LLC Oppression Under Section 11.314(3)
Texas Business Organizations Code Section 11.314 provides:
A district court in the county in which the registered office or principal place of business in this state of a domestic partnership or limited liability company is located has jurisdiction to order the winding up and termination of the domestic partnership or limited liability company on application by an owner of the partnership or limited liability company if the court determines that:
(1) the economic purpose of the entity is likely to be unreasonably frustrated;
(2) another owner has engaged in conduct relating to the entity’s business that makes it not reasonably practicable to carry on the business with that owner; or
(3) it is not reasonably practicable to carry on the entity’s business in conformity with its governing documents.
The statute provides that the company becomes subject to district court jurisdiction to order winding up and termination if a petitioning member satisfies one or more of three tests, which we will refer to as the “economic purpose test,” the “owner conduct test,” and the “reasonable practicability test.”
No Texas cases have applied section 11.314 to an LLC, and only a small number of cases apply the same statute to partnerships. However, courts in other jurisdictions have applied statutes with wording essentially identical to the three tests set forth in section 11.314 to a wide variety of circumstances. Each of the three tests has been used to provide a remedy to dissension and oppression. Section 11.314 should provide meaningful relief and the possibility of a compulsory buy-out to oppressed members of Texas LLCs.
In Ritchie v. Rupe, the Texas Supreme Court held that the corporate receivership statute TBOC §11.404 provided an extremely limited remedy (with no buy-out) and that no common law cause of action existed for shareholder oppression. The court did not, however, consider the application of TBOC § 11.314(3), which would constitute one of the existing remedies not touched by the Ritchie opinion. This dissolution statute, which does not apply to corporations but only to partnerships and LLCs, may provide a powerful remedy to deal with dissension and oppression in Texas LLCs.
Dealing With Oppression
Without utilizing the language of the shareholder oppression doctrine, courts have found that when controlling owners have defeated the reasonable expectations of the shareholders or have acted so badly that the business is no longer carried on in a reasonable way, it becomes “not reasonably practicable” to carry on a company’s business in conformity with its governing documents.
A court ought to find that, “it is not reasonably practicable to carry on the entity’s business in conformity with its governing documents” if controlling members systematically and continually defeat important expectations that are expressly or impliedly part of the company agreement. Courts in other jurisdictions have held that the refusal by controlling members and managers of LLCs to govern according to the terms of the company agreement may constitute a basis for dissolution. Such a claim was made under the Georgia LLC Act in Simmons Family Properties, LLLP v. Shelton. In that case, the LLC’s sole manager never called an annual meeting, refused requests by the other members to do so, and refused to attend special meetings called by the other members so as to prevent a quorum. In response to the members’ request for a judicial dissolution, the manager argued that “dissolution is not allowed where, as here, the company was carrying on its business functions in accordance with the operating agreement, but there was a technical violation of the agreement regarding meetings, and two of the members simply wanted to rewrite the agreement.” The trial court disagreed and granted the dissolution, and the Georgia Court of Appeals affirmed. The court held that failure to allow meetings was “‘more than a formality,’ as such meetings are the primary venue in the operating agreement for non-managing members to have their voices heard” and that such conduct “impeded the members’ ability to protect their investments by contributing to the direction of the company”; therefore, “the trial court did not err in finding that it was not reasonably practicable for [the LLC] to carry on business in conformity with the operating agreement, and did not err in granting the petition to dissolve the limited liability company.”
