E in Asia.

Fiduciary Duties of Majority Shareholders in New York -- What the Courts Say

Duty of Good Faith

Fender v. Prescott, 101 A.D.2d 418,422 (1st Dept. 1984):

[T]he relationship between shareholders in a close corporation, vis-à-vis each other, is akin to that between partners and imposes a high degree of fidelity and good faith.

As was observed by Chief Judge Cardozo in Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545, 546 (1928) : "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."

The strict standard of good faith imposed upon a fiduciary may not be so easily circumvented.

Economic Duress and Minority Shareholder Oppression

If a majority shareholder terminates a minority shareholder’s employment or forces him to sell his shares in the company at a below-market price, the majority shareholder could be vulnerable to a claim of oppression.  But, what happens if the majority shareholder is able to obtain a signed agreement from the minority shareholder in which the minority surrenders its rights in return for some – but far less than fair market – consideration?  Typically, an agreement giving the minority shareholder some severance rights or compensation for his shares will contain a general release provision, which would provide that the minority shareholder releases all claims he may have against the majority shareholder.

Often the minority shareholder – having lost his job and means of support or being compelled to sell his interest in his business – will be under significant pressure to accept an offer that provides him some continuing income or compensation – even if it is much less than what he might legally be entitled to or could negotiate for is he were not under duress.