Deadlocked Manager and Deadlocked Members Plus Threatened Irreparable Harm Equals Judicial Dissolution of Solvent LLC
The LLC in In re Metcalf Associates-2000, L.L.C. v. Chambers, 213 P.3d 751 (Kan. Ct. App. 2009), owned real estate encumbered by a loan that was coming due in the near future. The real estate needed to be sold or the loan refinanced, but the LLC’s manager could not act because it was deadlocked internally. The owners of the two 50% voting blocks in the LLC were deadlocked and could not agree on a course of action. Because the LLC was in effect frozen, one group of owners petitioned the court for the dissolution of the LLC and the sale of the real estate. The Kansas Court of Appeals upheld the trial court’s order for dissolution of the LLC.
Many state LLC statutes provide for judicially ordered dissolution if it is not reasonably practicable to carry on the LLC’s business in conformity with the LLC’s operating agreement. E.g., Del. Code Ann. tit. 6, § 18-802. Washington’s LLC Act is similar, but adds “or other circumstances render dissolution equitable.” Wash. Rev. Code § 25.15.275. These statutes emphasize the role of the operating agreement in evaluating whether judicially ordered dissolution is appropriate.
The Kansas statute, by contrast, uses an “irreparable injury” test. Any member owning at least 25% of the outstanding interests in the LLC’s capital or profits and losses may petition the court for dissolution and sale of the LLC’s assets
[i]f the business of the limited liability company is suffering or is threatened with irreparable injury because the members of a limited liability company, or the managers of a limited liability company having more than one manager, are so deadlocked respecting the management of the affairs of the limited liability company that the requisite vote for action cannot be obtained and the members are unable to terminate such deadlock ….
Kan. Stat. Ann. § 17-76,117(b). The approach of the Kansas statute, with its emphasis on deadlock and irreparable injury, comes straight out of the corporate statutes. E.g., Wash. Rev. Code § 23B.14.300(2)(a); Model Bus. Corp. Act § 14.30(2)(i) (2008).
The defendant Michael Chambers argued that a unanimity provision in the LLC’s operating agreement precluded a finding of deadlock. Chambers argued that (a) the LLC’s purpose was to buy office buildings and sell them for a profit; (b) the operating agreement required the unanimous agreement of the members to sell the LLC’s real estate; and (c) therefore there could not be a deadlock because the members had not fulfilled the requirement for unanimous agreement that it was time to sell.
The court, however, recognized that there was a fundamental dispute between Chambers and Patrick Hayes (who controlled the other 50% of the LLC). Hayes wanted to sell the building in a short period of time, and Chambers wanted to acquire the building for himself at a price substantially below its fair market value. The court opined that the LLC’s operating agreement could have been drafted to specifically limit the situations in which the court could declare a deadlock, but held that the unanimity requirement did not preclude a finding of deadlock and application of the statutory remedy for deadlock. Metcalf, 213 P.3d at 757-58.
Chambers also argued that the LLC was not facing irreparable harm because it was a solvent, profitable company with substantial rental income. But the court noted that the LLC had no management because its sole manager was itself deadlocked, and the LLC had no way to sell or refinance its real estate because of the members’ deadlock. The statute allows for judicial dissolution when the LLC is suffering or is threatened with irreparable injury. “By including both the actual suffering of irreparable injury and the mere threat of that injury, the legislature has implicitly rejected Chambers’ argument that a company can’t be dissolved so long as it’s still solvent.” Id. at 759.
So is there any difference in outcome between the approach of the Kansas statute (deadlock plus actual or threatened irreparable harm) and that of the Delaware statute (not reasonably practicable to carry on the LLC’s business in conformity with the LLC’s operating agreement)? The Delaware approach looks to the expectations of the parties under the LLC’s operating agreement, while the Kansas test is independent of the operating agreement. Also, the Delaware approach does not require either deadlock or irreparable harm in order for dissolution to result. All that Delaware requires is that it not be reasonably practicable to carry on the LLC’s business in conformity with the LLC’s operating agreement. The cause is not specified, although in many cases it is likely to be a deadlock between the members.
