Important Changes that LLC Members Should be Concerned About Regarding New LLC Law in New Jersey
On March 1, 2014 the New Jersey Revised Uniform Limited Liability Company Act (“RULLCA”) became effective, and the New Jersey Limited Liability Company Act (the “Old Act”) was repealed. RULLCA has made a number of significant changes in New Jersey limited liability company (“LLC”) law. This article will examine some of the more important changes in New Jersey LLC law under RULLCA that LLC members and managers should be concerned about with respect to their involvement in a New Jersey LLC. As a result of the changes under RULLCA, it will be more important than ever for LLC members and managers to ensure that they have a comprehensive operating agreement in place to govern their LLC.
- Distributions. Under the Old Act, unless otherwise specified in the operating agreement for the LLC, each member was entitled to share profits or losses of the LLC based on the agreed value of each member’s capital contribution to the LLC. However, under RULLCA, each member of an LLC is entitled to an equal share of the profits or losses, regardless of capital contributions, unless the LLC’s operating agreement provides otherwise.
- Voting. Under the Old Act, unless otherwise provided in the LLC’s operating agreement, most matters, including mergers and consolidations, were decided by the members’ holding a majority of the percentage of profits of the LLC. Under RULLCA, unless otherwise provided in the LLC’s operating agreement, ordinary matters are decided by a majority of the members, with each member having one vote (per capita), regardless of the member’s ownership or profit percentage interest in the LLC. Under the Old Act, only a handful of matters required unanimous consent of the members (admission of a new member, dissolution of the LLC and expulsion of a member), while all other matters were generally decided by members holding a majority of the percentage of profits of the LLC. Under RULLCA, unless otherwise provided in the operating agreement, extraordinary matters such as mergers, consolidations and sale of all or substantially all of the LLC’s assets, are decided by the unanimous vote of the members. However, the ability to alter these rules in the operating agreement is qualified by some special rules relating to approval of certain merger, conversion and domestication transactions in which a member will have personal liability.
- Fiduciary Duty of Loyalty. Under the Old Act, no specific fiduciary duties were imposed on managers or LLC members. Under RULLCA, in a member-managed LLC, members now have a fiduciary duty of loyalty and in manager-managed LLCs, managers now have a fiduciary duty of loyalty (in a manager-managed LLC, members do not have a duty of loyalty). This new duty of loyalty requires the persons managing the LLC to account to the LLC and as trustee for it any property, profit or benefit derived (1) in conducting, or winding up, of the LLC’s activities, (2) from the use of the LLC’s property, and (3) from misappropriation of any business opportunities of the LLC. Persons managing the LLC are now also required to refrain from competing with the LLC and refrain from engaging in “interested transactions” with the LLC, such as lending money to the LLC or leasing property to the LLC. However, there are certain limited defenses to the duty of loyalty, including situations where it can be shown that a specific “interested transaction” involving a governing person of the LLC was fair to the LLC, such as loans with market interest rates and arms length terms and conditions and leases with market rents and arms length terms and conditions. Additionally, there is a “savings clause” under which members of an LLC may, after full disclosure of all material facts, authorize or ratify any act or transaction that violates the duty of loyalty.
RULLCA provides that an operating agreement of an LLC may restrict or eliminate the duty of loyalty specified under RULLCA, so long as doing so is not determined to be “manifestly unreasonable” (discussed in further detail below). For example, an operating agreement, if not “manifestly unreasonable,” may identify specific types or categories of activities that do not violate the duty of loyalty (such as members of an LLC that own a gym agreeing that members of the LLC may have ownership interests or other interests in other LLC’s holding interests in other gyms located at least 10 miles from the LLC’s gyms). Additionally, in lieu of the default requirement for all members to approve an “interested transaction” involving a managing person, an operating agreement may require a super-majority or majority of the members to authorize or ratify an “interested transaction,” and may also provide a detailed mechanism for disinterested and independent persons to authorize or ratify “interested transactions” that violate the duty of loyalty after a full disclosure of material facts.
