In my experience, most operating agreements of New York LLCs include a provision barring amendments unless made in writing and executed by all members. Such provisions are especially prevalent with smaller, member-managed LLCs as opposed to larger, manager-managed LLCs having some number of passive investors. With the latter, I would venture to say that the larger the company in terms of its capitalization and assets, the more its governance resembles traditional corporate-style management, and the greater the number of its inactive members (especially if there are multiple classes of investing members, some of which have limited or no voting rights more akin to limited partners), the more likely it is to find at least some power of non-unanimous amendment reserved to the controlling members.
But whatever the size, membership structure, or governance of the LLC, before drafting an amendment provision in the initial operating agreement, and certainly when considering any post-formation amendment to the existing operating agreement, attention must be paid to Section 417 (b) of the New York LLC Law which contains default limitations on the power to amend without the consent of each “adversely affected” member.
Section 417 (b) starts off with the broad pronouncement authorizing amendment of an operating agreement “from time to time as provided therein.” The language essentially gives unrestricted leeway to include in the original operating agreement, subscribed by all the members, a provision allocating the power to amend — and any limitations on that power — to any grouping or subgrouping of members and managers, ranging from unanimous consent of all members, to super-majority consent of members, to majority consent of members, to consent of a majority of the managers, and so on.
Next, prefaced by the familiar phrase, “except as otherwise provided in the operating agreement or the articles of organization,” the statute sets forth a series of default limitations on the power to amend “without the written consent of each member adversely affected thereby,” to wit, any amendment that:
- increases the obligations of any member to make contributions;
- alters the allocation for tax purposes of any items of income, gain, loss, deduction or credit;
- alters the manner of computing the distributions of any member; or
- allows the obligation of a member to make a contribution to be compromised by consent of less than all the members.
One shouldn’t be surprised by these common-sense, default restrictions on amendments to essential economic rights, sans consent of the adversely affected members. If, upon joining the LLC, for example, a member hasn’t agreed ex ante to give others the power to increase their obligation to contribute capital or to dilute their tax allocations and distribution rights, you wouldn’t expect them to suffer, without their consent, the adverse consequences of such amendments that go to the heart of their membership interest.
The most straightforward court contests that apply Section 417 (b)’s default rule to disputed amendments are those where the amendment clause in the pre-amendment operating agreement requires the unanimous consent of the members, period. For example, in the Kings County Brewers Collective case my partner and fellow blogger Frank McRoberts wrote about here, the court enjoined the majority members from amending the operating agreement, which prohibited any amendment “except by a written instrument executed by all of the Members,” by adopting new provisions that, among other things, converted the plaintiff’s Class A membership interest into a new “Class D” interest with no management rights.
The more complex cases involving disputed amendments are those where the pre-amendment operating agreement affirmatively permits amendment without the consent of all members. In many if not most of these cases, the pre-amendment provision retains at least some of the protections found in Section 417 (b)’s default rule against adverse impact on the non-consenting members, as illustrated in a case decided earlier this year called Gallagher v Crotty.
The Gallagher Case
Gallagher is a multi-faceted case featuring the plaintiff Gallagher’s claims that defendants squeezed him out of certain alleged partnerships and LLCs involved in affordable housing development in New York City.
As relevant to this discussion, Gallagher was one of four members with equal 25% membership interests in the LLCs. The LLCs had substantially similar operating agreements containing a waterfall provision in Section 13.1 providing for pro rata member distributions. Section 19.1 (a) authorized amendment of the operating agreements by majority consent for various remedial measures such as compliance with various external legal requirements, but also to alter member duties or “to make such other changes as such members determine, by Majority Consent, to be advisable and in the best interests of the Company.”
Section 19.1 (b) further authorized amendment of the operating agreements by majority consent (which practically speaking, meant three members holding a combined 75% interest) using the following language, somewhat narrower in its protective scope than that used in LLC Law Section 417 (b) (“without the written consent of each member adversely affected thereby”):
none of the following amendments shall be made with respect to any such Member if the effect on such Member is disproportionate to such Member as compared to the effect on all other Members without such Member’s consent . . .. [Italics added.]
