LLC operating agreements sometimes need to be amended. Members may come and go, more capital may be necessary, or the timing of distributions may need to be changed, for example. If the agreement is to be amended, normal principles of contract law will require that all the members agree.

Sometimes, however, the members will agree in advance that future amendments will require less than unanimity. For example, an operating agreement might provide: “This Agreement may be amended in any respect by the affirmative vote of Members holding a majority of the Units.” Or a supermajority of two-thirds or 80% might be required. This approach is used to provide flexibility, since otherwise a recalcitrant member holding a small ownership percentage could veto necessary change or demand concessions from the company for approving the change.

In some cases a majority-vote provision like the one quoted will include limits on the majority’s ability to amend, such as a prohibition on changing any member’s interest in profits, losses or distributions, without unanimous approval. But what if no limits are included? Are there any limits on the power of the majority to amend the operating agreement?

The California Court of Appeals held last week that there are limits. Abbey v. Fortune Drive Assocs., LLC, No. A124684, 2010 Cal. App. LEXIS 2860 (Cal. Ct. App. Apr. 20, 2010) (unpublished).

Fortune Drive Associates, LLC was a Delaware limited liability company. Brandon Abbey was a member and held a 3% interest. John Sheputis was a member, held a majority interest and was the sole manager. A dispute over a proposed restructuring of the LLC developed between Sheputis and Abbey, and Sheputis concluded it was in the best interest of the members to involuntarily terminate and buy out Abbey’s interest in the LLC.

The LLC’s operating agreement did not authorize the involuntary buyout of a member’s interest. But the operating agreement did provide that it could be amended by a majority vote of the LLC’s member interests. So, Sheputis prepared an amendment that:

  • authorized the termination of a member upon the vote of three-fourths of the LLC’s member interests;
  • specified the financial terms of the LLC’s buyout of the terminated member’s interest; and
  • required that any dispute over the buyout price or any other matter related to the termination be resolved by binding arbitration.

Prior to the amendment, the operating agreement simply provided that any lawsuit relating to the agreement had to be filed in San Francisco.

With no prior notice to Abbey, Sheputis obtained the consent of all members other than Abbey to the amendment and to Abbey’s termination. Abbey filed a lawsuit, the LLC commenced arbitration over the value of Abbey’s interest in the LLC, and Abbey sought a stay of the arbitration and a declaration that he was not bound by the arbitration clause of the amendment.

The court looked to earlier California law on the enforceability of amendments to bank credit card agreements, including Badie v. Bank of America, 79 Cal.Rptr.2d 273 (Cal. Ct. App.1998). Under the prior cases, said the Abbey court, a party with the unilateral right to modify a contract does not have carte blanche to make any kind of change merely by following the prescribed procedure. Abbey, 2010 Cal. App. Unpub. LEXIS 2860, at *13. (The court applied California law because the parties agreed that California law applied to the issue of contract interpretation.)

The court determined that for a non-unanimous amendment to be enforceable against a non-consenting member, the general subject of the amendment must have been anticipated when the agreement was entered into. The court found that three distinct constraints applied: (1) the intent of the parties, (2) whether the terms of the agreement were sufficiently definite, and (3) the implied covenant of good faith and fair dealing.

In analyzing the amendment to Fortune Drive’s operating agreement, the court focused primarily on the intent of the parties. The court noted that although the amendment was written in general terms, it was adopted to deal with the specific situation of Abbey’s termination, limited the types of claims Abbey could bring, and restricted the recovery he could receive. The court found that no member could have had that type of amendment in mind when they agreed that a majority of the member interests could amend the agreement.

While the members might have anticipated adopting arbitration in a manner that was not prejudicial to their individual interests, it is inconceivable [that] any member intended to authorize the majority’s adoption of an arbitration provision that would benefit other members at the expense of his or her own interests. Yet that is what the Third Amendment’s arbitration provision would accomplish in any dispute with Abbey.

Abbey, at *19.

The court concluded that this particular amendment was beyond the intent of the parties when they agreed to majority amendments of the operating agreement, and that therefore it would not be enforced. The court said it did not have to reach the questions of whether the amendment violated the members’ fiduciary duties and the implied covenant of good faith and fair dealing.

Operating agreement provisions that allow amendments by less than all of the members are useful because they allow the LLC to deal with new situations without being held hostage by the demands of a minority member, so long as the necessary majority approves the change. But Abbey shows that there are limits to the kinds of non-unanimous amendment that can be made. An amendment that is targeted at a dispute with a non-consenting member and that significantly disadvantages that member is not likely to be enforceable.

More broadly, amendments that affect all the members in the same way also may be unenforceable if the general subject matter of the amendment was not anticipated when the contract was entered into. That’s a broader constraint, and its limits may be difficult to predict for a particular agreement and amendment.

The Abbey court hung its opinion on the intent of the parties and said it did not have to reach the question of whether the implied covenant of good faith and fair dealing was violated. The obvious unfairness of the Abbey amendment suggests that analyzing the amendment under the implied covenant of good faith and fair dealing would have led to the same result – invalidation of the amendment.