Over the past decade, limited liability companies (LLCs) have become the entity of choice to form new businesses. Proponents extol the virtues of limited liability (like the shield of a corporation), the pass-through tax benefits, and the flexibility of operational and legal structure. Organizers may adjust ownership, dividend rights, management, and other entity governance like the dials on radio. If not structured or documented properly, however, many business partners, particularly minority investors, could find themselves without adequate rights and remedies should the LLC fail and owner relations devolve into an acrimonious business divorce.
The flexibility of the entities also exposes minority owners to absolute control by the majority. First, unlike corporations, LLCs are governed by a statute that provides little guidance on structure and terms. Like a parking lot with no lines, the LLC laws permit the organizers to go anywhere at practically any speed. Corporation statutes, however, are more like the drive-up to a crowded nursing home – many rules and slow speeds. Corporate laws outline shareholder rights and are the subject of thousands of cases providing guidance on how owners are to behave and share the wealth of the enterprise. The LLC, more than the corporation, depends on the skills of the contract drafter in outlining the precise rights and procedures that govern the entity. In the case of an LLC operating agreement that governs the company, less benefits the majority, and more can benefit the minority.
A Deleware statutory example may help clarify the potential problem. All LLCs are governed by statute and, like corporations, is the law commonly used to form many new business ventures. Under the Delaware LLC Act, there are no provisions specifically imposing the fiduciary duties of care or loyalty on LLC members or managers (typically found in corporate law). Instead, the Delaware LLC Act contains a number of provisions that can protect those in control of an LLC business venture, particularly from claims of those who may only have minority membership interests in the business. Oftentimes, the minority owner is tied to the entity by way of his or her investment and employment such that up-front protection and after-the-fact rights and remedies become critical should the business or the relationships of its members, officers and employees splinter, become irreconcilable, or end up in a business divorce. Thus, ensuring that the majority or those in control of the LLC adhere to fiduciary duties is imperative, but not after the fact, as it may by that time be too late should the business and its underlying relationships begin to unravel.
The situation is not much better in other states. About 20 state statutes impose a “gross negligence” standard for managers of LLCs – that is, a member, officer or employee of an LLC must show “gross negligence” by the manager in order to impose liability. Similarly, another roughly 20 statutes are silent on whether managers have any standard of care, and many other statutes protect those in control of an LLC, particularly if the disadvantaged officer or employee is a minority member of the business. These barriers to holding the majority accountable include (1) limitations on the right to obtain LLC records, (2) indemnification provisions that protect those in control, (3) protection of manager decisions if made in good faith reliance on the terms of the LLC’s operating agreement or on outside experts, and (4) requirements that claims for mismanagement be brought only “derivatively,” loosely meaning that there is no right of an individual who has been harmed to file a claim against the manager of the LLC.
While LLCs are effective options, legislatures and the courts have deferred to the four corners of the operating agreement, rather than impose judge-made standards of fairness as sometimes occurs with corporations. Courts will more likely give maximum effect in LLC to the principles of freedom of contract. Those with new businesses, especially where they invested significantly in, or are employed by, the entity, should negotiate an operating agreement with adequate minority rights and remedies for protection in the worst of time – or as importantly, the best of time.
For more information on this topic, please contact Fee Mendelsohn at (312)840-7004 or fmendelsohn@burkelaw.com or Craig McCrohon at (312) 840-7006 or cmcrohon@burkelaw.com.