In Metcalf, the result would likely have been the same under the Delaware statute, since it’s hard to see how the LLC’s business could have been carried on in any manner, let alone in conformity with the operating agreement.
Connecticut Orders LLC Dissolution and Winding Up - Member Acrimony Prevents LLC from Carrying On Its Business
It’s a classic fact pattern that is all too familiar to many business lawyers. Two good friends decide to start a business. In their enthusiasm they create a 50/50 ownership structure and launch the business. Later, things change. One starts devoting more time to the business. Or maybe the business develops a commercial relationship with a separate company owned by one of the friends, which benefits only that one. Their business relationship becomes asymmetrical. Their views of how each should be compensated or how the business should be conducted diverge.
That’s essentially what happened in Saunders v. Firtel, 978 A.2d 487 (Conn. Sept. 22, 2009). Saunders and Firtel were friends who began a business relationship in the mid-1980s. Saunders joined Firtel as an employee and shareholder in Adco Medical Supplies, Inc. (Adco) in 1986. Saunders held 49% of the stock, Firtel held 51%. Firtel was President and Saunders Vice President, and they agreed that each would receive the same annual salary. In 1999, when things were still going well, Saunders and Firtel formed Barbur Associates, LLC (Barbur), a Connecticut LLC in which each owned a 50% interest. Barbur acquired real estate and leased it to Adco on an oral month-to-month lease.
The stage was now set. By 2004, Saunders had become dissatisfied because he perceived that he was doing most of the work but receiving the same compensation as Firtel. Saunders advised Firtel that the 1986 agreement for equal compensation was no longer acceptable. Firtel responded by firing Saunders from Adco in July 2004, lowering the rent charged by Barbur to Adco, unilaterally authorizing repairs by Barbur to the building Adco rented, and arranging a $5,000 loan from Barbur to Adco. Adco refused to pay Saunders his salary for 2004. Shortly thereafter, Saunders and Firtel ceased having any business or personal relationship, and made accusations against each other of theft, breach of fiduciary duty, self-dealing and other “improper and felonious conduct.” Saunders, 978 A.2d at 500 n.22.
Saunders sued Adco for his unpaid 2004 compensation, and for a decree ordering the dissolution and winding up of Barbur. The trial court found for Saunders on his wage claim and ordered double damages pursuant to Conn. Gen. Stat. § 31-72. The trial court also ordered a dissolution and winding up of Barbur, under Conn. Gen. Stat. §§ 34-207 and 34-208.
The Connecticut LLC Act authorizes the superior court to order dissolution “whenever it is not .jpg)
reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” Conn. Gen. Stat. § 34-207. The LLC Acts of Washington, Delaware, New York and many other states have similar provisions, as does NCCUSL’s Revised Uniform LLC Act. The essence of this test is whether or not the business of the LLC can be carried on in a reasonable way. The court has discretion; this is an equitable proceeding in which factors such as oppression, wrong-doing or deadlock are considered.
The court concluded that “the trial court’s order of dissolution is well supported by the evidence.” Saunders, 978 A.2d at 500. In reaching its conclusion, however, the court simply recited the facts identified above. The court did not examine Barbur’s articles of organization or operating agreement to see if the business was being carried out in conformity with the articles or the operating agreement, or refer to any such examination by the trial court. The two Connecticut cases cited by the court don’t seem particularly relevant, since both involved dissolutions of corporations for deadlock under prior corporate statutes. Those statutes, unlike Connecticut’s LLC Act, allowed dissolution for deadlock or other good and sufficient reasons. The court may have concluded that the various abuses by Firtel and the hostility and lack of cooperation between Firtel and Saunders simply made it impossible for the LLC to carry on any business, but the court’s analysis is conclusory and opaque.
