40 Year Idaho Business Law Attorney Rips Idaho’s RULLCA

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40 Year Idaho Business Law Attorney Rips Idaho’s RULLCA

In a detailed September 2009 article called “Critique of the Idaho Uniform Revised Limited Liability Company Act” in the Idaho Bar Association’s magazine Idaho attorney Winston Beard was extremely critical about Idaho’s enactment of the Revised Uniform Limited Liability Company Act (RULLCA).  Mr. Beard had over 40 years of legal experience and served for many years on the governing council of the Business & Corporate Section of the Idaho State Bar where he worked on improving Idaho’s LLC laws.

A seven member Legislative Committee of the Business Section of the Idaho State Bar reviewed RULLCA, but took no position on the model law.  Nor did the Idaho State Bar take a position with respect to the adoption of RULLCA.  Nevertheless one of the members of the Uniform Laws Commission who was in the Idaho legislature championed the defective RULLCA and the Idaho legislature replaced Idaho’s LLC law with RULLCA with few changes effective July 1, 2008.

The following are some of the more frightening statements Mr. Beard wrote in his excellent critique of Idaho’s version of RULLCA.  Note the last four sentences.  I agree with those statements.  Any state that adopts RULLCA is creating a nightmare for the members and managers of LLCs formed in the state.  If Arizona were to adopt RULLCA as rewritten by the Arizona State Bar RULLCA subcommittee knowledgeable people and attorneys will form LLCs in non-RULLCA states like Nevada and Delaware that have good LLC law.

“The positions of the IULLCA regarding operating agreements, the absence of statutory apparent authority, the disregard of capital, the absence of a management structure, the absence of an allocation structure, the preference for fact and circumstances tests, the lack of clear definitions and guidelines that businesses can rely on, and the invitations for direct suits by disgruntled members, makes the Idaho LLC an unacceptable choice for businesses. Some of the problems can be corrected by an operating agreement drafted by a lawyer familiar with the 704 rules. But the IULLCA makes it impossible even with good draftsmanship to eliminate the problems with the fiduciary duties and direct action issues. Rather than simplifying the operating agreement, the IUCCLA increases its complexity to a point that demands LLC specialization.

The IULLCA undermines limited liability by imposing personal liability on the members and managers for breach of trustee duties, for taking distributions, and for authorizing distributions when the balance sheet may be negative when based on fair market values. The problems in the IULLCA overwhelm its utility.

The concept of ‘holding as a trustee’ is foreign to business. The role of a trustee is not to take risk. The role of business is to take risk. Concepts of trustee, fiduciary, and prudence have all been deleted from the Model and Idaho Business Corporation Act.22 The breadth of the IULLCA standard is troubling. It includes any property, profit or benefit. Thus, any compensation, any fringe benefit, or any distribution is to be held in trust for the benefit of the corporation. Every member or manager is personally liable to pay back to the LLC all benefits received. That goes a long ways towards destroying the concept of limited liability.

The proponents of IULLCA state that it is consistent with the Revised Uniform Partnership Act and other partnership laws. That misses the point. The question is whether the IULLCA will promote and facilitate business entities in Idaho and will it facilitate a rapid and cost efficient resolution of issues. The answer is a resounding no.

IULLCA and Bushi combine to make Idaho LLCs unfriendly to business. Business lawyers cannot reasonably advise their clients to take the risks inherent in forming or operating an LLC under IULLCA.”

Emphasis added.

The following is the complete text of Winston Beard’s article, which is republished with his permission.

Critique of the Idaho Uniform Revised Limited Liability Company Act

by Winston Beard , Idaho business law attorney

On July 1, 2008, Idaho became the first of only two states to adopt the Uniform Revised Limited Liability Company Act.1 The 2007 Idaho Legislature had the opportunity to provide Idaho with limited liability company (LLC) laws particularly suitable for medium sized entities with simple capital, management, authority, and management liability structures. The new Idaho Limited Liability Company Act fails to meet that need. That failure arises in significant part from the fundamental assumptions on which the Act is premised. In effect, the Act undermines the very concept of limited liability by treating managers and owners like trustees. It adds new complexity making Idaho LLCs unfriendly to business.

Assumptions

The new Idaho Uniform Limited Liability Company Act (IULLCA) was framed around the following assumptions:

  • Fairness is paramount. Fact and circumstances tests are common in the IULLCA. There are few solid guidelines for business.
  • Partnership law serves as the model. LLCs were initially patterned after partnership law to avoid having too many corporate characteristics under tax law. The check-thebox rules of the Internal Revenue Service (IRS) made that unnecessary.2 Most states have followed the assumption that LLCs are a new entity and that neither partnership nor corporation law serves as a pattern. The new Idaho LLC law rejects that approach.3
  • Capital is irrelevant. The new LLC law does not define capital and does not allocate rights on the basis of capital. Capital is central to business persons and central to the IRS, but it is irrelevant under Idaho LLC law.
  • Management is not needed. The new law assumes members are equal and management structure is not necessary. It simultaneously exposes management to greater liability than exists under any other Idaho entity law, except for general partnerships.

Operating Agreement

The operating agreement has always been central to an LLC and most lawyers assume that LLC law is premised on freedom of contract so the operating agreement will always control. That is no longer the law in Idaho.

IULLCA assumes that an operating agreement exists the minute the articles of organization are filed.4 The question is only what is the operating agreement. The operating agreement can be oral (discussion at lunch by organizers), based on emails, course of dealing, or tax returns.5 The official comments to the IULLCA state that the operating agreement includes not only “all relations inter se the members and the limited liability company,” but also all “activities of the company and the conduct of those activities.”

Operating agreements are governed by the complex rules set forth in sections 110-112.6 Idaho Code § 30-6-110(3) sets forth eleven items that the operating agreement may not do. Section 110(4)-(7) defines what portions of IULCCA the operating agreement may modify if the modification is not manifestly unreasonable.7

To further complicate the matter, Idaho Code § 30-6-102(15) has two pages of official comments trying to interface IULLCA with the statute of frauds and § 30-6-107 incorporates the parole evidence rule.8 There are no meaningful guidelines on whether a requirement that the operating agreement be in writing is enforceable.9 Thus a written operating agreement cannot be relied upon unless there is a current certification of all members that (i) there are no other oral agreements or unanimous consents changing its terms and (ii) the business is operated in accordance with the operating agreement.

Capital Structure

Since the IULLCA assumes the entity has no capital, there are no provisions in the Act that define capital, create capital accounts, or regulate rights based on capital. That deficiency can be corrected in the operating agreement.

The official comment to 53-2-503 (ULPA) expresses the concept of the IULLCA drafters: “Nearly all limited partnerships will choose to allocate profits and losses in order to comply with applicable tax, accounting and other regulatory requirements. Those requirements rather than this Act, are the proper source of guidance for that profit and loss allocation.” To create capital accounts and allocate rights based on capital, the drafter of the operating agreement must be thoroughly familiar with the IRS 704 regulations. If profits and losses are not allocated in proportion to properly maintained capital accounts, the IRS doesn’t have to follow the operating agreement.10 I have found few Idaho lawyers that have a working knowledge of the IRS 704 rules. Often capital accounts are created by assigned percentages that do not change as the capital accounts change. Those operating agreements clearly violate the 704 rules.

The concept adopted in many states is to allocate rights to vote and to receive annual and liquidating distributions on the basis of “agreed capital.”11 So if A contributes $1 million, B contributes his knowledge and his possession of market opportunities, and it is agreed A has a 60% interest, then B’s intangible asset has an agreed value of $667,000. The agreed value concept controls rights in the Idaho Limited Partnership Act,12 but the new IULLCA reverts to very old general partnership law.

The LLC default rule is that all rights are allocated by the head count. Thus, if $100,000 is to be distributed to A, with a capital account of $1, and B, with a capital account of $1 million, they each receive $500,000. Also, they have the same voting rights. Obviously this is not acceptable in any business setting so an operating agreement that follows the 704 rules is essential. If the drafter fails to properly draft the agreement, or if the written agreement is irrelevant because course of operations varies from the agreement, there is no agreed capital safe harbor to fall back on. This leaves the majority contributor vulnerable to the unreasonable demands of the minority and requires the majority investor to monitor compliance each year to make sure the operating agreement is being followed.

The 704 rules require the use of fair market value capital accounts and the book-up of those accounts upon any withdrawal or addition of contributed capital. The 704 rules make arbitrarily assigned percentage capital accounts highly suspect. It is necessary for intangible capital to be valued at the time it is contributed, and it is important for services not to be considered capital until the services are performed and not otherwise paid for. None of these basic rules are in the IULLCA, which reflects the drafters’ concept that the IULLCA was not designed for businesses with capital.

Contributions

Idaho Code § 30-6-102 states that a contribution is any benefit provided by a person to an LLC in order to become a member. The contribution can include a promissory note, services, or intangibles. The use of a promissory note, not yet performed services, or unspecific intangibles may violate the Idaho Constitution.13 Idaho Code § 30-6- 102 does not include a requirement of a writing to prove the agreement to contribute or to prove an employee was performing services for an oral promise of an interest in the LLC. An employee can sue for what he perceives was a verbal promise of an interest in exchange for work. Both the LLC and its creditors can enforce oral promises to contribute that may have been made over lunch. This rule is the opposite of the rule applicable to old Idaho LLC’s.14 This requires one more provision in the operating agreement to change the new rule back to the old rule.

Allocations and Distributions

The IUCLLA has no provisions governing allocations. Idaho Code § 30-6-404 governs distributions and provides for distributions to be equal to each member. The drafters got this backwards from a business perspective since allocations need to be defined while distributions do not need to be defined so long as they impact the capital accounts. Allocations of profits and losses are reported on K-1 statements and must follow the 704 rules. One of the great advantages of an LLC is that distributions are totally flexible since they are not taxable. The distributions must impact the capital accounts, but they are not governed by the capital accounts. Most operating agreements that I see specify fixed percentages for both allocations and distributions. Fixed percentages most likely violate the 704 rules on allocations while destroying the flexibility of an LLC on distributions. They prevent the LLC from being used as a vehicle for retirements and flexible buy-ins and buy-outs. At a minimum, the default IULLCA rule that distributions are based on head count and not capital must be changed in the business entity operating agreement. Even that change leaves unaddressed the issue of how allocations are made. Since there is no default rule in the statute, the business entity operating agreement should establish rules consistent with the 704 provisions.

An Idaho LLC cannot make a distribution if it is not able to pay its debts as they become due or if the liabilities exceed the assets.15 If a distribution is made in violation of Idaho Code § 30-6-405, the following section provides all those consenting to the distribution are personally liable to pay the LLC the amount of the illegal distribution. These provisions significantly weaken the limited liability shield of the LLC particularly where the value of real estate assets may be in decline while rents continue as normal. This means even the single member LLC set up to hold real estate may have little practical purpose.

Authority

In business, the offices of president or CEO, treasurer, secretary, and manager have traditionally carried statutory apparent authority. Official comment (a)(1) to § 30-6-301 rejects the concept of statutory apparent authority. That means no one has the right to rely on a person’s status as a member, manager, or officer of an LLC.

The concept of apparent authority is not rejected; it is just turned into a fact and circumstances test. The IULLCA solution to the uncertainty of a fact and circumstances test is a statement of authority16 that is filed with the Secretary of State’s office.17 Can a CPA rely on the representations of the president or manager of an LLC? Only if there is a statement of authorization on file or a specific authorization by the members. The same is true with attorneys seeking to know the LLC’s position in litigation or contract negotiations. Absent a filed statement of authority, attorneys have no right to rely on the engagement by a member or manager of an LLC on the basis of the person’s position. Apparent authority could be created by a holding out by the company, but the holding out must be something other than the conferring of a title. Whether an annual statement creates apparent authority will be determined on a fact and circumstances test. The only safe position is to require the filing of a statement of authority.

