LLC Operating Agreements Should be Reviewed in Light of the New LLC Law.
By: Kenneth W. Chung
Effective January 1, 2014, the California Revised Uniform Limited Liability Act became the new law governing limited liability companies in California. This new law replaced the prior law known as the Beverly-Killea Act which was enacted in 1994. The new law applies to (i) all domestic LLCs existing on or after January 1, 2014; (ii) all foreign LLCs registered with the California Secretary of State prior to, on or after January 1, 2014; and (iii) all actions taken by managers of members of an LLC on or after January 1, 2014.
The prior LLC law generally provided LLC members much flexibility in drafting their operating agreement. The prior law only had a limited number of provisions that were required and the rest were subject to default rules which applied only if the operating agreement did not provide a contrary provision. Therefore, an important consideration in drafting an operating agreement was to make sure to override or address any default rules that the LLC members did not wish to be applicable to their LLC. The new LLC law generally expands the number of such default rules. The following reflects some of the more noteworthy default rules and changes presented in the new law. Existing operating agreements should be reviewed to determine whether the new default rules are consistent with the members’ intent, and if they are not, then the operating agreement should be specifically revised to reflect such intent.
Manager-Managed LLC: An LLC will now be deemed member-managed unless the LLC (1) has filed Articles of Organization stating that the LLC is manager-managed; and (2) has a written operating agreement establishing management by a manager. If the LLC does not comply with both of these requirements, then it will be at risk of being deemed a member-managed LLC.
Management Authority: The consent of all members of an LLC will now be required to do any of the following: (1) sell, lease, exchange, or otherwise dispose of all, or substantially all, of the LLC’s property, with or without the goodwill; (2) approve a merger or conversion; (3) undertake any other act outside the ordinary course of the LLC’s activities; or (4) amend the operating agreement. The operating agreement may be drafted to specify different consent standards. If the operating agreement does not clearly specify a different consent standard, then a member holding a minority ownership interest may now effectively veto certain significant actions of the LLC.
Events Forcing the “Dissociation” of a Member: Certain events will now automatically result in the “dissociation” of a member, changing the member’s status to that of a “transferee.” These events include: (1) the death of a member who is an individual; (2) for a member-managed LLC, the appointment of a guardian or conservator for an individual who is a member, or a judicial order declaring a member incapable of performing his/her duties as a member, or the initiation of a bankruptcy by a member; and/or (3) for any LLC member that is a trust, the trust’s membership interest in the LLC is distributed. If an existing LLC does not wish to have any these events result in the dissociation of a member, the operating agreement should be modified accordingly.
Non-Economic Members: A member may now have voting rights, or other non-economic rights, without requiring that member to make a contribution to the LLC. One effect of this new default rule is that a full LLC member may transfer his economic interest in the LLC while maintaining his voting rights and status as a member. This is different from prior law which equated LLC membership with the holding of the economic rights associated with it.
Transfers of Membership Interests: An amendment to the operating agreement after a person becomes a “transferee” is now effective against that transferee. This new rule clearly gives LLC members the ability to amend their operating agreement to eliminate, reduce, or change the obligations owed to transferees. To reduce the risk of disputes with transferees, an existing LLC should consider modifying the operating agreement to clearly state that the obligations owed to transferees cannot be modified without the consent of the transferee, or at least a majority vote of then-existing LLC members.
Indemnification: An LLC must now indemnify members of a member-managed LLC and managers of a manager-managed LLC, so long as the member or manager has complied with its duties under the law. This is in contrast to the default rule under the prior law that provided that an operating agreement may, but is not required to, provide for the indemnification of any person acting on behalf of the LLC. If the LLC does not want indemnification to be mandatory under these circumstances, the operating agreement should be modified to override this new default rule.
Reimbursements: An LLC is now required to reimburse members of a member-managed LLC, and managers of a manager-managed LLC, for payments made by them while acting on behalf of the LLC. If the LLC does not want to maintain a mandatory reimbursement obligation, or if it desires the completion of specified conditions before the member or manager is eligible for reimbursement, the operating agreement should clearly override this new default rule.
Death of a Sole Member: If the sole member in an LLC dies, his/her heirs may be admitted as substitute members, thus allowing the LLC to remain in existence. Under the prior law, if the sole member of an LLC dies, leaving no remaining LLC members, the LLC is automatically dissolved.
Member Consent Assumed: A member in an LLC will now be assumed to have agreed to the terms of an operating agreement even if that member did not physically sign the operating agreement.
Scope of Fiduciary Duties: The prior law did not specifically identify the fiduciaries duties owed by managers or members. The new law provides that the manager or member(s) in control of the LLC owe a “duty of loyalty” and a “duty of care” to the non-controlling member(s). The duty of loyalty under the new law is limited to specified activities, and the duty of care is limited to refraining from grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law. In addition, all LLC members owe a “duty of good faith and fair dealing” to each other. The new law limits the extent to which the members of an LLC can modify the managers’ or managing members’ fiduciary duties. The duty of care, the duty of loyalty, and the contractual duty of good faith and fair dealing may not be eliminated, but they may be modified. In addition, the duty of care may not be “unreasonably reduced.”
Under the new law, significant changes have been made to the law governing LLCs in California. The discussion above summarizes only some of the changes established by the new law. The operating agreement should be reviewed with corporate counsel to ensure that the intent of the members are not superseded by a new default rule, and to minimize disputes that may arise from provisions or standards that are vague and subject to alternative interpretations. The corporate attorneys at Kring & Chung, LLP are experienced and adept in the formation and maintenance of legal entities including LLCs and corporations. Please contact Kenneth Chung or one of our corporate attorneys to schedule the review of your operating agreement.
Kenneth Chung is a Managing Partner at Kring & Chung, LLP‘s Irvine office. He can be reached at (949) 261-7700 or [email protected].