Whether an elimination or restriction of fiduciary duties is “manifestly unreasonable” is an issue of law to be decided by the court based on the circumstances as of the time the provision was added to the operating agreement of the LLC. The court can invalidate the limiting provision if it is readily apparent in light of the purposes and activities of the LLC, that the objective of the term is unreasonable or the term is an unreasonable means to achieve the term’s objective.
- Fiduciary Duty of Care. The Old Act did not impose any duty of care on members or managers in the operation of an LLC. Under RULLCA, in a member-managed LLC, each member owes a duty of care to the other members and in a manager-managed LLC, each manager owes a duty of care to the members (but members do not have a duty of care in a manager-managed LLC). Under RULLCA, the duty of care requires a managing person to refrain from engaging in grossly negligent or reckless conduct, intentional misconduct or a knowing violation of law. Unlike the fiduciary duty of loyalty, an operating agreement of an LLC cannot eliminate the duty of care (regardless of whether the elimination could be found not to be “manifestly unreasonable”). However, the operating agreement of an LLC may alter the duty of care (if not “manifestly unreasonable”), except to authorize intentional misconduct or knowing violation of law.
- Contractual Obligation of Good Faith and Fair Dealing. Under the Old Act, there was no statutory covenant of good faith and fair dealing. Under RULLCA, members and managers of an LLC are required to exercise their rights and perform their duties under both RULLCA and the LLC’s operating agreement, under a standard of good faith and fair dealing. Under RULLCA, the contractual obligation of good faith and fair dealing cannot be eliminated in an LLC’s operating agreement, but the LLC’s operating agreement may prescribe standards by which to measure whether a member or manager has complied with the obligation.
- Exculpation. Under RULLCA, an LLC’s operating agreement may eliminate or limit a member’s or manager’s liability to the LLC and members for money damages, except for (a) breach of the duty of loyalty; (b) a financial benefit received by the member or manager to which the member or manager is not entitled; (c) a breach of a member’s duty to not consent to or receive any distribution from the LLC if the LLC is insolvent or would become insolvent as a result of the distribution; (d) intentional infliction of harm on the LLC or a member; or (e) an intentional violation of criminal law.
- Oppression. Under the Old Act, there were no rights or remedies available to oppressed members of an LLC such as those that are available to oppressed minority shareholders of corporations under the New Jersey Business Corporation Act. Under RULLCA, members of LLCs are given rights and remedies similar to those oppressed minority shareholders of corporations. Under RULLCA, a court can dissolve an LLC or appoint a custodian or provisional manager and exercise other remedies on grounds that the managers or controlling members (a) have acted, are acting, or will act in an illegal or fraudulent manner, or (b) have acted or are acting in an oppressive manner that was, is or will be directly harmful to a member. Under RULLCA, the rights and remedies available to oppressed members of an LLC may not be eliminated or altered in the LLC’s operating agreement.
- Resignations. Under the Old Act, a resigning member was entitled to receive fair value from the LLC for the member’s equity interest as of the date of resignation, less all applicable discounts, unless otherwise provided in the LLC’s operating agreement. Under RULLCA, a member who resigns or withdraws from an LLC is not entitled to fair value for that member’s equity interest or any other distribution upon withdrawal from the LLC. Rather, the withdrawing or resigning member simply becomes a disassociated member who continues to be entitled to distributions and a liquidating distribution on dissolution, without a right to vote or participate in the management of the LLC. However, the LLC’s operating agreement can include provisions which address buyouts on resignations or withdrawals so as to avoid this issue.
