Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason #7
Forrest Gump’s mother used to tell him “Life is like a box of chocolates. You never know what you’re gonna get.” This statement applies to Section 29-3409 of the new Arizona Limited Liability Company Act (ALLCA) effective September 1, 2019. Members who are subject to Section 29-3409 will NEVER know what they get under this statute until they win or lose a law suit for breach of one or more of the new duties levied on members of member managed Arizona LLCs. This new law imposes fiduciary duties for the first time on members of all member managed Arizona LLCs.
Instead of calling the ALLCA by its full legal name, I frequently refer to ALLCA as the Arizona Liability Company Act because of the many fiduciary duties the new law levies on members of member managed Arizona LLCs. New duties means new potential liabilities imposed on members that can cause them to be named as defendants in lawsuits and to be liable for attorneys’ fees and damages.
Fortunately most of the new fiduciary duties levied on members and managers of Arizona LLCs under ALLCA can be eliminated or modified by a well drafted Operating Agreement. Members of Arizona LLCs that hire a competent Arizona LLC attorney will be able to sign an ALLCA compliant Operating Agreement. Unfortunately it will be the unsuspecting members of member managed multi-member Arizona LLCs that lack an ALLCA compliant Operating Agreement that will be subject to the new fiduciary duties. These new duties levied on members and mangers are a litigation attorney’s dream because they will have many new reasons to sue members of multi-member Arizona LLCs that are member managed.
Current Arizona LLC Law
Current Arizona LLC does not impose any fiduciary duties on members of an Arizona LLC. The Arizona Court of Appeals case called TM2008 Investments, Inc., vs. ProCon Capital Corp. involves a dispute among the two members of Doveland Developments, LLC, a company formed to buy land and develop it into homes. ProCon Capital sued TM2008 Investments for breach of a fiduciary duty called the implied covenant of good faith and fair dealing. The issue before the Arizona Court of Appeals was whether or not Arizona’s limited liability company law provides that a member of an Arizona LLC owes a fiduciary duty to the other members of the LLC. The court said:
“We decline in this case to mechanically apply fiduciary duty principles from the law of closely-held corporations or partnerships to a limited liability company created under Arizona law. The legislature did not explicitly outline any such duties for members of an LLC; instead, the LLC Act allows the members of an LLC to not only create an operating agreement, but also delineate in that agreement the duties members owe one another.”
The times they are a changing. The drafters of ALLCA decided to change drastically Arizona LLC law by adding language in ALLCA that expressly creates new fiduciary duties on members of member managed Arizona LLCs.
Definition of Fiduciary Duty
Cornell Law School’s Wex Legal Dictionary defines “fiduciary duty” as follows:
A fiduciary duty is the highest standard of care. The person who has a fiduciary duty is called the fiduciary, and the person to whom he owes the duty, is typically referred to as the principal or the beneficiary. If an individual breaches the fiduciary duties, he or she would need to account for the ill-gotten profit. His or her beneficiaries are entitled to damages, even if they suffered no harm.
Fiduciary duties exist to encourage specialization and induce people to enter into a fiduciary relationship. By imposing these duties, the law reduces the risk of abuse of a beneficiary by the fiduciary. As a result, potential beneficiaries can have greater confidence in seeking out a fiduciary.
New Arizona Revised Statute Section 29-3409
New Arizona Revised Statutes Section 29-3409 levies the following fiduciary duties on members of member managed Arizona LLCs formed after August 31, 2019, and members of all Arizona member managed LLCs after August 31, 2010:
A. A member of a member-managed limited liability company owes to the company and the other members the duties of loyalty and care . . .
B. The fiduciary duty of loyalty of a member in a member-managed limited liability company includes the following duties:
1. to account to the company and hold as trustee for the company any property, profit or benefit derived by the member to which the member is not entitled:
(a) in the conduct or winding up of the company’s activities and affairs.
(b) from a use by the member of the company’s property.
(c) from the appropriation of a company opportunity.
2. to refrain from dealing with the company in the conduct or winding up of the company’s activities and affairs as or on behalf of a person having an interest adverse to the company.
3. to refrain from competing with the company in the conduct of the company’s activities and affairs before the dissolution of the company.
4. to disclose to each of the other members that are considering or voting on a decision or transaction regarding the company or one or more of the members’ interests in the company both of the following:
(a) any material conflict of interest on the part of the disclosing member with respect to the decision or transaction.
(b) if a material conflict of interest exists, all material facts relating to the decision or transaction that are within the disclosing member’s knowledge and not known or reasonably available to the affected members.
C. The duty of care of a member of a member-managed limited liability company in the conduct or winding up of the company’s activities and affairs is to refrain from engaging in grossly negligent or reckless conduct or willful or intentional misconduct.
D. A member shall discharge the duties and obligations under this Chapter or under the operating agreement and exercise any right consistently with the contractual obligation of good faith and fair dealing. [Author’s comment: Section 29-3105.C.5 says that an Operating Agreement cannot limit or eliminate a person’s liability for any violation of the contractual obligation of good faith and fair dealing.]
