California Amends Its Revised Uniform Limited Liability Company Law

On October 11, 2015, California Governor Jerry Brown signed into law Assembly Bill 506, which amends the California Revised Uniform Limited Liability Company Act that became effective on January 1, 2014.  AB 506 was primarily drafted by the Partnership and Limited Liability Companies Committee of the Business Law Section of the California State Bar to fix what were perceived as problems with the original California RULLCA.  I’ll be posting a more detailed look at the revisions to RULLCA, but at first glance the amendments reinforce my belief that ALL California LLCs should adopt an Operating Agreement that is expressly drafted to comply with RULLCA as amended by AB 506.

Here’s the text of the Legislative Counsel’s comments on AB 506:

“Existing law, the California Revised Uniform Limited Liability Company Act, authorizes one or more persons to form a limited liability company by, among other things, signing and delivering articles of organization to the Secretary of State. The act authorizes a person, as defined, to dissociate as a member of a limited liability company at any time by withdrawing as a member by express will. The act deems a person to be dissociated from a limited liability company upon the occurrence of certain events, including, among others, an individual’s death. The act provides the effects when a person, including an individual, is dissociated from a limited liability company. Existing law limits the application of an operating agreement.

This bill would specify that upon dissociation a person’s right to vote as a member in the management and conduct of the limited liability company’s activities terminates. The bill would authorize, if a member dies, or a guardian or conservator of the estate is appointed for the member, or a member’s interest is being administered by an attorney-in-fact under a valid power of attorney, the member’s executor, administrator, guardian, conservator, attorney-in-fact, or other legal representative to exercise all of the member’s rights for the purpose of settling the member’s estate or administering the member’s property, including any power the member had under the articles of organization or an operating agreement to give a transferee the right to become a member. The bill would also modify the definition of “electronic transmission by the limited liability company” and would expand the definition of “person” under the act. The bill would modify what an operating agreement may provide, as specified. The bill would provide that specified provisions of the Labor Code, relating to consideration for employment and employment contracts, shall not apply to membership interests issued by any limited liability company or foreign limited liability company, as specified.

Existing law requires that any distributions made by a limited liability company before its dissolution and winding up be among the members in accordance with the operating agreement.This bill would further require that the profits and losses of a limited liability company be allocated among the members, and among classes of members, in the manner provided in the operating agreement, and would require that profits and losses be allocated in proportion to the value of the contributions from each member if the operating agreement does not otherwise provide.

Existing law requires the consent of all members of the limited liability company to approve a merger or conversion and to amend the operating agreement.  This bill would eliminate that requirement.
Existing law requires a limited liability company to reimburse for any payment made and indemnify for any debt, obligation, or other liability incurred by a member of a member-managed limited liability company or the manager of a manager-managed limited liability company in the course of the member’s or manager’s activities on behalf of the limited liability company, if, in making the payment or incurring the debt, obligation, or other liability, the member or manager complied with specified duties.
This bill would require the limited liability company to indemnify the agent of a limited liability company to the extent that the agent has been successful on the merits in defense or settlement of any claim, issue, or matter if the agent acted in good faith and in a manner that the agent reasonably believed to be in the best interests of the limited liability company and its members, as provided.
Under existing law, the persons who filed the certificate of dissolution are required to sign and file with the Secretary of State a certificate of cancellation of articles of organization upon the completion of the winding up of the affairs of the limited liability company, except as specified. Existing law requires the certificate of cancellation of articles of organization to include, among other things, that upon the filing of the certificate of cancellation, the limited liability company is required to be canceled and its powers, rights, and privileges are required to cease. Under existing law, a limited liability company that is dissolved continues to exist for the purpose of, among other things, winding up its affairs and prosecuting and defending actions by or against it in order to collect and discharge obligations.
This bill would instead provide that a limited liability company that has filed a certificate of cancellation continues to exist for those purposes, as specified.
This bill would limit the applicability of the act to acts or transactions by a limited liability company or by the members or managers of the limited liability company occurring, or an operating agreement or other contracts entered into by the limited liability company or by the members or managers of the limited liability company, on or after January 1, 2014.
This bill would incorporate additional changes to Section 17710.06 of the Corporations Code made by this bill and AB 1471 to take effect if both bills are chaptered and this bill is chaptered last.
This bill would incorporate additional changes to Section 17713.12 of the Corporations Code made by this bill and AB 1517 to take effect if both bills are chaptered and this bill is chaptered last.”
By |2016-12-13T21:20:06-07:00October 14th, 2015|Categories: CA Law, CA LLC Statutes, Operating LLCs|0 Comments

