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Bench & Bar of Minnesota is the official publication of the Minnesota State Bar Association.

Minnesota’s LLC Makeover: Increased Certainty Heightens LLCs’ Appeal

Minnesota’s new LLC act, adopted in 2014, will automatically cover all the state’s newly formed LLCs as of August 1, 2015 and will cover all Minnesota LLCs as of January 1, 2018, regardless of when they were created.  The new statute makes Minnesota a more competitive venue and may encourage more businesses to subject themselves to Minnesota jurisdiction.

On April 11, 2014 the Minnesota Legislature adopted the Minnesota Revised Uniform Limited Liability Company Act (the “new LLC act”) which was unanimously approved in both the Minnesota House and Minnesota Senate.  This is the most significant development in the law governing Minnesota limited liability companies since the LLC was first recognized as a domestic entity here in 1993.  As LLCs have largely become the entity of choice for entrepreneurs and other business owners seeking to organize, competition from other states with business-friendly LLC acts, primarily Delaware, and the perceived need for certainty in ownership relations may have prompted this upheaval of the original Minnesota Limited Liability Company Act.1 (hereafter the “prior LLC act”).

All LLCs formed in Minnesota on or after August 1, 2015 will automatically be subject to the new LLC act.  Effective January 1, 2018, all Minnesota LLCs will be governed by the new LLC act regardless of when they were created.  In the meantime, any existing LLC may elect to “opt-in” to the new LLC act subject to the terms and provisions of its operating agreement or bylaws.  The Minnesota Secretary of State has taken the position that the new LLC act is not effective until August 1, 2015 and therefore any election will not be effective until that date.

The new LLC act will change the way LLCs operate and may encourage more businesses to subject themselves to Minnesota jurisdiction.  Substantive changes under the new LLC act include its enabling of the members to contractually agree to:  (1) reduce or eliminate the duty of loyalty and the duty of care and to define the contractual obligation of good faith and fair dealing (all subject to the caveat such limitations or definitions must not be “manifestly unreasonable”); (2) reduce the grounds for judicial relief of oppressive conduct; and (3) provide restraints and presumptions concerning derivative actions and special litigation committees.

Context for Changes

Minnesota courts have earned a reputation as being very protective of shareholders and members.  The prior LLC act created statutory protections that offer wide latitude to the court in enforcement, but give the company little latitude in defining the duty of care and what can be expected of the company and its members insofar as these standards may differ from the statutory default or a court’s perception of “equity.”  This framework has made predicting the outcomes of shareholder or member disputes difficult, even with a well-drafted set of organizational documents.

Businesses and their owners always seek to maximize predictability. As a consequence, many sophisticated investors and organizers have actively avoided participating in Minnesota entities.  In fact, many venture capitalists and angel investors require that Minnesota entities be reorganized in more management-friendly jurisdictions like Delaware to avoid the uncertainty that comes with the current protective regime.  As Minnesota businesses embrace the new LLC act, investors who may have been reluctant to invest in Minnesota LLCs may become more likely to do so.

The vast majority of those business entities that are being organized in Minnesota now are LLCs as opposed to corporations or other entities and that gap has widened significantly over the past eight years.  Of the approximately 35,000 entities organized in Minnesota in 2013, approximately 29,000 of them were LLCs. That trend continued in 2014.

Given the relative popularity of the LLC form and the potential that more businesses will choose to organize under the new Minnesota law, it is increasingly important for practitioners to understand the differences between the prior LLC act and the new LLC act so that they can best advise their clients.  The changes can be broken down into three categories: (1) increased flexibility in defining the fiduciary duty and minimizing the likelihood of a lawsuit for oppressive conduct; (2) recognition of the derivative claim distinction and special litigation committees; and (3) changes to the default rules pertaining to organization, governance, and distributions.

