If an LLC’s Operating Agreement contains a sufficiently broad arbitration clause, most disputes raised by the LLC’s members relating to the LLC will be sent to arbitration (instead of the court system) for resolution.
But what if the complaint is brought by a third party seeking to enforce a promised membership interest in the LLC?
A recent unpublished opinion from California’s Fourth Appellate District — Kothari v. Desai — addressed this issue. While the Kothari opinion is not published (and therefore not binding precedent), it may provide useful guidance as to how courts could rule in similar situations.
Facts: promises of LLC membership unfulfilled
Mira Kothari and Christian Michel, a married couple, filed a civil lawsuit in court against Ashok Desai arising from the business operations and ownership of Desai’s LLC — MBKV.
The parties had a history. Desai and his wife raised Kothari from the age of four years old until she was twelve. They maintained a “close familiar relationship” and Kothari viewed Desai “as a father figure.” Kothari earned an undergraduate degree from Harvard and a law degree from Stanford. In 2011, Kothari decided to pursue a career as a talent agent in the entertainment industry. However, she was persuaded by Desai to participate in a business “opportunity” relating to patented cosmetic dental paste used to whiten teeth.
Kothari provided consulting and legal services and also contributed money to the newly formed LLC. She also drafted its operating agreement, which included a broad arbitration provision. The agreement listed Kothari with a five percent ownership interest, but she alleged Desai promised to increase her percentage to reflect her status as a “co-founder.”
Kothari and Michel signed an Employment Agreement with the LLC, under which the LLC would pay them salaries. Kothari and Michel alleged that the salaries were “lower than market value benchmarks,” but they agreed because Desai orally promised to partially compensate them with additional ownership shares in the LLC.
After four years of work, Desai refused to give Kothari and Michel their promised ownership interests. After Kothari and Michel made a written demand for their ownership interests, Desai terminated their employment.
Kothari and Michel sued, asserting claims based on their promised LLC membership interests and their wrongful employment termination, among others.
Trial court: motion to compel arbitration denied
Desai filed a motion to compel arbitration.
Desai asserted that the operating agreement’s arbitration provision broadly covered all disputes “relating to the LLC among members,” and therefore the trial court was required to compel arbitration of Kothari’s and Michel’s claims. Desai conceded that Michel was not an LLC member, but argued that Michel was still bound by the arbitration clause as a “third party beneficiary” of the operating agreement.
Kothari and Michel opposed the motion, arguing their claims were based not on the operating agreement, but on their employment agreements and Desai’s oral agreements regarding equity interests.
The trial court denied Desai’s motion, and Desai appealed.
Court of Appeal: affirmed; no arbitration because non-member not bound
The Court of Appeal affirmed the trial court’s ruling.
The court first pointed out that under California Code of Civil Procedure section 1281.2, one exception to the enforceability of a contractual arbitration clause is when pending litigation with a third party (such as Michel in this case) creates the possibility of conflicting rulings on common factual or legal issues.
Desai argued that Michel’s claims were subject to the arbitration clause because the lawsuit’s ultimate goal “was to gain LLC membership interests.” Desai’s briefing referred to Michel as a “purported member of the LLC” instead of an employee.
But the court held this argument “puts the proverbial cart before the horse. Regardless of the breadth of the contractual language, a plaintiff can only be forced to arbitrate their claim if they are a party bound by the terms of the arbitration agreement.” Michel was not a member and did not sign the operating agreement, and he was never told that his employment status with the LLC was dependent on his willingness to arbitrate. His employment agreement with the LLC did not mention arbitration, the operating agreement, or a potential equity stake in the company.
The court acknowledged that a nonsignatory is sometimes required to arbitrate a claim if they are a “third party beneficiary” of the arbitration agreement. But here, there was no evidence that Michel was an intended third party beneficiary of the operating agreement. The operating agreement was formed before Michel had any involvement with the company.
It was not enough that Michel’s claims sought LLC membership status. The court held: “The question is not what a third party seeks or desires, but rather whether the original contracting parties intended to confer any benefit on the third party.”
Thus, even though Kothari’s claims alone might have been captured by the arbitration clause, because they were factually and legally intertwined with Michel’s third party claims, the trial court properly denied Desai’s motion to compel arbitration.
Under the holding of the unpublished Kothari opinion, claims by a “purported” LLC member seeking an award of promised equity interests in the LLC might not be subject to the operating agreement’s arbitration clause.