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Fryar Law Firm Knows Shareholder Oppression-Knowledge Makes the Difference

Remedy for LLC Oppression

Texas law provides a unique remedy for member oppression in a limited liability company.

LLC Oppression Remedies

Oppression in Texas LLCs

Legal Development Post-Ritchie

The Supreme Court stated that numerous statutory and contractual protections and other common-law remedies currently exist to protect against oppressive conduct.  The Court also stated that “we do not foreclose the possibility that a proper case might justify our recognition of a new common-law cause of action to address a ‘gap’ in protection for minority shareholders.”  The Court made clear that “we have not abolished or even limited the remedies available under the common law or other statutes for the kinds of conduct that give rise to rehabilitative receivership actions, whether under the oppressive-actions prong or other prongs. . . . [T]he actions that give rise to oppressive-action receivership claims typically also give rise to common-law claims as well, opening the door to a wide arr,ay of legal and equitable remedies not available under the receivership statute alone. Those remedies, whether lesser or greater, are not displaced by the rehabilitative receivership statute, which merely adds another potential remedy available in extraordinary circumstances when lesser remedies are inadequate.” 

One of these statutory protections that remains neither “abolished or even limited” by the Ritchie decision is Section 11.314 of the Texas Business Organizations Code, which is a dissolution statute applicable only to partnerships and LLCs. This statute—particularly as that statute was expanded with respect to LLCs in 2017—may serve as a powerful remedy to combat oppressive conduct against minority owners in an LLC.

Resisting Member Oppression Under Section 11.314

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 ower 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.” The provision was significantly amended in 2017 to make the first two tests applicable to LLCs. Prior to 2017, only the reasonable practicability test applied to LLCs.

Professors Miller and Ragazzo have noted that opinions from other jurisdictions interpreting essentially the same language have held that judicially decreed dissolution is available in a variety of circumstances, including when the company is unable to carry on its business at a profit, when there is dissension or deadlock among the owners or managers, or when the controlling member has engaged in serious misconduct.  Professors O’Neal and Thompson commented that, as LLC law has moved toward more entity permanence, statutes providing for judicial dissolution have taken on a greater role in regulating LLCs.

No Texas cases have applied Section 11.314 to an LLC, and only a small number of cases apply 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 situations of dissension among the owners and to squeeze-out and freeze-out fact patterns. Section 11.314 should provide meaningful relief, and the possibility of a compulsory buy-out, to oppressed members of Texas limited liability companies.

Reasonable Practicability Test

The reasonable practicability test stated in Section 11.314(3) is whether “it is not reasonably practicable to carry on the entity’s business in conformity with its governing documents.” Prior to 2017, this was the only test that applied to LLCs. While Texas case law is sparce, almost every other jurisdiction either permits or requires winding up of LLCs when it is not reasonably practicable to carry on an LLC’s business in conformity with its governing documents.

Texas courts interpreting the “reasonably practicable” language in the limited partnership context have held that the provision “is unambiguous, and the legislature’s intent is clear; we therefore apply its plain and ordinary meaning.”  The Colorado court of appeals interpreting identical language in the Colorado LLC statute  held: “Based on these common definitions, we conclude that to show that it is not reasonably practicable to carry on the business of a limited liability company, a party seeking a judicial dissolution must establish that the managers and members of the company are unable to pursue the purposes for which the company was formed in a reasonable, sensible, and feasible manner.”  “Not reasonably practicable” to carry on the business does not mean “impossible.”  “Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue.”

Courts have considered a number of factors in determining reasonable practicability: “These include, but are not limited to, (1) whether the management of the entity is unable or unwilling reasonably to permit or promote the purposes for which the company was formed; (2) whether a member or manager has engaged in misconduct; (3) whether the members have clearly reached an inability to work with one another to pursue the company’s goals; (4) whether there is deadlock between the members; (5) whether the operating agreement provides a means of navigating around any such deadlock; (6) whether, due to the company’s financial position, there is still a business to operate; and (7) whether continuing the company is financially feasible.”  “No one of these factors is necessarily dispositive. Nor must a court find that all of these factors have been established in order to conclude that it is no longer reasonably practicable for a business to continue operating.”

“Not Reasonably Praticable to Carry on Business”

The reasonable practicability test has two operative concepts. The first is the practicability of carrying on the business, and the second is the practibility of doing so in comformity with the governing documents. If an LLC is simply not able to carry on the business for which it was created, then it obviously cannot satisfy the reasonable practicability test. There are a number of reasons that business have been dissolved due to the inability to carry on their business at all.