Increased Flexibility 

The starting point for eliminating the risk that the LLC member’s intentions will be misconstrued is to define the terms most germane to the relationship.  The new LLC act permits owners to define the following terms in their operating agreement, so long as such definitions do not create a “manifestly unreasonable” standard:

(1) modify or eliminate the duty to refrain from competing with the company2;

(2) modify or eliminate the duty to refrain from dealing with the company in the conduct or winding up of the company’s business as or on behalf of a party having an interest adverse to the company3;

(3) identify specific types or categories of activities that do not violate the duty of loyalty4;

(4) alter the duty of care, except to authorize intentional misconduct or knowing violation of law5;

(5) alter any other fiduciary duty, including eliminating particular aspects of that duty6; and

(6) prescribe the standards by which to measure the performance of the contractual obligation of good faith and fair dealing.7

Further, the new LLC act provides the operating agreement may specify the method by which a specific act or transaction that would otherwise violate the duty of loyalty may be authorized or ratified by one or more disinterested and independent persons after full disclosure of all material facts.8

Accordingly, under the new LLC act, members may create a governance structure fairly designed to protect their bargained-for and agreed-upon common objectives without the uncertainty that chilled investors under the prior LLC act.  Thus, the new LLC act generally allows the LLC members to create a contractual relationship among themselves without including extracontractual terms, unless such provisions would yield a manifestly unreasonable result.

The new LLC act provides a court shall determine whether a provision in an LLC operating agreement is manifestly unreasonable.  In making such a determination the court:  (1) shall make its determination as of the time the challenged term became part of the operating agreement and by considering only circumstances existing at that time; and (2) may invalidate the term only if, in light of the purposes and activities of the limited liability company, it is readily apparent that: (1) the objective of the term is unreasonable; or (2) the term is an unreasonable means to achieve the provision’s objective.9

Unfortunately, the new LLC act fails to provide illustrative examples of manifestly unreasonable provisions.  Attorneys drafting around the duties described above should therefore take care to:

  • Draft the provisions so that they specifically and unambiguously address or pertain to the desired standard of such applicable fiduciary duties;
  • Demonstrate in the subscription agreements the sophistication and independent bargaining power of each member, perhaps recite that all parties had or had the opportunity to have been represented by counsel and/or other advisors they deemed necessary; and
  • avoid an inherently unreasonable construction or result

A member’s claim for breach of fiduciary duty is often accompanied by a claim for a fair value buyout of the member’s equity interest based on a claim that the member’s reasonable expectations were frustrated.  In fact, generally, any conduct that would constitute a breach of fiduciary duty will also serve as the basis for a claim for a fair value buyout.10

Under the new LLC act the operating agreement can define the “reasonable expectations” of the members subject to the “manifestly unreasonable” standard referenced above.  Even more important, the operating agreement can carve out the relief available under the statute for a forced, fair-value buyout.  This means that for the first time Minnesota LLCs and their owners can be certain that their fellow members cannot assert a claim forcing the company or members to buy out their equity interest for fair value, typically 30 percent more than fair market value, regardless of any buy-sell agreement.

The new structure should provide LLCs and their members with a greater degree of confidence that a court will enforce the written operating agreement to the extent that it defines or explains the level of loyalty expected and the type of conduct that the company and its members agree is acceptable. This is in stark contrast to the prior LLC act.  To understand the impact of the passage of the new LLC act requires an understanding of the preamendment state of the law regarding shareholder/member disputes.

Shareholder/Member Disputes

The most typical member or shareholder dispute revolves around a claim that members are frozen out of the company, they are not allowed input into management, and the company withholds information from them.  This conduct gives rise to claims for breach of fiduciary duty, claims for failure to produce corporate records, a derivative of both claims, and a statutory claim requiring that the company buy out the member’s ownership interest for fair value. Generally, any conduct that would constitute a breach of fiduciary duty will also serve as the basis for a claim for a fair value buyout.11

Currently, under Minnesota law, both the company and the members risk triggering the most extreme consequences if they do anything to ensure they can dictate the type of conduct that members and the company can engage in.  Companies and owners are often surprised to learn how these claims can be triggered and the relief available.

Under the prior LLC act, the courts in several reported decisions overlooked or completely disregarded agreements between the company and the owner (whether a member control agreement or an employment agreement) in the name of “fairness” or “equity.” For example, in Gunderson v. Alliance of Computer Professionals, Inc., the court considered whether the plaintiff had a reasonable expectation of continuing employment by virtue of his shareholder status, a business plan, and another shareholder’s alleged promises of job security. 12 The court held that any expectation based on the business plan was unreasonable because the shareholders never adopted it or learned of it. The court did say that the promises of an alleged shareholder “may be probative” of an expectation of continued employment even though the promise was insufficiently definite to create a contract. The court further noted that the buy-sell agreement failed to address the shareholder’s right to continued employment.13 The appellate court remanded the case to the trial court to address issues of fact that remained relating to the reasonable expectations of the shareholder.

