Protections available to majority and minority business owners can vary greatly, depending if your business is a corporation or an LLC. It’s crucial to understand these differences when you are starting a business, so you can plan properly and minimize potential problems down the road.
The differences between corporations and LLCs are shown starkly in a March 9, 2016, decision of the North Carolina Business Court. Four members of an LLC, holding 60% of the membership interests, terminated a 40% member as manager and tried, unsuccessfully, to force a sale of the business. The sale required a supermajority approval of 75%, and the forty percent holder objected. The majority owners issued a $100,000 capital call, and when the 40% member did not meet that capital call, the majority sued him. The 40% member counterclaimed, alleging that the majority owners owed him fiduciary duties which they violated by using a capital call to force him out.
If the same facts happened in a corporation, the minority owner would have had a good case. North Carolina courts have ruled that “a fiduciary duty could arise where multiple minority shareholders in a corporation acted in concert to control the corporation.” But, as we have previously written in this newsletter, corporations are creatures of statute, and LLC’s are creatures of agreement. The LLC statute says that “[i]t is the policy of this Chapter to give the maximum effect to the principle of freedom of contract and the enforceability of operating agreements.” N.C. Gen.. Stat. § 57D-10-01(c).
The Business Court ruled that the requirement for a supermajority vote for designated actions adequately protected the 40% owner, who therefore did not have a claim for breach of fiduciary duty. Therefore, there was nothing to prevent the 60% majority from using a capital call to dilute the 40% owner.
What is the lesson? If you are investing in an LLC as a minority owner, your only protections are in the Operating Agreement. Make sure it is done correctly. If you want the ability to veto certain decisions as a minority owner, that must be spelled out in the Operating Agreement. Conversely, if you are starting a business that will have minority owners, the LLC is an attractive vehicle, because unless the Operating Agreement itself restricts what you can do as a majority owner, the courts are less likely to exercise judicial oversight.
View the Business Court’s decision here: