Virginia State Bar

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Trusts and Estates

A Section of the Virginia State Bar.

Spring 2015 Newsletter

Newsletter - Trusts and Estates

Volume 22, No. 12

The Top Five Mistakes in Drafting LLC Agreements You Will Never Guess How to Keep Charlie Sheen out of Management!

By Kathleen A. Kelley

Trusts and estates lawyers form limited liability companies (individually, an “LLC”) for a variety of reasons: liability reduction, the consolidation of estate assets, a mechanism in the event of incapacity, contractual dispute resolution, and the ability to transfer interests with a minority discount are just some examples. A successful lawyer will use the LLC form to provide all of these benefits and more for the estate; however, for the unwary, drafting the LLC Operating Agreement can thwart some of the best laid plans and resemble a Kardashian wedding banquet.

This article focuses primarily on typical mistakes made in drafting Operating Agreements, but the issues considered herein also translate to the corporate, partnership, or limited partnership arenas.

1. Not Defining a “Unit” – Three and a Half Units?

In Virginia, members of an LLC own membership interests in the company.1 Under the Virginia Limited Liability Company Act (the “Virginia LLC Act”), a membership interest is defined as “a member’s share of the profits and the losses of the limited liability company and the right to receive distributions of the limited liability company’s assets.”2 A member’s membership interest consists of the member’s entire bundle of rights with respect to the LLC. Each member owns a membership interest - one membership interest, not several membership interests. Unlike Virginia corporations in which shareholders own shares of stock, a membership interest is not divided into separate shares or units; the division of membership interests must be done through the terms and conditions of the LLC’s Operating Agreement.

Frequently, the terms of the Operating Agreement provide that the LLC will only issue a certain number of “Units,” similar to the restrictions on corporations. A common mistake found in Operating Agreements is the omission of a definition of “Units.” Either the definition is missing entirely (the drafter believing Unit is the term for ownership of the LLC) or provides some definition that Units are membership interests in the LLC (but each member only has one).

The savvy drafter will provide a definition of Units, such as “a representation of a fractional part of all of the Membership Interests (as defined in the Statute) owned by all of the Members in the LLC.” This way, the definition refers back to the statutory definition, provides for an understanding of one hundred percent of the membership interests in the LLC, and then further divides those membership interests. With a good definition of Units, the drafter can provide for Non-Voting Units, Voting Units, Class A Units and so forth, further delineating the rights of ownership in the LLC.

2. Exit Strategies – Celebrity Break-Ups.

After reading popular articles on the Internet, clients may be well aware of the numerous celebrity couples that are no longer together, however, that does not always translate into the realization that a business relationship may not last happily ever after. While this may not appear to be an issue for trusts and estates lawyers, lawyers must counsel their clients on exit strategies should the LLC have more than one member or have the possibility of more than one member.

Many clients have heard of “Buy-Sell” Agreements – an arrangement in which one of the parties buys out another party for a pre-determined price at a pre-determined time. The concept is that while everyone gets along the parties agree how they are going to break up. The pre-determined price need not be a set price; a formula or mechanism to determine the value is all that is needed. The pre-determined time can be the death or incapacity of one of the parties, but it could also be at a deadlock. A typical drafting strategy would be that a “Deadlock” is called at the point when the parties have been at an impasse for two consecutive manager meetings, or sixty days, whichever is shorter. Upon a Deadlock, one of the parties (“Gwyneth”) can then purchase the other party’s (“Chris”) interests for a named price, or Chris can buy Gwyneth’s interests for that named price. The plan is to provide conscious uncoupling, in a smooth process.

Trusts and estates lawyers may think: “but my client will be the sole owner of this business, I don’t need to worry about disagreements!” This is true, but you must also analyze the ultimate end of the business. If the LLC is intended to continue past the death of the client and pass to the client’s children or to multiple parties while remaining an LLC, a properly drafted exit strategy is essential.

3. Management Issues - Who’s The Boss?

Many times when a client asks you to transfer assets or real property into an LLC, the intent is that the client will control the business or assets while he or she is alive and upon the death of the client, the LLC is no longer needed. The LLC is then dissolved, the assets liquidated, and the proceeds go to a trust or directly to descendants. If the intent is that someone other than the client manages the business, or if the LLC is intended to continue past the death of the client, consideration must be provided to management.

