Rock, Paper, Scissors, Shoot: Deadlock-Breaking Mechanisms in Limited Liability Companies

A deadlock occurs when the voting interests of members of an LLC are split right down the middle on an important decision regarding the management of the LLC. Problems arising from a deadlock between members or managers of an LLC are not few and far between. Deadlocks in LLCs most typically arise in a number of situations involving important decisions, including: (1) the failure of equal members or managers to come to an agreement; (2) the failure to obtain an obligatory majority vote; (3) the failure to obtain a required approval from a member with approval rights; and (4) the failure to obtain unanimous consent where unanimity is required.

The failure to provide deadlock-breaking mechanisms in the operating agreement that address any or all of the above will result in substantial expense; contentious relations among members; loss of time; and possible mediation, arbitration, or, worse, costly and protracted litigation. The final result of most unresolved deadlocks among members is a dissolution of the LLC, which typically involves excessive cost, lost opportunity, and bitter consequences for the members of the LLC.

Deadlock-Breaking Mechanisms

Members of an LLC have boundless freedom when drafting deadlock-breaking provisions and can be as creative as they would like. All states, including Florida, provide for freedom in drafting operating agreements, subject only to the “nonwaivable” default rules in the applicable LLC act.[1] It is important that the operating agreement specify whether a court must enforce the chosen deadlock-breaking mechanism, unless it is deemed “manifestly unreasonable.” Operating agreements that address deadlock generally do so in one or more of the following ways.

I. Buy-Sell Provisions

Most often, these provisions take the form of either: (1) an “appraisal” model, requiring an independent appraisal by a qualified expert as to the value of the interest to be purchased; or (2) the “shotgun” model, which permits one member to offer to purchase the interest of the other deadlocked member at a set price and terms, and the offeree must then either accept that price and terms, or purchase the offeror’s interest for the same price and terms. The “shotgun” model has been seen to end in litigation and inequitable outcomes, specifically: (1) where the parties have wildly different notions about the value of the membership interest to be purchased, (2) where there is a substantial gap in knowledge about the particular business or industry, or (3) where the parties have significantly different economic resources. However, both of these models, under the right circumstances, have proven effective in compelling the parties to find a way to compromise and break the deadlock to avoid the potential of one party actually deciding to resort to this provision.

II. “Tie-Breakers”

This provision delineates the procedure in which the deadlock members refer to the decision of a tie-breaker, which may be a group like the board of an affiliated entity, inside or external professional advisors, mediators or arbitrators, or industry experts. One significant problem with this method is often that, in taking such an action, the decision is removed from the members, who are most familiar with the company and its business, and leaves the discretion to decide to third-party outsiders who may not have the necessary understanding of the business. Thus, this mechanism should be used only when the members can decide on third parties to whom the decision may be referred that have some history and familiarity with the specific business and industry.

III. “Rotating/ Alternating” or “Casting” Vote Mechanisms

These mechanisms allow the members to rotate “tie-breaking” or “casting” votes whenever there is a deadlock on a decision. These are often complicated to draft, and frequently leave everyone unhappy. Essentially, the members—assuming it is a member-managed LLC—will try to reach agreement on a list of “major issues” when they arise. If they fail to come to an agreement, one member will break the deadlock by exercising his or her casting vote, essentially the deciding vote. The next time there is a deadlock on a major issue, another member gets the “casting vote,” and so on and so forth. This approach has significant drawbacks, can drive significant wedges between members, and is rarely successfully employed.

IV. “Put” or “Call” Mechanisms

These mechanisms are very well-known and are often drafted into LLC operating agreements as the deadlock-breaking provision. The nuances of these mechanisms are significant, however, and must be carefully and meticulously drafted. Apart from the valuation issues in put and call mechanisms, perhaps the most vital matter associated with drafting these mechanisms involves the determination of triggering events. A triggering event is basically an action, event, or circumstance that, once it occurs, allows one party to exercise a put or a call.

Here is an example of a “triggering event” that might be found in an operating agreement utilizing this method: “Any transfer or encumbrance of any of the Members’ Membership Interest in the Company or any portion thereof or any direct or indirect interest therein not permitted herein without the Approval of all the Members.” The operating agreement will then list remedies available to the members if this “triggering event” occurs. An example of a remedy usually found in this list is the right of the other members to either oust the offending member or dissolve the company entirely.

