A Road Map for the New North Carolina Limited Liability Company Act
LLC Laws Changing in 2014
Article Date: Wednesday, November 13, 2013
Written By: Warren P. Kean
Recently the laws governing limited liability companies in North Carolina have been under construction. On Jan. 1, 2014, Chapter 57C of the North Carolina General Statutes (the “Old LLC Act”) will be repealed and a new Chapter 57D will take its place (the “New LLC Act”). See N.C. Sess. L. 2013-157 (enacting Senate Bill 439). This article provides an abstract of the fundamental principles that underpin the New LLC Act. Further, this article sets out guideposts to provide some roadside assistance to the reader’s understanding of the New LLC Act’s design. Practitioners involved in formation, planning, and litigation of disputes between stakeholders in LLC’s should take note of the various ways in which the “LLC roads” have been re-routed.Transition Rules |
Recently the laws governing limited liability companies in North Carolina have been under construction. On Jan. 1, 2014, Chapter 57C of the North Carolina General Statutes (the “Old LLC Act”) will be repealed and a new Chapter 57D will take its place (the “New LLC Act”). See N.C. Sess. L. 2013-157 (enacting Senate Bill 439). This article provides an abstract of the fundamental principles that underpin the New LLC Act. Further, this article sets out guideposts to provide some roadside assistance to the reader’s understanding of the New LLC Act’s design. Practitioners involved in formation, planning, and litigation of disputes between stakeholders in LLC’s should take note of the various ways in which the “LLC roads” have been re-routed.The Central Traffic Circle. |
The core of the New LLC Act – as far as the rules governing ownership interests in a North Carolina limited liability company are concerned – is found in the following three sets of provisions: (1) N.C.G.S. Section 57D-10-01, (2) N.C.G.S. Sections 57D-2-30 through 57D-2-32 (Part 3 of Article 2), and (3) N.C.G.S. Section 57D-1-03(23). All analyses (and in particular judicial legal analyses) under the New LLC Act with respect to the relative rights and obligations of the owners (and, to a lesser extent, non-owner managers or other company officials of LLCs) are expected to begin with those provisions. For most LLCs with comprehensive, well-written operating agreements, legal analyses are expected to end with those provisions as well.
The Operating Agreement Controls. N.C.G.S. Section 57D-10-01 shows a clear intent to have an LLC’s operating agreement control the rights and duties of the LLC’s owners and any other parties to the agreement. All judicial decisions involving disputes between the owners of an LLC are expected to begin with the following stated purpose of, and policy underlying, the New LLC Act:
The purpose of this Chapter is to provide a flexible framework
under which one or more persons may organize and manage one
or more businesses as they determine to be appropriate with
minimum prescribed formalities or constraints. It is the policy of
this Chapter to give the maximum effect to the principle of free-
dom of contract and the enforceability of operating agreements.
Id. This policy statement was added to the Old LLC Act in 2009 and is derived from Section 18-1101(b) of the Delaware Limited Liability Company Act. See Del. Code § 18-1101(b) (2013). It serves as the premise for Delaware judicial decisions involving disputes between members of Delaware limited liability companies and was included in North Carolina’s Old LLC Act for that purpose. To apply N.C.G.S. Section 57D-10-01 requires an understanding of the terms and concepts referenced therein, in particular: “business,” “operating agreement,” and the “minimum prescribed formalities or constraints” under the New LLC Act.
“Business” has essentially the same meaning that it has had since 1999 under the Old LLC Act. See N.C. Sess. L. 1999-189 that amended this definition. This definition makes it clear that an LLC may be utilized for any legal “purpose or activity, whether or not conducted or undertaken for profit.” N.C.G.S. § 57D-1-03(3). For that reason the provisions concerning low profit limited liability companies (so-called “L3Cs”) that were added to the Old LLC Act in 2011 were deleted as unnecessary.
