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LLC Member Oppression

Shareholder Oppression is a problem for members of limited liability companies.

Oppression in Limited Liability Companies

Minority owners in small limited liability  may be oppressed just like minority owners in corporations.  Manager-managed LLCs are little different from corporations from an operational standpoint. Members have no management authority but elect managers to run the business, just like shareholders in a corporation who vote for directors who run the business. Usually, the person or group holding a majority ownership in an LLC will have control over the selection of managers. In a member-managed LLC, majority members usually make sure that they have management control.

Members of closely-held LLCs are vulnerable to oppression for exactly the same reasons that shareholders are vulnerable in closely-held corporations. Members in closely-held LLCs work together with a small number of other members, making interpersonal conflicts that may develop into ownership issues. Majority rule grants some members control over 100% of the management decisions. These members decide who to hire and fire, whether and how much to distribute, and who gets what information about the business. Majority members have the same temptations to abuse that power. Finally, LLC members, like stockholders, ordinarily have no exit  and thus no ability to escape the trap of oppressive conduct other than to sell at an unfairly low price. Professor Douglas Moll refers to these factors as the “seeds” of oppression,  and notes that “the problem of oppression is ‘portable’ to the LLC context.”

Majority LLC members oppress minority members in exactly the same manner as in corporations. Members controlling the LLC will exclude the oppressed member from participation, usually cut off information, divert profits away from the minority member, and almost always terminate the minority member’s employment. Majority members then use their economic leverage to “squeeze out” the minority by forcing them to sell at an unfair price or to “freeze” them out by denying them all benefits of ownership and basically pretending they don’t exist.

Minority members of LLCs are also just as able to protect themselves contractually as shareholders in a corporation—perhaps more given the importance of the company agreement LLC governance.  However, LLC members are just as trusting of their friends and family and are just as naïve as shareholders;  therefore, effective contractual protection against oppression is as rare in the LLC as it is in the corporation.

Application of Shareholder Oppression in LLCs

Two Texas appellate cases applied the shareholder oppression doctrine to limited liability companies. Neither opinion questions the appropriateness or the applicability of a doctrine developed for corporations.

In Pinnacle Data Services, Inc. v. Gillen,  the court applied the shareholder oppression doctrine to a member-managed LLC in a cause of action it termed “member oppression.”  The plaintiff alleged that the defendant committed member oppression “by wrongfully withholding profit distributions, firing Max and Morris Horton from MJCM, failing to inform PDS of company actions, and paying for their personal legal fees in this lawsuit with MJCM funds.”  The court affirmed a no-evidence summary judgment against the plaintiff because the summary judgment record failed to raise a genuine issue of material fact as to any of the claims.

In Kohannim v. Katoli,  the El Paso Court of Appeals affirmed a judgment for what it termed “oppression” in favor of the assignee of an interest in an LLC. The plaintiff was assigned her ex-husband’s 50% ownership in an LLC in their divorce.  The assignment did not make the plaintiff a member,  but it did confer a property right,  which the court held entitled the plaintiff to assert an oppression claim.  The court held:

A member oppression claim may exist when: (1) a majority shareholder's conduct substantially defeats the minority’s expectations that objectively viewed, were both reasonable under the circumstances and central to the minority shareholder's decision to join the venture; or (2) 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 every shareholder who entrusts his money to a company is entitled to rely.

The court of appeals held that the evidence was sufficient to sustain a judgment for oppression based on the failure to make distributions where the defendant “paid himself $100,000 for management services that were not performed and failed to make any profit distributions to [plaintiff] even though more than $250,000 in undistributed profit had accumulated in the company’s accounts.”  The court stated: “We also agree with the trial court’s conclusion that the established facts demonstrated [defendant] engaged in wrongful conduct and exhibited a lack of fair dealing in the company’s affairs to the prejudice of [plaintiff].”  The judgment ordered the liquidation of the assets and provided that plaintiff would be paid more than 50% of the proceeds to compensate her for the loss of value caused by the defendant.

Ritchie v. Rupe

In Ritchie v. Rupe,  the Texas Supreme Court completely rejected the shareholder oppression doctrine. The Supreme Court also expressly disapproved of the two cases  that had recognized a cause of action for oppression in LLCs.

The Court first turned to the receivership statute as a source for the duties recognized by the shareholder oppression doctrine.  The court held that the “construction of former article 7.05, like any other statute, is a question of law for the courts.”  “To determine the meaning of ‘oppressive’ in the receivership statute, our text-based approach to statutory construction requires us to study the language of the specific provision at issue, within the context of the statute as a whole, endeavoring to give effect to every word, clause, and sentence.”  The Court focused particularly on the other statutory grounds for imposing a receiver, concluded that all involved a “serious threat to the well-being of the corporation,” and held that “[w]e must construe ‘illegal, oppressive, or fraudulent’ . . . in a manner consistent with these types of situations.”  The Court rejected the two definitions of oppressive that had been developed by the intermediate courts under the shareholder oppression doctrine and concluded:

Considering all of the indicators of the Legislature’s intent, we conclude that a corporation’s directors or managers engage in ‘oppressive’ actions under former article 7.05 and section 11.404 when they abuse their authority over the corporation with the intent to harm the interests of one or more of the shareholders, in a manner that does not comport with the honest exercise of their business judgment, and by doing so create a serious risk of harm to the corporation. 

