For purposes of this article, a minority member is a member who does not have voting control or the power to exercise voting control over the limited liability company that the minority member is joining or has joined. This article identifies those provisions that may be important to a minority member and may be subject to negotiation.
Leverage
Even though a client is a minority member, the client may still have significant leverage to negotiate the terms of the limited liability company agreement (the operating agreement). For example, a real estate developer who has control over an opportunity to acquire or develop a property but needs a money partner controls the opportunity and can (hopefully) pick the money partner. Although the money partner may have voting control, the minority partner may retain control over day-to-day operations, and the minority partner may also retain the ability to find funding from another source. Similarly, an owner of a business who is selling control, but is retaining a minority ownership share, controls the opportunity and may be able to find a buyer offering friendly terms in the operating agreement. In addition, minority owners who have little leverage by themselves may be able to team up with other minority owners and gain leverage through their teamwork. However, in a situation where the client is an investor who simply is providing funding and the organizers can find replacement investors, the client is likely to have little negotiating leverage.
Purpose Clause
The purpose clause is a statement of the scope of the LLC’s authority to conduct business; management may not cause the LLC to enter into agreements or conduct business outside the scope of this purpose. From the standpoint of the minority investor, a purpose clause permitting “any business” or “any purpose,” or a clause permitting broad types of activity, may allow a manager or majority members to engage, without the approval of the other members, in businesses that were not contemplated at the venture’s outset.
The ability of a minority member to negotiate a limited purpose often depends on the type of LLC and custom within the industry. The purpose of an LLC organized for investment purposes is often broad, and a minority investor may not be able to negotiate any limitations. If the LLC is investing in a single piece of real estate, mortgage lenders frequently require that the purpose of the LLC may be limited to dealing with the particular real estate.
However, if the LLC is organized to undertake a particular type of business, such as a law or dental practice, a plumbing business, or operation of a dealership or other specific business, a minority member should expect and require that the purpose clause be limited to the intended business and related activities, and a minority investor would want the LLC’s purpose clause to reflect a limited scope of authority.[1]
Additional Capital Contributions
An LLC that needs additional capital may attempt to seek that capital through capital calls. If the minority member is an investor, notice and the opportunity to elect to invest additional funds may be all that the minority member is willing to commit. Minority members in businesses formed for a particular venture may be obligated to commit additional capital in the future, but may negotiate a cap on their future contribution obligations. If a minority member cannot control the making of a capital call or obtain a cap, the minority member may be able to require that there be a demonstrated “need” for additional funds, or to include a provision that requires management to attempt to borrow funds to meet the need before a call is made.
Failure to Fund a Capital Call
A minority member’s failure to fund a capital call may drastically affect the minority member’s interest. Operating agreements that provide for dilution of the defaulting member’s interest as a remedy (a reduction in the defaulting member’s interest in the LLC) often base dilution on relative capital accounts or contributed capital. If the value of the venture has appreciated, dilution on either basis will not take into account the defaulting member’s share in the “equity” of the venture.
A common alternative for the minority member to consider is a provision that permits other members to elect to fund the defaulting member’s capital call and to make a “deemed loan” to the defaulting member, repayable from future distributions. Unless these “deemed loans” are convertible into equity at the option of the funding member, provisions of this type should not result in dilution. However, if future distributions are not sufficient to repay the “deemed loan,” the defaulting member may wind up with personal liability for the unpaid contribution. Other possible penalties for a defaulting member include loss of voting rights or the triggering of a buyout (generally at an unfavorable price).
Distributions
From a minority member’s standpoint, an operating agreement that mandates quarterly distributions of all or a specified percentage of cash flow (after objectively determined reserves) best protects the minority member. However, in many cases, a minority member will not be able to negotiate for mandatory distributions. Moreover, even if distributions are mandatory, if the manager or managing member has the discretionary power to determine the amount of reserves, the manager or managing member might conservatively establish reserves and thus keep distributions artificially low.
