The law governing California limited liability companies evolves in real time | Lessons from the courtroom battlefront

Why Having “Co-Managers” for Your LLC is a Terrible Idea

The trend in most real estate-related LLCs is to have a single appointed manager.  Under the LLC’s operating agreement, the manager typically has authority to make the day to day business decisions on behalf of the LLC, while the members usually play no role in those day to day decisions.

Occasionally, however, LLCs are structured differently.  Some LLCs with an egalitarian bent might appoint “co-managers” who will (theoretically) make decisions together.  That might work — IF the operating agreement contains an appropriate “tie-breaking” mechanism.  But all too often, the operating agreement does not envision any type of discord, and might simply contain a boilerplate tie-breaker of a “majority membership vote” when the only members might be the co-managers.  And when the vote is 1 to 1, there is no majority.

When an LLC has two co-managers in conflict, without a tie-breaking mechanism, the disruption can be wide-spread.  A recent decision from California’s Sixth District Court of Appeal — Jarvis v. Jarvis — illustrates the point.  While the Jarvis decision addressed a partnership with two general partners, the lessons are equally important for LLCs.

Facts: partnership with two general partners; no tie-breaking mechanism

Jarvis Properties is a limited partnership that owns a two-acre parcel of land in Salinas.  Its two general partners — brothers Todd Jarvis (“Todd”) and James Jarvis (“James”) — each owns a 50 percent interest in the partnership.

Under the governing partnership agreement, majority consent was required to act on behalf of the partnership.  The agreement contained no mechanism for handling a decision-making deadlock.  The two general partners disagreed on what to do with the partnership’s property.

James filed an action for partition by sale, naming Todd and the partnership as defendants.  The lawsuit asserted that the brothers are “unable and unwilling to collectively manage or develop” the property.

In response, Todd hired one attorney to defend himself, and hired a second attorney (William Roscoe) to represent the partnership.

James objected to Roscoe’s representation of the partnership, and filed a motion to disqualify Roscoe on the ground that Roscoe was not authorized to act by the required majority of the general partners.  James argued that Roscoe was taking direction from Todd, and could not remain neutral.

The trial court granted the motion and disqualified Roscoe from representing the partnership.

Todd filed an appeal on behalf of himself and the partnership.

Court of Appeal’s opinion: disqualification was proper due to the conflict in authority

The Court of Appeal affirmed the trial court’s order, holding that Roscoe was properly disqualified from representing the partnership.

The court made clear that it was not a “conflict of interest” that barred Roscoe’s representation, but rather a “conflict in authority” — the two general partners of the partnership could not agree on Roscoe’s representation.

The court stressed that an attorney representing a corporate entity owes duties to the entity, and normally takes direction from whoever has authority to manage the entity.  Looking to a State Bar ethics opinion, the court went on:

Lack of clarity over who is authorized to oversee the engagement of the attorney for the partnership places the lawyer in a position where he or she cannot follow one partner’s instruction without violating the other partner’s instruction. … [W]here the lawyer cannot reasonably determine which partner’s instruction the lawyer may follow, the lawyer cannot take any action for the partnership in connection with the matters in dispute, until the dispute is resolved.

Where neither the entity’s governing documents nor state law dictate how to handle a decision-making deadlock, the attorney may have no choice but to withdraw (or face disqualification).

The court noted that disqualification was appropriate because of the concerns raised regarding Roscoe’s duty of loyalty.  “Since Todd selected Roscoe, is paying Roscoe, and is directing the litigation, there is the appearance that Roscoe may advance Todd’s interests over James’s interests, which may not necessarily be in the best interests of the Partnership.”

The Court of Appeal left it to the trial court to fashion an appropriate remedy, which might include: allowing the brothers to continue the litigation with the entity remaining on the sidelines and bound by whatever outcome the brothers reached; appointment of a receiver to act for the entity; or appointment of neutral counsel to protect the entity’s interests.

Lesson

Decision-making within a small business entity is usually best performed by one person.

If the governing documents appoint two “co-managers” or co-general partners, then there should be a clear and sensible mechanism for resolving decision-making deadlocks.  (Hint — not by majority vote.)  The agreement could, for example, provide for the appointment of a neutral provisional manager or partner to act as a tie-breaker.

Leave a Reply

Basic HTML is allowed. Your email address will not be published.

Subscribe to this comment feed via RSS