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Seven Critical Mistakes Real Estate LLCs Make (and How to Avoid Them) — Mistake #7: Sinking Profits on Messy “Business Divorce” (Judicial Dissolution)

We’ve come full circle from MISTAKE #1: Choosing the Wrong Business Partners.

Often, choosing the wrong business partners ends in messy divorce, otherwise known as judicial dissolution.

MISTAKE #7: Sinking Profits on Messy “Business Divorce” (Judicial Dissolution)

Common statutory grounds for the involuntary dissolution of a California LLC through a court action include:

  • it’s no longer reasonably practical to carry on the business
  • dissolution is necessary for the protection of member rights
  • the business of the LLC has been abandoned
  • management of the LLC is deadlocked
  • fraud, mismanagement, or abuse by those in control of the LLC

Translation: The relationship has soured, and the yard duty (court) needs to step in.

A Contested Dissolution can be Costly

Business dissolution provides a fertile source of employment for many professionals — not just lawyers.

Forensic accountants, business valuation experts, provisional directors, receivers, fiduciary duty experts — you name it.

Luckily, there are some alternative procedures available to accomplish “divorce” at a reduced cost.  A few are highlighted below.

Statutory Buyout Option

How it works:  If one LLC member (plaintiff) initiates a judicial dissolution lawsuit, then the other members (one, some, or all) have the option to buy out the plaintiff’s LLC interest at “fair market value.”

If the parties can’t agree on the price, the court will appoint three appraisers to make a recommendation as to fair market value.

(Contrast this procedure with the analogous procedure for California corporations, which refers to “fair value” — defined as “liquidation value.”)

The statutory buyout procedures can’t be eliminated or even modified by the Operating Agreement.

Once the buyout procedures are initiated, the plaintiff can’t avoid the buyout by dismissing his action.  In fact, the entire court action is stayed, and in many instances other claims in the action (such as derivative claims for damages) will get wrapped into the appraisal process.

Once valuation is determined, the exercising members don’t have to complete buyout, but if they don’t they must pay the plaintiff’s attorney fees incurred during the buyout process.

Buyout Tips for Non-Dissolving Members

  • Use the buyout option to cut off costly litigation.  Exercising the buyout option eliminates the need to spend resources litigating over whether the grounds for dissolution exist.
  • If the non-dissolving members still believe in the business, and can afford the buyout option, then buyout will almost always be more attractive than dissolution litigation.
  • Be prepared to pay what the appraisers and court determine is “fair market value” because if you don’t, you’ll owe attorney fees.

Buyout Tips for Dissolving Member

  • Think twice before including a claim for dissolution in a complaint with other valid claims for damages.  By including a claim for dissolution, all of your claims might be resolved through a forced sale of your LLC interest — at a price you might not agree with.
  • Including a claim for dissolution might also cause a loss of control over the litigation timing.  The current statutes allow the buyout option to be exercised late in the game — even after months of litigation.  And the default valuation date used by the appraisers is the date the complaint was filed.  (This can be changed for “good cause,” but that’s no sure thing.)

Negotiated Withdrawal and Redemption

Another alternative to litigation (or a means of settling litigation before costs start to escalate) is to negotiate the disgruntled member’s withdrawal and the redemption of his membership interest.

This alternative can be framed in the Operating Agreement to make its implementation smooth.

Keep in mind: This is a rare scenario in which California law allows a non-compete agreement (as long as it is geographically tailored and reasonable).

Forced Dissociation

Forced dissociation (withdrawal) of a member is another potential alternative that might be available depending on the facts and the terms of the Operating Agreement.  This represents a “preemptive strike” against a disgruntled member before hostilities have a chance to escalate toward dissolution.

An Operating Agreement might provide for forced dissociation as follows:  If a member is in default under the Operating Agreement, then the manager can promptly declare a “default” and strip the member’s voting and governance rights.  The dissociated member becomes a technical “transferee” of his own interest — like most other transferees, he retains an economic interest in the LLC, but no longer has a say in voting, management, or any internal affairs.

Using this alternative can often provoke heated litigation over whether the declaration of default and forced dissociation were justified, so be sure that the Operating Agreement and facts support your position.

Lesson

Keep the business relationship transparent, honest, and in good faith, and the grounds for judicial dissolution will probably never arise in the first place.

Use alternative procedures to avoid the often ruinous expense of dissolution litigation.

 

Prior posts in this series:

MISTAKE #1: Choosing the Wrong Business Partners

MISTAKE #2: Skimping on the Formation and Operating Documents

MISTAKE #3: Ignoring Member Rights and Duties

MISTAKE #4: Stepping into “Alter Ego” Liability

MISTAKE #5: Misunderstanding Secured Loan and Guaranty Rights / Liability

MISTAKE #6: Failing to Protect Trade Secrets

 

 

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