Pennsylvania Limited Liability Company Operating Agreements Must Be Signed (or at least agreed to) by All Members -or- Why LLC Minority Interest Holders Might Rather be in Pennsylvania

April 19, 2017

It seems obvious, doesn’t it? A limited liability company operating agreement governs the relationships among a limited liability company (“LLC”), its owners (called “Members”), and the people running the LLC (who may be Members or “Managers” appointed by the Members). It often serves the same purposes for the LLC as stock subscription agreements, By-laws and a shareholders’ agreement collectively serve for a corporation. This important contract should not be imposed on any Member without that Member’s consent. While this may be true in Pennsylvania, the LLC laws in New York and Delaware have led courts to reach different results in those states.

New York. Shapiro, Ettenson and Newman organized ENS Health LLC as a Member-managed LLC in New York.  Each was to have a 1/3 interest in ENS Health. For two years the LLC had no operating agreement until Ettenson and Newman executed a partial written consent pursuant to which:

-the LLC’s formation document was amended to provide for management by Managers; and

-an operating agreement was signed (by Ettenson and Newman) providing for action to be taken by a majority vote of the Managers (Ettenson, Newman and Shapiro) or a majority in interest of the Members.

This operating agreement, never signed by Shapiro, thus gave Ettenson and Newman the authority to make decisions without Shapiro’s input.  They proceeded to do so, reducing Shapiro’s salary to zero and approving a $10,000 capital call. Under the operating agreement they had approved Shapiro’s failure to meet the capital call could have resulted in a reduction in his interest in the LLC.

Shapiro sued[1], seeking to void the amended formation document, operating agreement, salary reduction and capital call.  The New York courts sided with Ettenson and Newman.  The trial court relied on a provision of the New York LLC Act that states: “Except as provided in the operating agreement . . . the vote of a majority in interest of the members entitled to vote thereon shall be required to . . . adopt, amend, restate or revoke the articles of organization or operating agreement . . ..”[2]   Under this provision the Court held that the formation document and operating agreement were validly adopted by a majority of the Members, and thus Shapiro was bound by the operating agreement he had not signed, and the actions against Shapiro were validly taken.

Delaware. Seaport Village Ltd. (“Ltd.”) was a Member of Seaport Village Operating Company, LLC, a Delaware LLC (“Operating Company”). Operating Company managed a retail development in San Diego, California. Operating Company’s Operating Agreement, which was not signed by Ltd., contained a fee shifting provision requiring the non-prevailing party to cover the prevailing party’s litigation costs in any dispute under the operating agreement. On the losing end of such a dispute, and faced with a legal bill in the mid $300k range, Ltd. asserted in Delaware Chancery Court that it was not bound by the agreement it had not signed. The Vice-Chancellor disagreed[3], pointing to amendments to the Delaware LLC Law that make an operating agreement binding on the LLC and the LLC’s Members whether or not they have signed it.[4] The Vice Chancellor noted the following, somewhat disturbing, rationale:

“Basic principles of contract law support this reading. As a general matter, “only parties to a contract are bound by that contract.” Am. Legacy Found. v. Lorillard Tobacco Co., 831 A.2d 335, 343 (Del. Ch. 2003) (holding that an entity formed by operation of a settlement agreement, although not a signatory, was a party to the settlement agreement). Likewise, “only a party to a contract may be sued for breach of that contract.” Gotham P’rs, L.P. v. Hallwood Realty P’rs, L.P., 817 A.2d 160, 172 (Del. 2002) (citation omitted). By binding a Delaware LLC and its members to their operating agreement, Section 18-101(7) makes them parties to the operating agreement.” Seaport Village at 4.

The Vice Chancellor seems to be saying that the State’s interest in enforcing Delaware LLC governing documents can force an unwilling Member into an agreement they never contemplated. But doesn’t that beg the question of whether there was an agreement to begin with?

Pennsylvania’s New LLC Law. On November 21, 2016, the new Chapter 88 of Title 15 Pa. C.S. was adopted. On April 1, 2017, Chapter 88 became the law governing Pennsylvania LLCs.

Section 8812 of Title 15 defines “Operating agreement” as “The agreement, whether or not referred to as an operating agreement and whether oral, implied, in record form or in any combination thereof, of all the members of a limited liability company . . .concerning matters described in section 8815(a) (related to contents of operating agreement). The term includes the agreement as amended or restated.” (emphasis added).

