The following was produced by Shah & Associates, P.C.
Since New Jersey adopted the Revised Uniform Limited Liability Act (“New Act”) in September of 2012, many advisors have been left wondering about how it might affect their clients. The New Act makes sweeping changes in a variety of categories that may catch unprepared businesses off-guard.
The New Act will become operative on March 18, 2013 for all new LLC’s and will apply to all existing LLC’s beginning on April 1, 2014. Since it is based upon a uniform law which has already been adopted in other jurisdictions, the New Act will provide New Jersey with case law from other jurisdictions and various other scholarly analyses of the New Act.
Whether your client is planning on forming an LLC or currently has a membership interest in an LLC, the New Act makes significant changes which may adversely affect your client’s interests. However, well-drafted Operating Agreements and other corporate governance documents customized for each LLC will help to mitigate problems that can arise with the New Act. This article should serve as a primer to what pitfalls await the unprepared business.
Below are some of the most significant changes:
1. Profit, Loss and Distribution Allocations
The current law provides for allocations of profit and loss based upon the capital contributed by each member. Under the New Act, allocations of profit and loss will be made on a per capita basis. For example, assume Member John owns 85% of an LLC and Jane owns 15% of the LLC. Member John makes a capital contribution of $85,000 and Member Jane makes a capital contribution of $15,000 to the LLC. Under the old law, John would receive 85% of the profits and Jane would receive 15% of the profits. Under the New Act, John and Jane would each receive 50% of the profits.
In addition, the New Act prohibits an LLC from making distributions to members if the LLC cannot pay its debts as they become due or the LLC’s assets would be less than its liabilities after giving effect to the distribution. An LLC’s liabilities include the amounts needed to satisfy any preferential rights of members payable upon the dissolution of the LLC.
2. Voting and Management
The New Act significantly alters voting, management, and decision-making in the LLC. Under the default rules of the New Act, Members will makes decisions on a per capita (one-member one-vote) basis in the ordinary course of business. This gives each member equal rights in management regardless of the capital contributed by each member. Matters outside the ordinary course of business (extraordinary matters, e.g. mergers) must be decided unanimously.
By way of example, Member John owns an 85% interest in the LLC and Jane owns a 15% interest. Even though John owns a significantly higher portion of the LLC, John and Jane would have equal (50/50) voting power for ordinary matters under the default provisions of the New Act. For extraordinary matters (such as mergers), John and Jane would have to unanimously agree on any extraordinary matters. However, the default voting and management provisions can be altered in the LLC Operating Agreement in order to avoid the issues posed in the above example.
Another new concept introduced by the New Act provides for alternative management structures, such as a board of directors and officers, similar to corporation management structures.
3. Oral and Implied Operating Agreements
Under the New Act, Operating Agreements are no longer required to be in writing. Instead, they may be oral, written or implied based on the way the LLC has operated. In addition, an Operating Agreement may provide that any amendment to the Operating Agreement would require the satisfaction of a condition or the approval of a person not a party to the Operating Agreement. This provision is especially relevant to financing arrangements, allowing lenders to assert more control over how an LLC operates.
4. New Remedies for Minority Members
Minority members are now permitted to seek a court order dissolving the LLC on the grounds that the managers or the controlling majority have acted or are acting in a manner which is oppressive and was, is or will be directly harmful to the minority member. A minority member may also apply for the appointment of a custodian to manage the LLC’s affairs on the grounds that the LLC’s activities are unlawful or that the majority members or managers have acted illegally, fraudulently, or oppressively to the minority member.
5. Fiduciary Duties to the LLC and their Limitations
The New Act imposes newly defined duties on members and managers of LLCs, which may be modified or restricted by the Operating Agreement with few exceptions. Specifically, the New Act codifies the duty of loyalty, the duty of care, and the obligation of good faith and fair dealing in the discharge of a member’s duties to the LLC. The duty of loyalty includes refraining from competing with the LLC and accounting to the LLC for any profits or benefits derived by a member or manager from misappropriating an opportunity belonging to the LLC.
The Operating Agreement may eliminate or limit a member or manager’s liability to the LLC and members for money damages, except for (1) breach of the duty of loyalty; (2) a financial benefit received by the member or manager to which the member or manager is not entitled; (3) an improper distribution; (4) intentional infliction of harm on the LLC or a member; or (5) an intentional violation of criminal law. The Operating Agreement can eliminate or restrict the elements of fiduciary duties, but only ifelimination or restriction of fiduciary duties is “not manifestly unreasonable,” to be determined by a Court under specified circumstances.
If the LLC is member-managed, the new duties and obligations are imposed on the members. However, if the LLC is manager-managed, the duty of loyalty and duty of care are imposed on only the managers, but the obligations of good faith and fair dealing in the discharge of their duties continues for members and managers in an LLC.
In order to provide maximum flexibility to the LLC, the New Act allows an Operating Agreement to include a mechanism for disinterested and independent persons, after full disclosure of all material facts, to authorize or ratify an act that violates the duty of loyalty. Even if the LLC agreement does not restrict or eliminate the duty of loyalty, the members may unanimously authorize or ratify a member’s act that violates the duty.
6. Indemnification from Claims and Demands
The New Act requires an LLC to indemnify and hold harmless members, managers, officers and directors under certain specified circumstances so long as the member, manager, officer or director complies with the fiduciary duties enumerated in the New Act.
7. Statement of Authority
An LLC may now file a “statement of authority” with the Division of Taxation or with the office for recording transfers of real estate (usually the County Clerk’s office). The statement of authority authorizes specified individuals or entities to make binding decisions on behalf of the LLC.
8. Domestication and Conversion
The New Act provides for conversion, which allows a New Jersey LLC to convert to a different form of New Jersey Business Organization, such as Corporation or Limited Partnership, and will also allow a non-LLC form of Business Organization to convert to a New Jersey LLC. This may assist businesses which have experienced changed circumstances such that the current form of entity is no longer appropriate.
In addition, the New Act provides for domestication, whereby an LLC may choose to operate under the laws of a different state or a foreign LLC may choose to operate under the laws of New Jersey. However, both conversion and domestication can only be accomplished where the laws of the foreign state must authorize conversion and domestication.
9. Member Dissociation
Under the New Act, Members who withdraw or resign from an LLC will no longer be entitled to receive the fair value of their LLC interest as of the date of resignation. Instead, the resigning member is dissociated as a member and only has the rights of an economic interest holder, with no management or voting rights. However, a Dissociated Member will be entitled to receive distributions, if any, made by the LLC. The New Act also provides that withdrawal does not discharge the person from any debt, obligation or other liability to the company or the other members that was incurred while the disassociated member was a member of the LLC.
The New Act provides that any distributions to members before the dissolution and winding up of the LLC are to be made to members in equal shares unless the members of the LLC agree otherwise.
As illustrated above, sweeping changes in the LLC statute will affect both new LLC’s and existing LLC’s. If your clients own Membership Interests in an LLC, now is the time to talk to them about the potential for disaster and the solutions to prevent it.
For more information on how to take steps forward to protect your investments please contact our office.
Ralph Anderson: email@example.com
Pursuant to IRS Circular 230 regulation: "Any tax advice expressed was not intended or written to be used, and cannot be used, by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. If this advice was written to support the promotion or marketing of partnership or other entity, investment plan, or arrangement to any taxpayer then the advice was written to support the promotion or marketing of the matters addressed by the written advice and the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax adviser."