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

Why You May Need an LLC Update in 2017

Ready or not, Minnesota’s LLC law changes in January 2018

Many Minnesota LLCs have not yet updated their member control agreements and related documents to accommodate the new realities of a Chapter 322C world, but starting in 2018 that statute will govern all LLCs in the state. This article explores the impact of the change and explains why it’s crucial for businesses to adapt to Chapter 322C on their own terms while there is still time to do so.

For Minnesota LLCs, the clock is ticking to update member control agreements and related documents before a new and different LLC statute automatically applies on January 1, 2018.

Since August 1, 2015, anyone forming a new LLC in Minnesota has confronted the Minnesota Revised Uniform Limited Liability Company Act, also known as Chapter 322C. Minnesota’s new LLC statute differs significantly from the “old” LLC statute, Chapter 322B, but many existing LLCs and their owners have continued under Chapter 322B unaffected by (and perhaps unaware of) this major change and have been spared the necessity of confronting the new law because Chapter 322C currently only applies to newly formed companies and Chapter 322B LLCs that take action to opt in to Chapter 322C.

That all changes in January, when Chapter 322C will automatically apply to all Minnesota LLCs, whether their owners ever intended to be subject to Chapter 322C or not. This article explores the impact of this looming change and posits that it is crucial for businesses to adapt to Chapter 322C on their own terms rather than be forced (perhaps unawares) into Chapter 322C next year.

Background

Since January 1, 1993, LLCs in Minnesota have been subject to a set of laws based on Minnesota’s familiar corporate statutes. The Minnesota Limited Liability Company Act (Chapter 322B) was nearly a word-for-word clone of Minnesota’s corporate statutes and imported to the world of LLCs traditional corporate law concepts—shareholders, governing boards, bylaws setting forth voting and procedural matters at formal regular and special meetings, committees, executive officers reporting to the board, etc. North Dakota followed Minnesota’s corporate approach to LLCs, but nearly every other state in the country adopted a fundamentally different approach that treats LLCs more like partnerships, with a primary emphasis on flexibility and respect for the negotiated business agreement among co-venturers.

Minnesota took a step to catch up to the rest of the U.S. with the enactment of Chapter 322C, which implements the partnership-style approach common in most states and provides greater flexibility to members to craft custom business arrangements in the “operating agreement,” defined under Chapter 322C as the single agreement among the members that governs virtually all aspects of the relationship among the members. Chapter 322C is a version of a model statute—the Revised Uniform Limited Liability Company Act (RULLCA)—developed by the Uniform Law Commission for the purpose of standardizing the law governing LLCs from state to state. To date, a version of RULLCA has been adopted in 17 states plus the District of Columbia, and has been introduced for adoption in two more states in 2017.

In most states where a version of RULLCA has been enacted, the model act replaced what was already a partnership-style statute, making for a relatively smooth transition.  Not so in Minnesota, where Chapter 322C is dramatically different from the corporate statute it replaces. The stark legislative change offers opportunities for Minnesota LLCs to update and clarify business arrangements but also lays traps for unwary business owners who fail to take action to adapt.

A second bite at the apple

The mandatory application date of Chapter 322C provides a perfect opportunity for LLCs and their owners to revisit their existing LLC agreements, likely reflected in a member control agreement and in bylaws (confusingly also called the “operating agreement” under Chapter 322B), and perhaps an additional buy-sell agreement. Those agreements may have been written years ago, perhaps prior to significant changes in the LLC’s business operations. Even for businesses that haven’t undergone operational changes, sometimes actual governance practices deviate over time from what was initially envisioned and memorialized in the written agreements. It is not surprising that continuously tracking the terms of a member control agreement buried in a file cabinet somewhere turns out not to be a high priority for many busy entrepreneurs. The application of Chapter 322C is a catalyst for revisiting those old agreements and initiating conversations about whether they are still appropriate for the business in a non-confrontational way that doesn’t imply a desire to simply renegotiate a “done deal.”

Aside from better tailoring the operative documents to match actual practice, the transition to Chapter 322C provides a chance to catch issues that may have been overlooked when the member control agreement was first drafted. Take, for example, the matters of indemnification and advancement of expenses. Under Chapter 322B, governors, managers, and members of an LLC are entitled to indemnification for losses incurred with respect to certain legal proceedings, and to the advancement of expenses from the LLC for the purpose of funding the defense of such legal proceedings. Indemnification and advancement of expenses for board members and officers are well understood by many entrepreneurs as a general concept.

