Getting a Business Divorce from your LLC Without and Operating Agreement May Force you to Stay in the Marriage

An LLC is the premiere small business entity for a reason. It is efficient, flexible, and generally easy to run. But as with all entities, an LLC is still a union of partners that are in it for better or for worse. Sometimes however, better gives way to worse and the partners may have to split…they have to divorce. And although one would like to believe that the separation of partners is a professional affair, it can often be as bitter, vicious, and out of bounds as the separation of spouses.

The critical difference in a separation of partners is that the LLC should provide a reasonable framework to facilitate the exit. Yet often, LLC’s do not have that framework, because they lack an Operating Agreement. In New York, an Operating Agreement is the basic partnership agreement for LLC members (i.e., partners), and should, among other things, specify an exit strategy for individual members or the whole enterprise. The most critical thing to keep in mind is that in New York, an Operating Agreement is both statutorily mandated and, as per certain court decisions, necessary to release members from each other. In short, the Operating Agreement not only lays the foundation for day to day operations, but also for the dreaded divorce scenario.

Consider the case of Horning v. Horning Construction LLC. There, Horning a successful construction business owner, eventually gave two of his employees, Klimowski and Holdsworth, a one-third interest each in a new entity, Horning Construction, LLC. That LLC became the successor to Horning’s business. However, the three members never could finalize the terms of an operating agreement. When Horning eventually offered to sell his interest to the two remaining members for a price he considered fair and equitable, he was rebuffed. Unfortunately, as these things tend to become, the situation became hostile and Horning simply wanted to make an exit.

Since he could not get the other members to agree to buy him out, he sought to have the LLC dissolved and liquidated by court order. Section 509 of the New York Limited Liability Company Law states that if a member withdraws from the LLC, where there is no operating agreement, he can get fair market value for his interest. However, Section 606 provides that without an operating agreement, a member cannot withdraw without causing dissolution first. The court focused on Section 702, stating that in the absence of an operating agreement, dissolution can only occur, "whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement."

Under the Section 702 standard, the court concluded that dissolution was not justifiable. Ironically cursed with success, Horning could not distract the court from the fact that the LLC employed over 40 people and was more than fully operational. As far as the court was concerned, the LLC could carry on its business. Accordingly, Horning was simply trapped.

With regard to his failure to setup an operating agreement and giving the interest to the other members, the court stated “he did this without prior or contemporaneous execution of an operating agreement giving him fair exit rights in the event of future disharmony. Moreover, during the next few years, despite having failed to secure an operating agreement to protect him, he transferred the business of his corporation to the LLC (something he did not have to do if he was dissatisfied with the parties' arrangements. . .”

Dissolution or withdrawal in the absence of an operating agreement is not simply there for the asking. The court in Horning made clear that dissolution as a very last resort, given the LLC laws’ apparent desire to preserve continuity and minimize disruption to ongoing business concerns. Hence an operating agreement is absolutely critical to being able to escape ugly situations, or get a business divorce.