LLC Problems With a Minority Shareholder

By John Stevens J.D.

A limited liability company is a business entity designed to combine the tax advantages of a partnership with the limited liability protection of a corporation. Corporations can majority and minority shareholder, but LLCs have majority and minority members. The difference in terminology only reflects the difference in the type of business entity. Although the relationship between majority and minority members is often harmonious, problems can arise. The specific resolutions options vary by state, but all states take into account the same basic considerations for the more common scenarios.

A limited liability company is a business entity designed to combine the tax advantages of a partnership with the limited liability protection of a corporation. Corporations can majority and minority shareholder, but LLCs have majority and minority members. The difference in terminology only reflects the difference in the type of business entity. Although the relationship between majority and minority members is often harmonious, problems can arise. The specific resolutions options vary by state, but all states take into account the same basic considerations for the more common scenarios.

Fiduciary Duty

A member in an LLC, whether a majority or minority member, owes a fiduciary duty to the other members. This means that the members must act in good faith with each other and with the LLC. If a member breaches this duty, she could be liable for damages. For example, if a minority member fails to inform the company that it was being charged above-market rentals for space the member is leasing to the company, that minority member could be liable for the overcharged amount. Most state statutes require this duty and this duty is often reiterated in a well drafted LLC Operating Agreement, the document that governs the describes that management of the LLC and the rights of its members.

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Restrictions on Transfer of Shares

Some LLCs want to ensure that the company’s ownership is held by only a certain group of people. To prevent a minority member from selling her certificates to a person or entity outside of the company, LLCs sometimes restrict the transfer of certificates. Whether such a restriction is enforceable varies by state, but the general rule is that the restriction must be noted conspicuously on the membership certificate. A restriction is conspicuous if it would give notice to a reasonable person that the restriction exists.

Deadlocks

A deadlock occurs when the votes of the voting members are evenly split. For example, if the company’s voting members consists of four people and two are in favor of taking some action while the other two oppose that action, the board is deadlocked. Where a minority member opposes the deadlock, a court may choose between two options. An LLC Operating Agreement might state the proper course of action when a deadlock occurs. If the operating agreement does not state what action should be taken, one option is to dissolve the LLC. Another more common option, is to force a buyout, meaning that the court will order the majority members to buy the disgruntled minority member’s share. But first the minority member must convince the court that the majority members are oppressing her.

Pre-emptive Rights

Companies sometimes attempt to dilute a member’s interest by issuing new certificates. Problems can arise if the company issues new membership certificates and a minority member wants to buy stock from that new issuance, but the majority members do not want to sell it to her. To avoid potentially unfair results, some states provide that the minority member has a right to buy her proportional share of a new certificate issuance, regardless of whether the LLC’s articles or operating agreement expressly give this right. This right is often referred to as “pre-emptive rights.” In other states, a minority member has pre-emptive rights only if the LLC’s articles or operating agreement expressly say so.

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References

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