Termination of Operating Agreement Triggers LLC Dissolution
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"What were they thinking?"
It's a rhetorical question lawyers in my field reflexively ask themselves with a sideways shake of the head when a new client in a shareholder dispute involving a closely held business walks in with a poorly drafted shareholders' agreement that, rather than serving its expected purpose to cement relations and avoid strife, is now the cause of expensive litigation due to some language ambiguity, vagueness, omission or other absurdity.
Judges deciding the dispute have to pose and answer the same question, albeit framed a bit more soberly: Based on the language used in the provision at issue, interpreted in the context of the entire agreement, is enforcement of the rights, obligations and remedy identified by the complainant consistent with the discernable intent of the parties to the contract?
So what were the members of Emmy Kodiak Developers of Woodbury, LLC thinking when they made the operating agreement at issue in Matter of Fassa Corp., Short Form Order, Index No. 018824/10 (Sup Ct Nassau County Feb. 1, 2011)? The case stems from a petition to wind up the company's affairs under Section 703 of the LLC Law. The agreement contained a provision, the likes of which I've never seen, that gives any member the unqualified option at any time to terminate the operating agreement upon 60-days notice to the other members. Stranger yet, the provision does not address the effect of the agreement's termination on the status of the LLC, i.e., whether it is supposed to continue or dissolve.
According to the decision by Nassau County Commercial Division Justice Stephen A. Bucaria, in 2008 the three co-equal members of the LLC agreed to invest $600,000 each to acquire and develop a particular parcel of residential real property in Woodbury, New York. The president of the petitioning member, Fassa Corp., who also was a lawyer, prepared the operating agreement by adapting a form used in prior real estate deals between the other two members.
Fassa alleged that, after contributing its $600,000 capital, the other members acquired title to the Woodbury parcel in the name of a different entity in which Fassa had no interest. Fassa also alleged that one of the respondent members deliberately delayed the project until after he sold another property in the same area owned by him.
In July 2010, Fassa served the other members with 60-days written notice, purporting to terminate the LLC's operating agreement and to dissolve the company. In September 2010, Fassa filed articles of dissolution with the New York Department of State. Soon afterward, Fassa filed a lawsuit seeking judicial winding up of the "dissolved" LLC under Section 703.
The respondents argued that, in accordance with the termination clause's express language, the notice to terminate only terminated the operating agreement and did not result in dissolution of the LLC. In support they cited LLCL Section 701(a)(2), which provides that the company is dissolved upon the "happening of events specified in the operating agreement." Therefore, they concluded, Fassa must proceed by way of a petition for judicial dissolution of the company under LLCL Section 702.
In his decision, Justice Bucaria states that "an operating agreement is essential to determining whether judicial dissolution should be granted." This imperative, he explains, arises from LLCL Section 417(a), providing that "the members of a limited liability company shall adopt a written operating agreement," and from LLCL Section 702, providing that a court may decree dissolution whenever it it not reasonably practicable to carry on the business "in conformity with the . . . operating agreement."
Justice Bucaria then turns to the critical question presented, namely, whether the LLC can continue after termination of its operating agreement. He concludes not, in the following passage from the decision:
Where the operating agreement is silent as to the events which will trigger dissolution, the court must look to Limited Liability Company Law §702 ([Matter of 1545 Ocean Avenue, 72 AD3d 121, 124]). However, if the operating agreement is terminated, there is no basis for the court to determine whether "in the context of the operating agreement," the stated purpose of the company may be realized or is financially unfeasible (Id. at 131). Since the parties could not have intended for Emmy Kodiak to continue without an operating agreement, the court interprets the 60 day notice provision as providing for dissolution of the company. Thus, the court determines that Emmy Kodiak Developers of Woodbury, LLC was dissolved as of September 18, 2010.
Alternatively, even if the termination notice did not effect a dissolution, Justice Bucaria finds dissolution warranted under LLCL Section 702 based on "'fundamental and intractable'" conflict among the members "'regarding the means, methods, or finances of the company's operations'" thereby making it "'unfeasible for the company to carry on its business as originally intended'" (quoting the late Justice Steven Fisher's partially concurring opinion in 1545 Ocean Avenue).
As a practical matter it's hard to quarrel with Justice Bucaria's pivotal finding that "the parties could not have intended for [the LLC] to continue without an operating agreement." What's the alternative? Could the members have intended to continue their business relationship in the absence of the agreement, governed by the LLC Law's default rules? After all, notwithstanding LLCL Section 417(a)'s mandate that every LLC have an operating agreement, there are plenty of LLCs that operate under the default rules because the members never get around to making a written agreement. But still, why would business partners, each of whom obligated themselves to contribute $600,000 for a multi-year real estate development project, and who went to the trouble of making an operating agreement at the outset of their venture, contract to continue without one? And why would they opt to allow termination of their operating agreement only so that, going forward, the applicable default rules arguably would make it harder to dissolve the company? And if that was their intent, odd as it would have been, wouldn't you expect them to say so in black and white?