Problem if Sole Member is Not the Organizer of a CA LLC

Question:  I am to be the sole member of a new California limited liability company, but I did not sign the Articles of Organization as the organizer of the LLC.  Is that a problem?

Answer:  Maybe!  California Corporations Code Section Section 17704.01(a) states:

If a limited liability company is to have only one member upon formation, the person becomes a member as agreed by that person and the organizer of the limited liability company.

If the organizer of a single member LLC is the sole member then everything is good.  However, if the would be sole member of a single member California LLC (the “Prospective Member”) is not the organizer who signed the Articles of Organization filed with the California Secretary of State then:

  • The Prospective Member will never be a member of the LLC unless and until the Prospective Member and the organizer agree that the Prospective Member is the sole member.  The agreement should include the date the Prospective Member becomes a member and any conditions required by the organizer.
  • How does the sole member prove that the organizer agreed that he/she/it could be the member?
  • A prudent Prospective Member will obtain a written statement signed by the organizer that states that the Prospective Member is the sole member of the LLC as of a specified date.  Recommendation:  The Prospective Member must get a written statement from the organizer.  If the Prospective Member does not obtain a written statement from the organizer, how can the Prospective Member prove he/she/it is the sole member if challenged in court?

Warning to Entities and Trusts:  When a California LLC is to be owned by a sole member that is an LLC, corporation, partnership or trust most of the time the organizer is a person rather than the sole member.  To avoid the California Corporations Code Section Section 17704.01(a) problem the sole member should be the organizer that signs the Articles of Organization.  The California Secretary of State says:

  • If Form LLC-1 is signed by an entity, the person who signs on behalf of the entity should note their name and position/title and the entity name. Example: If a limited liability company (“Smith LLC”) is the organizer, the signature of the person signing on behalf of the Smith LLC should be reflected as Joe Smith, Manager of Smith LLC, Organizer.
  • If Form LLC-1 is signed by a trust, the trustee should sign as follows: ___________, trustee for ___________ trust (including the date of the trust, if applicable). Example: Mary Todd, trustee of the Lincoln Family Trust (U/T 5-1-94).

Practice Pointer:  If the organizer is not the Prospective Member the best way to solve this problem is to: (i) have a statement at the end of the LLC’s Operating Agreement that says the organizer authorizes the Prospective Member to be the sole member of the LLC as of the date the Articles of Organization were filed with the California Secretary of State, and (ii) have the organizer sign the Operating Agreement immediately under the statement.  This is something we do routinely when we know that the sole member was not the organizer.

By |2016-12-13T21:20:06-07:00August 2nd, 2015|Categories: CA LLC Formation, FAQs, Members|0 Comments

California Court of Appeal Rules RULLCA Does Not Apply to LLC Lawsuit Filed before 1/1/14

The California Court of Appeal held in Kennedy v Kennedy, 235 CA4th 1474 (2015), that the California Revised Uniform Limited Liability Company Act (RULLCA) did not apply to a dispute among members of a California limited liability company because their lawsuit was filed before January 1, 2014, the RULLCA effective date.  The court based its ruling on California Corporations Code Section 17713.03 which states,

This title does not affect an action commenced, proceeding brought, or right accrued or accruing before this title takes effect.

The defendants argued that RULLCA applied because they wanted to be able to use the mandatory disgruntled member buy-out scheme set forth in Corporations Code Section 17707.03(c)(1) which states:

In any suit for judicial dissolution, the other members may avoid the dissolution of the limited liability company by purchasing for cash the membership interests owned by the members so initiating the proceeding, the “moving parties,” at their fair market value.

