Ohio LLC Amendments, Now in Effect

Posted by on May 22, 2012 in Blog, Corporate, Front Page, Small Business | Comments Off

Ohio Statehouse: Where the Legislative Magic Happens

Ohio passed its limited liability company statute in 1994 and has amended it several times since. The latest amendments, passed as H.B. 48, substantially and significantly update Ohio’s LLC statute and bring it in line with leading case law and commentator opinion. With these changes now firmly in place and effective, it may be time to revisit your LLC’s operating agreement.

Each change is described below in detail. The most significant of these include the clarification that, in Ohio, the creditor of an LLC member may obtain a “charging order” against the member’s LLC interest, but the creditor may not foreclose on that interest or seize LLC assets. This has been an unsettled point for years. It is now clear that Ohio provides maximum protection for LLC members.

The second major update clarifies the law of LLC fiduciary duties. Courts have long held that LLC members owe fiduciary duties to one another and to the company itself. But without explicit statutory authority, it was not clear to what extent these traditional duties should apply to LLCs.

Section 1705.081 – Operating Agreements

It has always been the case that an LLC is governed by its operating agreement. The addition of Section 1705.081 merely clarifies and formalizes that point. It is now explicitly in the statute that “an operating agreement governs relations among members and between members, any managers, and the limited liability company.” The amendment also states that the LLC itself is bound by the operating agreement, whether or not the company signs.

Although the operating agreement controls the operations of the LLC, and generally supersedes any contrary provisions in the Limited Liability Company statute, the amendment carves out eight specific provisions than an operating agreement cannot override.

Here’s what you can’t change:

  1. The rights and duties related to filing Articles of Organization, which is the document that creates an LLC.
  2. The rights of the members to access the books and records of the company.
  3. The duty of loyalty, although the duty can be narrowed or waived in specific instances with adequate member support.
  4. The duty of care, although, again, it can be reduced, just not “unreasonably.”
  5. The obligation of good faith and fair dealing.
  6. The duties of a manager of the company. (In an LLC, a manager is roughly equivalent to a director or executive officer, depending on how the company is structured.)
  7. The requirements to wind up the company.
  8. The rights of third parties under the LLC statute, such as they are.

Section 1705.161 – Quitting the Company

In this section, the legislature wanted to make it clear that the duties of loyalty and good faith, introduced below, would not run forever, but cease upon a member’s withdrawal. As you might expect, the member’s right to control also ceases on withdrawal.

Section 1705.18 – New Members, Old Operating Agreement

The control, management, and economics of an LLC are governed by its operating agreement. All members are bound by the operating agreement, as noted above. But there is a bit of confusion created when new member join an existing LLC.

Ordinarily the operating agreement will state that it applies to all future members. And new members ideally join by signing a document that states they will be subject to the operating agreement. But conditions aren’t always ideal. Sometimes members sell or assign their interests without proper documentation or attention to detail. And just like any other contract, an operating agreement only binds those who have agreed to it. So new members come in without being explicitly bound to the operating agreement.

The LLC statue now explicitly provides that substitute members are bound by the operating agreement. If you sell your membership interest in an LLC, whoever buys your interest steps into your shoes, and succeeds to your obligations and rights. This calls for a word of warning to buyers: if you are buying an LLC interest, be sure to review the company’s operating agreement, because you will be bound to it. Have a lawyer review the tax provisions. They are not simple.

All of this still leaves some ambiguity where new members join an LLC directly, rather than through the purchase of an existing interest. However, admitting a new member to an LLC is an event that should always be negotiated and carefully documented.

Section 1705.19 – Charging Order, Sole Remedy

Protection from creditors is perhaps the central reason that one forms an LLC. Ohio’s LLC statute has long stated that the creditor of a member of an LLC may apply to the court for a “charging order” against the member’s LLC interest, which places the creditor in the position of an assignee of the member’s interest. The creditor is then entitled to LLC distributions, if and when they are made. But the creditor has not been permitted to take control over LLC assets or demand a distribution.

For years, creditors have been battling this rule. They scored a major victory with the Florida Supreme Court’s decision in Olmstead v. The Federal Trade Commission. In Olmstead, the court held that the owner of a single-member LLC must hand over all right, title, and interest in the LLC to his creditor, the FTC. The majority opinion suggested a similar remedy may be available in the context of a multi-member LLC.

