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Avoid Lock-Ins of LLC Minority Members

| Nov 17, 2008 | Business Litigation

An operating agreement of a Maryland limited liability company (an “LLC”) that does not require the unanimous consent of the members for its amendment leaves the minority member(s) vulnerable to oppression and investment lock-in — even if it provides for voluntary withdrawal or buy-out rights. When faced with a draft operating agreement of such nature, counsel for the minority member(s) should negotiate, at a minimum, if possible, for the inclusion of corporate-style rights of appraisal and/or judicial dissolution, preferably both. For the sake of simplicity, this text addresses these issues in the context of a two-member LLC.

Adopting corporate appraisal rights provisions is an effective way to prevent a majority member from depriving the minority member of any independent right exit the LLC. The LLC appraisal rights statute, Md. Corps. & Ass’ns Sec. 4A-705, unlike its corporate counterpart, Md. Corps. & Ass’ns Sec. 3-202(a)(4), does not confer appraisal rights (i.e. the right to demand and receive the member’s fair value of his or her interest) on a minority member in the event the operating agreement is amended such that it “substantially adversely” affects the minority member’s rights. Absent unanimous consent requirements, a majority member intent on engaging in oppressive behavior may single-handedly amend the operating agreement to deprive the minority member of any distributions, to restrict or deny employment, and to lock the minority member in his or her investment indefinitely. The LLC statutes permit the majority member to deny the minority member the practical alternative of withdrawing from the LLC by amending the operating agreement to that effect. See Md. Corps. & Ass’ns Sec. 4A-605. The law also permits the majority member to do away with any express buy-out rights the minority member may have had in the operating agreement. In contrast, such unilateral actions on the part of a majority stockholder may trigger the minority stockholder’s appraisal rights. A minority stockholder who negotiated an express appraisal rights provision into the corporation’s charter is likely to be entitled to appraisal rights if the majority stockholder “alters the contract rights, as expressly set forth in the charter, of any outstanding stock and substantially adversely affects the stockholder’s rights” by amending the charter to eliminate the minority stockholder’s express appraisal rights (unless, of course, the right to such alteration is reserved by the corporate charter). See Md. Corps. & Ass’ns Secs. 3-202(a)(4) and (c)(4).

Adopting corporate judicial dissolution provisions offers an exit from an oppressive company environment. A court may dissolve a corporation on grounds that the acts of those controlling the corporation are “illegal, oppressive, or fraudulent.” Md. Corps. & Ass’ns Sec. 3-413(b)(2). Despite oppressive behavior by the majority LLC member, however, a court may dissolve an LLC only if the majority member’s acts are such that they make it not “reasonably practicable to carry on the business in conformity with the articles of organization or the operating agreement.” See Md. Corps. & Ass’ns Sec. 4A-903. Since Maryland case law does not address the issue of whether oppression renders the operation of an LLC as not “reasonably practicable,” adopting the corporate oppressive conduct standard for dissolution brings clarity into the members’ relationship.

In negotiating the inclusion of appraisal rights and judicial dissolution provisions, counsel for the minority member can make the following points: (1) the provisions are necessary to avoid oppression and lock-in; (2) the provisions are preferable to including a unanimous consent requirement, the power of which can be abused by a minority member to hold the majority member “hostage;” and (3) it should be acknowledged that the inadequacy of statutory protections for minority members is largely attributable not to any business purpose but to estate tax planning under an estate tax regime that ignores, for purposes of discounting the value of minority interests, contractual restrictions on minority rights that are more restrictive than default state statutes. See, e.g., I.R.C. Sec. 2704(b) and Knight v. C. I. R., 115 T.C. 506, 519 (U.S. Tax 2000).

This article was originally published in the Fall/Winter 2008 issue of the Business Law Newsletter, a publication of the MSBA Section of Business Law.