Minority members (of LLCs with taxable income) also should seek assurance in the operating agreement that mandatory tax distributions (an amount sufficient to pay income taxes, assuming maximum marginal tax rates are applicable, on income allocated to members) are made quarterly so that members will be able to make estimated payments. If the members of the LLC work for the LLC (for example, lawyers, dentists, or plumbers) and are the drivers of the LLC’s business on a full-time basis, those members will expect to receive regular distributions. “Guaranteed payments” may be negotiated for service members, which may be in a fixed amount or may be determined by a formula or by agreement. A service member may be required to treat regular payments as a draw against projected cash-flow distributions. However, minority members who provide services typically would not want to lose the right to receive past payments even if cash flow does not meet projections.
Voting and Control
By definition, a minority member does not have voting control. However, any minority member should have the right to consent to amendments to the operating agreement that, among other things, disproportionally affect the minority member’s limited liability, economic interest, or voting interest. In that regard, the minority member’s share of income and loss and other fundamental rights should be protected. If the LLC is formed to operate a specific business, and the LLC’s purpose clause is limited (or if each member’s consent is not required to amend the purpose clause), a minority member may have a veto over the LLC’s entrance into a different line of business.
Minority members may seek the right to require a certain level of consent in order for “major decisions” to be made, and if the venture has more than one minority member, that consent will frequently require only a majority of the minority members. Major decisions often include amendments to the operating agreement, sale of the business/mergers, etc., changes in long-term business plan/type of business conducted, dissolution, bankruptcy of the LLC, issuing equity beyond initial capital commitments (i.e., dilution), related party transactions/management compensation, initiation or settlement of major litigation, transfers of manager’s interest/management rights, material tax elections, borrowings in excess of a defined leverage limit, and removal/election of a manager of the LLC.
Although attractive at the outset, minority approval rights over more operational matters can be costly to the LLC, particularly if there are numerous minority members. For example, if entering into a significant lease is a major decision, delay in obtaining approval may result in the loss of the tenant. As a result, in most cases, minority members have few rights to consent to day-to-day operational matters. Service-provider members of an LLC engaged in a service business often have approval rights over more types of operational decisions, such as the annual budget or major personnel changes. Even so, only the manager or managing member is usually authorized to propose a “major decision.”
Prospective members should review a list of possible major decisions with a view toward understanding the effect on the LLC’s business if a major decision is delayed or not approved at all. The simplest resolution is that if there is no approval, then the LLC will maintain the status quo. Frequently, however, if a dispute persists, members may initiate a buy-sell process, which often favors a member who has the resources to execute a purchase. When representing a member who must find funding in order to be the buyer, the buy-sell process should be negotiated to provide for enough time before closing for the member to obtain and close on funding. If a member fails to close on the purchase, the quid pro quo may be that the member loses voting rights for future major decisions or loses other rights.
Duties of Control Persons
Under most state LLC statutes, the duties of those in control of an LLC are based on corporate principles and include a duty of loyalty and a duty to not compete with the LLC’s business. If the purpose of the LLC is reasonably limited to a particular business, the duty to not compete may prohibit any activity that competes with the LLC’s stated purpose. If the purpose of the LLC is not limited, in most cases courts will examine the actual business of the LLC to determine what types of activities unreasonably compete with the LLC’s business.
Many operating agreements include provisions that allow members and managers to undertake other activities, including competing activities, unless the members or managers are expected to work full-time for the LLC (such as lawyers, dentists, or plumbers). LLCs organized as investment vehicles should contain provisions that clearly define when a particular investment vehicle must be allocated to the LLC, and when the persons managing the LLC can invest in the opportunity themselves or allocate it to another vehicle. In addition to addressing the power of a manager or majority member to compete with the LLC, the operating agreement should resolve whether members may participate in related or competing activities. In most cases, a minority member who does not participate in management or provide services to the LLC should be permitted to compete.
In some states, such as Delaware, duties other than the implied contractual covenant of good faith and fair dealing may be waived. Even if the manager or majority members have waived their duties to the minority, the minority member should seek to obtain the right to consent to “interested transactions”—that is, transactions between the LLC and a controlling member of an affiliate after being provided all material information relating to the transaction. If the minority members do not have the right to approve interested transactions, the operating agreement should, at a minimum, specify that an “interested transaction” must be “entirely fair” to the LLC and its members.
Indemnification and Advancement
Control persons frequently include indemnification provisions in the operating agreement so that the LLC will indemnify the control person against claims (by members and the LLC) for actions taken on behalf of the LLC. An indemnification provision should mesh, and not conflict, with provisions dealing with fiduciary duties, meaning that a control person should not be entitled to indemnification for conduct that violates his or her duties to the LLC.
