Corporations or LLC’s Cannot Amend Bylaws to Impair Vested Shareholder Contract Rights
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Occasionally we are engaged to represent members of a closely held company who are being “squeezed out” of their business. This comes in many forms, but one of the fact patterns I have seen is when an LLC management committee meeting is conducted without notice, without proper quorum or in a way that makes the decisions voidable by the oppressed member/shareholder. Specifically, Florida law prohibits amendment to the bylaws of a company that are purposefully sought to restrict a particular shareholder’s original and vested contract rights, in an operating/ shareholder’s agreement or otherwise.
There is a well-established general rule that a corporation is prohibited from amending its bylaws so as to impair a shareholder’s contract rights. First Florida Bank, N.A. v. Financial Transaction Systems, Inc., 522 So.2d 891 (Fla. 2d DCA 1988), review denied, 531 So. 2d 168 (Fla. 1988). In that case, the Second District Court of Florida held that even though the defendant had signed a statement to abide by all amendments to the corporation’s operating agreement, the plaintiff was precluded from validly amending the parties’ original agreement in a manner that would deprive the defendant of its vested contractual rights. Id. at 892. See also Feldkamp v. Long Bay Partners, LLC, 773 F. Supp. 2d 1273 (M.D. Fla. 2011) (applying this doctrine to a Limited Liability Company.)
Corporate bylaws are a set of governing documents that help manage business and regulate the business’ affairs. In a corporation, the board of directors hold the power to make, alter, amend, and repeal the bylaws of the corporation, unless the articles of incorporation reserve the powers to shareholders. Notwithstanding the foregoing, the shareholders may amend or repeal the bylaws, even though the bylaws may also be amended or repealed by the board of directors.
Shareholders are essentially the owners of the corporation, but have limited control and power in that they may only act in the following manners, provided that the documents do not state otherwise: election and removal of directors; approval or disapproval of corporate operations that are void or voidable unless ratified; approval or disapproval of amendments to articles of incorporation or bylaws constituting the contract between the corporation or shareholders; and approval or disapproval of fundamental changes to the regular course of business. Thus, by virtue of the statutory scheme, the board of directors have more power than shareholders with respect to corporation governance.
The power to amend bylaws is limited in several respects. Furthermore, not all amendments to bylaws are the treated alike and certain amendments may call for certain procedural limitations with regard to who must vote or how many votes are required. Generally, a provision adopted by the shareholders may be changed only by the shareholders. Fla. Stat. § 607.1022(I)(a). However, a provision adopted by the board may be changed by either the board or the shareholders. Fla. Stat. § 607.1022(I)(b).
In addition to procedural limitations, certain amendments are limited based on the content of the amendment. For example, the articles of incorporation may delegate to the bylaws the power to increase the quorum or voting requirements for shareholders’ meetings. Fla. Stat. § 607.1021 (1). Notwithstanding the general ability of the board of directors to adopt or amend bylaws, action on a bylaw provision affecting the quorum or voting requirements for shareholders’ meetings must be taken by the shareholders. Fla. Stat. § 607.1021 (2). In addition, the action must meet the higher quorum and voting requirements, whether they are the old requirements or the requirements proposed to be adopted. Fla. Stat. § 607.1021 (1).
The preceding limitations are commonly known and readily accessible in Florida Statutes. However, the limitations that often cause litigated issues are restrictions on amendments that affect vested rights or contract rights which are not necessarily addressed in statute. To determine if an amendment to the bylaws would be valid, the corporation or LLC must look at whether and how the amendment affects contract rights or vested rights.
A contract right is established by way of the existence of a contract. A vested right is “[…] ‘an immediate, fixed right of present or future enjoyment’ and also as ‘an immediate right of present enjoyment, or a present, fixed right of future enjoyment.” Promontory Enterprises, Inc. v. S. Eng’g & Contracting, Inc., 864 So. 2d 479, 485 (Fla. 5th DCA 2004), citing City of Sanford v. McClelland, 163 So. 513, 514–15 (Fla. 1935). Notably, these rights are treated the same in Florida as case law delineates a general rule that impairment of vested rights or contract rights is prohibited. At times, these terms are used interchangeably and synonymously.
The United States Constitution, as well as the Florida Constitution, provide protections to rights established by contract and prohibit impairment of the rights. The Florida Supreme Court has recognized this prohibition in multiple cases. Yamaha Parts Distributors, Inc. v. Ehrman, 316 So. 2d 557, 559 (Fla. 1975) (“[v]irtually no degree of contract impairment has been tolerated in this state”); Dept. of Transportation v. Edward M. Chadbourne, Inc., 382 So. 2d 293, 297 (Fla. 1980) (“this Court has generally prohibited all forms of contract impairment.”).
The issue in corporate litigation is where to draw the line in the sand with respect to what bylaw amendments are valid and what amendments infringe on those protected shareholder rights? To flesh out this issue, it is important to look at case law to determine where the line is, so entities know what not to do. In First Florida Bank v. Financial Transaction Systems, Inc., 522 So. 2d 891, 892 (Fla. 2d DCA 1988), a bylaw amendment that required a $9,000.00 penalty fee to parties that were in business with and members of the corporation was prohibited. The agreement between the corporation and the members was that membership was conditioned on the parties signing a statement agreeing to abide by the charter, bylaws, and operating rules, and any subsequent amendments to those documents. The court found that the amendment, which was not voted on by the parties, impaired the contract rights of these parties who were members of the corporation.
