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 dispute or minimize disruptions to the business. Best practice is for LLC members to consult with an attorney to ensure the LLC’s operating agreement addresses essential issues that could become problems in the future.
What Duties Do LLC Members Have to Each Other and the LLC?
The LLC members’ duties to each other and to the LLC are usually set for in the LLC’s operating agreement. This includes fiduciary duties. A fiduciary duty is an obligation that one person act in the best interests of another person or an entity. The three types of duties are duty of care, duty of loyalty, and duty of candor. LLC members may either accept the default fiduciary obligations provided by statute, or, with carefully drafted operating agreements, limit or waive many fiduciary duties.
Why Is an LLC Operating Agreement Essential to the Business?
While an LLC operating agreement may not be required in some states, the California Corporations Code § 17701.02(s) requires an LLC’s members to agree that they are to be bound by RULLCA via an operating agreement.
Best practice is to create a written operating agreement to formally establish how the LLC will be run, and avoid 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, how profits and losses will be divided, who will manage the business and the way the company will be dissolved, if necessary.
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 through their verbal agreement, which is why it is important to have a written agreement.
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 arrangement, 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.
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. Section 17709.02 of RULLCA explicitly covers derivative action procedures for California LLCs, which allows members to sue on behalf of the business.
Deadlock Provisions
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
There are also various options whereby individual members rotate the right to be the tie-breaker or have the right to exercise a put or call.
Custodianship/Receivership
When conflicts are so severe as to threaten operation of the business, a court can appoint a custodian to manage the business while the dispute is resolved in litigation. This keeps the LLC from becoming insolvent but puts the company in third-party hands. If the issues are resolved, the custodian will step down. If liquidation of the company is needed, the court will appoint a receiver.
Injunction
An LLC member can petition a court for an injunction prohibiting or requiring certain actions by another party. There must be a risk of irreparable harm to the company or its members and no other adequate remedy at law.
Specific Performance
Where there has been a breach of contract, the non-breaching party may be able to obtain specific performance – that is, the breaching party will be forced to perform under the contract.
Expelling Members
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 under § 17706.02 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.
Judicial Dissolution
Courts may order dissolution (i.e., dissolving the entity by termination or 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 articles of organization or operating agreement. RULLCA’s § 17701.03 sets forth the events in which dissolution will or can occur. These include when it is not reasonably practicable to carry on the business within the confines of the operating agreement, dissolution is necessary for the protection of the members’ rights, abandonment of the business, deadlocked management of the LLC, or illegalities of those in control of the business.
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 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 arbitration award.
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.
Romano Law can provide guidance on business disputes in New York, California, and Florida.
Photo by Joel Muniz on Unsplash
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