Fun with Arbitration: Washington Rules LLC’s Bound to the Arbitration Clauses in Their Own Operating Agreements

From the Desk of Partner Gordon C. Klug:

Arbitration agreements are necessary and irreplaceable tools used to avoid the expense and public exposure of litigation. However, if the language of an arbitration clause does not make clear which parties are subject to the arbitration agreement, litigation may be necessary to correct the ambiguity.  

Claims Pointer:

In this case, the Washington Court of Appeals determined that limited liability companies can be compelled to resolve their disputes via arbitration when their own operating agreements require arbitration by its members.

Berman v. Tierra Real Estate, LLC, 83311-1-I, 2022 WL 3584302 (Wash. Aug. 22, 2022).

Facts:

Limited Liability Companies (“LLCs”) are legal entities created by statute that limit liability for their members to the extent of their financial investment into the LLC.  The same is true of corporate business entities, however LLCs have the additional benefit that profits created by the LLC are only taxed once (as personal or business income of the member) and not twice as you see with traditional corporate business entities. 

Plaintiff was a minority owner of three LLCs: Tierra Real Estate Group, LLC (“TREG”), Boyden Investment Group, LLC (“BIG”), and Phat Sacks Corp. These three LLCs owned and operated retail cannabis stores. The other owners of these three LLCs, not including Plaintiff, also owned part of two additional business entities.

In August 2017, the other owners, apart from Plaintiff, formed a new corporation named Interurban Capital Group, Inc. (“ICG”) to coordinate management services between the retail stores of all five entities, and to facilitate expansion of their stores. Plaintiff received shares of ICG at its inception.

In April 2018, under a “Sublease Agreement”, Plaintiff agreed to exchange approximately half of his shares of ICG for $35,000 a month until ICG acquired all the planned retail stores.

In March 2020, ICG was acquired by another company, Harvest Health and Recreation, Inc. (“Harvest”). After this acquisition, Harvest stopped making the $35,000 monthly payments to Plaintiff.

In March 2021, Plaintiff filed a complaint against all five business entities (TREG, BIG, Phat Sacks, and the two entities of which Plaintiff was not an owner) for breach of the Sublease Agreement and added the individual managers of the entities as defendants.

In August of 2021, Plaintiff amended his complaint and added a laundry list of additional claims including wrongdoing related to the merger, promissory estoppel, breach of operating agreement, unjust enrichment, tortious interference with contract, breach of fiduciary duty, declaratory relief, civil conspiracy, and dissolution. Several claims were brought by Plaintiff individually and several were brought on behalf of the entities of which Plaintiff was a member, TREG and BIG.

Various defendants moved to compel arbitration based on the arbitration clauses within both the BIG and TREG operating agreements, and the trial court compelled arbitration on some, but not all, of Plaintiff’s claims. The trial court determined that Plaintiff’s individual claims for breach of fiduciary duty and civil conspiracy, brought against the individual Defendants, were arbitrable under the respective operating agreements, but that Plaintiff’s identical derivative claims on behalf of TREG and BIG were not arbitrable. The trial court also did not compel arbitration of Plaintiff’s personal civil conspiracy claims against TREG and BIG.

TREG, BIG, and several individual defendant members appealed.

Law:

An LLC is a flexible business structure that is authorized by statute. Chadwich Farms Owners Ass’n v. FHC LLC, 166 Wn.2d 178, 186­­–87, 207 P.3d 1251 (2009).

Washington’s Limited Liability Company Act (“WLLCA”) provides that “the limited liability company agreement governs . . . [r]elations among the members as members and between the members and the limited liability company.” RCW 25.15.018(1)(a) (emphasis added). Under the WLLCA, to the extent that the claims at issue fall within the scope of the arbitration agreement, both the members and the LLC are bound to the terms of the agreement.

Further, Washington courts apply a “strong presumption in favor of arbitrability,” and have stated that “[d]oubts should be resolved in favor of coverage.” Peninsula Sch. Dist. No. 401 v. Pub. Sch. Emps. of Peninsula, 130 Wn.2d 401, 414, 924 P.2d 13 (1996).

Waiver of a contractual right to arbitration is disfavored, and a party seeking to establish such a waiver has a “heavy burden of proof.” Steele v. Lundgren¸85 Wn. App. 845, 852 P.2d 671 (1997).

Analysis:

In this case, the Washington Court of Appeals dissected the Plaintiff’s claims to decide whether the claims fell under the scope of each entity’s respective arbitration agreement. Ultimately, based on the language of each entity’s arbitration agreement, the Court held that each of the claims did fall under the scope of the arbitration agreements and were thus arbitrable. 

For each separate claim, Plaintiff argued that despite the broad language in the arbitration clauses in the entities’ operating agreements, the arbitration provisions only applied to “disputes arising between members”, meaning that arbitration would not be appropriate for a suit brought against an LLC itself.  The Court disagreed, holding that the broad language of the arbitration provision unambiguously indicated an intent to arbitrate all disputes between the parties, including the LLCs as entities. The Court came to this same conclusion as to each of Plaintiff’s claims, determining that based on the language of the arbitration clauses in each of the entities operating agreements, that the LLCs themselves were bound to arbitrate.

The Court also analyzed whether the Defendants had waived arbitration by litigating for several months instead of pressing for an arbitration hearing. Specifically, Plaintiff argued that Defendants waived their right to arbitration when they filed a motion to dismiss Plaintiff’s initial complaint for failure to state a claim, and again when they served discovery on Plaintiff. To this, the Court held that the Defendants had not waived arbitration because the motion and service of discovery took place before Plaintiff amended his complaint to include the arbitrable claims at issue. Plaintiff’s initial complaint only included a claim for violation of the Sublease Agreement, which the Defendants did not seek to arbitrate. Further, Defendants moved to arbitrate within 30 days of Plaintiff’s amended complaint, which included the arbitrable claims. Based on this analysis, and because waiver of arbitration is generally disfavored in Washington, the Court concluded that the Defendants did not waive their right to arbitrate.

Big Picture:

In the context of arbitration agreements, wording matters. Even though Washington Court’s typically have a strong presumption in favor of enforcing arbitration agreements, an arbitration agreement still must be clear about which parties are subject to the agreement.  The parties in this case undoubtedly spent a significant amount of money in legal fees over an operating agreement that was crystal clear.