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 Apr. 20, 2010) (unpublished).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.
How Not to Draft an Attorneys' Fees Clause
Many LLC operating agreements include a fee-shifting provision, a clause that requires the losing party in litigation between members to pay the prevailing party’s reasonable attorneys’ fees. These fee provisions are usually relegated to the boilerplate sections near the end of the operating agreement, and often don’t get much attention when the agreement is being prepared. A ruling last month from the Idaho Supreme Court shows that if the attorneys’ fees clause is not carefully crafted, it may not work the way the parties intended.
In Henderson v. Henderson Investment Properties, L.L.C., No. 35138, 2010 WL 569890 (Idaho Feb. 19, 2010), the Supreme Court reversed the trial court’s award of $21,552 in attorneys’ fees. The LLC in the case was formed by a husband and wife and their son and daughter-in-law to operate a sandwich shop. Acrimony later developed between the generations, and the father brought suit to dissolve the LLC. The Idaho LLC Act allows a court to order dissolution if actual or threatened irreparable harm results either from member deadlock or from illegal, oppressive or fraudulent acts of the controlling members. Idaho Code Ann. § 53-643.
Mr. Henderson alleged both deadlock and illegal, oppressive or fraudulent acts, with resulting irreparable harm. The trial court dismissed the complaint, holding that although there had been a deadlock it had not resulted in actual or threatened irreparable injury, and that there had been no illegal, oppressive or fraudulent acts. The trial court also awarded attorneys’ fees to the son and daughter-in-law, based on this provision in the LLC’s operating agreement:
In any action or proceeding brought to enforce any provision of this Agreement, or where any provision is validly asserted as a defense, the successful party is entitled to recover reasonable attorneys’ fees in addition to any other available remedy.
The Supreme Court analyzed that language and reversed the award of attorneys’ fees because it found that the plaintiff did not seek “to enforce any provision of the Agreement,” as required by the clause. The plaintiff instead sought dissolution, which is a statutory remedy.
If the parties had been asked about this clause when they signed their operating agreement, they probably would have interpreted it to mean that in any litigation about their rights and duties as members, the winner would have been entitled to recover its reasonable attorneys’ fees.
This clause did not work that way because it applied only to contractual disputes, i.e., disputes over the terms of the operating agreement. The clause did not apply to any of the rights of members that are defined by the statutory provisions of Idaho’s LLC Act. In this case the dispute was over dissolution, a purely statutory remedy. The irony is that if the operating agreement had simply parroted the language of the statute’s dissolution remedy, Idaho Code Ann. § 53-643, then under the court’s reasoning the defendants would have been entitled to attorneys’ fees.
Many important rights of LLC members, such as sharing of profits, rights to distributions, and rights to certain records of the LLC, are controlled by provisions in Idaho’s LLC Act. The Act allows some of those provisions to be waived or modified in the operating agreement, while others are non-waivable. That approach is typical of other states’ LLC statutes.
Under an attorneys’ fees clause like that in Henderson, and under that court’s reasoning, the right of the winning party to get a judgment for attorneys’ fees will depend on whether the dispute was governed by the LLC statute or by specific terms in the operating agreement. That does not seem like the result most business people would intend when they put an attorneys’ fees clause in their operating agreement.
A better solution, of course, is to use a broader attorneys’ fees clause. One example I’ve seen is:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement or to interpret or enforce any rights under this Agreement, [the prevailing party may recover.]
The language “any controversy arising out of this Agreement” may be broad enough to cover both contractual and statutory claims, although it is perhaps susceptible to the argument that statutory rights not referred to in the operating agreement do not “arise out of” the agreement.
I've also seen another approach that would have changed the result in Henderson, but it may be too broad for some situations:
In the event that any dispute between the Company and the Members or among the Members should result in litigation, [the prevailing party may recover.]
This language literally applies to “any dispute” between members, which could cover a dispute between members that has nothing to do with the LLC. A more natural interpretation would limit the scope of the clause to member disputes that have something to do with the LLC, i.e., with their status as members of the LLC. But to be safe, something like the following might be best:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement, or to interpret or enforce any rights under this Agreement or the [name of State] Limited Liability Company Act, [the prevailing party may recover.]
Some LLC operating agreements require that disputes be settled by binding arbitration instead of litigation. A recently-published treatise on drafting operating agreements for Delaware LLCs has a nice treatment of arbitration and attorneys’ fees, among other things. John M. Cunningham & Vernon R. Proctor, Drafting Delaware Limited Liability Company Agreements: Forms and Practice Manual (2009).
