The risk of member deadlock
There are three main ways two-member LLCs can prevent one
There are about 10,000 two-member LLCs in good standing under New Hampshire law. Many of them are small businesses, such as husband-wife LLCs, with capital of only a few thousand dollars. But some conduct large multi-state and even international businesses worth tens of millions of dollars.
However, because of the very fact that they have only two members, all of these LLCs, both large and small, face a serious risk: Sooner or later, their members will be unable to agree about serious LLC matters. And since New Hampshire’s LLC Act was enacted in 1993, these member deadlocks have seriously damaged or even destroyed hundreds and perhaps thousands of New Hampshire LLCs.
Appropriately, Section 134 of the LLC Act deals in considerable detail with the risk of LLC deadlocks in a provision entitled “Judicial Dissolution Upon Application by a Member.”
In essence, Section 134 as applicable to two-member LLCs, provides that if there is a deadlock between the members, either member can petition a New Hampshire court to dissolve the LLC if he or she can prove either that the deadlock is preventing the LLC from carrying on its business profitably or that it is causing or threatening to cause the LLC irreparable damage.
When an LLC is dissolved under Section 134, this doesn’t mean that it is automatically terminated. What it does mean is that the LLC must cease its ordinary business, sell its assets, pay its creditors and pay whatever remains to its members.
Reading Section 134, you might think it provides a very simple and effective solution to deadlocks between the members of two-member LLCs. But you’d be wrong. Among other problems:
• Because of the negative impact of LLC dissolutions on their employees, creditors and customers, the courts are often very reluctant to order them.
• As a result, it can be extraordinarily difficult for petitioning members to persuade the courts that no reasonable restructuring of their LLC can preserve it as a viable business.
• Even if a petitioning member does make the above proof, Section 134 gives the courts very broad discretion in remedying deadlocks. This can include, for example, transferring key assets of the LLC not to the petitioning member but to the other member.
Furthermore, even if the petitioning member obtains a dissolution of the LLC on favorable terms, the suit in which he or she does so is likely to be lengthy, complicated, extremely expensive and, even for the petitioner, emotionally devastating.
Thus, before you form your LLC, you need to take every reasonable step to prevent a deadlock. There are three main ways you can do so:
• Make sure you know the character of your potential co-member as deeply as possible. Even lifelong friends can become bitter enemies when they try to run a business together. If you have even a modest suspicion that eventually your potential co-member may someday become hard to work with, proceed with extreme caution in forming your LLC.
• Work closely with your co-member and with any lawyer involved in forming your LLC to identify every possible legal, tax, business and personal issue that might eventually create controversy between the two of you, and resolve each such issue in a manner acceptable to both of you in a written operating agreement. One of the best things lawyers can do for their LLC formation clients is to persuade them, if the facts warrant, that because of the risk of eventual deadlock, they shouldn’t form their LLC.
• Include in your operating agreement every type of provision that may be useful to members if, despite their best efforts, a deadlock between them proves unavoidable. These may include dispute resolution provisions providing for mediation, arbitration or litigation. They may also include “Texas shootout” provisions under which either member may propose to buy out the other on specified terms and the other member must either accept those terms or apply them in buying out the offering member.
Obviously, if you are a member of an existing two-member LLC, it’s a little late to make sure you pick the right co-member. But you still have time to make sure that your operating agreement identifies the issues that arise between you, resolves them in a way that makes sense to both of you, and contains appropriate deadlock provisions.
John Cunningham, principal of the Law Offices of John M. Cunningham and of counsel to McLane Middleton, can be reached at 603-856-7172 or firstname.lastname@example.org.