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Posted: March 21, 2016

Client Q&A: My friends and I jointly own a corporation and an LLC, but disagree about everything lately. How can I get out of the business?

My friends and I jointly own a corporation and an LLC, but disagree about everything lately. How can I get out of the business?

By Vitali S. Rosenfeld

Separating from one’s business partners in a closely held entity—commonly known as business divorce—is a distinct area of modern commercial law generating a lot of litigation. Like any other dispute, it may be possible and preferable to negotiate the terms of such separation without involving the court system. But sometimes the majority owners resist dividing the business, or the parties may be unable to agree on company valuation and mutual accounting. This often gives rise to a dissolution proceeding.

For dissolution purposes, each entity (such as a corporation, an LLC, a partnership, etc.) should be considered separately, because different kinds of entities are governed by different rules. We previously touched upon the topic of dissolution of corporations. To recap, in New York there are three different sets of standards depending on your level of ownership.

Dissolution of a Corporation

If you (alone or together with other aligned shareholders) own at least 50% of the corporation, the Business Corporation Law (BCL) allows you to petition for dissolution based on a deadlock, i.e., constant disagreement between shareholder factions that prevents effective decision-making. In this scenario, it is not necessary to prove anyone’s wrongdoing—just irreconcilable differences. This is no-fault divorce, so to speak.

If you (and others aligned with you) own less than 50% but at least 20% of the corporation, then you can seek dissolution under a different provision of the BCL, based on various types of wrongful conduct by the majority in control. That includes fraudulent, illegal or oppressive conduct, as well as waste or mismanagement of corporate assets. Notably, petitioning for dissolution under this provision triggers the majority’s right to buy out the petitioners’ shares at fair value.

Finally, if you own less than 20% of the company, then you cannot base your dissolution petition on any particular provision of the BCL, but you can still make a claim for “common law dissolution” on the ground that the majority owners engage in systematic and egregious breaches of their fiduciary duties—for instance, looting the corporation by diverting its funds, resources and opportunities for personal use. Courts have held that these grounds for dissolution largely parallel the statutory grounds available to 20% shareholders. Likewise, common law dissolution claims often result in a buyout of the petitioners’ shares by the majority.

Dissolution of an LLC

As for LLCs, they are governed by an entirely different statute—the Limited Liability Company Law (LLCL). Under that statute, a member may petition the court for dissolution if it is no longer “reasonably practicable” to continue operating the business in conformity with its articles of incorporation or operating agreement. Naturally, such analysis begins with the contractual language of these foundational documents. The operating agreement may itself contemplate dissolution and set specific terms for it. Or at least it could otherwise shed light on what is or isn’t “reasonably practicable” with regard to this particular company.

But the contractual analysis may lead to a dead end where the operating agreement does not exist or where it provides no explanation of the company’s business goals. In such situations, the court may use other evidence as to the company’s intended purpose. In any event, that intended purpose often becomes the focal point of the court’s analysis. The court is likely to look beyond the members’ respective ownership interest shares and examine each member’s specific role in the business.

If the petitioning members establish that the company’s intended purpose is defeated by the controlling members’ conduct, the court will likely grant dissolution. Simple disagreement between member factions, however—or even some wrongdoing by the majority—will not necessarily be enough to meet the stringent LLCL dissolution standard. On the other hand, that standard will probably be met where the majority’s management makes the company insolvent or brings it close to insolvency: New York courts have held that it is by definition “not reasonably practicable” to continue carrying on a financially failing business.

Withdrawal from an LLC

What if the court decides that the LLC dissolution standard has not been met—does that mean you are stuck in an unhappy “business marriage”? Not necessarily. Another possible option is a member’s “withdrawal.” While conceptually different from dissolution (one member may withdraw while the company as a whole continues to exist), the practical result may be the same, especially where the LLC consists of only two members.

The previous version of the LLC Law (which may still be applicable to LLCs created before 1999) allowed withdrawal by any member on six months’ notice to the other members. The current version of the LLCL, however, is much less liberal: it provides that withdrawal is not allowed unless the company’s operating agreement contemplates it. This makes withdrawal difficult (or impossible) where the operating agreement lacks a clear withdrawal provision or makes withdrawal subject to various limitations.

Just as with corporations, petitioning for dissolution of an LLC or for withdrawal from an LLC may in practice lead to a buyout of one member’s interest by other members. Even though the LLCL has no express buyout provision, courts have held that buyout may be ordered as an equitable alternative to dissolution of the entire business. If so, the remainder of the proceeding would focus on fair valuation of the company and of the outgoing member’s ownership interest. Such valuations often become the focus of the litigation and the subject of expert analysis.

Dissolution lawsuits are most commonly commenced as “special proceedings” subject to a particular set of procedural rules. While the procedural requirements for a lawsuit seeking dissolution of a corporation and one seeking dissolution of an LLC are somewhat different, it is usually possible to combine both claims in the same proceeding. It is also often possible to add other claims related to the same business – for instance, for breach of the operating agreement, breach of fiduciary duty, mismanagement of corporate assets, and other misconduct in connection with the same companies.

Conclusion

If you are in conflict with your business partners and would like to get out of the business, to buy them out, or otherwise to resolve your differences, make sure you consult with competent counsel and carefully consider your options. Schlam Stone has significant and wide-ranging experience in litigating corporate governance disputes and dissolution of corporations, LLCs, partnerships and other business entities.

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