By Jennifer M. Osgood, Esq. on May 06, 2022.
Traditionally, courts tasked with resolving irreconcilable differences between owners of a Limited Liability Company (“LLC”) had one primary tool available: judicial dissolution. Changes to the LLC laws in several states, however, have opened an alternative: the compulsory buyout. For drafters of LLC operating agreements and members of LLCs, it is important to understand how these changes may affect the process by which LLCs do (or do not) come to an end, and what that means for Colorado LLCs.
Compulsory Buyouts: What Are They?
Compulsory buyouts offer an arguably less drastic remedy when the only way to resolve an ownership dispute is to judicially dissolve the company. Compulsory buyouts work as follows: when irreconcilable disputes among members arise, rather than ordering the dissolution of an LLC, certain jurisdictions permit one member to buy another member out (regardless of whether the operating agreement contemplates such a buyout) in order to save an otherwise viable business.
A limited number of jurisdictions have adopted a “statutory buyout” provision. In these states, within the context of a judicial dissolution action, a non-moving member is statutorily authorized to purchase the interest of the moving member at fair market value. Other jurisdictions, however, provide for a compulsory buyout even without express statutory or contractual authority (as set forth in an LLC’s operating agreement). This is referred to as an “equitable buyout.”
At this time, Colorado has not adopted a statutory provision that provides for compulsory buyouts within the Colorado Limited Liability Company Act (the “LLC Act”). Nor has any Colorado court recognized compulsory buyouts as an equitable remedy in LLC dissolution cases. However, this trend towards compulsory buyouts (statutory or equitable) as an alternative to judicial dissolution is worth monitoring. Indeed, compulsory buyouts could have a significant impact on Colorado practitioners (both litigators and transactional attorneys) and LLC members in the future.
For non-moving members, the all-or-nothing outcome of a dissolution proceeding can be jarring.
LLCs as Contracts
Although Colorado LLCs are subject to the LLC Act, they are fundamentally creatures of contract between members, primarily by means of the LLC operating agreement. As such, when disputes arise among the owners of an LLC, Colorado courts look first to what the owners said in their contract (i.e., the operating agreement). This contractual flexibility gives wide berth for an LLC to conduct its affairs as it chooses, so long as the conduct is lawful.[1] As the Colorado Supreme Court put it in Lafond v. Sweeney, the “provisions of an operating agreement shall control over any provision of this article to the contrary, with limited exceptions.”[2]
As noted above, the LLC Act does not provide for compulsory buyouts as an alternative to dissolution. Consequently, when members of a Colorado LLC can no longer carry on the business of the LLC, unless otherwise provided for in the operating agreement, judicial dissolution is often the only available remedy. For non-moving members, the all-or-nothing outcome of a dissolution proceeding can be jarring.
Equitable Buyout to Avoid Judicial Dissolution
A handful of states have enacted statutes to avoid the potentially harsh result of judicial dissolution.[3] Some other jurisdictions have adopted the concept of common law “equitable buyout.” For example, in Mizrahi v. Cohen, a New York court held that (in the absence of an express statute authorizing compulsory buyouts) “a buyout may be an appropriate equitable remedy upon the dissolution of an LLC” as long as the other requirements for judicial dissolution had otherwise been met.[4] There, an accountant and an optometrist formed an LLC “for the purpose of the construction and operation of a mixed-use commercial/residential building.”[5] When one member failed to make equal capital contributions to their 50-50 venture, the other member petitioned “for an order authorizing him to purchase the defendant’s interest in the limited liability company upon its dissolution.”[6] The Court held that, although “[t]he Limited Liability Company Law does not expressly authorize a buyout in a dissolution proceeding . . . [n]onetheless, in certain circumstances, a buyout may be an appropriate equitable remedy upon the dissolution of an LLC.”[7] The Court then remanded the matter for the trial court to determine the value of the ownership interest of the party subject to compulsory buyout.[8]
Judicial Dissolution and Compulsory Buyouts in Colorado
The LLC Act does not contain a compulsory buyout provision, and no Colorado Court has yet addressed the issue of equitable buyout in the context of an action to dissolve an LLC. Absent an express buy-out provision in the operating agreement, judicial dissolution is the only means by which Colorado courts can currently resolve irreconcilable disputes among the owners of LLCs. And even then, judicial dissolution is only permitted in limited circumstances.