Corporations are relatively easy to manage: they will have shareholders which elect a Board of Directors, and then the Board sets long-range plans and elects officers to implement those plans. Additionally, the Virginia Stock Corporation Act and Virginia’s case law protects minority shareholders against (some) oppression from majority owners or directors.3 In contrast, LLCs typically have a single manager or a board of managers to make decisions and may have officers to implement day-to-day business, but the management structure is not set by statute. The Virginia LLC Act is heavily deferential to the contractual language in the Operating Agreement.4 Case law setting forth guidance on LLC management is still sparse in Virginia.

With the Operating Agreement, the first question is who will manage the LLC: a single manager or a board of multiple managers? (Of course, the LLC can be member-managed or grand-poobah-managed, but for the sake of this article, that is considered management by a single manager.) With a single manager, that manager must be trusted implicitly by the other parties. With several managers on a board, there is a much greater possibility of a deadlock in any decisions. Additionally, who will choose the manager(s) and how is a manager removed? With this open-ended structure, the drafter must think through and anticipate all of these variables.

One solution to these problems is to keep as much of the power and management as possible with the client for as long as possible: issuing “voting” units to the client and “non-voting” units to the other members, and providing that the managers may only be elected or removed by the client for as long as the client is living and competent, and upon the client’s death that power passes to a pre-selected individual. Alternatively, if the drafter is working with a family consisting of multiple generations, it is possible to draft language providing that the individual descendent starts out with a “non-voting” interest, but can then receive “voting” interests upon the death of one or more ancestors or upon the attainment of a certain milestone. Of course, as with the problem of a fertile octogenarian, this can get tedious and more and more remote for drafting.

4. Missing Transfer Restrictions – Charles is Not in Charge.

Many times assets are placed into an entity so the client can obtain various “discounts” on the LLC ownership and gift more ownership than if the assets were all reduced to cash. Discounts can be provided for lack of marketability (who would want to buy 2% of a business) or lack of control (that 2% right won’t change anything). Ownership of the entity may be disbursed throughout many individuals. Each of those individuals may then want to gift or possibly sell the interest to others. At that point, the client could find himself or herself operating a business or managing an LLC with Charlie Sheen.

A well drafted Operating Agreement will include provisions allowing certain types of transfers (typically defined as “Permitted Transfers”), and disallowing all other transfers. Normally, transfers for the owner’s own estate planning or transfers approved by the manager (which would be controlled by the client or client’s representative), will be allowed.

Regardless of the restrictions in the Operating Agreement, transfers may occur by operation of law: death, bankruptcy, or divorce are examples. In that case, the member’s ownership interest will then pass automatically to the member’s estate, to the trustee in bankruptcy, or through a court proceeding.

In order to fix this problem, the drafter should include language in the Operating Agreement that should these “involuntary transfers” occur, what is transferred is solely the economic interest, not a “membership” in the LLC, and that the LLC has a right of first refusal in the interest before it is formally transferred. This language would allow the manager to admit the new holder, if the new holder is an appropriate member, or to purchase the subject membership interest for a pre-determined price, if the new holder is not an appropriate member. Regardless of the actions taken, with an effective Operating Agreement, at no point would Charlie Sheen be able to participate in management, unless the client is Mr. Sheen, of course.

5. Failure to Consider Fiduciary Duties – Law and Order: LLC Manager Edition.

Probably the most discussed issue with respect to LLCs within the legal community in the past few years has been the fiduciary duties that managers, members, and officers of an LLC owe to the LLC. Delaware’s judiciary spent many years arguing about the existence of “default” fiduciary duties and the ability of members to contract out of those default duties. Eventually, Delaware’s legislature acted so that it is clear that for a Delaware LLC, “[fiduciary] duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.”5

Under Virginia law, directors of a corporation are subject to two fundamental fiduciary duties: the duty of care and the duty of loyalty.6 The traditional duty of care requires that managers or directors be attentive to the business and inform themselves of all material facts regarding a decision before taking action. The traditional duty of loyalty requires that managers or directors act in the best interests of the corporation and not further their personal gain at the expense of the corporation.

