Many LLC operating agreements include a fee-shifting provision, a clause that requires the losing party in litigation between members to pay the prevailing party’s reasonable attorneys’ fees. These fee provisions are usually relegated to the boilerplate sections near the end of the operating agreement, and often don’t get much attention when the agreement is being prepared. A ruling last month from the Idaho Supreme Court shows that if the attorneys’ fees clause is not carefully crafted, it may not work the way the parties intended.

In Henderson v. Henderson Investment Properties, L.L.C., No. 35138, 2010 WL 569890 (Idaho Feb. 19, 2010), the Supreme Court reversed the trial court’s award of $21,552 in attorneys’ fees. The LLC in the case was formed by a husband and wife and their son and daughter-in-law to operate a sandwich shop. Acrimony later developed between the generations, and the father brought suit to dissolve the LLC. The Idaho LLC Act allows a court to order dissolution if actual or threatened irreparable harm results either from member deadlock or from illegal, oppressive or fraudulent acts of the controlling members. Idaho Code Ann. § 53-643.

Mr. Henderson alleged both deadlock and illegal, oppressive or fraudulent acts, with resulting irreparable harm. The trial court dismissed the complaint, holding that although there had been a deadlock it had not resulted in actual or threatened irreparable injury, and that there had been no illegal, oppressive or fraudulent acts. The trial court also awarded attorneys’ fees to the son and daughter-in-law, based on this provision in the LLC’s operating agreement:

In any action or proceeding brought to enforce any provision of this Agreement, or where any provision is validly asserted as a defense, the successful party is entitled to recover reasonable attorneys’ fees in addition to any other available remedy.

The Supreme Court analyzed that language and reversed the award of attorneys’ fees because it found that the plaintiff did not seek “to enforce any provision of the Agreement,” as required by the clause. The plaintiff instead sought dissolution, which is a statutory remedy.

If the parties had been asked about this clause when they signed their operating agreement, they probably would have interpreted it to mean that in any litigation about their rights and duties as members, the winner would have been entitled to recover its reasonable attorneys’ fees.

This clause did not work that way because it applied only to contractual disputes, i.e., disputes over the terms of the operating agreement. The clause did not apply to any of the rights of members that are defined by the statutory provisions of Idaho’s LLC Act. In this case the dispute was over dissolution, a purely statutory remedy. The irony is that if the operating agreement had simply parroted the language of the statute’s dissolution remedy, Idaho Code Ann. § 53-643, then under the court’s reasoning the defendants would have been entitled to attorneys’ fees.

Many important rights of LLC members, such as sharing of profits, rights to distributions, and rights to certain records of the LLC, are controlled by provisions in Idaho’s LLC Act. The Act allows some of those provisions to be waived or modified in the operating agreement, while others are non-waivable. That approach is typical of other states’ LLC statutes.

Under an attorneys’ fees clause like that in Henderson, and under that court’s reasoning, the right of the winning party to get a judgment for attorneys’ fees will depend on whether the dispute was governed by the LLC statute or by specific terms in the operating agreement. That does not seem like the result most business people would intend when they put an attorneys’ fees clause in their operating agreement.

A better solution, of course, is to use a broader attorneys’ fees clause. One example I’ve seen is:

If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement or to interpret or enforce any rights under this Agreement, [the prevailing party may recover.]

The language “any controversy arising out of this Agreement” may be broad enough to cover both contractual and statutory claims, although it is perhaps susceptible to the argument that statutory rights not referred to in the operating agreement do not “arise out of” the agreement.

I've also seen another approach that would have changed the result in Henderson, but it may be too broad for some situations:

In the event that any dispute between the Company and the Members or among the Members should result in litigation, [the prevailing party may recover.]

This language literally applies to “any dispute” between members, which could cover a dispute between members that has nothing to do with the LLC. A more natural interpretation would limit the scope of the clause to member disputes that have something to do with the LLC, i.e., with their status as members of the LLC. But to be safe, something like the following might be best:

If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement, or to interpret or enforce any rights under this Agreement or the [name of State] Limited Liability Company Act, [the prevailing party may recover.]

Some LLC operating agreements require that disputes be settled by binding arbitration instead of litigation. A recently-published treatise on drafting operating agreements for Delaware LLCs has a nice treatment of arbitration and attorneys’ fees, among other things. John M. Cunningham & Vernon R. Proctor, Drafting Delaware Limited Liability Company Agreements: Forms and Practice Manual (2009).

In the model operating agreements provided by Cunningham and Proctor, arbitrable matters include “material matters: (1) That arise under or relate to this Agreement or that relate to the LLC…” Cunningham & Proctor, supra, at Form 6.1, § 30.3. Their model agreement then goes on to assign attorneys’ fees to the nonprevailing party:

To the extent that an arbitrator determines that a party to an arbitration has failed to prevail in that arbitration, the arbitrator shall allocate to that party the costs of the arbitration, including reasonable attorneys’ fees and fees payable to the arbitrator.

Cunningham & Proctor, supra, at Form 6.1, § 30.11(c). This approach allows the arbitration to cover any dispute related to the operating agreement or the LLC, and applies the “loser pays” rule to the entire arbitration. This approach would avoid the type of problem dealt with in the Henderson case.

The clause at issue in Henderson, and the court’s ruling, show in microcosm why contract drafting is difficult. The unexpected scenario can rise up to swat the drafter. I’ll wager that when the parties put together their operating agreement in the Henderson case, they paid little or no attention to the exact words of the clause. Before any disputes arose I’m sure they would have said that any dispute directly related to the LLC was intended to be covered by the “loser pays” rule of the clause. But yet it wasn’t.

It was not a case of the language being unclear (although some might argue that); it was primarily a case of the language not reaching far enough in its scope. The Henderson case is an object lesson in vignette form for lawyers who draft contracts. The lesson? Know the underlying law and the context in which you’re drafting, and don’t rely too quickly on language taken from other contracts.