The report of the Title 15/Business Associations Committee of the Section of Business Law of the Pennsylvania Bar Association, September 12, 2016 version (“PA Bar Report”), includes the following commentary on this definition:

“Unless the operating agreement itself provides otherwise:

“an operating agreement may comprise a number of separate documents (or records), however  denominated; and

“subject to 15 Pa.C.S. § 8816(b) (deeming new members to assent to the then-existing operating  agreement), a document, understanding etc. can be part of the operating agreement only with  the assent of all persons then members.

“An agreement among less than all the members might well be enforceable among those members as parties, but would not be part of the operating agreement. However, under 15 Pa.C.S. § 8815(a)(4), an amendment to an operating agreement can be made with less than unanimous consent if the operating agreement itself so provides.” PA Bar Report at 360.

So, under Pennsylvania’s new statute, although an operating agreement need not be in writing it must be agreed to by all Members (which is obviously easier to prove if the agreement is in writing and signed). A prospective minority Member of a Pennsylvania LLC will NOT be bound by an operating agreement it has not assented to, regardless of whether the majority has adopted it. Probably.

Why probably? Unlike New York, which requires LLC operating agreements to be in writing, Pennsylvania does not. The terms of an unwritten contract could be proved by evidence of the parties’ assent, including non-verbal assent by course of dealing. So with just the wrong facts one could find oneself a Member of a Pennsylvania LLC “by estoppel” despite one’s efforts not to be.

Is the Statute of Frauds any help?  The Pennsylvania Statute(s) of Frauds apply (i) to the sale of goods in excess of $500[5] (ii) to sales[6]  and certain leases[7] of real estate and personal property and (iii) to certain transactions with executors and trustees[8].  When applicable, there must be a writing supporting the subject contract. In most cases Pennsylvania’s Statute of Frauds will not apply to an LLC operating agreement because no transfers of goods or realty are contemplated between the Members.[9]

Prospective minority members of LLCs organized in any state, including Pennsylvania, New York and Delaware, would be well advised to insist on completion of the operating agreement before agreeing to any participation in the entity. In New York and Delaware, that is because other Members could possibly reach an agreement on your behalf that you might not like. In Pennsylvania, the concern is that a prospective Member not passively acquiesce in the terms of an unwritten operating agreement by course of dealing. The bar is thus a bit higher for imposing unagreed terms on a minority Member in Pennsylvania. On the flip side, parties desiring to control an LLC with less interference from pesky minority owners should prefer a Delaware or New York entity.

Strassburger McKenna Gutnick & Gefsky assists its clients in forming business and nonprofit entities in Pennsylvania, Delaware, New York and other jurisdictions, and in understanding the importance of both the form and place of formation of those entities. If you have a question about your business entity, or would like to create one, contact David L. Pollack, Julie I. Kline or any member of our Business Services group.

[1] Shapiro v Ettenson, 2015 NY Slip Op 31670(U) (Supreme Court, New York County, August 16, 2015); Affirmed, 2017 NY Slip Op 00442 (Ap. Div. January 24, 2017)

[2] New York Limited Liability Company Law §402(c)(3)

[3] Seaport Village Ltd. v. Seaport Village Operating Company, LLC, et al. C.A. No. 8841-VCL (Opinion letter of J. Travis Lastor, Vice-Chancellor, September 24, 2014)

[4] Delaware LLC Act, Section 101(7)

[5] 13 Pa. C.S. §2201

[6] 33 P.S. §1

[7] 68 P.S. §250.202; 13 Pa.C.S. §2A201

[8] 33 P.S. §4

[9] The New York and Delaware Statutes prohibit contracts that require more than a year to perform unless in writing. Pennsylvania does not have a parallel provision. The Delaware Chancery Court once held that the Delaware Statute of Frauds can apply to a Delaware Operating Agreement. Olson v. Halvorsen, Del. Ch., 2008 Del. Ch. LEXIS 156 (Oct. 22, 2008) The Delaware legislature promptly overruled it. 6 Del Code §18-101(7) (8/2/2010); “A limited liability company agreement is not subject to any statute of frauds . . . .”