Statute Trumps LLC Agreement’s Voting Rights Provision in Dispute Over Manager’s Removal

Farrell Fritz, P.C.
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LLC enabling statutes authorize two types of management structures. The default structure is member-managed in which all members participate in the management of the company’s business affairs. Member-managed LLCs usually have a relatively small number of members who are actively involved in the company’s business and who owe fiduciary duties.

Then there’s the manager-managed LLC, more akin to a corporation-style management structure and sometimes featuring a Board of Managers and designated officers, in which one or more persons or entities (who may be, but need not be, members of the LLC) are responsible for managing the LLC’s business affairs. Manager-managed LLCs typically have a number (which could be large) of non-managing members who owe no fiduciary duties and essentially serve as passive investors, not unlike limited partners.

The manager-managed LLC offers flexibility and efficiencies not available with a member-managed structure. But, as with any agency relationship, care must be taken in the operating agreement to spell out not only the scope of the managers’ authority, but also the voting requirements and circumstances under which the managers can be removed or replaced by the members.

A California intermediate appellate court’s ruling earlier this month involving a manager-managed LLC, in Hillsborough Development Co., LLC v Annen, illustrates what can go wrong when the operating agreement names one of its members as sole manager but fails to include any provision addressing manager removal.

Background

The LLC in Hillsborough has four members. Its operating agreement names one of them, Sparber, as sole manager. As noted in the court’s opinion, “the Operating Agreement does not include any provision that relates to the removal of the manager or the installation of a new manager.”

Many years after the LLC’s formation, two of its non-managing members together holding 53.3% of the membership interests executed a written consent removing and replacing Sparber as manager with one of themselves. In doing so they relied on the default rule in § 17704.07(c)(5) of California’s LLC Act (codified in the California Corporations Code), which essentially is cloned from § 407(c)(4) of the Revised Uniform LLC Act and which provides:

A manager may be removed at any time by the consent of a majority of the members without cause, subject to the rights, if any, of the manager under any service contract with the limited liability company.

If it was that simple, there’d be no case for me to write about. It wasn’t. Sparber refused to accept his removal and brought suit to enjoin the other member from taking his place as manager, relying on a unanimous voting provision in the operating agreement’s “Voting Rights” section stating:

Except as otherwise specifically provided herein, in all matters in which a vote, approval or consent of the Members is required, a vote, approval or consent of all the Members (or, in instances in which there are defaulting or remaining Members, the vote of all non-defaulting or remaining Members), shall be required to authorize or approve such act. [Italics added.]

In a nutshell, Sparber contended that the Voting Rights provision requiring unanimous member consent displaced the statutory default rule authorizing manager removal by majority vote.

Sparber Wins Round One

The trial court granted Sparber’s application for a restraining order and preliminary injunction seeking to enjoin the other member from acting as manager, basically holding that the policy “to give maximum effect to the principles of freedom of contract and to the enforceability of operating agreements” required the court to elevate the agreement’s unanimous voting requirement above the statute’s lesser quantum of consent in the manager-removal statute.

Sparber Loses Round Two

The two members who voted to remove Sparber appealed the decision to the California Court of Appeals which issued a 23-page opinion reversing the lower court’s ruling and dissolving the interim injunction.

The appellate panel’s decision rested on two, critical predicate findings. First, because the operating agreement “was silent on the issue of removing a manager,” the court was required “to look outside the provisions of the Operating Agreement for a process that will govern the removal of [the LLC’s] manager.” Second, because the operating agreement “does not otherwise provide for the matter of removing a manager, it is clear that . . . section 17704.07(c)(5) governs the parties’ conduct with respect to removing a manager.”

That did not end the court’s analysis, however. Rejecting the appellants’ view that the statute was mandatory and not a default rule, the court found unanswered the question whether the parties intended to vary the statute’s voting rule in the event of manager removal. The court explained:

[T]he question remains whether the terms of the Operating Agreement reflect the parties’ specific intention to deviate from the majority vote rule provided in section 17704.07, subdivision (c)(5) and instead to apply the unanimity requirement in the “Voting Rights” provision in the Operating Agreement to any process for removing the manager, as [Sparber] argues. On this point, we conclude that [Sparber] has not met [his] burden of demonstrating a probability of prevailing on the merits.

Specifically, our review of the Operating Agreement and the record, which contains scant extrinsic evidence as to the parties’ intentions in creating the Operating Agreement, demonstrates that the Operating Agreement is ambiguous with respect to the question at hand. Such ambiguity, in the absence of extrinsic evidence to support [Sparber’s] interpretation, is insufficient to demonstrate a probability of prevailing for purposes of obtaining a preliminary injunction.

