April 23, 2015

Protecting the Deal: Enforcing and Protecting the Owners’ Agreement

Daniel S. Kleinberger

From 2009 through 2013, a drafting committee of Uniform Law Conference (ULC) worked to harmonize nine separate uniform acts dealing with business entities (the “Harmonization Project”). The acts address topics ranging from registered agents to statutory trust entities, but for most practitioners, the three most important acts will be those providing respectively for limited liability companies (ULLCA (2013)), general partnerships (UPA (2013)), and limited partnerships (ULPA (2013)). 

Due to the Harmonization Project, most provisions in these three acts now use essentially identical wording. Moreover, each of the acts is designed to “protect the deal” made by the owners through their operating or partnership agreement. The following article explains those deal protection provisions. 

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According to the comments to ULLCA (2013), “A limited liability company is as much a creature of contract as of statute,” and the same assertion appears in the comments to UPA (2013) and ULPA (2013) – i.e., the harmonized general and limited partnership acts. These three acts comprise the most widely enacted business entity statutes promulgated by the Uniform Law Commission, and each of the three features nine important protections for the deal the owners have made for themselves. 

These protections include provisions:

  1. Establishing the primacy of the operating or partnership agreement over the default rules established by each act;
  2. Providing certainty as to what an operating or partnership agreement may and may not do;
  3. Empowering the operating or partnership agreement to fundamentally reshape the fiduciary duties of those who manage the entity;
  4. Bringing clarity to the implied contractual covenant of good faith and fair dealing;
  5. Accommodating sophisticated deals by authorizing the operating or partnership agreement to control the manner of its amendment, while defining the agreement in a way that reflects business practices in thousands of small enterprises (especially those formed and operating without legal advice);
  6. Making those who claim membership automatically subject to the operating or partnership agreement and making the entity itself subject to and able to enforce the agreement;
  7. Resolving the tension between the rights of members or partners still participating in the business and the rights of former owners and other transferees of economic rights;
  8. Codifying the question of who has standing to enforce the operating or limited partnership agreement; and
  9. Protecting the agreed-upon allocation of management authority in LLCs and limited partnerships by authorizing special litigation committees (SLC). 

As a result of the Harmonization Project, ULLCA, ULPA, and UPA use essentially identical wording to protect the agreement the members or partners have made for themselves. The harmonization extends even to the numbering of statutory sections. For simplicity’s sake, the rest of this article discusses ULLCA. However, except as noted below concerning derivative suits, the points made about ULLCA apply equally to UPA and ULPA. 

The Fulcrum of the Act – Sections 105–107 

The key to understanding how ULLCA protects the members’ agreement is to understand Sections 105, 106, and 107. As the comment to Section 105 explains: “The operating agreement is pivotal to a limited liability company, and Sections 105 through 107 are pivotal to this act. They must be read together, along with Section 102(13) (defining the operating agreement).”

Of the three sections, Section 105 is the most detailed. Again according to its comment: 

This section performs five essential functions. Subsection (a) establishes the primacy of the operating agreement in establishing relations inter se the limited liability company, its member or members, and any manager. Subsection (b) recognizes this act as comprising mostly default rules – i.e., gap fillers for issues as to which the operating agreement provides no rule. Subsection (c) lists the few mandatory provisions of the act. Subsection (d) lists some provisions frequently found in operating agreements, authorizing some unconditionally and others so long as “not manifestly unreasonable.” Subsection (e) delineates in detail both the meaning of “not manifestly unreasonable” and the information relevant to a determining a claim that a provision of an operating agreement is manifestly unreasonable. 

As for Sections 106 and 107, Section 106 details the effect of an operating agreement on the limited liability company and on persons becoming members of an LLC. Section 107 concerns the effect of an operating agreement on third parties.

The Primacy of the Operating Agreement 

Many LLC statutes sprinkle throughout their respective provisions statements that this or that statutory rule applies “except as otherwise provided by the operating agreement.” In contrast, ULLCA provides a general, centralized grant of authority, and, moreover, makes clear that the operating agreement is the first place to look for the rules governing the members and their enterprise. Thus, Section 105(a) states that, subject to limited exceptions: “[T]he operating agreement governs: (1) relations among the members as members and between the members and the limited liability company; (2) the rights and duties under this [act] of a person in the capacity of manager; (3) the activities and affairs of the company and the conduct of those activities and affairs; and (4) the means and conditions for amending the operating agreement.” The statutory rules apply only where the agreement has gaps or with regard to selected issues warranting special treatment.