Internal Management

Idaho Code § 30-6-302(3) reminds us that the apparent authority and the statement of authority apply only on external authority issues. They do not control internal authority; so, again the office of a person and even a statement of authority filed with the Secretary of State does not create internal authority.

IULLCA fails to provide any internal management structure. The rules in Idaho Code § 30-6- 407 state each member or manager has equal authority. Comment (c) (3) states: “subsection (c) (3) does not describe board management.” The effect of section 407 is that each member or each manager has the same authority as any other member or manager. If there are three managers, each manager has full authority to act but without any statutory apparent authority. The three do not need to meet to confer and vote. Each is fully empowered to act on his/her own. If a difference arises, the difference is to be resolved by a vote of the majority.18 Thus, so long as a manager acts without consulting and is therefore not aware of a difference he/she can act with full authority. This management structure motivates members not to talk to each other and to act before discussion. It is imperative that the business entity operating agreement undo the statutory provisions and set up an internal management structure that makes sense.

Management Liabilities

IULLCA sets up four categories of duties for those who manage an LLC. Idaho Code § 3-06-110 restricts a practitioner’s ability to eliminate or modify those duties. First, IULLCA adopts the covenant of good faith and fair dealing. That covenant cannot be eliminated or modified, although standards to measure performance can be specified and the Act allows for indemnification and limitations on damages.19 Second, the IULLCA adopts a due care standard subject to the business judgment rule. The due standard of care is similar to the corporate standard. The duty of care cannot be eliminated but can be altered if the alteration is not manifestly unreasonable and does not affect knowing and intentional acts.20 The first two duties and the restrictions on them are consistent with business practices and should not pose a problem to Idaho lawyers.

Third, IULLCA recognizes uncabined duties. The Revised Uniform Partnership Act, Uniform Limited Liability Company Act, and the Uniform Limited Partnership Act cabined the duties and stated the duties of management included only those set forth in those laws. The new IUCLLA reverses those positions and allows a judge to impose unspecified and unknown duties.21 Idaho Code § 30-6-110(4) (d) allows the uncabined duties to be modified but does not allow them to be eliminated. Thus, to modify the uncabined duties they must first be set out in the operating agreement. Since most attorneys would be unwilling to enumerate the uncabined duties, those unspecified duties will be included in most operating agreements by default and without modification.

Fourth, the duty of loyalty is set forth in Idaho Code § 30-6- 409(2)(a) picks up language from partnership law and from the old Idaho LLC law. However, it is inconsistent with business standards. It includes the duty to “account to the company and to hold as trustee for it any property, profit or benefit derived by the member” in the conduct of the company’s activities, from use of the company property, or appropriation of a business opportunity. It also includes a prohibition on related party transactions and competitive activities.

The concept of “holding as a trustee” is foreign to business. The role of a trustee is not to take risk. The role of business is to take risk. Concepts of trustee, fiduciary, and prudence have all been deleted from the Model and Idaho Business Corporation Act.22 The breadth of the IULLCA standard is troubling. It includes any property, profit or benefit. Thus, any compensation, any fringe benefit, or any distribution is to be held in trust for the benefit of the corporation. Every member or manager is personally liable to pay back to the LLC all benefits received. That goes a long ways towards destroying the concept of limited liability. Idaho Code § 30-6-110 allows the duty of loyalty to be eliminated or modified if the modification is not unreasonable. There is a strong risk that elimination would be viewed as unreasonable so modification is the only safe course of action. Presumably, a modification to exempt approved compensation, distributions, and benefits would fall within the ambit of a reasonable modification. However, this modification must be in the operating agreement.

