atLaw
Kathleen E. Cross
617 226-3433
Shareholder
Areas of Concentration
Business Litigation
Business Separation
Education Law
Office
For members of a limited liability company (an “LLC”), planning from the outset for the termination of a membership and the possible dissolution of the company is imperative. The statutory law in Massachusetts for either event is minimal. Instead, the statutory scheme favors self-determination, allowing the LLC’s members great latitude to orchestrate rules for operation and governance in the LLC’s Operating Agreement. An LLC’s members may specifically contract for separation events such as voluntarily departing or expelled members, decision making deadlock, the division of the LLC’s assets, and ultimately, the circumstances that will trigger dissolution of the LLC and provisions for accomplishing wind up of its affairs. Failure to look down the road and explicitly provide for these eventualities in a written Operating Agreement, preferably when forming the LLC and through periodic updating, will almost surely lead to a painful and expensive breakup when one inevitably occurs.
Unless the Operating Agreement clearly and comprehensively addresses an issue, Massachusetts courts will apply the provisions of the Massachusetts Limited Liability Company Act, Chapter 156C, § 1 et seq. (the “LLC Act”) by default. Below, for each of the key events resulting in the disassociation of a member or the deadlock or dissolution of the LLC, the statutory provisions of the LLC Act are compared to some of the options available for members to include in their Operating Agreement. However, as already noted, the provisions of the LLC Act addressing termination, resignation, and dissolution are sparse and should be viewed as a last-resort option when they provide any option at all. The benefits of self-determination are patent.
1. Death or Incompetence of a Member.
The LLC Statute: If a member dies or is adjudged mentally incompetent, his representative may exercise the member’s rights in order to administer the member’s estate or property. While the precise authority of a decedent/member’s representative is somewhat ambiguous with respect to the LLC, commentators have likened the rights of a decedent’s representative to those of an assignee of a member’s interest—no right to participate in the LLC’s management, but a right to receive financial benefits and responsibilities flowing from the assigning member’s rights. Notably, the death of a member does not constitute automatic dissolution, and the decedent’s heirs or representatives may be forced to wait indefinitely for a liquidity event in order to realize any financial benefit from the LLC. Furthermore, the death or incompetence of a member arguably leaves the remaining members with the ability to exercise the disassociated member’s voting rights, which may result in a windfall to the remaining members in the event a dissociated member had disproportionately large share of the company.
Options for Operating Agreement: The members of an LLC may provide, by agreement, for the dissociation of a member by death, incompetence or any other physical or mental incapacity that would impair his or her ability to contribute the skills and participation contemplated by the members when the LLC is formed (for example, if all members in the LLC are pilots expected to provide full-time flying service but one member develops a degenerative ocular disease that grounds her). Members may provide in the Operating Agreement that such a separation may trigger a pre-ordained buyout of the dissociated member’s share through an agreed process that may include a method of determining value of the membership and a plan for the payout by the LLC (perhaps payment over time, or payment triggered by attaining revenue targets or sale of the company). Advance planning provides potential benefit to both the departing member or her estate in the form of timely resolution of the disassociated member’s interest, as well as to the LLC, allowing it a means to carry on its business upon loss of a member (continuity of business operations is no longer taboo under the IRS regulations) and preventing liquidation of vital LLC assets to meet payout obligations.
2. Resignation of a Member.
The LLC Statute: A member may resign by providing at least six months’ notice to the LLC. If such resignation violates the Operating Agreement, however, the resigning member is liable to the LLC for damages. As to payout, a resigning member is entitled to receive the fair value of his or her interest in the LLC in proportion to his or her right to distributions, paid within a reasonable time.
Options for Operating Agreement: Members of an LLC are well advised to address treatment of voluntarily departing members in their Operating Agreement. If members and their talents are important for the successful startup of the LLC, the Operating Agreement may contain a minimum term before which a member may not resign or withdraw without violating the Operating Agreement and subjecting him or her to damage and/or some other disincentive for early withdrawal, such as the time over which any capital investment will be returned. In addition, the members may consider adding a reasonable noncompetition clause to the Operating Agreement to prevent a departing member from setting up shop in direct competition with the LLC. When crafting such disincentives, however, members and their counsel must be cognizant of statutes and ethical considerations prohibiting noncompetition provisions for certain professionals, such as doctors and lawyers. Last, but by no means least, members may include provisions that would allow a minority member to pull out of an LLC and recapture some or all of her investment on articulated terms in order to escape what he believes to be “oppressive” rule by majority members.
Perhaps the most important provision in an Operating Agreement for a departing member is his or her entitlement to a financial payout upon resignation. The statute provides that a resigning member will be paid a pro-rata share of the fair value of the LLC within a reasonable time, absent alternative provisions in an LLC’s Operating Agreement. In Massachusetts, there is little case law interpreting “fair value” when a payout is triggered to a departing member, although with similar entities such as closely held corporations and partnerships, a substantial discount is often applied for a minority ownership interest. Practically, even in light of such a discount, a departing member could cause the dissolution of an LLC that has neither the resources nor the liquidity satisfy a required payout. However, the members have great flexibility to soften or even eliminate the adverse financial consequence to the LLC upon a member’s departure by providing for the terms of the payout—amount, timing, and so forth.