The Parameters of the Operating Agreement. The definition of “operating agreement” in N.C.G.S. Section 57D-1-03(23) is perhaps the most important and nuanced of the defined terms in the New LLC Act. The definition establishes the following four main principles:
First, the operating agreement need not contain the words “operating agreement” in its title. Id. at 57D-1-03(23). Instead, an operating agreement is any agreement concerning the LLC to which each member or other “interest owner” (as defined in N.C.G.S. Section 57D-1-03(15)) of the LLC is a party “as an interest owner,” and not a party in some other capacity. Id.
Second, the operating agreement, including any portion of the operating agreement, may be in any form: written, oral or implied. Id. This is a change from the Old LLC Act that required a “written operating agreement” to modify or eliminate many of the Old LLC Act’s default rules. All requirements that any part of the operating agreement be in writing have been eliminated under the New LLC Act. Id. As under the Old LLC Act, N.C.G.S. Section 57D-1-03(23) makes it clear that the parties may agree on the form that an operating agreement and its amendments must take to be enforceable, such as only in a document signed by all (or other prescribed number) of the LLC’s members. Id.
Third, all LLCs will have an operating agreement because N.C.G.S. Section 57D-1-03(23) provides the articles of organization are deemed to be part of the operating agreement. Id. Accordingly, as between the owners of an LLC, any conflict between the articles of organization and the operating agreement is to be resolved by the general rules of contract construction. Id. Third parties, however, are entitled to reasonably rely on the articles of organization as part of the public record. See id. at § 57D-2-30(d)(2).
Fourth, when an LLC has only one economic interest owner, any document or record that economic interest owner intends to serve as the operating agreement will be the operating agreement. Id. at § 57D-1-03(23).
The Limitations of Freedom of Contract. The guardrails contained in Part 3 of Article 2 of Chapter 57D provide the third leg of the foundation of the New LLC Act. Unlike the Old LLC Act, which provided for the default statutory rules being applicable only to the extent the operating agreement did not provide otherwise, N.C.G.S. Section 57D-2-30 provides that, as between the owners (and any non-owner managers or other company officials of an LLC), all of the provisions of the New LLC Act may be “supplemented, varied, disclaimed, or nullified” by the operating agreement. However, there are two main exceptions to this rule.
First, any provision in an operating agreement that purports to deny members access to certain information will have no effect. Id. at 57D-3-04(f). This information may include a copy of the LLC’s operating agreement, the LLC’s income tax returns or financial statements, the names and addresses of the interest owners, information from which a member’s capital interest may be derived, and “any information from which the status of the business and the financial condition of the LLC may be ascertained.” Id. However, under no circumstances will the LLC to be compelled to disclose or make available “trade secrets or other confidential information of a nature that its disclosure would adversely affect the LLC” if the information cannot be adequately safeguarded by other reasonable means. Id.
Second, any provision in an operating agreement that purports to eliminate the right of a member to bring a derivative action or a demand for judicial dissolution will have no effect, unless an alternative remedy or means is provided to resolve disputes that would otherwise be the subject of such proceedings. Id. at §§ 57D-2-30(b)(5) and 57D-2-30(b)(6).
The other exceptions under N.C.G.S. Section 57D-2-30(b) to the deference to be given to operating agreements include (i) the administrative provisions of the act (such as the process to be followed to form a LLC), id at 57D-2-30(b)(1), (ii) the provisions relating to government officials (such as the Secretary of State and the Attorney General), id., and (iii) the rights of third parties (those who are not parties to the operating agreement), including the rights that creditors and other third parties may have with respect to wrongful distributions (those made when the LLC is insolvent or to the extent they cause the LLC to become insolvent), id at 57D-2-30(b)(2).
In addition to the above-described mandatory provisions of the New LLC Act, N.C.G.S. Section 57D-2-30(e) refers to contract law and agency law, as liberalized by other provisions of the act (e.g., N.C.G.S Section 57D-2-32(a), authorizing the assessment of penalties for the breach of the operating agreement), to police the parties’ freedom to order their affairs as they may agree in the operating agreement. Id. at § 57D-2-30(e). Specifically mentioned in that respect is the implied contractual covenant of good faith and fair dealing that has been the subject of many court cases in Delaware and other jurisdictions. Id. Also specifically mentioned is the requirement that the terms of the operating agreement not be unconscionable at the time they are made. Id.Tour of the Side Streets. |
To navigate the provisions discussed above and the remainder of the New LLC Act, one must apply the following nomenclature found in N.C.G.S. Section 57D-1-03, most of which is new:
“LLC,” “foreign LLC,” and “limited liability company.” The New LLC Act refers to a domestic limited liability company formed under Chapter 57D or former Chapter 57C as an “LLC”. Id. at § 57D-1-03(16). A foreign limited liability company is referred to as a “foreign LLC”. Id. at § 57D-1-03(13). A “limited liability company” refers to either an “LLC” or a “foreign LLC”. Id. at § 57D-1-03(18).
