Negotiating on behalf of minority members of an LLC requires careful attention to their unique position. The minority (“Minority”) may include those who have no voting rights at all or limited rights to participate in voting, or those who have a vote but not enough to control. Although the Minority may not have voting control, the Minority may have other leverage in negotiating the deal, such as being a key manager or bringing key knowledge, controlling the deal or access to the opportunity, or owning the business but selling a majority position. As with any negotiation, understanding the leverage is key. Counsel should focus on (i) the Minority’s access to information, (ii) limiting risks to the Minority, and (iii) ensuring that there are few opportunities for mischief on the part of the majority.
Points of Concern for the Minority
Purpose Clause. A commonly overlooked provision, the purpose clause either provides broad authority for the LLC to engage in “any lawful business under the Act”, narrows the scope of the authority by referencing the project generally, or narrows the purpose even more to only address the specific purposes of certain identified activities. The purpose should clearly identify what the members expect the LLC to do. By allowing a very broad purpose, the majority may be able to expand the business or activities to those the Minority never contemplated when the original deal was struck. By narrowing the purpose, the Minority prevents an unintended expansion of the activities of the LLC.
Additional Capital Calls. How additional capital calls are made, and the consequences of a failure to contribute required capital, should be a primary focus of counsel reviewing these types of agreements. Typically, either the manager or the majority will make a call for additional capital, leaving the Minority without any recourse. In some instances, counsel may be able to negotiate a cap on required capital contributions, or require that such additional capital satisfies a documented “need”. In the event that any member fails to contribute the required capital, a penalty will almost always follow. Penalties may include the option for other members to contribute the required capital, resulting in the dilution of the non-contributing member. Such a dilution may be pro-rata, or may include an additional penalty, or the other members might contribute on behalf of the non-contributing member, treating such contribution as a loan, with no voting rights or distributions for the non-contributing member until the loan is fully satisfied. The non-contributing member may be required to sell, facing unfavorable pricing and terms. These provisions are not intended to be gentle on the non-contributing member, so counsel for the Minority needs to focus on these provisions.
Distributions. The determination of when and what to distribute can be a material point of disagreement. Often, distributions are made pursuant to the timing and discretion of the manager or the majority. In some instances, cash flow is distributed quarterly and some distributions are guaranteed (such as fees or salary). If a manager is entitled to retain certain cash “reserves” as needed for operation of the Company, the determination of how the reserves are established and what they consist of should be discussed by the parties, determining whether the maintenance of a “reserve” is mandatory or is at the discretion of the manager. Giving discretion to the manager to make distributions or withhold them can result in an opportunity for pressure exerted on the Minority to sell or to take other action. In considering distributions, counsel should also consider the expectations of the Minority: Is the Minority a service provider who uses distributions to replace a salary? Should those distributions be made on a monthly basis? Or is the Minority receiving distributions subject to a sort of financial incentive or metric that may require a look-back or true up on occasion? Counsel should request that clients make their expectations very clear as to how often distributions will be expected and why.
Mandatory Tax Distributions. Anticipated significant taxable income may necessitate mandatory tax distributions. An analysis of the Minority’s expectations and capacity to withstand any taxable income may require emphasis on the inclusion of a mandatory tax distribution.
Voting and Control. The Minority should consider who is making decisions for the LLC and how those decisions are being made. Will the decisions be made by the manager alone or by the majority? Perhaps a little of both? At a minimum, counsel for the Minority must ensure that decisions that affect the fundamental rights or economic interest of the Minority must have the consent of the Minority. As an aside, counsel should consider the process for removing a manager. If the manager is also the majority in interest, it will be exceedingly difficult for a Minority to remove the manager. Consider negotiating for removal of the manager under certain conditions that rise to the level of “cause”, such as gross negligence or fraud. It will be necessary to set out the elements of “cause” and determine the level of proof required.
