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In the wake of World War I, the terms of the Versailles Treaty restricted the size of the German army to no more than 100,000 troops, in essence demanding that its numbers be seven times smaller than in 1904.
This answer choice is stylistically flawed. The modifying clause (in essence) demanding... should appear next to what it modifies - the terms of the Versailles Treaty. However, it appears next to troops, creating ambiguity regarding what it refers to (the terms or the troops).
This answer choice is grammatically incorrect. Demand is one of the nine verbs to which the Subjunctive rule applies (if it is followed by that). This means that the next verb after demanded...that should be in base form. However, will be is not in base form.
What helps us identify this question as a Subjunctive question as well as identify the mistake is the following Stop Sign:
Whenever you come across this Stop Sign, make sure that the following verb is in its base form.
This answer choice is grammatically incorrect. Less (seven times less than) cannot be used to describe the numbers (of the German army's troops); instead, the numbers should idiomatically be described by smaller :
Incorrect: The number of visitors is less than yesterday.
Correct: The number of visitors is smaller than yesterday.
Correct: There are fewer visitors than there were yesterday.
This answer choice corrects the ambiguity in the original sentence by changing the modifier demanding into a conjugated verb demanded, making it clear that it refers to the terms of the Treaty of Versailles.
While this answer choice corrects the original ambiguity, it is illogical.
The plural pronoun they can only refer to plural noun. However, because numbering no more than 100,000 troops is between commas, the only plural noun in the main clause is terms. It is illogical to say that the terms demanded that the terms be smaller.