In the model operating agreements provided by Cunningham and Proctor, arbitrable matters include “material matters: (1) That arise under or relate to this Agreement or that relate to the LLC…” Cunningham & Proctor, supra, at Form 6.1, § 30.3. Their model agreement then goes on to assign attorneys’ fees to the nonprevailing party:
To the extent that an arbitrator determines that a party to an arbitration has failed to prevail in that arbitration, the arbitrator shall allocate to that party the costs of the arbitration, including reasonable attorneys’ fees and fees payable to the arbitrator.
Cunningham & Proctor, supra, at Form 6.1, § 30.11(c). This approach allows the arbitration to cover any dispute related to the operating agreement or the LLC, and applies the “loser pays” rule to the entire arbitration. This approach would avoid the type of problem dealt with in the Henderson case.
The clause at issue in Henderson, and the court’s ruling, show in microcosm why contract drafting is difficult. The unexpected scenario can rise up to swat the drafter. I’ll wager that when the parties put together their operating agreement in the Henderson case, they paid little or no attention to the exact words of the clause. Before any disputes arose I’m sure they would have said that any dispute directly related to the LLC was intended to be covered by the “loser pays” rule of the clause. But yet it wasn’t.
It was not a case of the language being unclear (although some might argue that); it was primarily a case of the language not reaching far enough in its scope. The Henderson case is an object lesson in vignette form for lawyers who draft contracts. The lesson? Know the underlying law and the context in which you’re drafting, and don’t rely too quickly on language taken from other contracts.
Confusion Over LLC Units
LLC operating agreements often use the term “units” to describe member rights in the LLC. It is convenient to have a word like “units” to label the members’ rights, and “units” is widely used. But “units” has no uniform definition or generally accepted meaning when applied to LLCs.
Andrew Immerman recently authored an article that examines the inherent ambiguity and the confusion that often results from using units to describe LLC member rights. L. Andrew Immerman, Is There Any Such Thing as an LLC Unit?, 11 No. 4 Bus. Entities 20 (July/Aug. 2009), 2009 WL 2563091. The article is a good review of how and why the units terminology is used and misunderstood. It provides examples of the mistaken conclusions that business people can reach when they ignore the differences between shares of stock in a corporation and the rights of a member in an LLC.
Immerman ascribes this confusion to three principal causes. First, business people and sometimes lawyers often think of an LLC as essentially similar to a corporation. Second, the state laws that authorize LLCs do not expressly authorize the issuance of LLC units or define an LLC unit. Third, LLC members are taxed differently than shareholders. LLC taxation can cause units in the same LLC to unexpectedly provide different benefits to their owners, unlike shares of stock, which are usually interchangeable.
There is no concept of “units” in the various state LLC statutes. For example, Washington’s LLC Act makes no reference to units, and simply defines a member’s LLC interest as personal property comprising the member’s share of the profits and losses of an LLC, and the right to receive distributions of the LLC’s assets. Wash. Rev. Code §§ 25.15.005(6), 25.15.245(1).
Delaware’s LLC Act likewise makes no reference to units, and has an almost identical definition of a member’s LLC interest. Del. Code Ann. tit. 6, §§ 18-101(8), 18-701. And neither NCCUSL’s Revised Uniform Limited Liability Act nor the Revised Prototype Limited Liability Company Act from the American Bar Association uses that terminology.
LLCs are distinct from corporations in a number of ways. One major difference is that an LLC is much more a creature of contract than is a corporation. LLC member rights are normally defined by the members’ operating agreement, and only secondarily by the LLC Act. Members are parties to the operating agreement, whereas corporate shareholders hold shares of stock but need not be parties to any contract. Most of a shareholder’s rights will generally be defined by the applicable corporate statute, while an LLC member’s rights will be defined by the terms of the operating agreement. A potential investor in an LLC cannot know what rights the holder of a unit will have without a careful examination of the operating agreement.
Another difference between LLCs and corporations is that the rights associated with ownership of a share of stock are not normally divided. If a share of stock is sold, the rights to receive dividends, to vote, and to receive corporate information will usually all go with the share of stock. Transfer of a member’s interest in an LLC, on the other hand, will convey the right to receive profits, losses and distributions, but it will not necessarily carry with it the right to vote and participate in management of the LLC. All the members must approve the transferee’s admission as a member and participation in management, or the operating agreement may provide for the transferee’s admission as a member. E.g., Wash. Rev. Code §§ 25.15.250, 25.15.260; Del. Code Ann. tit. 6, §§ 18-702, 18-703.
