Articles Posted in Operating Agreement | Shareholder Agreement

The parties to a transaction, including a transaction that concludes a business divorce, will often include a provision that states that neither side is relying on verbal representations of the other.  Most often, this provision refers to the due diligence that precedes a transaction, but it can also refer to other circumstances including the discovery in an ongoing litigation.

We were recently involved in a case in which one of the parties claimed that it had been fraudulently induced into a transaction, notwithstanding the substantial discovery that had occurred.  It wasn’t a successful argument, but it added to the complexity of the case.

More often, however, there is a claim either that there were facts or circumstances that were hidden or that that there were oral representations made that were material to the decision to enter into the transactions.  A recent decision of the Delaware Chancery Court in  IAC Search, LLC v. Conversant LLC , C.A. No. 11774-CB (Del. Ch. Nov. 30, 2016) demonstrates that an anti-reliance provision in a contract can avoid such a fraud in the inducement claim.

Attorney for Buy-Sell Agreement
A business divorce case came into the office a couple of years ago, one of the second-generation owners was looking to force one of the first generation owners — who never came to work anymore — into retiring and selling his interests.

We reviewed the shareholder ledger and the by-laws and the second generation had a clear majority of shares.  So at least the majority could terminate the employment of the minority if that was the way they wanted to go, and he would then have the ability to bring a suit to be bought out.  Or more likely, once he was fired, he would want to be bought out.  So far, so good.

But then the buy-sell agreement.  It provided a formula for valuation that was pegged to the equity accounts of the shareholders some 25 years earlier.  The books and records for that time period had long since disappeared.  In the end, we were able to piece together a guess about the equity accounts and to negotiate a package.

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Agent Fails to Dislcose Principal Exists, Avoids Liability

Was the limited liability company statute supposed to eliminate basic principles of agency law?  That seemsto be the import of a decision by the Appellate Division of Superior Court in Castro v. Giacchi, Docket No. A-6220-12T2 (N.J. Super. App. Div. agent3December 5, 2014)(Opinion Below) that reversed a judgment against an individual who failed to disclose that he was acting on behalf of a limited liability company.

Perhaps just as important as our first question: does it really matter?  Here the answer is pretty easy.  Absolutely.  Understanding agency law – that is the law that governs when one person acts on behalf of another – is critical to understanding how business entities function.  The reason is that even though a business entity is a legal person, but it can an only act through its agents.  The business entity is distinct from its principals.

Contractor’s Handshake Deal with Sub

The decision arose out of a contruction contract.  Castro was subcontracted to do carpentry work on a new home under construction in Southhamptom by Defendants.  It was a handshake deal.  Plaintiff contended that he never knew Giacchi was acting on behalf of anyone other than himself, but he received two progress payments John & Sons ANG, LLC.  The final bill was sent to ANG.

Ordinarily, an agent who fails to disclose he is entering into a contract on behalf of a principal is individually liable on the contract, unless the other party knows or had reason to know the agent was acting on behalf of a principal.

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But N.J.S.A. 42:2B-23 shielded a member or agent of a limited liability company from all of its debts. The statute did not limit the circumstances under which a member or agent was immune from liability, including those where a member or agent of a limited liability company entered into a contract without disclosing the identity of its principal. Being clear and unambiguous, our sole function is to enforce the statute according to its terms.

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Most of the cases that we handle – like any other litigation – get settled before trial. One of the incentives to settle is that invariably the departing owner will agree to some sort of restrictive covenant against competing against his former company.

The case that goes to trial, or which is resolved on a substantive motion, leaves this issue wide open.  In fact, there is no statutory basis to deter the ousted business owner from setting up a competitor and trying to lure away the business of his former company, and one would suppose with a bankroll secured by the purchase of his or her interest.

Since most business divorce litigation ends with a deal, and restrictive covenants are critical aspects of those transaction, I thought it worthwhile to write about a recent decision of the Appellate Division that gives a stern warning that the restrictive covenant had better been honored.

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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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Purchaser Alleges Mortgage Was Not Approved by All LLC Members

A mortgage given by a New Jersey limited liability company to one of its members can be challenged by the purchaser in a court-approved sale of the business, the Appellate Division holds, reversing the trial court.

This case arises out of the estate planning undertaken by John Best and his wife, defendant Patricia Ann Best, after Mr. Best learned that he was terminally ill.  The couple owned Sea Village Marina in Northfield (across the bay from Margate).  They had transferred 25 percent of the business to their son, John, in 1994.

Buy Or Sell

Dispute Related to Repurchase of Shares Under Buy-Sell Agreement Subject to Agreement to Arbitrate

Agreements to arbitrate are frequently added to buy-sell agreements and other corporate governance contracts.  These agreements will be enforceable in nearly all circumstances and the parties should be certain that arbitration – rather than litigation in court – is what they really want.

In a recent appeal from a court order refusing to enforce an agreement to arbitrate after the parties had already been in litigation for two years, the Appellate Division of Superior Court rejected arguments that the arbitration clause was narrowly drawn.  Gatta v. Gatta, Docket No. A-3161-11T (App. Div. October 26, 2012).  Because the subject matter of the dispute was also the subject matter of the contract, the agreement to arbitrate was enforceable notwithstanding the delay in asserting the right.

Shareholder Seeks to Enforce Arbitration Right

The appeal was brought by Defendant Joseph Gatta from the trial court’s denial of an application to compel arbitration under a shareholders agreement.  Gatta and the company, Joseph Gatta & Sons, Inc., were sued by Gatta’s brother, Anthony Gatta, one of four shareholders in the business.  Anthony sued after he was fired and the company did not respond to his demands to purchase his interest.

 

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Operating Agreements for Limited Liability Companies to Change Under Revised Limited Liability Company Act

 

Part of an ongoing series on the adoption of New Jersey’s revised limited liability company act.

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The amendments to the New Jersey’s Limited Liability Company Act, N.J.S.A. 42:2C-1-94 that begin to take effect in March 2013 will bring a new era in the way the members of a limited liability company structure their affairs.  The days in which the members must put their agreements in writing will soon be over, and the owners of New Jersey LLCs should take a hard look at their own operating agreements and course of doing business.

In adopting the Revised Uniform Limited Liability Company Act, the state legislature has approved a fundamental change to the way LLCs operate in New Jersey.  We are examining these changes in a series of articles and today focus on the effect of the changed definition of operating agreements.

Written Operating Agreements Not Required

The old law may have been rigid, but at least it was clear.  It was not required in New Jersey (as in some other states) to have an operating agreement, but if you did, it had to be in writing.  If there was no written operating agreement, then the “default” rules provided by the statute governed.  That has changed significantly.  The new law defines an operating agreement as

“the agreement, whether or not referred to as an operating agreement and whether oral, in a record, implied, or in any combination thereof, of all the members of a limited liability company …”

To understand just how much of a change is this definition, we can look at a 2004 decision of the Appellate Division in Kuhn v. Tuminelli, 366 N.J. Super. 431, 841 A.2d 496 (App. Div. 2004).  In that case, the plaintiff and defendant owned a limosine service and the defendant embezzled funds by endorsing checks to the company and keeping the funds.  Kuhn argued that the defendant did not have authority to convert the checks and named as a defendant the check cashing service that had negotiated the checks.

 

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Fraudulent Inducement Claims Rejected by Court

In Shareholder Buyout Dispute

The broad release language contained in a buyout agreement is enforced, despite claims of fraudulent inducement, affirms the Appellate Division of Superior Court in Marino v. Twin Rivers Podiatry, P.A., Docket No. A-5630-10T1 (May 19, 2012).

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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.

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