Summer Shorts: LLC Minority Member Oppression and Other Decisions of Interest

August 12, 2019

It’s that time of year again, when I offer some lighter fare for poolside consumption consisting of summaries of a few recent decisions of interest involving disputes between business co-owners.

This year’s summaries include:

a New York case in which a minority member of a Delaware LLC asserted an ill-fated claim for minority “shareholder” oppression;
a California case in which the court disqualified a lawyer hired by one of two 50/50 partners to represent the partnership in a partition action;
a Delaware case in which the court dissolved a limited partnership going through a business meltdown exacerbated by the controlling general partner’s refusal to cooperate with the court-appointed receiver;
and an Illinois case in which an appellate court revived a minority shareholder’s suit to set aside a zero-dollar buyout settlement agreement based on an alleged pre-agreement misrepresentation by the buyer’s counsel that the company was in debt.

New York Court Dismisses Minority “Shareholder” Oppression Claim by Delaware LLC Member

Does Delaware law recognize a non-dissolution cause of action for “minority shareholder oppression” of an LLC member? In 3P-733, LLC v Davis, 2019 NY Slip Op 30946(U) [Sup Ct NY County Apr. 2, 2019], Manhattan Commercial Division Justice Andrea Masley dismissed such a claim on other grounds, namely, because the claim was duplicative of the plaintiff LLC member’s separate claim for breach of fiduciary duty.

Had she reached the question, and putting aside the plaintiff’s use of the misnomer “shareholder” in describing his claim, Justice Masley almost undoubtedly would have found the claim invalid under Delaware law, for several reasons:

Delaware’s LLC Act, like New York’s LLC Law, does not authorize a claim for oppression of a minority LLC member.
As Justice Elizabeth Emerson observed some years ago in the Zutrau case, the “Delaware Supreme Court ha[s] unequivocally rejected the notion that there are any special, judicially created rules to protect the minority shareholders of Delaware corporations.”
Given freedom-of-contract’s primacy in Delaware LLC jurisprudence, it’s even less likely that Delaware courts would create a judicial rule to protect minority members of Delaware LLCs than they would for minority shareholders of Delaware corporations.

California Court Disqualifies Counsel Hired by One of Two 50% Partners to Represent the Partnership in Partition Action

Can one of two 50% general partners hire counsel without the other partner’s consent to defend the partnership in a partition action brought by the other partner? Not according to a recent decision by a California intermediate appellate court in Jarvis v Jarvis, No. H044930 [Cal. Ct. App. 6th Dist. Mar. 19, 2019].

Jarvis involves a dispute between two brothers who couldn’t agree on the operation and disposition of realty owned by their 50/50 partnership. Each brother engaged their own counsel to represent them individually in a partition action brought by Brother #1. Brother #2 also selected, hired, and paid separate counsel to represent the partnership.

Brother #1 moved to disqualify partnership counsel on the ground that Brother #2 as 50% partner lacked the requisite majority consent to engage counsel for the partnership. He argued that Brother #2 planned to oppose partition on the same grounds as partnership counsel; that Brother #2 could articulate his arguments regarding partition directly without the need for separate partnership counsel; and that although the partnership is a separate entity, it has no position independent of the general partners.

Brother #2 argued that Brother #1 lacked standing to seek disqualification because he never had an attorney-client relationship with partnership counsel. The lawyer representing the partnership also opposed disqualification, arguing that while neither partner should participate in or direct the partnership’s defense, there is no conflict if one partner sues the partnership and one partner “merely arranges for independent representation” of the partnership.

In its lengthy opinion, the court looked at the partnership agreement and the governing partnership statute — neither of which resolved the deadlock over retention of partnership counsel — as well as rules of ethics, state bar opinions, and California case law. In granting disqualification, the court was

persuaded that [Brother #1] has demonstrated a risk that [partnership counsel], who is being paid by [Brother #2] and directed by [Brother #2], may advance [Brother #2’s] interests; that his representation may not be in the best interests of the Partnership, and may unnecessarily deplete the Partnership’s assets. Additionally, [partnership counsel] has stated that he believes he can act on behalf of the Partnership without direction from either of the partners in contravention of [the rules of ethics].

