Forming a Business with Others — Be Afraid, Be Very Very Afraid
Okay, so the quote from the Gina Davis character in the remake of the SciFi classic The Fly may be over the top. But when forming a business venture with others, a person should keep a healthy but critical eye out for the possibility of being screwed by one’s partners. To help prevent such a possibility, a key element in any business formation and for the ongoing relationship of its
members is having an operating agreement (if the company is an LLC) or a shareholders’ agreement (if it is a corporation). However, too often new businesses put such important legal concerns on the back burner until … well, until the pot and its contents get burned. A recent New York appeals court decision has now highlighted how devastating such dilatoriness can be.
First some background: The operating agreement in an LLC or the shareholders’ agreement in a corporation determine the rights, interests and obligations of the LLC members or the corporation’s shareholders. Absent a signed agreement being in place and in the event of a dispute among the members, the fallback will be what law will allow and provide — and that too often means the matter gets resolved in an expensive lawsuit.
However, the LLC Law differs substantially in many ways from the Business Corporation Law, particularly in New York. For instance, in many states the Business Corporation Law specifically allows minority shareholders to seek dissolution of the company if they have been shut-out or oppressed by the majority shareholders. But that right is not mirrored in New York’s LLC Law. And so, we come to Shapiro v. Ettenson, decided by the Appellate Division First Department in Manhattan on January 24, 2107 (2017 Slip Opin. 00442).
The Shapiro case concerned ENS Health, LLC, a company with three co-equal founding members. The company was founded in 2012, but without an operating agreement. Then in 2013, two of the members by majority vote and consent adopted and signed an operating agreement. That operating agreement provided that by majority vote the members could require additional capital contributions (a capital call) from all members and could reduce any member’s percentage of ownership interest and operational participation if he failed to contribute. The third member, plaintiff Robert Shapiro, never approved of or signed that operating agreement.
The two majority members issued the capital call, Mr. Shapiro refused to pay, the majority then reduced his capital ownership interest in the company and also reduced his salary to zero. Shapiro sued, claiming that when the three members founded the company they had an oral agreement that all company decisions had to be unanimous and that the operating agreement was invalid because they had not unanimously adopted it.
However, the New York LLC Law only requires a majority vote to adopt, amend, restate or revoke a company’s articles of organization or its operating 
agreement, unless the members have a signed agreement stating otherwise. So, the court rejected Mr. Shapiro’s contention of the prior oral agreement and found that the majority had properly adopted the operating agreement that allowed for the majority to reduce Shapiro’s ownership interest. The Appellate Division affirmed the lower court but also found, ironically, that the operating agreement, which Shapiro refused to sign, did give him a modicum of protection from having his salary arbitrarily reduced to nothing.
Unfortunately, it is not uncommon for three-member companies to wind up in two-against-one situations. If the members of ENS Health, LLC truly intended that all company acts had to be unanimously approved, then they should have memorialized that requirement in an operating agreement. By allowing the company to operate for more than a year without an agreement, Shapiro provided an opportunity for the other members to oppress him and to do so legally under the LLC Law. The moral here is that people going into business with others should not invest their money, time and effort without first providing for the future, and that means adopting a properly prepared operating agreement or shareholder’s agreement.