ABA Section of Business Law
May/June 2001 (Volume 10, Number 5)
Those
Delaware LLCs - another look
How they could work for you
By Fredric J. Bendremer
Could the limited liability company be the way of the future?
In recent years, business lawyers have been making unprecedented use of the limited liability company (LLC) form of business organization. Delaware, because of its business-friendly disposition, well-developed body of corporate law, business savvy courts, and attentive legislature, is often considered the jurisdiction of choice for forming LLCs.
Continuing its look at Delaware and LLCs, Business Law Today now provides an overview of the Delaware Limited Liability Company Act, 6 Del. C. § 18-101, et seq. (the act), the nature of an LLC organized under the act, as well as the essential legal principles governing Delaware LLCs.
The LLCs' operating agreement also governs many LLC matters. The act emphasizes principles of freedom of contract and the enforceability of operating agreements. An LLC's members thus have broad latitude in structuring the LLC, providing for its operation, and defining their relationships in the operating agreement. As a result, the operating agreement may modify or supplement many provisions of the act.
Business organizations in the United States most often take the form of corporations, general partnerships, limited partnerships, proprietorships and certain types of trusts. Each form of organization has its own legal characteristics, which in some cases may include separate legal existence or limited liability, or both. In addition, each has certain business, structural, managerial, operational, ownership and tax advantages and disadvantages. The suitability of a particular form of organization and the choice of jurisdiction of organization are matters that require case-by-case analysis.
LLCs are relatively new in the United States and constitute something of a hybrid between a partnership and a corporation. One of the major advantages of LLCs is that they offer the same pass-through income tax characteristics as a partnership while providing limited liability similar to that of a corporation, but without the burdens and rigidity of a corporate organization. LLCs have existed for many years in other countries, particularly in Europe and Latin America.
In 1977, Wyoming was the first state to authorize the formation of LLCs. Wyo. Stat. 1977 § 17-15-101, et seq. Florida, in 1982, was the second. Fla. Stat. § 608.401. All of the other states and the District of Columbia subsequently enacted some form of LLC legislation.
The Delaware act, which was one such piece of legislation, went into effect in 1992. The so-called "limited liability partnership" is conceptually and temporally related to LLCs but constitutes a legally distinct form of business organization with its own body of governing law.
An LLC is formed on the filing of a certificate of formation with
the Delaware secretary of State, or any later time specified in
the certificate. The LLC constitutes a separate legal entity and
will continue as such until its certificate is canceled. The act
requires the maintenance of a registered office and registered agent
for service of process.
Only limited information must appear in the certificate of formation,
namely, the LLC's name, the address of the registered office and
the name and address of the LLC's registered agent. Neither the
operating agreement nor the identity of the members and managers
need be made a public record. The LLC's members may include additional
information at their election. The name of the LLC must include
"Limited Liability Company" or the abbreviation "L.L.C."
or "LLC." Another entity may also convert to a Delaware
LLC.
The LLC may carry on any lawful business, purpose or activity, whether or not for profit, except for insurance or banking. An LLC has the powers and privileges conferred under the act and its operating agreement, and so-called incidental powers, including those necessary or convenient to the conduct of its business. Except as provided in the agreement, members or managers may transact business with the LLC on the same basis as third parties, subject to other applicable law, and may be indemnified by the LLC.
The only filing that Delaware requires on a periodic basis, from the standpoint of continuing legal existence, is an annual tax statement. That statement, which is essentially a coupon that the Delaware secretary of State's office forwards to the LLC's registered agent, must be returned with $100 in annual franchise tax by June 1 of each year. Of course, Delaware and other jurisdictions may require additional filings on other matters.
Significantly, the act does not prescribe the familiar "formalities" usually associated with corporations. There are no specific requirements along the lines of annual shareholder meetings, periodic meetings of directors, regular corporate resolutions or votes, and the like. By design, the LLC thus can be streamlined from a formalities standpoint and have a more informal management process.
Unlike a number of jurisdictions, the act requires that the LLC maintain certain records, including information on the status of the business and financial condition of the LLC, tax returns, members and managers, cash on hand and contributions, as well as agreements to make future contributions, among other things. In general, members must have reasonable access to the books and records of the LLC. Some exceptions exist, such as with respect to trade secrets and other confidential business information. An LLC may maintain its records in other than written form if conversion to written form is possible within a reasonable time.
Notwithstanding these requirements, it would still be prudent for an LLC to maintain sufficient records for members to determine their share of profits and losses and their rights on dissociation. Also, federal and state taxing authorities require the maintenance of certain records.
One of the principal characteristics of an LLC is limited liability for members and managers. In that respect, LLCs are similar to corporations. All things being equal, members and managers should bear no liability for the debts and obligations of the LLC, and the risk to holders of equity interests should be limited to their investment. Unlike a corporation, however, members may participate in the management of the LLC without enhancing their risk of personal liability.
