Under Section 603 of New York’s LLC Law, unless the operating agreement says otherwise, membership interests in limited liability companies (LLCs) are freely transferable but the transferee only gets the transferor’s economic rights to distributions and allocation of profits and losses. Under Section 604‘s default rule, the transferee becomes a full-fledged “member” with voting and management rights only upon the consent of a majority in interest of the existing members (other than the transferor). The default rules in Sections 18-702 and 704 of Delaware’s LLC Act essentially are the same.
The typical, closely held LLC has relatively few members, most if not all of whom are active in the business. In my experience, the bulk of operating agreements deal with membership interest transfers in one of two ways, either by prohibiting all transfers of any kind except as specifically allowed by the agreement, or by including provisions that track the statutory default rules. The primary aim and practical effect of both versions is to prevent membership interest transfers to outsiders in furtherance of the members’ all-important right to choose their own business partners.
But what about insider transfers, that is, from one existing member to another existing member? Does the default rule (and operating agreements that track the default rule) requiring member approval to bestow voting rights on new members apply to an existing member acquiring an incremental interest? For example, in an LLC with three co-equal members A, B and C, if A assigns his entire one-third membership interest to C, does C end up with a two-thirds economic interest and 50% voting interest (B holding the other one-third economic interest and 50% voting interest) or does C end up with two-thirds economic interest and two-thirds voting interest?
The question came to the fore in Achaian, Inc. v. Leemon Family, LLC, C.A. No. 6261-CS (Del Ch Aug. 9, 2011), decided earlier this month by Chancellor Leo Strine of Delaware Chancery Court (HT: Pileggi). In Achaian, involving a three-member LLC, Chancellor Strine construed the operating agreement’s transfer provisions, which generally tracked the Delaware statute’s default provisions, as allowing one 30% member to transfer both its economic and voting rights to another 20% member without obtaining the third, 50% member’s consent, based on the agreement’s definition of a member’s interest as “the entire ownership interest of the member.” The ruling created a 50/50 deadlock between the two remaining members and laid the basis for the court’s order granting judicial dissolution of the LLC.
The subject company in Achaian, called Omniglow, LLC, manufactures chemiluminescent novelty items such as glowsticks. Omniglow’s operating agreement authorized a member to “transfer all or any portion of its Interest in [Omniglow] to any Person at any time” but also provided that “no Person shall be admitted as a Member of [Omniglow] . . . without the written consent of the Member[s].” The agreement defined “Interest” as “the entire ownership interest of the Member in Omniglow.”
The existing 50% member, in his opposition to dissolution, argued that these provisions do not vary the statutory default rule limiting the assignment to economic rights absent member consent, and that the assignee-member did not acquire any voting rights associated with the assigned 30% interest. Chancellor Strine disagreed, writing:
When read as a whole, as it must be, the LLC Agreement provides that all of the rights accompanying the Interest–including voting rights–in Omniglow may be transferred to an already existing Member of Omniglow without the written consent of the other Members. Read in complete context, the LLC Agreement makes Interests in Omniglow freely transferable subject only to a limited proviso that requires the written consent of the existing Members in order for a transfer to confer the status of Member on a Person, who at the time of the transfer was not already a Member. Because Achaian was already a Member at the time of the Purchase Agreement and nothing in the LLC Agreement requires that it be readmitted as a Member with respect to each additional Interest it acquires in Omniglow, it was entitled to receive the “entire ownership interest” owned by Holland [the assignor], including the Interest’s corresponding voting rights. [Footnotes omitted.]
Professor Larry Ribstein commenting on Achaian concludes that the decision “reaches the wrong result.” In his view, the operating agreement does not vary the default rule primarily because the Delaware statute (Section 18-101) defines “interest” as including only economic rights, therefore the agreement’s use of the modifier “entire” in the phrase “entire ownership interest” only modifies economic rights. Since the other pertinent provisions do not address the situation in which an existing member acquires additional voting rights, he reasons, “the statute fills in the gaps by providing that a member can get shares with voting rights only by member consent.”
Section 18-101 has its analog in Section 102(r) of the New York LLC Law which defines “membership interest” as including economic and voting rights. It’s doubtful, however, that the New York statute brings any greater clarity to an Achaian-like situation in view of the explicit language found in LLC Law Section 603 providing that “the only effect of an assignment of a membership interest is to entitle the assignee to receive, to the extent assigned, the distributions and allocations of profits and losses to which the assignor would be entitled.”
Any shift of voting power among existing members can be just as consequential–and sometimes more consequential–as the addition of a new member. A shift in control from inter-member transfers can occur when no single member has a 51% interest (as in Achaian) or, even if there is a member with 51% voting power, when the operating agreement requires a super-majority vote to approve certain major decisions.
There’s no single drafting solution.
Sometimes the parties to the operating agreement collectively will prefer explicit prohibition on transfer of membership interests–both economic rights and voting rights–to any person inside or outside the LLC, absent the unanimous agreement of the other members or otherwise subject to express rights of first refusal that temper any realignment of voting power among the remaining members.
Sometimes the parties will want the right freely to assign economic rights, in which case the operating agreement should address explicitly whether the assignor can or cannot also freely convey voting rights to an insider or an outsider.
And, of course, in the push and pull of negotiations between members with disparate interests, and depending on the specific voting percentages at inception and the presence or absence of super-majority voting requirements, one or another party may desire (or resist) a provision allowing inter-member assignments of membership interests inclusive of voting rights.
In all events, the fact that the top judge on the Delaware Chancery Court and the top expert on LLC law disagree on the outcome in Achaian should serve as a red alert for lawyers drafting operating agreements for any LLC with three or more members, not to overlook prospective scenarios involving transfers of membership interests between existing members.