Courts have also found it not reasonably practicable to carry on the business of a company in conformity with its governing documents as a result of a wide range of oppressive conduct by controlling owners. In Ramos v. Perez, a dispute between LLC members was arbitrated, and the arbitrator found that an LLC member breached fiduciary duties to the LLC and to one of the other members by transferring company property to other entities. The arbitrator awarded no damages but ordered equitable relief of “zeroing out capital accounts and winding up of the company.” One of the parties attacked the award under § 10(a)(4) of the Federal Arbitration Act, claiming that the arbitrator had “exceeded [his] powers or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made,” on the grounds that the winding up order based on a finding of breach of fiduciary duties was not available under Texas law. The trial court granted the motion and vacated the award. The Corpus Christi Court of Appeals reversed and held that the law permitted equitable relief, including dissolution, to be awarded for breach of fiduciary duties, citing section 11.314. In Suntech Processing Sys., L.L.C. v. Sun Communications, Inc., one member of an LLC sued the controlling member claiming that the controlling member was breaching fiduciary duties by causing the company to transfer over $9 million for his benefit. The trial court granted a temporary injunction prohibiting the transfer but also ordered the liquidation of the LLC and appointed a receiver. The Dallas Court of Appeals did not question the basis of the order, and it expressly overruled the appellant’s argument that there was an adequate remedy at law, however, the court reversed the receiver and liquidation on the grounds that this was an ultimate relief and not available through a temporary injunction.
In Gagne v. Gagne, the Colorado Court of Appeals held that misconduct is “one factor that a court may consider in determining whether a business’s continued operation is reasonably practicable.” In In re Cat Island Club, the Louisiana Court of Appeals concluded that it was not reasonably practicable to carry on the business of an LLC where certain members believed another member was engaged in self-dealing, and the members had “clearly reached an inability to work toward any goals or reasons for continued association with each another.” In McGovern v. Gen. Holding, Inc., the Delaware Chancery Court dissolved a limited partnership, based on language nearly identical to section 11.314(3). The court found it was unlikely that the general partner and 90% owner, who committed a variety of fiduciary and contractual breaches, would “mend his ways and begin to act as a trustworthy general partner,” but it was also unlikely that the partnership would be viable under substitute management given the general partner’s large ownership stake and the importance of his knowledge and skills to the business. In In re Rueth Development Co., the Indiana Court of Appeals rejected a claim that the court had no jurisdiction to order a dissolution under a statute nearly identical to section 11.314(3), where the death of one of the parties had resolved the deadlock. The court held that breaches of fiduciary duties had been alleged as an alternative ground for dissolution and that the trial court retained jurisdiction over the dissolution claim because “a breach of fiduciary duty may also make it impracticable to carry on the business of the partnership.” In Connors v. Howe Elegant, LLC, a Connecticut court ordered the dissolution of an LLC under the reasonable practicability test where the two members were unable to come to terms about the business’s future or the terms of dissolution, and one member then locked the other out of the business’s premises, subsequently closed the business’s bank account, transferred those funds into an account that the other member could not access, and personally withdrew about $4,500 in operating cash.
Equity jurisprudence in Texas has long held that egregious misconduct by those in control of a company may be grounds for dissolution where there is no other way to protect minority interests. The Texas Supreme Court in Patton v. Nicholas held: “Our conclusion is that Texas courts, under their general equity powers, may, in the more extreme cases of the general type of the instant one [malicious suppression of dividends], decree liquidation.” That opinion noted the availability of dissolution under the court’s equitable powers “where control of an evidently solvent corporation by the dominant stockholder-officer operated to deny dividends to the principal minority stockholder over a period of years as well as to cloak considerable piracy of corporate assets by the former” and where it would likely be futile to try to protect the minority shareholder “against the probable future misconduct of an evidently wrong-minded person in control of a corporation.” The Ritchie v. Rupe opinion extensively considered the Patton decision. Ritchie did not overrule or limit Patton, but rather held:
Our recognition in Patton that the statutory action for receivership did not displace Texas courts’ historical power to grant receivership as an equitable remedy under a common-law cause of action does not support the court’s construction of former article 7.05 [§ 11.404] to provide a different statutory remedy, a buyout, without regard to any common-law cause of action.
Courts in other jurisdictions have been particularly willing to grant dissolution where the controlling member was acting oppressively by operating the business for his sole benefit. Haley v. Talcott found that, although the LLC was “technically functioning” and financially stable, meaning that it received rent checks and paid a mortgage, it should be dissolved because the company's activity was “purely a residual, inertial status quo that just happens to exclusively benefit one of the 50% members.” The South Dakota Supreme Court held: “Leaving two sisters, half the owners, with all the power in the operation of the company cannot be a reasonable and practicable operation of a business.”