- Member Retention of Rights, Duties and Obligations After Transfer of the Member’s LLC Interest. Under the Old Act, upon the transfer of a member’s limited liability company interest to a third party, the member generally ceased to be a member and ceased having the power to exercise any rights or powers of a member. Under RULLCA, unless otherwise provided in the LLC’s operating agreement, when a member transfers a “transferrable interest” of the member (the right to receive distributions), the transferring member retains the rights of a member other than the interest in distributions transferred and retains all duties and obligations of a member of the LLC. Under RULLCA, there is an exception under which a transferring member does not retain the rights of a member, but that exception requires the transferring member to be disassociated as a member of the LLC and being expelled by the unanimous consent of the other members of the LLC upon the transfer of all of the person’s “transferrable interest” in the LLC. Therefore, unless otherwise provided in an LLC’s operating agreement, a transferring member of an LLC will continue to be a member of the LLC with all rights and duties, except the right to receive distributions, unless affirmatively expelled by the other members (in which case the expelled person would have no management rights but would remain liable for any liabilities and obligations incurred while a member of the LLC). Though a transferring member and the LLC could try to negotiate this issue at the time of transfer (to allow the transferee to obtain all member rights), it is in the interest of LLC members to have this issue resolved in their operating agreement so that no last minute negotiations of this issue will be necessary.
- Oral and Implied Operating Agreements Permitted. Under the Old Act, an LLC was not required to have an operating agreement, but if it had one, it had to be in writing in order to be valid and enforceable. Under RULLCA, oral and implied operating agreements are permitted. If an LLC does not have a written operating agreement which addresses the concerns described above or otherwise modifies the default rules under RULLCA, LLC and members may be faced with the very difficult task of proving their oral or implied agreements regarding the LLC in court in lengthy and expensive litigation.
- Information Rights. Under RULLCA, information rights are broken down between member-managed LLCs and manager-managed LLCs. In a member-managed LLC, (a) a member has a right to inspect and copy any records regarding the LLC, to the extent the information is material to the member’s rights and duties under the operating agreement or under RULLCA, (b) the LLC is obligated to furnish to each member, without demand, any information regarding the company which the company knows and is material to the exercise of the member’s rights and duties under the operating agreement or RULLCA (unless the company can establish its reasonable belief that the member already knows the information) and (c) the company must also furnish to each member, on demand, any other information concerning the LLC, except to the extent the demand or information demanded is unreasonable or otherwise improper under the circumstances. In a manager-managed LLC, a manager is entitled the same information described above for members, in lieu of the members having those rights. However, in a manger-managed LLC, an LLC member may inspect and copy information regarding the LLC as is just and reasonable if the purpose for which the member seeks the information is material to the member’s interest as a member of the LLC, the member makes a written demand describing with reasonable particularity the information sought and the purpose for seeking the information and the information sought is directly connected to the member’s purpose.
- Indemnification. Under the Old Act, an LLC was permitted, but not required, to provide indemnification for the LLC’s members and managers. Under RULLCA, indemnification of members, managers, employees and agents of an LLC is mandatory under certain circumstances. However, this mandatory indemnification may be restricted, altered or eliminated in the LLC’s operating agreement.
- Conversion and Domestication. The Old Act did not contain any provisions regarding conversion of other forms of entities into LLCs or the domestication of foreign LLCs or other entities into a New Jersey LLC. Similar to Delaware’s LLC law, RULLCA now provides a streamlined process under which other corporate entities can be converted to LLCs and under which foreign LLCs or other entities can domesticate into a New Jersey LLC. It is apparent that the provisions regarding conversion into an LLC will not be available for New Jersey corporations or other New Jersey entities wanting to convert until the New Jersey statutes governing those other entities are amended to expressly provide for such conversion. However, under RULLCA, a foreign LLC may become a domestic LLC and a domestic LLC may become a foreign LLC, in each case pursuant to a written plan of domestication if the domestication is permitted by the application foreign laws (for example, a New Jersey LLC converting to a Delaware LLC, or vice versa).