The duty of loyalty also includes the prohibitions on related party transactions, business opportunities, and competitive activities. Conflicting interest transactions are made subject to a defense of fairness and all of the prohibitions are made subject to a defense of approval or ratification.23 The concern with these duties is that most closely held entities involve related party transactions, allocations of business opportunities, and allowance of some competitive activities by the members. The Delaware Limited Liability Company Act took a much simpler approach. It approves all related party transactions unless the operating agreement provides otherwise.24

Direct Actions

Idaho Code § 30-6-901 allows a member to maintain a direct action against any other member or manager to enforce the member’s rights or protect the member’s interests provided the member can show injury to the member that is not solely injury to the LLC. Few lawyers will have difficulty showing injury to the member; thus, direct actions can be expected to be plead and allowed in almost all situations. Idaho Code §§ 30-6-110(i) provides the operating agreement cannot unreasonably restrict the right of a member to maintain a direct action. Thus concerns about the threat of direct actions cannot be effectively dealt with in the operating agreement. This adopts a radically different policy than the independent panel that can substitute for court action in the corporate shareholder setting.25 One must wonder why corporate shareholder lawsuits are discouraged, while LLC member lawsuits are encouraged. The prospect of direct member suits further erodes the limited liability shield of an Idaho LLC.

Compensation

Idaho Code § 30-6-407(6) provides that a member or manager does not have claim for compensation for services except in connection with winding-up an LLC. The default rule means that payments made to a member for services are charged against his capital account. The operating agreement needs to expressly provide that routine payments to members working in the LLC are to be section 707 guaranteed payments and thus chargeable as an expense. If the payments are charged to the capital accounts, the capital account of the one being paid the most will decrease and his ownership and rights may similarly decrease. I have seen accountants charge unequal monthly compensation to the capital account resulting in unintentional changes to carefully balanced ownerships. Every operating agreement in a business setting needs to reverse the Idaho Code § 30-6-407(6) rule and distinguish between IRC § 707 distributions and IRC § 704 distributions.

Liquidation

The liquidation rules under IULLCA are the same as under the old LLC law. That rule provides for contributed capital (not earned capital) to be returned and then the balance be distributed equally to members.26 Thus, if A contributed $1 and B contributed $1 million and if the business a few years later has $5 million to distribute, B will have his $1 million returned. The remaining $4.0 million will be distributed $2.0 million to each. That means the one who took the greatest risk will get the least return on his money and the one that took the least risk will get the greatest return on his money. In a society that rewards successful risk taking, the economics of the IULLCA is backwards. The solution is to return the capital in proportion to the capital accounts.

Bushi v. Sage Health Care PLLC

In Bushi v. Sage Health Care PLLC, 203 P.3d 694 (2009), the Idaho Supreme Court confirmed my worst fears about IULLCA. Although Bushi was decided under the LLC law prior to the adoption of the Idaho Uniform Revised Limited Liability Company, its principles and logic will be easily applied to the new law. Applying Bushi to the new law leads to the following conclusions:

  • IULLCA will be interpreted under the law of general partnerships and common law equity principles.
  • Adherence to an operating agreement does not protect business owners even if the operating agreement is legal and even if it is applied consistent with the covenant of good faith and fair dealing.
  • Uncabined duties are recognized in Idaho and are applicable to both members and managers.
  • One of the uncabined duties is that members and managers of an LLC are considered true fiduciaries and must set aside their self interests and not use their positions to obtain financial gain that is not shared by those who disagree with them.
  • Members of LLCs can sue directly for breach of duties. Bringing a derivative action is not necessary. Since duties are owned to members rather than to the entity, the member can always show actual or threatened injury to the member.

Business leaders are not fiduciaries. They owe duties to their business but those are not duties of a trustee. The role of a business leader is to take risk. A fiduciary’s role is to avoid risk. A business person is expected to seek economic gain and is not a disinterested trustee who has no personal stake in the business. In small and medium size LLCs the member and most managers usually have a self interest. Bushi requires them not to protect their self interest. This may sound good to the Supreme Court, but businesses cannot operate under rules applicable to trustees. Business requires that decisions be made. Decisions always adversely affect someone. Bushi is simply impractical and will create an atmosphere of risk avoidance, failure to make difficult decisions, and a constant threat of litigation.

