In drafting operating agreements and shareholder agreements, the members of multi-member LLCs taxable as partnerships and of multi-shareholder business corporations taxable as C corporations have virtually unlimited contractual freedom.
For example:
LLC members can provide in their operating agreements the complex capital structure provided for under an IRS proposed regulation designated Prop. Reg. § 1.1402(a)-2 and can thus obtain substantial Self-Employment Tax reductions.
They can also provide in their operating agreements for “profits partners” — members who make little or no capital contributions to the LLC but who nevertheless have substantial rights to LLC income.
Profits partner arrangements can be invaluable, for example, in persuading highly skilled managers to join LLCs.
Similarly, in order to meet shareholder needs and interests, multi-shareholder business corporations taxable as C corporations can provide for an unlimited variety of classes of corporate stock.
However, in the formation of LLCs and corporations whose potential investors are sophisticated and in which they may be contributing hundreds of thousands or even millions of dollars, investors may want to make use of complex arrangements involving financial terms that no “plain vanilla” LLC is ever likely to know of. These may include not only a wide variety of preferred and common investment classes but also of “put,” “call” and “conversion” provisions well understood by sophisticated investors but not by unsophisticated parties.
Put provisions provide that under specified conditions, one or more parties — the “put” parties — may require one or more other parties to purchase some or all of the put parties’ ownership interests for specified prices. Not only the put provisions themselves but also the purchase price provisions under these arrangements are often quite complex.
Call provisions provide that under specified conditions, call parties may require other parties to sell them some or all of the other parties’ interests.
Conversion provisions provide that conversion parties may convert their ownership
interests from, for example, common interests to preferred interests. These preferred interests may provide for preferential treatment with regard to allocations and distributions of profits and for preferential non-economic rights such as voting rights.
Not infrequently, sophisticated investors whose lawyers are drafting the above provisions in investment contracts — including, for example, LLC operating agreements that functions as investment contracts — may employ seemingly innocent contract terms that, when applied, may give the lawyers’ clients advantages which only equally sophisticated counterparties would recognize but which sophisticated parties will not.
However, if unsophisticated parties find they are subject to such provisions, there is a little- known legal doctrine potentially available to them, called the “forthright negotiator” doctrine, which can protect them from the disadvantages that sophisticated parties are seeking to impose on them. Under this doctrine, unsophisticated parties can negate these disadvantages on the grounds:
That when negotiating their deal, sophisticated parties had a legal duty to advise them of these disadvantages — in other words, they had a duty to be “forthright”; and
That their failure to do so makes these disadvantages legally invalid.
In other words, the forthright negotiator doctrine can override the doctrine of “caveat emptor” (“let the buyer beware”); and it can protect unsophisticated parties from even the most subtle deceits by sophisticated parties.
John Cunningham is a lawyer licensed to practice law in New Hampshire and Massachusetts. He is of counsel to the law firm of McLane Middleton, P.A. Contact him at 856-7172 or lawjmc@comcast.net. His website is llc199a.com. For access to all of his Law in the Marketplace columns, visit concordmonitor.com.
Law in the Marketplace is a legal advice column. It runs every week in the Sunday Business section. The author is a lawyer in Concord and not a member of the Monitor’s staff.