The appellate panel court left it to the trial court to determine whether the brothers “can adequately articulate their positions and guide the trial court in determining what is in the best interests of this two-person partnership.” Alternatively, the court wrote, the trial court may “explore options for resolving deadlock at the entity level and consider the appointment of a receiver, neutral counsel, or other neutral to protect the interests of the partners and the Partnership.”

Delaware Chancery Court Dissolves Failing Limited Partnership Based on General Partner’s Non-Cooperation with Receivers

In GMF ELCM Fund, L.P. v ELCM HCRE GP LLC, C.A. No. 2018-0840-SG [Del Ch Aug. 7, 2019], Vice Chancellor Sam Glasscock granted a petition to dissolve a limited partnership that sat atop a maze of dozens of real estate and operating entities involved in the management and leasing of nursing facilities in a number of states, all under the control of an individual named Andrew White.

The first 32 pages of VC Glasscock’s 36-page opinion tell the story of what he calls the “curious and insidious nature of the business’s failure, as well as the similar nature of the litigation itself.” In a nutshell, authorities in a multitude of states had shut down and/or placed the nursing facilities in receivership as a result of gross mismanagement by the time the limited partners sued for dissolution. Mr. White’s conduct in the Chancery Court litigation was non-cooperative at best if not contemptuous, prompting the receiver appointed by VC Glasscock — himself a former Vice Chancellor — to resign in frustration.

VC Glasscock had little trouble concluding that “the portion of the Partnership’s business devoted to operating nursing facilities has been frustrated, and is no longer reasonably practicable to continue.” The court likewise found that the other portion of the partnership’s business devoted to investment in and acquisition of new facilities “is also no longer practical to pursue” and “must be liquidated to preserve what value remains.”

Illinois Court Finds Ongoing Fiduciary Duty in Decision Reviving Minority Shareholder’s Suit to Invalidate Settlement Agreement Notwithstanding Release and Non-Reliance Provision

Arndt v Nardulli, 2018 IL App (1st) 173044-U [Ill. App. Ct. 1st Dist. Dec. 21, 2018], is another reminder to minority owners of pass-through entities who give up their shares as part of a litigation settlement that they need to secure protection against taxes on phantom income reported on a post-closing Form K-1.

The plaintiff minority shareholder in Arndt gave a release and relinquished his shares for zero dollars in settlement of a suit and countersuit with the controlling shareholder. Prior to entering into the settlement agreement, which also included a non-reliance provision, the minority shareholder received a K-1 for the year before showing a loss. Also prior to the agreement, the controller’s lawyer stated in a letter that the company’s affairs “at this stage only involve debt, not profit.”

A week after the closing, the minority shareholder received a K-1 for the final tax year in which he held a stock interest, allocating to him almost $80,000 in profit. He then sued to set aside the settlement based on claims of fraudulent inducement and breach of fiduciary duty. The defendants won a dismissal motion before the trial court based on the release and non-reliance provision.

On appeal, the Illinois Court of Appeals reversed and reinstated the complaint. The court held, notwithstanding the defendants’ argument that the parties’ relationship had already turned adversarial, that “the parties maintained a fiduciary relationship at the time of defendants’ attorney’s alleged misrepresentation.”

Key to the court’s holding was its finding that “the record does not reveal any mutual document demonstrating that the parties had agreed to dissolve their relationship until after the date of defendants’ attorney’s letter” and “does not clearly support a finding that the parties were engaged in arm’s length negotiations when the misrepresentation occurred.”

As I’ve cautioned before, it can be a costly mistake for the seller, when negotiating a buyout of an interest in a pass-through entity whether as part of a litigation settlement or otherwise, not to ascertain possible exposure and seek indemnification for taxes on phantom income reported post-closing.