The Perils of LLC Flexibility – How are Operating Agreements Interpreted

It is imperative that LLC members and management understand their company’s operating agreement and the role it will serve in a legal dispute. In an LLC operating agreement, Delaware law permits members to craft bespoke terms governing the LLC’s operation and the members’ rights, obligations, and duties vis a vis the company and one another. It provides far more flexibility than the State’s corporate law. The Delaware Limited Liability Company Act (the “DLLCA”) acts as a gap filler, as it governs only by default when an operating agreement does not address (or sufficiently address) the circumstances of the dispute before the court.^[1] Although this flexibility is the touchstone of the LLC form and is critical to its popularity, Delaware courts often have noted that it creates a risk for the parties and the courts “that the resulting LLC agreement will be incomplete, unclear, or even incoherent.”^[2]

Too often, LLC members and management are unaware of what the company’s operating agreement says (and, thus, how it will be interpreted), whether it accurately and fully reflects their agreement and understandings, and whether it addresses the topics it should.

• Part 1 of this two-part article series describes how Delaware courts review and interpret operating agreements.

• Part 2 will discuss critical scenarios that are often unaddressed or poorly addressed in operating agreements and for which the DLLCA provides little assistance, such as removing a member or breaking management deadlocks.

An LLC Operating Agreement is Interpreted as a Contract

            If Unambiguous, the Words of the Operating Agreement are Paramount

Generally, Delaware courts interpret an operating agreement like a contract, meaning that the language as written is paramount.^[3] If the court finds the words of the operating agreement are unambiguous when applied to the dispute at hand, it will apply the plain meaning regardless of whether this meaning reflects the understanding or intention of the parties.^[4] The court treats the language of the operating agreement, as read by a reasonable person (discussed below), as the best and conclusive evidence of the will and intention of the parties.^[5] The Court will not consider testimony or evidence regarding the parties’ intention or understanding apart from the agreement’s words (referred to as “parole evidence”) if it determines a provision is ambiguous under the facts at issue.

            Finding Ambiguity

The Delaware courts’ primary task in examining the language of an operating agreement (or other contract) is to determine “what a reasonable person in the position of the parties would have thought the language of the contract means.”^[6] A provision is ambiguous when it is “reasonably or fairly susceptible of different interpretations or may have two or more different meanings.”^[7] Critically, however, a provision is not ambiguous “simply because the parties disagree about what the contract means.”^[8] Determining the ambiguity of a provision “lies within the sole province of the court.”^[9] Because the court will not consider extrinsic evidence until it finds the agreement’s language objectively ambiguous, testimony or evidence regarding the parties’ intent or discussions cannot “be used to manufacture an ambiguity in a contract that facially has only one reasonable meaning.”^[10]

Further, a single provision is not looked at in isolation; instead, the agreement is read “as a whole” and the court seeks to “give effect to all of the contract terms and to reconcile or harmonize all of the contract‘s provisions.”^[11] Often, template or poorly-drafted agreements (or, in complex situations, even well-drafted operating agreements) may contain terms that conflict or arguably overlap, creating complex issues of interpretation. Courts often find a party’s interpretation of a provision, even if reasonable in isolation, is untenable and fails to create ambiguity if it fails to account for the totality of the agreement’s provisions, including the primacy, subordinacy, and content of other provisions that touch on the relevant issue(s).

Ambiguity and Proof of the Parties’ Intent – Parole Evidence

Parole evidence is used to discern the meaning of an ambiguous term, which courts have described as “evidence of prior agreements and communications of the parties as well as trade usage or course of dealing.”^[12] The goal is to ascertain the “reasonable shared expectations of the parties at the time of contracting.”^[13] Such evidence can be drawn from a wide range of sources, including email or other message exchanges, past drafts of the document created in the negotiation process, and the conduct of the parties in performing their obligations prior to the dispute. Notably, even when a provision is deemed ambiguous and the court considers evidence outside the “four corners” of the operating agreement, it must attempt to ascertain the reasonable expectations, intentions, and understandings of the parties at the time the operating agreement was adopted (or amended, as relevant). If a term simply was not reasonably contemplated in the operating agreement, or does not appear to have been within the purview of the parties when they adopted the agreement, the court will not, absent exceptional circumstances, untenably stretch the language or use extrinsic evidence to create additional terms or obligations.

Because operating agreements often raise issues that turn upon wide variations in their language and specific terms, case law interpreting operating agreements often provides only limited future guidance. Delaware courts also interpret operating agreements by drawing from case law in the limited partnership agreement context, which has a longer history than the relatively new LLC form and which is generally treated as analogous. In some circumstances, although somewhat controversial, courts may even look to corporate law principles where the operating agreement appears to adopt corporate structures (such as board management akin to a corporation) or other corporate mechanisms.

The DLLCA Acts as a Gap Filler

The DLLCA applies when an operating agreement does not address an issue or the parties did not contemplate it in or as part of the agreement.^[14] When the provisions of an operating agreement and the DLLCA conflict, the operating agreement controls.^[15]

Conclusion

The operating agreement will govern disputes as an initial matter. Persons forming LLCs should take great care in hammering out their operating agreement and ensuring that it not only embodies the terms agreed upon, but also that it is sufficiently clear in how various situations will be handled within the four corners of the agreement. Part 2 of this series will address certain key issues that an operating agreement must contemplate, ensuring it is sufficiently fulsome. Taking time with the agreement at the outset and understanding what it actually says is a necessary step in forming a company, even if only between two members. Time taken at the outset gives all parties, prior to a dispute, an understanding of their rights and obligations.