Articles Posted in Fiduciary Duties

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Derek Jeter promised his new business partners that his ownership and support of the Frigo brand of men’s underwear would not conflict with the superstar Yankee’s obligations to sportswear giant Nike.  In return, RevolutionWear, Inc. gave him 15 percent of the company and a seat on the board.

Apparently, Nike did not take too kindly to Jeter becoming well-known as one of the principal owners of a competitor, and when the athlete failed to embrace the brand — $50 undershirts and $100 briefs — the relationship spun out of control.  Jeter filed suit first, seeking a declaration supporting his conduct.  RevolutionWear counterclaimed, alleging fraud and breach of fiduciary duty.

The decision of the Delaware Chancery Court in Jeter v. Revolutionwear, Inc., C.A. No.11706-VCG (Del. Chancery July 19, 2016) points out some of the pitfalls in trading equity for services.  Once Jeter was on board, according to the plaintiff’s counterclaim, he was loathe to be publicly associated with the enterprise, or in other words, to live up to his obligations.

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Talk about playing your cards wrong.

A partner with a 3.08% interest worth $4.85 million in a partnership that owns a major shopping mall likely will walk away with only a few hundred thousand dollars after a court decision finding that he wrongfully dissolved the partnership and deducting from the value of his interest the other partners’ damages including legal fees, a 15% discount for goodwill, a 35% marketability discount, and a whopping 66% minority discount.

Last week’s decision by the Brooklyn-based Appellate Division, Second Department, in Congel v Malfitano, 2016 NY Slip Op 03845 [2d Dept May 18, 2016], rejected the partner’s appeal from the trial court’s determination of wrongful dissolution and also upheld its valuation determination with one major exception: the appellate court held that the trial court erred by failing to apply a minority discount and that it should have applied a 66% minority discount based on the “credible” expert testimony “supported by the record.”

Fiduciary Duty of Majority Owners

The three majority members of a five-member limited liability company decide that they want to take a major action, such as selling the assets of the business or buying another business. They present the decision to the minority and proceed over their objections (We’ll assume for the moment that the action is permitted by the Operating Agreement.) The minority are bitterly opposed. Is this a problem? Often, it is.

Majority Rule and Minority Rights

The line between what is a right as an equity owner and what is a breach of fiduciary duty to the minority members is often blurry. We presume that as the owner of equity in a business, be it a limited liability, partnership, or a corporation, that we have the right to vote our economic self interest.

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New Jersey Limited Liability Company Attorneys

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

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

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

New Jersey Limited Liability Company Operating Agreement

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

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

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Statutory Fiduciary Duties May Be Limited or Eliminated – Sometimes

 

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

 

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

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

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

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

 

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Law Specifies Fiduciary Duties for Members and Managers of New Jersey LLCsfd-proxy

 


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

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

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

Uncertain ResponsibilitIes of LLC Members

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

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

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

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

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

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

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

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

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

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Employee Held Liable for Actively Competing With Current Employer

The success of businesses in specialized fields often depends on the employees’ ability to deliver consistent-quality service and implement specialized techniques and processes.  Business owners in these fields know that the costs of investment in employee training and development can be very high.  What is a business owner to do when employees take this costly knowledge and expertise to a new company and begin competing against the former employer?  Fortunately, New Jersey offers relief from such acts, as discussed in the recent Appellate Division case of Baseline Services, Inc. v. Kutz, et al., A-5214-09T3.

Baseline provides metrology services involving repair, maintenance, and calibration of laboratory equipment to its clients.  The corporation had a substantial annual contract – in the amount of $269,000 – with Global Pharmaceutical Sourcing Group (GPSG), which is a division of Johnson & Johnson, Inc.  The contract was primarily serviced from 2002 to 2006 by two Baseline employees – Kutz and Nicoludis.

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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.)

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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.

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