New Arizona Limited Liability Act: Do I Really Need a New Operating Agreement?
The Revised Arizona Limited Liability Act ("New Act") has been effective since September 1, 2019 for new limited liability companies ("LLCs"). It now becomes effective for any existing LLCs on September 1, 2020. Especially with the pressures of dealing with COVID-19, many business owners are probably thinking about why they have to take on the additional cost of modifying or restating their existing Operating Agreements. This Article will point out some of the major issues that need to be addressed under the New Act, and some of the new default rules that will apply to all LLCs as of September 1, 2020. Some of these default rules cannot be changed by an Operating Agreement and give members and managers of LLCs new rights and obligations that did not exist under prior law. However, some of these default rules can be overridden by a properly drafted Operating Agreement. If a default rule can be overridden by a new Operating Agreement, and your Operating Agreement has not been updated, there may be unintended consequences.
This article is not intended as an extensive discussion of all of these issues, but is intended to analyze some of the more pressing issues under the New Act that impact Operating Agreements going forward.
Fiduciary Duties to Members
The prior Arizona LLC Act did not address whether in manager–managed LLCs, managers or members owed a fiduciary duty to the members, or whether in member-managed LLCs, members owed a fiduciary duty to the other members. Fiduciaries have been common in other areas of business law for many years. [i],The law requires fiduciaries to live up to a certain standard of care. Fiduciaries are required to exercise the utmost care in making business decisions, and to put the interests of others above their own interests. Prior to the New Act, case law was developed by the Arizona Courts that added some of these duties in certain circumstances. [ii]
Under the New Act, fiduciary duties apply to members in member-managed LLCs and to managers in manager-managed LLCs. Fiduciary duties may even apply to members in manger-managed LLCs to the extent that a member has control over, or participates in, management decisions. These fiduciary duties include the duty of loyalty, the duty to refrain from competing with the LLC business, and the duty to disclose a material conflict in connection with a decision or transaction. [iii] Certain of these statutory fiduciary duties can be waived, expanded or limited in an Operating Agreement. Others cannot be waived. These include the contractual obligation of good faith and fair dealing and the duty to refrain from misconduct that is willful or intentional. Liability for breach of fiduciary duties may, however, be limited in an Operating Agreement.
An Operating Agreement may provide for indemnification for violation of fiduciary duties, but if the Operating Agreement is silent on this matter, there is no other remedy for indemnification under the New Act. For example if an Operating Agreement only states that it is member-managed or manager-managed, this is not enough to specify a method for indemnification or reimbursement.
It is not uncommon in closely held LLCs for a manager or member to enter into a transaction in which they may have an interest, or are on both sides of the transaction. As part of their fiduciary duties, members or managers must disclose any conflict of interest transaction to the other members or managers under the New Act. Unless changed in an Operating Agreement, any transaction that constitutes a material conflict must be authorized by the unanimous approval of the members.
Right to Receive Disclosures
The New Act provides that members and managers have specific rights to receive disclosure of information before decisions are made. In order to protect the disclosing party, the Company may impose reasonable restrictions on the disclosure of information, such as requiring a non-disclosure agreement. If information is not provided, the New Act provides remedies and the opportunity for the requesting party to go to Court in order for members or managers to receive the information to which they are entitled.
Litigation Committee Provision
Provisions that impact litigation should also be addressed. The New Act provides for the appointment of a litigation committee to manage litigation cases, which can be eliminated by an Operating Agreement. Members now also have additional rights to maintain an action against LLCs. An Operating Agreement may require that the member prove actual damages in order to maintain such an action in order to reduce the threat of litigation by members.
Impact on Existing LLCs
An Operating Agreement entered into before the New Act becomes effective for all LLCs is still valid under the New Act after September 1, 2020. If an existing Operating Agreement does not address some of the issues addressed in this article, or other issues under the New Act, the default provisions of the New Act will control.
In addition to the items discussed in this Article, there are many more issues under the New Act that need to be addressed in an Operating Agreement. Many of them are more technical in nature such as formation, definition of the percentage membership interest of each member, [iv] distributions, reorganizations, dissolution, rights upon transfers of interests, and approval needed for certain actions impacting the LLC. We are available to help guide you through these decisions and the impact they may have on your existing LLC or any new LLC you may form in the future.
About the Authors: Beth S. Cohn is a State Bar of Arizona certified tax specialist, CPA and business attorney and shareholder at the Phoenix law firm of Jaburg Wilk. Nichole Wilk, Stephanie Fierro and Lisa Paine are all partners of the firm in the corporate transactions and business planning group. They assist clients with various business matters including entity formation.
[i] By statute in Arizona, directors and officers owe a fiduciary duty to the corporation and shareholders, and general partners owe a fiduciary duty to the partnership of the limited partners of a partnership.
[ii] A discussion of these cases is beyond the scope of this article.
[iii] These are examples of the fiduciary duties under the New Act; a more expansive explanation of these duties is beyond the scope of this Article. See A.R.S. Section 29-3409.
[iv] The New Act provides that without an Operating Agreement, the "percentage interest" of a member is defined by a member's interest in profits. An interest in profits may be different than a percentage determined by the actual number of members.