Subsections (c)(2) – (6) set forth a procedure for consummating the buy out.  Subsection (c)(6) states,

A dismissal of any suit for judicial dissolution by a manager, member, or members shall not affect the other members’ rights to avoid dissolution pursuant to this section.

The defendants wanted RULLCA to apply so they could carry out a buy out under Section 17707.03(c) despite the fact the plaintiff had dismissed the claim for judicial dissolution.  There is no mandatory buy out under California’s LLC law before January 1, 2014.

By |2016-12-13T21:20:06-07:00July 3rd, 2015|Categories: CA Law, CA LLC Statutes, Lawsuits, Member Disputes|0 Comments

New Member of a California LLC Bound by Operating Agreement

Question:  The initial members of my California LLC signed an Operating Agreement.  One of the initial members assigned ten percent of the membership interests to John Doe.  The initial members agreed to admit John as a member.  John refuses to sign the Operating Agreement.  What can we do?

Answer:  The good news for the initial members who signed the Operating Agreement is that Section 17701.11(b) states “A person that becomes a member of a limited liability company is deemed to assent to the operating agreement.”  John Doe is legally bound by the obligations contained in the Operating Agreement despite the fact he never signed it.

Warning to Prospective Members of an Existing California Limited Liability Company:  If you are thinking of becoming a member of an existing California LLC that has an Operating Agreement, do not become a member until you review the LLC’s Operating Agreement and approve all of its provisions.

By |2016-12-13T21:20:06-07:00May 10th, 2015|Categories: CA LLC Statutes, FAQs, Operating Agreements, Operating LLCs|0 Comments

California LLC Allocation of Profits

Question:  My friend and I started a California LLC.  We never signed an Operating Agreement.  I assumed that we would share the profits equally, but my friend says that he gets 60% of the profits and I get 40%.  This dispute has ruined our business relationship.  What should I do?

Answer:  Your dispute is too common.  Unfortunately the toothpaste is out of the tube, and it may be too late to solve the huge problem created by the members failure to sign an Operating Agreement that states how profits and losses will be allocated among the members.  The California Revised Uniform Limited Liability Act does not specify how profits and losses will be allocated among members of a multi-member California LLC.

Members of a California limited liability company must agree in an oral agreement or in a written and signed Operating Agreement as to how profits and losses will be allocated among the members.  The problem with an oral agreement is that it is a recipe for disaster because when people disagree they have no way to prove what they previously agreed to.

One of the main reasons all of the members of a multi-member California LLC need to sign an Operating Agreement is so they have proof in the document as to how the profits and losses are allocated among the members.

By |2015-05-09T10:34:06-07:00May 9th, 2015|Categories: FAQs, Member Disputes, Operating Agreements, Operating LLCs|0 Comments

Sending Copies of LLC Tax Returns to Members of a California LLC

Question:  I am a member of a California LLC, am I entitled to get a copy of my LLC’s federal income tax return?

Answer:  It depends.  If the LLC has 35 or fewer members California Corporations Code Section 17704.10(e) requires that all members be given copies of the LLC’s federal, state and local income tax return for the year.  Section 17704.10(e) states:

The limited liability company shall send or cause information to be sent in writing to each member or holder of a transferable interest within 90 days after the end of each taxable year the information necessary to complete federal and state income tax or information returns and, in the case of a limited liability company with 35 or fewer members, a copy of the limited liability company’s federal, state, and local income tax or information returns for the year.

By |2016-12-13T21:20:06-07:00May 3rd, 2015|Categories: CA Law, CA LLC Statutes, FAQs, Operating LLCs, Tax Issues|0 Comments

Disassociation of a Member of a California LLC

Question:  Can a member of a California LLC disassociate (withdraw or terminate membership) from the LLC at any time even if disassociation is prohibited by an Operating Agreement?

Answer: Yes.  A good Operating Agreement will contain provisions that prevent a member from dissociating or that allow a member to disassociate only on the occurrence of one or more conditions.  See California Corporations Code Sections 17706.01(b)(1) and 17706.02(b).  However, even if a member is prohibited from disassociating the member may quit (disassociate) at any time by notifying the other members of the disassociation.

If the disassociation is prohibited by the LLC’s Operating Agreement, the disassociating member may be liable to the LLC for damages.  California Corporations Code Sections 17706.01(c). The disassociating member will not be entitled to any money or property unless the Operating Agreement provides otherwise.  California Corporations Code Section 17704.04(b).

By |2016-12-13T21:20:06-07:00May 2nd, 2015|Categories: FAQs, Operating Agreements, Operating LLCs|0 Comments

How Does the Agent for Service of Process of a CA LLC Resign?

Question:  I am the agent for service of process for a California limited liability company.  How do I resign the position of the LLC’s agent for service of process?

Answer:  You must prepare, sign and file a California Secretary of State Form RA-100, Resignation of Agent Upon Whom Process May Be Served, with the California Secretary of State.  There is no fee to file the form.  Mail the form to Secretary of State, Document Filing Support Unit, 1500 11th Street, 3rdFloor, Sacramento, CA 9581. Upon filing Form RA-100, the authority of the agent for service of process to act in that capacity will cease,and the Secretary of State will give written notice of the resignation to the entity.

A non-refundable $15.00 special handling fee is applicable for processing documents delivered in person (drop off) at the Sacramento office. To get a copy of the filed document, include a separate request and payment for copy fees when the document is submitted. Copy fees are $1.00 for the first page and $.50 for each additional page. For certified copies, there is an additional $5.00 certification fee, per copy.
By |2016-12-13T21:20:13-07:00April 30th, 2015|Categories: FAQs, How Do I, Miscellaneous|0 Comments

Don’t Use a PO Box for LLC’s Designated Office

Question:  Line 3.a of the California Secretary of State’s Articles of Organization, Form LLC-1, requires the initial street address of the LLC’s designated office in California.  Can the designated office be a U.S. post office box?

Answer:  No.  If the LLC’s designated office in California is a U.S. post office box the California Secretary of State will reject the Articles of Organization.  If the LLC’s mailing address is different from the address of the LLC’s designated office in California it is ok to enter a U.S. post office box on line 3.b of the Articles of Organization, Form LLC-1 for the LLC’s mailing address.

By |2015-04-29T22:19:58-07:00April 29th, 2015|Categories: Articles of Organization, FAQs, Formation Issues|0 Comments

What’s a California Franchise Tax Board Form 3832?

Question:  My California LLC generates income from its business inside California.  One of the members is a nonresident of California and another member is a company formed in a state other than California.  I heard that my California LLC must file a California Franchise Tax Board Form 3832.  Is that true and if if so, what is the Form 3832?

Answer:  If your California limited liability company is taxed as a partnership for U.S. income tax purposes then it must file an FBT Form 3832 with the California Franchise Tax Board when it files its first FBT Form 568. The completed FTB Form 3832 must contain the following:

  • The names and social security numbers (SSNs), individual taxpayer identification numbers (ITINs), or federal employer identification numbers (FEINs) of all members that are people who are not residents of California and companies that are not formed in California.
  • The signature of each nonresident member evidencing member’s consent to the jurisdiction of the State of California to tax that member’s distributive share of income attributable to California sources. If the nonresident member has a spouse or registered domestic partner (RDP), the spouse / RDP must also sign the Form FTB 3832.
Anytime an existing California LLC acquires a member that is not a resident of California the LLC must obtain the nonresident’s consent and consent of the nonresident’s spouse or RDP if the nonresident is married and file the FTB Form 3832 with the LLC’s tax return for the year in which the nonresident acquired his/her/its membership interest.
Note:  By signing and submitting the FTB Form 3832 to the California Franchise Tax Board, the nonresident member is alerting the FBT that it should expect the nonresident member to file an annual California income tax return and pay tax on all income earned by the LLC from inside California.
Warning:  If a member fails to sign form FTB 3832, the LLC must pay tax on the member’s distributive share of income at that member’s highest marginal rate.  Any amount paid by the LLC will be considered a payment made by the member.
By |2016-12-13T21:20:13-07:00April 12th, 2015|Categories: FAQs, Franchise Tax Board, Tax Issues|0 Comments

How Do I Acquire an Ownership Interest in a California LLC as Separate Property?