These provisions are heavily negotiated and require careful drafting. Consider questions such as whether they should be based on deadlock or on only a few specific matters,[2] or whether they should be exercisable on matters that go beyond deadlocked voting. The list can be quite extensive, or it can be narrowly drafted.

V. Partition or Sale of the Company or Its Assets

The prospect of partition of the business or an involuntary sale of the company or its assets, may also compel disagreeing members or managers to forge a resolution of the deadlock. Partition of the LLC assets or business can work only in limited settings, usually where the assets or business activities are easily divided among the members without destroying the business model itself and where the value of the assets are equal and separation and division is easily agreed upon by the disagreeing members. A forced sale of the company or its assets similarly has complications, mainly timing, market forces, absence of interested buyers, or determining who sets the price and terms. Thus, the initial drafting must be comprehensive and complete, and frequently must be given to third parties to assist.

What Happens if a Deadlock Occurs Without Deadlock-Breaking Provisions?

When these mechanisms fail, or if one fails to draft them into the LLC’s operating agreement, the most common alternatives are: (1) involuntary or judicial dissolution; (2) custodianship or receivers; (3) injunctions; (4) specific performance; (5) judicial expulsion of a member; or (6) mediation or arbitration.

I. Involuntary or Judicial Dissolution

A judicial action that seeks involuntary dissolution by a member is far and away the most common form of breaking a member deadlock when the operating agreement lacks deadlock-breaking provisions. Involuntary dissolution petitions may be coupled with claims for other forms of relief, including demands for an accounting, appointment of a receiver or custodian, a change in control of the LLC, etc. In Florida, a court may dissolve an LLC in a proceeding brought by a member or manager if the following is established: (1) the managers or members of the LLC are deadlocked in the management of the LLC’s activities and affairs; (2) the members are unable to break the deadlock, and irreparable injury to the LLC is threatened or being suffered. Fla. Stat. § 605.0702(b)(5).

The negatives associated with judicial dissolution include a lesser realized value of the membership interests or assets and an incapability to continue the business. The respondent in a petition for involuntary dissolution regularly claims bad faith by the petitioning members as a defense. Therefore, litigation ensues. The resolution can quickly become costly.

II. Receivership/ Custodianship

A custodian may be appointed by a court to run the LLC in situations where the members’ partition is so contentious and hostile that it prohibits the orderly operation of the business and threatens the entity with irreversible damage. The court-appointed custodian effectively substitutes the members or managers in control of the company and is tasked with operating the business until the court decides on a more permanent resolution.

The primary benefits of custodians include that the effect of the members’ division, and the management’s inability to manage the business, are removed, and the company may be protected from liquidation, unless it is already insolvent. The main disadvantage is that management decisions are within the discretion of a third party rather than in the hands of the members or managers. Upon the termination of the need for a custodian, the members or managers should negotiate and decide on a deadlock-breaking mechanism to resolve future deadlocks just in case the need to break a deadlock arises again.

A receiver is much like a custodian but for one glaring difference. A receiver can be appointed to liquidate the company if there is no viable alternative. Therefore, the receiver will not have the responsibility of running the business while the deadlock is resolved, and the receiver assists in the liquidation of the company and its assets.

III. Injunction

An injunction is a court order preventing or requiring the performance of certain conduct that is necessary to prohibit irreversible harm to the company or its members. An injunction is often a prequel to inevitable dissolution and may be used in the context of deadlock offensively or defensively. Reasons a member may petition the court for an injunction include to stop a member or manager from looting, stop waste of company assets, stop a member from breaching a fiduciary duty, or stop oppression by managing members. A member that is the target of a petition for judicial dissolution or appointment of a custodian may seek an injunction to stop the petition. Injunction orders can be very simple matters that stop or order conduct, or they can be more complicated, stipulating the means in which the company will continue doing business and the managers who will manage it.

In Florida, injunction may be granted where: (1) irreparable harm will result if the injunction is not granted; (2) there is no adequate remedy at law; (3) the party has a clear legal right to the requested relief; and (4) the public interest will served by the temporary injunction. See Provident Mgmt. Corp. v. City of Treasure Island, 796 So. 2d 481, 485 (Fla. 2001). Though an injunction ideally allows for the continuation of the company’s business activities, it does not break a deadlock, it clasps a contentious relationship between members or managers together, and it is challenging to obtain due to a high standard of proof.