Under existing LLC law in Colorado, an LLC may be dissolved in a judicial proceeding brought for fraud or abuse, or “if it is established that it is not reasonably practicable to carry on the business of the limited liability company in conformity with the operating agreement.”[9] Whether it is reasonably practicable to carry on the business is determined by weighing seven factors:
(1) Whether the company’s managers are unable or unwilling to pursue the purposes for which the company was formed; (2) whether a member or manager has committed misconduct; (3) whether it’s clear that the members aren’t able to work with each other to pursue the company’s purposes; (4) whether the members are deadlocked; (5) whether the company’s operating agreement provides a means for resolving any deadlock; (6) whether, in light of the company’s financial condition, there remains a business to operate; and (7) whether allowing the company to continue is financially feasible.[10]
But even where it is clear the owners are at loggerheads, dissolution is a remedy not often applied. The Colorado Court of Appeals in Gagne v. Gagne, for example, held “that to show that it is not reasonably practicable to carry on the business of a limited liability company, a party seeking a judicial dissolution must establish that the managers and members of the company are unable to pursue the purposes for which the company was formed in a reasonable, sensible, and feasible manner.”[11] On remand, the district court—after reviewing the factors outlined above—entered an order for the dissolution of the Gagne LLC.[12] A later decision of the Colorado Court of Appeals in the long-running Gagne litigation affirmed the lower court’s order on dissolution, but noted that that court was reluctant to dissolve the LLC—still, “it felt it had little choice given the ‘clearest evidence’ of [member] misconduct.”[13]
Founding members of an LLC can and should consider alternatives to dissolution while drafting an operating agreement.
While the district court may have been reluctant to dissolve the LLC at the request of a single member, this was the only remedy available to the parties under the LLC Act and the operating agreement.
Discussion
It may be tempting in circumstances such as Gagne’s to invoke “equity,” and to fashion an alternative to dissolution, particularly when one or more members want to continue the business. This kind of remedy, however, runs contrary to the principle that LLCs are creatures of contract and enjoy primacy over statutory or judge-made rules (except in specifically delineated circumstances[14]). Founding members of an LLC can and should consider alternatives to dissolution while drafting an operating agreement. But giving Courts discretion to craft remedies never contemplated or agreed to by the members in the operating agreement can leave drafters and practitioners uncertain as to how their LLCs will (or will not) come to an end.
In lieu of a court-created “equitable” solution, Colorado could enact statutory law to provide for compulsory buyout as an alternative to dissolution in the future.[15] Such a statutory buyout scheme would provide clarity for drafters of LLC operating agreements and for members of LLCs. With a statutory buyout framework lurking in the background, for instance, LLC members could contract around the buyout remedy if they wanted to do so in the operating agreement. By the same token, members who did not address buyout rights in their operating agreement would run the risk that the LLC Act would fill any contractual gaps—as is the case with a number of other member rights.
Conclusion
At present, Colorado law does not provide for compulsory buyout as an alternative to the judicial dissolution of an LLC. It remains to be seen whether it will do so in the future. In the interim, LLC members should proactively review their current operating agreements and consider whether they should provide an alternative to judicial dissolution before a dispute arises.
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[1] C.R.S. § 7-80-108(1)(a); Lafond v. Sweeney, 343 P.3d 939, 945 (Colo. 2015)(“Members or managers may include in the operating agreement any provisions regarding ‘the conduct of its business to the extent such provisions are consistent with law.’”).
[2] Id. (internal quotations omitted).
[3] E.g., Cal. Corp. Code § 1770703(c)(1); Fla. Stat. Ann § 605.0706; 805 Ill. Comp. Stat. Ann. 180/35-1(b); Minn. Stat. Ann. § 322B.833(2); N.D. Cent. Code Ann. § 10-32.1-50(2); Utah Code Ann. § 48-3a-702.
[4] Mizrahi v. Cohen, 104 A.D.3d 917, 920 (N.Y. App. Div. 2013).
[5] Id. at 918.
[6] Id. at 917.
[7] Id. at 920.
[8] Id.
[9] C.R.S. § 7-80-810(2).
[10] 338 P.3d 1152, 1160 (Colo. App. 2014).
[11] Id.
[12] Gagne v. Gagne, 2019 COA 42, ¶ 8.
[13] Id., ¶¶ 14-37.
[14] See C.R.S. § 7-80-108(2).
[15] Moreover, to the extent that Colorado chooses to adopt a statutory buyout provision within the LLC Act, they would not need to look too far for guidance. When a partner dissociates from a partnership dissolving the LLC, the Colorado Uniform Partnership Act allows the partner to “buy out” the dissociated partner for “an amount equal to the value of the partner’s interest in the partnership.” In addition, in July 2021, the Colorado Corporations and Associations Act was amended to include a statutory provision which allows a corporation or its shareholders to purchase the shares of a shareholder moving for judicial dissolution. See C.R.S. § 7-114-305.