The act specifically states that except as otherwise provided, the "debts, obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities" of the LLC, and no member or manager shall be "obligated personally for any such debt, obligation or liability . . . solely by reason of being a member or acting as a manager" of the LLC. Act § 18-303(a). According to the operating agreement or another agreement, however, members or managers may agree to be obligated personally for the LLC's obligations.
The protections against personal liability conferred by the act are not necessarily absolute. Although the absence of corporate-type formalities may reduce the burdens of LLC maintenance, a court could still conceivably apply the doctrine of piercing the corporate veil if it finds a failure to follow the procedural or substantive provisions of the act or the operating agreement.
In addition, in cases of fraud, undercapitalization, improper transfers and distributions, and the like, there is a real risk of personal liability. Instrumentality and alter ego theories could apply as well. Personal liability may also result from certain types of tortious or otherwise wrongful conduct. Another potential basis for personal liability, as discussed in greater detail below, is breach of fiduciary duty.
The operating agreement is the LLC's central organizational document. Itcombines the materials that would ordinarily appear in a corporation's certificate of incorporation or charter, and the corporation's bylaws. The operating agreement may also contain provisions that would ordinarily appear in a shareholder's agreement as well as various other corporate documents. The act does not mandate a written agreement but recognizes that one will usually exist. A Delaware LLC need not have more than one member.
Among the many matters that the operating agreement might address
are:
formation;
purpose;
term;
principal office;
management;
capitalization;
profits, losses and distributions;
books and records;
liability of managers and members, exculpation and indemnification;
rights and limitations of members;
transfers and assignments;
changes to managers; and
dissolution and winding up.
Given the flexibility of the Delaware act, members have the opportunity to address all matters of particular business or legal concern. In addition, the members may in many cases include their own provisions regarding matters covered by the act, and in essence "opt out" of provisions of the act that would otherwise apply.
Members of an LLC are analogous to shareholders in a corporation, partners in a general partnership and limited partners in a limited partnership - albeit with a number of critical distinctions. Once admitted to membership, subject to the operating agreement, members generally hold an LLC interest that represents the member's share of the profits and losses of an LLC and the right to receive distributions of its assets. Any person or entity may be a member of an LLC, but not all members need hold an LLC interest. In general, the agreement will set out the procedures for admitting new members. Unless otherwise provided, the consent of all members is generally required.
The act states that the operating agreement may establish "classes
or groups of members having such relative rights, powers and duties"
as the agreement may provide. Act § 18-302(a). In addition,
the agreement may provide for the future creation of additional
classes or groups, as well as the taking of an action, including
the amendment of the agreement, without a vote. Further, the agreement
may provide for the absence of any voting rights for any member
or class or group of members.
According to the operating agreement, specified members or classes
or groups may vote separately or in virtually any combination, with
votes calculated on a per capita, number, financial interest, class,
group or any other basis.
The agreement may contain provisions addressing the time, place, or purpose of a meeting, notice and waiver of notice, action by consent without a meeting, establishment of the record date, quorum requirements, voting in person or by proxy or any other related matter.
An action of the members may be taken by written consent without
a meeting, prior notice and without a vote so long as it is signed
by the members having at least the minimum number of votes that
would be necessary to authorize the action at a meeting with all
eligible members voting. Subject to the operating agreement, voting
may be in person or by proxy. The act provides that a person ceases
to be a member of an LLC, unless provided otherwise in the agreement
or with the consent of all members, on various voluntary or involuntary
events of insolvency or bankruptcy, exceeding in certain cases time
that may be specified.
Unless otherwise provided in the operating agreement, the act states that management of an LLC shall be vested in members in proportion to the then current percentage or other interest of members in the profits of the LLC owned by all members, with the decision of members owning more than 50 percent controlling. Consequently, members may have complete management authority. Unless otherwise provided in the agreement, each of the members and the managers, if any, has the right to bind the LLC.
While the act provides that the operating agreement will generally
govern voting matters, the following specific matters require a
vote by members or managers, or both, in the absence of controlling
provisions in the agreement:
mergers;
transfer or domestication;
termination of a series;
conversion;
admission of a nonassignee as a member;
termination of membership following bankruptcy of a member;
compromise of the obligation of a member to make a contribution;
participation in the business and affairs of the LLC by an assignee;
full membership for an assignee;
dissolution; and
appointment of a person or entity to wind up the affairs of the
LLC.
The act states that if the operating agreement provides "for the management, in whole or in part, of a limited liability company by a manager, the management of the limited liability company, to the extent so provided, shall be vested in the manager." Act & 18-402. The act also states that the manager shall hold the offices and have the responsibilities accorded to the manager set forth in the agreement. Managers may make their own contributions to an LLC and share in the LLC's profits, losses and distributions.
