Arbitration and the Prospective LLC Member

In the beginning of May, a California appellate court issued an interesting ruling regarding whether or not an individual who wished to become a member of an LLC could be compelled to arbitrate under the LLC’s existing operating agreement.

In the case, Kothari v. Desai, Kothari and her husband, Michel, were employees of a start-up venture associated with toothpaste, run by Desai. Kothari had a quasi-familial relationship with Desai as Desai raised Kothari from the age of 4 until 12. Desai allegedly made repeated oral promises to both Kothari and Michel that he would grant them significant ownership in the business. After four years, Kothari (holding an undergrad degree from Harvard and a law degree from Stanford), issued a written demand for their promised ownership interests and Dasai summarily fired them.

The issue the court had to deal with was whether or not the the broad arbitration agreement in the operating agreement (ironically, written by Kothari) was applicable to Michel. Kothari did have a nominal 5% interest already, so she was bound. But Michel had nothing. Desai wanted them both to go into arbitration against him.

The courts determined that the arbitration provision did not apply to Michel and he could not be compelled into arbitration. While there are instances that a non-signatory to an agreement might be viewed as a third-party beneficiary and, accordingly, found to be bound, there was no evidence that Michel was in such a position. The question at issue, the court held, was whether or not “the original contracting parties intended to confer any benefit on the third party” when they entered into the agreement.

In business arbitrations, one of the threshold issues is arbitrability and this is a prime example of that being missing as to Michel.