Finally, a note of caution—the Operating Agreement providing for dissociation of a member from the LLC should ensure that the separation is complete. At least one court in Delaware has determined that an Operating Agreement which provides for termination of a member’s interest without obtaining a release of his personal guaranties and other individual contract liabilities is in-effective and constitutes grounds for judicial dissolution of the LLC. If releases will be logistically difficult, members should consult with counsel for an acceptable alternative, such as appropriate indemnification.
3. Involuntary Termination or Expulsion.
The LLC Statute: The statute makes no provision for involuntary termination or expulsion of a member. Without a provision in the Operating Agreement addressing circumstances that would constitute grounds to expel and how such expulsion may be accomplished, the LLC cannot remove a member, absent dissolving the LLC altogether. Furthermore, attempts to expel a member indirectly may result in litigation by which a constructively expelled member may allege that the other members are attempting to freeze him out of the benefits of ownership—a breach of their fiduciary duties. Lack of an Operating Agreement or silence there-in on duties owed one another will compel the operation of common law, which has recognized a high level of fiduciary obligation among partners or shareholders in a closely held corporation—entities closely analogous to an LLC.
Options for Operating Agreement: Failure to address the scenario where a member has become counterproductive or even harmful to business operations of the LLC may result in disastrous consequences for the business.
Depending on the business purpose of the LLC, the members should consider providing for automatic expulsion upon certain occurrences that undeniably harm the LLC or the member’s ability to participate productively. For instance, a member’s loss of a critical license, conviction of a serious crime, theft, fraud, gross misuse or destruction of company property, severe impairment or incapacity, and bankruptcy or receivership of a member should be considered as grounds for termination or expulsion in the Operating Agreement. While more subjective criteria for expulsion may be included, exercising subjective judgment to expel a member without inciting litigation will be difficult.
Operating Agreements may also provide for expulsion based on an affirmative vote of a certain percentage of the members, but members should exercise such a right carefully as an arbitrary use of such a power may raise claims of freeze out or breach of fiduciary duty by the expelled member, as discussed above.
Finally, the Operating Agreement should consider any financial payout to a member who is expelled and how such payment will be made.
4. Dissolution/Deadlock of an LLC
The LLC Statute: There are four ways an LLC formed on or after January 1, 1997 may be dissolved: 1) at a time specified in the Operating Agreement, 2) upon the occurrence of an event articulated in the Operating Agreement, 3) by agreement of all members, and 4) by a decree of judicial dissolution. For those LLCs formed before January 1997, a few additional circumstances may result in dissolution.
For judicial dissolution, a member of an LLC must show that it is not “reasonably practicable to carry on its business in conformity with the certificate of organization or operating agreement,” a standard which, notably, has been met in Massachusetts even where an LLC is operating at a profit. This provision is often used when the members of an LLC are deadlocked over key business decisions, as there is no alternative provision for resolving deadlock in the LLC Act. On its face and in operation, a Superior Court judge has wide discretion to dissolve based on this standard, and there is little appellate authority for guidance.
The LLC Act also provides for the winding up of the LLC’s affairs post-dissolution by a member or, upon application to the Superior Court by a member, wind up may be accomplished by the court or through a court- appointed liquidating trustee who takes control and liquidates the assets of the dissolved company. Appointment of a liquidating trustee, while often a practical necessity when an LLC has been dissolved for member dysfunction, can be extremely costly, as her fees as well as those of professionals she hires are paid from LLC assets before any distributions to members.
Options for Operating Agreement: Certainly members may provide for dissolution in an Operating Agreement upon occurrence of conditions that make the continuation of the business impracticable, such as achieving the business purpose of the LLC when formed for a single event or goal (i.e., developing and selling a property or putting on a sporting event) or upon a vote of less than all members, as required by statute.
The more weighty issue for members of a nascent LLC, however, is including a process in the Operating Agreement for resolving member deadlock, especially when the LLC has very few members and they are evenly split on a matter of business operations, strategy or finances. When members do include a deadlock clause in an Operating Agreement, they often gravitate to-ward giving one or more arbitrators the final word. While arbitration is a good option when the dispute is fact-bound, such as valuation of the LLC or the best type of equipment to purchase, more ephemeral, strategic decisions, such as whether to enter a new business venture or whether to hire a manager, may not be decisions that members want to vest in a third party. As at least one commentator has noted, for matters of critical business strategy or as a last resort after an arbitrator’s decision, members may consider including a buy/sell option (where a dissatisfied member has the option to submit a price at which he would either sell his interest or acquire the interest of his fellow members), or a means of setting the fair value for a member’s interest for a buy/sell offer (which should include a decision as to whether such value will be discounted for a member’s minority status before seeking a judicial remedy), or a certain period of notice to fellow members be-fore resorting to judicial dissolution.
In the end, the Operating Agreement should provide for business governance and operational issues not only for the best of times, but also for the worst of times. Members need to consider an endgame for membership, for ownership, for deadlock, and, in some instances, for the life of the LLC itself in a comprehensive, written Operating Agreement signed by all members. Negotiating all components of an Operating Agreement as part of the formation of an LLC, or at least before major disputes arise, is undoubtedly the best way to ensure that, if and when divorce comes, it does not overwhelm and defeat all the good of the marriage.
