At the outset of forming an LLC, everyone gets together around the table to agree on the operating agreement and its provisions. A party who is always at the table, but who is frequently forgotten, is the LLC itself. Sometimes, I see operating agreements signed by the members, but not the LLC. A recent Washington Court of Appeals case, Berman v. Tierra Real Estate Group, LLC, 515 P.3d 1004 (2022), highlights some of the issues in making an LLC a party to its own operating agreement through a dispute over the arbitrability of direct vs. derivative claims.
The Dispute
The dispute in Berman likely began where all business divorce cases start: everyone on the same page and excited for the prospects of the pending business venture. In Berman, the parties formed three entities that owned and operated retail cannabis stores. To facilitate expansion, the members formed a new corporation, ICG, that would apparently oversee management of the existing stores and new stores the parties intended to either open or acquire. Briefing by the parties before the Court of Appeals indicates that ICG (1) “would provide coordinated back-office management services such as human resources and regulatory compliance to all the Stores, and thereby achieve economies of scale for those services” and (2) “would allow the Stores to exploit their combined retail experience to attract investors and thereby facilitate expansion into other states such as California and Iowa, and perhaps complete a public equity offering or be acquired by a venture capital firm.” The plaintiff, Berman, received shares in ICG at its inception.
In April 2018, the parties entered into an agreement they styled as the “Sublease Agreement,” where Berman agreed to exchange almost half of his shares in exchange for a monthly payment of $35,000. Shortly after this arrangement was finalized, a publicly traded cannabis firm, Harvest Health & Recreation, Inc., acquired ICG. Harvest, however stopped making payments to Berman after the acquisition. Litigation between ICG and Harvest erupted, resulting in a settlement to which Berman objected. Berman proceeded to file a lawsuit asserting various claims, both direct and derivative, for breaches of fiduciary duty, civil conspiracy, and judicial dissolution.
Trial Court Kicks Some Claims into Arbitration, But Not All Claims
The Defendants moved to compel arbitration on Berman’s claims. Interestingly, the trial court split the baby and ordered arbitration on Berman’s direct claims, but not Berman’s derivative claims. The Court of Appeals did not elaborate on the trial court’s reasoning. But after examining one of the arbitration clauses, there may be some indication as to why the trial court did not require arbitration of the derivative claims.
The arbitration clause provides as follows: “In the event that the Members are unable to reach agreement through mediation, then such dispute arising among the Members shall be resolved by arbitration…” Significantly, derivative claims are claims brought by a member on the LLC’s behalf. In other words, derivative claims are technically an LLC’s claims. As such, derivative claims may not necessarily be considered a “dispute…among the Members.” This may be the reason why the trial court ultimately decided to only compel arbitration on the direct claims.
Court of Appeals Compels Arbitration on All Claims
Nevertheless, I certainly think the Court of Appeals correctly overturned the trial court in deciding that all claims—both direct and derivative—are subject to arbitration. An argument that derivative claims do not constitute disputes among the members is certainly a stretch.
In making its rule, the Court of Appeals noted one particular fact that is significant for practitioners to consider: “[The LLC] is a party to the agreement: a representative of [the LLC] signed the agreement on behalf of the entity.” 515 P.3d at 1009. Frequently, I see operating agreements where only the members sign the agreement. This ignores the reality that—as the Court of Appeals noted—“the limited liability company agreement governs … [r]elations among the members as members and between the members and the limited liability company.” Id. (emphasis from Court). In light of this, we always recommend that the LLC be a party to its own operating agreement.
However, the Court did go on to cite the Uniform Limited Liability Company (ULLCA) in noting that the LLC does not necessarily have to be a party to its own operating agreement: “A limited liability company is bound by and may enforce the operating agreement, whether or not the company has itself manifested assent to the operating agreement.” Id. Interestingly, the Court noted that it could make that allusion to ULLCA because “Washington’s act was substantially modeled on the ULLCA.” In making this reference the Court cites to Dragt v. Dragt/DeTray, LLC, which is a case from 2007 decided 10 years before Washington amended its LLC Act (perhaps the validity of the Court’s citation is a blog post for another time).
Takeaways for Practitioners
Practitioners should always make the LLC a party to its own operating agreement. A legitimate question arises as to whether an LLC can enforce the terms of the operating agreement to which it is not a party. And, while the Court of Appeals cited the 2007 case for its reliance on ULLCA, there is good reason to believe that after the 2016 amendments to Washington’s LLC Act, such references to ULLCA may not be as reliable as they once were.
Another issue to consider is the consistency of dispute resolution clauses when the same individuals have multiple entities governed by multiple operating agreements. This was not an issue before the Court in Berman, but frequently some individuals sign multiple operating agreements, particularly for sophisticated ventures. An issue arises when one of those operating agreements includes a mandatory arbitration, while other agreements do not. Consistency is key and can be achieved at the outset when everyone is on the same page, rather than trying to pick up the pieces after a dispute arises.