For months, if not years, you received distribution checks from the business in which you own an interest. The funds came without question and like clockwork. You relied on them. Then suddenly, they stopped coming. Is this the result of a downward business cycle or something more sinister? Before jumping to conclusions, you should seek answers. Here’s how.
Often privately held businesses are organized as limited liability companies (“LLCs”). LLCs are hybrids of corporations and partnerships. They typically insulate members from personal liability to outside parties, a corporate characteristic, and the members are only taxed at the personal level, like partnerships.
Although they are creations of statute, subject to certain conditions, LLCs are governed by their operating agreements. These documents are the contractual agreements among an LLC’s members laying out how the company does business and who is responsible for what. Your rights as an owner of an LLC should be provided in the operating agreement, subject to certain statutory guardrails. So, the first stage of this information gathering process likely lies therein.
Seeking Pertinent Information
The path to obtaining financial and operational information from the company may hinge upon how it is structured. LLCs are either member-managed, or manager-managed. The former is exactly how it sounds: the company is managed by the members themselves. In a manager-managed entity, however, a designated manager runs the company’s day-to-day affairs, subject to certain limitations. The operating agreement should lay out the company’s management structure. If it does not specify that the company is manager-managed, the management of the entity defaults to member-management by statute.[1]
In a member-managed LLC, without demand, a member is entitled to “any information concerning the company’s activities, financial condition, and other circumstances which the company knows and is material to the proper exercise of the member’s rights and duties…”. Additionally, a member in a member-managed company has the right to inspect the company’s records on “reasonable notice”, during “regular business hours” and at a “location specified by the company”, to the extent that information is material to the member’s rights and duties.
In a manager-managed LLC, a member’s right to access company information also exists, but is somewhat more constrained. For example, while a member may still access “information regarding the activities, financial condition, and other circumstances of the company as is just and reasonable” “during regular business hours” and at a “reasonable location”, the purpose of such an inquiry must be a) material to the member’s interest as a member, b) the member must make a demand describing with particularity the information sought and the purpose for seeking such information, and c) the information sought is directly related to the member’s stated purpose for seeking the information. If the company declines the request, it must provide its reason for doing so.
Generally speaking, under either management structure, a member would be entitled to information related to the financial condition of the company--even though the steps to obtain that information may vary in process and exertion.
What to Consider Once You Obtain the Company’s Financial Information
Many variables affect a company’s financial well-being. It’s possible that the cessation of distributions came about due to economic factors or even good organizational governance. Indeed, the person or people managing the company may actually have been following the rules of the road. For example, by statute, New Jersey LLCs are prohibited from making a distribution if doing so would leave the LLC insolvent insofar as “the company would not be able to pay its debts as they become due in the ordinary course of the company’s activities” or “the company’s total assets would be less than the sum of its liabilities plus the amount that would be needed, if the company were to be dissolved, wound up, and terminated at the time of the distribution” in order to satisfy preferential rights which are superior to those of the person receiving distributions. In fact, within the statutory framework, there exists a function to claw back such improper distribution. Consequently, the lack of distributions could have been in line with the company’s statutory obligations, and presumably, the information you (hopefully) receive should demonstrate as much.
The alternative reason for not receiving distributions could arise from much more nefarious origins. It is entirely possible that those running the company are enriching themselves at your expense. Put another way, they are paying themselves distributions masked as fees or otherwise, instead of paying you the distributions you had been receiving previously and otherwise may be entitled to. Depending on the circumstances, such an unfortunate development could be a breach of the fiduciary duties LLC members and managers owe to one another. It goes without saying that if such machinations are afoot, don’t expect the company to be forthcoming with the information you request.
Takeaways
There’s no reason to sit idly by when the spigot has been turned off. Even in situations where you have but a minority interest in an LLC or have taken a passive role and entrusted its management to someone else, you have the right to ask questions, seek information, and if the circumstances merit it, push for reforms to the company’s governance. If after making those inquiries, you are not satisfied with the level of cooperation or information you have received from the company, a deeper legal inquiry could be merited.
[1] References throughout are to New Jersey statutes.
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