“The More Reasonable Interpretation”

The appellate court was not called upon to make a dispositive ruling on the removal voting issue given the procedural posture of the appeal from the grant of interim injunctive relief. It did, however, offer what it considered the “more reasonable interpretation” of the Voting Rights provision which likely will seriously impair Sparber’s hopes of success on remand to the lower court.

Applying the rule requiring courts to construe contracts and to reconcile inconsistent provisions “in such a manner that will give effect to the entire contract,” the court offered a “more reasonable” reading of the Voting Rights provision that gives effect both to it and to the removal statute. Here’s what it wrote:

Specifically, the terms of the “Voting Rights” section of the Operating Agreement may be reasonably interpreted as referring only to those voting rights that are bestowed on members by the Operating Agreement itself. The Operating Agreement requires unanimous consent of the members not with respect to “all matters” generally, but with respect to “all matters in which a vote, approval or consent of the Members is required.”  The Operating Agreement requires a vote of the members in at least three circumstances, but otherwise allows for virtually all other business decisions to be handled by [the LLC’s] manager. . . .

Further, the [statute’s] default rule regarding the removal of a manager does not contemplate simply that consent to the removal be obtained generally. Rather, the [statute] specifies that the removal of a manager may occur specifically “by the consent of a majority of the members.” The extent of the consent of the members that is required by the default rule is defined in the rule itself — i.e., the consent required by the statutory rules is that of a majority of the members. It would make little sense to import only a portion of the relevant rule (i.e., “consent”), as [Sparber] urges, rather than the entire rule (i.e., the “consent of a majority”), particularly where, as here, the Operating Agreement is silent on the matter, and the “Voting Rights” rule in the Operating Agreement can be reasonably understood as referring only to matters in which the right to vote or give consent derives from authority granted to the members by the Operating Agreement itself. This is particularly true given that the “Voting Rights” provision does not imply or suggest that it is intended to apply to procedures and rules imported from outside of the Operating Agreement.

Avoiding “An Illogical Result”

As I see it, the court waited until the end of its opinion to address the “elephant in the room,” namely, that under Sparber’s interpretation of the Voting Rights provision, his removal as manager would require Sparber’s own consent.

The court wasn’t buying it:

Under [Sparber’s] theory, in any situation in which the members other than the member who is serving as the manager become unhappy with the manager’s performance, those other members would have to obtain the consent of that manager, himself, in order to remove him as manager. However, if the manager agreed to be removed as manager, that person could simply withdraw as manager, and there would be no need for a removal process at all. Such an illogical consequence is not one that we can infer the members of [the LLC] intended when they adopted the “Voting Rights” provision in the Operating Agreement. This becomes even less likely given that there is no indication that the parties ever contemplated any process by which to remove and replace the manager of the company. It would thus appear that a reasonable reading of the “Voting Rights” provision of the Operating Agreement is that it imposes a unanimity requirement only with respect to those provisions in the Operating Agreement, itself, that specifically require the vote, approval or consent of the members. For the reasons stated above, such an interpretation appears to be the more reasonable interpretation of the terms of the Operating Agreement.

Although not cited in the court’s opinion, a very similar point was made by an Ohio appellate court in a 2001 opinion in Stark v Fuchs. In that case the operating agreement stated that “[a]ny officer or agent may be removed by the Members whenever in their judgment the best interest of the Company would be served thereby.” Rejecting the argument that “removed by the Members” required a unanimous vote including the member whose removal was at issue, the court ruled that only majority consent was required because otherwise the manager:

could block his removal by voting against the actions of his fellow members, thereby making it impossible to give effect to the provisions of the operating agreements permitting election, replacement, or removal of an officer. This situation would be untenable and frustrate the continued and orderly operation of the companies within the framework of the operating agreements, effectively turning the LLCs into the personal fiefdom of a Manager who would be unaccountable to the members of the LLCs as long as that Manager disagreed with any of the remaining members of the LLCs. The only reasonable voting method that could accomplish and give effect to the previously mentioned Articles contained within the operating agreements is to permit a simple majority vote of the members to control LLC elections or removals.

Other Cases Involving LLC Manager Removal

For those interested in the topic, here are three other New York cases involving disputes over manager removal about which I’ve previously written:

  • Concord Development Co., LLV  v Amedore Concord LLC, in which the trial court rejected a member’s challenge to his removal as manager by the other member where the operating agreement allocated voting rights in proportion to the members’ capital contributions.
  • Lehey v Goldburt, in which an appellate panel reinstated the managing member whom the lower court had removed and replaced with another member on the latter’s application for interim relief.
  • Ross v. Nelson, in which an appellate panel upheld the removal of an LLC member-manager by majority vote of the members, notwithstanding a provision in the operating agreement requiring all members to vote for the ousted member-manager in any election for managers.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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