The Business Divorce Law Report
Limited liability companies are creatures of contract, and the Operating Agreement is the Magna Carta of the business. Because it is a contract, however, all of the members must consent to any changes to the Operating Agreement, which means that the holdout member has a veto. In short, the minority rules on major changes.
The Minority Rule Problem
All of the members, save one, may agree that a change to an operating agreement is in the best interests of the business. Yet that one holdout, for whatever reason, can veto the change because a contract cannot be changed unless all of the parties’ to the original agreement consent.
To avoid minority rule, most operating agreements contain some provision permitting amendment by a majority or super-majority vote. But does that mean that the members can treat amendments as arms length transactions in which they are free to vote as they choose? Probably not.
You won’t find any new Jersey cases on point, but a recent decision involving a Delaware LLC, decided by a court in California, provides some insight on how those issues are likely to be treated.
The Abbey Decision
In Abbey v. Fortune Drive Associates, LLC (Abbey v. Fortune Drive Associates.pdf), the LLC’s operating agreement permitted amendment by majority vote. The majority decided they would be better off without Mr. Abbey and amended the operating agreement to provide for termination of members by majority vote, the terms of the buyout and binding arbitration of termination disputes. And, of course, immediately voted to terminate the plaintiff. The LLC then commenced an arbitration, and litigation followed over whether the arbitration provision was enforceable. The trial court stayed the arbitration.
On appeal the issue was whether the amendment, including the arbitration provision, was enforceable because the LLC in making the amendment had followed the procedures of its Operating Agreement. While giving deference to the LLC’s ability under Delaware law — and New Jersey is no different — to govern their relationship by contract, the California court held that different principles apply to amendments. They key points of the decision included:
- The broad freedom of members to structure the operating agreement does not mean that the members have the same broad authority to amend the agreement if the vote is less than unanimous.
- Once the operating agreement has been executed, the members expectations constrain the changes that can be made without all of the members’ consent.
- The members are subject to fiduciary duties to each other in adopting amendments
- The obligation of the parties to act in good faith and to deal fairly with each other limit the permissible scope of an amendment.
New Jersey LLCs
New Jersey’s LLC Act contains a provision, N.J.S.A. 42:2b-22, modeled on the Delaware code allowing the members of an operating agreement to order their affairs by contract and giving broad discretion to the members to provide for amendments.
And while the scope of the fiduciary duties owed between members of a limited liability company are still developing — some commentators insist there are none — it is not realistic to expect that a court would find that some level of loyalty is owed among the members.
New Jersey courts are solicitous of the rights of minority business owners and, given the broad powers of the courts to fashion an equitable remedy, it is unlikely that a wrong will go unremedied even if there is no explicit treatment of the issue in the LLC act.
Members of an LLC also should bear in mind that New Jersey courts apply broad principles of good faith and fair dealing in contractual disputes when one party is being deprived of the benefit of its bargain in a contract. Over-reaching behavior — even in an arm’s length commercial transaction and even in strict compliance with the terms of an agreement — can still result in a damages award.