Failure of Stated Purpose

Limited liability companies fail the reasonable practicability test if they were formed for a specific purpose and are then unable to pursue that purpose for some reason. Examples include a company formed for the purpose of operating TGI Fridays restaurants at DFW airport that loses its lease at the airport,  a company formed to operate a horse racing track that fails to obtain a racing license,  and a company formed to operate a professional hockey team that fails to obtain the franchise.  When a company “cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created,” dissolution has been allowed.  “While no definitive, widely accepted test or standard exists for determining ‘reasonable practicability,’ it is clear that when a limited liability company is not meeting the economic purpose for which it was established, dissolution is appropriate. In making this determination, we must first look to the company’s operating agreement to determine the purpose for which the company was formed.”  “In determining whether an LLC should be dissolved because it is no longer reasonably practicable to carry on the business of the LLC, this court must look to the operating agreement of the LLC to determine the purpose for which it was formed, and not to an initial business plan that any rational businessperson would expect to evolve over time.”  However, this analysis is of limited utility for most companies in Texas because LLCs formed in Texas may state that they are formed “for any lawful purpose.”

Financial Failure

A more obvious example of a business that is not reasonably practicable to carry on is one that is failing financially. Courts have ordered dissolution under the “reasonable practicability” standard when the LLC “is financially unfeasible.”  “Dissolution generally has been deemed appropriate … when the company is failing financially.”  A business that is not financially viable will fail to achieve the purposes stated in its governing documents—no whatever they are.

Deadlock

Another reason that it would be not reasonably practicable to carry on the business at all would be when the company’s decision-making capacity is deadlocked.  “[A] deadlocked management board is a quintessential example of a situation justifying a judicial dissolution.”  Under Texas law, a deadlock can occur in an LLC any time there are an equal number of managers (or members in a member-managed company) and the company agreement does not provide for weighted voting or some tie-breaking mechanism. Unless otherwise provided in the Company Agreement, “[e]ach governing person, member, or committee member of a limited liability company has an equal vote at a meeting of the governing authority, members, or committee of the company, as appropriate.”  “[I]f that deadlock cannot be remedied through a legal mechanism set forth within the four corners of the operating agreement, dissolution becomes the only remedy available as a matter of law.”

Where the parties are able to resolve the deadlock by, for example, lawfully expelling a member or purchasing his interest, dissolution will be denied.  However, courts do not consider a deadlock to be resolved where one party has control as a practical matter and cannot be ousted because of the deadlock. As the Delawary Chancery Court has stated, “this court has rejected the notion that one co-equal fiduciary may ignore the entity’s governing agreement and declare himself the sole ‘decider.’”

“In Conformity with the Governing Documents”

Section 11.314(3) qualifies the concept of “not reasonably practicable to carry on the entity’s business” with the phrase “in conformity with its governing documents.” Limited liability companies that cannot function at all because they are financially defunct, because they are unable to pursue the specific purpose for which they were formed, or because the company cannot function due to its management being hopelessly deadlocked, are easy cases. Some courts have effectively limited dissolution of LLCs under statutes similar to Section 11.314 to those specific instances.  However, the plain language of Section 11.314 demands a broader reading. The South Dakota Supreme Court noted: “There is no dispute that the ranching and livestock operation, as a business, can continue despite the sisters’ dissension. However, the question is whether it is reasonably practicable for the company to continue in accordance with the operating agreement.”

A reading of the statute that limited it application to the question of whether the company was able to carry on its business at all would render the phrase “in conformity with its governing documents” superfluous. If the review of the governing documents was limited to the stated purpose of the entity (which will almost always be “any lawful purpose”),  then only the certificate of formation should be referenced, not the “governing documents.” The company agreement frequently does not address the company’s purpose; the function of the company agreement is to govern the relations among the members, manager, and the company and other internal affairs of the company.  One can certainly envision situations in which the LLC is otherwise perfectly capable of carrying on its business to achieve “any lawful purpose” but fails to do so in a manner that complies with the terms that its governing documents set forth to govern the relations of the members and the internal affairs of the company. Section 11.314 grants the court jurisdiction to order winding up in those situations. One Texas court has rejected a narrow reading of the language,  and as noted below, most courts in other jurisdictions do as well.

