Amendment of Operating Agreement by Less Than All Members
LLC operating agreements sometimes need to be amended. Members may come and go, more capital may be necessary, or the timing of distributions may need to be changed, for example. If the agreement is to be amended, normal principles of contract law will require that all the members agree.
Sometimes, however, the members will agree in advance that future amendments will require less than unanimity. For example, an operating agreement might provide: “This Agreement may be amended in any respect by the affirmative vote of Members holding a majority of the Units.” Or a supermajority of two-thirds or 80% might be required. This approach is used to provide flexibility, since otherwise a recalcitrant member holding a small ownership percentage could veto necessary change or demand concessions from the company for approving the change.
In some cases a majority-vote provision like the one quoted will include limits on the majority’s ability to amend, such as a prohibition on changing any member’s interest in profits, losses or distributions, without unanimous approval. But what if no limits are included? Are there any limits on the power of the majority to amend the operating agreement?
The California Court of Appeals held last week that there are limits. Abbey v. Fortune Drive Assocs., LLC, No. A124684, 2010 Cal. App. LEXIS 2860 (Cal. Ct. App. Apr. 20, 2010) (unpublished).
Fortune Drive Associates, LLC was a Delaware limited liability company. Brandon Abbey was a member and held a 3% interest. John Sheputis was a member, held a majority interest and was the sole manager. A dispute over a proposed restructuring of the LLC developed between Sheputis and Abbey, and Sheputis concluded it was in the best interest of the members to involuntarily terminate and buy out Abbey’s interest in the LLC.
The LLC’s operating agreement did not authorize the involuntary buyout of a member’s interest. But the operating agreement did provide that it could be amended by a majority vote of the LLC’s member interests. So, Sheputis prepared an amendment that:
- authorized the termination of a member upon the vote of three-fourths of the LLC’s member interests;
- specified the financial terms of the LLC’s buyout of the terminated member’s interest; and
- required that any dispute over the buyout price or any other matter related to the termination be resolved by binding arbitration.
Prior to the amendment, the operating agreement simply provided that any lawsuit relating to the agreement had to be filed in San Francisco.
With no prior notice to Abbey, Sheputis obtained the consent of all members other than Abbey to the amendment and to Abbey’s termination. Abbey filed a lawsuit, the LLC commenced arbitration over the value of Abbey’s interest in the LLC, and Abbey sought a stay of the arbitration and a declaration that he was not bound by the arbitration clause of the amendment.
The court looked to earlier California law on the enforceability of amendments to bank credit card agreements, including Badie v. Bank of America, 79 Cal.Rptr.2d 273 (Cal. Ct. App.1998). Under the prior cases, said the Abbey court, a party with the unilateral right to modify a contract does not have carte blanche to make any kind of change merely by following the prescribed procedure. Abbey, 2010 Cal. App. Unpub. LEXIS 2860, at *13. (The court applied California law because the parties agreed that California law applied to the issue of contract interpretation.)
The court determined that for a non-unanimous amendment to be enforceable against a non-consenting member, the general subject of the amendment must have been anticipated when the agreement was entered into. The court found that three distinct constraints applied: (1) the intent of the parties, (2) whether the terms of the agreement were sufficiently definite, and (3) the implied covenant of good faith and fair dealing.
In analyzing the amendment to Fortune Drive’s operating agreement, the court focused primarily on the intent of the parties. The court noted that although the amendment was written in general terms, it was adopted to deal with the specific situation of Abbey’s termination, limited the types of claims Abbey could bring, and restricted the recovery he could receive. The court found that no member could have had that type of amendment in mind when they agreed that a majority of the member interests could amend the agreement.
While the members might have anticipated adopting arbitration in a manner that was not prejudicial to their individual interests, it is inconceivable [that] any member intended to authorize the majority’s adoption of an arbitration provision that would benefit other members at the expense of his or her own interests. Yet that is what the Third Amendment’s arbitration provision would accomplish in any dispute with Abbey.
Abbey, at *19.
