Ask 10 lawyers whether the best form for your small or medium business is a corporation or a limited liability company (LLC), and you will likely get 12 different answers. Depending on which issues matter more to you and your partners (taxation, limiting personal exposure, limiting access for future creditors, ease of entry for new partners, etc.), the question will result in a different answer. This article will focus only one factors, but a substantial one: the powers of a partner who feels aggrieved to use judicial intervention to end his or her predicament, and the balance of leverage between the minority and majority owners. Let us first lay out the legal differences between the two forms.
A corporation is a creature of statute, with well-delineated rules inscribed in the Business Corporate Law (BCL), and its owners are referred to as “shareholders”. The BCL is an arcane tome of great complication and length; indeed, a printed copy could be used as a mace if attached to a stick. Article 11 of the BCL governs judicial (meaning involuntary, without a vote of all or most of the shareholders), and involves two extremely-confusingly-similarly numbered provisions: 1104a and 1104-a (yes, I am serious).
1104(a) governs “deadlock”, which requires a Petition (lawsuit) be brought by half of the shareholders of the corporation stating that the shareholders or directors are so divided that the corporation cannot obtain enough votes for important actions, for elections of directors of the board, or that there is enough dissension between two or more factions (you would be surprised how quickly small businesses can degenerate into Game of Thrones folks) that dissolution would be in the benefit of the shareholders. Subsections b and c expand this remedy for corporations with super-majority voting requirements, and for those where no new directors have been elected for two years. The petitioning party must show that the “competing interests alleged prevent the efficient management and corporate success of the company.” In Re Fazio Realty Corp. (2004). The dispute needs to be sufficiently acrimonious between two equally-powerful parties such that the company cannot function as intended. Neville v. Martin (2006). In sum and substance, there must be a situation where neither the petitioner nor the respondent can act due to veto power of the other. Imagine the Aesop’s tale of two goats stuck on a bridge with only enough room for one to pass.
The other grounds to dissolve a corporation is under a theory of oppression of one shareholder by another under 1104-a, where the animal analogy is more akin to a cat and a mouse. This section requires that one or more shareholders combining for at least twenty percent of total votership (to avoid giving excess leverage to minimal owners) prove that the “directors or those in control of the corporation” either have oppressed the petitioners, or that looted corporate assets. Oppression generally means that the controlling party “substantially defeats expectations that objectively viewed were both reasonable under the circumstances and were central to the shareholder’s decision to join the venture.” Burack v. I. Burack, In. (1988). It is interesting to note that there is no requirement that the victim be a minority shareholder, or that the oppressing party be in total control. All that is absolutely is one has leverage or power over the other or the corporation, and is abusing it. The mouse can be bigger than the cat, and the theory still workable.
The point of this article is not to distinguish the two theories for corporate dissolution, or how they differ in both proof and outcome (oh baby, do they ever!) That article would be a separate adventure. The only point is to illustrate that in the context of corporations, they exist under a statutory scheme.
LLCs, on the other hand, are creatures of contract. They are created by consenting adults making an agreement (known as “members”, not shareholders), and with several core exceptions, the LLC Law (LLCL) punts to what the contract forming the LLC, known as the “Operating Agreement” says. The LLCL features a lot of language like “unless stated otherwise in the operating agreement.” You are picking your own adventure, but with great freedom comes great danger.
LLCL § 702 is the only section that addresses judicial, involuntary dissolution. The only grounds enumerated is “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” In order to succeed, the petitioner must in essence show either that the company “is unable to function as intended or that it is failing financially.” Schindler v. Niche Media Holdings (2003). Acrimony, hatred, and such is not sufficient, and neither is oppression, unless the Operating Agreement openly says that a member can arbitrate his or her alleged oppression, and force a buy-out or dissolution upon success. Furthermore, while certain general corporate principles have been imported into LLCs (like derivative actions, a separate topic), the Second Department (Brooklyn, Queens, and Long Island) has held that “it would be inappropriate for this Court to import dissolution grounds from the Business Corporations Law or Partnership Law to the Limited Liability Company Law.” In Re 1545 Ocean Avenue, LLC (2010). The protections given to shareholders under the BCL are not afforded under the LLCL.
Nowhere better is the divergence between the two ownership forms in this area than Kassab v. Kassab, where two brothers (again, very medieval stuff) sued over their joint ownership of two real estate parcels. The allegations of abuse of trust, theft, and oppression were more-or-less the same with regards to both properties, but with one major difference: one building was owned by a corporation, and the other by an LLC. The Court granted a forced buy-out to the minority-owner brother after weighing various allegations going both ways pursuant to the BCL as to the corporation, but first utterly dismissed the same exact claims as to the LLC. The Court found, quite simply, that the LLC ownership allows dissolution only when the business cannot conform to the expectations set by the Operating Agreement, or, alternatively, it is a financial failure. Neither was true, and the same claims that led to a huge and complex resolution as the sister corporation resulted in a dismissal as to the LLC. The brothers were left buying each other out of one entity by force, and owning the other together, unless one stepped up to buy out the other voluntarily. A half-divorce, how about that?
There are a few more considerations to…consider. First, BCL § 1118 allows the non-petitioning shareholders accused of oppression to redeem the petitioner’s shares by a Court-appointed buyout sum. The petitioner cannot withdraw their claim of oppression once the oppressor springs this trap. In some cases, this requires petitioners to think twice if their true goal is an actual dissolution rather than a buy-out at market price of their shares. This would be most applicable to real-estate ventures, where the Court would apply a minority-share discount to the value of the shares on a buy-out, whereas sale of the real estate in a true dissolution of the corporation would be full-market. No such “gotcha!” clause exists under LLC dissolution.
Another consideration is that, since the LLCL so heavily empowers the contracting parties to fashion their own remedies in the event of a intra-company dispute, the members can more easily delineate how and when a party can either dissolve the entity, remove another member, or force the other owners to buy them out. The BCL’s various protections can also be an inhibition on the freedom to run the business in a unique or non-conforming way, and the LLC form allows much more flexibility in dispute resolution.
To those of you still reading, I owe a conclusion that goes beyond a comparison, and instead takes a position. If there is one gem to take away from this difference, it is that those with bargaining power, control of the enterprise, and sharp lawyers onboard during the formation phase should use an LLC vehicle. This is also true for companies not planning to seek additional investors after the fact. If, on the other hand, you will be a minority owner, have distrust towards the other owners, or are entering a business after its formation, the corporate form under the BCL will provide you with unwaivable protections that you may not be able to force an LLC majority member to adopt in the Operating Agreement. If you have any questions, feel free to contact me at Yan@MargolinLawNY.com, or call at (212)964-6200.