California has a new LLC act, which took effect January 1, 2014. Although the new law has some useful features, most LLCs won’t need them. Unfortunately, the new law automatically applies to existing LLCs, and the new law contains provisions that can alter the setting for members of existing LLCs in a legally lethal way. I don’t usually use a lot of bold-faced text in blog posts, but the problems created are so severe that this post calls for them.
Here is what could happen under the new law.
Let’s say that a four-member LLC owns real estate as an investment, and each member is the husband in a married couple with children. Let’s say that one member, John, is doing some estate planning, and he transfers his entire economic interest in the LLC to his children without violating the operating agreement. The term “economic interest” means only the right to receive distributions and does not include management rights. John retains all management rights and does not in any way attempt to involve his children in the LLC’s decision-making.
Under the new law, the other three members could vote unanimously (not including John) to expel John as a member–even though the operating agreement contains no provision authorizing them to do this.
This could not have happened under the old law, but the new law itself expressly allows it! Upon expulsion, John would lose all management and voting rights, depriving him of any say in the LLC’s affairs. Under the new law, the remaining members would have no further fiduciary duty to John (and none to his transferees, his children), so decisions could be made to the detriment of John (and his children).
It gets worse. The new law also authorizes the remaining members to amend the operating agreement without John’s consent, and as the remaining members would have no fiduciary duty to John, the amendment could adversely affect John’s (and his children’s) shares of profit and loss and distributions.
But, what, you may say, if John never transfers his interest and has no plan ever to transfer his interest. He is still at risk.
John doesn’t transfer his interest; he dies. Same result except that no need to expel John. By operation of law, his estate would be treated like John’s children in the previous example. Neither John’s estate nor his heirs would have any management or voting rights. The estate would have limited rights to inspect the books for the purpose of settling the estate (but not an on-going right.) The remaining members would have no fiduciary duty to John’s estate or his heirs. And the new law authorizes the remaining members to amend the operating agreement without the consent of the estate or the heirs.
Other Facts –Same Result
The fact that the LLC in the example owned real estate has nothing to do with the outcome. It could be an operating business. And the fact that an individual, rather than an entity, transferred his interest in the LLC also has nothing to do with the outcome. In fact, if an entity dissolves and distributes its LLC interest to its owners, that would have the same outcome as if John had died.
There are serious problems with the new law that can remit members to relying not on their legal rights but on the hoped-for fairness of the other members.
Sidestepping the Pitfalls
The new law grants the parties freedom of contract, which allows the operating agreement to eliminate the power given to the remaining members in the foregoing examples. In other words, if members don’t want these new rules to apply, they can simply negate them in the operating agreement, but unless these new rules are neutralized by the operating agreement, they apply by default. It’s a simple matter for a lawyer to negate unwanted aspects of the new law if the lawyer is well-versed in the new law.
The problem therefore is most severe with existing LLCs whose operating agreements were drafted without knowledge that a new law was going to change the rules. Most LLC operating agreements were drafted without taking into account these new rules because no one knew until the new law was enacted that the rules were going to change. Of course, if a lawyer drafting an operating agreement is not well-versed in the new law and relies on existing forms that were drafted under the old law, there could be a serious problem.
At this point, some may be wondering, Couldn’t John or his estate get the courts to remedy the problem if the remaining members use their new power abusively? Maybe. Every case turns on its own facts, and with the right set of facts, a court might say that the remaining members acted in bad faith and might overturn their actions. Or a court might say that the new law doesn’t say what it appears to say. Maybe. More important, however, litigating a case could cost $100,000 or more and, depending on the county, take a year to five years to come to trial. And might the legislature cure this problem? Maybe.
It’s better to act now and amend an operating agreement than to take one’s chances.
Lack of General Awareness by Most Lawyers
Last year, I conducted a webinar on this new LLC law (jointly sponsored by the state bar’s Partnerships and LLC Committee and the Corporations Committee), and I have spoken and will speak at county bar associations on this topic as well. Based my experience, I believe that most lawyers don’t know about the serious potential for harm that the new law creates for members of existing LLCs. The typical response when I discuss this with other lawyers is “You’re kidding!?” Sad to say, no, I am not.
Nothing in this blog post, by the way, applies to foreign LLCs that have qualified to do business in California. So a Delaware LLC doing business in California is not affected.
And the new rules are not important for single-member LLCs or husband-and-wife LLCs.
Having spent untold hours studying the new law and having fully revised several chapters in the LLC handbook commonly used by California lawyers (of which I am co-author), I can offer clients a quick and efficient review of their operating agreements. I don’t need to come up to speed at a client’s expense. I don’t have associates learning on your dime.
If a client wants a limited engagement in which the operating agreement is reviewed and solutions to the kind of problems outlined in this email are proposed, I can do so for a fixed fee, allowing a client to know in advance exactly how much the review would cost. If the client would then like corrective amendments, I can provide a fixed-fee quote for that as well.
Of course, if a client wants a full review of the existing agreement, that is available as well (on an hourly basis).
Acting Now Can Eliminate the Risk
If you have a California LLC that is not a single-member or husband-and-wife LLC, contact me here. With phone and email, I can serve a client anywhere in the state.