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Amendment Provisions: Beware of Letting the Tail Wag the Dog

Aug 2

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8/2/2014 12:31 PM  RssIcon



This is the second in a series of advisories highlighting how those miscellaneous provisions at the end of most contracts - which many people don’t even read - can really matter.

Toward the end of most contracts, in the “miscellaneous” provisions, there is a provision that might read something like this:

“This Agreement may only be amended by a writing signed by each of the parties hereto.”

This sounds like a no-brainer and you would usually blow right past this without thinking about it, right?  Usually you can.  But sometimes, you should think really hard about whether you should actually agree to this.  This concern frequently comes up in the context of agreements that have more than two parties, like limited liability company operating agreements, shareholder agreements, and venture capital investment documents.

Let me give you an actual real-world example from my recent experience.  A limited liability company has multiple members, one of which is an intellectual property attorney who purchased a 5% interest from an existing member.  To save money, the other members of this limited liability company agreed to let the new attorney-member draft their operating agreement.

As time wore on, several things became apparent.  First, on almost all issues, the multiple holders of an aggregate of 95% of the company were in agreement on one side of the issue, and the 5%  attorney/member was on the other.  Second, the operating agreement unfortunately had a number of ambiguities and inconsistencies in it that made it very difficult or impossible to determine how exactly a decision was to be made on many issues.  Third, it was a huge problem for the holders of 95% of the interest in the company that for many actions – including dissolving the company, selling the assets of the company, merging the company, amending the articles or organization or amending the operating agreement itself – the agreement of each of the members was required.  The 5% member made endless trouble for the holders of the remaining 95%.  He made what the 95% owners considered unreasonable demands, took what they considered to be unreasonable positions, insisted on getting his way on all issues and refused to cooperate in any way.

The amendment provision of the operating agreement reads in part that “A proposed amendment will be adopted and become effective . . . only upon on the written approval of all of the Members.”  In the absence of an amendment to the operating agreement, the 5% member has to agree before the other members can dissolve the company, merge the company, sell all of the company’s assets or do anything to eliminate the troublesome member.  The 5% member refused all offers to be bought out at any realistic valuation and refused to agree to amendments to the operating agreement to provide for clearer and more reasonable decisionmaking processes.  The company remains effectively paralyzed when it comes to major corporate actions and remains subject to the terrorism of the 5% owner.

Similar situations can arise in many other types of agreements.  You needn’t go so far as to provide that a mere majority can make any decision - an arrangement that can also result in abuse.  You could provide that major decisions require some supermajority (greater than 50%, in order to give comfort that there is practical consensus on an issue) to agree, or maybe even put in place a tiered system that requires different levels of vote for different actions.  You can also put in requirements that certain specific people or groups must be among those to approve specified types of decisions.  But beware of unanimity requirements that can enable the tail to wag the dog!

What would any written material coming from a lawyer be without a disclaimer?  Here it comes: This advisory contains general information only.  It is not intended to be and should not be relied upon as legal advice for any specific situation.  Your mileage may vary.  Offer void where prohibited.

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