Advantages of Detailed Agreements between Owners of a Business: Part II, Enforceable Legal Rights Only Available in a Written Agreement

As mentioned at the end of Part I, negotiating and agreeing to a detailed intra-owner agreement (be it a “Shareholders’ Agreement,” “Buy/Sell Agreement,” “Operating Agreement,” etc.) at the outset of a business enterprise is not only beneficial for avoiding or mitigating disputes, but also gives the entrepreneurs the opportunity to grant themselves legal rights and protections they might not otherwise have.  Below are a few examples. 

Ownership Transfer Restrictions

The first such right is restriction on transfer of an owner’s interest in the business to a third party.  Under the default rules for Corporations, LLCs, and Limited Partnerships, an ownership interest may simply be personal property,^[i] and any owner may freely transfer (sell, assign, gift, pledge, hypothecate, pawn, etc.) all or part of that interest without having to even ask the other owners for their permission or input.  While the precise effect of such a transfer varies depending on the entity, this could result in the other owners effectively going into business with someone completely unworkable, and on an involuntary basis.  Very often, such an interloper may be the heir of a deceased owner, or the spouse of an owner following a divorce, who may not even have any interest in providing value to the business, but merely wants to cash out, putting incredible strain on the working owner(s).  This can readily be prevented, or at least heavily mitigated, in a properly drafted intra-owner agreement. 

General Partnerships present a different problem: the death/departure of a partner or attempted transfer of a partnership interest generally results, under the default rules, in an immediate dissolution of the General Partnership,^[ii] triggering an accounting and distribution of the partnership’s assets.^[iii]  That result can also readily be prevented in a written Partnership Agreement by providing for an orderly mechanism of transfer of the interest and an express declaration that the partnership will survive the event.   

Supermajority Voting Requirements

A second highly desirable legal right is making key business decisions subject to supermajority voting requirements.  Generally, the default rules for all entities require a simple majority (51%) of the equity ownership to vote in favor of a business action in order for all owners and the business to be bound by that decision.^[iv]  However, it is prudent to have a higher voting threshold—perhaps including unanimous voting—for major actions like mergers and acquisitions, the offer or transfer of an ownership interest to a new person, adding or discontinuing lines of business or locations, capital expenditures or indebtedness above a certain value, or the decision to dissolve and wind down the business.  Without a written agreement requiring supermajority approval, it is much easier for certain owners or blocs of owners to run away with the business and “oppress” the minority owners, and even force them out of the business.

Determining the Cash Value of an Ownership Interest

A third such right is the ability to fix the valuation of the ownership interests in the business, or at least fix the means of finding that value.  Otherwise, it will be up to the individual owners in a dispute to obtain expert valuations—which are not cheap and which can be highly variable—and then litigate over the value.  Litigation may happen in a dispute where there is a written intra-owner agreement, anyway; but if the agreement provides a value or methodology, any court hearing the dispute is likely to follow what the agreement provides.^[v]

Advance Payment of Litigation Costs

Another important right is the subject of a very recent decision from New York’s highest court, the Court of Appeals.^[vi]  This is the right of owners to be “indemnified” by the business or an adverse owner for the costs of litigation among the owners, such as attorney’s fees, expert’s fees, discovery expenses, etc., which can get very large very quickly in this type of dispute.  As discussed in Part I, the business entity can shield owners from monetary liability to third parties outside the business—but not from each other. 

The “default” rule is that each party pays its own costs out-of-pocket to sue his/her co-owners (or defend such a suit), regardless of who may ultimately win.  However, if explicitly stated in a written intra-owner agreement, an owner defending against such a lawsuit may be able to be indemnified in two ways: (a) have the business “advance” all costs of litigation, i.e. pay the bills as they accrue, and then (b) recover those costs from the disputing owner if successful in the litigation.  This is both a significant deterrent to the bringing of litigation in the first place, as well as an important tool for ensuring that the defending owners can continue to operate the business while the dispute plays out.   Such a contractual provision must be clear and unambiguous, however, or else a court may not allow a successful owner to be indemnified for defense costs.  Note also that an unsuccessful owner who received an advancement of litigation costs may be required to reimburse to the business for those costs.

Operating Agreements: A Wealth of Options

In addition to the rights discussed above, LLCs are legally designed to give their owners a great deal of flexibility in how they conduct their business relationship.  They are more like partnerships than corporations (particularly regarding simpler tax treatment), but with the liability shield afforded to corporations—and they can be structured for both large and small businesses.  Key to doing so are two steps: formation of the LLC via Articles of Organization that allow the exercise of certain rights, followed by a well-tailored Operating Agreement to detail those rights. 

