|May 2, 2014|
Previously published on April 2014
A new California law governing limited liability companies became effective as of January 1, 2014. The California Revised Uniform Limited Liability Company Act (RULLCA) makes significant changes in the rights and responsibilities of members and managers of LLCs. But most of the provisions of RULLCA are “default” provisions that apply only if the members have not agreed otherwise in a written LLC Operating Agreement. If an existing (or amended) Operating Agreement adopts rules for operation that are different from the “default” rules stated in RULLCA, then the terms of the Operating Agreement will override the default rules of RULLCA. Therefore, it is important that all LLCs have comprehensive written Operating Agreements, to ensure that the parties’ intentions are reflected in the Operating Agreement and that the terms of the Operating Agreement override any default rules of RULLCA that do not conform to the parties’ expectations.
Here are some examples of new default rules imposed by RULLCA that may not reflect the parties’ expectations, and should therefore be modified in a written Operating Agreement:
Manager Authority. RULLCA provides that, if the LLC is managed by a Manager (rather than its members), then the Manager may not take any action “outside the ordinary course of business” without the consent of all of the members. We believe that most LLCs will want to allow the Manager to take such actions with the consent of a majority, or a specified supermajority, of the members, but that requiring the consent of all members may unduly hinder desirable action or thwart the will of the majority.
Dissociation Events. RULLCA introduces a new concept not included in the prior LLC law: Certain events in the life of a member constitute “dissociation events” the result of which is that the member (or its successor) retains an economic interest in the LLC, but loses certain membership rights such as voting rights and the right to information about the business of the LLC. Dissociation events include the death or incapacity of an individual member, the bankruptcy or dissolution of an entity member, and the distribution of assets by a trust to its beneficiaries. We believe that most people would expect the membership rights of an LLC member to pass to the member’s legal successor upon the occurrence of these dissociation events (i.e., to the executor or administrator of a deceased member, the guardian or conservator of an incompetent member, the bankruptcy trustee or debtor in possession of a bankrupt member, and the beneficiaries of a distributed trust member), but unless the written Operating Agreement so specifies, RULLCA will strip those members of certain membership rights.
Dissociation of Manager. If a member who serves as a Manager of the LLC experiences a dissociation event, that member is automatically removed as a Manager. If the parties intend that the LLC Manager should continue to serve as Manager regardless of the Manager’s status as a member, then the Operating Agreement should explicitly state that.
Members without an Economic Interest. Unlike the former law, under RULLCA, an LLC can have members who have no economic interest in the LLC. That is, they make no capital contribution, and they have no interest in the profits, losses, and distributions of the LLC, but they may have voting rights. Similarly, the Operating Agreement may provide that the consent of a certain non-member third party is required for certain actions by the LLC. If this is a feature that the members would like in their LLC, or if a third party such as a lender requires this feature, it may be included in the Operating Agreement.
- Under RULLCA, each of the members of a member-managed LLC, and the Manager of a manager-managed LLC, owes to the LLC and the other members a duty of care, a duty of loyalty, and a duty of good faith and fair dealing.
- The duty of care is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or knowing violation of law.
- The duty of loyalty encompasses a duty to account for benefits and profits, a duty to refrain from appropriating company opportunities, a duty to avoid adverse interests, and a duty to refrain from competing with the LLC.
- The duty of good faith and fair dealing is not defined or explained in RULLCA, but is generally understood to mean that the parties will deal honestly and fairly with one another.
- Under the former law, the Manager’s duties were the same as under RULLCA, but the former law was silent as to whether members of a manager-managed LLC owe any fiduciary duty to the LLC or the other members. RULLCA explicitly states that members of a manager-managed LLC have no fiduciary duty.
- A written Operating Agreement should address any variations desired in these fiduciary duties. For example, the members may wish to include exceptions to the prohibition on competition for existing businesses or investments of the members, or may wish to authorize specific transactions or relationships between the LLC and other businesses controlled by a member or Manager. Or, the members may wish to increase the duty of care required of a Manager to something similar to the duty owed by a director of a corporation, that is, to conduct the affairs of the LLC with such care, including reasonable inquiry, as an ordinarily prudent person would use in similar circumstances.
Indemnification. Under the prior law, an LLC may indemnify members of a member-managed LLC, or Managers of a manager-managed LLC, but is not required to indemnify them. Under RULLCA, unless the Operating Agreement provides otherwise, the LLC must indemnify members of a member-managed LLC, or Managers of a manager-managed LLC, as long as they have complied with their statutory duties. If the parties do not desire mandatory indemnification, and if the existing Operating Agreement does not address indemnification of managers or members, then the Operating Agreement should be amended to reflect the parties’ preferences.
We recommend that the Operating Agreements of existing LLCs be reviewed to determine whether any revisions are desirable to avoid unintended consequences of the default provisions of RULLCA.