BUSINESS LAW STATE BAR CONVENTION PREVIEW The Business Law Section is pleased to be hosting Harold A. (“Hal”) Hadden, of the Denver, Colorado firm of Hadden, Morgan & Forman, P.C. Mr. Hadden, who will lead off the afternoon session with a discussion of the issues facing companies being investigated in the highly charged corporate compliance environment following the fraud scandals that have rocked the corporate and accounting professions nationally in recent years. Sarbanes-Oxley Legislation; Corporate Fraud Mr. Hadden has substantial experience with national cases involving SarbanesOxley where significant allegations of corporate fraud were at stake. The Section is truly fortunate to be able to offer his perspectives on these very important issues at the upcoming Convention. In addition to examining corporate criminal enforcement issues on the national level, the Section’s Friday afternoon session will include a panel discussion on white collar criminal enforcement in Arizona. This program will be moderated by Lee Stein of Fennemore Craig. Mr. Stein will be joined by a distinguished panel consisting of Paul Charlton, the United States Attorney for the District of Arizona; Donald E. Conrad, Chief Counsel, Criminal Division, Arizona Attorney General’s Office; and a representative of the Phoenix Division of the Federal Bureau of Investigation. In addition, Mr. Stein will be joined by two other criminal defense attorneys in private practice in Arizona, Doug Behm, of Jennings, Strouss & Salmon, P.L.C., and Tom Henze, of Gallagher & Kennedy, P.A. The panel will address federal and state criminal law enforcement issues, overview and impact of Sarbanes-Oxley, practical considerations when representing a corporate client who is the subject of a criminal investigation, and ethical issues. We are very excited about our programming for the upcoming State Bar Convention, and hope that you will join us on Friday, June 13, at The Phoenician. Drafting LLC Operating Agreements: Beware of Statutory “Default” Rules By Kathleen Giancana Perhaps the most important chapter in a basic primer on “How to Draft Arizona Limited Liability Company Operating Agreements” would provide an outline of the default rules contained in the Arizona Limited Liability Company Act, A.R.S. §§ 29-601 – 29-857 (the “Act”). What is a default rule and why is an understanding of the default rules important? The Act basically contains three types of provisions. First, it provides instructions on how to form a limited liability company (an “LLC”), how to amend the articles of organization, what fees are required, etc. Second, it contains various mandatory rules governing Arizona LLCs that cannot be changed by agreement of the members.1 Finally, it contains various default rules that essentially create an operating agreement for LLCs that do not have one, or resolve matters upon which an existing operating agreement is silent. A default rule is a statutory provision that governs the operation of an LLC unless an operating agreement provides otherwise. Some of the default rules are surprising. For example, the default rule on member voting provides that each member is entitled to one vote, regardless of percentage interests. A.R.S. § 29-681.E. Thus, if the percentage interests of A, B, and C in an LLC are 85%, 10%, and 5%, respectively, B and C voting together can control any vote requiring a majority vote unless the operating agreement provides otherwise. A capable practitioner is likely to include provisions dealing with most matters covered by the default rules. But unless the drafter of an operating agreement has a checklist of these rules, either written down or in his head, he runs the risk of unintended consequences that may result from failing to address one or more of these matters. Knowledge of the default rules is also useful in answering the common client question: “Why do I need an operating agreement?” In most cases, clients will not be satisfied with the manner in which the default rules would govern the operation of their LLC. A brief description of those rules will persuade them of the benefits of having an operating agreement. Statutory Model Operating Agreement Most LLCs represented by legal counsel have an operating agreement. The “model” operating agreement resulting from the default rules in the Act appears to have been designed to protect and anticipate the needs of unsophisticated joint venturers who do not have legal advice in structuring their LLC arrangement. Under the default rules, each member is treated equally with respect to voting, distributions, allocations of taxable income, etc. The only exception is that distributions are made in proportion to capital contributions, but only until all capital contributions have been repaid. A.R.S. § 29-703.B. For example, if the contributions to an LLC made by A and B are $750,000 and $250,000, respectively, the first $1,000,000 of distributions will be made 75% to A and 25% to B, but all further distributions will be made to A and B equally. Thus, the Act does not reflect the concept of “percentage interests,” common to many operating agreements, where the interests of A and B in all operating and liquidating distributions might be 75% and 25%, respectively, even after capital contributions have been repaid. It is important to note in the following discussion of the default rules that, unless otherwise stated, all of the rules can be modified by an operating agreement. Capital Contributions Services as Capital Contribution. Under the Act, the term “capital contribution” includes services. The value of a contribution of services is the fair market value of the services at the time they are rendered. A.R.S. §§ 29-601.3, 29-703.C.1. Assume, for