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Oral or Implied Modifications of a...

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Oral or Implied Modifications of a Written Operating Agreement of a LLC

The impact of the 2014 Utah Revised Uniform Limited Liability Company Act, Utah Code Ann. § 48-3a-101, et seq., (the “2014 LLC Act”) upon disputes between and among members of a limited liability company (“LLC”) is a topic which could consume days of discussion and debate. This blog is limited to oral or implied modifications of a written operating agreement for an LLC.

For reference, it is estimated that at least 60% of all LLCs formed in Utah do not involve attorneys. Some of these persons who form Utah LLCs on their own – especially small business people and other entrepreneurs – may be very surprised with the results of what they created without the guidance of an attorney.

The 2014 LLC Act was enacted in 2013 as part of Utah Senate Bill 131. With certain exceptions, after January 1, 2016, it governs all Utah LLCs as well as all foreign LLCs that do business in Utah. Prior to that date, generally it “governs only: (a) a limited liability company formed on or after January 1, 2014; and (b) . . . a limited liability company formed before January 1, 2014, which elects, in the manner provided in its operating agreement or by law for amending the operating agreement, to be subject to this chapter.” Utah Code Ann. § 48-3a-1405.

The pre-2014 version of the Utah LLC Act, titled the “Utah Revised Limited Liability Company Act,” Utah Code Ann. § 48-2c-100, et seq., (the “Prior LLC Act”) continues to apply, until January 1, 2016, to each Utah LLC formed prior to January 1, 2014, unless that LLC elects to come under the 2014 LLC Act before January 1, 2016. Effective January 1, 2016, the Prior LLC Act is repealed. Thus, during 2014 and 2015, there are two separate Utah LLC statutes potentially in play.

On the topic of oral modification to controlling organic documents, or perhaps the oral or implied creation of an operating agreement, the Utah Revised Business Corporation Act, Utah Code Ann. §§ 16 10a 101 et seq. (the “Revised Corporation Act”), the pre-2014 version of the Utah LLC Act, titled the “Utah Revised Limited Liability Company Act,” Utah Code Ann. § 48-2c-100, et seq., (the “Prior LLC Act”), and the 2014 LLC Act provide interesting contrasts.

Utah Revised Corporation Act. In the corporate context, since at least 1992, a shareholder agreement allowing restructure of management has been authorized as long as it is in writing and signed by all shareholders. Historically, only the board of directors – not the shareholders – governs a corporation. Only the board of directors has the power to declare distributions (dividends), appoint officers, and set policy and initiate major transactions. To provide flexibility for business corporations and, at the same time, predictability, in 1992, Utah adopted the Utah Revised Business Corporation Act, Utah Code Ann. §§ 16-10a-101, et seq. (the “Revised Corporation Act”) and, in such adoption, became one of 24 states that has adopted the Model Business Corporation Act.

A key provision in the Revised Corporation Act is Utah Code Ann. § 16-10a-732, which enables shareholders to usurp or override director authority in specified circumstances. When viewed from an historical perspective, the logic behind Section 16-10a-732 allowing shareholders of closely-held corporations a level of flexibility in determining corporate governance, becomes clear.
Corporations are creatures of statute and, in Utah, exist pursuant to the Revised Corporation Act. The Revised Corporation Act not only authorizes the creation and maintenance of corporations, it establishes the basic organization and management structure of corporations. Prior to passage of the Revised Corporation Act in Utah in 1992, neither case law nor statute authorized shareholder agreements with provisions inconsistent with the statutory requirements of Utah’s corporate code. In 1992, Section 732 was enacted which, for the first time, authorized shareholder agreements having provisions designed to override certain requirements of Utah’s corporate code.

Section 732(2)(a)&(c) of the Revised Corporation Act requires all shareholder agreements, which usurp or override director authority, to be in writing, to be signed by all shareholders and to have a term of only 10 years (unless the agreement provides otherwise):

 

(2) An agreement authorized by this section shall be:

(a) set forth:

(i) in the articles of incorporation or bylaws and approved by all persons who are shareholders at the time of the agreement; or

(ii) in a written agreement that is signed by all persons who are shareholders at the time of the agreement and is made known to the corporation;

. . . .

(c) valid for 10 years, unless the agreement provides otherwise.

 

Utah Code Ann. § 16-10a-732(2)(a)&(c) (1992).

