Limited liability company statutes in Delaware and a number of other states — but not New York — expressly authorize oral operating agreements, as does Section 102(13) of the Revised Uniform Limited Liability Company Act (2006). Most if not all states also have a general statute of frauds that bars enforcement of an agreement that cannot be performed within one year unless it is contained in a writing signed by the party against whom the agreement is to be enforced.
What happens when the two statutes collide? Deciding an issue of first impression, the Delaware Court of Chancery has ruled that the statute of frauds applies to an LLC operating agreement under Delaware law. The court therefore dismissed a lawsuit seeking enforcement of an alleged oral operating agreement the performance of which necessarily extended beyond one year. Olson v. Halvorsen, C.A. No. 1884-VCL (Del. Ch. Oct. 22, 2008). Click here to read the decision.
The decisive facts in Olson were largely undisputed. In 1999 the parties founded a hedge fund known as Viking Global. The ownership and administrative structure comprised a Delaware limited partnership and three Delaware LLCs. The plaintiff, Olson, held a 22.5% interest. Short-form operating agreements were signed for the LP and LLCs #1 and #2. Long-form operating agreements for those three entities also were drafted (only one of them was signed), each of which provided that a partner or member who leaves Viking is only entitled to his capital account balance and compensation owed.
LLC #3 had a draft, unsigned long-form operating agreement with an earnout provision not included in any of the other operating agreements. The earnout gave a member varying percentages of the LLC’s income over the six years following retirement. The unsigned agreement also contained provisions requiring the remaining members to adjust the profit percentage of the retiring member so as to maintain his economic interest; preventing the remaining members from taking any action to reduce the retiring member’s interest; and restricting the remaining members’ right to reduce their investments below a specified level.
In 2005, after Olson returned from a six-month sabbatical, his partners called a meeting and removed him from his position at Viking. Olson received $100 million (that’s not a typo) representing his capital account balance and the remainder of his 2005 salary.
Olson demanded an earnout under LLC #3’s unsigned operating agreement. The other members refused, denying that they ever reached agreement on the operating agreement’s terms. Olson brought suit in Delaware Chancery Court asserting claims, among others, for breach of contract, breach of fiduciary duty and payment for the fair value of Olson’s interest under Section 18-604 of the Delaware LLC Act.
Both sides sought summary judgment on what Vice Chancellor Stephen P. Lamb described in his opinion as "the purely legal question of whether the statute of frauds applies to LLC operating agreements." VC Lamb noted that neither side provided any case law directly on point, and he pointed to disagreement among commentators on the issue. He also observed, as a practical matter, that
Few oral LLC operating agreements are likely to contain any term or provision that cannot possibly be performed within one year. To that extent, the statute of frauds will not limit enforcement of any such agreement.
VC Lamb ultimately came down on the side of applying the statute of frauds to operating agreements. Here’s the heart of his ruling:
This court holds that if an LLC agreement contains a provision or multiple provisions which cannot possibly be performed within one year, such provision or provisions are unenforceable. The basis for this decision is in line with the policy for the enactment of the statute of frauds — to protect defendants against unfounded or fraudulent claims that would require performance over an extended period of time. However, in keeping with the legislature’s expressed intent "to give maximum effect . . . to the enforceability of limited liability companies," provisions of an oral LLC operating agreement that could possibly be performed within one year will not fall within the statute of frauds and will remain enforceable. [Footnote omitted.]
Did the alleged earnout agreement based on the unsigned LLC #3 operating agreement fall within the statute of frauds? Olson argued that it did not because the obligation to make payment under the earnout provision could occur within one year, e.g., Olson could have been fired less than one year from Viking’s founding thereby triggering the earnout obligation. Citing New York and Delaware case law, Olson argued that the mere calculation and payment of his interest in the period extending beyond one year does not violate the statute of frauds.
VC Lamb disagreed. In the cases cited by Olson, "nothing remained to be done after one year except payment of money" (italics in original). "Here," VC Lamb wrote, "all amounts except the first earnout payment cannot possibly be calculated until after one year following the alleged agreement." In addition, "there are substantive obligations and restrictions extending for multiple years [that] would be placed on [the other members] by the unsigned [LLC #3] operating agreement."
On that basis, and after rejecting Olson’s arguments advancing exceptions to the statute of frauds based on multiple writings and part performance, VC Lamb granted summary judgment dismissing Olson’s claims for the earnout.
What bearing might Olson have on New York LLCs? Unlike Delaware’s statute, New York LLC Law Section 102(u) defines operating agreement as a "written agreement of the members." The threshold issue under New York law, therefore, is whether Section 102(u) operates like a super statute of frauds to bar enforcement of any "agreement of the members" not in writing, thereby obviating application of the general statute of frauds (applicable when performance extends beyond one year) under Section 5-701 of the General Obligations Law. Section 102(u) certainly does not read like a traditional statute of frauds, and I suspect there’s no relevant legislative history, so until some court tackles the question I’m going to punt. I will speculate, however, that if a New York court were to conclude that Section 102(u) does not preclude enforcement of an oral operating agreement, then likely it would apply the general statute of frauds for the same reasons as did the Olson court.
And what of New York LLCs that have no written operating agreement? New York LLC Law Section 417 states that the members "shall adopt a written operating agreement" but imposes no consequences for non-compliance. In my own practice I’ve encountered numerous LLCs that lack written operating agreements. In those circumstances courts have held that there is a "statutory operating agreement" consisting of the LLC Law’s comprehensive default provisions. The leading case for that proposition is Matter of Spires (Lighthouse Solutions, LLC), 4 Misc 3d 428 (Sup Ct Monroe County 2004).
If you’d like to learn more about the statute of frauds and other issues surrounding oral operating agreements, I recommend starting with the official Comment to RULLCA Section 102(13). The link is provided above.
My thanks to Delaware lawyer Dominick Gattuso of Proctor Heyman LLP for alerting me to Olson.
Update October 30, 2008: Read here Professor Larry Ribstein’s observations on Olson and what he calls the "huge issue" of oral LLC operating agreements.
Update October 10, 2009: Read here the post-trial decision by (now former) Vice Chancellor Lamb dated May 13, 2009, rejecting Olson’s claims for additional compensation.
Update December 17, 2009: On December 15, 2009, the Delaware Supreme Court affirmed Chancery Court’s rulings including its application of the statute of frauds to oral LLC agreement. Read here.
Update June 22, 2010: Over at the Unincorporated Business Entities Law blog, Gary Rosin reports that the Delaware legislature has enacted an amendment to the definition of "limited liability company agreement" in § 18-101(7) of the Delaware LLC Act which overrules the Supreme Court’s Olson ruling by explicitly stating that "[a] limited liability company agreement is not subject to any statute of frauds." How’s that for plain-English drafting?