If laws were algorithms and lawyers and judges were computers, ULLCA’s “primacy” approach would produce the same outcomes as would a statute that prefaces each of its default rules with “except as otherwise provided in the agreement.” But, despite the growing primacy of LLCs over corporations (except in the publicly-traded sphere), law schools still pay scant attention to LLCs. As a result, most judges and lawyers remain schooled only in the world of corporations, where the corporate statute establishes the primary governance rules and agreements among the owners are secondary. In a world in which courts and practitioners still occasionally refer to “limited liability corporations,” it is crucial to emphasize that an LLC is a contract-based organization and that analysis of inter se issues must always begin (and often end) with the operating agreement.

Providing Certainty as to the Powers and Limitations of the Operating Agreement           

In addition to centralizing the power of the operating agreement, ULLCA also centralizes the few limitations on that power. Section 105(c) lists these limitations – e.g., no power to change requirements for submitting documents to the filing office; no power to “eliminate the contractual obligation of good faith and fair dealing;” no power to entirely eliminate the fiduciary nature of a manager’s (or managing member’s) duties.           

But even as to the stated limitations, ULLCA authorizes various work-arounds “if not manifestly unreasonable.” For example, under Section 105(c)(6), the operating agreement “may not . . . eliminate the contractual obligation of good faith and fair dealing,” but does have the power to “prescribe the standards, if not manifestly unreasonable, by which the performance of the obligation is to be measured.” The comment to Section 105(c)(6) shows how an operating agreement might use that power to clarify a manager’s rights in conflict-of-interest situations. 

EXAMPLE: The operating agreement of a manager-managed LLC gives the manager the discretion to cause the LLC to enter into contracts with affiliates of the manager (so-called “Conflict Transactions”). The agreement further provides: “When causing the Company to enter into a Conflict Transaction, the manager complies with [the implied contractual covenant of good faith and fair dealing] if a disinterested person, knowledgeable in the subject matter, states in writing that the terms and conditions of the Conflict Transaction are equivalent to the terms and conditions that would be agreed to by persons at arm’s length in comparable circumstances.” [In a way that is not manifestly unreasonable, this] provision “prescribe[s] the standards by which the performance of the [good faith] obligation is to be measured. 

The inquiry as to whether a particular term is “manifestly unreasonable” is carefully delineated in Section 105(e). As the comment explains, “Subsection (e) is fundamental to this act, because: (i) this act generally defers to the agreement among the members; and (ii) Subsection (e) safeguards the operating agreement in . . . [several] ways.” According to the comment, those safeguards include rules for:

  • who decides the issue of “manifestly unreasonable”
    • “the court . . . as a matter of law,” Subsection (e);
  • the framework for determining the issue
    • determination to be made “in light of the purposes, activities, and affairs of the limited liability company,” Subsection (e)(2);
  • the temporal setting for determining the issue
    • “determination [to be made] as of the time the challenged term became part of the operating agreement,” Subsection (e)(1); and
  • what information is admissible for determining the issue
    • “only circumstances existing” when “the challenged term became part of the operating agreement,” Subsection (e)(1). 

Perhaps most importantly, Subsection (e)(2) sets a very high standard for claimants: “The court . . . may invalidate the term only if, in light of the purposes, activities, and affairs of the limited liability company, it is readily apparent that: (A) the objective of the term is unreasonable; or (B) the term is an unreasonable means to achieve the term’s objective.” (Emphasis added.) 

Operating Agreement’s Power to Re-Shape Fiduciary Duty           

The power of an operating agreement to change the fiduciary duties of managers and managing members has been much debated. For example, the Delaware LLC statute is famous for permitting an operating agreement to eliminate all fiduciary duties. Yet, two of Delaware’s leading jurists have recently written: “As judges who have seen our fair share of alternative entity disputes, we do not immediately grasp why [“the elimination of fiduciary duties and the establishment of a purely contractual relationship between entity managers and investors”] would be seen as a compelling advantage.” Leo E. Strine, Jr., J. Travis Laster, “The Siren Song of Unlimited Contractual Freedom,” Elgar Handbook on Alternative Entities (Eds. Mark Lowenstein and Robert Hillman) (forthcoming 2015) available at SSRN: http://ssrn.com/abstract=2481039

