In my recent paper, Close Corporation Remedies and the Evolution of the Closely Held Firm, written for a symposium on the famous Massachusetts close corporation case Wilkes v. Springside Nursing, I focused on the LLC alternative to close corporations. I observed that
by providing a clearly non-corporate structure of default rules and a variety of state statutes, LLCs make it easier than close corporations for parties to reach agreements that approximate their ex ante expectations. Courts can then fill in the gaps using the contract and statute as general guidelines rather than having to construct a contract from a whole cloth as in Wilkes.
Judicial opinions in close corporations tend to proceed from a generalized notion of what the minority shareholder expected from the deal – that is, the ability to get distributions or salary – without regard to the express and implied contract terms. By contrast, courts in LLC cases increasingly have focused on what parties actually put in their contracts, interpreted in light of the statutory standard form they used as a basis for their business agreement. Instead of asking what reasonable parties would want if they could contract cheaply, courts now tend to ask what the specific parties actually wanted given what they contracted for.
I noted that Delaware and New York are leading the way in creating a distinct LLC contractual approach to judicial dissolution of closely held firms. A leading example is New York’s Matter of 1545 Ocean Avenue, LLC v. Crown Royal Ventures, LLC, which I discussed here. My blog post noted four important elements of the 1545 Ocean test:
- The LLC statute clarifies that the test for dissolving an LLC is distinct from that for a close corporation.
- The statutory test emphasizes the operating agreement — specifically, whether it is “reasonably practicable” to operate “in conformity with the operating agreement.” This is consistent with the Delaware judicial dissolution standard I have discussed, e.g., here, here and here, and in my Rise of the Uncorporation, 180-82.
- The court might dissolve an LLC even when it can continue operating under the agreement, but when it “cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created.” I noted that the parties therefore “may need to be careful about specifying the purpose of the LLC in the operating agreement.”
- The LLC generally cannot be dissolved merely because of managerial self-dealing unless the above standard is met. The remedy for self-dealing is usually a derivative claim. Although my article Litigating in LLCs suggests that dissolution sometimes works better than wasteful litigation, this choice may be a matter for the operating agreement.
Now the ever-helpful Peter Mahler provides an analysis of recent NY cases applying the 1545 Ocean standard. He summarizes three cases reaching three results:
- Mehraban v. McIntosh, Short Form Order, Index No. 001683/09 (Sup Ct Nassau County Jan. 19, 2011). The case holds that where the operating agreement provided that the “prime intent of the members, initially, is to implement the Joint Venture Agreement.” Given these terms, the LLC’s debt, lack of an income stream, and inability to obtain subdivision made approval made this “financially unfeasible.”
- Matter of Singh (Data Palette Information Services, LLC), Short Form Order, Index No. 4797/10 (Sup Ct Queens County Jan. 7, 2011) held that, despite allegations of majority malfeasance, including improper decision making, improper loans and check signing and co-mingling of funds, the court found, per Mahler’s summary
that the petitioners failed to show that the LLC “can no longer meet its business purpose regarding the intake of consumer database,” and also fail to make any “showing that the company is financially unfeasible.” A petitioner “must plead facts reflecting the inability of the entity to carry on its business in accordance with the articles of organization” and may not merely “parrot” the language of LLCL 702. The “palpable” animosity between the parties, Justice Strauss adds, “alone will not support a petition for dissolution.”
- Matter of RBR Equities, LLC, Short Form Order, Index No. 40736/10 (Sup Ct Suffolk County Jan. 18, 2011). In a case similar to Mehraban involving a real estate development that had financial difficulties and couldn’t get site plan approval, the court held there were factual issues precluding dissolution. The respondent claimed petitioners approved modified site plans and failed to respond to cash calls. The respondent also argued that the operating agreement’s broad purpose “to engage in any lawful act or activity” “is being achieved and that the development plan for the LLC’s property is extremely close to approval and fruition.” The court reasoned that despite unexpected difficulties:
The records both in support and in opposition to the dissolution present numerous issues of fact as to the operations and purpose of The LLC as well as whether or not, it is reasonably practicable to carry on The LLC. In addition, attached to the opposition papers, the Respondent has provided copies of letters from 3rd parties, expressing interest in the Subject Property, which may weigh in on the issue of financial feasibility. Therefore, the Court cannot determine as a matter of law, that it is no longer reasonably practicable to carry out the purpose of The LLC and judicial dissolution at this time, is not warranted.
As Mr. Mahler points out, “it’s hard to say whether the result in any of these three cases would have been different in the free-wheeling, pre-1545 Ocean era. But it does seem clear that the courts are approaching the issue in a uniform fashion guided by the appellate decision’s contract-based analysis.”
The real test will come when the court is faced with a case that is very strong for dissolution on traditional close corporation equitable grounds but where it can find no plausible basis in the operating agreement.
It is interesting to ask whether this New York development is an example of jurisdictional competition with Delaware, which originated this approach as discussed above.
One thing is clear: the LLC, at least in its NY/Delaware manifestation, now represents a superior technology compared with close corporations in dealing with the dissolution of any firm that has an operating agreement. If one assumes that contracts should be the basis of closely held firms, then the LLC approach is superior, period. In any event, the close corporation approach should be regarded as reserved primarily for very informal firms that want limited liability. The question is whether that should be a null set. After all, creditors as well as shareholders gain from the predictability and stability that an enforceable agreement provides.
One would think that there would still be some judicial remedy in In re Singh, if the allegations of the Complaint re co-mingling of funds, improper check signing and improper loans are true, even if judicial dissolution is not the proper remedy. It is a little hard tell if that would be in the nature of a derivative action, or if it might amount to some other breach of fiduciary duty by a manager.
It also seems that while “palpable” animosity alone might not justify dissolution, that this might be an appropriate justification if would often make continued operation to carry out the purposes impracticable if both members were active service providers and sweat equity was necessary to make the venture work.