By: Frederick C. Leech, Esq.
The Pennsylvania limited liability company law has been revamped as new Chapter 88 of Title 15 of the Pennsylvania Consolidated Statutes (the “New Act”). The New Act is entitled the “Pennsylvania Uniform Limited Liability Company Act of 2016.” The New Act became effective on February 21, 2017, and it will govern all Pennsylvania limited liability companies – whenever formed – from and after April 1, 2017.
This Practice Alert is the first in a series of three. This first Alert addresses the impact of the New Act on the duties of members. The second Alert will address the impact of the New Act on financial matters concerning the company and its members. The third Alert will address the rights of members to bring actions against each other as well as the impact of the New Act on termination events – including dissolution of the company and dissociation of a member from the company.
Prefatory Remarks – Overall Nature of the Statutory Changes
The New Act is based on the Uniform Limited Liability Company Act (2006) (Last Revised 2013), drafted by the National Conference of Commissioners on Uniform State Laws (the “Uniform Act”). The New Act represents Pennsylvania’s “second generation” of statutory authority for limited liability companies (“LLCs”).
Pennsylvania’s “first generation” LLC statute (the “Old Act”) was a model of statutory economy. The Old Act incorporated by reference many legal rules (commonly referred to as “default rules” or “gap-filling rules”) from Pennsylvania’s corporation, general partnership and limited partnership statutes. Further, as was common with many “first generation” statutes, the Old Act included relatively few default rules (whether imbedded in the Old Act or incorporated by reference). While few default rules fortified the notion of “freedom of contract”, in practice, the absence of a statutory framework of default rules provided too little guidance for many members in the formation of their operating agreements. Often, the result was the formation of operating agreements that were ill-suited to the business and legal expectations of the members.
By contrast, the New Act sets out extensive default rules in virtually every substantive and procedural area of limited liability company law. This is a good step forward. The default rules in the New Act – and the statutory boundaries governing the extent to which they can be altered – should provide members with a useful discussion framework, thus resulting in operating agreements that better serve their enterprise needs.
This statutory approach under the New Act has implications for all Pennsylvania limited liability companies. On and after April 1, 2017, the broad set of default rules will govern all LLCs unless the rules are altered in the operating agreement. Company members should review carefully their current operating agreements in light of the New Act’s default rules. Members should put in place operating agreement amendments to alter default rules which are inconsistent with their business and legal objectives.
Standards of Conduct for Members
The New Act sets forth as default rules certain core duties that members owe to each other. These include (1) the fiduciary duty of loyalty, (2) the duty of care, and (3) the obligation to discharge duties and exercise rights under the New Act and the company’s operating agreement in a manner consistent with the contractual obligation of good faith and fair dealing.
Section 8849.1 of the New Act sets out these core duties as default rules, and provides in part as follows:
(a) General rule.–A member of a member-managed limited liability company owes to the company and, subject to Section 8881(b) (relating to direct action by member), the other members the duties of loyalty and care stated under subsections (b) and (c).
(b) The fiduciary duty of loyalty of a member in a member-managed limited liability company includes the duties:
(1) 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 or winding up of the company’s activities and affairs;
(ii) from a use by the member of the company’s property; or
(iii) 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; and
(3) to refrain from competing with the company in the conduct of the company’s activities and affairs before the dissolution of the company.
(c) Duty of care.–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 gross negligence, recklessness, willful misconduct or knowing violation of law.
(d) Good faith and fair dealing.–A member shall discharge the duties and obligations under this title or under the operating agreement and exercise any rights consistent with the contractual obligation of good faith and fair dealing.
Consistent with the retained statutory objective of “freedom of contract,” these default rules can be altered in certain instances through the operating agreement. Section 8815 is the key provision in the New Act which sets the boundaries on the manner and extent to which default rules can be altered.