In First Florida, First Florida Bank became a member of Financial Transaction Systems, Inc. (“FTSI”), a “nonprofit organization formed for the purpose of processing credit card transactions for its member banks.” Id. “In connection with its application for membership, First Florida signed a statement agreeing to abide by all existing provisions of the charter, bylaws, and operating rules of FTSI and any future amendments ….” Id. The articles of incorporation, which never changed, allowed First Florida to “voluntarily terminate” its membership without penalty. Id. at 891-92. The bylaws and operating rules at the time First Florida joined in 1980 provided the same. Id. at 892. FTSI later amended the bylaws and operating rules to impose a penalty, which it then sought to collect from First Florida when the bank withdrew from FTSI. Id. at 892. The court invalidated the penalty provision because it found that the parties’ “original agreement” gave First Florida “vested contractual rights.” Id. The articles of incorporation established First Florida’s right to voluntarily terminate its association with FTSI, and there is no indication in the Court’s decision that it allowed for any amendments, let alone the changes FTSI tried to effect through separate instruments (the amended bylaws and operating rules).
Distinguishing the First Florida Bank case, the case of Hamlet Country Club, Inc. v. Allen, 622 So. 2d 1081, 1083 (Fla. 4th DCA 1993) determined the validity of a bylaw that changed the terms under which members were entitled to resign or transfer their country club memberships. In coming to its decision, the court cited many cases that have permitted bylaw amendments where the bylaw amendments did not affect vested contract rights, but rather, the amendments affected conditional and qualified rights. In Hamlet Country Club, Inc. v. Allen, certain members of a golf club sued after the club amended its bylaws to limit their right to redeem their membership certificates. 622 So.2d 1081. Each member had paid $16,500 upon joining the club, and it was unclear in the original bylaws whether the redemption right was conditioned on the club having at least 365 members. Id. The club’s amendment “cleared up any doubt,” stating in no uncertain terms that there was no such right if the membership roles dropped below 365. Id. The plaintiff members argued that the amendment did not apply to them because it “impaired their vested rights.” Id.
The Fourth District Court of Appeal ruled that the club was entitled to “amend its bylaws to change the terms under which members are entitled to resign or transfer their memberships,” because the members had no vested rights that could not be altered. Id. at 1083. The appellate court explained that the member’s rights were not vested because they were “governed by and subject to the bylaws,” which were “subject to amendment.” Id. The key in this case was that members had no specific unalterable vested rights.
Similarly, in Susi v. St. Andrews Country Club, Inc., the Fourth District Court of Appeal also upheld an amendment to a country club’s membership terms. 727 So. 2d at 1058. The Susis had a tennis membership at St. Andrews Country Club and sought to upgrade to a golf membership. Id. at 1059. The club, however, had amended its bylaws after the Susis joined the club to reduce the number of offered golf memberships, and the club started a waiting list. Id. at 1060. The members later voted to amend the bylaws again to create 38 new golf memberships, but while the ballot made clear that the newly-created memberships were reserved for the owners of certain “vacant lots and spec/model homes” – not the Susis – the amendment itself contained no such restriction. Id. The Susis sued, claiming entitlement to one of the new golf memberships based on the wording of the amendment and an unchanged bylaw that set forth the “Priority for Offering of Memberships.” Id. at 1060-61. The club rejected their claim and maintained that no memberships were available in light of the reservation in the ballot. The trial court granted summary judgment in favor of the club and the appellate court affirmed based partly on the club’s discretion to interpret its own bylaws. Id. at 1061. The appellate court found that the club’s “interpretation [of its bylaws was] neither arbitrary nor unreasonable,” and, thus, found no reason to interfere with its decision. Id. A key delineation in Hamlet and Susi from First Florida Bank is that the Plaintiff’s in Hamlet and Susi had no vested membership rights because the terms of their club membership were subject to a contract, not bylaws, that is by its terms expressly subject to amendment by club bylaws. Therefore the priority of the bylaws inherently trumped the priority of the vested contract rights.
Note that the differentiating factor as to whether an amendment is valid is the effect of the bylaw. Amendments that are typically valid are administrative bylaws, which include general administrative policies or other internal matters of the corporation. However, amendments that affect contract rights and that are usually found to be invalid are as follows: (1) amendments that affect insurance plans; (2) amendments altering consideration to be received upon redemption of shares; or (3) amendments altering the right to receive value for shares upon termination of a membership.
To state it another way, bylaw provisions that govern the internal affairs of the corporation may be freely amended, but bylaw provisions in the nature of a contract that vest property rights in the stockholders or third parties typically cannot be repealed or changed without the consent of the parties whose rights are affected. What does this mean for corporations? Corporations must determine the effect of the amendment prior to acting to amend; otherwise, the corporations may be subject to litigation initiated by the affected parties.
A Limited Liability Company (“LLC”) has bylaws, except that they are not referred to as bylaws and are known as operating agreements. The operating agreement governs relations among the members of the LLC, the rights and duties of managers, the affairs of the LLC, and the means and conditions for amending the operating agreement. Fla. Stat. § 605.0105. The members maintain the power to amend the operating agreement, by default of the statute, but the articles of organization or operating agreement may vest the right to amend in the managers. While the terms utilized in the corporation and LLC context are different, the two separate entity types are typically treated the same with regard to the governing documents and limitations thereof. Additionally, Florida case law is clear that no actions of any entity may impair contract rights. Thus, when amending an operating agreement, the same rules for a corporation apply to an LLC that no amendment shall be permitted that effectively impairs vested rights or contractual rights.
While these types of cases are very fact specific and are largely decided based upon the language of the agreements of the parties, it should be noted that after the fact amendments to corporate documents that affect contract rights may be voidable. If you are an oppressed shareholder who is concerned about corporate maneuvering that has negatively affected your ownership interests, please contact a lawyer well versed in business litigation.