New California LLC Law Requires Members To Reconsider Their Operating Agreement

Introduction

A new California law governing limited liability companies (New Law) becomes effective January 1, 2014, (Effective Date) and replaces the Beverly-Killea LLC Act (Old Law).  The New Law governs every act taken by a California limited liability company (LLC) on or after the Effective Date.  With one exception regarding rights of California members of a non-California LLC to information from that LLC, the New Law does not apply to an LLC organized under the law of another state such as Delaware, even if the Delaware LLC is doing business in California. 

For existing LLCs the provisions of the New Law may effectively supplant portions of existing operating agreements, significantly altering the legal relationships among members themselves and between members and LLC managers, if any.  This is particularly the case where existing operating agreements are silent and rely on the provisions of the Old Law to govern.  The New Law provides a more detailed set of default rules that apply when an operating agreement is silent.  In addition new rules governing fiduciary duties provide LLCs with greater flexibility, but vary some of the fiduciary duties previously in effect.  The New Law is a potential source of disputes, some of which can be avoided by reviewing and amending existing LLC operating agreements where desired to preserve the original intent of LLC members.

Potential Challenges of the New Default Rules

Following are a few examples of potential challenges arising from default rules under the New Law.

Designation of LLC as “Manager-Managed”  Under the Old Law, an LLC is by default member-managed unless the articles of organization state otherwise.  Under the New Law, an LLC is by default member-managed unless both the articles of organization and the operating agreement state otherwise.  Thus, an existing manager-managed LLC that relies solely on its articles of organization to designate the LLC as manager-managed must amend its operating agreement accordingly if it wishes to avoid becoming a member-managed LLC by default.

Member Consent Requirements  A new default rule under the New Law requires an LLC manager to gain unanimous consent of the members before performing an act outside the ordinary course of business.  For many manager-managed LLCs, the operating agreement was drafted with the intent of giving the manager the maximum amount of control over business decisions, regardless of whether such decisions are in the ordinary course of business.  Once the New Law goes into effect, if the operating agreement fails adequately to reflect this intent, 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.  It is also worth noting that because the New Law does not define “the ordinary course of business,” the operating agreement should define that term as broadly as the members wish.

Dissociation Events  The New Law provides that certain events automatically result in a member’s dissociation and change of status to that of a transferee ( under which there is retention of economic rights but loss of rights to participate in management of the LLC or obtain information).  For example, in a member-managed LLC, a member who becomes a debtor in bankruptcy is automatically dissociated.  Further, a person who is both a member and a manager, and who becomes dissociated, is automatically removed as manager.  If it is the intent of the LLC members that no such automatic dissociation or removal occur then the operating agreement should address this issue.

Mandatory Reimbursement Unlike the Old Law, which merely permitted reimbursement of members or managers for expenses incurred on behalf of the LLC, the New Law mandates such reimbursement provided the incurrence of such expense was not in violation of fiduciary duties of the member or manager.  Those LLCs that wish to avoid this mandate, or at least limit it (e.g., by placing a ceiling on the requirement to reimburse or requiring preapproval), should amend their operating agreements accordingly. 

Mandatory Indemnification  Similar to the rule on reimbursement, the New Law requires, rather than permits, indemnification of those who incur liabilities while acting on behalf of the LLC, provided such incurrence is not in violation of their fiduciary duties.  If LLC members do not want such mandatory indemnification or at least want to restrict it, then they should address this in their LLC operating agreement.

Greater Flexibility with Regard to Fiduciary Duties

The New Law makes significant changes to the rules governing the fiduciary duties of managers of manager-managed LLCs and the members of member-managed LLCs.  While the New Law prohibits an operating agreement from eliminating the fiduciary duties of a manager (or a member of a member-managed LLC), it clarifies the duties that are owed, and allows some room for modification of those duties, thus affording LLCs greater flexibility when drafting their operating agreements.

Duty of Loyalty  The New Law specifically limits the duty of loyalty to three duties: (1) the duty to account, (2) the duty to refrain from self-dealing and (3) the duty to refrain from competing.  In addition the New Law permits an operating agreement to designate certain acts as not violating the duty of loyalty, provided such list is not “manifestly unreasonable.”  The New Law 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 that does violate the duty of loyalty.

Duty of Care  The New Law 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 Law the operating agreement may prescribe the standards by which fulfillment of the obligation of good faith and fair dealing is to be measured, provided that such standards are not “manifestly unreasonable.”

Conclusion

The discussion above summarizes only a limited number of changes to Califronia limited liability company law.  In light of the New Law, a review of existing California LLC operating agreements is advisable for three reasons: (1) to prevent the New Law, in particular through its new default rules, from overriding the intent of the LLC’s members, (2) to avoid or narrow disputes or litigation as a result of ambiguities created by the New Law and (3) to take advantage of the greater flexibility that the New Law affords with respect to defining the scope of fiduciary duties.