April 15, 2019

Business owners: avoid potential grief and take note of the new LLC Act

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A few months ago, I gave you an overview of Arizona’s new Limited Liability Company Act (the “New Act”). Unless there is some last-minute legislative wrangling, it is slated to go into effect for new LLCs formed after August 31, 2019, and for all existing LLCs after August 31, 2020. The purpose of the New Act is to fill in many of the gaps that existed under the original LLC Act, which was “thin” at best---the kind of legal silence that leaves drafters guessing and litigators busy. This month, we are going to explore the most significant impact of the New Act--specifically, the fiduciary duties that members and managers owe to the company and each other under the new law.

What’s a Fiduciary Duty and why should I care?

Good question. Generally speaking under the law, a fiduciary is in a unique position of trust and confidence to someone else. A fiduciary has duties to ensure they act for this person’s benefit, subordinating their own interest if necessary. Under Arizona law, directors and officers of corporations and members of a partnership clearly owe a fiduciary duty to the corporation or partnership. It’s been vague under Arizona law, though, whether managers and members of LLCs owe fiduciary duties to the company and/or other members. And, although some LLC Operating Agreements attempted to disclaim these duties if they did exist, whether that language really did the job was also guesswork. The New Act changes that.

Duties under the New Act

The New Act imposes affirmative fiduciary obligations (the duties of loyalty and care) on members and managers of Arizona LLCs and requires that they discharge their duties consistent with the contractual obligation of good faith and fair dealing in two primary instances: (1) when there is no Operating Agreement; or (2) when the Operating Agreement says nothing about fiduciary duties. This makes your Operating Agreement critically important, particularly in situations where there are multiple members in an LLC. If you don’t deliberately deal with fiduciary duties, then you will “get what you get” under the New Act and that may not be what you intended.

Let’s take an example. You own and run a BBQ restaurant. It’s a manager-managed LLC and you are the manager. You have several minority investor members. Another restaurant group, which plans to open five restaurants, one of which will serve BBQ, offers you an ownership stake and you decide to become involved. Have you breached a fiduciary duty under the New Act? Most likely. The “Duty of Loyalty” requires, among other things, that you refrain from competing with the company. The Duty of Loyalty also requires that you account to the company for benefits you receive that you may not be entitled to, refrain from dealing with someone who might have an interest adverse to the company, and disclose any material conflicts of interest and material facts relating to a decision or transaction. See generally A.R.S. § 29-3409.

The “Duty of Care” under the New Act requires that a manager refrain from engaging in grossly negligent, reckless, or intentional misconduct. This is the same standard that has traditionally been used in partnership agreements. Importantly, in a manager-managed entity, members will not owe duties to one another solely because they are members and it will depend on how much control a member has over the management of the company. Id.

Can we eliminate these duties in the Operating Agreement?

Yes. The New Act allows you to modify or eliminate these duties with two notable exceptions: (1) you can’t get rid of the obligation of good faith and fair dealing; and (2) you can’t eliminate the duty to refrain engaging in grossly negligent or reckless conduct or intentional misconduct. Id. But even though you can eliminate these duties, should you do it as a matter of routine practice? This is where I think the New Act may be most valuable. It will require you to dive into these subjects before you jump into a deal. I can tell you that when drafting Operating Agreements, there is usually a lot more discussion about transfers and voting rights than about fiduciary duties. And yet, when a venture goes south, the first words out of any aggrieved party’s mouth is that someone was not acting in the best interest of the company, was diverting opportunities, or was withholding information. All of those complaints can be breaches of fiduciary obligations and though tough to pursue under the old law, are much clearer under the New Act.

The New Act also allows you to incorporate the business judgment rule from the corporate code--an option I really like. See A.R.S. § 29-3105. I also have some concern that if you fully disclaim all fiduciary duties, the one you can’t disclaim (the covenant of good faith and fair dealing) is so broad that it may still produce a fair amount of litigation.

Care to know my recommendation?

From where I sit, I would rather advise an LLC to adopt the same duties of a director, officer, or shareholder under Arizona law along with the rules of evidence and presumptions that apply to these duties, including the business judgment rule. Id. This means is that if you, as a manager or member, breached a duty but reasonably believed it was in the best interests of the corporation, you will apply that standard to the behavior.

One other note: the New Act allows members to authorize or ratify an action taken by a manager or member even if it would violate the Duty of Loyalty. But such a ratification has to be unanimous, a tough but not impossible standard.

Fiduciary Duties aren’t the only things changing under the New Act. My bottom line recommendation is that if you haven’t looked at your Operating Agreement in a while, dust it off and roll up your sleeves. It is a perfect time to take stock of what you have and look at what you might need moving forward.