Don't Bet the Business

It is no secret that limited liability companies, or “LLCs,” are the first choice when forming small, privately held businesses. 

LLC’s are easily formed and for a relatively low cost.  However, the ease with which legal status is achieved very often comes with a trap for the unwary.

An operating agreement is a written description of how an LLC will be operated, managed and governed.  It also typically describes rights and duties owed to, and by, the owners known as “members.” Michigan does not require that LLCs adopt an operating agreement to form and operate, but perhaps it should. 

I frequently see small businesses, formed as LLCs, with the members choosing to operate with no written operating agreement. Even when members foresee the benefits of an operating agreement, they all too often adopt “boiler-plate” documents lifted from some random website. Little care is given to the form and content of the agreement, the assumption being that it was free and good enough to get started. This is a choice that often is regretted. 

Indeed, the one-size-fits-all operating agreement causes more problems than it solves.  It can even mask serious issues that are only revealed after a lawsuit is filed.

It is fairly common for closely held, often family owned, LLCs to be managed and controlled by a single member. Things usually start out fine and with good intentions, but when the money starts to roll in, or worse starts to dry up, fingers point, blame is assessed and, in my world, lawsuits get filed.

One of the most common allegations pled is what is known as a claim for “minority member oppression.” In simple terms, the member owning less than a majority or controlling interest in the LLCs contends that his or her rights or interests were not properly protected by those in control.

A claim for minority member oppression is governed by the Michigan Limited Liability Company Act. Under MCL 450.4515, to succeed on this type of claim, the minority member must show that the person or persons in control of the LLC have engaged in conduct that is “willfully unfair and oppressive.” What constitutes “willfully unfair and oppressive” is not always clear. Actionable conduct can differ depending on the facts and context of any given case. What is clear, however, is that the definition of “willfully unfair and oppressive conduct” excludes conduct that is allowed under the company’s operating agreement.

What this means is that when problems arise and members begin to question the actions and decisions of those exercising control over the LLC, those actions and decision – even those that damage the minority member – may be insulated from a challenge under MCL 450.4515(2) if the operating agreement permitted those things to happen. Put another way, while MCL 450.4515 prohibits “the substantial interference with the interests of the member as a member,” conduct allowed under an operating agreement cannot be willfully unfair and oppressive to the minority member.

When an operating agreement precludes an oppression claim, minority members often want to assert that the controlling member breached the statutory duty of care found in MCL 450.4404.  Under MCL 450.4404(1), a manager of an LLC is obligated to discharge his or her duties “in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner the manager reasonably believes to be in the best interests of the limited liability company.”  Reading that section carefully reveals, however, that this duty is owed by the manager to the company, not the individual member.

Even in those cases where a member can show a right to sue on the company’s behalf under MCL 450.4404, those claims often are swept away by the “business-judgment rule.” Under this rule “courts will refrain from interfering in matters of business judgment and discretion unless the directors or officers ‘are guilty of willful abuse of their discretionary powers’ or act in bad faith.” Franks v Franks, 330 Mich App 69, 100; 944 NW2d 388 (2019). In a courtroom, this can be a very difficult standard to satisfy.

Recently, the Michigan Supreme Court, in Murphy v Inman, ___ Mich ___, ___; ___ NW2d ___ (2022) (Docket No. 161454); slip op at 11, concluded that directors of a corporation owe a common-law fiduciary duty to the shareholders of the corporation. Assuming the Murphy decision extends to controlling members of an LLC, this fiduciary obligation may not help the minority member. This common law fiduciary duty would only require the controlling member to act “with due care, with loyalty, and in good faith.” Id., slip op at 12.  What this means, and legally includes, was left unclear and with the Supreme Court cautioning that the scope of the duty will “depend heavily upon context.” Id.

The moral of this story is not that a well-crafted operating agreement solves all problems and prevents all disputes. However, starting out with an operating agreement that is considered and thought-out will, at the very least, forces members to confront and consider the details of their ownership, how the company is to be managed and what may happen when disputes arise.  You will not find that through an internet search. What is found will be a pale substitute for what we can offer.