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 Apr. 20, 2010) (unpublished).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.
Oregon Clarifies LLC Derivative Suit Requirements
The Oregon Court of Appeals has clarified when and how members of an Oregon LLC can maintain a derivative suit in the name of the LLC. Bernards v. Summit Real Estate Mgmt., 229 Or.App. 357, 213 P.3d 1 (July 1, 2009). Oregon’s LLC Act allows member derivative suits, but the court imposed additional pleading requirements on the complaint. The court also found that a requirement in the LLC’s operating agreement of unanimous member approval before commencing any suit in the name of the LLC was subject to the agreement’s standard of care and to the implied duty of good faith and fair dealing.
The plaintiffs (Bernards) were minority members of two member-managed LLCs. Each of the LLCs owned apartment buildings and entered into management contracts with the defendant management company (Summit). Bernards claimed that Summit and one of its officers (McKenna) had embezzled the LLCs’ funds, and demanded that the other members approve lawsuits by the LLCs against Summit and McKenna to recover the funds. (The operating agreements for the LLCs required the unanimous approval of the members to bring legal action in the name of the LLCs.)
The other members refused to approve a lawsuit without giving any reasons for their refusal, even though McKenna had admitted embezzling substantial amounts from the LLCs. Bernards then brought derivative suits against Summit, McKenna and the other members, alleging that the other members had breached their duty to the LLCs by refusing to approve the lawsuits against Summit and McKenna.
Oregon’s LLC Act authorizes derivative proceedings by a member in the name of an LLC. Or. Rev. Stat. § 63.801(1). The statute requires that the complaint allege with particularity either that a demand to file the suit was made of the managers (or members in the case of a member-managed LLC), or why a demand was not made. Or. Rev. Stat. § 63.801(2).
The statute does not explicitly refer to any requirement of wrongdoing by the members that refused to approve the lawsuits. The court nonetheless held that when the members have refused the demand for litigation, the complaint must allege facts showing wrongdoing by the refusing members. Bernards, 229 Or. App. at 364.
The court analogized LLC derivative suits to corporate derivative suits. The court had previously held that Oregon’s almost identical corporate statute required, albeit in a demand-futility case, that the complaint in a shareholder derivative suit plead facts showing wrongful conduct by the directors. The court in Bernards applied the corporate rule, holding that in order to rebut the presumption that the members were exercising their business judgment, the complaint must allege facts showing wrongful conduct by the members.
Section 63.801(2) of Oregon’s LLC Act allows the LLC’s operating agreement to vary the statutory pleading requirements. The court therefore looked to the operating agreements and applied their standard of care as the definition of wrongful conduct—gross negligence, fraud or willful or wanton misconduct.
The other members argued that the operating agreements’ requirement of unanimous member consent trumped the pleading requirements of Or. Rev. Stat. § 63.801(2). The court disagreed and held that the requirement of consent was not equivalent to giving every member the unfettered authority to withhold consent. The right to consent was subject to the express standard of care in the operating agreement and the implied duty of good faith and fair dealing. The court noted that the requirement of unanimous member consent meant that the plaintiffs had to allege facts demonstrating that all of the member defendants refused wrongfully. “[I]f even one of them refused to proceed and had a valid business reason for doing so, the LLCs could not bring legal action against McKenna and Summit.” Bernards, 229 Or. App. at 367-68.
The court concluded that the facts alleged by the plaintiffs were not adequate to demonstrate wrongdoing. Yes, there was a clear right to recover the embezzled funds (one defendant had admitted the embezzlement). Yes, the other members refused to sue when a demand was made. Yes, the other members had not provided an explanation for their refusal. Yes, one member had stated that he would not authorize legal action against McKenna and Summit “no matter how much money they had embezzled.” Bernards, 229 Or. App. at 362. But, said the court, it was not alleged, for example, that the members had refused to provide an explanation, or that they had a personal financial interest in McKenna or Summit, or that they were driven by some personal animus against the plaintiffs. The result was that the court affirmed the trial court’s dismissal of the complaints.
The Bernards opinion is noteworthy not only because it answered an open question under Oregon law, but also because it reasoned by analogy and applied Oregon’s corporate law of derivative actions to LLCs. And the result here was clearly right--why should a minority member be able to sue in the name of the LLC to initiate litigation when the other members have decided that the LLC should abstain, without alleging some facts showing that that there was something wrong with the other members’ decision, such as a conflict of interest? Also noteworthy is that the court applied the business judgment rule, while implicitly recognizing that an LLC’s operating agreement could change the rule for that LLC.
