Joining a Limited Liability Company: Be aware of the risks

Today’s entrepreneur can choose from a variety of business forms including partnerships, sole proprietorships, corporations and, most recently, limited liability companies. The Limited Liability Company (LLC) is still in its infancy in New York. Having only adopted the Limited Liability Company Law (LLCL) in 1994, there is not a large body of case law to analyze the ins and outs of an LLC’s existence. Yet, despite the fact that most people have very little knowledge of how an LLC actually works, it has become one of the most popular forms of business in New York today. The reasons for the LLC explosion are clear: you get the limited liability protection of a corporation without having to jump through all the corporate formality hoops and, at the same time, get the flexibility of management previously reserved only for partnerships.

However, as the business world tests the functional aspects of the LLC, some chinks in the armor have appeared. One of the greatest problem areas is dealing with conflicts between members of the company. In the world of close corporations, shareholders are fairly well protected by the Business Corporation Law (BCL). When disputes arise, the BCL has specific provisions to address them and allow a minority shareholder to protect his or her interest in the business. If the minority shareholder believes he or she is being oppressed by the actions of the majority, BCL §1104-a allows him or her to dissolve the corporation thereby pulling out, at least partially, the value that he or she has put into the corporation. Likewise, if the shareholders are deadlocked in what course of action the corporation should take, the BCL again specifically allows them to dissolve the corporation.[1] In addition, courts recognize a common law cause of action to dissolve a closely held corporation. These avenues provide the close corporation’s shareholder with a number of exit options should the waters become too rough.

Unfortunately, the LLCL does not provide the same guidance as the BCL in the event oppression of a minority member occurs or a deadlock among members occurs. This is most likely a direct result of the LLC’s intent to give members liability protection with extremely few restraints on the actual make-up of the business or the method of running the business. But as those who have encountered problems in an LLC have discovered, flexibility does not come without its drawbacks. When a dispute arises between the members of an LLC, and a mutual agreement to dissolve the LLC and go their separate ways cannot be reached, an oppressed member will quickly learn that he or she may be trapped.

A member’s rights in an LLC are determined by two things: 1) the provisions in the company’s operating agreement; and 2) the statutory provisions of the LLCL. Of course while the LLCL does require every LLC to have an operating agreement[2], it is also silent on the effect of not having an operating agreement. The courts have determined that where no operating agreement exists, the default provisions of the LLCL apply. If that doesn’t sound so bad – you should read the LLCL.

As far as the LLCL is concerned, a minority member may only dissolve in a single situation: where “it is no longer reasonably practicable to carry on the business in conformity with the articles of organization or the operating agreement.”[3] This standard presents two frightening problems for the minority member in the LLC: 1) most operating agreements, if they list a purpose, list the purpose as “to engage in any lawful activity” and; 2) if the operating agreement is silent, or if no operating agreement exists, the law assumes the purpose to be “to engage in any lawful activity.” If you think about the broad scope of tasks that can fall within the realm of “any lawful activity”, there is little question that a minority member will be hard pressed to judicially dissolve an LLC that does not have a separation clause in its operating agreement. As a result, this can leave a member with no way out and no control over the business.

The solution is simple: before forming an LLC, consult an attorney to prepare a thorough operating agreement that will protect your rights should something go wrong down the line. Its not only required by the law, but it has the practical effect of potentially saving you thousands of dollars in future legal fees if a power struggle erupts among the members. Likewise, if you are thinking of joining an existing LLC as a member, make sure that you review the operating agreement with an attorney to determine your exit rights in the event that you want to separate from the company. If you don’t, you and your financial contribution to the company may be trapped in a box with no way out.

DISCLAIMER: THIS INFORMATION HAS BEEN PREPARED FOR INFORMATIONAL PURPOSES ONLY AND IS NOT LEGAL ADVICE. YOU SHOULD CONSULT AN ATTORNEY FOR INDIVIDUAL ADVICE REGARDING YOUR SITUATION.


[1]BCL §1104.

[2]LLCL §417.

[3]LLCL §702.

Comments are closed.