In contrast to the corporate statute, the Virginia LLC Act only expressly provides for a duty of care: “A manager shall discharge his or its duties as a manager in accordance with the manager’s good faith business judgment of the best interests of the limited liability company.”7 There is no provision in the Virginia LLC Act similar to that found in the corporate statute, requiring that managers avoid transactions involving a conflict of interest. Additionally, the United States Bankruptcy Court for the Western District of Virginia recently refused to impose a duty of loyalty on a manager of an LLC, finding that no such duty existed under the statute or the common law.8

With this (and the dearth of Virginia LLC case law) in mind, the careful drafter should consider what fiduciary duties are appropriate in the situation and include the standard in the Operating Agreement. Clients who desire to have the managers of the LLC subject to fiduciary duties, should state those fiduciary duties in the Operating Agreement. Drafting such provisions can even be as simple as “The Managers [and Officers] shall owe the same fiduciary duties to the Company that directors of a Virginia corporation owe to a corporation.”

Conversely, there may be situations where the client desires to modify or eliminate fiduciary duties owed to the LLC. In the case of a family owned LLC, the specific member serving as manager or on a board of managers may have other business lines or opportunities, and presenting each opportunity he or she wants to pursue independently may be unreasonable. In another case, a manager may serve at the appointment of a specific family branch, and want his or her loyalties to go to that family branch rather than to the LLC as a whole.

There are several possible approaches to addressing these situations. First, consider forming a Delaware LLC rather than a Virginia entity for the certainty. Second, consider narrowly focusing the “Business” or “Purpose” of the LLC. For an example, if the purpose of the LLC is to develop and manage real property located in X neighborhood, it is unlikely a manager would be subject to a breach of loyalty claim for developing real property located would not be considered a breach, along with robust exculpation and indemnification provisions, may work, although this approach still involves risk.

Although far from all the considerations that must be evaluated when drafting or reviewing LLC Operating Agreements, this article attempts to highlight some of the important points. The most frequent mistakes come from not thinking through the possibilities and planning for the “what-ifs.” With the proper counsel, your client can stay out of the entertainment pages and stay comfortably in the “Business” section.

Kathleen A. Kelley is a Member of Protorae Law in Tysons Corner, Virginia, where she practices general corporate law with a particular emphasis on mergers, acquisitions, joint ventures and private equity transactions. She has significant experience forming, organizing and managing all types of Delaware, Virginia, Maryland and DC entities, including corporations, limited liability companies, limited partnerships, general partnerships and statutory trusts. Ms. Kelley is admitted to practice in Virginia and Delaware and is a member of the Virginia State Bar and the Fairfax Bar Association.

Ms. Kelley received her Juris Doctorate, cum laude, from Washington & Lee University School of Law, and received her Bachelor’s degree from the University of Virginia in History and Middle East Studies. Ms. Kelley lives in Falls Church with her husband and two sons. Should Mr. Charlie Sheen desire representation in forming or managing an LLC, Ms. Kelley would welcome the call.

(Endnotes)

1. VA. CODE ANN. §13.1-1002.

2. Id.

3. See VA. CODE ANN. §13.1-747; Colgate v. The Disthene Group, Inc., 85 Va. Cir. 286 (2012), appeal granted 2013 Va. LEXIS 60 (Apr. 25, 2013).

4. VA. CODE ANN. § 13.1-1023(A)(1) (“An operating agreement may contain any provisions regarding the affairs of a limited liability company and the conduct of its business to the extent that such provisions are not inconsistent with the laws of the Commonwealth or the articles of organization.”).

5. DEL. CODE ANN. tit. 6, § 18-1101(c).

6. See VA. CODE ANN. § 13.1-690(A); Willard ex rel. Moneta Bldg. Supply, Inc. v. Moneta Bldg. Supply, Inc., 258 Va. 140, 156 (1999) (noting the common law as opposed to statutory origin of the duty of loyalty); Simmons v. Miller, 261 Va. 561 (2001); Colgate, 85 Va. Cir. at 292 (“The statute sets the standard by which a director is to discharge those duties [i.e., the duty of care and duty of loyalty].”).

7. VA. CODE ANN. § 13.1-1024.1(A).

8. In re Virginia Broadband, LLC, 521 B.R. 539 (Bankr. W.D. Va. 2014).