The court concluded that this particular amendment was beyond the intent of the parties when they agreed to majority amendments of the operating agreement, and that therefore it would not be enforced. The court said it did not have to reach the questions of whether the amendment violated the members’ fiduciary duties and the implied covenant of good faith and fair dealing.
Operating agreement provisions that allow amendments by less than all of the members are useful because they allow the LLC to deal with new situations without being held hostage by the demands of a minority member, so long as the necessary majority approves the change. But Abbey shows that there are limits to the kinds of non-unanimous amendment that can be made. An amendment that is targeted at a dispute with a non-consenting member and that significantly disadvantages that member is not likely to be enforceable.
More broadly, amendments that affect all the members in the same way also may be unenforceable if the general subject matter of the amendment was not anticipated when the contract was entered into. That’s a broader constraint, and its limits may be difficult to predict for a particular agreement and amendment.
The Abbey court hung its opinion on the intent of the parties and said it did not have to reach the question of whether the implied covenant of good faith and fair dealing was violated. The obvious unfairness of the Abbey amendment suggests that analyzing the amendment under the implied covenant of good faith and fair dealing would have led to the same result – invalidation of the amendment.
Substance Over Form - LLC "Distributions" Are Recognized as Product Sales
Every so often a case comes along where you read the opinion and say to yourself, “Did they really think this would work?” Meadowsweet Dairy, LLC v. Hooker, Commissioner of Agriculture and Markets, No. 1868, 2010 N.Y. App. Div. LEXIS 1841 (Mar. 11, 2010) is one of those cases.
Steven and Barbara Smith operated a New York dairy and produced and sold unpasteurized milk from 1995 to 2007. During that time they were regulated and inspected by the New York Department of Agriculture and Markets (the Department), and held the permits required by the Department.
In March 2007 the Smiths surrendered their permits and formed Meadowsweet Dairy, LLC. Meadowsweet began operating the dairy and producing unpasteurized milk, cheese and yogurt. But instead of selling milk to the general public, Meadowsweet dealt only with individuals who became members of the LLC. Meadowsweet complied with none of the Department’s permit, inspection and other regulatory requirements.
Meadowsweet’s members were required to make an initial capital contribution of $50, and to make capital contributions at the start of each quarter based on the member’s estimated consumption of milk and dairy products during the quarter. Members were then entitled to receive what were called “dividends,” i.e., distributions from the LLC, in proportion to their capital contributions. The list price of milk received by the member was then credited against the member’s capital account. Milk and other dairy products produced by Meadowsweet were only available to Meadowsweet’s members.
In October 2007 the Department seized 260 pounds of unpasteurized milk from Meadowsweet for noncompliance with its regulations. Meadowsweet then commenced suit, seeking a declaration that the Department lacked jurisdiction.
Meadowsweet’s principal argument was that it was not selling products – that no sale occurred when its members received milk products as distributions. The court, however, looked at Meadowsweet’s system of prepaid capital accounts and offsetting credits equal to the list price of the member’s milk dividend and concluded that “[r]ather than truly constituting dividends in return for their investment in the LLC, this arrangement appears to be a system of prepayment for the sale of dairy products.” Meadowsweet, 2010 N.Y. App. Div. LEXIS 1841, at **10.
The court did not analyze why the arrangement “appears to be a system of prepayment,” but it’s not hard to see what must have been the court’s reasoning. First, the adoption of the new business model (capital contributions and milk distributions that offset against the member’s capital) coincided with surrendering the Department’s permits. But more tellingly, the so-called capital contributions were not used as capital in any normal sense of the word.
The “capital” of a business usually means its assets, such as cash, goods, and machinery, that are used to generate income. Capital is usually held for the long term. An LLC’s operating agreement can specify how distributions are made, see New York Limited Liability Company Law Section 504, and LLCs almost always severely limit the extent to which distributions can be made to members. In contrast, Meadowsweet’s members could unilaterally decide how much milk to consume and thereby control their receipt of “dividends.” Each member’s capital fluctuated during the quarter based on its milk consumption.
