“You can’t dissolve the company, you’re crazy!”
That more or less sums up one of the most novel defenses I’ve ever come across in a dissolution proceeding, in which the respondent 50% member of an LLC argued that the petitioning 50% member could not dissolve the company because he was under a mental disability as defined in the parties’ operating agreement. Although the defense ultimately failed in this case, there’s a lesson to be learned about the proper drafting of disability clauses in shareholder and operating agreements.
The case is Matter of Swett (Factors Walk, LLC) decided several years ago by Monroe County Commercial Division Justice Kenneth R. Fisher. In 2002, Bradford Swett and W. Curtis Barnes as 50/50 members formed a limited liability company known as Factors Walk, LLC to develop and sell real estate consisting of a 75-acre subdivided tract. The operating agreement vested management in the two members equally. It also appears to have included a provision, not fully described in the court’s decision, authorizing a member to precipitate voluntary dissolution simply by giving notice to the other member.
In 2005, Swett gave Barnes the prescribed notice following which he commenced a proceeding for judicial supervision of the winding up of the LLC pursuant to LLC Law Section 703(a) . The statute authorizes a member to seek such relief for an LLC that has been dissolved either voluntarily or by judicial decree under LLC Section 702.
Swett’s petition alleged that he and Barnes had been unable to agree on business matters for more than two years and that judicial supervision was necessary to ensure that Barnes did not take actions harmful to the interests of Swett or the LLC. Swett accused Barnes of mishandling the LLC’s funds, retaining engineers without Swett’s approval, failing to communicate with the LLC’s lawyers, and excluding Swett from the LLC’s management.
Barnes told a different tale, to say the least. His opposing affidavit disclosed that, in 2003, Barnes commenced arbitration against Swett for excluding Barnes from company management and barring him from access to books and records. The arbitrator’s August 2005 award in Barnes’ favor confirmed his 50% interest and awarded him legal fees. Following the award, and before Swett filed his court petition, Barnes served Swett with a demand to submit to a medical examination under Section 9.3(e) of the LLC’s operating agreement, setting forth the procedure for determination of a “Disabled” member as follows:
The term Disabled shall mean and a person shall be considered Disabled when he is unable to participate in the business of the Company because of physical or mental impairment, and such condition has continued for at least 180 days. In the event of dispute as to the existence of Disability, a Member or Designated Person shall submit to examination by two physicians, one selected by the person whose Disability is in question and the other selected by the other Member(s). If the two physicians agree, their decision shall be binding and final. If the two physicians disagree, they shall select a third physician, whose determination shall be final and binding. If the physicians determine with reasonable medical certainty before the end of the 180-day period that a person is unable to participate in the business of the Company because of physical or mental impairment and is unlikely to recover within the remainder of such period, the person shall be considered Disabled upon such determination.
Barnes contended that Swett had a mental impairment based on his “irrational”, “obsessive” and “destructive” behavior, and that such disability disqualified Swett from pulling the dissolution trigger under the operating agreement. Swett disputed his obligation to undergo a mental analysis as demanded by Barnes under Section 9.3(e).
Justice Fisher’s decision is based on principles of contract construction. He finds that the “provisions for a mental examination made in Section 9.3(e) are clear and unambiguous” and that the members agreed to submit to an examination in the event of dispute as to the existence of disability. “Despite this clear language,” he continues, “the court disagrees with Barnes’ interpretation of Section 9.3(e) and consequently opts not to sua sponte require the parties to comply with the provisions of Section 9.3(e).” Barnes’ argument, that Section 9.3(e) authorizes a 180-day retrospective disability determination and thereby negates actions taken by Swett during such period,
defies both logic and the language implemented in Section 9.3(e) to state that physicians would be able to assess Swett and, assuming a mental disability was found, determine that said disability had been in existence for 180 days previous, or any other period of time prior to the time the physicians examined him. Rather, a simple reading of Section 9.3(e) reveals that a disability will only be found where physicians observe that a disability exists and continues “for at least 180 days.” . . . A contrary interpretation of Section 9.3(e) would render the last sentence of the section [concerning] a physician’s ability to make such a disability determination prior to the end of the 180 day period meaningless.
Since a subsequent determination of Swett’s alleged mental disability, i.e., made after he gave notice of dissolution and petitioned for judicial supervision of dissolution, would not negate his standing to take those actions,
the only effect compelling examinations pursuant to Section 9.3(e) would have at this juncture would be to forestall the inevitable dissolution and wreak havoc on decision making within this troubled LLC. . . .
. . . Consequently, as Swett was both a fifty percent member and a member holding a right to vote as of the date of his petition, he validly caused the dissolution of the LLC on that date. See N.Y. LLCL 701 (“A limited liability company is dissolved and its affairs shall be wound up upon the first to occur of the following . . . the happening of events specified in the operating agreement . . .”). As the dissolution has already occurred pursuant to Section 10.1(b), the issue remaining is the winding up of Factors Walk.
Based on the members’ mutual distrust, their longstanding dispute over control, and their ongoing inability to function as business members of the LLC, Justice Fisher granted Swett’s petition for judicial supervision and also appointed a receiver to wind up the LLC’s affairs.
I make no comment on the bona fides of Barnes’ ultimately unsuccessful reliance on the disability clause as a foil to Swett’s action to dissolve the LLC. The disability mechanism called for in their operating agreement nonetheless appears poorly thought out and subject to abuse. Buy-sell agreements frequently include death and disability as trigger events for the company’s obligation to purchase the affected owner’s interest. Typically, the disability clause will incorporate by reference the definition and procedures for determination of disability found in the waiver-of-premium provision in the life insurance policies purchased to fund buyout upon death or, alternatively, they may initially require a written opinion of disability by the affected owner’s personal physician. Such mechanisms appropriately give to the putatively disabled owner the sole right and initial burden to institute a disability determination, in contrast with the scheme used in Swett permitting one owner at will to initiate a disability determination of the other owner. The disability clause should be designed to serve its salutary purpose to resolve transfer of ownership interests and payment in the unfortunate event of a physical or mental impairment, and not as a potential sword or shield in a battle for company control.