- A limited liability company is no longer a new creation in business organizations law.
- The LLC was originally designed to answer the need for a business entity that combined limited legal liability (like a corporation) with pass-through taxation (like a general or limited partnership) to the owner.
- LLCs are an attractive organizational way to do business for many types of closely-held businesses.
Organization 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 member(s) are not responsible for the debts and obligations of the company and the member(s) may participate in management without losing limited liability. Management of an LLC may be structured like a corporation, with manager(s) functioning like directors of a corporation, or like a partnership in which the members manage the company directly without managers. On the other hand, unlike a NJ partnership which allows for the transfer of ownership interests, proposed NJ LLC members do not become members with voting rights unless all other existing members consent.
Potentially, the most important document of an LLC is the company’s operating agreement. The LLC statute is designed to allow owners maximum flexibility in devising their own company structures and rules. While NJ LLC statute(s) provide many provisions and standards, most are by default only and almost all of them are subject to modification in the LLC operating agreement. As a result, “[t]he LLC’s model of contractual freedom is found in few other places in the world.”
Governance Issues Unique to LLCs
The certificate of formation and the company agreement are the governing documents of an LLC. The certificate states whether the LLC will be governed by its members or by designated managers. The NJ LLC statutes contemplate that the company operating agreement sets forth all matters relating to the governance of the LLC and the relations of its members. In the event of a conflict between the certificate of formation and the operating agreement, the certificate controls unless prohibited by law.
The law provides that all members must agree to the terms of the company agreement, and all members must agree to any amendment. Similarly, any amendment or restatement of the certificate of formation requires a unanimous vote of the members. However, these requirements may be modified in the certificate or company operating agreement. New Jersey law allows a single member LLC to execute an enforceable company agreement. Persons who join the LLC as members after its inception are bound by the existing certificate and operating agreement and are required to exercise diligence in obtaining and understanding the contents of the certificate and company agreement.
But understand that it is not statutorily mandated 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, the default provisions of the NJ LLC statute substitute for the omitted provision.
Member Management of the LLC
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 managed LLCs because the members are also the governing persons, with all the rights, powers, and responsibilities that accompany that position. For example, the rights of members to inspect company records are somewhat limited, however, when the members are also governing persons, they have virtually unlimited information rights.
Another area that can cause significant confusion is voting. Under the default provisions of the NJ LLC, every member and every manager have an equal vote. This may be changed in the certificate or company agreement, but it is often overlooked. Therefore, a two-member membership-managed LLC may find itself hopelessly deadlocked, even when one member owns 90% of the equity and the other member owns only 10%. This is a critical issue to identify and address, specifically in the operating agreement.
Fiduciary Duties in an LLC
NJ courts 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. The courts have also recognized a fiduciary duty between manager-members who control the LLC and non-controlling members based on the controlling member’s intimate knowledge of the company’s affairs.
Oppression in Limited Liability Companies
Minority owners in small limited liability companies may be oppressed in the same manner and for the same reasons as minority owners in small “S” and/or “C” corporations. Manager-managed LLCs are little different from corporations from an operational standpoint. Members have no management authority but elect managers to run the business, just like shareholders in a corporation vote for directors who run the business. Usually, the person or group holding a majority ownership in an LLC will have control over the selection of managers. In a member-managed LLC, majority members usually make sure that they have management control.
Members of closely-held LLCs are vulnerable to oppression just as shareholders are vulnerable in closely-held corporations. Members in closely-held LLCs usually work together with a small number of other members, making interpersonal conflicts that may develop into ownership issues. Majority rule grants some members control over 100% of the management decisions. These members decide who to hire and fire, whether and how much to distribute, and who gets what information about the business. Majority members in closely-held LLCs have the same temptations to abuse that power. Finally, LLC members, like stockholders, ordinarily have no exit and thus, no ability to escape the trap of oppressive conduct other than to sell at an unfairly low price. Professor Douglas Moll refers to these factors as the “seeds” of oppression and notes that “the problem of oppression is ‘portable’ to the LLC context.”
Thus, majority LLC members have the ability to oppress minority members in exactly the same manner as in corporations. Members controlling the LLC might exclude the oppressed member from participation, cut off information, divert profits away from the minority member, and terminate the minority member’s employment. Majority members can then use their economic leverage to squeeze out the minority by forcing them to sell at an unfair price or to freeze them out by denying them all benefits of ownership and pretending they do not exist.
Minority members of LLCs are also just as able to protect themselves contractually as shareholders in a corporation — perhaps more so given the importance of the company agreement in LLC governance. However, LLC members are just as trusting of their friends and family and are just a naïve as shareholders; therefore, effective contractual protection against oppression is as rare in the LLC as it is in the corporation.
To discuss your NJ LLC matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at firstname.lastname@example.org. Please ask us about our video conferencing consultations if you are unable to come to our office.
By Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold Township, Monmouth County, NJ LLC Law Attorney