Nature of Limited Liability Companies
The limited liability company is a relatively new creation in business organizations law. The LLC was designed to answer the need for a business entity that combined limited liability (like a corporation) with pass-through taxation (like a general or limited partnership). The first state to pass a statute allowing the creation of limited liability companies was Wyoming in 1977. Texas became one of only eight states to have recognized this new form of business organization, when the Texas Limited Liability Act became effective on August 26, 1991. By 1996, however, every US jurisdiction had LLC statutes. Texas LLC law is now codified in the Texas Business Organizations Code, particularly Chapter 101. Texas remains committed to staying on the cutting edge of the development of limited liability company law.
LLCs are an attractive organizational format for many types of closely held businesses. In less than three decades since its widespread adoption, the LLC has grown to be a more frequent choice of business organization than corporations, limited partnerships, and limited liability partnerships.
Organizational Structure of LLCs
The LLC is a hybrid entity, possessing both corporate and partnership features. However, LLCs are distinct organizations and are neither corporations nor partnerships. Like a corporation and unlike a partnership, an LLC may have one sole owner, the members are not responsible for debts and obligations of the company, and the members may participate in management without losing limited liability.
Management of an LLC may be structured more like a corporation, with “managers” functioning like directors of a corporation, or more like a partnership in which the members manage the company directly without managers. Ownership of an LLC is more in the partnership model, in that transferees of ownership interests do not become members with the rights of membership (primarily the vote) unless all other members consent.
The most distinctive feature of the LLC business form is the company agreement. The LLC statute is designed to allow owners maximum flexibility in designing their own company structures and rules. While the Business Organizations Code provides many norms and regulations, these are only “default” provisions, and virtually all of them are subject to modification in the company agreement. “The LLC’s model of contractual freedom is found in few other places in the world.”
Governance Issues Unique to LLCs
The governing documents of an LLC are the certificate of formation and the company agreement. The certificate is required to state whether the LLC will be governed by managers or by its members. The Code contemplates that all matters relating to the governance of the LLC and the relations of its members will be set forth in a company agreement; however, anything that may be included in a company agreement may also be stated in the certificate. In the event of a conflict between the certificate and the agreement, the certificate controls.
The Code provides that all members must agree to the company agreement, and all members must agree to any amendment. Similarly, any amendment or restatement of the certificate requires a unanimous vote of the members. However, these requirements may be modified in the certificate or company agreement. The Code provides that a single member LLC may execute an enforceable company agreement. Persons who join the LLC as members later are bound by the existing certificate and company agreement and are required to exercise diligence in obtaining and understanding the contents of the certificate and company agreement.
There is no requirement that an LLC have a company agreement or that a company agreement cover all the possible topics. If the LLC fails to execute a company agreement or fails to address a matter in the company agreement, then the default provisions of the Code supplement or event function as the company agreement.
Limited liability companies may be member managed or manager managed. In a member-managed LLC, the members operate the business directly as in a partnership. In a manager-managed LLC, the members elect managers who then run the business—similar to shareholders and directors in a corporation. Significant confusion can sometimes exist in member-member managed LLCs because the members in such an organization are the governing persons, with all the rights and liability of governing persons. For example, the rights of members under the Code to inspect company records are somewhat limited; however, when the members are also governing persons under the Code, they have virtually unlimited information rights. Individual members in a manager-managed LLC probably owe no duties to the company; however, when the members managed the LLC, they almost certainly do.
Another area that can cause significant confusion is voting. Under the default provisions of the Code, every member and every manager has an equal vote. This may be changed in the certificate or company agreement, but is often overlooked. Therefore, a two-member, member-managed LLC may find itself hopelessly deadlocked, even when one member owns 90% of the equity and the other member owns only 10%.
Fiduciary Duties in an LLC
Texas courts generally hold that governing persons in an LLC owe fiduciary duties to the company in the same way that directors owe fiduciary duties to a corporation. Generally, no fiduciary duties are owed by members of an LLC to each other. However, some courts have recognized an informal fiduciary duty between members controlling an LLC and other members based on the controlling member’s “intimate knowledge” of the company’s affairs. One court has recognized a formal fiduciary duty owed by a majority member to a minority member in the limited circumstance of negotiating the redemption or purchase of the minority member’s ownership.
This article is based on an article by HCWD, PLLC recently published in the Houston Business and Tax Law Journal. Download the entire article with full analysis and case citations: