News & Noteworthy

No Written Operating Agreement? … Big Problem.

Sometimes when partners are starting up a business, they fail to follow corporate formalities.  Whether because of a lack of funds, lack of attention to detail, lack of time, lack of desire to crimp new business relationships or simply a lack of desire, corporate founders can fail to exercise various good corporate governance practices.  Written agreements among owners are vital to make clear (and enforceable) the agreements between new partners in a startup company, and can be especially important to minority partners.  One of the reasons that limited liability companies have become the go-to corporate form is because the New York Limited Liability Company Law allows tremendous flexibility in the terms of operating agreements – the agreements governing the relationship between the members of the company.  But, to take advantage of these vast corporate governance rights, the LLC Law states that operating agreements have to be in writing.

A recent New York plaintiff came to learn the downside to laxity in demanding a written agreement when a limited liability company is formed.  In Shapiro v. Ettenson, 2015 N.Y. Slip Op. 31670(U) (Sup. Ct. N.Y. Co. Aug. 16, 2015), aff’d 146 A.D.3d 650, 45 N.Y.S.3d 439 (1st Dep’t 2017), three founding members, each with an equal 1/3 ownership interest, formed a limited liability company.  Two years later and without prior notice, the plaintiff received a notice from the two other members stating that they had adopted a written operating agreement, which provided for management action to be approved by only a majority in interest of the members.  A year later, the two other members provided notice to the plaintiff, pursuant to the new operating agreement, stating that the other members (constituting a majority in interest) voted to issue a capital contribution call and that plaintiff’s equity interest would be diluted if he failed to make the capital call and another member did so in his place.

The plaintiff refused to recognize the validity of the operating agreement and make the capital call pursuant to the agreement.  The other two members diluted the plaintiff’s membership.  The plaintiff sued claiming that the three members orally agreed that such decisions would require unanimous consent (a common provision with two or more members with equal membership interests).

The case started in a Manhattan trial part and ended in an appeal to the First Department Appellate Division (the appellate court that covers New York County and Bronx County).  The appellate court affirmed the holding of the trial court that the alleged oral agreement requiring unanimity in corporate decision-making was void and unenforceable under the New York LLC Law.  The LLC Law expressly provides that in the absence of a written operating agreement, action may be taken after a vote of the majority in interest of the members (i.e. over 50%).  The court found the defendant members, collectively holding a majority interest, properly adopted the operating agreement, made the capital call and diluted the plaintiff’s membership interest – all without notice to the plaintiff and without the plaintiff’s consent.