Preparing for war in your LLC operating agreement

A possible solution: mediation and arbitration provisions

Of all the issues New Hampshire businesspeople should address when forming LLCs, the most important – but also the most neglected – is the issue of what to do when one or more members come to believe that one or more other members are breaching their LLC duties.

A very common situation of this kind is when LLC minority members claim they’re being “oppressed” (the technical term for “treated unfairly”) by the majority.

The New Hampshire Revised Limited Liability Company Act, which went into full effect in January, does a much better job at providing for oppression claims than the old act, but it doesn’t provide a magic bullet.

The old act provided that the minority would have to make its oppression claim in a “derivative action” against the majority — i.e., in a lawsuit not in the minority’s own name but in the name of the LLC itself. The rules governing derivative actions are complex, they are expensive to comply with, and they’ve never made the slightest sense for small, informal LLCs — namely, for 95 percent of all New Hampshire LLCs.

The revised act didn’t eliminate the right of the minority to bring derivative actions, since, among other considerations, if these actions succeed, the minority will be entitled to reimbursement of their attorneys’ fees — a result otherwise difficult to achieve in New Hampshire courts. However, the revised act also permits minorities to bring “direct actions” — i.e., lawsuits in their own name. In direct actions, successful plaintiffs won’t normally get reimbursement of their attorneys’ fees, but they may get other forms of relief — e.g., generous money damages — that would make their lawsuits worthwhile.

However, direct actions, like derivative actions, have a problem that, for many LLC plaintiffs, can be very serious — namely, that they have to be brought in court.

It happens that in New Hampshire, we have a first-rate business court — technically, the “Business Docket” of the New Hampshire Superior Court. This court is fair, smart, fast and reasonably affordable. However, by definition, lawsuits in the Superior Court are public. So they often involve a painful airing of an LLC’s dirty laundry.

Advantages, disadvantages

In their operating agreements, how should New Hampshire businesspeople address the possibility of eventual claims between minority and majority members of their LLCs?

The revised act provides the members with four main options for drafting these provisions. Each of these options has major advantages and major disadvantages.

I’ve already discussed the main advantages and disadvantages of the first two options — namely, provisions for derivative and for direct actions. The third and fourth options — namely, provisions for mediation and arbitration — aren’t expressly addressed in the revised act, but they are unquestionably permitted by it.

In mediation provisions, the members agree that if they have claims against one another, they must hire a mediator to resolve them. Skilled mediators can work miracles. But mediators can only mediate LLC disputes; they can’t decide them. And often, disputes among LLC members are so serious and so bitter that even the most skilled mediators can’t find solutions for them. So mediation provisions in LLC operating agreements, valuable as they may be, should always be accompanied either by provisions for derivative or direct actions, as discussed above, or by arbitration provisions.

Arbitration provisions in operating agreements usually provide that if members make claims against other members that they can’t resolve among themselves and that mediators can’t resolve, these claims will be finally resolved, without any access to court appeal, by a single arbitrator.

In effect, this arbitrator will be a paid private judge for the members. The operating agreement should provide comprehensive rules governing arbitration among the members — for example, rules as to the degree of discretion of the arbitrator in deciding what evidence to admit and what to address in writing arbitration orders.

If these arbitration rules are well drafted, arbitration can often be faster and cheaper than any possible litigation. Furthermore, as in Las Vegas, what happens in arbitration stays in arbitration. Arbitration, like litigation in court, can get very ugly. But at least it will be confidential.

Attorney John Cunningham, of counsel to the Manchester-based law firm of McLane, Graf, Raulerson & Middleton, is author of “John Cunningham on New Hampshire’s New LLC Act,” available at johncunninghamonnhllcs.com/blog and llcsforaccountants.com.