Two-Member LLC Operating Agreement Contains Recipe for Dissension and Litigation
Last month, in Lola Cars International, Ltd. v. Krohn Racing, LLC, No. 4479-VCN (Del. Ch. Nov. 12, 2009), Vice Chancellor John W. Noble of the Delaware Court of Chancery issued a 31-page letter opinion addressing a number of important issues, including the adequacy of a deadlock dissolution claim, in a dispute involving a two-member Delaware LLC that built and sold Daytona-class Lola race cars (pictured). The case is noteworthy in the business divorce arena for two reasons, one spot-lighted by the decision and the other further off-stage.
The plaintiff, Lola Cars International, Ltd. ("LCI"), as 51% member teamed with defendant Krohn Racing, LLC ("Krohn"), as 49% member, to form Proto-Auto, LLC ("Proto") to manufacture and sell Grand Am Series professional race cars. Despite LCI's majority interest, under Proto's operating agreement the two members were equally represented on its governing board. As one of Krohn's primary obligations under the Operating Agreement, it agreed to provide the services of its manager, Jeff Hazell, as Proto's chief executive officer. LCI and Krohn had a falling out within the first two years of their venture, prompting LCI to sue for dissolution.
Center stage in Lola is Vice Chancellor Noble's analysis of the standard for judicial dissolution of LLCs under Section 18-802 of the Delaware LLC Act, which substantially resembles Section 702 of New York's LLC Law in requiring a showing that it is "not reasonably practicable to carry on the business in conformity with" the LLC operating agreement. Lola makes no new law. Rather, it builds on Chancellor Chandler's analysis in Fisk Ventures, LLC v. Segal, 2009 WL 73957 (Del Ch. Jan. 13, 2009) (read my prior post on Fisk with a link to that decision here), summarized as follows in Lola:
The Court in Fisk laid out three factual scenarios this Court should consider when ordering judicial dissolution under Section 18-802's reasonable practicability standard: (1) whether the members' vote is deadlocked at the Board level; (2) whether there exists a mechanism within the operating agreement to resolve this deadlock; and (3) whether there is still a business to operate based on the company's financial condition. The Fisk court explained that none of these factors is individually conclusive, nor must each be found for a court to order dissolution. Rather, they provide guidance to the ultimate inquiry of whether the company can continue to pursue its stated business purpose with reasonable practicability.
In denying a pretrial motion to dismiss the complaint for failure to state a claim, Vice Chancellor Noble found that LCI's allegations satisfied two of Fisk's three criteria. First, the complaint alleged that the two, co-equal managers were irreconcilably deadlocked over replacement of Proto's chief executive officer, Hazell, whom LCI accused of managing Proto more for Krohn's benefit than Proto's. Second, the complaint raised serious doubt whether Proto could continue to operate in its current financial condition which allegedly rendered the company insolvent. In response to Krohn's counter-argument regarding company finances, the Vice Chancellor echoed a theme sounded in Fisk and other dissolution precedents involving LLCs as well as limited partnerships, that the standard for judicial dissolution is not "whether the Company cannot possibly continue its business in accord with the Operating Agreement, but rather whether to do so would be reasonably practicable" (emphasis added).
The Fisk factor not satisfied in Lola, i.e., whether the operating agreement lacks a deadlock-breaking mechanism, is my segue into what I above called the off-stage aspect of the case and the basis for the title of this post. Proto's Operating Agreement did indeed contain a buy-out mechanism in the event of a member dispute or, as Vice Chancellor Noble colorfully described it, a "self-help disentanglement provision." However, as he also noted, the mechanism was entirely voluntary and, predictably, was exercised by neither of the two members. In addition, the Operating Agreement contained a termination clause that could be invoked by either member after a breach of the Operating Agreement by the other. Under this provision, the non-breaching member must notify the other member of the breach as well as the consequences of a failure to rectify the breach which, if not cured within 21 days, authorizes the non-breaching party to terminate the Operating Agreement. Alongside its dissolution complaint, LCI filed a second lawsuit seeking to enjoin Krohn from interfering with LCI's sole management of Proto based on LCI's prior notice of breach given to Krohn and the latter's alleged failure to cure.
What's wrong with this picture? Plenty. First of all, a voluntary buy-out provision, i.e., one that gives neither member the right to put its interest to the company or the other member, is as good as no buy-out provision at all. Second, the termination clause in this case is one of the surest-fire recipes for dissension and litigation I've ever come across. Termination of Proto's Operating Agreement automatically means governance under the Delaware LLC Act's default provisions, which means LCI as 51% owner gains sole control of Proto under Section 18-402. In other words, the termination provision gives LCI a powerful incentive to declare Krohn in breach of the Operating Agreement, and an equally powerful incentive to Krohn to contest any alleged breach. By the same token, the provision is useless to Krohn for the obvious reason that it would not want to gift sole control to LCI by invoking termination based on LCI's breach. No one should be surprised that this venture ended up in Delaware Chancery Court.
It's possible that the termination clause was the quid pro quo for LCI's agreement to give 49% member Krohn equal management rights on Proto's board of managers. Yet there are dysfunctional incentives built into the bargain that render it extremely short-sighted. It's not always easy, but sophisticated business partners with experienced counsel usually are able to devise and include in the operating agreement a workable, compulsory buy-sell agreement that will keep them out of destructive and expensive court proceedings, or at least will limit potential disputes to appraisal issues.
Read here Professor Ribstein's analysis of the Lola case, in which he queries whether the court should have held that the statutory dissolution remedy was foreclosed by the contractual termination remedy.