example, that A contributes $1,000,000 to an LLC and B only contributes services. Many operating agreements would provide that A was to receive a return of his Continued on page 3 2 May 2003 • The Arizona Business Lawyer Drafting Limited Liability Company Operating Agreements: Beware of Statutory “Default” Rules $1,000,000 contribution before any amount was distributed to B. Under the default rules, however, it would be necessary to determine the value of B’s services. Initial distributions to A and B would be made on a pro rata basis as if B had contributed cash in an amount equal to the fair market value of those services (which arguably would be worth $1,000,000 if B received a 50% interest). If this is not the intended result, the operating agreement should specifically provide that the provision of services is not treated as a capital contribution. The capital contribution default rule also creates a lurking tax problem. In general, if one member gives up any part of his right to be repaid his capital contribution in favor of another member as compensation for services, the services member has upfront income in an amount equal to the value of his right to the other members’ capital contributions. Treas. Reg. § 1.721-1(b)(1); Rev. Proc. 93-27, 1993-2 C.B. 343. In the example above, B may have a right to a portion of A’s $1,000,000 contribution under the default rules if he has already performed the services for which he is receiving the capital contribution at the time A contributes the $1,000,000. This could cause the receipt of the interest to be immediately taxable to B.2 Thus, an operating agreement should specifically provide that the provision of services is not treated as a capital contribution or, if it is intended that capital contribution credit be given for services, the tax consequences of the provision should be carefully analyzed and explained to the members prior to their execution of the operating agreement. Value of Capital Contributions. Unless an operating agreement provides otherwise, the value of capital contributions is determined as follows: (a) the value of services is the fair market value of the services at the time they are rendered, (b) the value of property other than cash is the fair market value of the property at the time it is transferred to the LLC, (c) the value of the “use of property” is the fair market value of such use when the LLC enjoyed the possession or use, and (d) the value of other non-cash contributions is zero. A.R.S. § 29703.C. As in the case of services, if the value to the LLC of the use of a member’s property is not intended to be treated as a capital contribution, this needs to be specifically stated in the operating agreement. Consent to Capital Contributions. Under the default rules, the consent of all members is necessary to fix or modify the amount of capital contributions required to be made by the members, or to release a member from an obligation to make a capital contribution. A.R.S. §§ 29701.B, 29702.C. Thus, even in a “manager managed” LLC, the manager cannot require additional capital contributions to be made by the members unless the operating agreement specifically provides him with that power. Inability to Perform. Under the default rules, a member is required to perform any enforceable promise to make a capital contribution, including a promise to perform services, even if he is unable to perform because of death, disability, or any other reason. A.R.S. § 29-702.B. If a member does not make a required capital contribution or perform required services when due, he is obligated at the option of the LLC to contribute cash equal to the value of that portion of the promised capital contribution or services that have not been made. This provision should be taken into account when representing services members because, unless the operating agreement provides otherwise, the estate of a services member may be monetarily liable if the member ceases to be able to perform services because of his death or disability. any vote requiring the approval of a majority of the members or managers requires the affirmative vote of more than one-half of the members or managers, respectively, voting on the basis of one vote per member or manager. A.R.S. § 29-681.E. Thus, if the percentage interests of the members are not equal and a vote reflecting the different percentage interests is desired, the operating agreement must provide that each member has a percentage vote equal to his percentage interest. Actions Requiring Unanimous Vote. The following actions require the unanimous vote of all members under the default rules (whether the LLC is “member managed” or “manager managed”): (a) adopting or amending the operating agreement, (b) authorizing a transaction or action unrelated to the purpose or business as set forth in the operating agreement, (c) issuing an LLC interest to any person, (d) approving a plan of merger or consolidation with or into another business entity, and (e) changing the status of the LLC from member managed to manager managed or vice versa. A.R.S. § 29-681.C. Unless an operating agreement contains specific provisions to the contrary, these default rules may give a minority member more power than is intended by the parties. For example, it is not uncommon for an operating agreement to fail to address a merger of the LLC into another entity. If the agreement is silent, however, the approval of all members is required, no matter how slight their percentage interest may be. Actions Requiring a Majority Vote. The following actions require the approval of a majority of the members or managers under the default rules (depending upon whether the LLC is member managed or manager managed): (a) resolving business