As explained in the comment to Section 105(d)(3), ULLCA “rejects the ultra-contractarian notion that fiduciary duty within a business organization is merely a set of default rules and seeks instead to balance the virtues of ‘freedom of contract’ against the dangers that inescapably exist when some persons have power over the interests of others.” However, Section 105(d)(3) specifically authorizes the operating agreement to reshape, restrict, and even eliminate fiduciary duties: 

If not manifestly unreasonable, the operating agreement may: (A) alter or eliminate the aspects of the duty of loyalty stated in [the act]; (B) identify specific types or categories of activities that do not violate the duty of loyalty; (C) alter the duty of care, but may not authorize conduct involving bad faith, willful or intentional misconduct, or knowing violation of law; and (D) alter or eliminate any other fiduciary duty. 

The comment to Section 105(d)(3)(A) provides a useful example: 

EXAMPLE: ABC LLC (“ABC”) is a manager-managed limited liability company with three managers and two entirely separate lines of business, the Alpha business and the Beta business. Under ABC’s operating agreement:

  • Manager 1’s responsibilities pertain exclusively to the Alpha business; responsibility for:
    • the Beta business is allocated exclusively to Manager 2; and
    • ABC’s overall operations is allocated exclusively to Manager 3.
  • Manager 2’s responsibilities pertain exclusively to the Beta business; responsibility for:
    • the Alpha business is allocated exclusively to Manager 1; and
    • ABC’s overall operations is allocated exclusively to Manager 3.
  • Manager 1 has no fiduciary duties pertaining to the Beta business.
  • Manager 2 has no fiduciary duties pertaining to the Alpha business. 

The “not manifestly unreasonable” standard applies to these provisions under Subsection (d)(3)(A) and (D), and the provisions are not manifestly unreasonable. 

Implied Contractual Covenant of Good Faith and Fair Dealing           

The implied covenant of good faith and fair dealing can be a useful and bargain-respecting tool for dealing with gaps in contractual language. The covenant can also be a vehicle for “buyer’s remorse” and an invitation to judges to rewrite contracts to protect a party from a risk the party agreed to take. Using both the statutory text and official comments, ULLCA takes the first approach.           

Section 409(d) refers to “the contractual obligation of good faith and fair dealing.” (Emphasis added.) As the comment explains, “the adjective (‘contractual’)” should preclude courts from deciding that the statute creates an obligation separate from “the implied obligation that exists in every contract.” Such a separate obligation would be without definition and therefore without limitation.

The comment takes great pains to explain what the implied obligation is and is not. “[T]he purpose of the contractual obligation of good faith and fair dealing is to protect the arrangement the members have chosen for themselves, not to restructure that arrangement under the guise of safeguarding it.” Moreover:

Courts should not use the contractual obligation to change ex post facto the parties’ or this act’s allocation of risk and power. To the contrary, the obligation should be used only to protect agreed-upon arrangements from conduct that is manifestly beyond what a reasonable person could have contemplated when the arrangements were made. . . . Conduct does not violate the obligation of good faith and fair dealing merely because that conduct substantially prejudices a party. Indeed, parties allocate risk precisely because prejudice may occur.

Amendments – For Both the Sophisticated and the Non-Lawyer 

Each year, the overwhelming majority of new LLCs are formed with neither benefit of counsel nor a written operating agreement. For these deals, the conduct and words of the members provide key data for determining the members’ actual agreement. At the other end of the spectrum are highly-lawyered deals, with detailed operating agreements reflecting lengthy and careful negotiations. For these deals, it is highly disruptive and expensive to allow claims that conduct or statements have changed the written agreement.

ULLCA accommodates both ends of the spectrum. The definition of operating agreement, Section 102(13), is very inclusive: “‘Operating agreement’ means the agreement, whether or not referred to as an operating agreement and whether oral, implied, in a record, or in any combination thereof, of all the members of a limited liability company. . . .” (Emphasis added.) At the same time, ULLCA permits the operating agreement to control its manner amendment (and thereby reduce the definition’s inclusivity). Section 105(a)(4) states: “[T]he operating agreement governs . . . the means and conditions for amending the operating agreement.” Section 107(a) states: “An operating agreement may specify that its amendment requires the approval of a person that is not a party to the agreement or the satisfaction of a condition. An amendment is ineffective if its adoption does not include the required approval or satisfy the specified condition.” (Emphasis added.) Despite courts’ well-known penchant for allowing waiver of “no oral modification provisions,” an operating agreement certainly can make a signed writing a condition to amending the agreement.