Conclusion

The positions of the IULLCA regarding operating agreements, the absence of statutory apparent authority, the disregard of capital, the absence of a management structure, the absence of an allocation structure, the preference for fact and circumstances tests, the lack of clear definitions and guidelines that businesses can rely on, and the invitations for direct suits by disgruntled members, makes the Idaho LLC an unacceptable choice for businesses. Some of the problems can be corrected by an operating agreement drafted by a lawyer familiar with the 704 rules. But the IULLCA makes it impossible even with good draftsmanship to eliminate the problems with the fiduciary duties and direct action issues. Rather than simplifying the operating agreement, the IUCCLA increases its complexity to a point that demands LLC specialization.

The IULLCA undermines limited liability by imposing personal liability on the members and managers for breach of trustee duties, for taking distributions, and for authorizing distributions when the balance sheet may be negative when based on fair market values. The problems in the IULLCA overwhelm its utility.

The proponents of IULLCA state that it is consistent with the Revised Uniform Partnership Act and other partnership laws. That misses the point. The question is whether the IULLCA will promote and facilitate business entities in Idaho and will it facilitate a rapid and cost efficient resolution of issues. The answer is a resounding no.

IULLCA and Bushi combine to make Idaho LLCs unfriendly to business. Business lawyers cannot reasonably advise their clients to take the risks inherent in forming or operating an LLC under IULLCA.

About the Author

Winston Beard is an attorney and shareholder at the law firm for Beard St. Clair Gaffney and has been practicing law in Idaho since 1967. With over 40 years of experience Winston has successfully litigated cases within all practice areas, lobbied numerous bills through the Idaho Legislature, participated in acquisition evaluations, and served on various boards of directors. Winston has extensive experience in employment and commercial litigation, tax planning, anti-trust matters, trademarks, agribusiness, and software development businesses to name a few. Winston served for many years on the governing council of the Business & Corporate Section of the Idaho State Bar where he worked on improving Idaho’s LLC laws. Winston is admitted in Idaho and Washington.

Endnotes

1 The other state is Iowa.

2 See Prefatory note to IULLCA, preceding Idaho Code § 3-06-101.

3 Prefatory note to IULLCA. paragraph 7, official comments to § 30-6-102(15).

4 Second paragraph of Official Comment to Idaho Code § 30-6-110.

5 Idaho Code § 30-6-102(15).

6 The official comments for those sections cover seven pages in the Idaho

7 The manifestly unreasonable standard is defined in IC § 30-6-110(8).

8 Official comment to Idaho Code § 30-6-110(a)(4).

9 Idaho Code § 30-6-110, Official Comment subsection (a)(4)

[(1)(d).

10 Internal Revenue Code § 704(b).

11 See LLC laws of Nevada and Delaware.

12 Idaho Code § 53-2-503.

13 Article 11, §§ 9, 16.

14Idaho Code § 63-627.

15 Idaho Code § 30-6-405.

16 Idaho Code § 30-6-302.

17 The statement of authority is only good for five years. Idaho Code § 30-6-302(10). It does not create internal authority. Idaho Code § 30-6-302(3). The statement of authority is probably essential in real estate transactions. Idaho Code § 30-6-302(6). The certificate of organization cannot include a statement of authority. Idaho Code § 30-6-201(3).

18 Idaho Code § 30-6-407(2)(c).

19 Idaho Code § 30-6-110.

20 Idaho Code § 20-6-110.

21 Idaho Code § 30-6-409 comment (a) and (b).

22 Idaho Code §§ 30-1-830 and 831 and official American Bar Association comment to Idaho Code § 30-1-830.

23 Idaho Code § 30-6-409 (5)-(6).

24 Delaware Limited Liability Company Act § 18-107.

25 Idaho Code §§ 30-1-740 to 747.

26 Idaho Code § 30-6-708.

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