Adoption of the Uniform Limited Liability Company Act (the “New Act[1]“): Actions by Members

By: Frederick C. Leech, Esq.

This Practice Alert is the third in a series of Practice Alerts. The first Alert addressed the impact of the New Act on the duties and obligations of members – the fiduciary duty of loyalty, the duty of care and the obligation of members to deal with each other consistent with the contractual obligation of good faith and fair dealing. [2]  The First Alert underscored the New Act’s retention of the principle of “freedom of contract,” permitting members wide latitude to alter default rules through the company’s operating agreement. The principle of “freedom of contract” particularly holds true in regard to inter se rules – rules confined to the members and not involving creditors or other third parties. The ability of members, however, to alter default rules – even inter se rules – is not without limits. The First Alert addressed these limits in the discussion of the duties of members to each other. [3]

The second Practice Alert addressed the concept in the New Act of “transferable interests.” This concept clarifies the distinction between governance rights and economic rights of members.

This third Practice Alert describes the manner in which the New Act addresses contentious matters between members. Several provisions of the New Act deal with this area – including Subchapter H (Actions by Members); certain provisions of Subchapter F (Dissociation); and certain provisions of Subchapter G (Dissolution and Winding Up). These Subchapters contain default rules. Accordingly, and as with virtually every aspect of the New Act, members need to ascertain if these default rules can be eliminated or altered by the operating agreement. Section 8815 of the New Act is the principal (though not exclusive) guiding provision of the New Act which addresses this feature.

Actions by Members

Subchapter H (Actions by Members) sets out rules by which a member can seek legal redress for harm caused by another member. Subchapter H provides for direct claims (Section 8881) and derivative claims (Sections 8882-8885).

Section 8881 provides as follows –

Section 8881. Direct action by member.

  • General rule. – Subject to subsection (b), a member may maintain a direct action against another member, a manager or the limited liability company to enforce the member’s rights and protect the member’s interests, including rights and interests under the operating agreement or this title or arising independently of the membership relationship.
  • Required injury. – A member maintaining a direct action under this section must plead and prove an actual or threatened injury that is not solely the result of an injury suffered or threatened to be suffered by the limited liability company.
  • Cross reference. – See Section 8815(c)(17) (relating to contents of operating agreement).

Sections 8882 – 8885 set out the right of a member or a manager to bring a derivative action on behalf of the company and the procedures and procedural safeguards under which a derivative action can be brought. This Practice Alert focuses on direct actions of members. Several points are worth making in regard to direct actions.

Standing for Direct Claims. In order for a member to have standing to bring a direct action against another member, the plaintiff member must be able to show harm which is unique to the member versus harm to the company overall. In the latter situation, appropriate redress would be a derivative action. The Committee Comments address this point –

“Although in ordinary contractual situations it is axiomatic that each party to a contract has standing to sue for breach of that contract, within a limited liability company different circumstances typically exist. A member does not have a direct claim against a manager or another member merely because the manager or other member has breached the operating agreement. Likewise a member’s violation of this chapter does not automatically create a direct claim for every other member. To have standing in his, her, or its own right, a member plaintiff must be able to show a harm that occurs independently of the harm caused or threatened to be caused to the company.”

Impact of the Operating Agreement on Right to Bring Direct Claims. Subchapter H is an exception to the general feature of the New Act that inter se default rules (or rules which are largely confined to relationships among members and not involving creditors or other third parties) can be eliminated by the operating agreement. Section 8815(c)(17) serves to retain the essential protections of the ability of members to bring actions pursuant to Subchapter H. Section 8815(c)(17) provides as follows:

(c) Limitations. – An operating agreement may not do any of the following:

(17) Unreasonably restrict the right of a member to maintain an action under Subchapter H (relating to actions by members).

To be clear, Section 8815(c)(17) does not require that Subchapter H remain untouched by the operating agreement. Rather, the restriction imposed by the New Act is that the operating agreement “not unreasonably restrict the right of a member to maintain an action under Subchapter H.” The Committee Comments address the nature of reasonable restrictions around a member’s right to bring an action –

“Subchapter H governs a member’s rights to bring direct and derivative actions. Subsection (c)(17) [of Section 8815] adopts the position that it would be unreasonable to frustrate these rights but not unreasonable to channel their exercise. For example, the operating agreement might select a forum or provide for arbitration of both direct and derivative claims.”

The default rule under Subchapter H provides that both members and managers have standing to maintain a derivative suit.[4] Notably, however, because Section 8815(c)(17) only addresses restrictions imposed by an operating agreement on the right of members to maintain a derivative action, the operating agreement may be drafted to restrict in any way – or even eliminate – the right of a manager to maintain a derivative action.

Nature of Rights Protected. Section 8881 of the New Act does not expand or create new rights. This is made clear in the Committee Comments. The Comments provide that the phrase “protect the member’s interests” in Section 8881(a) pertains to remedies and does not create any additional causes of action. The Comments further provide that the last phrase in Section 8881(a) (“or arising independently …”) does not create any new rights, obligations, or remedies. Rather, the phrase is included merely to emphasize that a person’s membership in a limited liability company does not preclude the person from enforcing rights existing “independently of the membership relationship” – for example, as a creditor.

