Commonly, in LLCs between two primary members or groups exercising managerial control, the members will appoint a tie-breaker manager to prevent a deadlock in decision-making. The tie-breaker, agreed upon by the parties at appointment, ideally will provide an independent vote to ensure the company continues to function and disputes do not become intractable. Recently, the Delaware Chancery Court addressed removal of such a tie-breaker, revealing a potential pitfall for the unwary.
LLCs – Creatures of Contract
Delaware LLCs are “creatures of contract”, governed first and fundamentally by their respective operating agreement and the terms the members agree upon as reflected in its provisions. The flexibility of the Delaware LLC requires careful drafting of such agreements, as well as close consideration and scrutiny of the meaning and implications of the language as written. Delaware’s Limited Liability Company Act (the “DLLCA”) only applies when an operating agreement does not address (or sufficiently address) an issue in dispute.
The DLLCA fails to address certain potentially catastrophic issues; for example, the DLLCA does not provide a means of breaking management deadlocks, save for permitting members to seek dissolution by the court when continuing a business has become impracticable as a result. Therefore, such measures must be addressed in the operating agreement adopted by the parties, often through the appointment of an LLC tie-breaker manager. In the event the two sides are deadlocked on a fundamental issue involving the LLC’s management, the tie-breaker prevents the deadlock from adversely affecting the company or, worse still, resulting in one party seeking an order of judicial dissolution.
Generally, members appointing an LLC tie-breaker manager mutually agree on the individual who will serve that role prior to any dispute. Generally, at least at appointment, the tie-breaker manager is a person perceived as neutral, fair, and respected by both sides. Over time, however, relationships and circumstances can change and develop in unexpected ways. One party may perceive that the tie-breaker is growing more aligned to one side, not merely through the exercise of proper judgment but perhaps through personal or financial interests or as a result of outside business dealings. But how does one effectively provide for his or her removal or replacement, other than for a good cause such as misconduct or fraud? Allowing unilateral removal by one party undermines the manager’s purpose -- to serve as a tie-breaker amidst a dispute.
The Recent Chancery Case
In one LLC deadlock provision example, Franco v. Avalon Freight Services LLC, the Delaware Chancery Court faced this issue and found that removal can only occur as set forth in the operating agreement. Avalon Freight Services LLC (“Avalon”) was owned by a single member, GH Channel Holding LLC (“Channel Holding”). Greg Bombard (“Bombard”) and Harley Franco (“Franco”) held equal interests and equal control in Channel Holding. Under Avalon’s operating agreement, Bombard and Franco each controlled two seats on its board-style management body, and mutually appointed a fifth tie-breaker manager. The operating agreement provided: “The fifth (5th) director shall be mutually agreed and appointed by Bombard and Franco, who shall initially be Doug Houghton. Further, it stated that “any vacancy in a Board seat may be filled only by the vote or action of the director entitled to designate and elect such seat,” but did not address the removal of managers serving on the board.
Bombard and Franco’s factions became deadlocked in managing Avalon, though the court does not address the nature of the deadlock. It states that “the nature of the underlying dispute is neither known to the Court nor relevant to this case, which is limited to the terms of Houghton’s continued service.” Franco sought Houghton’s removal, while Bombard sought to maintain Houghton in the tie-breaker role.
In the absence of a means of removing Houghton, whether deservedly or not, the court held that the mutual agreement appointing the tie-breaker manager did not require ongoing mutual agreement, and that neither party could unilaterally require Houghton’s removal. The court summarized Franco’s argument, stating “Franco contends that permitting Houghton to continue to serve even if he has displeased one faction would disturb the balance of power between Franco and Bombard, and allow one side to take control of the company by ‘endearing himself to Houghton. Of course, it then rightly notes that “preventing one side from unilaterally removing Houghton does not undermine his independence, but rather, protects it."
Because the operating agreement did not provide for Houghton’s removal (or, frankly, the removal of any other appointee to the management board), he could not be unilaterally removed by either party. The court notes that the operating agreement could have provided for such removal on some terms and subject to some conditions, but did not, leaving Franco stuck with what appears to be an increasingly hostile relationship with Houghton, the tie-breaker manager. It is difficult to say what provisions for removal would not, in fact, undermine the role of the tie-breaker. As noted above, removal for cause is essential. A deadlock provision in the operating agreement could also limit the conflicts of interest that may affect the tie-breaker manager, preventing one side from appealing to personal, professional, or economic influences.
Take care when appointing a tie-breaker manager and monitor his or her incentives and conflicts of interest, particularly as they relate to one member or faction that appointed the manager.
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