On LLC Agreements and Internal Affairs (Part 1 of 2)

If your family business, or part of your family business, is organized as a limited liability company ("LLC"), you should take care to specifically address matters of "internal affairs" in your LLC agreement (a/k/a operating agreement).  You should not rely on rules as they exist in common law, state statutes, or off-the-shelf LLC agreements.  Rather, you and the other owners (a/k/a members) of your LLC should execute an LLC agreement that is tailored to your family's objectives and expectations. This post (including part 2 of 2) suggests some specific provisions to consider.

Note, this post has nothing to do with the 1990 American film, "Internal Affairs," in which Richard Gere stars as "a suave womanizer, clever manipulator, and corrupt policeman who uses his fellow officers as pawns for his own nefarious purposes while showing a tender side as a devoted father." Wikipedia, "Internal Affairs (film)." In fact, the purpose of this post is to help you avoid drama, intrigue, and anything that could be the subject of a Hollywood thriller.

What are "internal affairs"?

In the context of a corporation, the U.S. Supreme Court defined "internal affairs" as "matters peculiar to the relationship among or between the corporation and its current officers, directors, and shareholders." Edgar v. MITE Corp. (1982).  In an LLC, therefore, internal affairs involve the following:

●    The relationship between the managers and the LLC;

●    The relationship between the owners and the LLC;

●    The relationship between the managers and the owners; and

●    The relationship between an owner and the other owners.

For example, the duties that the managers owe to the LLC and its owners, and the duties, if any, that the owners owe to one another are matters of internal affairs.  The extent of or limitations on an owner's ability to enforce those duties through litigation also are matters of internal affairs.  Most of the subject matter of an LLC agreement relates to internal affairs.

When you organize an LLC under the laws of a particular state, generally the laws of that state will apply to the LLC's internal affairs.  The applicable law will include default rules set forth under the state's statutes relating to LLCs and also may include elements of the state's common law (i.e., traditional duties, rights, and rules of conduct developed by case law).

It may seem odd to speak of "common law" with respect to LLCs because LLCs did not exist as a type of business entity until about thirty years ago.  LLCs, however, involve agency relationships and fiduciary roles that are similar to those that are present in more traditional forms of doing business, such as partnerships and corporations.  Some courts apply common law concepts to LLCs based on these similarities.  In fact, the LLC statutes of many states acknowledge the possible application of common law concepts to activities of LLCs and their constituents.  For example, the Revised Uniform Limited Liability Company Act ("RULLCA") includes a section that says, "Unless displaced by particular provisions of this [act], the principles of law and equity supplement this [act]." RULLCA, Sec. 111.

Members of an LLC can, and often should, change the statutory and common law rules that apply to an LLC's internal affairs by express terms of an LLC agreement.  The default rules are a blunt instrument because they apply to all LLCs, ranging from a single member LLC that holds only one asset to a manager-managed LLC with many owners, many employees, and complex business operations.  Therefore, it is important to understand the law that applies to your family LLC and then use an LLC agreement to adapt the law to better fit the nature of your business and the objectives and expectations of your family members.

Even if you own a single-member LLC you should consider executing an LLC agreement with appropriate provisions regarding internal affairs.  This is because, if ownership changes, especially involuntarily, the successors in control could try to assert claims against you based on duties that you theoretically owed to the LLC in a management capacity.  For example, if the LLC fell into receivership, the receiver could try to assert that you, as a managing member, conferred unfair benefits on yourself at the expense of the LLC, unless such benefits were permitted under the LLC agreement.

Why are internal affairs important in a family business?

Internal affairs are particularly important in a family business because the business relationships defined as "internal affairs" are made more complicated and sometimes more intense by the personal relationships of the parties involved.

Internal affairs will include legal duties that some family members owe to other family members by reason of their respective roles in the family business. Sometimes those legal duties are reciprocal, but often they are not.  Usually the law imposes greater duties on family members who have greater power or authority over business affairs and thus may have a greater impact on the value of the business for all family members who own an interest.  As William Lamb, Winston Churchill, and Spider-Man's uncle observed, "With great power comes great responsibility."

When an owner of a family LLC brings a lawsuit against another family member-owner, it is usually a matter of internal affairs.  Often the plaintiff claims that the defendant breached his or her duties to the LLC or the other owners.  An LLC agreement can include provisions that:

●    Expand or limit an owner's or manager's duties to the LLC and other owners;

●    Delineate an owner's right to pursue a remedy when another owner or manager breaches such duties; and

●    Indemnify an owner or manager from personal liability arising out of his or her duties to the LLC or other owners.

Part 2 (of 2) of this post suggests some provisions that you should consider including in your family LLC agreement…

Gregory Monday