At the end of March, the Fifth Division of the Colorado Court of Appeals upheld the dissolution of four limited liability companies (LLCs).FN1 The only members of the LLCs were a mother and son, and their relationship had deteriorated to the point that they each had sought judicial assistance to help resolve their business disputes.
Throughout its various stages, the litigation has taken more than six years and had already reached the Court of Appeals in September of 2014 when the court clarified the standard for judicial dissolution.FN2 It was the first time a Colorado appellate court had considered the matter.
Colorado Revised Statute (C.R.S.) § 7-80-810(2) governs the judicial dissolution of an LLC and it provides that an LLC may be dissolved when it is “not reasonably practicable to carry on the business of the limited liability company in conformity with the operating agreement of said company.” As interpreted by the appellate court, this section requires that “a party seeking a judicial dissolution show 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.”FN3
Judicial dissolution is properly considered a drastic remedy and Colorado courts should not authorize it “merely because the LLC has not experienced a smooth glide to profitability or because events have not turned out exactly as the LLC's owners originally envisioned.”FN4 After all, such events are “common in the risk-laden process of birthing new entities in the hope that they will become mature, profitable ventures.”FN5
Thus, the appellate court declined to adopt a “hair-trigger dissolution standard” while avoiding making dissolution depend upon the actual impossibility of continuing the business.FN6 Instead, the court suggested that “dissolution is reserved for situations in which the LLC's management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business, such as in the case of a voting deadlock.”FN7
The court laid out seven (7) nonexclusive factors that should be considered in evaluating whether judicial dissolution is warranted. These factors include:
Dissolution is reserved for situations in which the LLC's management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business...
whether the management of the entity is unable or unwilling reasonably to permit or promote the purposes for which the company was formed;
whether a member or manager has engaged in misconduct;
whether the members have clearly reached an inability to work with one another to pursue the company's goals;
whether there is deadlock between the members;
whether the operating agreement provides a means of navigating around any such deadlock;
whether, due to the company's financial position, there is still a business to operate; and
whether continuing the company is financially feasible.FN8
It isn’t necessary to establish all of the factors and other unstated factors may arise in certain situations. But the point is to use these factors as a lens to examine the extent to which the purpose of the business has been frustrated or the management has become dysfunctional.
Planning can’t always avoid problematic situations. Disagreements can arise among the best of business partners and not every business venture can become financially sustainable. These things aren’t always knowable at the outset and, as a result, many of the factors listed here cannot be adequately addressed in advance. These are, if you will, known unknowns.
The fifth factor – i.e. whether the operating agreement provides a means of navigating around any such deadlock – is an exception. A well-drafted operating agreement will provide an adequate means of resolving disputes and thereby avoid deadlock among an LLC’s members. Thus, with sufficient foresight in drafting, this factor can weigh against dissolution and courts will be less likely to find that judicial dissolution is warranted.
Moreover, by providing a means of navigating deadlock, actual deadlock can be avoided. As a result, the fifth factor bears on the fourth. Thus, by drafting carefully, both the fourth and fifth factors can count strongly in favor of the continued operation of a company.
As previously discussed, LLCs are “creatures of contract” and, as a result, members have considerable flexibility when it comes to determining the organizational structure of the business as well as their own rights and obligations. But this contractual flexibility can result not only in great successes, but also miserable failures.
Part of the trouble in Gagne v. Gagne was, in fact, the poor drafting of the relevant operating agreements. Indeed, in interpreting these agreements, the appellate court agreed with the findings of the district court that the provisions of the agreements “are difficult, poorly drafted and to some extent contradictory."FN9
While the mother was the Chief Executive Manager with fifty-one (51) percent voting rights, other provisions required the son’s participation, granted him rights of first refusal, and permitted the firing of his management company only for cause.FN10 As a result, the court determined both that there was actual deadlock and that the operating agreement did not provide a means of successfully navigating that deadlock.
Interpreting these agreements, the appellate court agreed with the findings of the district court that the provisions of the agreements “are difficult, poorly drafted and to some extent contradictory."
Having weighed these and the other factors, the court upheld the district court’s reluctant decision to dissolve all four of their companies. In doing so, the court also made determinations regarding the member’s relative distributions, the kind of distribution that would be received, and how it shall be made. To put it lightly, this is not the type of ending that most business owners would want.
No business owner wants to focus on the end before their business has even begun, but the issues around dissolution, withdrawal, the selling of substantial assets and other situations where there may be successors in interest, are important to address upfront. That way partners can reach a meeting of the minds before one of these issues arises. At that point, a lot more time and money will be needed in order to find an acceptable resolution.
It's not only important to reach an agreement about these and other issues before the business is up and running, but it is also important to draft this agreement carefully so that it actually has the intended legal effect. As a result, it is generally advisable to seek the assistance of a qualified attorney when it comes to drafting any operating or other ownership agreement.
If you would like to find out whether your LLC's operating agreement is meeting the needs of your business, please Reach out, Today!