Some courts have refused to consider breach of fiduciary duties and oppressive conduct as grounds for dissolution under the reasonable practicability standard. One Delaware court cautioned that dissolution will not be granted for claims of breaches of fiduciary duties when “more appropriate and proportional relief is available.” Additionally, a dissolution claim must not be used to skirt “policy-based rules governing such claims,” such as the demand requirement for derivative claims. However, that same court noted that there would be exceptions where the conduct was egregious and there was no indication that the wrong-doer would “mend his ways.”
The bottom line, according to the South Dakota Supreme Court, is: “As long as the company remains in control of, and favorable only to, half its members, it cannot be said to be reasonably practicable for it to continue in accord with its operating agreement.”
Even in the absence of outright refusal to comply with the company agreement, dissolution may also be available where dissension among the members is so severe that the company is dysfunctional. Texas courts construe contracts “from a utilitarian standpoint, bearing in mind the particular business activity sought to be served.” The business purpose to be served in most LLC company agreements is running of a business with the participation and for the benefit of all the members. Most company agreements and the provisions of the TBOC that are implied into those agreements contemplate meetings, votes, and input by members and managers. Dissension among the members, and particularly oppressive conduct by the controlling member that shuts out participation by certain members, may certainly render it not reasonably practicable to carry on the business of the LLC in conformity to its governing documents, when those documents are construed from a utilitarian standpoint.
In Dunnagan v. Watson, the Fort Worth Court of Appeals affirmed the dissolution of a limited partnership under the predecessor to Section 11.341 based on evidence that the “ends” partnership had been "frustrated not only by the failure of the limited partnership to obtain a racing license and operate a horse racing track, which was the ‘purpose’ of the limited partnership, but by the seemingly endless disagreements and discontent between Dunnagan and Watson. Accordingly, viewing the evidence favorable to the jury’s finding and disregarding the evidence and inferences contrary thereto, we hold that the evidence is legally sufficient to support the jury’s finding that the actions of Dunnagan rendered it not practicable for the limited partnership to continue."
In Kirksey v. Grohmann, four sisters each contributed their one-fourth interest in the family ranch and formed an LLC to hold title to the land and maintain the ranching operations. Subsequently, the family relationship went sour with the sisters deadlocked two against two at the member level, but with two of the sisters in management control of the company. The South Dakota Supreme Court held that “it is not reasonably practicable to carry on the LLC’s business in conformity with its articles of organization and operating agreement” because of the dissension among the members: "Here, we have two members of an LLC that hold all the power, with the other two having no power to influence the company’s direction. … The members cannot communicate regarding the LLC except through legal counsel. The company remains static, serving the interests of only half its owners. They neither trust nor cooperate with each other. The sisters formed their company contemplating equal ownership and management, yet only an impenetrable deadlock prevails."
In Taki v. Hami, the two parties “had not spoken to each other since 1995, except through their attorneys, and had filed three lawsuits against each other. Because of their inability to operate Showbiz together, and pursuant to the settlement of one of the lawsuits, Hami sold all of his interest in the corporation to Taki. Thereafter, Hami, on behalf of the partnership, attempted to evict Showbiz and Stallion from the partnership's premises without any notice or consultation with Taki and despite the fact that both tenants were paying the fair market rental value for the property. In addition, Taki was fearful of violence because Hami was carrying a firearm when he was planning on meeting with Taki.”
The Michigan Court of Appeals held that it was not reasonably practicable to carry on the business of the partnership because the dissension between the partners precluded their ability “to carry out the business of the partnership logically and in a reasonable, feasible manner.” In Gagne v. Gagne, the Colorado Court of Appeals upheld dissolution where “the summary judgment record is replete with evidence of extreme dysfunction between the parties. This evidence includes allegations of physical altercations; assertions that Paula fears Richard and his wife; and statements by Paula that her relationship with Richard and his family ‘ha[d] deteriorated to zero’ and that ‘[e]veryone in my life is unanimous that the partnerships need to end for both our sakes.’”
