The limited liability company (LLC) has only been around since the first LLC statute was enacted in 1977. Within a few decades, it has become the most popular legal entity formed by new US businesses due to its ease of formation, flexibility, low start-up costs, and limited liability for members.
Each state has its own LLC statute. These laws set forth default rules, which may not provide strong protections for minority members facing oppression—such as a squeeze-out or freeze-out—at the hands of other members.
A minority member’s best protection against oppressive conduct lies in negotiating favorable contractual provisions in an LLC operating agreement. While litigation may be an option to enforce a minority member’s rights, it should be the last resort—and is often the result of a failure to plan ahead.
Minority Members in an LLC
The owners of an LLC are known as members. Like the shareholders in a corporation, LLC members can be majority or minority members. A minority member of an LLC is a member who owns less than 50 percent of the company’s capital interest.
Under state LLC statutes, all LLC members, including minority members, usually have the right to vote on company actions, as well as the right to share in the LLC’s profits and distributions, inspect books and records, and sue another member for a breach of fiduciary duty if they engage in misconduct. A majority vote is typically needed to decide most matters related to the day-to-day business operations, so the ability of a minority member to influence decisions is limited. However, many LLC statutes require unanimous approval for some actions that are outside the ordinary scope of business. The scope of a member’s voting rights may also be limited if the LLC is managed by a manager rather than by the members.
State LLC Laws and the Operating Agreement
Every state has laws addressing LLC governance. These laws become the default rules applicable to an LLC if the company does not create an operating agreement that alters those rules.
LLCs are not required to create an operating agreement in order to form and operate. Those that fail to do so, however, are bound by default state LLC laws regarding the following important matters:
- how the LLC is managed (by members or managers)
- which company actions require a vote and the voting percentage needed for approval
- member duties and responsibilities
- criteria for dissociating a member
- how profits, losses, and distributions are allocated among members
- a member’s rights to sell their membership interest and leave the company and whether the LLC must buy them out
Without an operating agreement that describes each member’s rights and responsibilities and how to govern internal affairs, one-size-fits-all state LLC statutes control when questions and conflicts arise.
Minority LLC Member Oppression
In the absence of protections in their LLC operating agreement, minority members run the risk that the majority members will take actions harmful to them, such as reducing their involvement in the LLC or their ability to receive distributions. This is known as minority member oppression.
Majority members could take various actions that harm a minority member’s interests. These actions may take the form of squeeze-outs and freeze-outs.[1]
- A squeeze-out occurs when majority members deprive a minority member of managerial control over the company and any distribution of the business’s earnings.
- A freeze-out is when the majority forces a minority to unwillingly sell their interest in the company.
Many LLCs are small businesses, and many are family businesses. When they decide to form an LLC, members frequently know one other and approach the new venture with a sense of mutual trust. They may think they have nothing to worry about and that there is no need for contractual protection. But this trust may prove to have been a mistake if they later become the victim of minority member oppression.
Remedies for Minority Member Oppression
The legal recourse available to an oppressed minority member depends on state laws and whether there is an LLC operating agreement.
In the absence of an operating agreement, a minority member who is facing a squeeze-out or freeze-out may bring an action for breach of fiduciary duty.
Note: The existence of fiduciary duties—including the duty of loyalty and the duty of care—vary in member-managed and manager-managed LLCs. Typically, in a member-managed LLC, the members who run the business owe fiduciary duties to the nonmanaging members. And in a manager-managed LLC, a manager usually has a fiduciary duty to the members.
Another option for an oppressed minority member is to petition the court for an involuntary dissolution of the LLC. Following a judge’s order to dissolve the company, assets may be liquidated and distributed among the members. Alternatively, the judge may order majority members to buy out the interest of the minority.
But even if these options are allowable under state LLC laws, they may not be desirable or end in a way that is satisfactory for an oppressed minority member. Ultimately, the court will have the final say about what happens.
Call Us Today
The best way to prevent minority member oppression is to include protections in the LLC operating agreement. Although an operating agreement cannot prevent all disputes, it can provide a roadmap for how to deal with them in a way that protects a minority member’s interest better than the default rules provided by state law.
Our small business legal team can help LLC members review and negotiate the terms of an operating agreement to ensure that their rights are adequately protected. In addition to protections for minority members, the operating agreement can address capital contributions, distributions, voting and control, member and manager duties, indemnification, exit rights, and membership interest transfers. Contact us today to schedule a consultation.
[1] Franklin A. Gevurtz, Squeeze-Outs and Freeze-Outs in Limited Liability Companies, 73 Wash. U. L. Q. 497 (1995), https://journals.library.wustl.edu/lawreview/article/4032/galley/20865/view.