Dealing With Oppression

The reasonable practicability test has been used to deal with oppressive conduct. The definitions of oppressive conduct, as developed in Texas contemplated two situations: One in which the owner’s “reasonable expectations” were substantially defeated, and the other in which the conduct of the majority owner was “burdensome, harsh and wrongful” and departed from the standards of fair dealing on which every business owner relies.  The definitions are overlapping in that some level of fair dealing is obviously a reasonable expectation of the minority owner. Courts further developed the notion of reasonable expectations to include “specific” expectations, which were basically things that were agreed to expressly or impliedly, such as an agreement to participate in management or for continued employment, or “general” expectations that every owner has based on the nature of ownership, such as sharing proportionately in the profits of the entity.

While not using the language of the shareholder oppression doctrine, courts have found it not reasonably practicable to carry on an company’s business in conformity with its governing documents when controlling owners have defeated reasonable expectations contained in those documents or have acted so badly that the business is no longer carried on in a reasonable way.

Reasonable Expectations Expressed or Implied in Governing Documents

Courts applying language similar to Section 11.314(3) hold that the “reasonably practicable” analysis must begin with the company agreement, that the dissolution issue “is initially a contract-based analysis.”  As noted above, the “governing documents” of an LLC consist of its certificate of formation and company agreement. In order to determine whether an LLC is carrying on its business in conformity with its company agreement, we must first determine what are the terms of the company agreement.

The definition of “company agreement” in the Code is quite expansive: “‘Company agreement’ means any agreement, written or oral, of the members concerning the affairs or the conduct of the business of a limited liability company.”  There may be more than one company agreement. An LLC might have one document entitled “company agreement,” but other written or oral agreements among the members that address “the relations among members, managers, and officers of the company, assignees of membership interests in the company, and the company itself; and other internal affairs of the company” would also fit within the definition and constitute part of the “company agreement.”  In Boehringer, the appellate court based its holding of shareholder oppression on the defendant’s failure to comply with the oral agreement between the two owners at their first organizational meeting that their salaries would the same. In shareholder oppression language, that agreement was a specific reasonable expectation.  Under Section 11.314(3), it would be part of the company agreement, and the defendant’s failure to comply would be carrying on the entity’s business not in comformity with its governing documents.

Terms of the company agreement may also be implied-in-fact from the parties’ acts, conduct, and course of dealing.  For example, two persons may form an LLC with the unstated but mutual intent to receive their proportionate shares in all profits of the company. If both work in the company without salary but are compensated over the years by the consistent practice of distributing available cash, then a jury might very well find that the unstated agreement to distribute available cash to the owners is an implied-in-fact agreement, based on the circumstances, the parties’ conduct, and the course of dealing.  Such an implied-in-fact agreement, governing the internal affairs of the company, would be part of the company agreement. Professor Moll has written that specific expectations are often implied-in-fact contracts and may be enforced as such, independent of the shareholder oppression doctrine.  Under the shareholder oppression doctrine, the sudden refusal of the majority member to distribute available cash after a falling out between the members might constitute oppressive conduct, as it did under similar facts in Kohannim v. Katoli.  Under Section 11.314, it would constitute carrying on the business not in conformity with the governing documents.

Even in the absence of an express or implied agreement, the law often implies a contract term where it is “so clearly within the contemplation of the parties that they deemed it unnecessary to express it.”  Terms may be implied “where necessary to give effect to the actual intent of the parties” or “when deemed fundamental to the purpose of the contract.”  Courts “[i]mply certain duties and obligations in order to effect the purposes of the parties in the contracts made.”  For example, every contract has an implied duty to cooperate in its performance,  and “[a]ccompanying every contract is a common-law duty to perform with care, skill, reasonable expedience and faithfulness the thing agreed to be done.”  Such terms and duties that are implied by law would also constitute a part of the company agreement.

