Wednesday, June 29, 2016

Minority Oppression in the LLC

    The doctrine of shareholder oppression protects minority stockholders in closely held corporations from the improper exercise of majority control. When a minority shareholder claims abuse at the hands of a majority investor, courts applying the oppression doctrine will subject the majority’s conduct to a considerable amount of scrutiny.  Approximately thirty-nine states have statutes providing for dissolution or other relief on the grounds of “oppressive actions” by “directors or those in control.”  See Douglas K. Moll & Robert A. Ragazzo, Closely Held Corporations § 7.01[D][1][b], at 7-69 n.192 (LexisNexis 2015).

    The factors that give rise to the oppression problem in the closely held corporation context are also present in the LLC setting.  See, e.g., Douglas K. Moll, Minority Oppression & the Limited Liability Company:  Learning (or Not) from Close Corporation History, 40 Wake Forest L. Rev. 883, 925-57 (2005).  Indeed, the same combination of “no exit” and majority rule—a combination that has left minority shareholders vulnerable in the closely held corporation for decades—exists in the LLC.  Despite these similarities, only nineteen states have LLC statutes providing for dissolution or other relief on the grounds of oppressive conduct or similar language.

    Why the difference?  Why do twice as many states provide oppression-related protection in the corporation setting (as compared to the LLC setting)?  Some thoughts:

(1)      Differences in default exit rights:  In the corporation, state statutes do not provide default exit rights.  In the LLC, the situation is similar, as the passage of the check-the-box regulations led to most states eliminating default exit rights for estate planning and related purposes.  See id. at 925-40.  Nevertheless, in a small handful of jurisdictions (5 states by my count), default exit rights still exist in LLCs.  Such statutes usually indicate that the dissociation of a member leads to a buyout of the member’s ownership interest or dissolution of the company.  When minority owners have a statutory mechanism for exiting the venture with the value of their investments, there is little need for an oppression doctrine, as the oppression doctrine typically seeks to provide the same outcome (i.e., exit and return of capital). 

(2)      The oppression doctrine is too vague and unpredictable:  In many jurisdictions, oppressive conduct is defined as “burdensome, harsh, and wrongful conduct” by the majority, or a frustration of the minority’s “reasonable expectations” by the majority.  These definitions have been criticized on the grounds that they are too vague and general to provide any meaningful guidance to litigants and courts.  Importing the oppression doctrine with these definitions into the LLC setting may be viewed as compounding the problem.  One could argue, however, that oppression is no more vague and open-ended than the concept of fiduciary duty, particularly in jurisdictions where the scope of manager and member fiduciary duties is not circumscribed by statute.

(3)      Other dissolution grounds are broad enough to encompass oppressive conduct:  Almost all LLC statutes provide for judicial dissolution on the ground that it is not reasonably practicable to carry on the business in conformity with the governing documents of the LLC.    Such a ground is presumably broad enough to encompass certain types of oppressive behavior.  For example, if the majority consistently deprives the minority of distributions to which the minority is entitled, such conduct would likely run afoul of the operating agreement and would show a pattern of the majority violating the governing documents.  If this dissolution ground can handle oppressive conduct, the need for a dissolution statute explicitly tied to oppressive behavior is lessened.* 

    On the other hand, some types of oppressive conduct fail to fit neatly within the “not reasonably practicable” language.  In a classic freezeout where the minority is terminated from employment and denied any management role in the LLC, there may be no technical violation of the articles or the operating agreement.  Cf. Dennis S. Karjala, Planning Problems in the Limited Liability Company, 73 Wash. U. L.Q. 455, 471 (1995) (“[I]n Arizona, Delaware, and Oregon, a court may order dissolution in an action by a member if it is established that it is ‘not reasonably practicable to carry on the business’ according to the articles or an operating agreement.  Yet it is often possible to carry on the business while freezing a minority interest out of any return.” (footnote omitted)).  Thus, a more explicit dissolution-for-oppression statute may still be useful.

(4)       Fiduciary duties to members exist in the LLC:  Perhaps the most compelling reason for the lack of LLC dissolution-for-oppression statutes is that minority members may already be protected from oppressive conduct by fiduciary duties owed to them by managers (and, possibly, other members).  In the corporation setting, directors and officers traditionally owe fiduciary duties to the corporation itself, but not to individual shareholders.  By contrast, in the LLC setting, many jurisdictions indicate (either by statute or judicial decision) that a manager owes a fiduciary duty to an individual member as well as to the LLC itself.  See, e.g., RULLCA § 409 (2006).  A member’s ability to bring a breach of fiduciary duty claim on his own behalf lessens the need for an oppression action, as the oppression action is also designed to allow a minority owner to assert, on his own behalf, that he has been unfairly treated. 

