On January 1, 2014, the current LLC law in California (known as “the Beverly-Killea Limited Liability Company Act”) will be repealed and superseded by a new LLC law (known as the “Revised Uniform Limited Liability Company Act,” or “RULLCA”). Although the new RULLCA law does not require existing LLCs to file any new documents with the Secretary of State or to revise their operating agreements, it imposes many changes on LLC members and managers. Many LLCs will therefore want to file new documents and/or revise their existing operating agreements prior to January 1, 2014.
California’s new RULLCA began as Senate Bill 323 and was signed into law by Governor Jerry Brown on September 21, 2012. The new law takes effect on January 1, 2014 and will apply to all limited liability companies — both California and foreign — that are registered with the California Secretary of State’s office on that date for (1) all acts or transactions by the LLC (or its members or managers) occurring on or after January 1, 2014; and/or (2) all contracts entered into by the LLC (or its members or managers) on or after January 1, 2014.
The purpose of the new law was to clarify issues and questions that existed under the old law. Another goal of the new law was to give maximum effect to “freedom of contract” and the enforceability of operating agreements. A final goal was to better coordinate California’s LLC law with that of other states. California now joins Idaho, Utah, Wyoming, Nebraska, Iowa, Florida, New Jersey, and Washington, DC as jurisdictions that have adopted the RULLCA. In addition, the legislature in South Carolina recently introduced a bill to adopt the RULLCA.
Changes Brought by the New Law — New “Default Rules”
California’s existing LLC law generally provides LLC owners (known as “members”) a great deal of flexibility in drafting their operating agreement. The existing law only has a limited number of mandatory provisions and, instead, provides “default rules” which apply only if the operating agreement does not override them. Accordingly, one of the main goals in drafting an operating agreement is to make certain to override any default rules that the LLC members do not want to apply to their business.
Obviously, if the default rules change, an existing operating agreement may no longer contain all of the proper language necessary to override the default rule. In such a case, the LLC and its members would be subject to the new default rule even if it is contrary to their wishes. So it is critical that all LLCs operating in California understand the new default rules contained in the RULLCA to ensure that their operating agreements adequately address those.
In general, the new RULLCA greatly expands the number of default rules. Therefore, existing operating agreements have, in all likelihood, not addressed all these new rules properly. This puts existing LLCs at risk of having new default rules applied to them that fundamentally change the nature and/or intent of their business relationship. Some examples of how the new RULLCA changes default rules include the following:
Manager-Managed LLCs — The new default rule under RULLCA is that an LLC is 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 expressly establishing management by a manager. Many existing manager-managed LLCs do not comply with both of these provisions and, therefore, are at risk of having their LLCs inadvertently converted to member-managed entities.
Management Authority — The new default rule under RULLCA is that the consent of all members of an LLC is 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 RULLCA allows a written operating agreement to change these default rules. Therefore, existing LLCs should consider drafting a new operating agreement (or revising an existing one) to specifically describe those actions that require unanimous consent, if any. In addition, existing LLCs should define in their operating agreements what types of activities are — and are not — “outside the ordinary course of business” for the LLC. Otherwise, there is a great risk that a minority LLC member could effectively have “veto power” over the affairs of the business.
Events Forcing the “Disassociation” of a Member — Another new default rule under the RULLCA is that certain events 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, (a) the appointment of a guardian or conservator for an individual who is a member, or (b) a judicial order declaring a member incapable of performing his/her duties as a member, or (c) 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 existing LLCs do not want any of these events to result in the dissociation of a member, they should amend their operating agreement to prevent these results.
Non-Economic Members — Another new default rule under the RULLCA allows a person to have voting rights, or other non-economic rights, without requiring that person 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 existing LLC law, which equates LLC membership with the holding of the economic rights associated with it. Therefore, existing LLCs should decide whether or not they agree with this default rule and, if not, amend their operating agreements accordingly.
Transfers of Membership Interests — Another new default rule under the RULLCA is that an amendment to the operating agreement after a person becomes a “transferee” is 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, existing LLCs should consider amending their operating agreements 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 — The default rule in the current LLC law is that an operating agreement may – but is not required to – provide for the indemnification of any person acting on behalf of the LLC. The new default rule under the new RULLCA is that the LLC must indemnify members of member-managed LLCs and managers of manager-managed LLCs, so long as the member or manager has complied with its duties under the law. If LLCs do not want indemnification to be mandatory under these circumstances, they should amend their operating agreement to override this new default rule.
Reimbursements — Another new default rule under the RULLCA is that the LLC is required to reimburse members of member-managed LLCs, and managers of manager-managed LLCs, for payments made by them while acting on behalf of the LLC. If LLCs would prefer that reimbursement not be mandatory, or that certain conditions be met for the member or manager to be eligible for reimbursement, the LLC’s operating agreement should clearly override this new default rule.
Other Changes to the LLC Law in California
The new RULLCA makes other important changes to the LLC law, as well. These changes include:
Scope of Fiduciary Duties — Whereas existing LLC law is unclear on the concept of fiduciary duties, the new RULLCA makes it explicit 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 specifically enumerated 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.
Limiting Fiduciary Duties: The new RULLCA 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.” Therefore, any existing LLC that wants to modify the modifiable fiduciary duties and standards imposed by the new RULLCA should consider an appropriate revision to its operating agreement.
Death of a Sole Member — Under existing LLC law, if the sole member of an LLC dies — leaving no remaining LLC members — the LLC is automatically dissolved. Under the new RULLCA, however, 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.
Conflicts in Governing Documents — Under existing LLC law, in any conflict between the LLC’s articles of incorporation and its operating agreement, the terms of the articles shall govern. Under the new RULLCA, however, it is the opposite — that is, the operating agreement governs in any conflict between that agreement and the LLC’s articles. The only exception under the new law is for third parties who reasonably rely on the articles. Therefore, any existing LLC that has been relying on a statement in its articles must amend its operating agreement prior to January 2014 to eliminate any conflicting provisions.
Member Consent Assumed — Under the new RULLCA, a member in an LLC will be assumed to have agreed to the terms of an operating agreement even if that member did not physically sign the agreement.
The RULLCA is a complex new law with potentially far-reaching consequences. This blog post only covers a few of the highlights of the new law. The full text of the new law can be found here. I strongly urge all LLCs operating in California to review the new law with their counsel and to consider drafting new or revised operating agreements that align the goals of the LLC and its members with the terms of the new law.