Texas shareholder oppression doctrine had a richly developed jurisprudence dealing with so-called “general expectations,” which are those expections that every business owner is presumed to possess merely by virtue of being an owner —such as the expectation to know what is going on in one’s business, the expectation to vote, and the expectation to share proportionately in the earnings of the company.  LLC are necessarily creatures based on contract. The parties entering into those contracts necessarily have certain, often unstated, assumptions. A person who invests his capital and labor into an entity expects to participate in the return. One who agrees to own 40% of a business necessarily expects that he will have 40% of the vote and 40% of the profits. One who enters into a company agreement that specifies what his vote is and how he exercises it, necessarily assumes that he will be given the opportunity to vote. These assumptions are universal and flow logically and necessarily from the nature of ownership in a company. They also necessarily imply a duty on all the other owners not to interfere with these expectations. The Boehringer court held that the cutting off dividends coupled with increased compensation to the majority owner in the nature of an informal dividend defeated the plaintiff’s general reasonable expectation of proportionate sharing in profits. In a case brought under Section 11.314(3), the court might hold that the defendant’s conduct failed to comply with implied terms of the company agreement and was thus the carrying on of the entity’s business not in comformity with its governing documents.

Finally, duties imposed on managers and managing members by the law are also implied terms of the company agreement. Texas law has long held that business organizations statutes are applied contractually to companies and owners—that is, the Code is part of the company agreement.  By its terms the LLC chapter of the Business Organizations Code provides that the Code “governs the internal affairs of the company” whenever not inconsistent with the company agreement.  Courts have applied the reasonable practicability test to companies without a formal company agreement based on whether it was reasonably practicable to carry on the entity’s business in conformity with the LLC statute.

Common law duties, such as the fiduciary duties of managers and members exercising management over an LLC,  would be implied into the terms of the company agreement. The general rule is that the law existing at the time a contract is signed is an implied term of that contract.  One Texas court has held that claims against LLC managers for breach of fiduciary duties are disputes “arising out of or relating to” the company agreement, and thus would be subject to an arbitration clause in that agreement.

Oppressive Conduct

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 of 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 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 a limited liability company 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 one 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),  because 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 Dev. 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 and 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 limited liability company 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.”  And 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: “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.”

Dissension

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 Code 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 11.314 based on evidence that “shows how the ends of the limited partnership have 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 ¼ 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 managment 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 the 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, L.L.C., the Louisiana Court of Appeals disagreed with the defendants’ argument that “it is still ‘reasonably practicable’ to carry on the business of the LLC” because numerous “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. With 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, 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 inequitable to force the plaintiff to exercise the contractual exit mechanism to avoid dissolution: “forcing 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.

Economic Purpose Test

Beginning in 2017, Texas LLCs also became subject to the test that “the economic purpose of the entity is likely to be unreasonably frustrated.”  As noted above, courts already find that “it is not reasonably practicable to carry on the entity’s business in conformity with its governing documents” when an entity is failing financially.  An economic purpose of every for-profit entity is to make money. “Dissolution generally has been deemed appropriate when a company’s economic purpose is not being met, or when the company is failing financially.”

The extension of the economic purpose test to LLCs must have been meant to address circumstances beyond those to which the reasonably practical test had been applied. The language provides some important clues. First, rather the use of the phrase “unreasonably frustrated” rather than the “not reasonably practicable to carry on” used in the other two tests must be significant. An economic purpose might “frustrated” even in situations where it is otherwise reasonably practicable to carry on the business. Second, the subject of the test—economic purpose—is not tied to the operating agreement. It does not seem a stretch to argue that the economic purpose of every venture is to make money for the benefit of its owners. This economic purpose might be “unreasonably frustrated” in an otherwise profitable entity where the finances are manipulated by the majority owner to the detriment of the minority owner. Third, the economic purpose test uses the term “likely,” meaning that the circumstances that might trigger the court’s jurisdiction include future or threatened events.

Agreed Purpose Frustrated

One recent Texas decision applies the economic purpose test in a partnership dissolution action. In CBIF Ltd. P’ship v. TGI Fridays Inc.,  the Dallas Court of Appeals affirmed the judicial winding up of a joint venture established to operate TGI Friday’s restaurants and café bars at DFW International Airport. The jury found that the court’s winding up jurisdiction was triggered by all three tests: “After a lengthy trial, the jury made the following findings: … The economic purpose of TGIFJV had been unreasonably frustrated and likely would be frustrated in the future; CBIF engaged in conduct that made it not reasonably practicable to carry on the business of TGIFJV in partnership with CBIF; and it was not reasonably practicable for the joint venture to carry on its business in conformity with its governing documents.”  But the court of appeals addressed only the economic purpose test. The principal argument on appeal was that the economic purpose of the venture was never frustrated because “the venture has made profits of over $70 million from 1995 through 2013.”  The court examined the joint venture agreement, which stated that the purpose was “to construct, outfit and operate for profit” Friday’s restaurants and café bars at the airport, and that the joint venture had entered into a lease agreement with the airport to accomplish that purpose.  The evidence established that the joint venture had lost the lease in one terminal and was likely to lose the remaining spaces. Without the lease, the joint venture’s agreed economic purpose “to construct, outfit and operate for profit,” the court held, “has been unreasonably frustrated and will likely be unreasonably frustrated in the future.”

