Limited Liability Company (LLC) Disputes
Limited liability companies (LLCs) are popular choices for many 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 New York Limited Liability Company Laws, that apply to LLCs, but the parties can contract to avoid disputes or minimize disruptions to the business. Best practice is for LLC members to consult an attorney to help 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 forth 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 provide for these duties or others, or completely waive any fiduciary duties, in the operating agreement.
Why Is an LLC Operating Agreement Essential to the Business?
While an LLC operating agreement may not be required in some states, the New York Limited Liability Company Law (LLCL) § 417 requires an LLC’s members to adopt an operating agreement addressing the business of the LLC, the conduct of its affairs and the rights, powers, preferences, limitations or responsibilities of its members, managers, employees or agents.
Regardless of whether it is a legal requirement, best practice is to draft an operating agreement to serve as a contract governing how the LLC will be run and avoid disputes over the terms of the business arrangement. 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 caselaw to decide the conflict. In New York, the LLCL 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 so 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 must 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 company 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?
LLC members 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.
In New York, courts have held that LLC members may sue derivatively, even though the LLCL does not expressly allow such actions. This applies to derivative suits against other LLC members who breached their fiduciary duties.
Right to an Accounting
As with derivative claims, New York’s LLCL does not expressly provide for the right of a member to bring an action to obtain an accounting. However, at least one New York court has found that LLC members may seek an equitable accounting.
How Can Deadlocks Be Addressed?
A deadlock among LLC members can arise any time the members have dispute concerning a major decision. However, the operating agreement can establish mechanisms to help resolve deadlocks. Absent such provisions, the LLC may need to go to court to seek judicial dissolution of the LLC or an alternative remedy, as discussed further below.
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.
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.
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.
Where there has been a breach of contract, the nonbreaching party may be able to obtain specific performance – that is, the breaching party will be forced to perform under the contract.
Some states allow judicial expulsion of an LLC member in the case of misconduct, although there is a high burden of proof. However, New York’s LLCL does not allow judicial expulsion. The only way to expel a member is in accordance with the LLC’s operating agreement.
Courts may order dissolution 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. New York courts will look to whether (1) the LLC’s management cannot or will not reasonably permit the identified purpose of the LLC to be realized, or (2) continuing the business is financially impractical.
Dissolution is an extreme remedy, often sought by members of an LLC who allege they are victims of a “freezeout.” A freezeout occurs when controlling members of an LLC take actions which cause other members of the LLC to lose voting power and/or the ability to receive income from the LLC.
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 does not impose a decision. In arbitration, a neutral party acts as a private judge, rendering a decision in 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.
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.
Romano Law can provide guidance on business disputes in New York, California, and Florida.
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