Clarifying Who is Bound By and Who May Enforce the Operating Agreement           

Although LLCs involve contractual relationships, most LLC operating agreements are not typical contracts. In addition to the oxymoron of an agreement of “a sole member,” special issues arise as to: (1) whether an LLC is subject to and can enforce the operating agreement; (2) how to address claims that a person has become a member without having acquiesced to the operating agreement; and (3) whether transferees of economic rights can acquire the same protectable interest as can traditional contract assignees.

ULLCA resolves each of these issues. “A limited liability company is bound by and may enforce the operating agreement, whether or not the company has itself manifested assent to the operating agreement. A person that becomes a member is deemed to assent to the operating agreement.” ULLCA § 106(a) & (b).           

As for the rights of transferees of economic interests, the comment to ULLCA 107(b) is instructive: 

The law of unincorporated business organizations is only beginning to grapple in a modern way with the tension between the rights of an organization’s owners to carry on their activities as they see fit (or have agreed) and the rights of transferees of the organization’s economic interests. Such transferees can include the heirs of business founders as well as former owners who are “locked in” as transferees of their own interests. If the law categorically favors the owners, there is a serious risk of expropriation and other abuse. On the other hand, if the law grants former owners and other transferees the right to seek judicial protection, that specter can “freeze the deal” as of the moment an owner leaves the enterprise or a third party obtains an economic interest. 

ULLCA follows the case law and favors the rights of members continuing the business over rights of transferees of economic rights. Subject to limited exceptions, Section 107(b)(1) provides that “an amendment to the operating agreement made after a person becomes a transferee or is dissociated as a member is effective with regard to any debt, obligation, or other liability of the limited liability company or its members to the person in the person’s capacity as a transferee or person dissociated as a member.” As the comment notes: “The question of whether, in extreme and sufficiently harsh circumstances, transferees might be able to claim some type of duty or obligation to protect against expropriation awaits development in the case law.” 

Protecting the Deal by Delineating Standing 

An operating agreement is both a contract among the members and the LLC’s foundational governance document. The latter characteristic differentiates the operating agreement from typical contracts and requires special attention to the question of who has standing to enforce the agreement. 

ULLCA is the only LLC statute which provides that attention. Section 901(b) states: “A member maintaining a direct action under this section must plead and prove an actual or threatened injury that is not solely the result of an injury suffered or threatened to be suffered by the limited liability company.” The comment notes: “This subsection codifies the rule of standing that predominates in entity law.” The comment then explains: “The distinction between direct and derivative claims protects the operating agreement. If any member can sue directly over any management issue, the mere threat of suit can interfere with the members’ agreed-upon arrangements.” (ULPA contains a comparable provision, but UPA does not. Although a general partnership is an entity separate from its partners, the drafters of UPA (1997) decided not to provide for derivative claims and the Harmonization Project did not revisit that decision.)

Special Litigation Committees and Deal Protection 

ULLCA expressly authorizes an LLC to appoint a special litigation committee. The comment to Section 901(a) explains: 

Although special litigation committees are best known in the corporate field, they are no more inherently corporate than derivative litigation or the notion that an organization is a person distinct from its owners. An “SLC” can serve as an ADR mechanism, help protect an agreed upon arrangement from strike suits, protect the interests of members who are neither plaintiffs nor defendants (if any), and bring the benefits of a specially tailored business judgment to any judicial decision. 

(Emphasis added.) 

Conclusion: Maximum Effect for the Contract of the Members 

Some LLC statutes express a general policy of giving “maximum effect to freedom of contract.” ULLCA eschews that pronouncement as ambiguous and unnecessary, but – as outlined above – ULLCA is constructed to give maximum effect to the contract the members have made for themselves. 

Daniel S. Kleinberger

Daniel S. Kleinberger was a co-reporter for the Uniform Law Commission’s Harmonization Project and was the principal drafter of the new comments to the Uniform Partnership Act, the Uniform Limited Partnership Act, and the Uniform Limited Liability Company Act. He serves regularly as an expert witness, consulting expert, arbitrator, and special consensual magistrate. This article reflects Professor Kleinberger’s opinions as an individual and does not state the views of the Uniform Law Commission.