The Perils of LLC Flexibility (Part 2) – Key Issues an Operating Agreement Must Address

It is imperative that LLC members and management understand their company’s operating agreement and the role it will serve in a legal dispute. In an LLC operating agreement, Delaware law permits members to craft bespoke terms governing the LLC’s operation and the members’ rights, obligations, and duties vis a vis the company and one another. As discussed in Part 1 of this two-part article series, the operating agreement is interpreted as a contract based upon its words, and the Delaware Limited Liability Company Act (the “DLLCA”) serves as a gap-filler for situations and issues the agreement does not address. But the DLLCA does not provide workable terms for many common but fundamental issues that arise during an LLC’s operations and life cycle, including:

• Removal of a manager,

• Removal of a member, and

• Deadlocks in management under the operating agreement (e.g., management disagreements with no tie-breaker mechanism).

In this Part 2, we discuss why these critical issues must be properly and carefully addressed in an LLC’s operating agreement. If not addressed in the operating agreement, such issues can destroy an otherwise viable and promising company, frequently leading to internal discord and litigation.

Removal of a Manager – The DLLCA Provides No Real Redress

An LLC’s management is flexible. While a corporation is managed by its board, subject to the delegation of certain day-to-day authority to its officers, the management of an LLC can vary. Generally, an LLC is managed by its members, one or more managing members, or an external, non-member manager, but within these categories, there can be infinite permutations of rights and obligations. It is imperative that an LLC agreement provide some means to remove a managing member or manager.

Section 18-402 of the DLLCA states that “a manager shall cease to be a manager as provided in a limited liability company agreement.” There is no default rule for removing a manager if the issue is not addressed in the operating agreement. LLC members, even if among management, will generally want the ability to remove a member for some form of “cause,” such as violation of a duty, illegal action, or even personal conduct involving moral turpitude that could materially and adversely reflect upon his or her ability to serve. Cause may also include conduct that brings the company into disrepute or which could adversely affect its reputation and public perception. The definition of “cause” should be discussed and negotiated, but should be present. Depending on the circumstances, members may want the ability to remove a member of an LLC by a vote, whether through a majority, super-majority, or other vote.

Without addressing how to remove a manager from an LLC in the operating agreement, even misconduct will not be sufficient. Addressing such an issue early, during the drafting of the agreement and prior to any dispute, prevents immense business disruption and, perhaps, the implosion of the LLC under later circumstances.

Buy-Out of a Deceased Member

The death of a member is never easy, both for the company and, of course, for those left behind by the deceased. Under the DLLCA, the estate of the deceased member and his or her heirs become members with the same powers as the original member. This is often undesirable for the remaining members. While they may have entered a business relationship with the deceased member, they likely did not contemplate continuing the business with then-unknown heirs who may have significant managerial or other rights.

It is imperative, and de rigueur in well-drafted agreements, that operating agreements provide for a potential buy-out of a deceased member’s interest. Commonly, an operating agreement will provide that upon the members’ death, the deceased member’s interest automatically converts to a non-voting, economic interest. Such an interest entitles the estate or heirs to the economic distributions of the original, deceased member, but not to his or her other rights, such as voting, veto rights, or appointment rights, among others.

Such agreements also will commonly provide for a buy-out right exercisable by the company or at the estate or heir’s election. Such a buyout right allows the remaining members to streamline the capital structure and governance of the LLC, as well as to provide funds for the deceased members’ heirs. The method of calculating the cash-out value should be clearly spelled out. Generally, in the event of death, the value will be the “fair value” of the inherited interest. The fair value is the maximum value, without discounts for the lack of a market for the interest or otherwise. Fair value equals the net assets of the company multiplied by the member’s percentage ownership (“fair value”).

The manner of payment should also be addressed. Often, payments will be made over time to avoid depleting the company’s available cash, particularly where “fair value” is the relevant measure, which considers all the company’s assets, liquid and illiquid, in determining the denominator of the fraction to which the estate or heirs are entitled. Such payment could be made over a period of years pursuant to a debt obligation or other instrument.

Deadlocks in Management – Preventing Dissolution

Among other topics, the flexibility afforded LLC members allows them to “shape, by contract, [their] own approach to common business relationship problems in the LLC operating agreement.”^[1] Not only does it permit such shaping, such shaping is a necessity. An operating agreement must plan for management disputes and disagreements, including those that become intractable and fundamental. The DLLCA does not provide for a means of resolving a deadlock, such as a disagreement of two equal members on an issue that requires unanimity, save for dissolution of the LLC upon application to the Chancery Court. This is, of course, a drastic result that could destroy the business of an otherwise functional and successful LLC. There are, however, ways to plan for such disputes in advance, including:

• Preventing the possibility of deadlock, such as through providing for a “tie-breaker” decider in the operating agreement should a deadlock occur, and

• Providing a means of buyout from one member (or a member faction) to the other member (or other faction) based upon pre-set mechanisms.

There are many common mechanisms to provide for buyouts, often bearing colorful names (Mexican standoff, Russian Roulette, shotgun clause, etc.). One LLC deadlock provision example, the Russian Roulette clause, assumes that members have reached an intractable deadlock in management for which the operating agreement provides no resolution. One member makes an offer for the interest of the other. The receiving party can either accept that offer or require the offeror to sell to the receiving party based on that valuation. This incentivizes the initial offeree to provide a value that he or she would be willing to accept, as the receiving party can accept or flip the proposed sale.

Absent a means of resolving an intractable deadlock in an operating agreement, deadlocked parties must apply to the Chancery Court to seek a judicial order of dissolution, requiring a finding that carrying on the business has become impracticable. This is far from an ideal or desired result in many cases, and can allow one party to hold the company and the other member(s) hostage by creating intractable disputes.

Conclusion

The flexibility of the LLC form is a great benefit, but with it comes the responsibility to ensure the operating agreement is coherent, fulsome, and effective. The DLLCA is an “enabling” statute and is often a poor tool to rely upon in structuring and LLC’s governance and operation. Skilled LLC counsel can draft terms, based on experience and precedent, to address the critical issues that may arise in the life of an LLC, and serve a critical role in ensuring the company’s future success.