The Gunderson court further held “courts may rely on written or oral agreements among shareholders or between shareholders and the corporation in determining whether shareholder expectations are reasonable … we recognize that written agreements are not dispositive of shareholder expectations in all circumstances.”14 In deciding whether to substitute the buy-sell agreement for the expectations of the members under the prior LLC act, the court will consider whether the buy-sell agreement was an arm’s length transaction and the relative input that the plaintiff shareholder had in the drafting of the agreement.15 The Gunderson court held that the court should give some deference to the agreements between the company and its owners; however, the court ultimately disregarded these agreements in the name of equity.  Neither owners and members of a company governed by Chapter 322B nor their attorneys can confidently assume that their agreements will be respected by the court under the prior LLC act.

The new LLC act provides a framework and analysis that makes clear that the contractual agreements between the members and the company as described in the operating agreement should control unless they are “manifestly unreasonable.”  This standard gives members much more flexibility to define the fiduciary duty and the reasonable expectations.  Equally, if not more important, under the new LLC act, the controlling members and the company can eliminate the fair value buyout claim and the risk that the buy-sell agreement will be completely disregarded in the name of equity.

Special Litigation Committees

The new LLC act clarified that the direct/derivative distinction that has long been recognized in the context of corporations will apply to LLCs governed by the new LLC act.16 Currently, only Minnesota corporations can be confident in relying on the special litigation committee as a procedural mechanism to protect governors, managers, the members, and the company from suit.

For LLCs governed under the new act, if a member brings a lawsuit against other members, governors, or managers and the claim is deemed a derivative claim, then the board of governors can appoint a special litigation committee (SLC) to determine whether it is in the best interests of the company to pursue litigation, regardless of the merits of a particular claim.

A claim is derivative if the damages are a function of reduction in share value and are common to all shareholders.17 The SLC can and often will recommend that the corporation not pursue the claim against the board of governors that appointed it. Regardless of the merits of a claim, a decision by an SLC will serve as the basis for a motion to dismiss the claims if the corporation can establish: (1) that the committee was sufficiently independent from the board of governors that appointed it, and (2) that the committee’s investigation procedures were adequate, appropriate and pursued in good faith.18

In many ways, the special litigation committee provides a procedural mechanism to provide the certainty, predictability, and in some cases, protection of those in control of an LLC.  Strong consideration should be given to incorporating SLCs in operating agreements for LLCs governed by the new LLC act.

Organization, Governance, and Distribution

The most significant changes related to organization include (1) simplified Articles of Organization (already accepted by the Minnesota Secretary of State); (2) the elimination of the member control agreement (effectively, the bylaws and the member control agreements will be combined into one “operating agreement”); and (3) changes to the default rules pertaining to governance and distributions, which can be overridden by the operating agreement.

An LLC organized under the new LLC act may be formed by filing articles of organization with the Minnesota Secretary of State.  Those articles must contain only the name of the LLC, the street address of the initial registered agent and the name of the initial agent for service of process, and the name and street address of the organizer.19 The member control agreement has been replaced by the operating agreement as the mechanism by which the members can alter the default rules.20

Under the new LLC act the default governance rule is a member-managed LLC as opposed to a board-of-governors-managed LLC, which was the default under the prior LLC act.21 Moreover, under the new LLC act both voting power and the allocation of distributions is determined per capita rather than per contribution and distributions must be distributed in equal shares unless otherwise provided in the operating agreement.22

Implementation

In light of the new act, Minnesota LLCs generally have three alternatives available to them: (1) do nothing and maintain the status quo; (2) opt in to be governed by Chapter 322C now, or (3) opt in and amend their operating agreement to take advantage of the increased flexibility and freedom of contract provided for by Chapter 322C.  If an LLC organized before August 1, 2015 does nothing now, it will continue to be governed by the prior LLC act until January 1, 2018 when Chapter 322B will be repealed and replaced by Chapter 322C.  At that point all of the changes to the existing law contained in the new LLC act will apply to the corporate documents designed to govern the company under a different statute with different default rules, terminology, and permitted terms of the operating agreement.

