Private Company Proxy Contest – Examples

In this third part of the series on private company proxy contest series, I want to illustrate the problem — or opportunity — which I have been hypothesizing in the prior two parts.

Definitions of Ownership Interests — the Gap Between Statutes and Governing Documents

In reviewing several representative versions of limited partnership agreements (LPA) and LLC company agreements (Company Agreement) [some I drafted, others were prepared by other law firms for their clients or CLE presentations, by bar association workgroups, or by treatise authors],  I noticed that the problem/opportunity arises at the core definitional level in most governing documents and the single significant way in which it usually differs from the corresponding statutory definition.

For example, in a Company Agreement, the definition of "Membership Interest" for purposes of the agreement might read like this one pulled from a Delaware  Company Agreement:

“Membership Interest” means the interest of a Member in the Company, including rights to distributions (liquidating or otherwise), allocations, information, all other rights, benefits and privileges enjoyed by that Member (under the Act, the Certificate, this Agreement or otherwise) in its capacity as a Member and otherwise to participate in the management of the Company….

Pay attention to the last part of the definition:  "all other rights, benefits and privileges enjoyed by that Member … to participate in the management of the Company…."

Even the State Bar of Texas, in its form Company Agreement, defines "Membership Interest" in much the same way:

The Member’s Membership Interest is such Member’s right (a) to an allocable share of the profits, losses, deductions, distributions, and credits of the Company; (b) to a distributive share of the assets of the Company; and (c) to vote on those matters described in this Agreement and the Code and to participate in the management and operation of the Company as set forth in this Agreement.

But attention must be paid to the statutory definition of the closest corresponding statutory term set forth in the Delaware Limited Liability Company Act:

"Limited liability company interest" means a member's share of the profits and losses of a limited liability company and a member's right to receive distributions of the limited liability company's assets.

And to the statutory definition of the corresponding statutory term in the Texas Limited Liability Company Act, which shows explicitly the difference between the statutory definitions and the contractual examples given above:

"Membership interest" means a member's interest in an entity.  With respect to a limited liability company, the term includes a member's share of profits and losses or similar items and the right to receive distributions, but does not include a member's right to participate in management.

Conflict  in Use of Contractually Defined Term in Transferability and Voting Sections of Governing Documents

Both Company Agreement examples cited above define "membership interest" to include a member's right to participate in management — which is explicitly NOT a right contained in the statutory definition of that term.

That point is why the transferability restrictions contained in the Company Agreements are somewhat confusing.

In the Delaware version, members are strictly prohibited from making any "Disposition" of "all or any portion of such Member’s Membership Interest" except to the extent expressly provided in the Article on transferability.  "Disposition" is defined as:

any direct or indirect transfer, assignment, sale, gift, inter vivos transfer, devise, transfer by operation of the rules of intestacy, pledge, hypothecation, mortgage, hedge or other encumbrance, or any other disposition (whether voluntary or involuntary or by operation of law), of Membership Interests or Units (or any interest (pecuniary or otherwise) therein or right thereto), including without limitation derivative or similar transactions or arrangements whereby a portion or all of the economic interest in, or risk of loss or opportunity for gain with respect to, Membership Interests or Units is transferred or shifted to another Person.

Notice that the definition appears to focus on the economic interests of a membership interest and not on the voting or management participation rights.  Nevertheless, the definition of "Membership Interest" expressly includes the right "to participate in the management of the Company…." so the question is whether or not the prohibition against unpermitted transfer, assignment or other disposition applies to the power to vote and participate in management.  The Article setting forth exceptions to the bar against any Disposition is silent on this issue, which suggests that the grant of a proxy to vote a member's Membership Interest is NOT a "Disposition" of a partial interest in the Membership Interest, despite the definition of that term in the Company Agreement.

In the section on member voting, this Company Agreement provides convincing evidence to support that interpretation:

Proxies. (i) Each Member entitled to vote at a meeting of Members or to express consent or dissent to action in writing without a meeting may authorize another Person or Persons to act for him by proxy.

So the conclusion that should be drawn in interpreting this Delaware Company Agreement is that the grant of a proxy is NOT a direct or indirect "Disposition" of any interest in or right of a "Membership Interest" (despite the inclusion of management participation rights in the definition of that term) and, not being prohibited or limited elsewhere in the Company Agreement, a member's right to grant a proxy to vote on any matter upon which he, in his capacity as a member, has the right to vote is measured by the applicable statutory provision of the Delaware Limited Liability Company Act — which specifically provides that a member may grant a proxy to another person to act in his place.

To reach any contrary interpretation, would be to ask a court to distinguish between "good proxies" (the proxyholder is acting  as agent for a principal who is unable himself to participate at the members' meeting and instead is acting indirectly through an agent who acts strictly in the principal's interest and at his direction, to vote the member's interest as he himself would do if present) and "bad proxies" (the proxyholder is acting pursuant to the authority granted in or by the proxy and may act in the proxy's interest whether or not that conflicts with the member's desires).

The statute does not make that distinction.  To the contrary, the statute clearly contemplates that a proxy may be coupled with an interest of the proxyholder (or his agent) which is not shared with nor subservient to the interest of the grantor of the proxy, and in that sense, the proxy holder is NOT the agent to the proxy grantor as principal.

In the preceding paragraphs, I have worked through a Delaware Company Agreement to highlight the drafting problem.

I could have worked through another example of a Delaware Company Agreement where the document dispenses with its own definition of  membership interest and relies instead upon the Delaware Limited Liability Company Act definition, which does NOT include the power to participate in management.  So when that Company Agreement provides that  "No Member may sell, assign, encumber or otherwise transfer all or any portion of its Membership Units other than with the prior written consent of the board of managers…." it is simple and obvious that grant of a proxy does not fall within the scope of that transferability restriction.

Working likewise through the Texas version Company Agreement cited above yields essentially the same outcome.  That example says:

A member shall not encumber or make a sale, assignment, transfer, conveyance, gift, exchange, or other disposition … of all or any part of his Membership Interest … without the prior written consent of all the remaining Members.

But that Company Agreement also says:

A majority of the outstanding Membership Interests, represented in person or by proxy, shall be necessary to constitute a quorum at meetings of the Members.

The Texas statutory "default" provision on LLC proxies says that members may vote in person or by proxy.  No condition or limitation is attached to the use of a proxy, except that  it be executed in writing by the member.  And if an LLC's existing management wants to direct a court's attention to the fuller TBOC corporation provisions on proxies in an attempt to find a basis upon which to refuse to recognize a proxy's validity based upon its being a "bad proxy" instead of a "good proxy" (as those terms are used above), management's claim will be dismissed even faster by a Texas court than a Delaware court.  The TBOC's corporation provisions on proxies expressly state state that a valid irrevocable proxy includes a proxy coupled to the interest of a  pledgee, a creditor, a transferee, or a party to a voting or shareholders agreement, persons (in other words) who clearly would exercise the proxy in their interests and not in the interests of the shareholder.

Looking Forward to the Final Installment in this Series

In the next and final installment in this series, I will offer up my comments on how this seeming gap in the fence erected by private LLCs against outsiders is just as big when it comes to private partnerships and (sometimes) corporations but how the hole can be boarded up with different drafting of the governing documents.

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