    That said, it is not clear that the scope of a manager’s fiduciary duty would be construed as broadly as the oppression doctrine has been construed, particularly with respect to protecting the minority’s participatory rights in the business (i.e., employment and management rights).  In fact, in some jurisdictions, a manager’s fiduciary duty of loyalty is limited by statute to harm caused to the LLC itself (and not harm caused to an individual member).  (Note:  I discussed this in the partnership context in a prior post.)  In addition, broad remedies for oppression, such as a buyout of the oppressed minority’s holdings, are already well-established in the case law.  Although a court has significant remedial discretion in fiduciary duty actions as well, in many jurisdictions there is no precedent for a buyout as a remedy for breach of fiduciary duty.

    What am I missing?  Are there other explanations for significantly fewer oppression statutes in the LLC setting?

*    Some LLC statutes allow for dissolution when member conduct makes it not reasonably practicable to carry on the company’s business with that member.  This ground seems even more tailored to oppressive conduct, but it is only present in seven jurisdictions.

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Haven't checked recently (but will for the next supp. of Carter's and my treatise - aka MyLateMother'sFavoriteTreatise), but some LLC statutes have been interpreted to bar such claims. From Carter G. Bishop & Daniel S. Kleinberger, LIMITED LIABILITY COMPANIES: TAX AND BUSINESS LAW (Warren Gorham & Lamont, 1994; Supp. 2016-1)

¶ 10.09[2][b][iii] Statutes that create immunity from claims.

Some LLC statutes express managerial duties in protective terms, stating that those who manage the LLC will not be liable “unless” they violate the statutory standards of conduct.305.7 If these standards are low enough, the resulting protection may bar typical “squeeze out” breach of fiduciary duty claims.305.8 That is precisely what happened in Ault v. Brady, an unreported federal appeals court decision. The case concerned a power struggle among owners of an Arkansas LLC.305.9 As part of that struggle, one member purchased another member's units. Upon learning of the purchase, the managing member terminated the purchasing member's contract to provide services to the LLC, and then invoked an operating agreement provision requiring the terminated member to sell his units back to the LLC.305.10 The terminated member responded, in part, by claiming a breach of fiduciary duty. The Court of Appeals rejected that claim as “without merit,” stating: “Under Arkansas law, a manager of a limited liability company is not liable to the company or other members unless he engages in ‘gross negligence or willful misconduct.'”305.11 Apparently, no such misconduct could have occurred because the managing member “acted well within his authority” under various provisions of the operating agreement. The court did not even pause to consider whether authorized actions might be willfully oppressive. 305.12
[footnotes omitted]

Another thought -- although after "check the box," the lock-in problem in closely held LLCs is at least theoretically worse than in CHBs, many LLC statutes depend on the limited partnership construct for dissolution -- "not reasonably practicable".

Best regards,

Dan Kleinberger
Daniel S. Kleinberger
Professor Emeritus – Mitchell Hamline School of Law
Research Director, Joint Editorial Board on Uniform
Unincorporated Organization Acts
Reporter, Uniform Law Conference Drafting Committee on the
Uniform Limited Liability Company Protected Series Act

Posted by: Daniel Kleinberger | Jul 6, 2016 6:50:11 AM

Great points Dan. Thanks very much. Hope you are well!

Posted by: Douglas Moll | Jul 6, 2016 7:34:16 AM

FWIW, I would suggest an additional ground against statutory protections, which is that LLCs and partnerships have relationships that are largely contractual in nature, and a prospective member should presumably protect himself before entering the deal by demanding the inclusion of protective language. A minority member in an LLC must know that they are in a very bad place to begin with, and I'm not sure that it is a particularly good idea to give such members "free bonus protections" that they could have bargained for, but didn't, at the outset. Caveat emptor. My $0.02

Posted by: Jay Adkisson | Jul 6, 2016 10:08:37 AM

Thanks for your comment Jay. Your observation is a good one. Allow me to mention, however, that many commentators have pointed out that effective contracting in a closely held business is difficult, if not impossible in some circumstances. See, e.g., Douglas K. Moll, Minority Oppression & the Limited Liability Company: Learning (or Not) from Close Corporation History, 40 Wake Forest Law Review 883, 911-16, 952-56 (2005).

Posted by: Douglas Moll | Jul 6, 2016 12:30:55 PM

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