Recently enacted changes under the Pennsylvania Uniform Limited Liability Company Act will have a dramatic impact on the governance of limited liability companies (LLCs) in Pennsylvania. The act took effect on April 1, 2017, and because LLCs are the most frequently used legal entity, it is essential that CPAs understand the new rules.
Areas of importance include voting rights of LLC members, rights of transferees to vote and obtain LLC financial information, rights of creditors of LLC members, and duties of LLC managers and members, among other changes.
If LLC members fail to have a comprehensive, signed operating agreement, the default provisions of the act take over. An operating agreement can be express or implied, oral or written, or in another recorded form. For example, a voicemail message or an email could arguably become part of the operating agreement, unless otherwise stated. To minimize the risk of a dispute, it is critical to have a comprehensive written operating agreement that clearly states the understanding among all members, superseding anything else, and which cannot be modified except in writing, signed by all members.
The default rules are skewed in favor of minority-interest holders. For instance, member voting is per capita (i.e., one vote per member – with a majority vote controlling) unless the operating agreement expressly provides for voting based upon percentage of ownership.
The act’s default provisions say an LLC is member-managed, with “each member [having] equal rights in the management and conduct of the company’s activities and affairs.” For routine matters, a majority vote controls; extraordinary acts require consent of all members. Under this template, two 5 percent owners would be able to out-vote a third member who owns 90 percent of the equity. Many investors would be shocked to learn they have no (or greatly reduced) power without a proper operating agreement in place.
It is all too common for members to neglect preparing or signing an operating agreement. Attempting to have an operating agreement signed after funding and commencement of operations can be challenging since minority-interest holders would be forfeiting the superior position of one-vote-per-member default voting rights. The heightened duty of good faith and fair dealing among members under the new law mandates full disclosure when altering any member’s rights, including voting rights.
Unless the operating agreement provides for permitted transfers of a member’s interest, the act details that transfers to a person not already a member of the LLC are limited to an economic right to share in distributions (called a transferable interest), without the new member having the right to vote or receive financial information about the LLC. The member assigning the interest retains all nondistribution rights, duties, and obligations of a member.
The act also covers the default expanded duties of loyalty and care owed by managers and members under various scenarios for member-managed and manager-managed LLCs. Clients should consult with counsel on the important differences between member-managed and manager-managed LLCs to carefully craft exceptions to the applicable statutory rights and duties, such as a member’s or manager’s right to engage in other businesses.
The act no longer requires the certificate of organization to state whether the LLC is member-managed or manager-managed. As stated above, all LLCs by default are member-managed. Only if the certificate of organization declares the LLC to be manager-managed will the manager have “statutory apparent authority” to act as “agent” for the LLC when contracting with third parties. Unlike prior case law, a member is no longer an agent of the company solely by being a member, even if it is a member-managed LLC. One option is to file a certificate of authority with the Pennsylvania Secretary of State to put the public on notice regarding who has authority to bind the LLC in transactions. Counsel can advise on making these elections and filings, depending on the nature of transactions the LLC expects to undertake.
The act expressly provides that a member or a manger is not personally liable for any debt, obligation, or other liability of the LLC solely by reason of being or acting as a member or manager. The intent here is to shore up limited liability and reduce the ability of a creditor to break LLC protections and hold a member or manager personally liable for a failure to follow legal formalities.
The act’s new default rules for when an LLC does not have a comprehensive operating agreement are not good for many investors. It is highly recommended that the operating agreement be fully executed by all members before or contemporaneously with funding and commencing LLC operations. Otherwise, the results will be surprising. The days of filing a certificate of organization without a signed comprehensive operating agreement are gone. Written operating agreements are now a necessity.
Herbert R. Fineburg, LLM, is a share-holder and the managing principal of the Philadelphia regional office of the law firm Offit Kurman PA. He can be reached at email@example.com.