In the Harry Potter universe (now returned to playing on Broadway), the wizarding world greatly feared the Dark Lord, Voldemort. In the business world, minority investors in private companies should rightly fear the power of majority owners who have the power to amend the company’s governance documents. Minority investors in Texas privately-held companies often assume—understandably, but wrongly—that their equity stake cannot be taken for little value by the majority owner(s). Minority investors further assume, naively, that if the majority owners suddenly changed the company’s rules to take minority investor’s stock or LLC units, the investor would have some sort of legal recourse and a strong claim to pursue against the majority owner.
But, the little-known and alarming reality is that, under Texas law, if minority investors are not careful to limit the “right of amendment” contained in the company’s governance documents, majority owners have the right to effectively pull the rug out from under minority investors. Using this amendment power, majority owners may be able to change the company’s bylaws or revise the terms of the LLC company agreement to remove minority investors as managers, directors and employees, and just as importantly, deprive minority investors of the fair market value of their ownership interest in the business.
Minority Owner Due Diligence – What is the Amendment Power
The questions that minority owners need to ask and fully understand before investing in or acquiring an ownership interest in a Texas private company are these: what is the power of amendment in the governance documents, and how can I protect myself from majority owners who would exploit this power to deprive me of my ownership stake in the business?
A real world example illustrates the power and the danger of the amendment power from the minority investor’s perspective. We recently represented a minority owner of a Texas limited liability company (LLC) with three total members, each of whom held a third of the units in the company. All three members were also managers of the business and participated in the company’s operations. The company’s operating agreement (LLC Agreement) provided that a member’s employment with the company could be terminated only “for cause” (for defined misconduct) and that, upon such a termination, the company would have the right to buy the terminated member’s ownership interest for book value. Book value is usually much less than the value of the interest on the open market, i.e., fair market value. The LLC Agreement also gave the power to amend its terms to members owning at least 66% of the company.
After almost a decade of actively participating in the business, our client had a falling out with the other owners. Soon after, without prior notice, the other two members gave our client a “consent resolution” that they had signed, amending the LLC Agreement to permit them to terminate a member with or without cause. This amendment thus allowed the majority owners to “fire” our client without no evidence of misconduct and then invoke the right to buy her minority interest at book value—less than 25% of its fair market value. And that is exactly what the two majority owners did. They amended the LLC Agreement, booted our client out of the company, and tendered her the book value of her interest to be paid over five years.
Why was this permitted? Texas statutes require all shareholders or members of an LLC to vote unanimously to approve amendments to bylaws or LLC Agreement. But, shareholders and LLC members can agree to change this default rule in the statutes and revise their bylaws and LLC Agreements to be amended by a majority of the owners or by a super-majority, e.g., 60% or 70% of the ownership group. If the bylaws or LLC Agreement allows for anything less than 100% of the company’s owners to approve amendments to the governance documents, nothing in Texas law imposes limits on the scope of the amendments that a majority of the owners can make to the bylaws or LLC Agreement.
Further, officers and managers of corporations and LLCs owe fiduciary duties to the company, not to the shareholders or members (owners) of the business. And the power to amend bylaws and LLC Agreements is conferred on owners, not on officers, managers or directors. Thus, Texas cases have not held that majority owners breach fiduciary duties to other owners when they amend the company’s governing documents. The bottom line is that once the amendment power is given to a majority of the company’s owners, the minority owners have no clear legal recourse when the majority owners amend the governance documents in ways that harm the minority owners. Some of the types of amendments to bylaws or LLC Agreement that majority owners can make to these documents that are harmful to minority owners are the following:
- Creating a new buyout right of minority interest that did not exist
- Creating the power to dilute the percentage of minority owner’s stake
- Setting a valuation formula that is not favorable to minority owner
- Expanding the size of the Board or Number of Managers
- Creating new rights to remove minority owner from the business
It is possible that if the majority owners in the case above had been even more adversarial in amending the LLC Agreement, that a court might have exercised its equitable powers to limit the proposed amendment. For example, if the majority owners had amended the LCC Agreement to provide that the minority member would receive nothing for her interest, not even book value, perhaps the court would have viewed that as too abusive. There is no clear Texas precedent, however, limiting the scope of the majority owners’ power to enact amendments to the bylaws or LLC Agreement once they are given the right to amend the governance documents.
Minority Investors – Defense to the Amendment Power
What actions can minority investors take to avoid being subject to majority owners amending the company’s governance documents in ways that are harmful to the investors? There are several steps that minority investors should consider to avoid the potentially harmful impact of an exercise of the amendment power by majority owners.
- Check governance documents before investing
- Require unanimous consent to amendments
- Restrict scope of amendment by majority owners
Requiring unanimous consent to amendments to the governance documents can also be narrowly targeted to protect the minority owners in the event the majority owners insist on retaining the power to amend. For instance, the governance documents can require unanimity as to specific matters (e.g., adding buyout rights, changing buyout rights in ways that would reduce the compensation paid to minority owners, etc.).
The lesson should be clear. If you are in Harry Potter’s world, avoid the Dark Lord at all costs. If you are a minority business investor, before making an investment decision to become part of a private company, take steps to protect yourself. Specifically, take time to review the corporate governance documents to make sure that the majority owners do not have unfettered “amendment power.” The scope of the majority owners’ power to amend the governance documents should be limited to prevent later amendments that directly harm the minority investor’s participation and ownership interest in the business.