LLCs are taxed as partnerships (absent an election to be taxed as a corporation), so items of profit and loss are allocated directly to the members. The LLC is not a taxpayer. Corporations, in contrast, are taxpaying entities and do not pass profits or losses through to shareholders. (One exception: a corporation can make a Subchapter S election, in which case its shareholders will each be allocated their proportionate share of the corporation’s profits and losses. An S corporation, however, can have only one class of stock and cannot have nonresident aliens or certain types of entities as shareholders.)
LLC members generally want the LLC’s allocations to be respected for tax purposes. This is a matter of predictability and being able to accurately assess and plan for the economic benefits and tax consequences of their LLC investment. For the LLC’s allocations of profit and loss to be respected for federal income tax purposes, the allocations in the operating agreement must comply with a set of complicated Treasury regulations intended to ensure that the allocations have “substantial economic effect.” I.R.C. § 704(b)(2). One of those requirements is that a capital account be maintained for each member. A member’s capital account is increased by the member’s contributions to the LLC’s capital, by profits allocated to the member, and by LLC liabilities assumed by the member, and decreased by distributions paid and losses allocated to the member, and by liabilities of the member assumed by the LLC.
The regulations also require, when the LLC is dissolved and its assets liquidated, that liquidating distributions be made to the members in accordance with the positive balances in their capital accounts. This is a key requirement of the allocation regulations, and has the effect of truing up the final, liquidating distributions with the effects of the LLC’s history. All the prior member capital contributions, distributions to members, and allocations of profits and losses would have impacted each member’s capital account in ways that may have varied from member to member.
Assuming the LLC’s operating agreement complies with these rules, the result is that on liquidation one member may receive substantially more or less per unit than another member receives per unit. A corollary is that at any point in the life of the LLC, one member’s unit may be worth more or less than a different member’s unit. One might try to define “unit” in the operating agreement to take capital account variations into effect, but then the definition would likely not work well for attributes such as voting and establishing percentages for profit and loss allocations.
In corporations it’s different and much simpler. At any given time the corporation’s capital per share is the same amount for all outstanding shares of common stock. If a corporation is dissolved and liquidated, the liquidating distributions per share of common stock will be the same amount for all the shares. “Holders of corporate stock need not worry about capital accounts, and the superficial resemblance of LLC units to corporate stock may create the impression that LLC members can safely ignore the concept as well. It can be perilous, however, to ignore LLC capital accounts.” Immerman, supra, at 62.
In all states LLCs now lead corporations in formations of new business entities. For many business people LLCs are relatively new and sometimes perplexing. Their lawyer or the other parties may present them with operating agreements that describe their interests as “units.” They may be familiar with corporations, but should not be misled by the surface similarities and assume that those units are comparable to shares of stock. The operating agreement should be read and analyzed carefully. The ways in which units are handled in the agreement needs to be thoroughly understood. Because many of the results of a member’s investment will depend on the tax treatment of allocations and capital accounts, an experienced tax advisor should usually be consulted.
Should State Laws Require LLC Operating Agreements to Be inWriting?
A committee of the Washington State Bar Association is currently reviewing the Washington Limited Liability Company Act, RCW ch. 25.15, with an eye toward recommendations for changes to the statute. One of the issues the committee is considering is whether Washington’s LLC Act should continue to require LLC agreements to be in writing. The Washington Act defines a “limited liability company agreement” as a written agreement (or a written statement of a sole member) concerning the affairs or business of the LLC. RCW 25.15.005(5). The result is that only written agreements of the members will control over the default provisions of Washington’s LLC Act.
The state LLC laws vary. Some require that member agreements (often called operating agreements) be in writing, while some allow oral agreements as well as written. Under Delaware’s LLC Act, for example, a limited liability company agreement can be “written, oral or implied.” In contrast, the New York LLC Act defines an operating agreement as a written agreement of the members, much like the Washington definition.
Business lawyers usually have an emphatic answer if asked about oral LLC agreements: “Of course they should be in writing.” That’s generally the right advice to give to a client considering any kind of business investment or transaction more complicated than getting one’s shoes shined at the shoe-shine stand. But some people inevitably will choose to form LLCs with only an oral agreement about matters such as capitalization, profit and loss allocations, distributions, voting control and so on. Should their oral agreement be disregarded if it would yield results different from the default rules under the statute?