differences, (b) authorizing distributions, (c) authorizing the repurchase of a member’s The capital contribution rule also creates a lurking tax problem. Voting Per Capita Basis. Under the default rules, Continued on page 4 The Arizona Business Lawyer • May 2003 3 Drafting Limited Liability Company Operating Agreements: Beware of Statutory “Default” Rules interest, (d) authorizing the filing of a notice of winding up or articles of termination concerning the LLC,3 and (e) authorizing most amendments to the articles of organization. A.R.S. § 29-681.D. the managing member/manager if the LLC were manager managed. A.R.S. §§ 29681.D, 29703.A. Choice of Manager. A manager of an LLC does not have to be a member unless otherwise provided in the operating agreement. A.R.S. § 29-681.B. If an operating Management agreement does not provide a manner for Member Managed versus Manager designating or electing additional or Managed. The decision with respect to replacement managers, on the withdrawal or whether an LLC should be member manresignation of a manager, management of aged or manager managed is very important the limited liability company continues to if the default rules are not considered carebe vested in the remaining managers, or if fully. Different default rules apply dependthere are no remaining managers, management is vested in one or more new managers to be designated or elected by a majority The decision with respect to of the members. A.R.S. § 29-681.B. whether an LLC should be member managed or manag- Distributions Timing and Amount of Distributions. If an operating agreement if the default rules are not does not specifically set forth rules for considered carefully. Different determining when distributions to members default rules apply depending are to be made and the amount that is to be upon the management status distributed, all distributions must be approved of the LLC. by a majority of the members, if the LLC is member managed, or by a majority of the managers, if the LLC is manager managed,. A.R.S. §§ 29ing upon the management status of the 681.D.2, 29-703.A. Almost all operating LLC.4 See, e.g., A.R.S. § 29681.D. Some LLCs are member managed but have a agreements deal with the priority of distrimanaging member who has broad managebutions, i.e., how distributions are to be ment authority. In that situation, many of allocated among the members. Care should the default rules will be applied differently be taken, however, to make sure that the than they would be if that managing memtiming and amount of distributions is also ber had been the designated manager in a addressed; otherwise, at least in the case of manager-managed LLC. For example, the a member-managed LLC, a majority vote timing of distributions would be decided by will be required each time a distribution is a majority of the members if the LLC were to be made. member managed, but would be decided by Priority of Distributions. The default rule er managed is very important for the priority of distributions may be surprising to some practitioners. Unless an operating agreement provides otherwise, distributions to members are made first in proportion to capital contributions (cash and the fair market value of other contributions, including services and the use of member property unless the operating agreement provides otherwise) until each member has been repaid his capital contributions, then to the members equally (i.e., not according to percentage interests). A.R.S. § 29-703.B. In other words, if A contributes $800,000, B contributes $200,000, and neither contributes services, the first $1,000,000 is distributed $800,000 to A and $200,000 to B, and all further distributions are split equally between them. In many typical arrangements with unequal capital contributions, A and B would have expected that A and B had acquired 80% and 20% interests, respectively, and would been allocated distributions in an 80/20 ratio, even after the return of capital contributions.5 Distributions on Liquidation. Under the default rules, distributions on liquidation, after paying creditors, are made first in satisfaction of certain statutory distribution requirements to members and former members, then to repay capital contributions, and then to the members equally (i.e., not according to percentage interests). A.R.S. § 29-708. Tax Allocations Allocation of Profits for Tax Purposes. Unless the operating agreement provides otherwise, the allocation of profits (i.e., taxable income and certain other items) for tax purposes is made in the same manner in which members share in the amount of distributions that exceed their capital contributions. A.R.S. § 29-709. Thus, if the default rules also apply for purposes of determining the allocation of distributions (e.g., if there is no operating agreement), profits are allocated to the members equally. A.R.S. § 29703.B. Allocation of Losses for Tax Purposes. Unless the operating agreement provides Continued on page 5 4 May 2003 • The Arizona Business Lawyer Drafting Limited Liability Company Operating Agreements: Beware of Statutory “Default” Rules otherwise, the allocation of losses for tax purposes is made according to the relative capital contributions the members have made, or have promised to make in the future. A.R.S. § 29-709. Sharing losses in accordance with capital contributions is what would be expected because that is how the members would economically suffer losses. However, the provision does not expressly limit the prescribed manner of allocation to the amount of capital contributions made by each member, or take into account the fact that the capital contributions may have already been repaid. Thus, if A contributes $800,000 and B contributes $200,000, the Act