“Interest owner,” “member,” “economic interest owner,” and “ownership interest.” The Old LLC Act, as other limited liability company and partnership statutes, provided that members could freely transfer their economic rights but not their non-economic rights (such as rights of governance and rights to information). The recipients of such economic-only rights are generally referred to as “assignees” in those statutes. The New LLC Act more directly provides for these different types of ownership. An owner who has only an “economic interest” (defined by N.C.G.S. Section 57D-1-03(10) as an interest owner’s rights in the “capital, income, losses, credits, and other economic rights and interests” of the LLC) is referred to as an “economic interest owner”. Id at § 57D-1-03(11). The “economic interest owner” may acquire that status either by acquiring only an “economic interest” from the LLC or by acquiring such an interest from another “interest owner.”
By contrast, “Ownership Interest” is referred to as “[a]ll of an interest owner’s rights and obligations as an interest owner in an LLC . . . .” Id. at 57D-1-03(25). These rights and interests include not only the “economic interest”, but also the management rights, derivative action rights, and rights to information. Id. Under the Old LLC Act, the “Ownership Interest” was referred to as “Membership Interest”. Under the New LLC Act, a “member” is defined as an owner who has been “admitted” as a member of the “LLC “or “foreign LLC” and, therefore, has the non-economic rights of a member as provided in the LLC’s operating agreement or, to the extent not otherwise modified or eliminated by the operating agreement, under the New LLC Act. Id. at § 57D-1-03(21). An “interest owner” is defined as either an “Economic Interest Owner” or a “Member.” Id. at § 57D-1-03(15).
As under the Old LLC Act, (i) persons other than interest owners may be parties to the operating agreement, (ii) members need not own economic interests, and (iii) persons may become members upon the occurrence of specified events provided in the operating agreement (so-called “springing members”). Id. at §§ 57D-2-31, 57D-2-30, and 57D-3-01(c).
“Capital interest,” “contribution amount,” and “distributions.” Terms related to an interest owner’s economic interest include the “capital interest” and “contribution amount” of the interest owner and the “distributions” made in respect of that interest. “Capital interest” is defined as the interest owner’s share of the owner’s equity of the LLC. Id. at 57D-1-03(4). A member generally is entitled to information from which the member’s capital interest may be derived under N.C.G.S. Section 57D-3-04(a)(4)(i), and a member or economic interest owner is not entitled to withdraw any portion of the interest owner’s capital interest except as provided in the LLC’s operating agreement or as the members may otherwise agree. Id. at § 57D-5-05.
The “contribution amount” attributable to an “ownership interest” is not only the net value of the property or services contributed in respect of that ownership interest but also includes the net value of property and services that the interest owner is obligated to contribute in the future in respect of the ownership interest. Id. at §§ 57D-1-03(6) and 57D-4-01. Transfers, or obligations to transfer, property or to perform services to the LLC in exchange for cash or other consideration, or which otherwise are “not made in respect of an “economic interest”, are not included as part of the interest owner’s contribution amount. Id. at 57D-1-03(6). This definition is important because in the absence of the operating agreement providing otherwise, the interest owners’ economic interests (i.e., their shares of distributions) are to be based on the “contribution amounts” of their ownership interests. Id. at § 57D-4-03.
