Whether they are relatives, friends, or strangers who happen to meet or be introduced, two people often go into business together on a 50-50 basis. This situation is similar to a couple deciding to marry. In each case, the participants have stars in their eyes, foresee only future prosperity, and believe the union will continue happily ever after. Unfortunately, the record of business breakup is not very different from the rate of matrimonial divorce. The fact is that people, circumstances and attitudes change over time.
It is not failure but success that leads to business divorce. The workaholic becomes frustrated by the co-shareholder who, content with what has been achieved, leaves at five o’clock. The member whose contribution is “sweat equity” grows irritated by the fact that the co-member, whose contribution financed the limited liability company (LLC) at the outset, continues to enjoy 50 percent of the profits. The fissure in the relationship grows until the two can no longer speak civilly to each other let along work together. Each thinks of the business as his or her “baby”; each wants custody and the other gone. A business often cannot be divided. Either one must buy and one must sell, or the enterprise sold or liquidated and the proceeds divided. The alternative is unholy deadlock. If litigation ensues, the parties quickly discover that there is no such thing as a no-fault business divorce.
While a prenuptial agreement may be anathema to a young couple contemplating marriage, a lawyer should not be shy to suggest a similar type of agreement to business people. Whatever its form—shareholder, partnership or operating—the agreement should provide for how decisions will be made, how profits and losses will be divided, and what will happen when one dies, becomes disabled, wants to retire, wants to withdraw or wants to expel the other. Who may buy out whom in a break up is unknown at the start of the relationship. When both are on the same side of the table, the parties can agree on how to of the enterprise and one’s interest in it to determine price, what terms will apply, and what if any restrictions on competition will be imposed. Without agreement, and as to items not covered, the parties are left to the default rules applicable to their entity, the vagaries of litigation, and the financial, emotional and physical toll litigation entails.
N.J.S. 14A:12-7, providing for deadlock and “minority oppression,” was added to the New Jersey Business Corporation Act in the 1970s. Its background is described in Pachman, “Divorce Corporate Style: Dissention, Oppression, and Commercial Morality,” 10 Seton Hall L. Rev. 315 (1979). Subsections (a) and (b) of N.J.S. 14A:12-7(1) address deadlock, the latter being more likely to come into play in a close corporation with two equal shareholders or factions. Deadlock is not simply personal dislike and disagreement; inability to effect action on “one or more substantial matters” is required. Earlier 50-50 breakup cases are reviewed in Pachman, “Corporations Evenly Divided: Judicial Remedies for Equal Shareholders,” 24 Seton Hall L. Rev.234 (1993). In addition to deadlock, a 50-percent shareholder can now be considered a minority under subsection 1(c).
When both parties desire to keep the business, the primary issue becomes who goes and who stays. Among the factors that influence the court in making a who goes/who stays determination are: who is better able to continue the business without the other; who is more at fault; whose efforts have resulted in the success of the business; and who has the contacts with vendors and customers. When the evidence shows that the person better able to continue the operation is also the one more at fault, the court has a difficult choice.
The case of Hendley v. Lee, 676 F. Supp. 1317 (D. S.C. 1987), discusses the 50-50 issue in detail. In Balsamides v. Protameen Chemicals, 160 N.J. 352 (1999), the business was awarded to the shareholder not only less at fault but whom people in the industry viewed as the “face” of the corporation. Mullenberg v. Bikon Corp., 143 N.J. 183 (1996), and Musto v. Vidas, 281 N.J. Super. 548 (App. Div. 1995), certif. den. 143 N.J. 328 (1996), although neither was a 50-50 situation, are also instructive on the issue of which party gets to buy out the other.
The corporate statute does not provide for expulsion. If the parties were to consider the ability of one shareholder to “expel” the other, perhaps the shareholder agreement could list certain express acts or omissions that would trigger an option for one shareholder to acquire the other’s shares at a set price and terms.
When LLCs were authorized in New Jersey in the early 1990s, the statute made no provision for minority oppression, and case law later determined the corporate provision inapplicable to LLCs. The original statute provided that a member could seek judicial relief to dissolve the LLC, but only if its activities were unlawful or if it was not “reasonably practicable” to carry on the business in conformity with either the certificate of formation or the operating agreement. The burden to establish those proofs is not easy. IE Test, LLC v. Carroll, 226 N.J. 166 (2016).
In 2013, N.J.S. 42:2C-1 et. seq., repealed and replaced the former LLC statute. At section 48a(5), it adds the minority oppression concept to LLCs. At section 48a(4), it carries over the “not reasonably practicable” provision from the former statute.
LLC members, like partners in a partnership, choose those with whom they wish to associate or remain associated in the business. Consequently, unlike the corporate statute, the LLC act at section 46c expressly authorizes the operating agreement to prove for expulsion. (The expulsion provisions in Sections 46d and e by their terms would not apply to a 50-50 situation.)
The Broad Reach of Equity
In both Brenner v. Berkowitz, 134 N.J. 488 (1993), and the Muellenberg case cited above, the Supreme Court confirmed that courts may employ a wide variety of equitable remedies. Operating and shareholder agreements are not immune from adjustment under equity’s broad powers to achieve a just result. Haley v. Talcott, 864 A.2d 86 (Del. Ch. 2004), is an excellent example. These two men each held a 50-percent interest in an LLC holding real estate on which Talcott owned a restaurant. Haley wanted out of the LLC. Its operating agreement contained buyout terms which Talcott sought to enforce, but which the court was reluctant to apply because, after the buyout, Haley would remain subject to the mortgage note on the real estate which he had guaranteed personally. The court ruled it would dissolve the LLC, but allowed the parties four weeks to submit a plan of dissolution (during which, we may infer, they might resolve their differences).
The Balsamides case cited above, provides another example of equity’s power to adjust an agreement’s provisions. There the Supreme Court left undisturbed the trial court’s conversion of the three-year restrictive covenant in the shareholder agreement to one year.
Shawe and Elting started their wildly successful business together while in college. At one time they were engaged to be married. Each held a 50-percent interest in the corporation. (To qualify the corporation as a majority women-owned business, Shawe’s mother held 1 percent and he held 49 percent.) The hatred, bizarre actions and “seriously dysfunctional relationship” that grew between the two founders are described in detail in the opinions of both the trial court and Delaware Supreme Court, Shawe v. Elting, 2015 WL 4874733 (Del. Ch. 2015), aff’d ___A.3d___(Del. 2017). The trial court found not only deadlock, but also “complete and utter dysfunction.” It rejected (i) leaving the parties where they were, (ii) judicially dissolving the corporation, and (iii) appointing a third director, which the judge observed would forever enmesh that director and the court in the parties’ constant squabbles. The remedy ordered and affirmed on appeal was the appointment of a custodian to sell the business. (Dissolution of the parties’ separate LLC was also ordered.) As this case and other litigation surrounding it illustrate, business divorce between two equal factions is no easy matter.•