seems to provide that 80% of all tax losses would be allocated to A, even if A had already been allocated $800,000 in losses and/or had already received a distribution of $800,000. As discussed below, however, regardless of the wording of the default rule, such an allocation would not be respected for tax purposes unless it were “in accordance with the partners’ interest in the partnership.” Profits and Loses. The application of the default rules dealing with profits and losses are subject to section 704(b) of the Internal Revenue Code and the Treasury regulations promulgated thereunder, which govern the allocation of profits and losses for tax purposes. Under section 704(b), if a partnership agreement is silent with respect to a partner’s distributive share of the partnership’s “income, gain, loss, deduction, or credit,” the partner’s distributive share of such items is to be determined “in accordance with the partner’s interest in the partnership.” This generally means allocations are to reflect the manner in which the partners have agreed to share the economic benefit or burden corresponding to the income, gain, loss, deduction, or credit that is being allocated. Treas. Reg. § 1.704-1(b)(3)(i). Among the factors considered are (a) the partners’ relative contributions to the partnership, (b) the interests of the partners in economic profits and losses (if different from that in taxable income or loss), (c) the interests of the partners in cash flow and other non-liquidating distributions, and (d) the rights of the partners to distributions of capital upon liquidation. Treas. Reg. § 1.704-1(b)(3)(ii). Transfers of LLC Interests In General. Unless an operating agreement provides otherwise, an interest in an LLC may be assigned in whole or in part. A.R.S. § 29-732.A. The assignee, however, does not become a member of the LLC unless all of the members consent to his admission as a member. A.R.S. §§ 29731.B.2, 29-732.A. Release of Transferor from Liability. Under the default rules, a member who has assigned all or part of his interest in an LLC is not released from his liability to the LLC without the written consent of all members; this rule applies whether or not the assignee becomes a member. A.R.S. § 29-732.C. In other words, if A assigns his entire interest to B, A remains liable to the LLC for, among other things, further capital contributions he was required to make (presumably unless they are made by B).6 It is not uncommon for operating agreements to fail to overcome this default provision. In representing an assigning member, therefore, if it important to examine the operating agreement, and if it does not overcome this default rule, make sure the assigning member obtains the consent of the other member’s to relieve him of all future liability to the LLC. Remaining a Member. The Act provides that a member who has assigned all of his interest in an LLC remains a member until the admission of one or more assignees as a member, but an operating agreement may permit the assigning member to remain a member until all assignees of the member’s interest have been admitted as members. A.R.S. §§ 29-732.C., 29-733.2. Thus, if A assigns half of his interest in an LLC to B and the other half to C, A ceases to be a member if either B or C is admitted as a member, unless the operating agreement provides otherwise. Withdrawal of Members Events of Withdrawal. An event of withdrawal is a circumstance under which a member ceases to be a member of an LLC, either voluntarily or involuntarily. The Act includes both default events of withdrawal (i.e., those that apply unless the operating agreement provides otherwise) and mandatory events or withdrawal. All of the provisions, even those that are mandatory, can be overridden by the written consent of all the members at the time of the event. The default events of withdrawal are as follows: (a) the member makes an assignment for the benefit of creditors or files a voluntary petition in bankruptcy, (b) one of various other bankruptcy-type events occurs with respect to a member, (c) the member is adjudicated incompetent, and (d) in the case of a member that is acting as a member by virtue of being a trustee of a trust, there is a termination of the trust (but not merely the substitution of a new trustee). A.R.S. § 29-733. The mandatory provisions (which still can be overridden by the consent of all the members at the time of the event) are (1) the death of member, (2) the voluntary withdrawal of a member, (3) the assignment of all of a member’s interest and admission of one or more assignees as a member (but an operating agreement may permit the assigning member to remain a member until all the assignees have been admitted as members), (4) in the case of an estate, the distribution by the fiduciary of the estate’s entire interest in the LLC (but an operating agreement may permit the estate to remain a member until all distributees have been admitted as members), (5) in the case of a member that is a partnership, corporation, or limited liability company, the termination or dissolution of such entity (but an operating agreement may allow the member to remain a member until it ceases to exist as a legal entity), and (6) the member is expelled as a member pursuant to the articles of organization or an operating agreement. A.R.S. § 29-733. It is advisable Continued on page 6 The Arizona Business Lawyer • May 2003 5 Drafting Limited Liability Company Operating Agreements: Beware of Statutory “Default” Rules for an operating agreement to list all of the mandatory events of default so that the members are aware of them. In addition, the operating agreement should either specifically include or exclude the events that constitute events of withdrawal