The court did not recognize any business purpose for Meadowsweet’s structure other than avoiding regulation, and found that Meadowsweet was in effect selling milk to its members. Meadowsweet labeled its members’ payments as capital and labeled the milk delivered to its members as dividends, but the court ignored the terminology and looked to the substance rather than the form of the transaction. Presumably the court was also influenced by the public health character of the Department’s regulations.
The court also found other reasons why Meadowsweet was subject to the jurisdiction of the Department. The regulations required that producers of milk products such as the cheese and yogurt produced by Meadowsweet must obtain a milk plant permit. The court also held that even if the milk was not sold, a permit is nonetheless required for unpasteurized milk given or otherwise made available to consumers.
In considering the results of this unsuccessful attempt to avoid the Department’s regulations, one wonders whether legal counsel were involved and what role they played. Did a lawyer for the Smiths originate the idea of using an LLC and recharacterizing milk sales as capital contributions and dividends? Or did the Smiths originate the idea and use a lawyer to form Meadowsweet and document the arrangements with milk consumers? Or was the entire plan carried out without the benefit of legal advice? If lawyers were involved they appear to have taken what a more conservative lawyer would call an overly aggressive approach, to put it charitably. Sometimes the best advice a lawyer can give is to say “Let’s stop and think this one over,” and that surely would have been good advice here.
Straightening Out Kinks in Washington's LLC Law
Last month Governor Gregoire signed into law a bill amending Washington’s Limited Liability Company Act (Act). The amendments address the confusion introduced by last year’s Supreme Court ruling in Chadwick Farms Owners Ass’n v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009), and eliminate a nonsensical provision that was injected into the Act in 2009. The amendments will take effect June 10, 2010.
Chadwick Farms dealt with dissolution and winding-up issues. The court held that once a Washington LLC’s certificate of formation has been cancelled, it cannot sue or be sued and any pending lawsuits by or against the LLC abate. The court also held that those who improperly wind up the LLC can be personally liable to the LLC’s creditors. I analyzed the court’s reasoning and some of the questions raised, here.
The bill’s amendments substantially change the Act’s dissolution procedures. Under the current Act, a Washington LLC’s dissolution is a private action that can be taken by unanimous member consent, or that occurs as specified in the certificate of formation or LLC agreement. Wash. Rev. Code § 25.15.270. No public filing is required upon dissolution, but upon completion of winding up, the LLC’s certificate of formation must be cancelled by filing a certificate of cancellation. Wash. Rev. Code § 25.15.080.
The amendments eliminate the entire concept of cancelling the certificate of formation. Effective June 10, 2010 there will be no requirement or ability to file a certificate of cancellation. Instead, a dissolved LLC may elect to file a certificate of dissolution with the Washington Secretary of State. Filing a certificate of dissolution is not mandatory, but if it is filed it commences a three-year survival period, after which claims may not be brought by or against the LLC or its managers or members.
If no certificate of dissolution is filed, claims by or against the LLC or its managers or members are not time-limited, except by any applicable statutes of limitations. Presumably most dissolving LLCs will file the certificate of dissolution in order to start running the three-year period.
The amendments also address the winding-up procedures for a dissolved LLC. A new procedure was added: an LLC that has filed a certificate of dissolution may give notice of the dissolution to known claimants and require that claims be asserted within 120 days of the notice. Claims not asserted within the time limit are cut off. If a claimant responds and the LLC then rejects the claim, the claim will be barred unless the claimant commences a legal action to enforce the claim within 90 days of the LLC’s rejection.
The new bill also addresses a 2009 amendment to the Act, currently codified in Wash. Rev. Code § 25.15.293, which I discussed here. The 2009 change made no sense, and the new bill simply deletes it.
The members of the Washington Bar Committee on the Law of Partnerships and LLCs, ably chaired by Brian Todd, as well as the Washington legislators who worked on this bill, are to be commended for their efforts. The new approach to LLC dissolution is a decided improvement over that of the prior Act.