An Operating Agreement is technically required by law to be executed by the owners within 90 days of forming the LLC.^[vii]  While there appears to be no direct legal consequence to the failure to enter into an Operating Agreement, owners of a minority share of the business (less than 50%) put themselves at great legal peril by proceeding to do business without one, as I’ve written about previously. 

Anyway, in an Operating Agreement for a properly-formed LLC, the owners can grant themselves rights such as:

• The ability to appoint one or more Managers to operate the day-to-day business, effectively the company’s president and other officers, who need not be owners themselves.^[viii]  Otherwise, any owner (a “Member”) of the LLC might have that authority,^[ix] which could lead to conflicts among owners, as well as confusion and potential liability concerning dealings with third parties.
• Creation of classes of ownership/membership,^[x] with some Members granted greater voting and/or economic rights (typically, those providing greater monetary investment or services), while others receive lesser such rights.  An ownership class can even be created for members to have no voting rights at all, only rights to profits—beneficial for startups seeking capital, but not wanting to cede any control.  Otherwise, all Members share profits, losses,^[xi] and voting power^[xii] in proportion to the percentage of the LLC that they own.   
• Similarly, establishment of a hierarchy for the distribution of company profits, sometimes referred to as “waterfall” provisions.  In this way, certain preferred class(es) of Members (such as major investors) can be paid some or all of their distribution entitlements first, with other Members only receiving distributions if there is excess money available.^[xiii] 
• Setting simplified procedures for voting on company actions, or eliminating the vote altogether.^[xiv]  In this way, an LLC can be more nimble than other business entities, particularly if the Manager is given unilateral authority to make significant decisions without a Member vote.  Caution must be taken, however, not to vest too much control in any single person. But whereas a corporation may require a vote of the board of directors or a full shareholder vote for major business decisions, an LLC can dispense with many of these formalities.

As you might be able to tell from all of these options, there is no one-size-fits-all agreement for any business.  Rather, the goal is for the owners to reach an understanding early, commit it to writing, and use their best efforts to follow it in good faith.  While no agreement can prohibit or prevent future strife, and perhaps a cynical attorney may think that strife is inevitable at some point, making the initial legal and accounting investment into a detailed intra-owner agreement can go a long way toward planning a successful and long-term business relationship. 

Michael R. Frascarelli, who may be reached at mfrascarelli@cmrlaw.com, is an attorney and counselor at law focusing his practice on general commercial contracts and litigation, construction contracts and litigation, business law and ownership disputes, intellectual property, insurance coverage, bankruptcy, environmental law, land use, employment, health care, appeals, and other matters before state and federal courts.  He also represents clients in alternative dispute resolution proceedings (mediation and arbitration) and in pre-litigation assessments and negotiations. 

Endnotes:

[i] LLC Law §601; Partnership Law §§ 52, 107.  As to stock in even a small business corporation, see Borden v. Guthrie, 23 A.D.2d 313, 260 N.Y.S.2d 769 (1st Dep’t 1965), aff'd, 17 N.Y.2d 571, 215 N.E.2d 511 (NY 1966) (“The general rule is that a stockholder has a legal right to vote and dispose of his stock as his self-interest dictates.”)

[ii] Partnership Law §62.

[iii] Partnership Law §71.

[iv] Business Corporation Law §614(c); LLC Law §402; Partnership Law §40(5).

[v] E.g.: Sitler v. Saratoga Assocs. Landscape Architects, Architects, Engineers, And Planners, P.C., 101 A.D.3d 1451, 956 N.Y.S.2d 339 (3d Dep’t 2012); In re El-Roh Realty Corp., 48 A.D.3d 1190, 851 N.Y.S.2d 777 (4th Dep’t 2008); Ehrlich v. Calabro, 280 A.D.2d 311, 721 N.Y.S.2d 23 (1st Dep’t 2001).

[vi] Sage Systems, Inc. v. Michael Liss, Oct. 20, 2022, available at https://www.nycourts.gov/CTAPPs/Decisions/2022/Oct22/75opn22-Decision.pdf

[vii] LLC Law §417(c). 

[viii] LLC Law §§ 408–410. 

[ix] LLC Law §412(a).

[x] LLC Law §418, Article V.

[xi] LLC Law §503.

[xii] LLC Law §402(a).

[xiii] For example, see AJG Parkview Corp. v. Calabrese, 187 A.D.3d 1175, 135 N.Y.S.3d 115 (2d Dep’t 2020) (in dispute between two LLC owners, lower court committed reversible error by ordering distribution of proceeds from construction project in a manner that deprived one owner of the benefits of waterfall provision in operating agreement). 

[xiv] LLC Law §§ 418–419.