The list of amendments that followed included “any amendment to this Agreement which alters the manner of computing the Distributions of any Member.” In other words, at least as regards member distributions, Section 19.1 (b) served as a check on the majority’s otherwise unfettered ability in Section 19.1 (a) to adopt amendments “in the best interests of the Company.” Yet, it did permit adverse changes to essential economic rights, so long as all the members are affected equally.
The showdown over Sections 13.1 and 19.1 of the operating agreements came about when the majority members, after they unsuccessfully sought Gallagher’s consent, adopted amendments to the operating agreements by majority consent, authorizing the three other members to pay themselves management fees which necessarily reduced the amount of excess cash available for distribution to members. Gallagher alleged the amendment cost him $463,000 per year in lost distributions.
Following discovery, Gallagher moved for a summary judgment of liability invalidating the amendment, arguing that the management fees “were specifically calculated to divert funds to the Defendants at the expense of Gallagher” and citing deposition testimony by one of the defendants as follows:
Q. Did you consider the effect to Kevin Gallagher prior
to passing this resolution?
Q. What did you consider?
A. We considered that it would have an economic
impact on Mr. Gallagher.
Q. What kind of impact would it have?
A. In theory, it would diminish distributions to Mr. Gallagher.
In their opposing papers, the defendants argued that the amendments:
- “benefitted” Gallagher because the “management duties had to be performed by someone”;
- Gallagher was “not performing any services” and had “abandoned all interaction with the Defendants”;
- consistent with their right to hire personnel to assist with management of the LLCs’ properties, the operating agreements were amended to provide all members of the LLCs who were “actively engaged in asset management responsibilities with a small fee to compensate them for their work”; and
- absent the amendments, the LLCs “would have had to hire an employee or contractor to perform the asset management” at greater cost to the LLCs.
The defendants also argued that their actions amending the operating agreements fell within the protection of the business judgment rule. Last but not least, they argued that Gallagher was not disproportionately affected by the amendments because all members — not just Gallagher — were equally affected by the reduction in member distributions resulting from the management fees paid to the three defendants.
The Court’s Decision
In his decision granting Gallagher’s motion for summary judgment of liability, Manhattan Supreme Court Justice David B. Cohen found that,
[b]ased on the evidence submitted, plaintiff establishes, prima facie, that the amendments were issued without his consent and in contravention to the parties’ operating agreements, and that they adversely affected him by diminishing the distributions he received. . . .
[T]he undisputed evidence supports plaintiff’s claim that defendants decided to pay themselves for work they were already doing, despite knowing that it would diminish plaintiff’s distributions, and defendants submit no evidence to support their argument that it would have cost more to hire a management firm. . . .
Having testified at their depositions that the amendments would diminish plaintiff’s distributions, and absent any evidence that such diminishment would have been greater if defendants had hired an outside management firm, defendants do not raise a triable issue as to whether the amendments adversely affected plaintiff.
Justice Cohen rejected out-of-hand defendants’ reliance on the business judgment rule as “inapplicable to obviously conflicted transactions.” He also rejected their contention that the facially indiscriminate amendments did not disproportionately affect Gallagher based on the “reality of the situation” in which plaintiff stood little or no chance of sharing in the management fees received by the other members.
It’s virtually inevitable that an operating agreement made at the inception of the LLC’s lifespan will warrant amendment at some point to address the unanticipated, evolving needs of the company’s business and its members, including a possible falling out among the members the creates economic distortions and/or management problems.
There is no one answer to the question whether the original agreement should allow amendment without the consent of all the members. Generally speaking,
- The more closely held the membership interests among relatively few co-managing members, the less likely you’ll want an amendment provision permitting less-than-unanimous consent to future amendments. If and when the need for amendment arises, the members will need to reach consensus on the necessary modifications.
- The more widely dispersed the membership interests and the more centralized the LLC’s management, the greater the need at the outset to authorize less-than-unanimous consent to future amendments, among other practical reasons, to avoid giving hold-out leverage to non-managing members with relatively small membership interests.
Finally, before drafting an amendment provision that authorizes amendment upon less-than-unanimous member approval, pay close attention to the statutory overlay in Section 417 (b).