Reasonable Expectations as Economic Purpose

As discussed above, reasonable expectations, both general and specific, may be part of the company agreement, but they may also constitute economic purposes of the company. In every case, in order to apply the economic purpose test, the finder of fact must determine the economic purpose or purposes of the LLC. The logical question to ask would seem to be: Why did the owners create and operate this company. In almost every case, one of the answers will be “to make money and share it in proportion to ownership.” Shareholder oppression jurisprudence recognizes that the “right to proportionate participation in the earnings of the company” is a general expectation, “arise from the mere status of being a shareholder” and “belong to all shareholders.”  Substitute the words “economic purpose” for “general reasonable expectation” and “LLC member” for “shareholder,” and the proposition will still always be true. Therefore, a member of an LLC who is systematically cut off from participation in the earnings of the company ought to be able to invoke the economic purpose test.

Some courts have expanded the economic purpose test to situations that are quite similar to classic shareholder oppression scenarios. One interesting opinion by the Virginia Supreme Court analyzed the economic purpose test in a partnership context. The Virginia partnership dissolution statute contains an economic purpose test identical to that in the Texas statute.  In Russell Realty Associates v. Russell the trial court ordered the dissolution of a partnership based on two alternative grounds, one of which was the economic purpose test.  The appellant argued to the Virginia Supreme Court that the economic purpose test was limited to companies that were failing financially and that the partnership in question was profitable. The court rejected that argument: “Neither the language of Code § 50–73.117(5) nor the RUPA comment relevant to that section requires that a partnership be a financial failure to sustain a judicial dissolution under the economic purpose prong.”  The court defined the economic purpose of the partnership based on the “partners’ expectations” of economic success through a business that operated “in an efficient and productive manner to maximize return to the partnership.”  The court held that the evidence established that the relations of the partners was characterized by distrust, dissension, and disagreement that had frustrated efforts to take advantage of business opportunities in the past, resulted in the incurring of additional costs in employing lawyers to facilitate communication, and interfered with the conducting of business in a timely and efficient manner.  “The relationship also imposed significant additional costs in terms of the time spent resolving issues directly and indirectly affecting the purposes of the Partnership. The relationship between the partners has deteriorated over the years and nothing in the record suggests that it will improve. For these reasons, we conclude that the record supports the circuit court’s holding that the economic purpose of the Partnership is likely to be unreasonably frustrated.”

In Wood v. Apodaca, the court found that a partnership’s economic purpose was unreasonably frustrated because certain partners “fail[ed] to fulfill their side of the bargain” by refusing to invest a promised sum of $250,000.  In Kirksey v. Grohmann, described in the preceding section, the South Dakota Supreme Court held the economic purpose test was a alternative ground for affirming the dissolution order. The court held that the economic purpose of the LLC was unreasonably frustrated where four “sisters formed their company contemplating equal ownership and management,” but now “two members of an LLC [] hold all the power, with the other two having no power to influence the company’s direction” and “company remains static, serving the interests of only half its owners.”

Owner Conduct Test

Finally, Texas LLCs may be subject to winding up if an “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.”  This “owner conduct test” occurs on “application by an ower of the partnership or limited liability company” complaining about the conduct of another owner to the effect that it is not reasonably practicable to for the two owners to continue in business together. This is a very different inquiry than under the other two tests, which focus on the company. The owner conduct test focuses on the actions of a particular owner and necessarily includes the specific treatment of other owners. O’Neal and Thompson posit that the owner conduct test “suggests a focus on the majority’s conduct toward a minority member.”  No Texas cases have been decided under the owner conduct test, but Texas shareholder oppression jurisprudence discussing the type of conduct that would justify the buy-out of a minority shareholder certainly seems to fit: “burdensome, harsh, or wrongful conduct; a lack of probity and fair dealing in the company’s affairs to the prejudice of some members; or a visible departure from the standards of fair dealing and a violation of fair play on which each [business owner] is entitled to rely.”  In fact, the definition of oppressive conduct may well be more narrow than the universe of conduct that would satisfy the owner conduct test.

