In Cline v. Grelock,[1] the business partners were two lifetime friends who started a towing business called American Asset Recovery, LLC (“AAR”) d/b/a Hound Dog Recovery. To get the business rolling, Grelock and Cline personally guaranteed a bank loan for AAR to purchase a motor vehicle for the business. Unfortunately, the business was not very successful—it had substantial debts and did not operate at a profit. The relationship between the two co-owners also deteriorated to the point where continuing the business was not practicable. After only seven months, Grelock unilaterally dissolved AAR and, together with his wife, started his own company called Hound Dog Recovery, LLC (“Hound Dog”), which provided essentially the same services, using the same business name, a similar logo, and the same car owned by AAR. The Grelocks also used the client list of AAR, but only for three customers.
While Grelock’s conduct seems outrageous at first, additional evidence at trial revealed another story. As is often the case, the source of many of the problems might have been the lack of a proper operating agreement. The accountant hired during the inception phase provided a standard LLC operating agreement, but never saw to the signing of the agreement or tailoring of it to their specific needs. The agreement called for Cline to make a capital contribution of $25,000, but it turned out that Cline never contributed any capital to the business or actively participated in running the business. Nevertheless, Cline insisted that he be paid a weekly salary, even as the business struggled, argued that he was a 50% owner of AAR, and claimed an equity interest in Hound Dog on grounds that AAR’s assets were being used to benefit Hound Dog.
The court noted that Grelock did not have the authority to dissolve AAR unilaterally, without Cline’s participation, and that he violated his fiduciary duty by doing so. Moreover, the court said, Grelock used AAR’s assets without an appropriate dissolution process or any payment to AAR or its members and, thus, he could be liable for profits earned using those assets. Nevertheless, the court found it unreasonable for Cline to claim that he was a 50% owner of AAR while at the same time denying that he had any capital obligation. And, perhaps most importantly, Cline failed to show the value of the AAR assets used by Hound Dog (i.e., the vehicle, the logo, and the customer list), which, in all likelihood, was no more than nominal. In short, although Grelock was not exactly clean hands, the court concluded that Cline, who never made any capital contribution to AAR, failed to convince the court that he had any ownership stake in Hound Dog. Additionally, the court ordered Grelock to obtain Cline’s release from the guaranty for the bank loan, since Cline received no benefit from that loan. In other words, as the court put it, “it all nets out.”
What could Cline and Grelock have done? While it might have been difficult to avoid the deterioration of their personal and business relationship, they could have done a better job delineating their capital obligations and seeing to the execution of the LLC agreement, as well as including a non-compete provision according to the state law, ideally by retaining an experienced business attorney at the outset. An accountant, however competent, is not the right person for the job.
This post was the second part of our multi-part series on business partnership, disagreement, and dissolution. You can find the other posts by searching our blogs at www.mcbrideattorneys.com. In our next and last post, we will discuss Saunders v. Firtel, a recent Connecticut case.
This posting is intended to be a planning tool to familiarize readers with some of the high-level issues discussed herein. This is not meant to be a comprehensive discussion and additional details should be discussed with your transaction planners including attorneys, accountants, consultants, bankers and other business planners who can provide advice for your circumstances. This article should not be treated as legal advice to any person or entity.
Steps have been taken to verify the contents of this article prior to publication. However, readers should not, and may not, rely on this article. Please consult with counsel to verify all contents and do not rely solely on this article in planning your legal transactions.
About the Author
So-Eun Lee is an associate attorney in the New York office of The R. Shawn McBride Law Firm, PLLC. She concentrates her practice on business law. So-Eun can be contacted at [email protected]. Her profile is available on www.mcbrideattorneys.com.
[1] Cline v. Grelock, C.A. No. 4046-VCN (Del. Ch. March 2, 2010). Unless otherwise noted, all references to the case are from this citation.