In Laurel Hill Advisory Group, LLC v American Stock Transfer & Trust Co., 2013 NY Slip Op 08351 [1st Dept Dec. 12, 2013], a Manhattan appellate panel recently reinstated a claim to enforce an alleged oral LLC agreement, among other provisions, granting the appellant a 10% membership interest. The decision turned on the lower court’s conclusion, with which the appellate panel disagreed, that the appellant had conceded the existence of a written operating agreement both that pre-dated the alleged oral LLC agreement and excluded him as a member.
The court’s brief decision aroused my curiosity, mostly because it didn’t mention the LLC’s state of formation which matters greatly because in some states, including New York, the LLC statutes mandate a written operating agreement. Nor did the opinion cite any case law on the point, from New York or elsewhere, that might have given it away.
Sure enough, when I checked the lower court’s decision (read here), I saw that the LLC in question, a New York based corporate governance/proxy solicitation firm known as Laurel Hill Advisory Group, is a Delaware LLC. Section 18-101(7) of the Delaware LLC Act defines an LLC agreement as “any agreement . . . written, oral or implied, of the member or members as to the affairs of a limited liability company and the conduct of its business.” Indeed, Delaware recently strengthened its policy protective of oral LLC agreements by amending § 18-101(7) to specify that such agreements are not subject to any statute of frauds, thereby legislatively overruling the Delaware Supreme Court’s 2009 ruling in Olson v Halvorsen.
Delaware is not alone in authorizing oral LLC agreements. California, Florida, New Jersey, Ohio, Iowa, Missouri, Wyoming, and New Hampshire are just a few of the many other states authorizing oral LLC agreements. The 1996 Uniform LLC Act, the 2006 Revised Uniform LLC Act, and the 2011 Revised Prototype Uniform LLC Act all define LLC agreements to include oral agreements.
New York appears to be in the minority of states that mandate a written operating agreement, in § 417(a) of its LLC Law, although the statute lacks any penalty or enforcement mechanism for failure to comply. The New York courts have devised a logical solution where no written agreement exists, by deeming an agreement consisting of the totality of the LLC Law’s default provisions. Matter of Spires (Lighthouse Solutions, LLC), in 2004 and Matter of Horning (Horning Construction, LLC), in 2006 were among the earliest decisions to apply this so-called “statutory operating agreement.”
I mentioned above that the Laurel Hill case involved a disputed 10% membership interest. There have been plenty of cases involving New York LLCs where, in the absence of a written operating agreement, the litigants dispute one another’s status as a member or the specific membership interest percentages. In such cases the outcome rests not on the LLC Law’s default provisions, but on direct or circumstantial evidence of ownership found in tax returns, loan applications, marketing materials, correspondence among the contesting parties, etc.
The difference between state laws that do and don’t recognize oral LLC agreements becomes much more critical when dealing with governance, capital contribution, membership interest transfer, and other fundamental management issues. The alleged oral LLC agreement in Laurel Hill, for instance, as described in the pleadings (read here) dealt not only with the disputed 10% membership interest, its proponent also sought to establish key provisions including:
- capital contribution obligations;
- compensation for the members’ services on the LLC’s behalf;
- members’ obligations to provide administrative and logistic support, and the terms of doing so;
- pro rata distribution of profits after the majority owner received a preferred return of its capital investment;
- financial accounting obligations;
- designation of officers and the allocation of management authority among the members; and
- manner of distribution of proceeds from the sale of the company.
The case is now back before the lower court where, presumably, the parties will each inflict and endure months if not years of discovery followed by the inevitable summary judgment motions and possibly trial as to the terms and enforceability of the alleged oral LLC agreement.
Prominent scholars and legal commentators have explored the pros and cons of oral LLC agreements. The late, great Professor Larry Ribstein, in a 2008 article critiquing the 2006 Revised Uniform LLC Act, commented that the Act’s inclusion of oral LLC agreements
may create significant uncertainty and invite litigation as to the terms of the operating agreement. The benefits of certainty must be balanced against the potential costs of frustrating the parties’ intent by refusing to enforce oral agreements, particularly in informal firms.
Professor Ribstein also identified one particularly troublesome byproduct of the oral LLC agreement concerning subsequently added members:
A specific effect of RULLCA’s open-ended approach to the operating agreement is that a person who joins an existing LLC may not easily be able to determine what she is agreeing to. RULLCA section 111(b) provides that “[a] person that becomes a member of a limited liability company is deemed to assent to the operating agreement.” The comment to this subsection notes that “a person becoming a member of an existing limited liability company should take precautions to ascertain fully the contents of the operating agreement.” This obviously presents problems where oral and implied-in-fact terms, and even the parties’ unanimous consent to a particular act, can be part of the operating agreement.
A somewhat different perspective is reflected in the commentary of LLC guru John Cunningham, who helped draft New Hampshire’s new LLC Act which went into effect last month, in which he explained the reasoning behind the addition of oral agreements to the new Act’s definitional provision:
Our reasoning, and our overall goal as a committee, was to revise the Old Act to make it as user-friendly as possible for New Hampshire small businesses. You see, many New Hampshire small-business LLCs don’t have written operating agreements but do have “handshake” agreements and agreements reflected in how they do business. Some of these agreements deal only with issues of profit-sharing and voting, but many also deal with other important things, such as the “fiduciary” expectations of the members about their duty to work hard for the LLC and not to compete against it. The best reason for continuing the Old Act’s rule that only written operating agreements are valid is to obtain certainty about the terms of LLC deals. The contents of written operating agreements are usually easy to prove. The contents of oral and implied operating agreements can be difficult to prove. However, to the extent their contents can be proved, oral and implied operating agreements deserve to be enforced just as much as written ones. In fact, not to enforce them would be to trample on the expectations of LLC members unaware of the Old Act’s writing requirement.
. . . The fundamental question here is this: Which is more important for LLC members — certainty about their LLC deal or a chance to prove their case? The New Act drafting committee and the New Hampshire Legislature chose the latter option. Were they right? Time will tell.
Yes, indeed, it will take more time before there develops a consensus whether the uncertainty associated with oral LLC agreements is worth the added risks and expense of litigation, and whether ultimately they encourage or deter use of the LLC form. My own view, perhaps reflecting my New York home pride, favors the relative certainty provided by the judicially imposed, statutory operating agreement that comes into play when the parties fail to enter into a written agreement.