Five other states have LLC dissolution statutes containing the three tests in essentially identical language to the Texas statute.  The official commentaries to the Montana and South Carolina statutes state that the owner conduct test is satisfied by “serious and protracted misconduct by one or more members.”  In Gordon v. Kuzara, a case decided under the Montana statute, the court held that the following conduct would be sufficient to satisfy the owner conduct test: depositing multiple checks into the LLC account, only then to write checks in the identical amounts to the defendant’s family corporation; writing a check without authority for $2,000 on the LLC account to his family corporation, causing an overdraft; and charging the LLC for his own time without authority.  The court held that dissolution of the LLC was warranted because “[t]he reasonable conclusion was that [the defendant], as a member of the LLC, was being disproportionately enriched … all to the detriment of the cattle business of the LLC and to the detriment of the [other members], who held a 50% interest in the enterprise.”

While there is little case law interpreting the owner conduct test in the LLC context, a number of states have the same test in their statutes dealing with the remedies of dissolution or dissociation in partnerships.  In Giles v. Giles Land Co., L.P,  the court held that the ownership conduct test was satisfied when one member of a family partnership harbored animosity toward the other partners, refused to communicate with them, and threatened them.  “Although Kelly contended that some of these statements were wholly unrelated to the partnership in question, the trial court determined that Kelly's version of the events lacked credibility. Thus, the appropriate remedy under these circumstances is the dissociation of Kelly under K.S.A. 56a–601(e)(3) [the owner conduct test].”  Courts have also ordered dissolution of partnerships under the owner conduct test based on a “history of the bad blood,”  the failure of a partner to pay rent on property leased from the partnership,  harassing other partners, refusing to correspond regarding partnership business, and refusing to participate in necessary meetings and voting procedures such that the majority of the partners were deprived of any benefit from the partnership.

In Brennan v. Brennan Associates,  the partner in control of the business “engaged in conduct to maintain such control to the exclusion of everyone else,” engaged in a “pattern of adversarial conduct with [the other partners] that had caused them to mistrust him, including besmirching [one partner’s] reputation with a false accusation of fraud.” The court held that such conduct justified expulsion of the controlling partner under a Connecticut statute permitting expulsion if “the partner engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with the partner....”  In Fernandez v. Yates,  the court dissolved a partnership under the owner conduct test where the controlling partner failed to prepare financial statement required by the partnership agreement, refused to meet with the other partners, and paid out $70,000 in partnership funds for his own legal fees with out the approval of the other partners.

Remedy

Unlike other states in which dissolution is mandatory and the only remedy,  the Texas statute is unique. Section 11.314 provides that, if the court determines that the one of the three tests is satisfied, then the district court “has jurisdiction to order the winding up and termination of the domestic partnership or limited liability company.”  A court with jurisdiction over an LLC presumably retains the discretion to order winding up and termination or not to do so. In fact, Section 11.054 makes clear that a district court with jurisdiction to order the winding up of an LLC, in fact, has extremely broad powers to act:

Subject to the other provisions of this code, on application of a domestic entity or an owner or member of a domestic entity, a court may:

(1) supervise the winding up of the domestic entity;

(2) appoint a person to carry out the winding up of the domestic entity; and

(3) make any other order, direction, or inquiry that the circumstances may require.

Winding Up

The remedy mentioned in section 11.314 is an order requiring “the winding up and termination” of the limited liability company. The court obviously may opt to do so. The Code provides the court with broad powers in a judicially-ordered winding up. Section 11.054(1) provides that the court may directly supervise the winding up. Presumably such court supervision would include orders requiring an accounting, sale of assets, payment of creditors, and distribution to owners. Alternatively, Section 11.054(2) permits the court to “appoint a person to carry out the winding up.”  The case law makes clear that the “person” described in this section is not a receiver.  Therefore, none of the provisions governing receiverships  applies.

Section 11.052 provides that the LLC in winding up must “cease to carry on its business, exept to the extent necessary to wind up its business.”  The LLC is required to send notice of its winding up to each “known claimant.”  The LLC must collect and sell its property to the extent the property is not to be distributed in kind,  and “perform any other act required to wind up its business and affairs.”  However, the court has broad authority to customize the winding up process.

