Penny Wise; Pound Foolish: Lack Of Careful Legal Planning Dooms Successful Business

The hallmarks of new business formation are energy, enthusiasm, and optimism.  Without these elements fueling the momentum, there would be no new businesses.  However, the result can be that legal planning is often brushed to the side, considered an uncomfortable and expensive foray into the land of pessimism where the devil lurks in unnecessary details.  After all, the intelligent and eager partners in the new venture are united in their goals, clear in their direction, and fully invested in the momentum of the enterprise.  

And, yes, proper planning for business organization, member buyouts, and dispute contingencies can seem to threaten disruption of the abundant positive energy for reasons that don't seem at first blush to be remotely relevant.  However, as a recent decision of the North Carolina Business Court reveals, proper legal planning for a business addressing remote, uncomfortable, but nevertheless possible crises is every bit as crucial to the business formation process as any other step.    

Chad and James created a limited liability company ("LLC") and owned it equally, 50-50.  They placed their names to an Operating Agreement for the LLC that, from the terms quoted by the Business Court, was a standard form Operating Agreement (the document which controls the organization and operation of a limited liability company).  The LLC operated a successful tavern for years.   

Unfortunately, in July of 2013, James was involved in a car accident and was injured.  The aftermath of the accident became the genesis of a dispute between Chad and James.  Chad contended that James ceased to uphold his duties and responsibilities concerning the LLC.  Chad and James both proceeded to engage in unilateral actions on "behalf" of the LLC (after all, they were equal owners) which eventually landed them before the North Carolina Business Court.  Among these unilateral actions were Chad's attempt to relocate the LLC's bank accounts to keep James from squandering them, James's attempt to hire lawyers to represent the LLC, and James's attempt to oust Chad from the latter's ownership/control interest.  

Chad ultimately moved the Court to disqualify the law firm hired by James.  The LLC, which for the purpose of the case was acting at James's direction through the law firm hired by James unilaterally, moved to oust Chad from ownership.  With respect to the disqualification of the law firm, the Court agreed with Chad, because the Operating Agreement entered into by the parties provided that only a member owning a majority of the ownership interests in the LLC could make such a decision.  Of course, as 50-50 owners, neither Chad nor James owned a majority, so neither could act.  

The Court found that James acted unilaterally, disqualified the law firm James hired, and struck all of the LLC's court filings made by that law firm.  

With respect to James's attempt to oust Chad, the Court ruled the ouster improper and ineffective based upon the language of the Operating Agreement, which set very strict requirements for ouster of a member that the Court found were not met.  

In reality, the language of the Operating Agreement for the LLC made little sense for an entity with only two owners, let alone two equal owners.  As a result, most likely unsatisfactory to either Chad or James, the Court appointed a receiver to control the LLC pending the Court's resolution of the dispute.  A receiver is nothing more than a neutral third party who operates the business under supervision of the Court.  In other words, because there were two equal owners who could not agree and no provision in the Operating Agreement to break the deadlock, the Court found it necessary to break the deadlock by removing both owners from control and appointing a receiver.  

No one who is venturing into a new business wants to consider the reality of a future dispute, or the reality of actually operating the business itself during the existence of an unresolved dispute.  However, proper legal planning on the front end, before these issues ever arise, not only can provide a roadmap for addressing a dispute when it arises, but also can prevent disputes from arising in the first place.  Experienced legal counsel, no matter how pessimistic they may seem, can provide real value by looking potential business owners in the eye and asking:  "But if X happens, and I sincerely hope it doesn't, here is how I suggest it be handled."  Fortunately for new business owners, an experienced business attorney will have dealt with more potential pitfalls than the owner is likely to ever encounter.  The recent Business Court case is an ominous reminder that all business owners should take the small amount of extra effort, time, and expense to consult with an experienced transactional business attorney prior to moving forward with a new venture.  The savings in money and heartbreak can be very significant.

© 2024 Ward and Smith, P.A. For further information regarding the issues described above, please contact Allen N. Trask, III.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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