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

This is part 2 of a post about why owners (a/k/a members) of a family business entity that is organized as a limited liability company ("LLC") should expressly and thoughtfully address matters of "internal affairs" in the company's LLC agreement (a/k/a operating agreement).  In part 1 of this post, I defined "internal affairs" and explained why internal affairs are especially important in a family-owned LLC.  In this post, I will suggest some specific elements of internal affairs that you should consider addressing in an LLC agreement for your family-owned LLC.

Agree to Choice of Law; Define "Internal Affairs".

You can organize your LLC under the law of any U.S. state (or you can change an existing LLC's state of organization to another state), even if you do not intend to do business in that state.  In most cases, the law of the state in which your LLC is organized will govern your LLC's internal affairs.  This is important because the statutes and common law of different states have different rules about internal affairs and how an LLC agreement is interpreted and enforced.

To be especially clear, your LLC agreement should define "internal affairs," and should expressly provide that the law of the state in which your LLC is organized will govern all matters of internal affairs.  See part 1 of this post for one possible definition of "internal affairs."

Separate Management from Ownership.

An LLC can be managed by "managers" or by its members (i.e., owners).  In matters of internal affairs, however, a person's duties to the LLC and the other owners may be different depending on whether they are exercising their powers to manage the LLC or exercising their rights with respect to their ownership interest in the LLC.  Therefore, you should consider organizing your LLC as a "manager-managed" LLC (rather than a member-managed LLC), so that your LLC agreement can be more clear about the duties and powers that apply to management activity as distinct from the duties (if any) and powers that apply to the exercise of ownership rights.

Define the Fiduciary Duties of Managers and Owners.

Under common law (i.e., traditional duties, rights, and rules of conduct developed by case law), managers of a business usually are deemed to owe fiduciary duties to the business and its owners.  Those duties typically are expressed as (a) the duty to act with due care in managing the business and (b) the duty to act in good faith and with loyalty to the business and its owners.  Sometimes, the common law also imposes good faith and loyalty duties on an owner who holds voting control of a business.

Some state LLC statutes limit these duties, categorically or in scope. Some state LLC statutes supersede common law with respect to these duties, but other state LLC statutes do not. Most state statutes allow an LLC agreement to waive duties of due care, but not duties of loyalty.  Some state statutes allow an LLC agreement to waive all duties except the duty of good faith and fair dealing with respect to honoring the terms of the LLC agreement.

Therefore, your LLC agreement should expressly state, with respect to managers and with respect to controlling owners, which duties apply and which duties are waived, to the extent possible under state statute.

Your LLC agreement also can be specific about particular activity that may be deemed to be in violation of a manager's or owner's duties, such as competing with the LLC, purchasing property from the LLC, or taking loans from the LLC.  Your agreement, however, should provide a means for approving activity or transactions that might otherwise be prohibited.  For example, your LLC agreement could allow managers to purchase LLC property or sell property to the LLC if a majority of informed, disinterested owners approve the transaction.

For an excellent discussion of the duties of LLC managers and owners (i.e., members), as well as language that could be adapted for use in an LLC agreement, see Section 409 of the Revised Uniform Limited Liability Company Act ("RULLCA").  Here is a link to the annotated RULLCA…


Provide a Process for Representing the LLC in Internal Affairs Claims.

If a manager or owner breaches a duty owed to the LLC, as distinct from a duty owed directly to a particular owner, the law of some states would allow any of the owners to bring a legal action to seek a remedy on behalf of the LLC (similar to the concept of derivative lawsuits in the corporate context). The law of other states would bar such lawsuits unless they were duly authorized, such as by majority vote of disinterested owners.

Your LLC agreement, therefore, should provide exclusive mechanisms for bringing a lawsuit on behalf of the LLC in matters of internal affairs.  You also should consider requiring such claims to be resolved by alternative dispute mechanisms, such as mediation and arbitration. (See my post "On Alternative Dispute Resolution for Family Business Owners," dated Monday, June 27, 2020.)

Indemnify Managers and Owners.

The laws of most states, require an LLC to reimburse a manager or owner for legal fees and other costs or losses the manager or owner may incur due to a lawsuit brought against the manager or owner on a matter of internal affairs, if the manager or owner prevails in the litigation.  In some cases, the LLC must advance the costs of defending the manager or owner in the lawsuit, if the manager or owner agrees to reimburse the LLC if the manager or owner is the losing party in the litigation.

To remove uncertainty about the rights of managers and owners to be indemnified and receive advances under these circumstances, you should adopt express rules in your LLC agreement about indemnification and advances to managers or owners for claims arising out of internal affairs.

Be Specific about "Affiliates".

Sometimes an LLC interest is held in another LLC, a corporation, a limited partnership, or a trust, and such ownership can cause confusion regarding application of the terms of an LLC agreement or state statute or common law. For example, if an LLC interest is held in a revocable trust, it may be unclear whether the trust settlor, trustee, or beneficiary should be bound by the duties imposed on the LLC's owners. Similarly, if an LLC interest is held in another LLC that is owned by only one person, it is unclear whether the other LLC or the owner of the other LLC should be bound by the duties imposed on the LLC's owners.

Therefore, your LLC agreement should specify when provisions of the LLC agreement apply to a manager's or owner's affiliates, and then clearly define the term "affiliates."  The applicable provisions might involve the managers' and members' duties, but they also might include buy-sell triggering events.  For example, if a revocable trust owns an LLC interest, then the death of the beneficiary may be treated the same as the death of an owner, triggering the LLC's right to reimburse the trust's LLC interest.

Require all Interested Parties to Sign the LLC Agreement.

To ensure that the LLC agreement is enforceable against all of the relevant parties, you should require all owners (and perhaps spouses of owners) and managers to sign the agreement, and you should require an authorized person to sign the agreement on behalf of the LLC itself.  In addition, you should consider having affiliates also sign the LLC agreement, at least as to the provisions that might apply to them, such as provisions relating to noncompetition, conflict-of-interest, buy-sell obligations, and alternative dispute resolution.

I have many more thoughts on this topic, but I have to stop the post here. I will address some of these issues in greater detail in future posts.

Gregory Monday