I’ve seen LLC operating agreements ranging from one page to over 100. Usually there’s a direct relationship between the length of the agreement and the complexity of the LLC’s capital and management structure.
But if there’s one thing I’ve learned about LLC agreements, it’s that no matter how comprehensive and tome-like their design, there’s no guarantee that a future, unanticipated dispute won’t expose the inevitable cracks in the design prompting the need for court intervention. Indeed, depending on the drafter’s skill, one can argue the more complex the LLC agreement, the greater the risk of a court contest over its interpretation.
Take the recent case of Tungsten Partners LLC v Ace Group International LLC, 2017 NY Slip Op 32025(U) [Sup Ct NY County Sept. 20, 2017], in which Manhattan Commercial Division Justice Shirley Werner Kornreich was called upon to decide whether the plaintiff holder of a 4% non-voting profits interest, identified as a “Management Member” in a 65-page operating agreement (plus another 170 pages of schedules and exhibits), was a member of the subject Delaware LLC for purposes of demanding access to books and records under § 18-305 of the Delaware LLC Act.
Tungsten is one of three lawsuits among the equity stakeholders in a Delaware LLC known as Ace Group International (“AGI”) that owns the rights and intellectual property of the Ace hospitality brand of hotels, following the death in 2013 of its founding majority member, Alexander Calderwood.
AGI was formed in 2011 as part of a reorganization under which Calderwood and a finance provider (“Ecoplace”) received 2/3 and 1/3 equity stakes, respectively. AGI’s operating agreement defined “Members” as Calderwood, Ecoplace, “and any other Person admitted to the Company pursuant to this Agreement.” The definition further stated, “For purposes of the [Delaware LLC] Act, the Members shall constitute a single class or group of members.”
The operating agreement in Section 9.5 expressly contemplated Calderwood transferring from his 2/3 equity stake “Management Interests” to plaintiff Tungsten — which held a 3% equity stake in AGI’s predecessor company — and to certain high level employees, and stated that “Any individual who is awarded such Management Interest shall be referred to as a ‘Management Member.'” The operating agreement did not otherwise define the term Management Member.
Upon consummation of the AGI Operating Agreement, the company and Tungsten entered into an Award Agreement granting Tungsten a 4% Management Interest defined as a “profits interest” with no voting or other control rights. The Award Agreement stated that it was governed by, and incorporated by reference, the terms of the AGI operating agreement. Tungsten’s acceptance of the award stated its agreement “to be bound by the terms of . . . the LLC Agreement, as applicable.”
Tungsten’s Books and Records Action
In 2016, Tungsten filed suit to declare and enforce its rights under Delaware LLC Act § 18-305 as a “Member” of AGI to inspect its books and records as addressed in Section 6.1 of the AGI operating agreement stating in pertinent part as follows:
all such books and records (and the dealings and other affairs of the Company and the Subsidiaries) shall be available to any Member at such location for review, investigation, audit and copying, at such Member’s sole cost and expense, during normal business hours on at least twenty-four (24) hours prior notice. In connection with such review, investigation or audit, such Member (and its Managers and agents) shall have the unfettered right to meet and consult with any and all employees and officers of the Company or any of the Subsidiaries and to attend meetings and independently meet and consult with any and all third parties (including, without limitation, governmental agencies and/or lenders) having dealings or any other relationship with the Company or any of the Subsidiaries. [Emphases added.]
AGI moved to dismiss Tungsten’s complaint, arguing that Tungsten was never admitted as a full-fledged Member with inspection rights under the statute or under Section 6.1. AGI’s argument relied heavily on Section 9.6 of AGI’s operating agreement (“Admission of Transferee”) providing that “no Transfer of Interests shall be permitted unless the potential transferee is admitted as a Member under this Section” and setting forth the conditions for becoming a member and limiting the rights of a transferee not admitted to membership to “such rights of an assignee under applicable law as are consistent with the other terms and conditions of this Agreement.”
The Court’s Decision
Justice Kornreich prefaced her analysis of the operating agreement by noting that AGI is a Delaware entity governed by Delaware law and that, unlike New York law, “the Delaware courts will interpret a contract in accordance with ‘what a reasonable person in the position of the parties would have thought the language of the contract meant'” and that “when faced with conflicting theories of interpretation, the Delaware courts will determine the superior interpretation by determining which interpretation better comports with the contents of the document.”
The “superior interpretation,” Justice Kornreich then concluded, is that “Tungsten became a Member” notwithstanding its ownership of a non-voting Management Interest. The court rested its conclusion on several features of the parties’ agreements:
- In Section 9.5 of the operating agreement, Ecoplace expressly approved Calderwood’s issuance of a Management Interest to Tungsten.
- The Award Agreement’s preface including the phrase, “If the Members (other than [Tungsten]),” along with similar references in AGI’s associated Management Incentive Program, indicated “that Tungsten was, in addition to gaining a Management Interest, becoming a Member.”
- The Award Agreement also provided that it was subject to the operating agreement’s terms, and included Tungsten’s signed affirmation to be bound by the terms of the operating agreement.
- Tungsten’s consent in the Award Agreement to be bound by the operating agreement’s terms satisfied the requirement in Section 9.6 of the latter agreement that a “transferee may become a Member if (i) such transferee executes and agrees to be bound by this Agreement.”
In upholding Tungsten’s Member status, Justice Kornreich rejected AGI’s reliance on the “as applicable” coda in Tungsten’s signed affirmation in the Award Agreement (“I agree to be bound by the terms of . . . the LLC Agreement, as applicable”), reasoning that, while “not all portions of the Operating Agreement are pertinent to Tungsten (e.g., it has no control rights), [AGI’s] interpretation of ‘as applicable’ to mean that Tungsten did not actually agree to be bound by the Operating Agreement within the meaning of section 9.6 is inferior to an interpretation to the contrary.”
Justice Kornreich buttressed her interpretation of the operating agreement by observing that the subordination of Tungsten’s distribution rights to Ecoplace’s $10 million preference “logically” necessitated Tungsten’s ability to “keep tabs on the Company’s performance by reviewing the Company’s books and records,” and that particularly in light of the parties’ acrimonious relationship and malfeasance allegations in the related litigation, “Tungsten having books and records access is a relatively minimal burden on the Company and serves to deter malfeasance (due to the knowledge that another investor is keeping tabs).”
The default rules in most LLC statutes (including Delaware and New York) limit books-and-records inspection rights to those Justice Kornreich referred to as “full-fledged members” with both voting and economic rights, meaning, for instance, that a “mere” assignee of a membership interest who hasn’t been admitted as a member and holds an economic interest only, cannot demand an inspection unless expressly afforded inspection rights under an operating agreement.
Had the AGI stakeholders intended not to provide a Management Member with the statutory and contractual right to inspect books and records, they could have done so easily by using a term other than Management Member, such as Non-Member Interest Holder (which I’ve seen used in other agreements) to make Tungsten’s non-member status absolutely clear.
On the other hand, if all I saw was Section 6.1 of the AGI operating agreement, which, in addition to providing broad access to the company’s books and records for “review, investigation, audit and copying,” gives a Member “unfettered” rights to consult with all company employees and to independently meet with “all third parties” including government agencies and lenders, I would not assume it was intended to cover holders of an economic interest such as Tungsten, with no voting or management rights. Such extraordinary rights to investigate and contact third parties are not normally associated with passive investor status.
Nonetheless, the AGI operating agreement’s use of the term “Member” for each of several categories of membership with differing rights, including “Member,” “Management Member,” and “Withdrawing Member,” together with the multiple “Member” references in Tungsten’s Award Agreement and the Management Incentive Program, together with Tungsten’s signed assent in the Award Agreement to the operating agreement in seeming (partial) compliance with Section 9.6, handed Tungsten an ultimately successful argument in support of its right to access books and records under Section 6.1. The fact that the parties and court had to draw upon so many diverse elements in the documents to figure out something so basic — who has access to books and records — highlights in this instance the perils associated with drafting complex agreements for complex organizational structures.