If you sign a poorly written or unfair operating agreement you are still contractually obligated.- This blog discusses how a Chancery Judge in NJ was reversed when he tried to rewrite the plain terms of an operating agreement between two doctors.
Background
Two doctors and business partners came into conflict regarding their medical practice. They filed lawsuits. The court awarded the plaintiff doctor compensation for his interest in the company and for profits owed to him. The losing doctor appealed the award of profits.
Why did the appeals court reverse the trial judge?
I’ve written extensively on this website about the importance of having a written operating agreement to address issues like (1) equally sharing the workload and (2) the profits of the business/enterprise. These doctors had no written agreement; it was all verbal.
Years later the doctors purchased the assets of another company. For this company they did execute a written operating agreement to secure a line of credit to help fund the purchase. The operating agreement was downloaded from the internet. It sucked!
The partners signed the operating agreement without discussing it with an attorney or with each other. The agreement was made effective years earlier than the date it was signed. Each doctor was identified as a member of the LLC, each with a 50% company interest.
One day after the acquisition of the new company, one of the doctors underwent emergency surgery. Shortly thereafter, new medical issues led to further hospitalizations and surgery. He was never able to return to work.
Prior to his debilitating medical condition, the two doctors received equal monthly draws and shared equally in the distribution of the net proceeds as each was a “Member” with a 50% share in the LLC.
The written operating agreement provided that if “a Member becomes a Disabled Member, such Member shall be paid by the Company for (3) months from the date [of disability] under the terms of any disability insurance policy.”
Under the operating agreement, a “Permanently Disabled Member” was defined as “a Member who is unable to perform his or her duties hereunder for twelve (12) months in any eighteen (18) month period. The parties agreed the one doctor qualified as a Disabled Member.
Legal analysis of the buy-sell agreement under the operating agreement by the court
Courts enforce contracts based on the intent of the parties, the express terms of the contract, surrounding circumstances and the underlying purpose of the contract. When the intent of the parties is plain and the language of the agreement is clear and unambiguous, a court must enforce the agreement as written, unless doing so would lead to an absurd result. The judicial task is simply interpretative; it is not to rewrite a contract for the parties better than or different from the one they wrote for themselves. However, to the extent any ambiguity exists, a court will seek to determine the parties’ intent from evidence bearing on the circumstances of the agreement’s formation, and of the parties’ behavior in carrying out its terms.
Here the operating agreement was silent regarding the division of profits to a Selling Member. The LLC and continuing doctor argued the agreement outlined compensation only for the members who perform their duties. The appellate court agreed.
Section 3 of the operating agreement stated: “Income from Operations” is defined as “all income and gain recognized by the Company for Federal income tax purposes, other than Income and Gain from Dispositions.” The agreement further stated that “[t]he Members are aware of the income tax consequences of the allocations made by this Section and hereby agree to be bound by the provisions of this Section in reporting their shares of Company income, gain, loss and deductions for Federal income tax purposes.”
The operating agreement had a logical progression regarding compensation and being able to work to earn that compensation. The agreement stated that “Members” must devote to the Company all of the time, attention and energy necessary to perform any and all duties assigned or delegated to him or her by the Company for the purpose of rendering medical services to the Company’s patients and for engaging in the practice of medicine in a manner consistent with accepted standards or care and competence of the medical community.
Each Member’s duties, shall be substantially similar to the duties of the other Member(s) of the Company, to include, but not limited to: covering office hours; meeting reasonable administrative responsibilities; keeping and maintaining (or causing to be maintained) appropriate medical records relating to all professional services rendered by him or her; preparing and attending to all reports, claims and correspondence necessary; and doing all things reasonable to maintain and improve his or her professional skills.
The members acknowledged and agreed that each Member must provide medical services on behalf of the Company on a “full-time” basis, it being understood by the parties that all of the Members of the Company shall work a five (5) day work week. In this regard, each Member shall devote all of his or her professional time and efforts exclusively to and for the benefit of the Company and shall not, directly or indirectly, render professional, medical, managerial or directive services on behalf of any other Person, whether or not for compensation, without the prior written consent of the Company.
A member who performs their duties under this Section 5 is entitled to the compensation framework established under the agreement. If a member has not performed their duties and has not provided medical services on behalf of the company on a full-time basis for a year, they are considered Permanently Disabled. And they must sell their interest in the company as does a Deceased, Terminated, Withdrawing or Bankrupt Member.
The parties’ past dealings and expressed intent demonstrated they intended to share profits and responsibilities equally (included being able to work).
Discretion given to a trial judge in NJ law in a business valuation dispute
A Chancery judge has broad discretion to adopt equitable remedies to the particular circumstances of a case. The appellate court said the trial court ignored “settled legal precedent…that in the absence of fraud, accident, or mistake, a court of equity cannot change or abrogate the terms of a contract.
The operating agreement regarding “Liability of Members” states that “[e]xcept as specifically provided for in this Agreement, no Member shall be liable to the Company or to any other Member with respect to liabilities and obligations of other Members.” Therefore, the doctor, in executing the operating agreement, agreed the company would have no personal legal liability against both the LLC or not against either doctor personally.
To discuss your NJ LLC litigation, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at fniemann@hnlawfirm.com. Please ask us about our video conferencing or telephone consultations if you are unable to come to our office.
By Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold Township, Monmouth County, NJ LLC Litigation Attorney