Section 29-3409 inflicts seven new duties on members of member managed LLCs. This means ALLCA creates seven new ways a member can be sued by another member or the LLC. Now do you see why I call ALLCA the Arizona liability company act?
Welcome to the New Age of Arizona LLC Law Uncertainty
It’s 2021 and you are a member of a three member Arizona LLC that is member managed. You are subject to Section 29-3409. Anybody can read this statute, but until an Arizona appellate court rules on the duties levied on members in this statute nobody has a clue what the statute means or how a member must act to avoid liability under the statute. Consider the following questions every member will have about Section 29-3409:
- What is the duty of loyalty?
- How does a member satisfy the duty of loyalty?
- What is the duty of care?
- How does a member satisfy the duty of care?
- When does a member get property, profit or benefit to which the member is not entitled?
- When must a member refrain from dealing with the company as or on behalf of a person having an interest adverse to the company?
- When does a member’s activities constitute competing with the company?
- When the members are voting on an issue when does a member have a material conflict of interest with respect to the decision or transaction?
- If the members are voting and a member has a material conflict of interest, how does the member with a conflict know if a fact is a material fact relating to the decision or transaction that are within the disclosing member’s knowledge and not known or reasonably available to the affected members.
- All knowledgeable attorneys will advise members of an Arizona member managed LLC that if the member has any material conflicts of interest with respect to an issue the members are voting on the only way that the member can protect himself or herself is by preparing a written document that discloses all material facts, give the document to all the other members and get a receipt signed by all the other members in which they acknowledge getting the written disclosure document at a specified date and time.
- What is the contractual obligation of good faith and fair dealing? How does a member satisfy this requirement?
How Do Members of a Member Managed Arizona LLC Eliminate or Modify Section 29-3409?
The Section 29-3409 problem is only a problem for member managed Arizona LLCs that are not single member LLCs and LLCs owned by a solely by a married couple. The member / members of these types of Arizona LLCs are not going to sue themselves or hold themselves liable for violating any duties in Section 29-3409.
The Section 29-3409 problem only exists for member managed multi-member Arizona LLCs other than a two member LLC owned by a married couple. My recommendation is that multi-member Arizona LLCs eliminate or modify member duties set forth in Section 29-3409. Here are two ways a member managed multi-member Arizona LLC can eliminate or modify the duties levied on members:
1. Form a manager managed LLC or amend the Articles of Organization of a member managed LLC to change it to a manager managed LLC. The duties imposed on members by Section 29-3409 apply to members only when the LLC is member managed. Warning: Although the members of an Arizona manager managed LLC are not liable for duties under Section 29-3409 all managers of a manager managed Arizona LLC will have similar fiduciary duties under Section 29-3409.
2. Have the members of a manager managed Arizona LLC adopt an Operating Agreement that eliminates unwanted duties in Section 29-3409 or that modifies the duties to make them acceptable to the members. Note: Section 29-3105.C.5 prohibits an Operating Agreement from limiting or eliminating a person’s liability for any violation of the contractual obligation of good faith and fair dealing.
Operating Agreement Can Eliminate or Modify Some Section 29-3409 Duties
One reason your Arizona member managed LLC needs an ALLCA compliant Operating Agreement is to have it eliminate or modify the fiduciary duties set forth in Section 29-3409. The general rule of Section 29-3105.A.3 of ALLCA is “in the event of a conflict between a provision of the operating agreement and this Chapter, the provision of the operating agreement governs” except an Operating Agreement may not:
- eliminate the contractual obligation of good faith and fair dealing or the duty to refrain from willful or intentional misconduct under Section 29-3409, or
- limit or eliminate a person’s liability for any violation of the contractual obligation of good faith and fair dealing or conduct involving willful or intentional misconduct.
KEYTLaw’s Operating Agreement Can Eliminate or Modify Fiduciary Duties
The Operating Agreement we prepare for all of our multi-member LLCs contains language that eliminates all of the members’ duties levied in Section 29-3409. Our Operating Agreements do not eliminate or modify the contractual obligation of good faith and fair dealing or the duty to refrain from conduct involving willful or intentional misconduct. If your member managed Arizona LLC wants its members to be subject to the fiduciary duties levied in Section 29-3409 we will modify the Operating Agreement to make Section 29-3409 applicable to the LLC and its members.
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How to Hire Richard Keyt to Prepare a Custom Operating Agreement
Option 1: Form a New LLC with a Custom Operating Agreement: When you hire me, Arizona LLC attorney Richard Keyt who has formed 8,900+ and has 349 five star Google & Facebook reviews), to form a new LLC I will prepare a custom Operating Agreement. Complete our online LLC formation questionnaire or call me at 480-664-7478 and give me your information. We form new LLCs and get them approved by the Arizona Corporation Commission the same day we are paid and you approve the LLC formation questionnaire you submit to us. See the “contents of the Bronze ($497), Silver ($797) & Gold ($1,297) LLC packages.
Option 2: Purchase a Custom Operating Agreement: If your Arizona LLC's Operating Agreement was drafted for the obsolete Arizona LLC law or if it doesn't have an Operating Agreement its members should hire us to draft a custom Operating Agreement by submitting our online Operating Agreement questionnaire.