Business Disputes in California

Limited liability companies (LLCs) are popular choices for individuals looking to start a business. While there is flexibility in how owners can decide to manage the LLC, conflicts can arise among the owners. There are laws, such as California’s Revised Uniform Limited Liability Company Act (RULLCA), that apply to LLCs, but the parties can often contract to avoid disputes or minimize disruptions to the business. Best practice is for LLC founders and members to consult with an attorney to ensure the LLC’s operating agreement addresses essential issues that could become problems in the future.

Why Is an LLC Operating Agreement Essential to the Business?

Although written operating agreements are not required, and even oral operating agreements are possible, the best practice is to create a written operating agreement to formally establish how the LLC will be run, and avoid misunderstandings and future disputes between members. Items that should be included in the agreement include capital contributions, voting requirements, decision-making procedures, restrictions on transferring and selling, divisions of profits and losses, and who will manage the business and any end of the business.

If there is no written operating agreement, or the agreement fails to address a disputed matter, courts will turn to applicable “default” statutes or case law (published court decisions) to decide the conflict. In California, the RULLCA is the default statute. Courts’ interpretations of default statutes may lead to a resolution that is vastly different from what members intended or understood, which is why a written agreement is important.

How Can LLC Disputes Be Prevented?

The best way to prevent conflict is to address potential problem areas in advance in the operating agreement. The members should clearly define their unique arrangements,and their respective rights and responsibilities, and not rely on boilerplate or standard form contracts. A well-drafted operating agreement can save the LLC significant time and money by avoiding costly litigation, minimizing interruptions to business operations, and preserving limited liability protection for members. In addition, it is important for members to seek legal advice as soon as possible if there is a conflict to determine the best course of action.

Deadlock Provisions

Deadlocks occur when the managers or members of an LLC are unable to decide how to conduct the business. There are several mechanisms which can be set forth in the operating agreement to resolve deadlocks, including:

• Buyout (or Buy/Sell) allowing members to buy out the interests of deadlocked members;
• Referral of the decision to “tie-breakers” who decide the matter;
• Forced partition or sale of the company.

Custodianship/Receivership

When conflicts are so severe as to threaten operation of the business, a court can appoint a custodian or receiver to manage the business while the dispute is resolved in litigation. This keeps the LLC from becoming insolvent, but puts the company in the hands of a non-member third-party. If the issues are resolved, the custodian or receiver will step down. If the issues cannot be resolved, a sale of the company or its assets may be necessary.

Injunction

An LLC member can petition a court for an injunction prohibiting or requiring certain actions by the LLC or another member, if there is risk of irreparable harm to the company or its members and no other adequate remedy at law.

Expelling Members for Misconduct

Some states allow judicial expulsion of an LLC member in the case of misconduct, although there is a high burden of proof. In California, RULLCA allows for the expulsion of members by judicial order only. The statute provides that a member may be expelled for engaging in wrongful conduct, willfully or persistently committing a material breach of the operating agreement, or engaging in conduct relating to the LLC’s activities that makes it not reasonably practicable to carry on the activities with the person as a member.

Can LLC Members Sue on Behalf of the LLC?

An LLC member can bring a “derivative claim” on behalf of the LLC against the company’s directors or third parties. However, the claim must arise from damages suffered by the LLC due to a director’s or officer’s misconduct. While any member can attempt to bring a derivative claim, the operating agreement often limits the type of member who may do so. Thus, the court has discretion to decide whether to allow the claim to continue.

Under RULLCA, an LLC’s operating agreement has the express authority to relieve members and managers from liability for money damages arising from breach of duty, subject to certain limitations.

Judicial Dissolution

Courts may order dissolution (i.e., dissolving the entity by sale in whole or in parts) of an LLC whenever it is not reasonably practicable for the business to continue on in accordance with the operating agreement. RULLCA sets forth the events in which dissolution will or can occur. These include when dissolution is necessary for the protection of the members’ rights, when the business has been abandoned, and when management of the LLC is deadlocked.

Alternative Dispute Resolution

The operating agreement can require that disputes be resolved through some form of alternative dispute resolution. In mediation, a neutral third party helps facilitate discussion and agreement between parties, but they do not impose a decision. In arbitration, a neutral party (arbitrator) acts as a private judge, rendering a decision on the matter. However, whether the award is legally binding depends on the parties’ agreement. Where it is legally binding, the courts can enforce the decision of an arbitrator.

Conclusion

Taking proactive steps can significantly reduce disputes among LLC members. Where conflict cannot be avoided, there are still options that could save the business. By working with an attorney from the time the LLC is formed, measures can be taken to prevent conflicts or minimize the harm they can do to the business and/or the individual members. Meet with a member of our California team today.

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