- Authority to Bind the LLC. Under the Old Act, in a member-managed LLC, a member generally had authority to bind the LLC. In a manager-managed LLC, the authority of a manager to bind the LLC had to be set forth of the operating agreement of the LLC. However, under RULLCA, in a manager-managed LLC, unless otherwise provided in the LLC’s operating agreement, the managers of the LLC will generally have authority to decide matters in the ordinary course of business of the LLC, but certain extraordinary matters (such as mergers and the sale of all or substantially all of the assets of the LLC) will require the consent of the members. In a member-managed LLC, unless otherwise provided in the operating agreement, the members of the LLC have the authority to decide all matters relating to the LLC. However, in the member-managed LLC, being a member by itself does not make the member an agent of the LLC or otherwise establish legal authority to bind the LLC. Rather, under RULLCA, the determination as to whether a member had the authority to bind the LLC will be determined under common law agency principles (unless otherwise provided in the operating agreement). RULLCA also permits an LLC to file a public statement of authority stating the authority, or limitations on the authority, of specific persons involved in the LLC, to execute documents or otherwise act on behalf of or bind the LLC. Therefore, it is imperative for an operating agreement of an LLC to specify who has power to bind the LLC under specific circumstances.
- Dissolution. Under the Old Act, dissolution of an LLC was a one-step process under which an LLC filed a certificate of cancellation after winding up the LLC. However, under RULLCA, dissolution of an LLC is now a two-step process under which the LLC must first file a certificate of dissolution with the New Jersey Division of Revenue, wind up the LLC and then file a certificate of termination upon the completion of the wind up of the LLC. RULLCA also contains detailed provisions regarding LLC dissolution procedures, including the changes related to the provision of notice of dissolution to known creditors and notices to bar creditors of the dissolved LLC, among other things. Under RULLCA, unless otherwise provided in the LLC’s operating agreement, any remaining funds of the LLC after payment of creditors and distribution of unreturned capital contributions is to be distributed equally to members and dissociated members (i.e., per capita). Under the Old Act, such liquidating distributions were to be distributed to members based on the percentages in which the members shared profit distributions unless otherwise provided in the LLC’s operating agreement.
- Duration of an LLC. Under the Old Act, unless the certificate of formation of the LLC specified that the LLC’s duration was perpetual, the LLC was to be automatically dissolved at the time specified in the LLC’s operating agreement or thirty years from the date of formation of the LLC if no specified time for dissolution and winding up was set forth in the operating agreement. Under RULLCA, all LLCs are deemed to have perpetual duration.
- Special Litigation Committees. Under the Old Act, a member was permitted to bring a direct action for injuries to that member and was also permitted to bring a derivative action in the right of the LLC. Under RULLCA, if an LLC is named in a derivative action or made a party to a derivative action, the LLC is permitted to form a special litigation committee to investigate the asserted claims and determine whether pursuing the action is in the best interests of the LLC. Additionally, the LLC’s special litigation committee is permitted to stay discovery for the time reasonably necessary to permit the special litigation committee to make its investigation. The special litigation may, after appropriate investigation, determine that the claims should be continued under the control of the plaintiff or under the control of the special litigation committee, or that the claims be settled on terms approved by the special litigation committee or dismissed. If the court finds that the members of the special litigation committee were disinterested and independent and that the committee acted in good faith, independently and with reasonable care, the court must enforce the determination of the committee. Otherwise, the court must dissolve the stay of discovery described above and allow the action to proceed under the direction of the plaintiff.
- Miscellaneous. Under RULLCA, there are a few other additional changes to administrative matters of New Jersey LLCs, including a new requirement to file annual reports with the NJ Division of Revenue, the ability to file an alternate business name and the ability to reserve a business name before formation of the LLC, in a manner similar to corporations under the NJ Business Corporation Act. RULLCA also provides that the failure of an LLC to observe any particular formalities relating to the exercise of its powers or management of its activities is not a ground for imposing personal liability on the members or managers for the debts, obligations or other liabilities of the company. This statement is of some importance due to certain prior case law in New Jersey relating to the piercing of the corporate veil in certain limited cases based on the failure of a corporation or LLC to observe corporate or LLC formalities.
As a result of the many changes made to New Jersey LLC law under RULLCA (some of which can have a major impact on the operations of a New Jersey LLC), it is imperative that members and managers of a New Jersey LLC have a comprehensive operating agreement in place to govern the LLC and, more importantly, avoid the application of some of the more undesirable default rules of RULLCA described above.