November 2015 Bar Bulletin
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November 2015 Bar Bulletin

Shotguns, Daggers and Triggers: Escape from LLC Island

By Thomas A. Lerner

 

In January, the new Limited Liability Act becomes effective. It is designed to simplify the process of entity formation even more than is now the case, and offers greater flexibility in the organizational structure.

The changes in the Act will require practitioners to review oft-used forms with a critical eye to account for changes in the Act. More customization will be required to take into account the need to clarify the duties among members, managers (if a manager-managed entity) and the entity itself.

For example, the statute includes a default duty for a manager not to compete with the entity. Absent provisions in the operating agreement to modify this duty, this could impair the activities of an individual who is the manager of multiple real estate entities.

While the Act makes changes to formation, management and operations, no substantive change has been made to the legal standards governing dissolution of the entity. Dissolution occurs by vote of the members, after the last member leaves or by judicial decree. RCW 25.15.275 currently provides:

On application by or for a member or manager the superior courts may decree dissolution of a limited liability company whenever: (1) It is not reasonably practicable to carry on the business in conformity with a limited liability company agreement; or (2) other circumstances render dissolution equitable.

The new Act barely modifies this to include a reference to the certificate of formation in subpart (1). Thus, the basis for dissolution absent the agreement of the members continues to be governed by an intentionally vague standard, with scant past judicial guidance.

The purpose of this article is to suggest that the new LLC Act presents an opportunity to revisit common approaches to deadlocks, departures and dissolution. Just as other common provisions of operating agreements will warrant reconsideration, so should those provisions that address what occurs when the principals of a closely held entity want to go in different directions.

Contemplating the End

When individuals undertake to form a new business venture, their focus is on moving forward with the business rather than when and how they will separate. After all, at the moment of formation, no one plans for the divorce. Developing a successful business plan is challenging enough.

By the time the principals meet with an attorney to discuss entity formation, they are likely already distracted by building the business. Still, diligent counsel will attempt to focus the principals not only on the inevitability of separation, but on how to implement that split when the time comes.

The typical LLC operating agreement makes it inordinately difficult for the principals to part ways once they conclude that their personal, financial or business goals differ from those of their business partner. In part, this difficulty is intentional - strong constraints on dissolution or separation make it more likely that the parties will work through their differences, allowing the business to continue. Too often, however, the typical structure crosses the line where accomplishing a separation of interests changes from being inconvenient to functionally impossible (or possible, but disastrous).

The structure for one member to leave is cumbersome and costly. A seller may suffer from discounted valuations. A buyer may need access to a reservoir of cash to begin the payout and fund operations. Decisions that could result in an orderly dissolution typically require a supermajority. In a closely held entity, this often translates into a need for unanimity right at the point where fundamental disagreements have crystallized.

In the context of professional associations, a member's withdrawal may also include non-compete restrictions that could cause someone to relocate. Payouts are substantially deferred and ultimately dependent upon both the success of the entity and the willingness of one's estranged business partner to prioritize payments to the departed member. The burdens on the continuing member increase while revenue sources diminish, and the payout obligation becomes an added overhead burden. In sum, it can be more onerous to try to start a new life without your business partner than without your spouse.

Options

Knowing this, the attorney preparing the company documents will lead the entity members through a variety of options to be included in a buy-sell agreement. Too often, during formation the principals will simply ask the attorney to prepare their "standard form" incorporating the attorney's recommendations.


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