under the default provisions. Mandatory Rule. A member of an LLC always has the power to withdraw from an LLC and no longer be a member. A.R.S. § 29-734. This is a mandatory provision that cannot be overridden by an operating agreement. The statutory rationale is presumably that no one should be forced to be a “partner” with another against his will. However, the Act provides that if the withdrawal violates an operating agreement, the LLC may recover damages from the withdrawing member. A.R.S. §§ 29-707, 29-734. Thus, if the members are concerned about a member withdrawing, the operating agreement should include a specific provision stating that the members agree not to withdraw and then specifically set forth the desired consequences of an unauthorized withdrawal. Distributions on Withdrawal. A withdrawn member (or his personal representative) has no right to receive any distributions by reason of his withdrawal from an LLC but instead has what is referred to as the “rights of an assignee” during the continuation of the business of the LLC (less damages if the withdrawal is a breach of the operating agreement). A.R.S. § 29707. In other words, unless the operating agreement provides otherwise, the withdrawn member has a right to distributions from the LLC, at the same times and in the same amounts as he would have had if he had remained a member, throughout the term of the LLC. A.R.S. § 29732.A. A withdrawn member, however, no longer has a right to vote or participate in the management of the LLC. A.R.S. § 29732.A. Dissolution Upon Written Consent. Unless the operating agreement provides otherwise, an LLC is dissolved upon the written consent of both (a) more than one-half of the mem- 6 bers (voting on a per capita basis), and (b) one or more members who on dissolution and liquidation would be entitled to receive assets valued at more than one-half the value of all the assets. A.R.S. § 29-781.A.2. Thus, if the percentage interests of A, B, C, and D were 40%, 40%, 10%, and 10%, respectively, a dissolution would have to be approved by both A and B (who together would be entitled to more than one-half of the assets on liquidation), and either C or D (one of whom would have to approve the dissolution for there to be a majority per capita vote). Need for at Least One Member. Unless the operating agreement provides otherwise, an LLC is dissolved upon an event of withdrawal of the last remaining member unless within 90 days all assignees by written consent agree to admit at least one member. A.R.S. § 29-781.A.4. This provision allows a 90-day window to find a new member following what may be an unexpected event of withdrawal, such as the death of a member. Involuntary Dissolution. Unless the operating agreement provides otherwise, involuntary judicial dissolution may be decreed upon application of any member if (a) members or managers are deadlocked and irreparable injury is threatened or suffered or LLC cannot be conducted to advantages of members, (b) members or managers are acting in an illegal or fraudulent manner, or (c) substantial assets are being wasted, misapplied, or diverted.7 A.R.S. § 29-785.A.2. Transactions Between the LLC and Its Members Loans and Other Transactions. Under the default rules, a member or manager may lend money to and transact other business with the LLC, and subject to applicable law, has the same rights and obligations with respect to those transactions as a person who is not a member or manager. A.R.S. § 29-608. Matters to Which Act Is Silent. The Act does not contain any specific fiduciary duty provisions, nor does it address the right of a member or manager to compete with the LLC. Conclusion The default rules of the Act can result in unintended consequences if an operating agreement does not specifically address the matters to which those rules apply. For this, and many other reasons, a thorough knowledge of the Act is necessary before drafting Arizona operating agreements. Endnotes 1. An example of a mandatory rule is discussed below under “Withdrawal of Members – Mandatory Rule.” 2. A discussion of the potential taxation on the receipt of an LLC interest in exchange for services is beyond the scope of this article. In general, however, a services partner is only taxed on the receipt of a “capital interest,” not on the receipt of a “profits interest.” A “capital interest” is an interest that would give the holder a share of the liquidating proceeds if, hypothetically, the LLC were liquidated immediately after the interest was received by the member. A “profits interest” is an interest other than a capital interest. See Revenue Procedure 93-27, 1993-2 C. B. 343. 3. The decision to dissolve, however, is made as described below in “Dissolution – Upon Written Consent.” 4. For examples of this distinction see “Voting – Actions Requiring Majority Vote” and “Distributions – Timing of Distributions.” 5. For a discussion of how the performance of services can affect the priority of distributions, see “Capital Contributions – Services as Capital Contribution.” 6. This may seem like an unusual provision, but it makes sense in the context of free assignability of LLC interests. Without this provisions, a member could relieve himself of future liability by assigning his interest to someone who may not have the ability to satisfy the liabilities of the assigning member. 7. There is also one mandatory provisions allowing an involuntarily judicial dissolution that applies if it is not “reasonably practicable to carry on the limited liability company business in conformity with an operating agreement.” The Arizona Corporation Commission may also dissolve an LLC under certain circumstances. See A.R.S. § 29-786.A. May 2003 • The Arizona Business Lawyer