Limited Liability Companies (LLCs)
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
The limited liability company, in effect an incorporated partnership, has gained considerable momentum since 1988, when the Internal Revenue Service ruled that a corporation organized under a special Wyoming statute qualified for pass-through tax treatment as a partnership even though the entity possessed the corporate characteristic of limited liability. The following discussion of the anatomy of a limited liability company is oriented toward the Delaware statute (the Act). In the following discussion, it should be assumed that unless otherwise indicated or unless the context suggests otherwise (i.e., fundamental rules on how the entity is to be organized), any provision of the Act can be modified by agreement of the parties.
The members may directly manage the company or they may delegate all or a portion of that task to "managers" (the limited liability company equivalent of directors or general partners). Limited liability companies can be organized in Delaware for any purpose other than banking or insurance.
A limited liability company is formed by filing a certificate of formation with the secretary of state. The certificate must set forth the name of the company (which shall contain the words "Limited Liability Company" or "LLC"), the address of its registered office, and the name and address of its registered agent for service of process. As opposed to statutes in other states, the certificate need not identify the names and business addresses of the initial members or managers, nor the purposes for which the LLC was organized. The omission of members' and/or managers' names is clearly the better practice. The list of limited partners required in the certificate by outdated versions of the Uniform Limited Partnership Act only served to identify prospects for salesmen pushing securities; if identification is required, publicity-shy members will employ dummies.
The Act contemplates that the affairs and conduct of the business of a limited liability company will be governed by a written operating agreement (the Agreement). There is no requirement that the Agreement be made public; some practitioners may, however, wish to publicize portions of the Agreement, by incorporating the same in the Certificate of Formation, in hopes that constructive notice to, say, creditors and vendors, will prove helpful at some point down the road. If an LLC is to be used as a special-purpose, bankruptcy–remote vehicle, for example, the sponsors might want a purpose clause on the public record indicating to all the world that the company is not authorized to borrow money or run up bills except in certain specified ways.
The Agreement may contain any provisions for the regulation and management of the company which are not inconsistent with the Act. The entity may be governed democratically like a general partnership, all members voting on all matters in proportion to their profits' interests, with no delegation to managers. However, the norm is expected to be delegation of management functions to managers (a.k.a. directors). The Act does not, parenthetically, mention officers specifically; but there is no reason not to appoint the same if deemed useful, much as partnerships appoint officers from time to time.
The Agreement will generally specify how profits and losses will be allocated and distributions made. An important query at this point is whether the Agreement should be like a typical partnership agreement in providing for such items as adjustments to keep the system in sync with the Treasury Regulations under I.R.C. §704 (e.g., minimum-gain charge-backs), the appropriate profit allocation upon a distribution in-kind, and the like.
Once a Delaware limited liability company has creditors, no distributions or returns of capital can be made if that action would cause the fair value of its net assets to be less than zero. Indeed, under applicable fraudulent-conveyance statutes, the constraint on distributions extends to those which might make the firm insolvent or leave it unreasonably short of capital. Other than that restriction, however, distributions by a limited liability company can be structured in any way the members or managers choose. If no allocation is specified in the Agreement, the Act specifies that distributions and profits and losses will be allocated by proportionate share of the "agreed value" of membership interests. But discriminatory distributions are allowed if the governing documents so provide. If a member resigns, he is entitled to receive within a reasonable time the fair value of his membership interest based on his right to share in distributions. (A reminder: as indicated above, this and most other rights can be modified or curtailed by the Agreement.)
This Act also clarifies relationships between members and the company. It is, for example, acceptable for a member to transact business with the company. In such a role, the member has the same rights as any nonmember. And, to the extent members have a right to distributions, they enjoy creditor status. Furthermore, it appears managers can be exculpated up to maximum limits one can imagine, absent their actual, knowing, and willful fraud.
The Act specifies that new members may be admitted only with the unanimous consent of the existing members unless the Agreement otherwise provides. And, the Agreement may provide, presumably, just about any admission procedure imaginable; thus, under the Act, one can become a member by orally agreeing to become a member. Stock or other certificates are not specifically mentioned. Moreover, unlike corporations in some states, membership interests can be issued for whatever consideration the members choose, including a promissory note or future services. At this point, of course, careful counsel will consider creating formalities in the Agreement so that, for example, when the time rolls around for an opinion to issue on, say, the status of certain issues, the lawyer concerned will have something to go on.
The Act has established a procedure whereby limited liability companies organized in other jurisdictions can qualify to do business in Delaware. And, the Act is specific on such issues as the LLC's ability to merge with LLCs and C Corporations (foreign and domestic). The Act provides for partnership-type rights of members to look at the books and lists of members, subject only to "reasonable" limitations.
Clearly, limitation of liability for members is a cornerstone of the Act. Members of limited liability companies are not risking their personal assets; they are not liable to creditors "solely by reason of being a member or acting as a manager." Members are, on the other hand, liable for any contributions they agreed in writing to make and the obligation survives death or disability; if required property or services are not contributed, the company may require a cash contribution of equal value. The Act also recognizes that there are contractual elements to the relationship of the members. For example, the Act allows for the resignation of a member or manager unless the Agreement provides he may not, in which case the company may recover damages for breach from the manager (no mention of the member) and offset those damages from other distributions. The Act imposes liability on managers and members to return improper distributions, but, in the case of members, only if the member knew at the time the distribution was improper.
It is likely that, barring unusual circumstances, the interest of a member in an LLC will be deemed to be a "security" under the test laid down in the landmark Supreme Court's SEC v. Howey decision and its progeny. In the event of bankruptcy of an LLC, the odds are that the rules pertaining to corporations (versus liability company) will apply. Most states (Florida being a prominent exception) treat LLCs as liability companies for tax purposes.