California limited liability company disputes | Courtroom war stories and lessons learned

Portrait of a Mangled Business Divorce

Business divorce can be messy, as reflected by many of the cases covered here at The LLC Jungle.

Two issues that frequently arise during the dissolution of an LLC are: (1) the statutory buyout procedure, and (2) claims for breach of fiduciary.

A recent opinion from California’s Second Appellate District — Schrage v. Schrage (order for publication here)– shows how both of those issues can go sideways.

Facts: warring brothers unwind the family car dealership empire

Brothers Leonard, Michael, and Joseph each owned one-third of a car dealership business founded by their father.  Their relationship disintegrated.  Leonard sued, alleging that Michael and Joseph breached their fiduciary duties to him by mismanaging the business, including misappropriating company assets to fund their separately owned businesses and pay for lavish personal expenses.

Michael and Joseph filed a motion exercising their statutory buyout rights, under which the defendant in a dissolution action has the opportunity to prevent dissolution by purchasing the plaintiff’s interest at an appraised value in a process overseen by the court.

Fail #1: botched buyout

Michael and Joseph’s buyout motion triggered a lengthy (and surely, costly) appraisal process initially involving five corporations, eight LLCs, and one limited partnership.  The parties later entered into a stipulation adding five additional LLCs to the buyout process.

The appraisal results were contested, and the court eventually resolved the disputes and valued Leonard’s interests in the entities at over $40 million.  The court set a deadline for Michael and Joseph to either pay the buyout amount (and avoid dissolution), or allow the companies to be dissolved and liquidated.

The deadline came and went without payment.  The trial court ordered Michael and Joseph to pay Leonard’s attorney fees incurred in the appraisal process (as allowed under the buyout statute), and the court of appeal (in an earlier appeal) affirmed the attorney fee order.  The trial court then appointed a receiver  to wind up and dissolve the entities.

Thus, the statutory buyout process — intended to provide a quick transition of ownership and avoid a lengthy and costly dissolution case — became an expensive and wasteful “detour” in this case.

Fail #2: damage award reversed for lack of standing

Leonard’s claims for damages based on Michael and Joseph’s breaches of fiduciary duty proceeded to trial.  Leonard asserted those claims directly (based on duties owed to him), not derivatively (based on duties owed to the entities).

After two months of testimony, the trial court issued a decision finding that Michael and Joseph breached their fiduciary duties to Leonard, and that their conduct involved “malice, oppression, and fraud” justifying punitive damages.  The court entered judgment in favor of Leonard for $31 million.

However, Michael and Joseph appealed, and the Court of Appeal reversed the judgment, finding that Leonard lacked standing to pursue the claims directly instead of derivatively.

Under California law, where a claim seeks to recover for harms to the entity, the individual owners have no direct cause of action because the entity “exists as a separate legal entity” and “is the ultimate beneficiary of such a derivative suit.”  An action is deemed “derivative” if the gravaman of the complaint is injury to the entity or its assets.

Looking to the allegations in Leonard’s complaint and the evidence at trial, the court held that the claims were derivative, not direct.  The complaint alleged a variety of wrongs by Michael and Joseph against the business in whole, including misappropriating company funds to open a  separate business, mismanaging the business using dishonest accounting practices, and using company assets for personal gain.  Likewise, Leonard’s expert witness at trial expressed his opinion of damages in terms of the “diminution in the value of the dealerships” in their entirety, not in terms of specific, direct harm to Leonard.

The court held that Leonard’s primary complaint was that his brothers’ mismanagement squandered the company’s assets and ultimately led to its demise.  “That is a derivative claim.”  The entity itself must bring the action, “or a derivative suit may be brought on the [entity’s] behalf.”

Because Leonard failed to allege a derivative cause of action on behalf of any of the related entities, his claims for damages failed for lack of standing.

Lesson

The statutory buyout procedure and the standing requirement for derivative claims are some of the trickier aspects of LLC law.

A buyout procedure meant to avoid dissolution and short-circuit contested proceedings can backfire if the buyout isn’t completed, with a lot of resources wasted on appraisals and attorney fee liability imposed against the buyer who backed out.

Pursuing damage claims without carefully selecting the “direct” versus “derivative” pathway can result in the dismissal of a case for lack of standing, often after years of wasted effort — and, in this case, a $31 million judgment that was erased on appeal.