If an LLC opts in to be governed by the new LLC act and does nothing more to take advantage of the increased flexibility and power given to the operating agreement, at a minimum, it will be clear that the derivative claim distinction and the SLC protection will be available to the company and governors.  Moreover, an LLC adopting Chapter 322C will preclude a member from asserting a dissenter’s rights claim as those claims have been omitted from the new LLC act.  Further, the standards for corporate record retention and demand of corporate records are changed by the new LLC act under the default rule.  Most LLCs would benefit most from the third option: opting in and amending the operating agreement to take advantage of the increased flexibility.

Although an election before August 1, 2015 may not be deemed effective until that date, a court may not agree with the secretary of state and may interpret Section 322C.1204 to allow an election now.  Given the significant advantages and increased flexibility provided by the new LLC act, the best course is to elect to be governed by the new LLC act through the operating agreement.  The election will state that the company elects to be governed by the new LLC act upon its effective date and at the latest, August 1, 2015.  The company will continue to operate pursuant to Chapter 322B until such time.  The operating agreement will take full advantage of the flexibility provided under the new LLC act.  By making this election now and preserving the argument that it is effective immediately, the client at least preserves the arguments that may have a significant impact on the outcome of a particular case as described above.  An added practical benefit is that the client will not organize an LLC now and have to return in one year to amend the operating agreement.

The operating agreement can be amended to define what type of conduct is acceptable to the company and the members and what type of conduct can give rise to a fiduciary duty claim or a claim for a buyout subject to the manifestly unreasonable limitation discussed above.  Since the manifestly unreasonable limitation focuses on the relative levels of sophistication and bargaining power of the member versus the company, the provision at issue would likely be less susceptible to attack if the member provides certain representations and warranties related to their level of sophistication, appreciation of risk, and opportunity to retain counsel and have input into the terms and provisions of the operating agreement.

Related, the operating agreement can alter the obligation of the LLC to maintain and produce certain records and information and can eliminate the personal liability of members, managers, or governors for failing to produce records as required by the statute or the operating agreement.  The operating agreement can also eliminate the fair value buyout as a remedy available to a member for unfairly prejudicial conduct.  This increased flexibility allows the company and the members to be confident that the buy-sell provisions in the operating agreement will provide the exclusive basis for a buyout for fair market value, rather than risking a claim for a forced fair value buyout.

Brett Larson is an attorney at Messerli & Kramer who represents small and medium-sized businesses as outside general counsel providing transactional and litigation management services.  Brett leverages his experience in a broad range of complex litigation and transactional settings to guide his clients to avoid and be well-prepared for litigation.

Nate Nelson is a shareholder at Messerli & Kramer who focuses his practice on representing closely held businesses with transactional services and succession planning. He also has extensive experience in business succession and tax planning issues and represents individuals and corporate taxpayers in tax controversies before the Internal Revenue Service.

Notes

1 Minn. Stat. §322B.01 et seq.

2 Minn. Stat. §322C.0110, subd. 4(1)(iii).

3 Minn. Stat. §322C.0110, subd. 4(1)(ii).

4 Minn. Stat. §322C.0110, subd. 4(1)(iii); Id. subd. 4(2).

5 Minn. Stat. §322C.0110, subd. 4(3).

6 Minn. Stat. §322C.0110, subd. 4(4).

7 Minn. Stat. §322C.0110, subd. 4(5).

8 Minn. Stat. §322C.110, subd. 5.

9 Minn. Stat. §322C.110, subd. 8(2).

10 Pedro v. Pedro (Pedro II), 489 N.W.2d 798, 802-03 (1992); Pedro v. Pedro (Pedro I), 463 N.W.2d 285, 288-89 (1990).

11 Id.

12 Gunderson v. Alliance of Computer Professionals, Inc., 628 N.W.2d 173, 184 (Minn. App. 2001).

13 Id. at 186.

14 Id. at 185 (emphasis added) (citing, Berreman, 615 N.W.2d at 374).

15 Id.

16 Minn. Stat. §322C.902.

17 Janssen v. Best & Flanagan, 662 N.W.2d 876, 888 (Minn. 2003).

18 In re UnitedHealth Group, 754 N.W.2d 544, 559 (Minn. 2008)(quoting Janssen, 662 N.W.2d at 889).

19 Minn. Stat. §322C.0201, Subd. 1.

20 Minn. Stat. §322C.0110.

21 Minn. Stat. §322C.0407.

22 Minn. Stat. §322C.0404.

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