Twenty-seven years ago, when the Dow Jones Industrial Average closed at 3301 and the price of a gallon of gasoline was $1.05, the Arizona legislature enacted its first Limited Liability Company Act. The prior law has been retired, updated by a comprehensive new law, signed by Gov. Ducey during the 2018 legislative session, that went into effect the first of this month.
Historically, lawyers chose LLCs over corporations for only a limited number of situations.
Over time, however, the ongoing trend has been that many more LLCs are formed each year in Arizona than corporations for a variety of purposes. The 1992 LLC Act was built on the premise that founders would sign robust operating agreements at the same time the company was formed. That has not held true. Many owners have overlooked the importance of a written operating agreement and have adopted one that is incomplete, or none at all.
As a result, the 2018 LLC Act was enacted, primarily to govern issues left unaddressed in an LLC’s operating agreement. For example, the 2018 LLC Act adds:
- Standards for fiduciary duties and duty of good faith and fair dealing;
- Centralized list of what statutory default rules can, and cannot, be changed in an operating agreement;
- New default rules for member voting; and
- Statutory indemnification rights for managers.
In particular, owners tend to leave out any clear statement of what fiduciary duties the members and managers owe to the company and one another. Generally, a person in a position of control and trust must act with care and loyalty to those he or she serves.
For lawyers, one assumption has been that those duties would be imposed by common law, even if they were not written in statute or an operating agreement. To date, the results in court are inconsistent, which does not provide a stable business environment. Now, the 2018 LLC Act defines specific duties for both members and managers: (1) duty of loyalty, (2) duty of care, and (3) good faith and fair dealing.
The duty of loyalty contains four parts: first, to account for any benefit to which the manager or member is not entitled; second, to refrain from dealing with the company “as or on behalf of a person having an interest adverse to” the company; third, to refrain from competing with the company before the company’s dissolution; and fourth, to disclose any material conflict of interest for any decision under consideration or any transaction regarding the company or another member’s interest in the company.
Unless expressly limited in an operating agreement, the managers of an LLC will be married to their business partners for all activities within the scope of the LLC’s business. For example, managers could have a duty to offer future opportunities or customers to the company and form no new ventures with anyone else.
Many business owners loathe such an outcome.
To fix those problems, one might proactively negotiate provisions in one’s operating agreement that: (1) expressly allow managers to use company property (for a fee or not); expressly permit or direct certain company opportunity to manager (e.g. sharing of leads, clients, or projects); (2) expressly allow solicitation of company employees for separate venture or affiliates; (3) expressly permit managers to own similar businesses, either without limits or with certain boundaries, like within geographic scope, within certain verticals, in connection with certain projects or opportunities or customers.
A duty of care has also been set. The standard rule requires managers to refrain from reckless or grossly negligent conduct or willful or intentional misconduct, which is where the duty of care has been traditionally set in partnership law.
Managers and majority owners would prefer to change that standard, lowering or eliminating it. On the other hand, owners with a small stake and less control would want to raise the standard, perhaps to hold managers accountable to what a “prudent person” would do in the relevant situation, which means to be more careful than merely not grossly negligent.
The duty of good faith and fair dealing (GFFD) comes hand-in-hand with the duty of care.
GFFD is the “floor” that cannot be waived or disclaimed further by an operating agreement. A covenant of good faith and fair dealing is an implied promise in in every contract — including LLC operating agreements. The essence of that duty is that neither party will act to impair the right of the other to receive the benefits that flow from their agreement or contractual relationship. If managers wholly disclaim their duty of care to the fullest extent allowed by law, they will still be accountable to act in good faith.
To conclude, the 2018 LLC Act accomplishes the task of providing the general population with standard rules. Sophisticated entrepreneurs, however, will want to rework their agreements in order to pursue ventures with other business partners. The 2018 LLC Act applies to new ventures as of September 1, 2019, and governs all existing companies after September 1, 2020.
Andy G. Anderson is a business attorney with Spencer Fane LLP in Phoenix. He works with clients on a wide range of corporate and commercial transactions. He is a member of the Executive Committee of the Business Section of the Arizona Bar and served on the subcommittee of the Business Section that drafted the Arizona Limited Liability Company Act.