On January 1, 2014, North Carolina’s new limited liability company act (Session Law, 2013-157, signed by the Governor on June 19, 2013, the “New NC LLC Act”) goes into effect, raising the following questions:
How Does the New NC LLC Act Affect Existing Limited Liability Companies?
The New NC LLC Act repeals the current North Carolina Limited Liability Company Act (the “Old NC LLC Act”) and replaces it with a new statute (new Chapter 57D of the North Carolina General Statutes). The New NC LLC Act provides a set of transition rules to accommodate existing foreign limited liability companies that are qualified to do business in North Carolina and existing North Carolina limited liability companies. The New NC LLC Act provides that references in operating agreements to provisions of the Old NC LLC Act will, instead, be deemed to be made to the corresponding provisions of the New NC LLC Act. Accordingly, the New NC LLC Act will have little or no effect with respect to a North Carolina limited liability company that is governed by a well-drafted operating agreement. Other North Carolina limited liability companies should have their operating agreements reviewed to determine whether they are consistent with the expectations of the parties. In addition, all limited liability companies should review their filings with the Secretary of State to make sure they are up to date.
a) Lack of a Signed Operating Agreement. The New NC LLC Act repeals all requirements that certain portions of an operating agreement be in writing to be enforceable. Instead, the New NC LLC Act contains no limitations on the enforceability of oral or implied-in-fact agreements. The New NC LLC, however, continues to allow the parties to agree on the form that the operating agreement must take to be enforceable, including for example, requiring that the agreement be in writing and signed by the parties. Operating agreements, by their nature, usually are long-term contracts, and it may or may not be appropriate to allow their terms to evolve by oral understandings or implication (which often are difficult to prove when disputed). Ideally, an operating agreement (including amendments to the operating agreement) should be in a written document that is signed by the parties and regularly updated.
b) Duties and Provisions of an Operating Agreement that are Limited by Applicable Law. The Old NC LLC Act required the managers of a NC limited liability company to exercise care and be loyal to the company. Those duties ostensibly could not be modified by the limited liability company’s operating agreement. The New NC LLC Act makes it clear that those duties may be modified or eliminated under general principles of agency and contract law. Thus, the provisions of an operating agreement that state that they are limited only to the extent required by law should be reviewed to confirm that those provisions function as intended under the New NC LLC Act. Conversely, members who wish to modify or eliminate default duties may now more confidently do so by amending the limited liability company’s operating agreement to correspond with their preferred standards of duty and liability.
c) Supplanting the Default Provisions of the Act. The New NC LLC Act specifically provides that the operating agreement will control the rights and duties of the owners of the limited liability company and any other party to the operating agreement except to the limited extent the New NC LLC Act or other applicable law provides otherwise. Accordingly, the default provisions of the New NC LLC Act and common law principles that otherwise would apply may be overridden by the limited liability company’s operating agreement. In addition to the default duties and potential liability of those who manage a limited liability company, default provisions of the New NC LLC Act that the owners of a limited liability company may want to alter or displace include: (i) each member of the limited liability company having equal management rights regardless of their economic interests; (ii) the members’ economic interests being based on their contributions of, and promises to contribute, capital and services to the company in exchange for those economic interests; (iii) the right of the managers to delegate their responsibilities to others; (iv) members being able to freely transfer their entire interests (governance, information and litigation rights as well as economic rights) to other members but only able to freely transfer their economic rights to non-members; (v) the degree to which information related to the limited liability company will be provided or made available to members; (vi) each member’s ability to bring derivative actions or proceedings to cause the company to be judicially dissolved; and (vii) the manner in which disputes between members and between members and the company are to be resolved.
d) Adoption of Corporate and Other Management Arrangements in lieu of Member or Manager Management. No longer do limited liability companies need to state in their articles of organization whether they are to be “member managed” or “manager managed.” The New NC LLC Act accommodates traditional corporate board of directors and officer management arrangements and other non-“manager” management structures. Limited liability companies being managed by boards of directors and officers are becoming increasingly common as limited liability companies displace corporations for privately-held businesses.
e) Review of Expiring Provisions in an LLC’s Articles of Organization or Operating Agreement and Provisions Making Reference to Laws that Have Changed. The North Carolina limited liability company act, as originally adopted 20 years ago, required all North Carolina limited liability companies to have a limited term of existence. This requirement was subsequently repealed, but the articles of organization and operating agreements of many of the earlier North Carolina limited liability companies likely provide that they must dissolve as of a certain date. In addition, operating agreements often provide for tax distributions and those provisions sometime set the rate at which those distributions are to be made at the “highest marginal income tax rate for individuals.” The new 3.8% federal net investment income tax technically is not a marginal income tax rate and, therefore, many tax distribution provisions may not automatically adjust to account for this new tax. Those are just two examples of why older articles of organization and operating agreements should be reviewed to determine if their terms have become anachronistic or obsolete.
f) Responsibilities of LLCs to Keep their Public Filings Current. The articles of organization and annual reports of limited liability companies should be kept current and consistent with the company’s operating agreement because the New NC LLC Act now clearly states that third parties may rely on those filings even when they conflict with the company’s operating agreement. However, as between the owners of the limited liability company and those who manage the company, the New NC LLC Act provides that the articles of organization are to be treated as a part of the limited liability company’s operating agreement and, therefore, general principles of contract law will apply to resolve any conflict between those two documents.
How Does the New NC LLC Act Affect Entity Selection?
In 2009, the Old NC LLC Act was revised to, among other things, affirmatively state that it is the public policy of North Carolina to “give maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.” This statement of the state’s public policy is repeated in the New NC LLC Act, and the New NC LLC Act was drafted to more clearly, concisely, and effectively achieve and implement that stated public policy objective. The North Carolina Business Corporation Act and the other North Carolina entity statutes do not provide a similar statement of public policy and, therefore, lack the added certainty that this statement provides to the enforcement of the owners’ contractual and other organization arrangements. Those other entity statutes also do not expressly provide the degree of flexibility afforded by the New NC LLC Act.
How Does the New NC LLC Act Affect Where to Organize an LLC?
Often limited liability companies are organized in certain states, principally Delaware, even though the entity is not expected to conduct any business in that state. No state LLC statute has features that are more favorable than those of the New NC LLC Act for limited liability companies transacting business in North Carolina. One exception to the foregoing is that organizing a limited liability company in a particular state usually allows the owners of that entity to litigate their disputes in that state. The Chancery Court and the Supreme Court of Delaware are held in particularly high regard by the business community, which is one of the principal reasons why many business people elect to organize their entities in Delaware.
Concluding a four-year drafting project of the North Carolina Bar Association chaired by the author of this alert, the New NC LLC Act will become effective on January 1, 2014. The remainder of this year is a good time to review the status and terms of the operating agreements and public filings of existing North Carolina limited liability companies and to finalize, or determine whether amendments should be made to, those agreements or filings. This also is a good time, particularly given the recent changes and proposed changes to federal and state tax law (see, for example, the February 4, 2013 alert “Exclusion from Tax Issued by Qualified Small Business Corporations”), to determine whether it may be worthwhile to reconstitute other entities or contractual arrangements as limited liability companies governed by the New NC LLC Act.