With respect to managers, the act contains provisions very similar to those concerning members in terms of the permissibility of creating classes or groups with different rights, powers and duties, as well as the future creation of additional classes or groups. The provisions respecting voting and the basis on which votes are calculated track those pertaining to members. Procedures for voting, including notice, waiver, action by consent without a meeting, voting by proxy and the like, are similar as well.
As for any potential liability for managers and members acting in a managerial capacity, the act provides exculpatory provisions for good faith reliance on the records of the LLC and information obtained from the LLC's other managers, members and other related parties, as well as from any other person, as to matters the member or manager reasonably believes are within the other person's professional or expert competence.
Unless the operating agreement provides otherwise, members and managers may delegate their respective rights and powers to "manage and control the business and affairs" of the LLC. Act § 18-407. That delegation may be directed to agents, officers and employees of a member or manager or the LLC, and may be embodied in management or other agreements. Unless otherwise provided in the agreement, delegation will not affect the status of the member or manager of the LLC.
The nature and extent of any fiduciary duties of members or managers or other persons is not specifically set out in the act and is thus not entirely clear. The act does state, however, "[t]o the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) and liabilities relating thereto" to an LLC or to another member or manager or certain other persons, none shall be liable for good faith reliance on the provisions of the operating agreement. Act § 18-1101(c). In addition, the act states that those duties and liabilities may be expanded or restricted by the agreement.
In keeping with the principle of flexibility embodied in the act, an LLC may have multiple series of members, managers or LLC interests, having "separate rights, powers or duties with respect to specified property or obligations of the limited liability company or profits and losses associated with specified property or obligations." Act § 18-215(a). Further, a series may have a "separate business purpose or investment objective."
When the operating agreement creates one or more series, and the LLC satisfies certain record keeping, accounting and notice requirements, and the agreement so provides, then the "debts, liabilities and obligations incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only." Act § 18-215(b).
In addition, unless otherwise provided in the agreement, the debts of the LLC or another series may not be enforced against the assets of the series. Therefore, an LLC with a separate series is analogous to two corporations in the same corporate family, with the attendant limitation on the availability of each entity's assets to satisfy the obligations of the other.
The act also permits the creation of classes or groups associated with a given series, with varying powers, rights and duties, including voting. Unless the operating agreement provides otherwise, management of a series will be conducted by members associated with the series, with members owning more than a 50 percent interest in the profits controlling. Alternatively, a manager may manage the series.
Members' contributions may take the form of cash, property, services or a promissory note or other undertaking. If a member fails to make the required contribution, the act authorizes a number of remedies, depending on the provisions of the operating agreement and the type of contribution at issue. Those remedies may include, among other things, requiring payment of cash in lieu of promised services, elimination or reduction of a membership interest, forced sale, subordination or forfeiture.
The operating agreement controls the allocation of profits and losses among members, and among classes and groups of members. If profits and losses are not specifically allocated in the agreement, they shall be "allocated on the basis of the agreed value (as stated in the records of the limited liability company) of the contributions made by each member." Act § 18-503. Similarly, distribution rights with respect to cash or other assets will be allocated in accordance with the agreement. In the absence of an express allocation, the agreed value of members' contributions will control. The act provides that an LLC shall not make a distribution if, after giving effect to the distribution, all liabilities of the LLC exceed the fair value of the LLC's assets.
The operating agreement may provide for "interim distributions" - those distributions available prior to a member's resignation and before dissolution and winding up. On resigning, a member has the right to receive any distribution to which the member is entitled under the agreement. In addition, if not otherwise provided, the member shall receive within a reasonable time the fair value of the member's interest based on the member's right to share in distributions. The form of distribution to which a member is entitled is generally cash. Under some circumstances, however, a member can be compelled to accept a distribution in kind if consistent with the member's percentage interest.
With regard to resignation, the operating agreement may deny a manager the right to resign. The manager may nevertheless resign, subject to damages for breach of the agreement, which damages may be subject to offset against any distributions due the manager. Members may not resign except in accordance with the agreement. Unless the agreement provides otherwise, and notwithstanding any applicable law to the contrary, a member may not resign prior to dissolution and winding up.
An LLC interest is personal property and the holder has no interest in specific property of the LLC. Holders of LLC interests may assign the interests to third parties unless prohibited by the agreement. An assignment generally pertains only to the economic entitlements of the membership interest and does not otherwise confer rights of membership, including any rights to participate in management. If a member assigns the entirety of the member's interests, the assignor-member's interest will generally terminate. The LLC interest may be certificated.
The LLC may acquire, by purchase, redemption or otherwise, outstanding LLC interests held by members or managers. Unless otherwise specified in the operating agreement, the acquired interests will be deemed canceled. Assignees who become members will succeed to certain obligations of the assignor-member, which may include obligations to make contributions to the LLC. The assignor-member, in turn, will remain liable for certain obligations.