The Olmstead decision sent shockwaves through the small-business legal community. Asset-protection blogs erupted with articles about the possible demise of LLCs as a protection vehicle. Even though Olmstead only applies in Florida, and only interprets the Florida LLC statute, judicial decisions have a way of spreading to other jurisdictions. This is particularly true where the decision interprets a relatively uniform law, such as the LLC provision in question. Ohio’s business lawyers were not at ease. (Are lawyers ever at ease?)

With the latest round of LLC amendments, the Olmstead-doctrine in officially dead in Ohio. The statute now provides that a charging order “is the sole and exclusive remedy that a judgment creditor may seek to satisfy a judgment against the membership interest of a member.” To make this crystal clear, the legislature added: “No creditor of a member … shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.” The asset-protection blogs are overjoyed.

Note that this is essentially the same protection afforded to corporate shareholders. And as with the corporate form, this LLC protection is subject to “veil piercing” if the legal entity is used as a shield for fraud and abuse. The idea is to protect entrepreneurs and their co-owners, not to provide cover for criminal enterprise.

Section 1705.281 – Fiduciary Duties

Fiduciary duties have long been a part of corporate law. A fiduciary is one of oversees the assets of another. The directors and officers of a corporation act as fiduciaries for the shareholders. And as fiduciaries they owe certain well-established duties, such as the duty to act in good faith, with loyalty and care.

Until now it was unclear exactly how far these corporate duties extended into the arena of LLC law. Egregious behavior was clearly out of bounds. But, as discussed in an earlier post, LLCs are more like partnerships than corporations in their governance. And no one really knew if LLCs carried the strong fiduciary obligations of a general partnership, or the more relaxed standards afforded limited partners.

The addition of Section 1705.281 clarifies this. LLCs impose a strong set of fiduciary duties including the duty of loyalty, the duty of care, and the obligation of good faith and fair dealing. I will save a full discussion of these duties and obligations for another time, but very briefly, here’s what the statute provides:

Duty of Loyalty – Members hold the assets of the company in trust for one another and cannot appropriate an opportunity that should belong to the company; members must avoid all conflicts of interest and may not compete with the LLC.

Duty of Care – Members must refrain from grossly negligent or reckless conduct, intentional misconduct, or any knowing violation of law in carrying out their obligations as members of the LLC.

Section 1705.282 – Manager Duties

This section provides, in a convoluted way, that if a member agrees in writing to act as a manager, that member also owes the duties of a manager. If the member doesn’t agree in writing to be a manager, she only owes the duties of a member. And, by implication, a manager who isn’t a member, only owes the duties of a manager.

Clear enough?

Managers, as noted above, have a role in a limited liability company similar to that of directors or officers in a corporation. If the operating agreement provides for managers—and it doesn’t have to, there are plenty of member-managed LLCs out there—but if it does, all day-to-day operations are controlled by the managers. The members are relegated to major decisions and to appointing managers, just as shareholders only vote on major corporate actions and on the election of directors.

Managers are obligated to act in good faith and in the best interests of the company. They aren’t allowed to take company opportunities for their own. And if they act to the reckless or deliberate injury of the company, they may be held liable for monetary damages. But members have even higher obligations and responsibilities to one another and to the company, so it’s not immediately clear what additional obligations this section imposes on member-managers.

Section 1705.29 – Managers Owe Good Faith

As noted above, managers of an LLC owe the company the fiduciary duty to act in good faith and in the best interests of the company. This section was amended to clarify that unless the manager is also a member who agreed to the job in writing, the manager only owes the duty of good faith—not all that other stuff added in 1705.281.

Section 1705.47 – Calling it Quits, by Court Order

It was previously the case that an LLC member could petition the court of common pleas for a decree of dissolution. The court could issue a decree if it was “not reasonably practicable to carry on the business of the company.” But the court didn’t have to issue the decree.

The amendment expanded this power, and now a court now must dissolve a company if:

  1. An event makes the business of the LLC unlawful (but the company has 90 days to cure before being dissolved).
  2. The court determines that “the economic purpose of the limited liability company is likely to be unreasonably frustrated.”
  3. The court determines that a member has engaged in conduct that “makes it not reasonably practicable to carry on the business with that member.” (like if one member is a crook or completely obnoxious.)
  4. The court determines that it is not reasonably practicable to carry on the company’s business in conformity with its Articles or operating agreement.

 

The recent LLC amendments add a great deal of clarity to Ohio’s LLC law. In some sense they limit the flexibility of LLC members, and the changes may encourage some types of businesses—in which conflicts are anticipated and unavoidable—to organize in states such as Delaware or Nevada. But on balance, I think that by adding clarity and predictability to the LLC environment, these changes are a big step forward for Ohio business law.

Read more about Starting a New LLC.