Pennsylvania has significantly overhauled its business laws through comprehensive legislation (“Act 170”), part of which has already gone into effect. Act 170 impacts a variety of business entities ranging from general partnerships to limited partnerships to limited liability companies (an “LLC”). The more significant changes include the explicit definitions of the duties of care and loyalty due from managers and members of an LLC.
This post will cover the following:
One part of Act 170, known as the Pennsylvania Uniform Limited Liability Company Act of 2016 (the “2016 Pa LLC Act”), governs all LLCs as of April 1, 2017. Prior to April 1, 2017, the 2016 Pa LLC Act governs only (i) an LLC formed on or after April 1, 2017, and (ii) an LLC formed before April 1, 2017, which elects in the operating agreement to be governed by the 2016 Pa LLC Act.
The 2016 Pa LLC Act provides that an LLC may be organized as either a member-managed LLC or as a manager-member LLC. Unless the LLC’s operating agreement affirmatively indicates that the LLC is a manager-member LLC, the LLC is deemed to operate as member-managed.
In a member-managed LLC, the management and conduct of the LLC are vested in the members. Each LLC member has equal rights in managing the LLC’s activities and affairs. Members of a member-managed LLC owe the LLC and other members duties of loyalty and care, standards which are explicitly stated for the first time in the 2016 Pa LLC Act. Members also now have a contractual obligation of good faith and fair dealing in discharging their obligations under the 2016 Pa LLC Act and operating agreement.
A member’s fiduciary duty of loyalty includes the duty to account to the LLC and hold as trustee any property, profit, or benefit derived by the member (i) in the conduct or winding up of the LLC’s activities and affairs, (ii) from a use by the member of the LLC’s property, and (iii) from the appropriation of an LLC opportunity. The member’s duty of loyalty also includes refraining from dealing with the LLC as or on behalf of a person with an interest adverse to the LLC and refraining from competing with the LLC before the LLC’s dissolution. A member’s duty of care requires that members refrain from engaging in gross negligence, recklessness, willful misconduct, or knowing violation of law in connection with their conduct or winding up of the LLC.
In a manager-member LLC, the manager exclusively decides any matter relating to the activities and affairs of the LLC. A manager is a person appointed under the operating agreement to perform the management functions of the LLC. If there are multiple managers, each manager has equal rights in the management and conduct of the LLC’s activities and affairs. A manager may be chosen or removed at any time by a majority vote of the members. In a manager-member LLC, the manager owes the LLC and members duties of loyalty and care similar to those owed by a member in a member-managed LLC.
Members do not have any duty to a manager-member LLC or any other member of the LLC solely by being or acting as a member. However, members are required to discharge their duties and obligations under the 2016 Pa LLC Act or under the operating agreement and exercise any rights consistent with the contractual obligation of good faith and fair dealing.
Although the 2016 Pa LLC Act provides inherent duties and obligations to members and managers, the operating agreement may alter these rights and duties. Certain operating agreement changes, however, will be held to a standard of manifest unreasonableness. The following are analyzed under the manifest unreasonableness standard: (i) altering the duty of loyalty, (ii) prescribing standards by which the performance of the obligation of contractual good faith and fair dealing is measured, (iii) identifying specific types of activities that do not violate the duty of loyalty, (iv) altering the duty of care, and (v) altering or eliminating any other fiduciary duty.
In determining whether a change is manifestly unreasonable, a court will make its determination as of the time when the challenged term became part of the operating agreement and consider only circumstances existing at that time. The court may invalidate the term only if, in light of the LLC’s purposes, activities, and affairs, it is readily apparent that the objective term is unreasonable or the term is an unreasonable means to achieve the term’s objective.
Given the prevalence of LLC formations in Pennsylvania, it is imperative that people consider the consequences of the 2016 Pa LLC Act prior to formation. A lawyer should be consulted to ensure the LLC is properly formed and that the operating agreement is properly drafted.