An LLC is dissolved and its affairs must be wound up:
at the time specified in the operating agreement, if any;
on the events specified in the agreement, if any;
unless otherwise provided in the agreement, on a vote or written
consent of two-thirds of the members, or each class or group of
members, in each case based on the percentage or other interest
in the profits of the LLC;
when there are no members, under certain circumstances and after
the expiration of certain time periods; and
on the entry of a judicial decree. Act § 18-801(a).
Absent any contrary provision in the operating agreement, the LLC will have perpetual existence. The death, retirement, resignation, expulsion, bankruptcy or dissolution of any member or any other event that terminates the membership of any member will not cause the dissolution of the LLC.
The driving force behind the passage of many LLC statutes was an IRS ruling in 1988 that provided qualifying LLCs with the same pass-through income tax status as a partnership. That status had already existed with respect to S corporations.
Essentially, qualifying LLCs under the IRS ruling were not subject
to taxation as a separate entity. Instead, the benefits and burdens
of the profits, losses, gains, deductions and credits pertaining
to the LLC, as allocated under the operating agreement, would be
taxable at the level of the LLC's membership interests.
Notwithstanding the IRS ruling, however, some uncertainty continued
to exist as to the availability of pass-through income tax status
for LLCs. The IRS maintained in its ruling that an LLC could qualify
for classification as a partnership only if it possessed no more
than two of the following four characteristics usually associated
with corporations:
- limited liability for corporate debts;
- free transferability of corporate ownership interests;
- centralized management; and
- continuity of life.
The IRS subsequently issued its so-called "check-the-box" regulations, which provided that effective Jan. 1, 1997, an LLC will be treated as a partnership for tax purposes unless it elects otherwise. The uncertainty that followed the IRS ruling has thus abated to a large degree and LLCs have proliferated.
While a qualifying S corporation has pass-through status, restrictions
continue in terms of the number of permitted shareholders, the different
types and residencies of shareholders and classes of stock, among
other things. Also, S corporations are subject to limitations on
filing consolidated tax returns and a number of other matters.
LLCs have far fewer restrictions. Moreover, LLCs have the additional
flexibility of making disproportionate allocations and distributions.
I.R.C. § 704. Members may also receive appreciated property
from the LLC and exchange appreciated property for membership interests
without recognizing gain or loss. I.R.C. § 731(b), § 721.
Under the act, a Delaware LLC will be treated as a partnership for
state tax purposes unless classified otherwise for federal income
tax purposes.
Note that with few exceptions, such as certain investment companies, an LLC that becomes a public company will be deemed a publicly traded partnership and thus a C corporation for tax purposes. I.R.C. § 7704. Conversion to corporate form prior to an initial public offering is thus the norm. It so happens, as well, that the securities markets still favor corporations over LLCs because of the relative maturity of corporate law over the law of LLCs.
LLCs are now accepted as being in the mainstream of business law. Indeed, they are being used in a wide variety of circumstances. Those uses range from special-purpose vehicles and bankruptcy-remote entities in sophisticated financial transactions to more ordinary business ventures, such as small businesses operating through single-member LLCs. LLCs, and in particular Delaware LLCs, are adaptable organizations that give their members maximum freedom to structure the LLC in the manner that suits their business objectives.
Commentators and lawyers alike have taken the view that LLCs are largely creatures of contract, and the Delaware act explicitly supports the notion of a substantial contractual element to LLCs. On one level, the act may be viewed as a piece of enabling legislation of sorts - enabling private parties to form a statutorily authorized entity within the general parameters of the act but with the specific structure and characteristics of the organization left to the parties themselves. Given that the act has been in existence only since 1992, however, there are relatively few cases of precedential import.
Whether the legal rights and standards applicable to LLCs thus
will be derived from contract law, corporate law, partnership law
or some combination or other law, or will be unique in all respects
to LLCs, is not entirely clear. Even assuming that only contract
law governs a particular matter, one should keep in mind that courts
may well recognize legal rights and impose legal standards even
when the contract itself does not purport, at least on its face,
to create those rights or establish those standards.
Consequently, until ample precedent exists, the law will remain
uncertain with regard to a number of critical issues, including
the nature and extent of fiduciary duties and the applicability
of the doctrine of piercing the corporate veil.
The LLC offers great flexibility in structuring the organization and defining the rights, powers and duties of members, managers and other relevant parties. Significantly, the LLC can provide limited liability in a manner similar to that of a corporation. The LLC form of organization also provides considerable latitude in allocating profits, losses, gains, deductions and credits, and qualifies for the same pass-through income tax status as a partnership.
Bendremer practices law in Weston, Mass. His e-mail is fjb@law.bendremer.com.