The Supreme Court further held that a buy-out was not available under the receivership statute: “Former article 7.05 creates a single cause of action with a single remedy: an action for appointment of a rehabilitative receiver.”  The Supreme Court rejected the argument that the provision in the receivership statute, requiring the court to find that all other remedies available at law or in equity are inadequate, implies the authority to order other appropriate equitable relief—“This provision is a restriction on the availability of receivership, not an expansion of the remedies that the statute authorizes.”

Next, the Court turned to the question of whether an independent cause of action should be recognized in the common law for shareholder oppression.  The Court held that such an inquiry requires “something akin to a cost-benefit analysis to assure that this expansion of liability is justified.”  After a thorough discussion of the vulnerabilities of minority shareholder and the risks and harm caused by oppressive conduct, the Court concluded “that the foreseeability, likelihood, and magnitude of harm sustained by minority shareholders due to the abuse of power by those in control of a closely held corporation is significant, and Texas law should ensure that remedies exist to appropriately address such harm when the underlying actions are wrongful.”  However, that conclusion “does not end our analysis” because “[w]e must next consider the adequacy of remedies that already exist.”

The Court then analyzed the existing remedies in each of five areas where oppressive conduct is most frequently present: denial of access to information,  withholding of dividends,  termination of employment,  misappropriation of corporate funds and opportunities,  and manipulation of stock values.  As to denial of information, the Court noted that “[t]he Legislature has already dictated what rights of access a shareholder has to corporate books and records, and no party alleges that the Legislature’s statutory scheme is inadequate to protect shareholders in closely held corporations from improper denial of access to corporate records.”  As to termination of employment, “our commitment to the principles of at-will employment compels us to conclude that the opportunity to contract for any desired employment assurances is sufficient.”  Misappropriation may be remedied through derivative claims based on “the duty of loyalty that officers and directors owe to the corporation specifically [that] prohibits them from misapplying corporate assets for their personal gain or wrongfully diverting corporate opportunities to themselves,”  which the Court reasoned might also be available to remedy withholding or refusing to declare dividends, termination of employment, and manipulation of corporate share values—“all relate to business decisions that fall under the authority of a corporation’s offices and directors. As such, they are subject to an officer or director’s fiduciary duties to the corporation.”  Ultimately the Court concluded that “these legal duties are sufficient to protect the legitimate interests of a minority shareholder by protecting the well-being of the corporation.”

The Court concluded, “[t]here must be well-considered, even compelling grounds for changing the law so significantly. . . . We find no such necessity here, and therefore decline to recognize a common-law cause of action for ‘shareholder oppression.’”

  1. Implications of Ritchie
  2. Difficulties for minority owners going forward

The Ritchie opinion eliminated the duty that majority owners owed to the minority. Ritchie holds that an “officer or director has no duty to conduct the corporation’s business in a manner that suits an individual shareholder’s interests when those interests are not aligned with the interests of the corporation and the corporation’s shareholders collectively.”  To recover individually, “a stockholder must prove a personal cause of action and personal injury.” 

Oppression is always directed at the minority owner, with the injury being suffered only incidentally by the company, if at all. The issue is not whether the minority owner has suffered “personal injury” but whether the minority owner has a “personal cause of action.”  The Ritchie Court refused to “impos[e] a common-law duty on directors in closely held corporations not to take oppressive actions against an individual shareholder even if doing so is in the best interest of the corporation.”  However, in an actual case of oppression, the best interests of the corporation do not motivate the oppressor and are not necessarily implicated one way or the other. The Supreme Court did not adopt a rule that the best interests of the company trumps the best interests of the individual owner when the two are in conflict. Rather, the Supreme Court held that the majority owner has “no duty” to the minority owner, and thus eliminated the possibility of any personal cause of action, “even if [the oppressive conduct is] motivated by malice toward the stockholder individually.” 

The buy-out remedy had provided the minority shareholder with an exit when trapped in an oppressive situation. The holding in Ritchie eliminated the buy-out remedy for oppressed shareholders.   Although the Court cited other legal remedies that remain available to deal with oppressive behavior, none provide the badly needed exit. As the dissent in Ritchie argued, “No other existing remedy the Court discusses adequately protects minority shareholders from such oppression.” 

 

This article is taken from an article recently published by Eric Fryar in the Houston Business and Tax Law Journal. Download the entire article with full analysis and case citations:

LLC Member Oppression Article

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