Investors and their counsel should be aware that a voting deadlock with respect to the management of a limited liability company that cannot be remedied by the terms of the limited liability company operating agreement itself could lead to the judicial dissolution of the company.
Investors in Delaware limited liability companies may be at some risk that the company in which they have invested may be dissolved by the Delaware Court of Chancery upon petition by a member or a manager if a voting deadlock occurs with respect to such company and, as a result of the deadlock, it is no longer reasonably practicable to continue running the business of such company. Conversely, if an investor in a deadlocked limited liability company is in favor of dissolution of the company, the investor should be aware that it may have the right to seek judicial dissolution of the company. Under Section 18-802 of the Delaware Limited Liability Company Act (the “Act”), “On application by or for a member or manager, the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” In 2004, the Delaware Court of Chancery in Haley v. Talcott1 established the principle that a court may decree dissolution of a limited liability company upon application by a member or manager when a voting deadlock occurs and is continuing and as a result it is not reasonably practicable to carry on the business of the company in conformity with the operating agreement of the company. In 2009, the Delaware Court of Chancery in Fisk Ventures, LLC v. Segal2 reaffirmed this principle and set forth three factual circumstances which, while not individually dispositive, are nevertheless helpful in determining whether or not the “reasonably practicable” standard under Section 18-802 of the Act has been satisfied: (i) the members’ vote is deadlocked at the board level; (ii) the operating agreement provides no means of navigating around the deadlock; and (iii) due to the financial condition of the company, there is no business to operate.
Lessons to Be Learned
- The discussion above relates to deadlocks in the context of Delaware limited liability companies. However, investors and their counsel should be aware that similar provisions and principles apply to Delaware limited partnerships and, to some extent, Delaware corporations.
- The Act explicitly states that its policy is to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements and therefore allows members of limited liability companies to arrange the appropriate manager/investor governance relationship by providing default provisions in the Act that can be modified as deemed appropriate by the managing members of the limited liability company. Thus, when drafting and negotiating a limited liability company operating agreement, investors and their counsel should consider specific provisions to avoid deadlocks and provide mechanics that will be triggered in the event a deadlock does occur. Further, investors and their counsel should be very specific as to whether Section 18-802 of the Act will apply in the event of a deadlock with respect to the limited liability company. Therefore, if the investor wishes for Section 18-802 of the Act to apply in the event of all deadlocks without the need for a court to conduct a Haley or Fisk analysis, it should be expressly stated in the operating agreement; likewise, if the investor does not wish for Section 18-802 of the Act to apply in the event of any deadlock, that too should be expressly stated in the operating agreement.
Deadlock Resolution Mechanisms
- Generally, disputes should be required to persist for some minimum period of time (at least two board or manager meetings) before a deadlock is declared and deadlock resolution mechanisms are invoked.
- Generally, all deadlock resolution mechanisms should be preceded by a mandatory negotiating period among relatively senior officers of the members (usually between 15 and 30 days).
- If still no negotiated solution can be reached, then recourse is addressed by the applicable deadlock resolution mechanism.
II. Tie-Breaker or Third-Party Consultant Provisions
- Any 50 percent/50 percent voting arrangement or any provision of a limited liability company agreement that provides a veto right (for example, supermajority voting similar to that in Fisk) effectively prohibits board domination by one party over another, but without the addition of a “tie-breaker” provision a stalemate could occur and the parties may become hopelessly deadlocked on material business issues (for example, raising capital, frequency of board meetings, acquisitions/divestitures).
- Investors and their counsel should consider “tie-breaker” provisions that would be triggered in the event of a board or manager deadlock whereby a predetermined person or an independent third-party/arbitrator with expertise in the industry will resolve the contested issue.
III. Put/Call or Buy-Sell Provisions
A. Put/Call Option
- Provisions can be included whereby one party has a put option and the other has a call option. The party with a put option has the right to require the other party to purchase its interests at a price based on a predetermined formula or at fair market value and the party with a call option has the right to require the other party to sell its interests to it at a price based on a predetermined formula or at fair market value.
- This mechanism is usually used when one party is of substantially greater size and economic strength than the other and usually where one party has a substantially greater investment than the other.
- Such provisions are more useful in a default context (for example, where further capital contributions are contemplated) but have the disadvantage in the deadlock context that they are triggered by the first member to serve the relevant notice and can thus be arbitrary and manipulated in a commercially opportunistic manner (that is, exercise the put/call at a favorable price) rather than using such provisions as a last resort, deadlock resolution mechanism.
B. Buy-Sell Provision
- Provisions can be included which entitle a member seeking to terminate a deadlocked limited liability company to serve notice on the other party requiring the receiving party to choose either to buy the entire holding of the initiating member or to sell its entire holding to the initiating member, in each case at the price set out in the initiating member’s notice.
- Although this appears to be a simple mechanism and helps ensure a fair price, it is quite draconian since neither party knows if it will ultimately be the buyer or seller if it decides to trigger the buy-sell provision. Accordingly, such risks provide incentives for both parties to avoid triggering the buy-sell provisions and instead reach agreement on the deadlocked issues.
- While such provisions can favor the financially stronger member in the event that the financially weaker member may not have sufficient liquidity to purchase the other member’s interest, such inequity can be addressed by including in the operating agreement provisions which would require the financially stronger member (upon request of the financially weaker member) to provide seller financing to the financially weaker member on terms set forth in the operating agreement (e.g., type of financing, term, interest rate, collateral) if the financially weaker member is ultimately the buying member as a result of the buy-sell provision.