IV. Specific Performance

A member or manager may seek specific performance of obligations owed by another member or manager if the claim arises under a contract that describes the obligations to be performed. Basically, the petitioner requests the court to force the respondent to perform its contractual obligations, which may include obligations under an operating agreement. Specific performance is hard to obtain because the standard of proof in Florida is “clear and convincing,” which is higher than “preponderance of the evidence.” See Palm Lake Partners II, LLC v. C & C Powerline, Inc., 38 So. 3d 844 (Fla. 1^st DCA 2010) (stating that specific performance of a contract provisions may granted only when the plaintiff is clearly entitled to it).

There are some drawbacks in seeking specific performance as a remedy for a member or manager deadlock. Specific performance is not always available because, in most cases, there are remedies at law, including monetary damages, partition, and dissolution. Further, specific performance is another mechanism which holds a contentious relationship together without providing a method to resolve a future deadlock.

V. Judicial Expulsion

Expulsion is an extreme resolution to a deadlock because it removes a member from the LLC entirely. The standards of proof are almost identical to those for involuntary dissolution, where it is “not reasonably practicable” for the LLC to serve the purposes sand function specified in the operating agreement. See Fla. Stat. § 605.0702(b)(2). The remaining members may continue to operate the company. The petition for expulsion is particularly fact-specific, and the judge must be satisfied that the high standard of proof establishes adequate fault to support expulsion. Mere disagreement over how to operate the company is not sufficient. Expulsion is not a remedy available in every state.

In Florida, expulsion of a member may occur one of two ways under the Revised Limited Liability Company Act. See Fla. Stat. §§ 605.0602(4) & (5). First, the operating agreement can delineate a process by which a member may be expelled. Id. Upon expulsion pursuant to the operating agreement, the member is dissociated. Id. Absent a method for expulsion in the operating agreement, the members may unanimously agree and vote to expel a member. Id. Expulsion by unanimous decision is only available if the LLC cannot lawfully carry on its business with the expelled member; the expelled member has transferred its entire transferable interest in the LLC; or the expelled member is a corporation or other entity that is dissolved. Id.

Expulsion of a member in Florida may also be achieved by judicial order in a case in which a member’s wrongful conduct adversely and materially affects the company’s activities and affairs, constitutes a willful or persistent and material breach of the operating agreement, violates fiduciary duties or other statutory standards of conduct, or makes it not reasonably practicable to carry on the company’s activities and affairs with that person as a member. Fla. Stat. § 605.0602(6).

VI. Mediation or Arbitration

Operating agreements that do not provide deadlock-breaking mechanisms may nevertheless provide alternative methods of resolving disputes, such as alternative dispute resolution. Mediation is a voluntary negotiation presided over by a neutral individual that assists the members in resolving the dispute and attaining a voluntary resolution through negotiation. Mediation is useful in circumstances where the members are interested in compromising and mending the relationship, but it may be futile when the members are so hostile and antagonistic that compromise is impossible. A strong choice in mediator is key. A strong mediator can shake members out of their stubborn trance and recognizes the risks and expense of dissolution and prolonged and contentious litigation.

Arbitration, like mediation, is conducted out of the courtroom. Unlike mediation, arbitration does not involve negotiating a compromise. Arbitration is basically a private trial. One or more neutral individuals, paid to function as judges, conduct discovery and motion practice, and preside at trial. Testimony is taken and evidence is submitted to the arbitrators for consideration, must like how a trial is conducted. The main goal of arbitration is to achieve a resolution in an adversary manner more quickly than might have occurred in court. A key advantage in arbitration is the members participate in selecting the arbitrators and often hire neutral individuals with significant experience with the business, specific industry, or subject matter in dispute. Another advantage arbitration boasts over mediation is that arbitration awards may be recorded as judgments and enforced in the same manner as judgments. A disadvantage is the need to compensate the arbitrators.

Conclusion

A well thought out and properly drafted LLC operating agreement will deliver deadlock-breaking mechanisms that will aid the members of LLCs in avoiding the need for expensive, prolonged, and disrupting litigation. However, if the operating agreement fails to deliver deadlock-breaking mechanisms or these mechanisms fail, resorting to the judiciary and alternative dispute resolution offers members flexible substitutes to achieve a resolution through adversary proceedings.

[1] Florida’s Revised Limited Liability Company Act may be found at Florida Statutes Chapter 605.

[2] For example, whether the company should take out a loan, make a capital call, admit a new member, or change the business.