But Chapter 322B goes further, providing in Section 322B.69 that the obligation to indemnify and advance expenses extends all the way to non-executive employees and agents of the LLC. The scope of the indemnity and expense obligations can be limited by a member control agreement, but in many cases Chapter 322B member control agreements do not capitalize on that opportunity. By updating the LLC’s documents into a Chapter 322C operating agreement, you can limit indemnity and expense obligations to only executive officers and those in control of the LLC—and thereby avoid ever being forced to fund the litigation defense of an entry-level employee who made a bad decision on the job. Aside from indemnification and advancement of expenses, there may well be other issues that were inadvertently overlooked or saved for later when the member control agreement was drafted. After all, start-up companies often need things done quickly and at low cost, narrowing the focus to the big-picture items at the expense of some of the details. This is an opportunity to revisit those details and plug any holes in the agreements.

Adapting agreements to Chapter 322C also provides an opportunity to incorporate other updates that may be necessary as a result of changes in other areas of the law. For example, multi-member LLCs are typically treated as partnerships for tax purposes, and member control agreements usually have tax sections that provide for a member to act as the “tax matters partner” for purposes of representing the LLC with regard to the IRS. Starting in 2018, new partnership tax rules from the IRS—termed the Uniform Audit Rules—may create significant changes in the way the IRS will interact with LLCs and partnerships. A Chapter 322C update can also incorporate reworked tax language to meet the Uniform Audit Rules.

New flexibility

Chapter 322C is a flexible statute that lets members tailor their legal agreement to fit their venture instead of applying a one-size-fits-all approach. The statute establishes three off-the-shelf methods for LLC governance:

  • member-managed, in which the owners make decisions directly by the vote of the majority;
  • board-managed, which mirrors the corporate structure in which owners elect a board to oversee one or more executives; and
  • manager-managed, in which one or more persons or entities has substantially all of the authority to run the LLC, subject to member approval requirements for certain significant actions.

The manager-managed structure is new to Minnesota but familiar to the rest of the country and provides an attractive option for businesses that can benefit from strong centralized control with a corps of passive members whose primary right is a financial return. Under Chapter 322B, an LLC needed one or more governors, and the governors had to be actual human beings; Chapter 322C allows for an LLC to be run by another company. The manager-managed structure is a particularly good fit for many real estate-related businesses and for companies with complex internal organizational structures.

A central tenet of Chapter 322C is that almost everything in the statute can be undone, changed, or modified by contractual agreement of the members through the operating agreement. The old statute forced all LLCs to look and act like corporations, whether that made business sense or not. Chapter 322C embraces but does not impose a one-size-fits-one approach, allowing for members to craft an agreement that meets their particular circumstances and needs. A prime example of this new flexibility is the power to modify the fiduciary duties that apply to those in control of the LLC. Under Chapter 322C, subject to some minor limitations, it is up to the parties to decide the depth and breadth of the duties owed to the LLC by its leaders, in contrast to the imposition of corporate-style fiduciary duties under Chapter 322B.

The mismatch problem

Maybe the most readily apparent problem facing LLCs that don’t opt in to Chapter 322C before January 1, 2018 is the mismatch between the statutory environment contemplated by the existing written agreements and the statutory environment of Chapter 322C. Legislators have attempted to preserve the status quo for companies caught off guard next year by providing in Chapter 322C that the content of the Chapter 322B written documents will be interpreted as if their terms were included in a Chapter 322C operating agreement.

This savings clause is better than nothing, but confusion will still abound when attempting to interpret those Chapter 322B agreements through the lens of Chapter 322C. Consider that under Chapter 322B the bylaws, which are mainly a procedural document establishing how meetings will run, are often referred to as the “operating agreement,” while under Chapter 322C the operating agreement is the document that contains the substance of the total deal among the members. Or that under Chapter 322B, the corporate-style officers who were subject to board supervision were called “managers,” while a “manager” under Chapter 322C denotes a person or entity with near-complete power to operate the LLC in a manager-managed governance structure.

