Monday, October 26, 2015
Enforcing an Operating Agreement Against a Member Who Didn’t Sign?
It is quite troubling when someone finds out that, after having joined an LLC, they can be bound to an operating agreement that they have never agreed to. That is, however, the manner in which many of the LLC statutes operate. Persons who agree to be minority members of an LLC are on notice of the need to consider this eventuality and, if possible, negotiate protections against it. Otherwise, they need to accept that this is a possible outcome.
In a recent decision from New York, Shapiro v Ettenson, 2015 N.Y. Slip Op 31670 (U) (Aug. 16, 2016), three individuals came together and formed a member-managed LLC, equally owned by the three of them. They did not, however, adopt a written operating agreement. Nearly 2 years after the LLCs organization, two of the members executed a written consent pursuant to which the articles of organization were amended to change the LLC from being member-managed to manager-managed and they also adopted a written operating agreement. In addition to addressing the management of the company, it provided that a majority of the members could determine to make a capital call upon all of the members and, upon a member’s failure to satisfy a capital call, their interest in the company would be diluted. After a capital call was made, one of the members, Shapiro, filed a lawsuit challenging the adoption of the written operating agreement and the capital calls.
Cutting to the chase, Shapiro lost, primarily because the New York LLC Act provides a default rule that a majority of the members can adopt or amend the articles of organization or operating agreement. A detailed analysis of this decision, prepared by Peter Mahler and posted on his (highly recommended) blog, New York Business Divorce, is available at Can LLC Agreement Be Enforced Against Member Who Doesn’t Sign It? (CLICK HERE to link to the posting).
Having reviewed Peter’s description of this ruling and as well the numerous additional questions he identified, it is important to consider whether a similar outcome could happen in Kentucky. In a word, “Yes.”
If the members never adopt an operating agreement per se, then the articles of organization and the LLC Act are the operating agreement. KRS § 275.003(8). Initially, the Kentucky LLC Act provides a default rule that the members vote in proportion to their capital contributions, and goes on to provide a default rule that a majority-in-interest of the members may pass on most points, including amendment of the operating agreement. See KRS § 275.175(1); id. § 275.175(2)(a). While the LLC Act does not allow a capital contribution obligation to be imposed upon a member absent their written consent thereto (KRS § 275.200(1)), it is open to question whether a majority of the members, over the objection of a particular member, could impose a capital contribution obligation that, even while not specifically enforceable against the objecting member, can still have any of the consequences for lack of performance or otherwise allowed to be set forth in an operating agreement. See KRS §§ 275.003(2)(a)-(g).
Another mechanism by which the same effect can come about is a merger. Under Kentucky law, absent a contrary provision in a written operating agreement, a majority-in-interest of the members can approve a merger. Utilizing this provision (i) a majority of the members set up a new company and with it a new operating agreement and then (ii) cause the existing LLC to be merged with and into the new LLC with the new LLCs operating agreement binding all of its members. See also KRS § 275.350(1). Upon the effective time and date of the merger, all of the members of the former LLC are bound by that new operating agreement. See KRS § 275.365(11); see also Rutledge The 2010 Amendments to Kentucky’s Business Entity Laws, 33 N. Ky. L. Rev. 383, 397-99 (2011). Again, while members who vote against the merger may not be subject to capital contribution obligations to the new company (KRS § 275.365(11)), they may be subject to various penalties, detailed in the new LLCs operating agreement, if they do not participate in additional capital raises (KRS §§ 275.003(2)(a)-(g)).
Depending upon the underlying state law, being a minority member in an LLC can be a precarious position. Some of those risks and some thoughts on how they maybe militated are addressed in Rutledge, Minority Members and Operating Agreements, 10 J. Passthrough Entities 21 (Nov./Dec. 2007). HERE IS A LINK to that article.