It is quite common for members of a recently formed LLC accustomed to a corporate governance structure (that is, one having directors, a board of directors and officers versus members and managers) to direct their attorney to draft their operating agreement so that the LLC will have a corporate governance structure too. The intention being to permit the members to continue to use the governance structure with which they are most familiar. (Some clients even enjoy holding board of directors meetings and the formalities of decision making.) Ordinarily, this is accomplished by a provision inserted into the operating agreement that states, more or less, that:
The members agree that the company shall be governed by a board of directors [or managers] (the board) acting collectively; and not by its members. The board shall be comprised of three (3) directors appointed by the members [or by the company’s managers if the company is manager-managed] designated on the attached Exhibit A. The foregoing is an express delegation to the board by the members of their individual right to manage the company including all powers and authority necessary for, ancillary to, or implied by such delegation to direct, manage and control the company’s business and affairs. The board may appoint one or more officers having such titles, rights and duties as are commonly given to them and as prescribed in Chapter 1701 of the Ohio Revised Code. . .
The Ohio Limited Liability Company Act (the Act), Revised Code Chapter 1705, provides in at least one provision that this type of corporate governance structure is implicitly allowed under the Act because it furthers the right of LLC members to govern their internal LLC affairs as they see fit subject however to certain non-waivable provisions of the Act. Specifically: Revised Code Section 1705.081(D), Effect of Operating Agreement, states that “it is the policy of this chapter , subject to the limitations of (B) and (C) of this section, to give maximum effect to the principle of freedom on contract and to the enforceability of operating agreements. . .”
So, given that the LLC’s members have elected and contractually provided for a corporate governance structure are they then bound by implication by the other ancillary duties that fall upon corporate directors and/or officers under Chapter 1701?
First, an answer in a state that has addressed this issue recently.
In Delaware, this question was raised and answered last year in Obeid v. Hogan, C.A. No. 11900-VCL (Del. Ch. June 10, 2016) (Laster, VC). The plaintiff brought a derivative action claim against his two fellow members in two related Delaware LLCs each of which had a corporate governance structure. The two members promptly tried to delegate the evaluation of the derivative action claim to an independent third party (a former federal judge) as a special litigation committee of one person (of the LLC board) to decide the issue of whether or not the LLC should take on the derivative action claim. Mr. Obeid challenged this delegation as improper. The Obeid court agreed.
The LLC operating agreement provided that the business and affairs of the LLC would be managed by or under the direction of its board of directors as permitted by Section 141(a) of Delaware’s General Corporation Law (GCL). The court determined as a matter of fact that “[i]n this case, the corporate LLC agreement substantially re-creates the governance structure of a Delaware corporation using language drawn from the corporate domain. As noted, the corporate LLC agreement creates a manger-managed LLC and empowers the corporate board to act as the manager.”
The agreement also permitted the board to delegate its authority to a committee comprised solely of board members pursuant to Section 141(c) of the GCL. The Obeid court referenced these provisions as well as related language in the operating agreement and held that it was appropriate to draw analogies to Delaware corporate law in determining whether the board of the LLC could authorize a special litigation committee comprised of a single non-director member.
For multiple reasons, the Obeid court determined that delegating such authority to an officer or non-director of the LLC would “risk an improper abdication of authority” under Section 141(c). That is, the duty to evaluate a derivative action claim by the board of directors under Delaware case law, Zapata v. Maldonado, 430 A.2d 779 (Del. 1981), is a director duty that may not be delegated. So, notwithstanding relevant language authorizing the delegation of authority in the operating agreement itself the court concluded that: “By opting for a corporate-style governance structure, the drafters evidenced their desire to have corporate-style legal rules govern the entity.”
In its further analysis, the Obeid Court reasoned that, to the extent the operating agreement does not provide guidance as to certain governance questions:
- If the LLC is a member-managed entity, then “the parties should expect the court to draw analogies to partnership law” given that this structure follows the general concepts of general partnership law which is the antecedent to LLCs.
- If the LLC is managed by a single manager with mostly passive, non-managing members, then “the parties should expect a court to draw analogies to limited partnership law.”
- Finally, if the LLC is manager-managed but also has a board of directors (or arguably a board of managers) and/or other corporate features, then “the parties should expect a court to draw analogies to corporate law.”
Further, the court observed that if an LLC has adopted a corporate governance structure with a board of directors then the board may not delegate certain authority or decision making (where such is contravened by the GCL or Delaware case law) to an officer of the LLC as that would entail an improper abdication of authority. So, if you have a board of directors, the authority and function of the board under corporate law concepts must be respected and followed at least in Delaware. The LLC board may not delegate a duty or power that it would have had to exercise if it were a corporation.
There are three lessons here:
First, be aware of “The Law of Unintended Consequences” – do not be too clever with a novel or hybrid LLC governance structure or else you might find a court construing a body of law governing all or a part of your very clever LLC operating agreement that imposes additional corporate (or partnership) obligations or limitations that you did not anticipate.
Second, the law regarding LLCs is constantly evolving as more and more disputes between and among members wind their way through the courts. Attorneys should periodically re-visit (or raise with their clients) the issue of whether their operating agreements, as originally drafted, are now outdated in some material respect. Frequently clients believe that once the operating agreement is signed its language is set in stone notwithstanding later changes in case law and even statutory law.
Third, be careful what you ask for or you might just get it.
Part two of this post will attempt to address the following troubling questions in the context of an Ohio LLC mimicking a corporate governance structure:
- In an Ohio LLC, having adopted a corporate governance structure, are the actions taken at the board of directors level the actions of the LLC itself (as under corporate law concepts) or of its members or managers (in a member-managed and manager-managed LLC, respectively)? That is, are the directors acting as managers in a manager-managed LLC, or as members in a member-managed LLC, or as something else entirely? Does their authority derive solely from general principles of contract law by way of the operating agreement or under the Act or Ohio’s General Corporation Law, Revised Code Chapter 1701?
- Who signs documents to bind the LLC with contracting counter-parties on the board’s behalf? An officer designated by resolution, any director, the board of directors acting as a group, or a manager (if the LLC is manager-managed) or designated member? The Act provides for managers and members with authority to act for and on behalf of the LLC. (Revised Code §1705.25) So, a director still has to derive his or her authority to bind the LLC based upon an underlying status as one of these, in this writer’s opinion, in addition to the internal contractual authorities agreed to by, between and among the members.
- Would a bankruptcy trustee be able to set aside or otherwise challenge an Ohio LLC’s corporate governance structure with respect to certain transactions preceding the filing of the bankruptcy as ultra vires acts or contrary to the Act?
- Given that there is no reference to a director in the Ohio LLC Act (there are only members and managers, Revised Code §1705.01, definitions), how does the director have to evidence his or her “official” capacity to sign on behalf of the LLC or the board? Does he or she have to attach a resolution of the board of directors indicating their authority to so act or should this be done by attaching a copy of the operating agreement (or such portion of the operating agreement as is necessary to prove this authority)?
- May a member provide a proxy to another person to vote at an Ohio LLC’s board of directors meeting? Ohio corporate law, Revised Code §1701.48, would permit this but there is no specific authority under the Act for a member or manager of an LLC to have the right and authority to provide a proxy or to vote one at a manager or member meeting. Again, would this require looking to Ohio’s general corporation law for guidance?
- Should the drafting attorney decide early on whether to expressly incorporate by reference the corporate governance provisions of the general corporation law, Revised Code 1701, to disclaim them entirely, or to merely reference the definitional aspects of the General Corporations Act to supplement or clarify the powers and authority of the directors while at the same time waiving or disclaiming any attendant corporate law duties?