Question:    I am married and live in California.  I intend to form a single member California LLC.  I know that California community property law my spouse will automatically own  one half of my interest in the LLC.  How do I acquire my LLC interest as my separate property?

Answer:  California residents who are married or who are domestic partners own assets one of two ways: (1) as community property or (2) as separate property.  Community property ownership means each spouse or partner owns an undivided one half of the total interest in the asset.  Separate property ownership means that one person owns 100% of the property and the other person does not own any interest in the property.  Because California law provides that all property acquired by one spouse or partner is automatically community property unless it comes from a gift or an inheritance both California residents will own the new LLC membership interest as community property unless the non-owner signs a document in which he or she disclaims any ownership interest in the LLC.

When we form a California LLC and the one of the members tells us that he or she is to own the membership interest as separate property we prepare a document called a “Disclaimer of Interest” for the non-owner to sign.  When signed the non-owner acknowledges that he or she does have have any ownership interest in the LLC membership interest.

By |2016-12-13T21:20:13-07:00April 7th, 2015|Categories: FAQs, Formation Issues, How Do I|0 Comments

California LLC Member’s Liability for Capital Contribution

Question:  A California LLC owes me money, but claims it is broke.  One of the members of the California LLC signed an Operating Agreement in which he promised to contribute $50,000 to the LLC.  The member never paid the money to the LLC.  Can I collect my debt from the member, but you may have to sue the member and the LLC in the same lawsuit?

Answer:  Yes.  California law provides that a member who makes a promise in writing to make a capital contribution is liable to a creditor of the LLC if the member fails to contribute the money to the LLC.  California Corporations Code Section 17704.03(c) states:

“A creditor of a limited liability company that extends credit or otherwise acts in reliance on an obligation described in subdivision (a) may enforce the obligation.”

By |2015-05-02T11:18:33-07:00March 25th, 2015|Categories: FAQs, Lawsuits, Operating Agreements|0 Comments

Conditions to Amending an Operating Agreement

Question:  Can the Operating Agreement of a California limited liability contain one or more provisions that create a condition that must be satisfied before the Operating Agreement can be modified?

Answer:  Yes.  RULLCA Section 17701.12(a).  Here are some common conditions members of a California LLC could put into the LLC’s Operating Agreement that must be satisfied before the Operating Agreement can be modfied:

  • The amendment must be approved by a person or entity that is not a member of the LLC.  For example, Homer Simpson’s three children have a CA LLC with an Operating Agreement that says the Operating Agreement cannot be modified unless their father Homer Simpson approve the change.
  • The Operating Agreement cannot be amended unless until after a specified date.
  • The Operating Agreement cannot be modified unless at least two thirds of the members approve the change.
By |2016-12-13T21:20:13-07:00March 23rd, 2015|Categories: CA Law, FAQs, Operating Agreements, Operating LLCs|0 Comments

California Agent for Service of Process

Every new limited liability company formed in California and every LLC formed outside California that intends to register to do business in California must appoint an agent for service of process, aka resident agent.  New LLCs must designate the agent for service of process in the Articles of Organization, Form LLC-1.

The agent for service of process can be a person or a corporation that has complied with Corp C §17701.13(c).  Before a corporation (domestic or a foreign corporation registered to do business in California) can become an agent for service of process, it must file the certificate required by Corp C §1505 with the California Secretary of State. A general partnership, limited partnership and a limited liability partnership can never be an agent for service of process in Item 4 of Form LLC-1.

If a natural person is the agent for service of process the person must be a California resident.  Corp C §17701.139c). The person’s street address cannot be a post office box, but it can be a residence address or a business address.  The address should never include a c/o or “in care of” because the California Secretary of State will probably reject the Articles of Organization.