Corporations, of course, are in the “put it in writing” camp. All state corporation statutes require that articles of incorporation, the basic charter document, be in writing and be filed with the appropriate state agency to create a corporation. Many state corporate statutes allow shareholder agreements to vary some of the statutory default rules, but those statutes require that the shareholder agreements be in writing and be executed by all the shareholders. E.g., RCW 23B.07.320. The Model Business Corporation Act, which has been adopted in 24 states, takes the same approach by requiring that shareholder agreements be in writing to override statutory default rules. Model Bus. Corp. Act § 7.32 (2002).
Partnership law approaches the issue differently. Partnerships are based on the agreement of the partners, and both the Uniform Partnership Act (UPA), Section 101(7), and the Uniform Limited Partnership Act (ULPA), Section 102(13), provide that partnership agreements can be written, oral or implied. Thirty-six states have adopted the UPA and 15 have adopted the ULPA, including Washington.
The common law concept of a partnership – an association of two or more persons to carry on as co-owners a business for profit – recognizes that partnerships can be formed informally and by oral agreements. Although the formation of a limited partnership also requires the filing of a written certificate with a state agency, the certificate of formation need contain only limited information such as the name and address of the limited partnership, and the name and address of each general partner. The certificate of formation is simply a notice filing and is not usually used to define the rights of the partners.
Even if a state’s LLC Act allows oral LLC agreements, the state’s statute of frauds will apply. A statute of frauds invalidates certain types of agreements unless they are in writing and signed, such as a guaranty of another’s debt or an agreement that by its terms is not to be performed in one year. E.g., RCW 19.36.010.
For example, last year the Delaware Chancery Court ruled that the Delaware statute of frauds applied to the oral limited liability company agreement of a Delaware LLC. Olson v. Halvorsen, No. 1884-VCL, 2008 WL 4661831 (Del. Ch. Oct. 22, 2008). The court accordingly dismissed a claim under the agreement that called for a multiyear earn-out after a member’s retirement, since by its terms that provision of the agreement could not be performed in a year.
Washington’s and New York’s LLC Acts do not invalidate an oral LLC agreement. Instead they simply define the LLC agreement as a written agreement. Many of their statutory rules may be waived or modified by the members’ agreement, if it is in writing. The New York court has held that if the member agreement is not in writing, the LLC exists but the default rules in the statute govern the LLC, rather than conflicting terms in the oral member agreement. Spires v. Casterline, 4 Misc.3d 428, 778 N.Y.S.2d 259 (Sup. Ct. 2004). Presumably an oral agreement that supplements but does not purport to override the defaults of the LLC Act would still be enforceable.
To return to the question, should state law require LLC agreements to be in writing? The policy in favor of requiring written agreements is similar to that behind the statute of frauds – experience teaches that certain types of agreements are so significant that the higher degree of certainty inherent in a writing should be required. In the event of a dispute, permitting oral LLC agreements will increase litigation costs because of the difficulty of proving the oral terms. It will also be more difficult for new members of an LLC to determine the oral terms governing the LLC.
The policy that supports allowing oral LLC agreements is that of not frustrating the expectations of the parties. LLCs are popular for smaller businesses with few members, who often form an LLC with minimal legal formalities. Many states, including Washington and Delaware, have recognized in their statutes the goal of maximizing the enforceability of agreements between members: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” RCW 25.15.800(2). That policy is undermined by not enforcing oral member agreements. Also, it seems anomalous to have a different rule on this point for LLCs than for limited partnerships, since in Washington and most other states the limited partnership agreement can be written or oral. RCW 25.10.010(9).
LLCs are used for a wide range of types and sizes of businesses. Large enterprises normally have legal counsel, accountants and written LLC agreements. Smaller, closely held enterprises sometimes don’t have written agreements. An efficient and flexible LLC statute should work well for the widest range of individuals and groups forming an LLC. To do that it should recognize that some LLCs will be based on oral agreements. The need to prove the terms of an oral agreement in the event of a dispute seems an inadequate reason for automatically disqualifying all oral LLC agreements. On balance, the policy reasons seem to tilt in favor of allowing LLC agreements to be oral as well as written.
When I started writing this post I was on the fence on this issue, but I’ve come to the conclusion that the best approach for the Washington LLC Act is to allow LLC agreements to be oral as well as written. But I recognize that people may differ on this point, and I would welcome any comments or input on this issue. Feel free to comment by clicking on the "Comment" link below.