Right to Force a Dissociation of a Member or Dissolution of the Company. In addition to pursuing a claim for money damages or injunctive relief, a member plaintiff bringing a direct claim under Section 8881(a) of the New Act can seek to have the offending member expelled from the company. This remedy is set forth in Subchapter F (Dissociation).

Section 8861(6) provides as follows:

On application by the company or a member in a direct action under Section 8881 (relating to direct action by member), the person is expelled as a member by judicial order because the person:

(i) has engaged or is engaging in wrongful conduct that has affected adversely and materially, or will affect adversely and materially, the company’s activities and affairs;

(i) has committed willfully or persistently, or is committing willfully or persistently, a material breach of the operating agreement or a duty or obligation under Section 8849.1 (relating to standards of conduct for members); or

(ii) has engaged or is engaging in conduct relating to the company’s activities and affairs which makes it not reasonably practicable to carry on the activities and affairs with the person as a member

Further, a member can seek a judicial order of dissolution arising out of wrongful conduct of other member(s). Section 8871(a)(4) of the New Act provides that –

(a) General rule. – A limited liability company is dissolved, and its activities and affairs shall be wound up, upon the occurrence of any of the following:

(4) On application by a member, the entry by the court of an order dissolving the company on the grounds that:

(i) the conduct of all or substantially all the company’s activities and affairs is unlawful;

(ii) it is not reasonably practicable to carry on the company’s activities and affairs in conformity with the certificate of organization and the operating agreement; or

(iii) the managers or those members in control of the company:

(A) have acted, are acting, or will act in a manner that is illegal or fraudulent; or

(B) have acted or are acting in a manner that is oppressive and was, is or will be directly harmful to the applicant.

While the default rule concerning dissociation of a member due to wrongful conduct of that member can be eliminated or altered by the operating agreement, the default rule permitting a member to seek judicial dissolution of the company due to wrongful conduct of a member may not be eliminated or altered by the operating agreement. It is notable, however, that the Committee Comments provide that where grounds exist for both dissociation and dissolution, a court has the discretion to choose between the alternatives.[5]

Conclusion

The practical point underscored in these Alerts is that members, in collaboration with their legal counsel, must pay attention to the New Act. Specifically, it is important for members to review their existing operating agreement and put in place amendments to reform or eliminate (if possible) inapposite default rules so that the operating agreement remains aligned with the business and legal expectations of the members.

If you have any questions regarding the Pennsylvania Uniform Limited Liability Company Act, please contact Fred Leech. Fred is a Partner and Chair of Leech Tishman’s Corporate Practice Group and is based in the firm’s Pittsburgh office. He can be reached at 412.261.1600 or fleech@leechtishman.com.

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[1] The Pennsylvania limited liability company law has been revamped as new Chapter 88 of Title 15 of the Pennsylvania Consolidated Statutes. The enabling Pennsylvania legislation was Act 2016-170 (H.B. 1398), which was approved on November 21, 2016, and became effective on February 21, 2017. As of April 1, 2017, the New Act now governs all Pennsylvania limited liability companies, whenever formed.

[2] The first Alert also described the principal differences in statutory approach between the New Act and Pennsylvania’s prior limited liability company law (the “Old Act”). (The Old Act was former Chapter 89 of Title 15 of the Pennsylvania Consolidated Statutes; P.L. 703, No. 106, as amended.) The New Act contains a considerably larger number of “default” or “gap filling” rules as compared with the Old Act, and the New Act is more self-contained and makes less use of incorporation of default rules from other Pennsylvania statutory schemes (e.g., corporation law, general partnership law and limited partnership law). Notably, however, the New Act defers to other bodies of law in a number of instances, including agency law, bankruptcy law and the Uniform Commercial Code.

[3] Correction and Amplification. The First Alert was in error in a portion of its description of those aspects of the duty of loyalty which can be eliminated by the operating agreement and those aspects of the duty of loyalty which cannot be eliminated by the operating agreement but which can be altered so long as such alterations are not manifestly unreasonable. The corrected statement is as follows:

  • The duty of a member to account to the company and to hold as trustee for it any property, profit or benefit derived by the member (i) in the conduct of or winding up of the company’s activities and affairs (Section 8849.1(b)(1)(i)) or (ii) from a use by a member of the company’s property (Section 8849.1(b(1)(ii)) may not be eliminated by the operating agreement but these aspects of the duty of loyalty can be altered by the operating agreement if the alterations are not manifestly unreasonable.
  • In a similar manner, the statutory duty of loyalty requiring a member 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 (Section 8849.1(b)(2)) may not be eliminated by the operating agreement but this aspect of the duty of loyalty can be altered by the operating agreement if the alterations are not manifestly unreasonable.
  • In contrast, the following aspects of the duty of loyalty may be eliminated completely by the operating agreement – (i) the statutory duty of loyalty of a member to account to the company and to hold as trustee for it any property, profit or benefit derived by the member from the appropriation of a company opportunity (Section 8849.1(b)(1)(iii)), and (ii) the statutory duty of loyalty requiring a member to refrain from competing with the company in the conduct of the company’s activities before dissolution of the company (Section 8849.1(b)(3)).

[4] Only members – and not managers – have the statutory right to bring direct claims under Subchapter H.

[5] “[T]here is no textual basis for imposing a higher burden of proof for dissociation than dissolution.”, 977 A.2d 107, 121 (Conn. 2009) (general partnership).