Dispute Resolution. In most operating agreements, the manager would be the sole party that can propose a major decision, which may be the only circumstance that could draw a deadlock, the sole manner to trigger a dispute that could create a resolution possibility. If there is no major decision proposed, status quo would remain. In the event of a dispute for which approval is not achieved, status quo would be maintained. Another option would be to provide for third party resolution, provided by an expert or other trusted party, such that a third party would break the deadlock. However, this is generally more useful for business decisions, rather that decisions as to disposition of the Company (sell or not to sell). Mediation or arbitration are almost always included and often there is some form of purchase option. When reviewing dispute resolution provisions, consider the effect on the business if a major decision is delayed due to a decision-making mechanism, and whether the opportunity to execute the major decision will disappear during the time it takes to resolve it. In most instances, the default would be to resort to litigation to address a deadlock. These provisions can be tricky and can have unintended consequences, so pay careful attention to them.
Duties of Control Persons. Standard provisions of good faith and fair dealing provide limited protection. Further, remembering that the LLC is a creature of contract, counsel may not want to rely on the Act for protection. The operating agreement should set forth the duties or provide the standard for the duties. Counsel should consider arguing for restrictions on the manager or majority. Consider whether the Minority might be involved in competing or related activities (i.e. counsel should require or eliminate any duty to provide other business opportunities or investments to the LLC). Counsel should consider restrictions on outside activities, depending on the “deal”. Generally, outside activities are not restricted, unless the manager or member in question is working for the LLC on a full time basis. Counsel may want to examine related party transactions, which generally require approval by the Minority, or the LLC entering into new business, if the “deal” is intended to operate a specific business. Any activities that may compete, or be tied to, the Purpose clause of the LLC should be restricted.
Indemnification and Advancement. Provisions are often included to provide advance payment of costs of defense of litigation involving a “covered person”. Generally, an advance must be specified in the LLC Agreement. Most provisions include certain standards of conduct that void indemnification, which should be carefully reviewed.
Inspection Rights. Generally, statutory inspection rights for members are, absent limitations in the operating agreement, very generous. The Minority may even prefer statutory provisions. Note with caution any attempt by the majority or manager to impose some sort of “reasonable” standard to the request, to seek to limit the information provided, or to impose a restriction on disclosure of confidential information. If there are members who are permitted to compete, counsel should limit disclosure to such competing members.
Exit Rights. Provisions often vary depending on the “deal” and nature of the LLC’s business. If the Minority is performing services for the LLC, counsel should expect to address or provide for termination or retirement. Counsel should review any buy-out provisions and provide possible scenarios to the Minority to consider. Purchase price determination often depends on nature of the LLC’s business – (i) an amount equal to the capital account, if the retiree/transferee is a working member, (ii) fair value vs. fair market value (considering whether discounts are appropriate), (iii) a multiple of earnings, or (iv) other formula valuation. These provisions may differ as between Minority and majority.
Transfers. As is often the case, transfers by the Minority will be restricted. Further, the Minority will rarely have the right to block a transfer of a majority interest. Therefore, the Minority will want to negotiate the addition of a “tag-along right”. Similarly, if the majority is requiring “drag-along rights”, counsel for the Minority should make every effort to (i) avoid the majority imposing contractual liabilities on the Minority; (ii) make sure that the Minority gets proportionate consideration; and (iii) avoid having these “drag-along rights” serve as a method to avoid already negotiated Minority rights and preferences.
Restrictions on Transfers. If membership in the LLC is intended as an investment, the Minority should consider whether it wants to preserve the ability to transfer to family members, family trusts, or related or affiliate entities. In most LLC operating agreements, there are absolute restrictions on transfers. Counsel for the Minority needs to work to get the manager and majority comfortable with any desired transfer structures. It is not uncommon for involuntary transfers, dissociation or withdrawals (death, divorce, bankruptcy) to trigger purchase rights (purchase price issues and enforceability of restrictions in bankruptcy). As referenced above, counsel should be careful to consider how the value is determined.
Amendments. Lastly, but perhaps most importantly, counsel for Minority must ensure that the manager or the majority do not have the power to amend the operating agreement to negate any rights negotiated by the Minority. Amending the operating agreement should not be possible without the consent of the Minority.