Operating Agreement vs. Member Rights in a Lawsuit

Common Reasons For Member Disputes And Lawsuits

What Does The Operating Agreement Say?

An operating agreement is a contract (verbal or written) among the members of the LLC which defines their relationship, responsibilities and economic benefits. While New Jersey does not require an LLC to have a written operating agreement, trust me when I tell you an oral/verbal “operating agreement” will likely lead to future costly conflicts, disputes and lengthy litigation if a disagreement develops. A well written operating agreement is an essential and critical organizational document to minimize, avoid and resolve conflicts among members. In the absence of an operating agreement the members of the LLC are bound by what are known as the default rules of the New Jersey Limited Liability Company Act, which means state laws will address the issue.

Disagreements Among Members in an LLC

Understanding Member Rights

The law gives members the right (subject to reasonable limitations specified in the operating agreement) to obtain information about the LLC “for any purpose reasonably related to the member’s interest” in the company including information concerning the: (1) financial affairs including income, expenses, profits of the LLC; (2) membership list of the LLC; the organizational documents of the LLC; (3) proof of contribution of funds by each member to the LLC; and (4) any other information about the LLC which is “reasonable”. Managers of the LLC and those who operate the LLC are given enhanced rights to access the records and confidential information of the LLC to effectively perform their responsibilities. In that light, a manager can, under limited circumstances keep confidential information from other members which includes trade secrets or “other propriety information the disclosure of which the manager believes to be (in good faith) not in the “best interests of the company” or which if disclosed could damage the economic interests of the LLC.” This right to exercise discretion over the release of information can of course be the subject of abuse, especially in the context of a dispute or struggle for the control of the LLC by its members. If a dispute develops then a court will apply the traditional business standard of “good faith” and fair dealing among members. In the absence of an objective and bonafide reason for a manager’s decision, to refuse disclosure of information about the LLC, such as a legal opinion of counsel, financial opinion of an investment banker/advisor, etc., a Court will be suspicious of any non disclosure and will likely overturn the refusal when challenged.

Common Reasons For Member Disputes and Lawsuits

Most closely-held NJ companies begin with a friendly, profitable relationship between a few members. Unfortunately, these relationships don’t always remain friendly. Once business gets underway, circumstances can change. Expectations of the members may vary as the business expands. One or more members may not carry their weight, neglect or refuse to honor their pre-formation promises. Attitudes toward other members may not be the same as they once were. As the business evolves, so do the views of the members. Often times, individuals disagree on the direction the company is headed, with some favoring expansion and others happy with the way things are.

A difference in opinion does not give majority members the right to oppress minority members within their NJ companies. The New Jersey legislature protects minority ownership members by creating laws that specifically address minority member oppression. These laws give minority members certain rights to take action in the Courts if they are taken advantage of by the majority members. The most common disputes between members that arise in the New Jersey courts are:

  • Breach of Fiduciary Duty;
  • Breach of the Duty of Loyalty;
  • Breach of Contract;
  • Tortuous Interference with a Prospective Economic Advantage;
  • Usurpation of a Company Opportunity;
  • Breach of the Covenant of Good Faith and Fair Dealing;
  • Fraud;
  • Conversion;
  • Violations of the revised Limited Liability Company Act
  • Unlawful Expulsion
  • Refusal to Disclose Information
  • Freeze Out of Involvement in the Officers of the LLC

 

A Fiduciary Duty is Owed to All Members of a NJ LLC

All members of an LLC owe what is known as a fiduciary duty to one another. This fiduciary duty stems from the nature of the business relationship. The relationship between members is that of partners in a Partnership. It is a relationship built on and requires trust, confidence, and good faith. Every member owes this duty to all of his/her fellow members, just as all partners owe a fiduciary duty to one another in a partnership.

New Jersey law allows for legal action to be taken by a member against other members, officers, and directors of companies who violate their fiduciary duty by operating the business in a manner that is detrimental to the members. For example, a member is prohibited from making a decision on behalf of the business for the sole purpose of personal financial gain, regardless of whether or not the decision is in line with the company’s normal business operations.

In corporate transactions where the majority of members, directors, and/or officers stand to realize a sizeable personal benefit, it is of the utmost importance that they respect their fiduciary duty owed to all members. If they do not uphold this duty and a member brings a claim alleging a breach of fiduciary duty, the burden is on the majority member to prove that the transaction was fair and equitable to all members. One must also keep in mind that the fiduciary duty of good faith and fair dealing requires truthfulness and transparency on behalf of majority member, directors, and officers. Any information that is misleading, inaccurate, or simply false is considered a breach of this duty and the minority member will have a rightful cause of action under NJ law.

Wrongful Expulsion From an LLC

The terms of an operating agreement may discuss if, how, and when a member can resign and/or terminate his/her interest in the LLC and receive a return of their capital contribution. You may be surprised to learn that sometimes a member cannot voluntarily leave the LLC. Yes, that’s correct. If the agreement requires the consent of all members or a stated percentage of the members before a member can resign, then without their consent a member who attempts to leave will be considered to have wrongfully disassociated himself/herself from the company per the operating agreement. The LLC statute (NJSA 42:2C845(b) provides that disassociation is wrongful if it is a breach of an express provision of the operating agreement and the operating agreement makes clear that consent is required. A breach has the potential for a lawsuit against the withdrawing member seeking damages and result in the member not receiving back his/her capital contribution and/or other economic benefits from the relationship.

