You Say You Want a Dissolution? Minority Investor Issues in Delaware LLCs
A recent opinion issued by the Delaware Court of Chancery serves as a cautionary tale to entrepreneurs, venture capitalists, and others entering into LLC operating agreements in connection with start-up companies. A minority investor with a substantial stake in a company sought to dissolve the company on the grounds it had abandoned its original business plan. However, because the purposes of the LLC were worded quite broadly in the operating agreement, the court ruled against the dissolution, much to the frustration of the minority investor. Thanks go to Francis Pileggi for bringing the case of In re: Arrow Investment Advisors, LLC to my attention and providing, as usual, an excellent summary and analysis of the court’s opinion on his blog.
Along with two others, Noah Hamman co-founded Arrow Investment with the intention of offering advisory services to investment funds. Hamman, who held a 30% membership interest in the company, had been its CEO until he was removed by his two fellow founders as a result of disagreements over management decisions. Like many other financial services firms, Arrow’s prospects began to sink with the market’s. In response, Arrow’s management committee decided to explore other investment opportunities and sent out a notice to the company’s members requesting capital contributions to fund their new programs. Hamman disagreed with this approach and brought a petition before the Court of Chancery seeking dissolution of the LLC under §18-208 of the Delaware LLC Act, alleging that Arrow had departed from the business strategy set out in its original business plan.
The court noted that Arrow’s LLC operating agreement, and not its business plan, was the controlling document for determining the company’s purpose. Arrow’s operating agreement clearly stated it 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.” Given the broad formation clause of the operating agreement, the court ruled that Arrow’s management had not violated the purpose for which the company had been formed simply by choosing to pursue new business strategies. In the words of Vice Chancellor Strine:
Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue.
A company suffering disappointing financial returns resulting from a downturn in general economic conditions did not meet this standard.
For most companies, including a broad purpose of formation clause in the operating agreement makes sense because it provides management with flexibility to adapt to changing business conditions. But founders of start-up companies should accept that the company’s eventual trajectory may not follow the one they initially conceived.
To address this unknown and unknowable future, LLC operating agreements can institute appropriate governance procedures and potential exit provisions that would allow management and the company’s members to resolve significant disputes, or, if necessary, to part ways. Members of LLCs with substantial minority stakes, for example, may be given veto rights over certain material managerial decisions (such as when capital calls may be made to fund new business ventures) or exit rights that would allow a withdrawal from the LLC under narrowly specified conditions.
Nobody won in the case of Arrow Investment Advisors. Hamman remains bound to a company he no longer wants to be a part of, management must continue to deal with a contrary minority investor, and the LLC itself has lost valuable time and money in defending this lawsuit.
