Breaking Up is Hard To Do

“Prepare for Liability to Members Withdrawing From a Limited Liability Company”

When the “problem” member of your professional services limited liability company (LLC) decides to exercise the buyback provisions of the operating agreement, you and the other members breathe a collective sigh of relief. You are happy when you close the transaction to purchase his minority interest back. After all, everyone agreed that the stipulated purchase price would be the only payment to a voluntarily withdrawing member and that the six figure amount was fair. Not so fast says your problem and now former member, who sues for additional compensation based on his accounts receivable and accuses the remaining members of various breaches of fiduciary duty to the minority, including a claim that he was wrongfully forced out of the LLC. And to top it off, the former member begins to use confidential information and solicit business from your customers in violation of restrictions in the operating agreement.

In a recent arbitration, I represented the remaining members of a Pennsylvania LLC engaged in technology consulting who were faced with $2 million in such claims by a former member who violated non-disclosure and non-solicitation provisions in the operating agreement. Although we defeated all of his claims, won a counterclaim to retain payments for his interest and obtained an injunction against him, it took years of litigation and arbitration to win and we are now involved in further legal proceedings to collect the $400,000 in reimbursement for attorneys’ fees and costs that the former member is required to pay. Why? In 20/20 hindsight, two big reasons were the vague LLC statute and an operating agreement that was not explicit about what seemed obvious at the time it was written.

Although the limited liability company has been a form of Pennsylvania entity since 1994, there is still not any Pennsylvania case law on liabilities arising due to voluntary or forced withdrawal of an LLC member. The statute is somewhat vague, stating that a withdrawing or “disassociating” member receives any distribution due under the operating agreement and within a reasonable time, the “fair value” of the member’s interest based on the right to receive distributions:

Upon the occurrence of an event of dissociation…, a dissociating member is entitled to receive any distribution to which the member is entitled under the operating agreement… and, within a reasonable time after dissociation, the fair value of the interest of the member in the company as of the date of dissociation based upon the right of the member to share in distributions from the company. 15 Pa. C. S. §8933

Just what distributions are required and what constitutes “fair value” can give rise to many long, legal arguments. As with most issues in a Pennsylvania LLC, however, the operating agreement can override the statute and control what a member is to receive when disassociating from the company and when. My clients’ operating agreement dealt with the “fair value issue through a stipulated price, but did not specifically state that the purchase price was the only payment and intended to cover all financial matters like capital, future distributions, accounts receivable and unbilled time. This allowed the former member to argue that the purchase price was solely for his interest (to be treated as capital gain), not his receivables (to be treated as ordinary income), making claims for both additional compensation and his tax liability differential due to an allegedly misstated K-1. A simple statement in the operating agreement on the exclusive nature of the purchase price and its intended scope may have shortened the proceedings considerably. As suggested in the Comments to the statute, providing for a special distribution on disassociation or mandating the timing of withdrawal to coincide with a distribution is also prudent.

Even more problematic is the question whether LLC members owe each other fiduciary duties. The Pennsylvania LLC statute is silent with respect to whether members who manage the LLC owe any fiduciary duties to fellow members beyond a duty to account for profits obtained without consent of the other members in 15 Pa. C. S. §8943(a). Despite the hope expressed in the Comments to that section that the courts would fashion rules similar to those in corporate and partnership settings, there are few cases that touch upon whether members of an LLC owe fiduciary duties to their fellow members. One well-reasoned trial court decision concludes that they do and it is highly likely that future decisions will reach the same result.

Therefore, it is advisable to clearly address the applicability and extent of fiduciary duties in the LLC operating agreement. Unlike Delaware and some other states, the Pennsylvania LLC statute does not contain a provision granting the parties the freedom to negate fiduciary duties. Since the Pennsylvania courts have yet to rule on this issue, it is unclear whether parties can eliminate, restrict or expand fiduciary duties in an operating agreement, but attempting to adopt some form of well-known standard such as the duty of loyalty or business judgment rule makes sense. It is certainly better than having no specified standards, which allowed my clients’ former member to argue that the most stringent standards applicable to the majority’s duty to minority shareholders in closely held corporations applied, dragging out the proceedings until we could prove that the remaining members had done nothing wrong.

So learn the lessons that cost my clients so dearly – be explicit in your next operating agreement or amend your existing one now to deal with disassociation and fiduciary duties.

Kevan F. Hirsch is a principal of the firm and represents a diverse array of clients in resolving their commercial claims and disputes through litigation, arbitration and mediation. A large segment of his practice is devoted to representation of national and regional general contractors, trade contractors, and industrial equipment manufacturers, on all phases of major public and private construction projects in the Delaware Valley from bid protests to post-construction claims. He can be reached at 610.941.2535 or by email at khirsch@kaplaw.com