By |2016-12-13T21:20:13-07:00March 22nd, 2015|Categories: Articles of Organization, California Secretary of State, Formation Issues|0 Comments

Original Signature on Articles of Organization

Question:  When I file the Articles of Organization for my new LLC with the California Secretary of State will the Secretary of State accept Articles on which the organizer’s signature is a facsimile rather than an original signature?

Answer:  Yes, however, California law requires that the person who signs the Articles of Organization as the organizer retain the Articles of Organization with the original signature on it for five years.  See Corp C §17.1(d).  After it approves the Articles the Secretary of State will return the approved Articles with original signature to the company.  If it contains an original signature, then put the document in a safe place for the next five years.

By |2016-12-13T21:20:13-07:00March 18th, 2015|Categories: Articles of Organization, FAQs, Formation Issues|0 Comments

Manager Managed CA LLC Change to Member Managed

Question:  I formed a manager managed California limited liability company.  Can the members of the LLC change the form of management from manager managed to member managed by amending the Operating Agreement to state that the LLC is manager managed?

Answer:  No.  To change from manager managed to member managed, a California LLC must amend its Articles of Organization to provide in item 5 that the LLC will be managed by all of it members.  Of course the members should also modify the LLC’s Operating Agreement to provide for manager management.

To amend the Articles of Organization file Form LLC-5 with the California Secretary of State.

By |2015-04-30T00:26:21-07:00March 9th, 2015|Categories: Articles of Organization, FAQs, How Do I, Operating LLCs|0 Comments

Missouri Court Holds Minority Member can Pierce LLC’s Veil

Recently, in Hibbs v. Berger, the Missouri Court of Appeals ruled that a 5% minority member can pierce the veil of the LLC.  This case shows how extensive the court’s power is in determining these types of cases.  All LLCs should be knowledgeable about veil piercing, and also what can be one to prevent it.

In Hibbs v. Berger, the plaintiff (Hibbs) was an ex-employee of Tavern Creek, an LLC.  The plaintiff had no voting or management rights in this LLC, which were split on a 50-50 basis between Tavern Creek and Wood Nuts, another LLC.  Tavern Creek and Wood Nuts appointed Taylor and Berger, respectively, as co-managers of Tavern Creek.  Though Hibbs had no voting rights or management rights, he did acquire 5% of economic interests when his employment agreement was revised (once Wood Nuts became 50% owner).

Soon after the new employment agreement in 2007, Tavern Creek experienced financial troubles.  Wood Nuts would assist Tavern Creek during these times by loaning Tavern Creek money.  Despite this, Tavern Creek was unable to recover, and defaulted on these loans.  Wood Nuts exercised its rights under the agreement of these loans, and  obtained all collateral as satisfaction in 2009.  During this time, Hibbs was working for Tavern Nuts.  He was not fully paid for his commission earned in 2007, and never paid for the commission in 2008.  In late August of 2008, Hibbs was terminated and then re-hired as an employee-at-will.  Hibbs then left Tavern Creek two months later.

In January 2010, Hibbs filed a claim against Berger and Taylor, in an attempt to pierce the corporate veil.  The defendants motioned for summary judgment, which was granted, but Hibbs appealed.  The Missouri Court of Appeals began by acknowledging that members of an LLC usually are not responsible for debts of the LLC.  Then, however, the court acknowledged a three-prong test that determines if the court will piece the business entity’s veil.  The parts of this test include:

“(1) Control, not mere majority or complete stock control, but complete domination, not only of finances, but of policy and business practice in respect to the transaction attacked so that the corporate entity as to this transaction had at the time no separate mind, will or existence of its own; and

(2) Such control must have been used by the defendant to commit fraud or wrong, to perpetrate the violation of a statutory or other positive legal

(3) The aforesaid control and breach of duty must proximately cause the injury or unjust loss complained of.”

