The New Act
The New Act is based on RULLCA and will apply to all existing and newly formed California LLCs and to all foreign LLCs that are registered to do business with the Secretary of State of the State of California. It is codified at Cal. Corp. Code Sections 17701. 01 – 17713. 13 and does not require existing LLCs to file any new or special documents to come under its governance. Accordingly, it will apply automatically to existing LLCs and, unlike other states’ new LLC laws primarily based on RULLCA (e. g., Florida and Minnesota); the New Act does not give existing LLCs a choice as to whether to be governed by the Old Act or the New Act. This means that as of January 1, 2014, operating agreements drafted pursuant to the Old Act may be out of harmony with the New Act.
Expansion of Default Rules Under the New Act
One reason for the popularity of LLCs is that LLCs generally have a great deal of flexibility in drafting their operating agreements. The Old Act had a limited number of mandatory provisions and instead provided “default rules,” which would apply only if the operating agreement did not override them. The New Act greatly increased the number of default rules, which means existing operating agreements may not address and override a new default rule. It is important that LLC members review the following changes associated with the New Act to determine whether or not their operating agreements need to be amended to preserve their original intent.
Requirement for the Designation of LLC as “Manager-Managed”
Under the Old Act, an LLC was by default member-managed unless the articles of organization state otherwise. Under the New Act, an LLC is by default member-managed unless both (1) the articles of organization and (2) the operating agreement state otherwise. As a result, an existing manager-managed LLC that relied solely on its articles of organization to designate the LLC as manager-managed became member-managed as of January 1, 2014. If the articles of organization state that an LLC is manager-managed, then an amendment to the operating agreement will be required stating the same to comply with the New Act.
Required Approval for Certain Decisions
Depending on the language in the operating agreement, the New Act may effectively limit the authority of a manager to take actions that the manager could have taken prior to 2014. For example, under the New Act, unless otherwise provided in the operating agreement, managers may not take actions outside the ordinary course of business without obtaining the unanimous consent of the members. This default rule is contrary to the intent of many manager-managed LLCs whose operating agreements provided the manager with the maximum amount of control over business decisions regardless of whether such decisions are in the ordinary course of business. Under the New Act, if the operating agreement does not provide for maximum manager control, a minority member could attempt to assert veto power over a manager’s decision by claiming such decision is not in the ordinary course of business. As a result, operating agreements that currently rely on the Old Act may need to be amended to allow managers to avoid disputes with minority members. Additionally, because the New Act does not define “the ordinary course of business,” existing LLCs should consider amending their operating agreement to define “the ordinary course of business.”
Dissociation Triggers and Potential Impact
The New Act provides a list of events that will result in a member’s dissociation, effectively giving an existing member the legal status of a transferee. These events include: (1) death; (2) the appointment of a guardian or conservator for a member of a member-managed LLC; (3) a judicial order that a member of a member-managed LLC is incapable of performing such member’s duties; (4) in the case of a member that is a trust, the distribution of the trust’s interest in the LLC; and (5) a member of a member-managed LLC becomes a debtor in bankruptcy. Additionally, a dissociated member will be automatically removed as a manager.
A dissociated member is subject to the same risk as a transferee — that the members may amend the operating agreement to modify the obligations owed by the LLC or its members to the dissociated member. Moreover, a dissociated member, by reason of its transferee status, no longer has the right to participate in the management or conduct of the activities of the LLC. If it is the intent of the LLC members that no such automatic dissociation or removal occur, then the operating agreement should be amended accordingly.
Conflicts Between Operating Agreements and Articles of Organization
Under the New Act, if a conflict exists between the terms of an LLC’s operating agreement and its articles of organization, the operating agreement prevails. This is contrary to the Old Act where the articles of organization prevailed over the operating agreement if a conflict existed. However, the rule is different for third parties under the New Act. Section 17701. 12 states that the articles prevail over the operating agreement to the extent a third party reasonably relies on the articles of organization (presumably without knowledge of any inconsistency with the operating agreement).
Mandatory Rules Under the New Act
Unlike the Old Act, the New Act requires, rather than permits, reimbursement and indemnification of members or managers who incur expenses or liabilities on behalf of the LLC.
Mandatory Reimbursement. Unlike the Old Act, which merely permitted reimbursement of members or managers for expenses incurred on behalf of the LLC, the New Act mandates such reimbursement provided that the incurrence of such expenses does not constitute a violation of fiduciary duties. As a result, those LLCs that wish to avoid this new mandate or limit it in some way (for example, by requiring pre-approval or receipts for reimbursement) should amend their operating agreements accordingly.
Mandatory Indemnification. Similar to the rule on reimbursement, the New Act requires, rather than permits, indemnification of those members or managers who incur liabilities on behalf of the LLC, provided that the incurrence of such liabilities does not constitute a violation of fiduciary duties. Thus, LLCs not intending to provide such mandatory indemnification should carefully review the applicable sections of their operating agreement and amend accordingly.
The New Act Enables Greater Flexibility with Respect to Fiduciary Duties
While the Old Act provided that the fiduciary duties a manager owed to the LLC and its members were equivalent to “those duties a partner owed to a partnership and to the partners,” the New Act clarifies those duties, which fall under three categories: (1) duty of loyalty; (2) duty of care; and (3) obligation of good faith and fair dealing. Although the New Act prohibits an operating agreement from eliminating the fiduciary duties of a manager (or a member of a member-managed LLC), it allows some room for modification of those duties, thus affording LLCs greater flexibility when drafting their operating agreements.
- Duty of Loyalty — The New Act specifically limits the duty of loyalty to three sub-duties: (1) the duty to account; (2) the duty to refrain from self-dealing; and (3) the duty to refrain from competing. Members may designate certain acts that do not violate the duty of loyalty so long as the list is not “manifestly unreasonable.” The New Act even permits the operating agreement to specify the number or percentage of members required to authorize or ratify, after full disclosure to all members, a specific act or transaction that otherwise would violate the duty of loyalty.
- Duty of Care — The New Act permits the operating agreement to modify the duty of care provided the operating agreement does not “unreasonably reduce” it.
- Obligation of Good Faith and Fair Dealing — Under the New Act, the standards by which this duty is measured may be modified so long as the new standards are not “manifestly unreasonable.”
Conclusion
The summary above only discusses a limited number of changes in California limited liability company law. LLCs are encouraged to review their existing operating agreements in light of the New Act and to modify those operating agreements to reflect the original intent of their members and managers. LLCs should particularly focus on: (1) preventing the New Act, through its new default rules, from overriding the intent of the LLC’s members; (2) avoiding or reducing disputes or litigation as a result of ambiguities in the New Act; and (3) taking into account the greater flexibilities the New Act provides with respect to defining the scope of fiduciary duties.
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this update or would like to discuss the topic further, please contact your Foley attorney or the following:
Bernardo O. Ainza
Los Angeles, California
213.972.4836
[email protected]
Michelle M. Gourley
Los Angeles, California
213.972.4556
[email protected]