We lawyers love a good statutory cross-reference from time to time, which is why you may read a provision in a Chapter 322B member control agreement that says something like “distributions of profits, as and when declared by the Board, shall be shared among the Members in the manner prescribed by Section 322B.50.” Right now, it’s easy to determine that the parties intend that members will share in distributions according to their respective percentage ownership interests in the LLC, because Chapter 322B is included in deskbooks used by many lawyers and is available for free viewing online from the website of the Minnesota Revisor of Statutes. But Chapter 322B isn’t going to be available forever. North Dakota adopted a version of RULLCA after Minnesota but completed implementation first, and already the former LLC statute has disappeared from free online resources. As the years go by, it will become increasingly difficult to interpret Chapter 322B agreements in a Chapter 322C world. What’s worse, any confusion will likely lie dormant, unnoticed by members until a transaction or a disagreement illuminates the issue—too late for the members to express clearly what they intended.

The empty gaps problem

Chapter 322B was designed to implement a standard corporate structure with limited customization. Chapter 322B supplied some terms that could not be modified, which were often left out of the written agreements. Take, for example, the methods for curing conflict-of-interest transactions set forth in Section 322B.666. A transaction between an LLC and a person who is associated with the LLC may be subject to attack and potential voidability on the grounds that it represents self-dealing. Chapter 322B.666 lays out procedural mechanisms that, if followed, inoculate the transaction from this type of challenge (for example, by having the transaction approved by disinterested members of the board). The conflict-of-interest cure mechanism is supplied by statute and not subject to modification by the member control agreement under Chapter 322B, so it is not always included in the text of the member control agreement. After all, why spend the time and money to copy a statutory mechanism into the agreement when the mechanism applies automatically? I call statutory provisions like this “gap fillers”—they fill gaps in the written agreements.

Consider the result on January 1, 2018 for an LLC that has not adopted a Chapter 322C operating agreement: The gap in the agreement will remain, but the filler will be gone. Chapter 322C doesn’t contain a similar provision to Section 322B.666. The stance of Chapter 322C is that if members want to establish a mechanism for curing a conflict-of-interest transaction, they are free to do so in the operating agreement, but the statute isn’t going to impose a structure on them.

Another example is the member-authority provision in Section 322B.606, Subd. 2, which provides that any power granted to the board by Chapter 322B can be exercised by the members acting unanimously, or Section 322B.33’s granting of pro rata rights for members to participate in future financings to prevent dilution. There aren’t corresponding provisions in Chapter 322C. These are empty gaps as of January 1, 2018, and they set up an LLC and its members for unexpected results.

My personal favorite empty gap relates to Section 322B.37, which requires that a member control agreement must be in writing in order to be enforceable. Under Chapter 322B it isn’t essential to include a clause stating that a member control agreement can only be modified by a writing; that was a gap that the statute filled. Chapter 322C, by contrast, expressly contemplates that the operating agreement may be established by oral agreements and course of conduct (unless the operating agreement itself provides otherwise). Imagine a dispute in February 2018 over a buy-sell mechanism, where one party argues that the old member control agreement applies, but the other argues that a contrary course of conduct (perhaps the buy-sell hasn’t been consistently applied to all prior transfers) establishes a different result. There’s a dearth of case law applying RULLCA, but a court may be forced to consider proof on the modification argument.

The unknown unknowns

This has not been a complete list of all of the advantages of updating an old Chapter 322B LLC to Chapter 322C before January 1, 2018 or of all the potential calamities awaiting LLCs that take no action. Trying to predict all of the potential negative consequences of failing to update to Chapter 322C before being dragged into the new partnership-style statute is an exercise in futility. The best we can say about the transition to Chapter 322C is that we know there are some risks in not taking action; we know some of those risks could be significant, depending upon individual circumstances; and we know that any list of risks we compose is necessarily incomplete. LLC owners have six more months to make the decision to either adapt to Chapter 322C on their own terms or embrace the unknown unknowns.


DAVID JENSON is a partner in Stinson Leonard Street LLP’s Minneapolis office, where his practice includes mergers and acquisitions, securities law and capital markets matters, and general business matters. He represents businesses in the broadcasting, manufacturing, financial services, restaurant, and energy and medical technology industries. He writes and presents frequently on the topic of Chapter 322C.

 

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