After establishing the rule for veil piercing, the Missouri Court of Appeals specifically discussed if an LLC’s minority member can pierce the entity’s veil.  The court mentioned that this was a case of first impression, meaning that the Court of Appeals has not dealt with this type of case.  Because of this, the court looked to a case in which the District of Columbia Court of Appeals held that a minority shareholder is not prohibited from piercing the veil of the business entity.  The Missouri Court also stated that precluding a minority member from piercing the corporate veil would be unfair to those members.  For these reasons, the Missouri Court of Appeals held that the minority member of an LLC can pierce the entity’s veil, if the plaintiff meets the requirements set by the three-prong test.

Although it was eventually determined that this plaintiff did not meet the requirements to overcome summary judgment, the case provides an important lesson.  LLCs and other business entities should not assume that a member is unable to pierce their entity’s veil.  These managers must know the veil-piercing standard of their formation state, and take steps to ensure that a disgruntled member cannot hold the majority member(s) personally liable.

 

 

By |2016-12-13T21:20:14-07:00February 25th, 2015|Categories: Lawsuits, Members, Operating LLCs, Veil Piercing|0 Comments

LLC Lawsuits- Direct or Derivative

Prior to the creation of the first limited liability company (LLC), shareholders were able to sue the corporation through a direct or derivative lawsuit.  Classifying the claim as direct or derivative would determine the procedure of the complaint, in addition to determining the remedy and likely outcome.  Now, with the popularity of the LLC, the derivative and direct classifications are applying to members’ complaints about the operation of the LLC.  Since LLC law does not have too many of these cases, it is beneficial to look at the corporate law (especially because LLC law often borrows from corporate law).  In fact, as seen in several states, it is often corporate case law which determines the outcome of LLC disputes between a member and the LLC itself.  For these reasons, a brief description of the differences between a direct and derivative lawsuit would be beneficial not only to a shareholder, but also to a member or manager of an LLC.

Direct

A direct claim allows the member or members to pursue the lawsuit in their own name(s).  This is allowed only if the member or group of members were injured by the actions of the LLC, and it is those members (not the LLC) who would receive the benefit of recovery.  However, if the entire LLC was injured by the action of a manager, the claim does not classify as direct.  An example of a direct claim would be if the voting rights or interests of a certain member were lost.  Here, it is not the entire LLC that is harmed, but only that member.

Furthermore, for a direct claim, the remedy sought is usually equitable, or non-monetary.  In the example above, the proper remedy would not be money damages, but an injunction to prevent the LLC from harming the voting interest of the particular member.  Overall, if a member is injured (not the LLC), and the remedy is equitable, then the claim is direct.

Derivative

A derivative claim is much more complicated than a direct claim.  A derivative lawsuit is one in which the entire LLC is harmed (by the LLC), rather than a specific member bring injured.  In other words, the lawsuit is brought by a member on behalf of the entire LLC, against the LLC itself.  An example of a derivative law suit would be if the LLC engaged in an agreement to pay an extraordinary amount of money to an individual who is not performing.  Here, a law suit would benefit the entire LLC, and the remedy would be the money lost on the violated agreement.

A key difference between a derivative and direct lawsuit is that the concept of “demand.”  Under a derivative lawsuit, the plaintiff is required to either make demand of the company, or prove that demand of the company is futile.  Demand refers to demanding the LLC take on the case.  Since the lawsuit is meant to benefit the entire LLC, courts have mentioned that the LLC should have the ability to investigate and determine the validity of the case itself.  However, it is apparent that if an LLC hears about the complaint and chooses to investigate, a conflict of interest could result in the LLC dismissing a valid claim, rather than bringing the suit.  Furthermore, since courts often defer to the business judgment of business entities like the LLC, there is a low likelihood that a plaintiff will be able to show that the LLC wrongfully dismissed the suit.

For all of the problems associated with making demand of the company, the plaintiff in this type of suit usually chooses to show demand futility.  To show demand futility, the plaintiff usually has to show that there is reasonable doubt that the managers and directors are independent, or that there is doubt that the agreement/transaction was a valid business decision.  In California, however, there is not a specific test to show demand futility.  If demand futility is shown, then the suit proceeds.  If not, then the suit is dismissed because demand should have been made.