Contract provisions don’t necessarily make disagreements between members go away, but sometimes they can provide helpful mechanisms to mitigate disputes and keep the parties out of court. For example, Saunders and Firtel apparently had no provisions in Barbur’s operating agreement to deal with deadlock. If their operating agreement had had a provision that allowed either party to initiate a buy-out process, they might have avoided litigation. A business person may assume that the initially cordial relationship with a potential business partner will continue indefinitely, but his or her lawyer should ask the hard-edged questions to challenge that assumption and help the parties build some safety nets into their agreement.
Deadlocks and Puts in Delaware
LLCs sometimes reach a point where the owners or managers disagree on business issues and find themselves unable to reach agreement on any course of action. This can happen because the members or managers have equally balanced voting power or because their LLC agreement requires a supermajority vote that neither side can reach. A long-running deadlock can be a huge problem for a business, since it will keep the company from responding to business changes. What’s the owners’ remedy then?
Sometimes the LLC agreement will have a solution. For example, the agreement may have a “cut and choose” provision, so that either side can initiate a buyout process that will leave one or the other with full ownership of the company. That may or may not be practicable, and in many cases the agreement simply has no answer for a deadlock.
If the agreement has no solution for deadlock, the parties are forced back to their state’s LLC statute. In Fisk Ventures, LLC v. Segal (Jan. 13, 2009), one member of a Delaware LLC asked the Court of Chancery to order dissolution, citing Section 18-802 of Delaware’s LLC Act. This section is short and sweet:
On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.
NCCUSL’s Revised Uniform LLC Act and many state statutes have similar provisions. Note that the operative word is “may” – the court has discretion. And the test is not one of oppression or wrong-doing, but simply a question of carrying on the business in conformity with the agreement.
In Fisk, the LLC agreement provided for a five-member Board to manage the LLC. One faction had three Board members; the other faction had two. (One side was dominated by the founder, the other by subsequent investors.) The agreement required a vote of 75% of the Board for most actions, including dissolution, and neither side could muster four Board members. The agreement provided no mechanism for resolving a stalemate. For five years the two factions had been in disagreement about financing and other issues. The result: five years of deadlock.
The court found that as a result of the deadlock and the Company’s inability to raise capital, the company had “no office, no employees, no operating revenue, and no prospects of equity or debt infusion,” and that there was effectively no business to operate.
Dr. Segal, however, argued that the LLC agreement did provide a means of navigating around the deadlock, because the agreement granted Fisk Ventures, the plaintiff seeking dissolution, a “put” right. The put meant that Fisk could require the company to buy Fisk’s interest in the company for its fair value. The agreement provided for the price to be determined by an independent valuation, and to be paid either in cash at closing or in time payments over two years, based on the amount. Exercise of the put was at Fisk’s discretion.
The court found that the existence of Fisk’s optional put right did not resolve the deadlock, and refused to force Fisk to exercise its put. The court analyzed the put as an independent, economic right that was not a remedy for the deadlock. In the court’s words, “it would be inequitable for this Court to force a party to exercise its option when that party deems it in its best interests not to do so.” The court emphasized the primacy of freedom of contract under Delaware’s LLC Act: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Section 18-1101(b).
Once the court had concluded that Fisk’s put was not relevant to whether it was “reasonably practicable to carry on the business” in conformity with the LLC agreement, and given the dismal five-year history of the company, the court easily found that the company should be dissolved. Under the LLC Act, of course, once dissolved the company would have to be wound up in accordance with Section 18-801.
The 75% supermajority requirement may have been intended to prevent a bare majority from dominating or oppressing the minority, but here it led to a different type of bad result. The agreement did not provide for a way to resolve a deadlock, and the put apparently turned out to be an unsatisfactory mechanism for its holder.
The obvious moral for founders and investors (and their counsel) is to think hard about the contingencies when the LLC is being formed and when new investors come in. Concentrate not only on the upside of the proposed business deal but also on the alternative scenarios, and address the potential for deadlock. This is basic risk analysis – not easy, as evidenced by our recent history, even for highly experienced investors and business people. There’s no substitute for probing the parties’ assumptions and asking the hard questions.