Advancement of expenses requires the LLC to pay the defense costs of a covered person before there has been a determination as to whether the person is entitled to be indemnified. Advancement is not an automatic right of a covered person and must be stated expressly in the operating agreement. Like indemnification provisions, advancement provisions should be carefully considered so that the scope of the provision is not broader than expected. Minority members should also be aware that a broad advancement provision may result in the LLC’s payment of defense costs for a person who truly has wronged the LLC, and that the wrongdoer may not be in a position to reimburse the LLC for defense costs when the matter is finally resolved against the wrongdoers.
To protect the minority member, exceptions to indemnification or advancement may be based on bad conduct (e.g., bad faith or fraud). In addition, advancement should generally not be available for proceedings brought by the covered person. Minority members may also want to ensure that capital calls cannot be made to fund advancement claims.
Inspection Rights
LLC statutes generally provide members with a relatively broad right to obtain information and access to records. This information typically includes a list of members, tax returns, the operating agreement, financial statements, and books and records, and may include the right to true and full information as to the status of the business and financial condition of the LLC. Limitations may be permitted under state statutes, and the organizers may want to impose reasonable restrictions standard on access to information or impose restrictions on the disclosure of information that may be used to compete with the LLC. Default statutory provisions typically are favorable to minority members.
Exit Rights
Minority members should also consider how they may exit from the LLC, given that most LLCs substantially limit or prohibit transfers of interests. If the member is a professional or other service provider who works for the LLC’s business, the concept of “exit” often is the person’s retirement. The retiring member typically would like to receive the member’s share of undistributed earnings and payment for the member’s share of the assets of the LLC. Often, however, a buyout will not include a payment for going concern value because the loss of the member in a service LLC will result in a loss of revenue and income that will only be replaced if the LLC is able to find another service provider who, in turn, will want to be paid for his or her services.
A more difficult problem arises when a member who used to be a productive contributor to the service LLC slows down and/or ceases to be productive for other reasons. If compensation is tied to effort, that member will see his or her compensation reduced. However, the members may want the operating agreement to address such a situation in other ways, such as the buyout of the nonproductive member.
The price to be paid for a withdrawing member’s interest can be specified in the operating agreement. If the member is a retired service provider, the price may be tied to the member’s capital account. If the price is based on “fair market value,” the price will typically include discounts for lack of control and lack of marketability, which can be substantial. If the price is based on “fair value,” the price would more likely be based on the value of the underlying assets or business of the LLC multiplied by the member’s percentage interest in the LLC. In the alternative, the operating agreement can provide for formulas to compute the fair value or fair market value, including specified discounts for lack of control or marketability (or elimination of such discounts). Disputes as to the establishment of the price can be resolved by means of the appointment of appraisers.
Transfers of Ownership Interests
If a minority member does not have the right to approve a transfer of a majority member’s membership interest, the minority member will want to attempt to negotiate a “tag-along” right, whereby the minority member may sell its interest on the same terms and conditions as the majority member. Similarly, a majority member, if the majority owner wishes to sell, may want the ability to “drag-along” minority members in a sale. Minority members should seek proportional consideration and should seek to avoid responsibility for breaches of the agreement of sale over which the minority member has no control. “Drag-along” provisions should be carefully reviewed to ensure that they cannot be used by the majority to avoid consent requirements.
If the LLC holds investment property, the interest may be transferable to heirs or trusts. Otherwise, operating agreements typically prohibit transfers or impose substantial restrictions on transfers.
Certain transfers may be unavoidable, such as those that occur as a result of death, divorce, or bankruptcy. The operating agreement may contain provisions for purchase or redemption rights if any of these events occurs (together with the issues relating to the determination of purchase price and timing of payment of the purchase price). Note, however, that compulsory redemption of the interest of a member who files bankruptcy may not be enforceable.
Amendments
Minority members should carefully review the amendment provisions in an operating agreement. Generally, amendments should not be permitted that would change the minority member’s economic rights or the “deal” without at least a majority of the minority’s consent.
[1] As discussed above, the minority member may also obtain consent rights that protect its interest.