“Distribution” is defined as the payments made in respect of an ownership interest. Id. at § 57D-1-03(9). Because “distributions” may need to be repaid under N.C.G.S. Sections 57D-4-05, 57D-4-06, and 57D-6-12 if they are made when the LLC is insolvent or to the extent they cause the LLC to become insolvent, distributions made as “compensation for services or to a bona fide retirement plan or benefit its program” are not treated as “distributions” for those purposes (wrongful distributions), but are treated as “distributions” for all other purposes under the act. Id. at § 57D-1-03(9).
“Managers” and “company officials.” The New LLC Act no longer requires an LLC’s articles of organization to state whether the LLC is “member managed” or “manager managed,” but as under the Old LLC Act, unless the operating agreement provides otherwise, the LLC will be managed by “managers,” and each member by virtue of being a member will be a “manager” of the LLC. Id. at §§ 57D-2-30(a) and 57D-3-20. Because of the intended flexibility afforded LLCs and their owners, the New LLC Act makes it clear that an operating agreement may provide that the LLC is to be managed by persons other than “managers,” for example by a board of directors and officers. Id. at §§ 57D-2-30(a) and 57D-3-20(d). For that reason, the New LLC Act refers to those persons who manage an LLC – be they “managers” or officials exercising their authority under some other title – as “company officials.” Id. at § 57D-1-03(5).
“Approve.” Members, organizers, and company officials are deemed to act by “approval” and may “approve” of a decision or other action to be taken by vote at a meeting or by “any other expression of assent to the action to be taken.” Id. at § 57D-1-03(1). If the operating agreement does not provide otherwise, approval is to be made in the manner that members approve amendments to the operating agreement (i.e., under the default rule of N.C.G.S. Section 57D-3-03(1), by unanimous consent, which under the default rules of N.C.G.S. Section 57D-1-03(23) may be expressed in writing, orally, or by implication through conduct). Id.
“Transfer.” The last important term of art in the New LLC Act is “transfer.” This term is defined broadly under N.C.G.S. Section 57D-1-03(34) to include the transfer of legal, equitable, or beneficial ownership of an ownership interest or other property by any means. This term is important because a transfer of an ownership interest without the admission of the transferee as a “member” causes the ownership interest that is “transferred” to become an “economic interest.” See id. at §§ 57D-5-02, 57D-3-01, and 57D-3-02. The definition provides the following examples of transfers of ownership interests: (i) gifts of ownership interests made during the interest owner’s life or upon or after his or her death, (ii) the appointment of a personal representative of a deceased interest owner or a guardian for an interest owner who is judicially declared to be incompetent, (iii) the appointment of a bankruptcy trustee for the interest owner, and (iv) transfers made to a spouse or former spouse in connection with a divorce or under any other circumstances. Id. at §§ 57D-1-03(34).Rules of the Road. |
Construction and other rules of general application are found in N.C.G.S. Section 57D-10-02. To avoid placing qualifiers such as “reasonable” throughout the New LLC Act, N.C.G.S. Section 57D-10-02(e)(1) provides that the provisions of the New NC LLC Act “are to be applied in a manner that is reasonable under the circumstances.” N.C.G.S. Section 57D-10-02(a), in coordination with N.C.G.S. Sections 57D-2-30(a) and (e), provides that unless the New LLC Act or an LLC’s operating agreement states otherwise, contract, agency, and other common law rules as well as rules of equity apply in governing the rights and obligations of interest owners, other parties to the operating agreement, and company officials. One exception to the application of common law include that the New LLC Act is not required to be strictly construed to the extent it conflicts with common law. Id. at § 57D-10-02(b). Another exception is the right of the interest owners to provide for penalties for breach of the operating agreement. Id. at § 57D-2-32(a).Conclusion |
The foregoing is not, nor is it intended to be, an exhaustive or comprehensive discussion of the New LLC Act. It is intended only as roadside assistance to give direction to the practitioner on how to move more confidentially and safely along the various re-routes of North Carolina’s “LLC roads”. These re-routes may affect the formation, planning, and of course, the litigation of disputes involving LLCs. •© Warren P Kean 2013. Warren Kean is a partner of K&L Gates LLP in Charlotte and was the chair of the committee of the North Carolina Bar Association that drafted the New LLC Act.
Views and opinions expressed in articles published herein are the authors' only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.