Legislature Poised To Impose Huge Costs By Rewriting Every California LLC Operating Agreement

by Allen Matkins
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On January 1, 2016, the operating agreement of every limited liability company organized under Beverly-Killea Limited Liability Company Act, Cal. Corp. Code §§ 17000 et seq. may be amended.  This is no Millerite prophecy. The legislature is poised to pass SB 323 (Vargas) when it returns from its summer recess on August 6.  That bill would make the current Beverly-Killea Act inoperative on January 1, 2014 and repeal it altogether on January 1, 2016.  On that date, all LLCs organized under the Beverly-Killea Act would be governed by the new California Revised Uniform Limited Liability Company Act.

The new LLC Act may well be an improvement over existing law, which was, after all, drafted when while the dew was still wet in the LLC garden. Nevertheless, all existing California LLCs have been organized based on the Beverly-Killea Act.  A forced change to the new law will impose a significant burden on many thousands of  California LLCs because they (and their counsel) will be forced to consider whether their current operating agreements conform to the new law, and if not, what changes will be required.  If changes are necessary or desirable, then LLCs will incur additional costs in drafting and obtaining any requisite approvals.

An even larger problem looms because the legislature’s action is likely to violate Article I, § 10, of the U.S. Constitution which provides: “No State shall. . . pass any . . . Law impairing the Obligation of Contracts.”  In the venerable decision of Trustees of Dartmouth College v. Woodward, 17 U.S. (4 Wheat.) 518 (1819), the U.S. Supreme Court held that the Constitution prevents states from legislatively amending corporate charters.   States responded to this holding by including reserve clauses in their state constitutions and business entity acts that expressly retain the right to alter, amend or repeal those acts.  Unfortunately, the California legislature failed to include a reserve clause when it enacted the Beverly-Killea Act.  See State Power over Corporate Charters.

The prohibition on state’s impairing the obligation of contracts arose from the economic turmoil in the post-revolutionary period.  States enacted measures to protect debtors from creditors but these measures had the unintended effect of undermining business, and indeed, the social order.  As James Madison explained in Federalist No. 44 (Jan. 25, 1788):

The sober people of America are weary of the fluctuating policy which has directed the public councils.  They have seen with regret and indignation that sudden changes and legislative interferences, in cases affecting personal rights, become jobs in the hands of enterprising and influential speculators, and snares to the more-industrious and less informed part of the community.  They have seen, too, that one legislative interference is but the first link of a long chain of repetitions, every subsequent interference being naturally produced by the effects of the preceding.  They very rightly infer, therefore, that some thorough reform is wanting, which will banish speculations on public measures, inspire a general prudence and industry, and give a regular course to the business of society.

Nearly two score years later,Chief Justice John Marshall reiterated these concerns:

The power of changing the relative situation of debtor and creditor, of interfering with contracts, a power which comes home to every man, touches the interest of all, and controls the conduct of every individual in those things which he supposes to be proper for his own exclusive management, had been used to such an excess by the state legislatures, as to break in upon the ordinary intercourse of society, and destroy all confidence between man and man.  This mischief had become so great, so alarming, as not only to impair commercial intercourse, and threaten the existence of credit, but to sap the morals of the people, and destroy the sanctity of private faith.  To guard against the continuance of the evil was an object of deep interest with all the truly wise, as well as the virtuous, of this great community, and was one of the important benefits expected from a reform of the government.

Ogden v. Saunders, 25 U.S. (12 Wheat) 213, 354-55 (1827).

What was true in 1788 remains true today.  However good the intentions, the wholesale rewriting of contracts imposes significant commercial and social costs.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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