Section 417 of the New York Limited Liability Company Law (NY LLCL) requires that the members of a limited liability company (LLC) adopt a written Operating Agreement establishing, among other things, the rights, responsibilities, and limitations of the members. The adoption of an Operating Agreement is a perfunctory exercise to many LLC members who are—unsurprisingly—more focused on growing their new business than planning for potential conflicts. The timely adoption of an Operating Agreement is, nonetheless, a crucial step in any LLC formation. Beyond establishing the rights and responsibilities of the members, the Operating Agreement establishes provisions to protect those rights. An often overlooked but equally important component of any Operating Agreement is the amendment provision. Minority members must ensure that the amendment provision will prevent majority members from abrogating the rights established in the Operating Agreement by later amendments. Ultimately, the rights provided by the Operating Agreement are only as strong as the amendment provision drafted to keep those rights in place.
The NY LLCL provides default rules for adopting, amending, or restating an LLC’s Operating Agreement based on the underlying premise that the operation and management of an LLC is determined primarily by contractual agreements as reflected in the Operating Agreement and the Articles of Organization. Except in certain limited circumstances, members of a New York LLC are free to determine by contract—in the Operating Agreement—the vote required to approve most actions. Absent failure to comply with the statute, or the existence of some other egregious conduct in violation of the law or the Operating Agreement, the courts generally are reluctant to invalidate or to refuse to enforce the Operating Agreement adopted by the members of an LLC.
A review of current New York case law strongly supports the members’ right to amend the LLC Operating Agreement, even at the detriment of minority members, if the amendment abides by the requirements set forth in the Operating Agreement.
In a recent New York decision, Shapiro v. Ettenson, the Appellate Division for the First Judicial Department of the New York State Supreme Court held that the majority members of an LLC validly adopted a post-formation Operating Agreement without the minority member’s consent. Shapiro v. Ettenson, 146 A.D.3d 650, 45 N.Y.S.3d 439, 440 (N.Y. App. Div.), leave to appeal denied, 29 N.Y.3d 915, 85 N.E.3d 100 (2017). The post-formation adoption of an Operating Agreement by less than unanimous consent was ultimately used to eliminate the minority member’s salary, dilute his membership interest, and eventually lead to his expulsion from the LLC. The members of the LLC did not adopt an Operating Agreement until two years after the LLC’s organization, at which time two of the three members voted to adopt an Operating Agreement. Id. The majority members then used a provision in the new Operating Agreement that allowed them to make a capital call upon the consent of a majority in interest and allowed for the dilution of the interest of a member who failed to satisfy the capital call. Id. After failing to satisfy the capital call, the minority member brought a lawsuit challenging the adoption of the Operating Agreement and the capital call. Id.
The court held against the minority member on the grounds that the NY LLCL provides clear default rules that act as an Operating Agreement where none has been adopted. The default rule for amending an Operating Agreement contained in NY LLCL § 402 allows for the amendment of the Operating Agreement by the vote of a majority in interest. Therefore, two out of three members could adopt the Operating Agreement that imposed new obligations upon all members so long as those two members owned a majority interest in the LLC.
In Ho v. Yen, 2017 Slip Op 32732(U) [Sup Ct Queens County November 13, 2017], the Queens County Court declined to grant injunctive relief to a minority member who challenged the majority members’ adoption of an Operating Agreement that authorized the expulsion of a member that engaged in certain enumerated criminal or negligent behavior that negatively impacted the company or its members. Id. The adoption of the amendment to the Operating Agreement by less than a unanimous vote was not the primary issue in this case. Nonetheless, it is significant that the court did not question the majority members’ right to amend the Operating Agreement without the consent of the minority member. The court in this case recognized the majority members’ right to amend the Operating Agreement even at the detriment of the non-consenting minority member.
In contrast to the above cases, a recent ruling by the New York County Court denied a motion to dismiss a minority member’s claim that the majority members of the LLC breached their fiduciary duties by adopting an Operating Agreement without the minority member’s consent that authorized mandatory capital calls and the ability to expel members who failed to contribute their share. Yu v Guard Hill Estates, LLC, 2018 NY Slip Op 32466(U) [Sup Ct NY County Sept 28, 2018]. The facts of this case involve a family dispute in which the parents’ disapproval of one child’s choices resulted in a litany of lawsuits and vindictive actions by the siblings who were two of the three members of the LLC (with the plaintiff being the third member). The judge, having dismissed all other complaints made by the plaintiff, allowed the single claim for breach of fiduciary duty to continue, stating, “[the majority members] did have certain rights under the [LLC] Operating Agreement, whether they exercised those rights in good faith and in an equitable manner is disputed and must be determined through the course of litigation.” Id.
Despite the glimmer of hope, handed to the plaintiff in Yu, the court’s ruling is far from final and the facts of the case are egregious—involving blatant actions specifically formulated to disenfranchise the minority member. Minority members should not read into this ruling a willingness of the courts to protect their minority interest. The NY LLCL and New York courts as a general rule protect the rights of majority members to amend Operating Agreements without the consent of—and even at the peril of—minority members so long as the amendment provision contained in the Operating Agreement is followed. Minority members must take particular care to ensure that the rights contained in the Operating Agreement are sufficiently protected themselves by an equally protective amendment provision.
Written by Austin P. Judkins, Esq.
Austin is an attorney in Boylan Code’s Business and Corporate Finance group. He concentrates his practice in entity selection and formation, and business transactions.
This article was published in The Daily Record.