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Does Your Operating Agreement Need to Be Reviewed?

 

Arizona’s Limited Liability Company Act affects existing LLCs.

Michael Margrave

 
 

In 2018, Arizona’s Limited Liability Company Act (the “Act”), governing limited liability companies in Arizona, was enacted and made applicable to all newly formed LLCs on or after September 1, 2019, and will be applicable on September 1, 2020, to LLCs formed prior to September 1, 2019. The Act has many significant changes that will likely affect your business. It is necessary to be aware of these changes and take the appropriate steps to adjust your operating agreements accordingly.

Background

Limited liability statutes are often referred to as “default statutes,” in that most provisions apply if your operating agreement does not address them. With limited exceptions, you are free to provide the contractual provisions that are best suited for your entity.

The Act is a major change from the old statutes and deals with issues not previously addressed. In certain areas not much has changed, but the new statute is abundantly clear on certain matters that may not be altered by an operating agreement. If your operating agreement contains provisions that violate this rule, your provisions would be unenforceable. If your operating agreement does not address the “changeable” provisions added to the Act, then the default provisions in the Act will govern.

In light of the impact of the Act’s changes, having your operating agreement reviewed would be a prudent business step. The main purpose of the review would be to point out (1) any provisions in your operating agreement that violate the “non-changeable” provisions of the Act, and (2) what “changeable” default provisions in the Act are missing from your operating agreement.

Key Components of the Act: Three Important Areas Affected by the Act

What major aspects of LLC law are not affected by the Act?

Many portions of the Act will not impact your operating agreement. As examples, the process of LLC formation and requisite documents for such formation will remain the same, as will the rules pertaining to mergers, conversions, and other entity transactions and creditors’ right.

What provisions in your operating agreement cannot be modified pursuant to the Act?

The Act has prescribed, in A.R.S § 29-3105, 13 very specific items that cannot be changed or eliminated in a company’s operating agreement. The following are six specific items:

  • Eliminate the contractual obligation of good faith and fair dealing or the duty to refrain from willful or intentional misconduct.

  • Limit or eliminate a person’s liability for any violation of the contractual obligation of good faith and fair dealing of conduct involving willful or intentional misconduct.

  • Unreasonably restrict the duties and rights of members and managers to inspect company records (reasonable restrictions related to the availability and use of information obtained by members and managers and appropriate remedies for breach are permitted).

  • Change the statutory default causes for company dissolution, although additional causes of dissolution may be added.

  • Unreasonably restrict the right of a member to maintain a derivative action, although the operating agreement may require a member maintaining a derivative action to plead and prove an actual or threatened injury not suffered by the company.

  • Vary the requirements of a plan of merger, plan of interest exchange, a plan of conversion, a plan of domestication, or a plan of division.

If your operating agreement currently violates, omits, circumvents, or is incompatible with any of these mandatory provisions, your provisions are invalid and need to be adjusted.

What Act provisions can be modified in your operating agreement?

LLCs continue to offer a lot of freedom and flexibility, and the operating agreement is the primary mechanism available to capitalize on those choices. One feature of the Act is that any non-mandatory default provisions in the Act that are not specifically addressed in your operating agreement would then to be applied to your situation. Conversely, you can modify or eliminate these non-mandatory provisions. Four notable default items are:

  • Member voting procedures is a key area to which many companies will need to pay special attention.

  • The fiduciary duties are owed by members and managers. Unlike the prior LLC statutes, under the Act members and managers will now owe fiduciary duties of care and loyalty to the company and other members. However, the contractual obligations of good faith and fair dealing or conduct involving willful or intentional misconduct cannot be modified.

  • The liability of members and managers upon a breach of the duties of care and/or loyalty and a duty or a breach of the operating agreement, which may be limited, expanded, and in some circumstances, eliminated as they relate to these duties.

  • Provisions for reimbursement or indemnification of members and managers have been expanded in the Act, making certain areas applicable unless changed. Other areas affected include principal address of a business versus. known place of business, scope of business purpose, and with respect to the Act, access to company records by members, majority versus unanimous voting by managers, judicial dissolution procedures, member expulsion, derivative actions, and dissolution procedures.

Not related to the Act itself are the recently revised federal partnership audit rules. Amending an existing operating agreement (or preparing a new operating agreement) should take these rules into account. The gist is that the IRS will audit LLCs taxed as partnerships at the entity level and not at the member level although there are opt-out and pushout elections available. The responsible person for the entity will be the Partnership Representative who will be the only person with the authority to deal with the IRS with respect to audits and is the only person empowered to make elections.

Our goal is to support all clients and ensure their businesses function optimally and in compliance with all applicable laws. If you would like to have your company’s operating agreement reviewed for potential issues or conflicts with the Act, please reach out to us.