Lesser Remedies

Given that the court has discretion as to the winding up and termination order under section 11.314, the court should certainly have the equitable power to fashion a different remedy.  Unlike receiverships, which the Texas Supreme Court has now held are exclusively statutory proceedings,  dissolution proceedings are equitable in nature.  Moreover, Section 11.054(3) empowers the court to “make any other order, direction, or inquiry that the circumstances may require.”

Professors Miller and Ragazzo have suggested that in a situation “in which a judicial decree requiring winding up is available, it may be preferable to pursue a less extreme remedy.”  Texas courts exercising their equitable powers undoubtedly have the authority to fashion appropriate remedies.  The Texas Supreme Court in Patton v. Nicholas held: “Wisdom would seem to counsel tailoring the remedy to fit the particular case. … [E]quity may, by a combination of lesser remedies, including exercise of its practice of retaining jurisdiction for supervisory purposes and reserving the more severe measures as a final weapon against recalcitrance, accomplish much toward avoiding recurrent mismanagement or oppression on the part of a dominant and perverse majority stockholder or stockholder group.” 

Buyout

In Davis v. Sheerin, the First Court of Appeals held: “[B]ased on the Patton holding that courts could order liquidation under their general equity powers in the absence of statutory authority, we hold that a court could order less harsh remedies under those same equity powers.”  In that case, the court held that Texas courts “may decree a ‘buy-out’ in an appropriate case where less harsh remedies are inadequate to protect the rights of the parties.”  One New York court noted that the “Limited Liability Company Law does not expressly authorize a buyout in a dissolution proceeding,” but held nevertheless that, “in certain circumstances, a buyout may be an appropriate equitable remedy upon the dissolution of an LLC.”

While the Texas Supreme Court in Ritchie held that the buy-out remedy was not available under the Section 11.404 and that there was no stand-alone common law buy-out remedy for shareholder oppression, the Court did not hold that a buy-out order was not available as an equitable remedy for other causes of action. Nothing in the Ritchie opinion questions the equitable power to order a buy-out as stated in Davis. On the contrary, the Ritchie Court expressly suggested that the remedy might be available for breach of an informal fiduciary duty between shareholders arising from a relationship of trust and confidence,  and did not foreclose a buy-out order as part of a receiver’s rehabilitation of a corporation.

Trial

Whether the economic purpose of an LLC is likely to be unreasonably frustrated, or whether one member has engaged in conduct that makes it not reasonably practicable to remain in business with that member, or whether it is not reasonably practicable to carry on the LLC’s business in conformity with its governing documents are fact issues that must be submitted to the jury. “When contested fact issues must be resolved before a court can determine the expediency, necessity, or propriety of equitable relief, a party is entitled to have a jury resolve the disputed fact issues. Dissolution proceedings are equitable in nature and contested facts concerning a basis for dissolution are for the jury.”  In cases tried under section 11.314 and its predecessors, the jury has simply been charged to answer whether each test was met. In CBIF Ltd. v. TGI Friday’s Inc., “the jury made the following findings: … The economic purpose of TGIFJV had been unreasonably frustrated and likely would be frustrated in the future; CBIF engaged in conduct that made it not reasonably practicable to carry on the business of TGIFJV in partnership with CBIF; and it was not reasonably practicable for the joint venture to carry on its business in conformity with its governing documents.” 

It is interesting to contemplate how a jury trial of a shareholder oppression fact pattern might play out using these jury questions. The court might instruct the jury as to what are the economic purposes of the LLC or what are the terms of the company agreement. Or those matters might be left to the jury to determine. What type of conduct would the jury be instructed would render it not reasonably practicable to continue doing business with a particular partner? Courts might very well instruct juries based on the definitions developed in shareholder oppression cases rather than leave the matter to their unbridled and uninstructed discretion. The language of the three tests does not seem to invite the business judgment rule as an affirmative defense. Bad conduct by the plaintiff would not seem to furnish a defense. If the actions of the defendant make it not reasonably practicable to carry on the business, bad conduct by the plaintiff would not change that situation. In fact, most defendants locked in serious dissension with their partners would have a hard time testifying that it is reasonably practicable to remain in business under the current situation.

Where the material facts were not disputed, Texas courts have also granted summary judgments under section 11.314.  It is also interesting to note that courts have held that the company itself is not a necessary party to a proceeding under section 11.314.

 

This article is based on a law review article recently published by Eric Fryar in the University of Houston's Business and Tax Law Journal. Download the entire article with complete analysis and case citations.

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