From time to time, The Tax Warriors® at Drucker & Scaccetti call on highly skilled friends of the firm in the areas of law and wealth management to share knowledge that can help you better understand your own tax situation. Today, attorney Herbert Fineburg, of the law firm Offit Kurman discusses the changes to the PA Uniform LLC Act and how these changes may have an adverse impact on members.
The recently enacted changes under the Pennsylvania Uniform Limited Liability Company Act, 15 Pa. C.S. §§ 8811 – 8898 (the “Act”), will have a dramatic impact on the governance of limited liability companies (“LLCs”) in Pennsylvania. The Act took effect on April 1, 2017 for all LLCs (old and new). Because an LLC is the most frequently used legal entity, it is essential that all accountants be familiar with the new rules under the Act.
Some key 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. There are many other changes beyond the scope of this article that you may need to know.
If the members fail to have a comprehensive signed operating agreement, the default provisions of the Act control. The operating agreement can be express or implied, oral or written, or in another recorded form. For example, a mere voicemail message or an email could arguably become part of the operating agreement, unless otherwise stated. Therefore, to minimize the risk of a dispute, it is critical to have a comprehensive written operating agreement clearly stating it is the entire agreement among the members, superseding anything else, and cannot be modified except in writing signed by all members.
The default rules are now 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. This is counterintuitive. Imagine a corporation in which each shareholder had an equal vote regardless of the number of shares owned.
By default, 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 in the ordinary course of business a majority vote controls, and extraordinary acts require consent of all members. Therefore, two 5% owners would be able to out-vote a third member owning 90% of the equity. Many investors would be shocked to learn they have no power without a proper operating agreement replacing the new default rules.
In reality, it is all too common for members to neglect preparing or even signing an operating agreement, especially if they use an online formation service instead of consulting their attorney or accountant. Attempting to have an operating agreement signed after funding and commencement of operations can be challenging since minority interest holders would be forfeiting their superior default 1-vote per member voting rights. The heightened duty of good faith and fair dealing among members under the new Act 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 provides 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 to receive financial information about the LLC. Instead, the member assigning the interest retains all non-distribution rights, duties and obligations of a member.
Similarly, a judgment creditor of a member executing upon the member’s LLC interest receives only a “charging order” to receive distributions from the LLC, similar to a mere “transferable interest”. An important exception applies when the judgment debtor is the sole member, in which instance the judgment creditor becomes the full substitute member with all member rights.
The Act now expounds upon the default expanded duties of loyalty and care owed by managers and members under various scenarios for member-managed and manager-managed LLCs worthy of a separate article. Clients should consult with counsel on the important differences between member-managed and manager-managed LLCs in order 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, by default all LLCs 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. A new 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, directly or indirectly, for any debt, obligation or other liability of the LLC solely by reason of being or acting as a member or manager. The intent of the new Act is to shore up limited liability to reduce the ability of a creditor to “pierce the corporate veil” of the LLC to hold a member or manager personally liable for the mere failure to follow legal formalities.
The net effect of the new Act is to implement default rules when the LLC does not have a comprehensive written operating agreement in place. As discussed above, 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 for your clients will likely be adverse and surprising. The days of filing a certificate of organization without a comprehensive operating agreement signed are gone. You need to caution and advise your clients that comprehensive written operating agreements are now, more than ever, a necessity.
Herbert R. Fineburg, LLM, is a shareholder and the managing principal of the Philadelphia regional office of the law firm Offit Kurman PA. He can be reached at firstname.lastname@example.org. This article also appeared in the Fall 2018 edition of Pennsylvania CPA Journal.