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  • Writer's picturePaul Peter Nicolai

Changing LLC Dissolution Landscape

Updated: Apr 11, 2022

The law on the creation, operation and duration of limited liability companies (LLC) has been changing over the years. Originally, LLCs were treated much like partnerships. This was because their status was unclear and practically everybody wanted partnership tax treatment of the entity; i.e., the entity did not pay any taxes; the owners did. In the 1990s, the Internal Revenue Service changed the rules so that the default tax treatment for LLCs was as partnerships. This allowed much more flexibility for the operation of the laws governing LLCs.

In fact, the LLC statutory norm now is perpetual existence, just like corporations. Corporate law dissolution norms embodied in most state laws allow shareholders to apply to a court for dissolution in certain situations. Along similar lines, the model LLC laws say LLC members can apply to a court for dissolution of the LLC under specified circumstances, including frustration of the LLC’s economic purpose, the conduct of another member making continuation of the business with that member reasonably impracticable, the reasonable impracticability of conducting the company’s business in conformity with the articles of organization and the operating agreement, and illegal, oppressive, fraudulent, or unfairly prejudicial managerial action. States have broadly adopted these provisions allowing for member applications for judicial dissolution.

Two grounds for LLC dissolution in many states are (1) frustration of the LLC’s economic purpose and (2) the reasonable impracticability of conducting the company’s business in conformity with the articles of organization and the operating agreement. Delaware, a leading business law state, has an LLC law that allows a member or manager of an LLC to petition for a decree of dissolution. The court may dissolve the LLC whenever it is not reasonably practicable to carry on the business in conformity with the operating agreement.

Judicial dissolution of an LLC is a discretionary remedy courts grant sparingly. Although it occurs less often than dissolutions based on deadlock, a court may dissolve an LLC where the defined purpose of the entity was fulfilled or impossible to carry out. To do that, the court has to decide what the “purpose” of the LLC is.

In a relatively recent case, the court found that its analysis of an LLC’s purpose should not be limited to what the LLC agreement said was the purpose. Although the court acknowledged that a purpose clause was of primary importance, it went on to determine that the purpose clause was not the only evidence the court may consider, even where the purpose clause was unambiguous. In particular, the court considered other agreements executed by the members of the LLC around the same time as the LLC agreement in determining the purpose of the LLC.

The decision marks a change in Delaware LLC law. Despite the stated policy of the Delaware LLC law to give the maximum effect to freedom of contract, the decision suggests that a court may consider material outside the four corners of an LLC agreement to determine the purpose of the LLC.

PRIOR LAW

Before the decision, opinions by the court looked to the text of the purpose clause in the LLC’s governing documents to determine an entity’s purpose when considering whether that purpose had been satisfied or was impossible to carry out. Given that the test of judicial dissolution is whether it is reasonably practicable to carry on the business in conformity with a limited liability company agreement, it is not surprising the court would focus on the language of the LLC agreement.

In one case, a member and cofounder sought dissolution based on the alleged failure of management to carry out the LLCs original business plan. According to its purpose clause, the LLC was formed for the purpose of acting as an investment adviser to certain investment funds and for such other lawful business as the Management Committee chooses to pursue. According to the petitioner, the original business plan anticipated the LLC being profitable by the time it had a certain amount of assets under management, but it still lost money. The petitioner also alleged management was expanding the services offered by the LLC beyond that envisioned by the original business plan.

The court focused on the text of the LLC agreement, stating that the petitioner was asking the court to ignore the entire clause of the agreement that authorized the LLC to engage in such other lawful business as the Management Committee chooses to pursue. Rejecting the argument that the purpose of the entity for dissolution purposes should be limited to the original business plan, the court noted that an important reason for parties to include a broad purpose clause in an entity’s governing instrument is to ensure that the entity has flexibility to adapt in the face of changing circumstances. Having agreed to such a clause, and therefore having contemplated the LLC may one day be something other than an investment advisor, parties cannot seek to prematurely end its existence because they are unhappy with how management chose to exercise its discretion. The court explained that it must look to the LLC operating agreement 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.

In a second case, the petitioner sought dissolution because the company was functioning only as a passive investment vehicle and had conducted limited active business over several years. The LLC’s charter said the purpose of the LLC was to engage in any lawful act or activity. Given that a Delaware entity could exist as a passive investment entity, the court concluded the LLC’s purpose had not been frustrated. Limiting itself strictly to the purpose clause when deciding the question, the court said it would not attempt to divine some other business purpose by interpreting provisions of the governing documents other than the purpose clause.

THE CHANGE

In this case, the court was again asked to dissolve an entity because its purpose could not be met. The LLC Agreement said that the purpose and business of the LLC would be limited to engaging in the business of marketing, distributing and selling natural Angus beef and beef products under the ‘Premium Natural Beef’ brand name. The court found this language unambiguous. Contemporaneously with entering into the LLC agreement, the parties also signed an output and supply agreement with two entities controlled by the minority owners. Under those agreements, the two entities were to supply qualifying cattle to sell. Pursuant to the output and supply agreement, the LLC had the exclusive right to purchase such cattle.

In a prior court action, the exclusive output and supply agreement was terminated by the court. Based on that, judicial dissolution of the LLC was requested on the grounds that continuation was not reasonably practicable because its purpose had been frustrated. The minority owners argued the motion should be denied because, among other reasons, the broad purpose clause, was to market, distribute, and sell natural beef.

The court determined that the purpose clause is of primary importance, but other evidence of purpose may be helpful as long as the Court is not asked to engage in speculation.

The party seeking dissolution argued the purpose of the LLC was narrower than the purpose stated in the LLC agreement because of the terms of the various agreements. The agreements, read together, meant that the LLC’s purpose was not only to sell natural beef but also to partner exclusively in a joint venture business. The court agreed and found the LLC’s purpose was to market and sell beef that had been supplied by the other companies. Given that the other companies refused to supply cattle, the court found it was no longer reasonably practical for the business to continue. Significantly, the court ordered the dissolution even though no deadlock existed and the LLC was profitable.

CONCLUSION

This case teaches that to the extent a party wishes to limit the purpose to that stated in the purpose clause, drafters should be cautious in referencing other agreements in the LLC agreement or vice versa. The court repeatedly noted that the output and supply agreement provided that it was made in connection with, and as a condition to the LLC agreement. The purpose clause remains of primary importance to the court’s decision as to purpose. Therefore, drafters should continue to carefully craft purpose clauses and consider whether the broader clauses should be used to make it easier for the company’s purpose to change from that envisioned at the time of formation.

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