Resolving Member Disputes in the Courts

The Limited Liability Company Act provides for several methods by which an LLC member may be disassociated from the LLC. One such procedure is expulsion by “judicial determination” under N.J.S.A. 21:2B-24(b)(3). The statute provides that a member shall be disassociated from a limited liability company under the following circumstances:

On application by the limited liability company or another member, a member’s expulsion by judicial determination can be ordered because:

(a) the member engaged in wrongful conduct that adversely and materially affected the limited liability company’s business;

(b) the member willfully or persistently committed a material breach of the operating agreement; or

(c) the member engaged in conduct relating to the limited liability company business which makes it not reasonably practicable to carry on the business with the member as a member of the limited liability company.

If a court makes a judicial finding that an LLC member engaged in the type of behavior/action(s) described in any one of the three subsections recited above, it may grant the remedy of expulsion. If expelled, the disassociated member’s interest in the LLC is immediately limited to the “rights of an assignee of a member’s limited liability interest, subject to the provisions of N.J.S.A. 42:2B-39. This provision of the law also addresses the issue of a buyout of a member’s interest at fair value, (see N.J.S.A. 42:2B-24.1). Pending a buyout (if ordered by the Court) the member may no longer take part in the day to day business decisions affecting the company, and may lose part or all of his or her investment.

As described earlier on this page the law also authorizes the expulsion of an LLC member (by order of a Court), based on the member’s “conduct with his or her co-members relating to the [LLC] which makes it not reasonably practicable to carry on the business with the member as a member of the [LLC].” N.J.S.A. 42:2B-24(b)(3)(c).

This statute does not define the term “not reasonably practicable,” nor does it describe the type of conduct by an LLC member that will trigger the application of subsection 3(c). It’s legislative history is also silent, but a recent and significant N.J. Supreme Court case discussed this section of the law at length. It’s a controversial decision in the business law community. This Supreme Court case is beyond the scope of this page so I invite you to contact me to arrange a consultation to discuss how and if this decision impacts you and your LLC.

It requires a very close reading to note the differences in the statute which allows a judicial expulsion of a member. The language of subsection 3(c) differs from the language of subsection 3(a). Subsection 3(a) involves any “wrongful conduct” by an LLC member that has “adversely and materially affected [the LLC’s] business. Under subsection 3(c), a court considers only the conduct by the LLC member “relating to the business of the limited liability company. It is less concerned about the relationship(s) between members.” Disagreements and disputes among LLC members are fairly routine but if it bears no nexus to the LLC’s business, such conflicts will not justify a member’s expulsion under subsection 3(c).

The distinction between subsections 3(a) and 3(c) seems confusing. But not really. Here’s why; subsection 3(c) uses different language to describe the impact a LLC member’s “conduct” must have on the LLC in order to warrant a member’s expulsion. To expel (disassociate) an LLC member under subsections 3(a), a court must find that the member’s wrongful conduct has “adversely and materially affected” the company’s business; the member’s “wrongful conduct” must have damaged the LLC’s business in the past. In contrast, subsection 3(c) does not mandate a finding that the LLC member’s conduct has materially and adversely affected the business in the past. Under subsection 3(c), the court looks to the future to analyze the probable impact of a likely member’s conduct upon the LLC, its members and its future operations. Because of this focus upon the future, a court will not expel a member merely because it would be less challenging or complicated for the other members to run the business without the “disruptive” LLC member remaining. The LLC member’s conduct must be so disruptive that it is “not reasonably” practicable” to continue the business in the future unless that member is expelled. (N.J.S.A. 42:2B-24(b)(3)(c)). Because the LLC laws in NJ authorize majority rule in the day-to-day management, and affairs of an LLC, if the LLC members fail to reach unanimous agreement on the conduct of the business then majority vote controls. Thus the courts believe disputes among LLC members on most issues relating to their business can be resolved by majority vote. Therefore despite an impasse among LLC members regarding the company’s management, an LLC can be effectively operated pursuant to majority rule and if still not adequate then according to the default provisions of the LLCA.

In short, LLC members seeking to expel a member under RULLCA, (N.J.S.A. 42:2C-46(e)(3)), are required to demonstrate a lot of negative outcomes to the LLC going forward. Neither provision of the law(s) I just discussed with you authorizes a court to disassociate a LLC member merely because there is a conflict. Instead, both sections of the statute require the court to evaluate the LLC member’s conduct relating to the LLC, and assess whether the LLC can be managed notwithstanding that conduct, in accordance with the terms of an operating agreement or the default provisions of the statute.

In that end, a trial court will consider the following factors, among others that may be relevant to a particular case: (1) the nature of the LLC member’s conduct relating to the LLC’s business; (2) whether, with the LLC member remaining as a member, the entity may be managed by majority vote or otherwise so as to promote the purposes for which it was formed; (3) whether the dispute among the LLC members precludes them from working with one another to pursue the LLC’s goals; (4) whether there is a deadlock among the members; (5) whether, despite that deadlock, members can make decisions on the management of the company, pursuant to the operating agreement or in accordance with applicable statutory provisions; (6) whether, due to the LLC’s financial position, there is still a business to operate; and (7) whether continuing the LLC, with the LLC member remaining a member, is financially feasible.

A trial court considering an application to expel a member under RULLCA, N.J.S.A. 42:2C-46(e)(3), will conduct a case-specific factual analysis with no requirement that all factors support expulsion, and no single factor alone will determine the outcome.

Fredrick P. Niemann Esq.

Have questions about your LLC operating agreement and a potential lawsuit by a member? Contact me personally today to meet and discuss your New Jersey LLC matter. I am easy to talk to, very experienced in New Jersey business and you will find me to be highly approachable. Allow me to offer you practical, legal ways to handle all of your LLC concerns. You can reach me toll free at (855) 376-5291 or e-mail me at fniemann@hnlawfirm.com.

 

 

 

Written by Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a New Jersey LLC Law Attorney