An appellate decision last week sounds alarm bells for minority members of New York LLCs that have no operating agreement and for anyone considering becoming a minority member of an LLC without first having in place an operating agreement.
By the same token, the decision provides opportunities for majority members of existing LLCs without operating agreements to cement and expand their control powers.
Last week’s unanimous decision by the Manhattan-based Appellate Division, First Department in Shapiro v Ettenson, 2017 NY Slip Op 00442 [1st Dept Jan. 24, 2017], affirmed the lower court’s order enforcing an operating agreement signed by two of the LLC’s three co-founding, co-equal members, adopted two years after the LLC’s formation without the signature or consent of the LLC’s third member. Among other features, the operating agreement departed from the statutory default rule by authorizing the reduction of the percentage interest of a member who fails to satisfy a capital call approved by the majority, which is exactly what the two majority members did following their adoption of the agreement, along with eliminating the minority member’s salary.
In a prior post I gave a detailed report of the case background and the lower court’s first-of-its-kind ruling. In a nutshell, the three founding members formed and began operating the LLC in January 2012 with no operating agreement. They subsequently negotiated and exchanged draft agreements but none was executed. In December 2013, two members acting by written consents and majority vote executed and adopted an operating agreement and filed amended articles of organization designating the LLC as manager-managed. The operating agreement authorized the members to approve, by majority vote, requests to members for additional capital contributions and the reduction of a member’s percentage interest upon failure to contribute.
The third member, who never signed or otherwise approved the operating agreement and who claimed the members at inception orally agreed to act only by unanimous consent, sued to invalidate the operating agreement after the two other members approved a capital call and resolved to eliminate the third member’s salary. The lower court agreed with the majority members that LLC Law § 402 (c) (3) (“except as provided in the operating agreement . . . the vote of a majority in interest of the members entitled to vote thereon shall be required to . . . adopt, amend, restate or revoke the articles of organization or operating agreement”) authorizes the adoption of an operating agreement by vote of a majority in interest, and disagreed with the plaintiff member that LLC Law § 417 (“the members of a limited liability company shall adopt a written operating agreement . . . before, at the time of or within ninety days after the filing of the articles of organization”) requires the members’ unanimous consent to adopt an operating agreement.
The Appellate Division’s decision affirming the lower court’s order devoted just a few sentences to the subject. Here’s what it wrote:
Plaintiff argues that [the] LLC’s operating agreement is invalid because its adoption was not unanimous. However, New York Limited Liability Company Law § 402(c) provides that the operating agreement may be adopted by “the vote of a majority in interest of the members entitled to vote thereon.” Plaintiff contends that the parties had an oral agreement regarding unanimity on this issue. However, Limited Liability Company Law § 417 requires a written operating agreement, and where there is no operating agreement or the operating agreement fails to address issues in dispute, the default provisions under the Limited Liability Company Law govern [citations omitted]. [¶] As the operating agreement explicitly provides that a member’s participating interest may be reduced proportionally if the member fails to make a requested additional capital contribution, defendants were acting in accordance with the agreement when they issued their “Notice of Call for Additional Capital Contributions from Members.” [Citations omitted.]
Ironically, the same operating agreement the plaintiff hoped to invalidate provided him with a small measure of relief based on the agreement’s provision stating that no compensation shall be paid to managers for their services, prompting the court to vacate the portion of the lower court’s order declaring that the defendants were authorized to set their own salaries and reduce plaintiff’s salary by majority vote. The relief may be fleeting, however, as the operating agreement also provides that it can be amended by written approval “in accordance with this Agreement and the [LLC Law]”, i.e., there’s apparently nothing to stop the majority members from again relying on § 402 (c) (3) to amend as they desire the operating agreement’s provision governing manager compensation.
I don’t know the derivation of § 402 (c) (3) and can’t explain how the legislature meant it to co-exist alongside § 417’s allowance for operating agreements to be adopted within 90 days post-formation, or how and whether it was intended to foster basic contract notions of mutuality and consent. But whatever the answer, the appellate court has spoken in Shapiro, and unless and until New York’s highest court says otherwise, if there isn’t an operating agreement signed by all members when the LLC is formed, at any time thereafter those holding a majority of the voting interests may adopt an operating agreement without the signature or consent of minority members.
For those wanting to dive deeper into the Shapiro case, you can read the appellate briefs by clicking on these links: Plaintiff-Appellant’s Brief Defendants-Respondents’ Brief Plaintiff-Appellant’s Reply Brief
Fallout From Shapiro
Effect on Existing LLCs With No Operating Agreement. There’s no way to calculate the number of active, multi-member New York LLCs without an operating agreement, or how many of those have majority/minority versus 50/50 ownership. Based on what I see in my own practice plus the many LLC cases I follow and write about, all I can say is that there are loads of multi-member LLCs out there with no operating agreement just as there are loads of multi-shareholder close corporations with no shareholder agreement. The absence of such agreements likely is due to the desire to avoid legal fees, or because a dominant member in the family-owned business sees no need for it or would take offense at the notion, or based on good old-fashioned trust in handshake deals among friends, or for any number of other reasons.
The publicity surrounding the lower court’s August 2015 decision in Shapiro undoubtedly spurred some number of copycat efforts by majority members in LLCs with no agreement to adopt an operating agreement with provisions enhancing their management authority and leverage over minority members in any number of ways. Now, with the emboldening effect of the Appellate Division’s stamp of approval, the pace of copycatting likely will increase.
The majority members in Shapiro adopted an operating agreement that allowed them to issue capital calls and reduce the membership interest of a member who fails to contribute his pro rata share. I’m not saying this is what was going on in Shapiro, but it happens to be one of the classic techniques used to squeeze out a minority member, particularly when the minority member is not receiving distributions or a salary from the LLC.
That’s just one example of the many types of provisions in operating agreements that can be used to advance the interests of the majority at the expense of the minority, including fiduciary waivers, expulsion or other dissociation provisions, and transfer restrictions coupled with unfavorable (for the transferor) mandatory redemption, to name just a few. As majority members push the envelope of such techniques in agreements adopted without the consent of all members, I predict an uptick in litigation brought by minority members advancing various legal theories challenging what they will characterize as unduly onerous impingements on their statutory and common law rights.
Effect on Persons Contemplating Becoming Minority Member of LLC. I’ve preached to anyone planning a multi-member start-up LLC, whether as majority, minority, or 50% member, that one of the keys to a long-term, stable, successful venture is having a well-considered, carefully drawn operating agreement that accommodates the members’ competing interests and includes reasonable exit and dispute resolution provisions for the inevitable parting of the ways.
With no operating agreement, the minority member has only statutory default rights which, while not insignificant, include no protection against oppressive majority conduct akin to that enjoyed by minority shareholders in close corporations. Shapiro widens the prospect for further encroachment upon the minority member’s interests by negating the non-mandatory default protections in the statute. In another words, in the post-Shapiro era, it is even more imperative for a prospective minority member to bargain for protection in a written operating agreement before joining the venture.
Effect on Lawyers Counseling Minority Members. Finally, I’ll go so far to say that, after Shapiro, any lawyer who counsels a prospective minority member of an LLC, and who allows the client to become a member without advising them of the elevated risks of not having a signed operating agreement in place, could face malpractice liability if the majority members subsequently adopt, without the minority member’s consent, an operating agreement that strips away important protections from the so-called statutory operating agreement.