By use of the word “shall,” the plain language of Section 732(2) of the Revised Corporation Act mandates that, to be valid, a shareholder agreement “shall” meet those three requirements. “The best evidence of the true intent and purpose of the Legislature in enacting the Act is the plain language of the Act.” Jensen v. Intermountain Health Care, Inc., 679 P.2d 903, 906 (Utah 1984). Once a Court determines that the language of Section 732 is clear, an examination of the legislative history for the purpose of determining the meaning of the statute is unnecessary and inappropriate. See Schurtz v. BMW of N. Am., Inc., 814 P.2d 1109, 1112 (Utah 1991) (“We first look to the statute’s plain language. Only if we find some ambiguity need we look further.” (citations omitted)). Because the language of Section 732 is plain and unambiguous, it is improper to look for legislative intent outside of the statute itself. The Official Commentary to the Revised Corporation Act confirms the Legislature’s intention that the writing requirement of Section 732 is mandatory.

Section 732 is not a Statute of Frauds: It is a statute that authorizes a contractual deviation from a statutory scheme. Where a Statute of Frauds makes unenforceable an otherwise valid contract, Section 732 of the Revised Corporation Act operates to validate agreements which would be unenforceable because they are contrary to the statutory scheme and the traditional rule that “[a]ll corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors . . . .” Utah Code Ann. § 16-10a-801 (1992).

In other words, Section 732 creates a safe harbor to enable certain shareholder contracts to override director authority. See McLaughlin v. Schenk, 2009 UT 64, ¶ 34, 220 P.3d 146 (The Court upheld a decision enforcing a shareholder agreement under Utah Code Ann. §16-10a-732. This shareholder agreement governed the management and affairs of the corporation and the relationships among the shareholders. It provided for decisions, without a properly noticed meeting, by two-thirds consent of the shareholders. It conflicted with and superseded the bylaws, which required decisions outside a properly noticed meeting be signed by all shareholders entitled to vote.)

It eliminates the issue as to whether an underlying shareholder agreement overriding the statutory scheme of corporate governance is valid. Under Section 732, if a shareholder agreement is “inconsistent” with the enumerated instances in subsection (1), such as overriding corporate governance by a board of directors, the shareholder agreement is invalid unless it complies with the mandatory requirements of subsection (2): The shareholder agreement must be in a writing signed by all shareholders.

Prior LLC Act. Under the Prior LLC Act, unless the operating agreement provided otherwise, a scenario difficult to imagine, “the operating agreement may be altered, amended, or repealed only by the written consent of all members.” Utah Code Ann. § 48-2c-506.

2014 LLC Act. The 2014 LLC Act, Utah Code Ann. § 48-3a-102(16), allows for oral modification of an operating agreement:

“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, including a sole member, concerning the matters described in Subsection 48-3a-112(1). The term includes the agreement as amended or restated.

It allows implied modifications, apparently referring to modifications through conduct alone, such as custom and practice. It allows oral modifications in combination with implied modifications and records other than the written operating agreement. It is easy to interpret this provision as allowing oral or implied modifications of an operating agreements, utilizing one member’s notes of a meeting as evidence, even if the operating agreement states that all modifications must be in writing. This becomes a playground for trial lawyers.

This provision of the 2014 LLC Act also allows for the oral or implied creation of an operating agreement, even if the parties do not use the magic words, “operating agreement.” It also is easy to interpret this provision as allowing oral or implied creation of an operating agreements, utilizing one member’s notes of a meeting as evidence.

Statutes of Fraud. The 2014 LLC Act’s validation of oral modifications of an operating agreement may often clash with the Statute of Frauds. If an original agreement is within the Statute of Frauds, any subsequent agreement which alters or amends it must also satisfy the requirements of the statute. Strevell-Paterson Co., Inc. v. Francis, 646 P.2d 741, 742 (Utah 1982). Operating agreements often contain integration clauses prohibiting oral modifications.

Under the Statute of Frauds contained in Utah Code Ann. § 25-5-4(1)(a), certain agreements are void unless written and signed, such as “every agreement that by its terms is not to be performed within one year from the making of the agreement.” See, e.g., MediaNews Grp., Inc. v. McCarthey, 494 F.3d 1254, 1263-64 (10th Cir. 2007). It is easy to imagine oral modifications of a written operating agreement which cannot be performed within one year. See, e.g., Orlob v. Wasatch Med. Mgmt., 2005 UT App 430, ¶¶ 22-25, 124 P.3d 269. Also, if the LLC only holds real estate, the Statute of Frauds contained in Utah Code Ann. § 25-5-3 may conflict with an oral modification of its operating agreement.

© 2014 Mark A. Larsen & Brent R. Armstrong

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