The next step in a derivative lawsuit is based on whether the LLC has hired a special litigation committee (SLC).  An SLC is a committee often employed by the LLC to settle these types of disputes.  A court will defer to the decision of the SLC, as long as the SLC is independent.  To test this, courts analyze how the SLC came to it’s conclusion, evaluating whether the SLC used good faith in it’s reasonable investigation.  If the SLC was not independent, the court could apply it’s own business judgment to determine the value of the suit.  After this, the derivative suit has taken all possible steps, and the suit either proceeds, settles, or has been dismissed along the way.

As one can easily imagine, the direct law suit is much easier for a plaintiff to bring than the derivative suit.  On the other hand, the LLC would prefer a suit to be classified as derivative, because of the multiple opportunities to dismiss the suit, through the demand doctrine or an SLC.  Therefore, if an issue arises in your LLC, be sure to investigate the complaint to determine what steps can and should be taken to protect yourself and the LLC.

 

 

By |2016-12-13T21:20:14-07:00February 25th, 2015|Categories: Lawsuits, Member Disputes, Miscellaneous|0 Comments

Can a California LLC Have an Oral Operating Agreement?

Question:  My California LLC has three members who never signed an Operating Agreement.  The members agree from time to time as to certain terms and conditions applicable to the LLC such as what actions the manager can take without the approval of all of the members.  If the members of a California limited liability company agree on an oral Operating Agreement is it legally enforceable?

Yes:  California RULLCA Section 17701.02(s) states:

Operating agreement” means the agreement, whether or not referred to as an operating agreement and whether oral, in a record, implied, or in any combination thereof, of all the members of a limited liability company, including a sole member.”

Caution:  As LLC attorneys who have formed 4,400+ LLCs my father and I have seen too many disputes among members who never signed an Operating Agreement and who cannot agree on LLC issues.  LLC members who don’t have a signed Operating Agreement and rely instead on oral agreements are “cruisin” for a “bruisin.”  Oral agreements result in he said she said disputes among members.  If the members resort to litigation to settle a dispute it is a roll of the dice as to who the jury will believe.

If your California LLC does not have an Operating Agreement signed by all of the members then do yourself and the other members a big favor and arrange for all the members to sign a good, custom Operating Agreement drafted to comply with California’s new Revised Uniform Limited Liability Company Act that took effect on January 1, 2014.

By |2015-02-25T20:03:50-07:00February 9th, 2015|Categories: FAQs, Formation Issues, Operating Agreements|0 Comments

Can People Agree on the Contents of an Operating Agreement before Forming an LLC?

Question:  I understand that California LLC law does not require my multi-member California LLC to have an Operating Agreement signed by all of the members.  However, I know that it is prudent that every California LLC have its members sign an Operating Agreement.  Several of us want to form a California LLC, but I am concerned that after we form the LLC we may not agree on the terms and conditions of the Operating Agreement.  Can the prospective members of a to-be-formed California LLC agree on the contents of an Operating Agreement before they actually file the Articles of Organization and form the LLC?

Answer:  Yes.  California RULLCA Section 17701.11(c) states:

“Two or more persons intending to become the initial members of a limited liability company may make an agreement providing that upon the formation of the limited liability company the agreement will become the operating agreement. “

I recommend that if you are considering forming a California LLC with multi-members that would involve a lot of money, services or members’ time, all of the prospective members should definitely sign a contract in which they agree that on forming the LLC each of them will sign the Operating Agreement that is attached as an exhibit to the contract.  The agreement to sign an Operating Agreement must be created as part of a legally binding contract.

Call me, California LLC attorney Richard C. Keyt, J.D., M.S. (accounting), at 480-664-7472 if you need a contract among prospective members to sign an Operating Agreement.

By |2019-03-17T11:15:54-07:00February 8th, 2015|Categories: FAQs, Formation Issues, Operating Agreements|0 Comments

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