Where substantial dissension exists, courts reject the argument that it is reasonably practicable to carry on the business in conformity with its governing documents merely because one party is in control of management and technically can continue operations. In Dunnagan v. Watson, the Fort Worth Court of Appeals rejected the defendant’s argument that the limited partnership should not be dissolved because the plaintiffs had been voted out of management and the defendant had acquired majority ownership in the limited partnership and its corporate general partner, holding that such a result would render the “reasonably practicable” language of the statute “virtually useless.” In In re Cat Island Club, the Louisiana Court of Appeals disagreed with the defendants’ argument that “it is still ‘reasonably practicable’ to carry on the business of the LLC.” The court stated: “[N]umerous accusations have arisen surrounding the operation of the LLC and the ownership interest of the members. There also appear to be competing interests regarding the use of the land, the only asset of the company, and the reason for which the LLC was created. In alleging a fraudulent Operating Agreement, Pentecost and Gaspard clearly believe there is self-dealing on the part of Ty–Bar. Ty–Bar and Davis want dissolution and liquidation of the land while Pentecost and Gaspard do not. The members have clearly reached an inability to work toward any goals or reasons for continued association with each other.”
In Gagne v. Gagne, the Colorado Court of Appeals rejected the defendant’s argument that her 51% voting interest and position as CEO of the LLC made it reasonably practicable to carry on the business “in a reasonable, sensible, and feasible manner.” The court reasoned that “[w]ith respect to Paula's position as Chief Executive Manager and her fifty-one percent voting interest, . . . it is not clear to us that the LLC Agreements give her the unilateral right to control all management of the properties, regardless of Richard’s views and cooperation.”
In Haley v. Talcott, the “parties have not interacted since their falling out in October of 2003. Clearly, Talcott understands that the end of Haley’s managerial role from the Redfin Grill profoundly altered their relationship as co-members of the LLC. After all, it has left Haley on the outside, looking in, with no power.” The Delaware Chancery Court rejected the defendant’s position that “the LLC can and does continue to function for its intended purpose and in conformity with the agreement, receiving payments from the Redfin Grill and writing checks to meet its obligations under the mortgage on Talcott’s authority. But that reality does not mean that the LLC is operating in accordance with the LLC Agreement. Although the LLC is technically functioning at this point, this operation is purely a residual, inertial status quo that just happens to exclusively benefit one of the 50% members.”
The court held that it was not reasonably practicable to carry on the business of the LLC in conformity with its governing documents because of the “strident disagreement between the parties regarding the appropriate deployment of the asset of the LLC, and open hostility as evidenced by the related suit in this matter” and because of the clear “inability of the parties to function together.” The fact that the dissension among the parties has effectively placed one party in operational control does not prevent dissolution if the other party “never agreed to be a passive investor in the LLC who would be subject to [the controlling party’s] unilateral dominion.” In Navarro v. Perron, the court held that it was not reasonably practicable for a partnership to carry on in conformity to its governing documents under a California statute where “the relationship between the parties has so deteriorated that common ownership is no longer possible,” based on “extensive litigation, including mutual restraining orders.”
Similarly, contractual mechanisms that might resolve an impasse do not necessarily make it reasonably practicable to carry on the business in conformity with the governing documents. In Gagne v. Gagne, the defendant had the unilateral right to sell all the assets of the LLC and terminate its existence, but the Colorado Court of Appeals held that such a right would not prevent dissolution unless and until it was exercised. In Haley v. Talcott, the LLC agreement provided an exit mechanism allowing either party to leave voluntarily; however, the Delaware Chancery Court held that it was inequitable to force the plaintiff to exercise the contractual exit mechanism to avoid dissolution: “[F]orcing Haley to exercise the contractual exit mechanism would not permit the LLC to proceed in a practicable way that accords with the LLC Agreement, but would instead permit Talcott to penalize Haley without express contractual authorization.” The inequity was particularly egregious in that case because a voluntary exit would not relieve the plaintiff of his personal guaranty on the mortgage on the LLC’s assets.
This post is taken from a recent law review article published by HCWD, PLLC in the Houston Business and Tax Law Journal. Download a copy of the complete article with full analysis of the issues and case citations: