Hackensack Limited Liability Company Attorneys
The operating agreement of a limited liability company often contains a restrictive covenant or covenant not to compete that prohibits members who withdraw from the LLC from immediately competing with their former business. However, if the LLC dissolves, that restrictive covenant is likely to become void.
The enforceability of a covenant not to compete (or restrictive covenant) can be an overlooked detail in disputes between the owners of a limited liability company. Restrictive covenants are not infrequently included in an LLC operating agreement, but applications for involuntary dissolution -- also known as judicial dissolution -- may make them meaningless. This is particularly true in disputes between the owners of professional firms, like lawyers or accountants, and in states other than New Jersey that strictly construe the circumstances in which one member of the limited liability company can force a dissolution against the wishes of the other owners. (See prior post here.)
Applications for involuntary dissolution are relatively rate under New Jersey law because the state's Limited Liability Company Act contains liberal provisions that permit the removal of members by a court. Nonetheless, judicial dissolution may be an appropriate remedy and must be considered in developing a litigation strategy.
In a decision of the Appellate Division of New Jersey Superior Court, Gaines v. Luongo (copy of opinion here), the minority owner of an accounting firm, Gaines, sued the majority owner of the company claiming that he had been locked out and seeking to enforce a restrictive covenant prohibiting his former partner from soliciting clients of the firm. Gaines also sought to involuntarily dissolve the limited liability company and to allocate its assets, including its clients, among the owners.
Operating Agreement of an LLC
The Operating Agreement that the members had executed provided for dissolution of the Limited Liability Company under various conditions, including any event that made it "impossible, unlawful or impractical" to continue operating the business of the company. The Operating Agreement of the LLC also provided that in distributing assets to members at the time of dissolution, if the LLC's assets could not be sold, they were to be valued on the LLC's books for the purpose of distribution to the owners.
The Operating Agreement of the LLC also contained a restrictive covenant that prohibiting Luongo, the defendant, from competing with the firm for one year and within a 10-mile radius. While Gaines claimed he had been locked out, the majority partner Luongo claimed that they had voluntarily agreed to dissolved and that the two partners would each would keep their own clients.
The trial court found that Gaines and Luongo had, in fact, agreed to dissolve and that the clients were not part of the assets to be distributed. (See blog post here). Significantly, the trial court held that because the LLC had dissolved, there was no entity left with which to compete:
"In sum, this Court finds that the parties agreed to part company and to dissolve … and that [the Operating Agreement] controls the various rights and obligations with respect to the dissolution. The Court finds that as a result of the dissolution … Luongo is not restricted from "competing" since [the LLC] has ceased to operate."
The Appellate Division affirmed by adopting the trial court's reasoning, which is a warning to consider the effects of dissolution in a proceeding that seeks an involuntary dissolution. In this case, the trial court found that each of the accountants simply kept their own clients after the LLC dissolved. Another set of facts may be present, however, and before seeking involuntary dissolution as one of the remedies careful consideration should be given to a number of issues.
- Is there any provision providing for the survival of any restrictive covenant or non-disclosure agreements within the operating agreements?
- Do the clients identify with particular members of the LLC or are they truly "clients of the firm" without specific loyalties to any individual? What is likely to happen as the former members compete for the business of these clients unhindered by any restrictive covenant?
- Does one of the members of the LLC have a special license that will cause him or her to retain clients individually to the detriment of the other members?
- Is there intellectual property that one of the members contributed that will make the distribution of assets in kind in some manner unfair to the others?
- Does the LLC have assets to distribute or are they likely to be made in kind?
- Is the LLC worth more as a going concern?