The Pennsylvania Committee Comments to Section 8815(d)(3) provide useful guidance concerning the standards by which members’ duties can and cannot be altered, as follows –
Chapter 88 rejects the ultra-contractarian notion that fiduciary duty within a business organization is merely a set of default rules and seeks instead to balance the virtues of “freedom of contract” against the dangers that inescapably exist when some have power over the interests of others. Nonetheless, a properly drafted operating agreement may substantially alter and even eliminate fiduciary duties. Two important limitations exist. First, arrangements subject to this subsection may not be “manifestly unreasonable” as that concept is delineated in subsection (e) [Section 8815(e)]. Second, the operating agreement may not transform the relationship among the members, managers, and the limited liability company into an entirely arm’s length arrangement. For example, displacement of fiduciary duties is effective only to the extent that the displacement is stated clearly and with particularity. This rule is fundamental in the jurisprudence of fiduciary duty. Paige Capital Mgmt., LLC v. Lerner Master Fund, LLC, Civ. A. No. 5502–CS, 2011 WL 3505355 at *31 18073 (Del.Ch. Aug. 8, 2011) (stating that, even under a statute that “permits the waiver of fiduciary duties … such waivers must be set forth clearly”). It would therefore be manifestly unreasonable for an operating agreement to negate this rule.
A brief summary of the ability of members to alter statutory default rules concerning the duties owed to each other is as follows –
- The duty of a member to account to the company for any benefit derived by the member from the appropriation of a company opportunity and the duty of a member to refrain from competing with the company in the conduct of the company’s activities and affairs before the dissolution of the company can be eliminated completely by the operating agreement. Updated May 2017 to correct an error.
- By contrast, the following duties of loyalty may not be eliminated by the operating agreement but they can be altered by the operating agreement if the alterations are not manifestly unreasonable: (1) 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 in the conduct of or winding up of the company’s activities and affairs; (2) 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 from a use by a member of the company’s property; and (3) the duty of 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. Updated May 2017 to correct an error.
- The obligation of good faith and fair dealing in Section 8849(d) must remain, but the operating agreement can prescribe standards to measure conformance with such obligation.
- The operating agreement can reduce the duty of care “almost to nil” (in the words of the Pennsylvania Committee Comments). In particular, the operating agreement can eliminate the aspects of the duty of care pertaining to gross negligence.
- The standard for persons claiming that a term of an operating agreement is “manifestly unreasonable” is very demanding. This is because the court may invalidate the term only if, in light of the purposes, activities and affairs of the company, the court determines that the objective of the term is unreasonable or that the term is an unreasonable means to achieve the term’s objective. As stated in the Pennsylvania Official Comments –
Determining manifest unreasonableness in the context of owners of an organization is a different task than doing so in a commercial context, where concepts like “usages of trade” are available to inform the analysis. Each business organization must be understood in its own terms and context and in light of the practices of its owners. If loosely applied, the concept of “manifestly unreasonable” would permit a court to rewrite the members’ agreement, which would destroy the balance Chapter 88 seeks to establish between freedom of contract and fiduciary duty.
Extensive default rules in the New Act should assist members to rethink – and reform if desirable – provisions in their operating agreements which govern the relationships among themselves. The New Act, however, demands attention. If members do not make appropriate amendments to their operating agreements, they could find themselves bound by default rules under the New Act which are at odds with their best interests.
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 firstname.lastname@example.org.
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 Correction and Amplification. This Alert as originally published 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. These statements have been corrected.
 Act 2016-170 (H.B. 1398), approved November 21, 2016, effective February 21, 2017.
 Formerly Chapter 89 of Title 15 of the Pennsylvania Consolidated Statutes; P.L. 703, No. 106, as amended.
 Further, in contrast to the Old Act, the New Act is largely self-contained, and avoids the approach of incorporating rules from other statutory schemes.
 As described in more detail below, Section 8815 of the New Act sets forth areas of limited liability company statutory law which cannot be altered by the operating agreement.
 Subsections (d) and (e) of Section 8815 provide as follows:
(d) Permitted terms.–Subject to subsection (c)(10), the following rules apply:
(1) The operating agreement may:
(i) specify the method by which a specific act or transaction that would otherwise violate the duty of loyalty may be authorized or ratified by one or more disinterested and independent persons after full disclosure of all material facts;
(ii) alter the prohibition stated in Section 8845(a)(2) (relating to limitations on distributions) so that the prohibition requires only that the company’s total assets not be less than the sum of its total liabilities; and
(iii) impose reasonable restrictions on the availability and use of information obtained under Section 8850 and may define appropriate remedies, including liquidated damages, for a breach of any reasonable restriction on use.
(2) To the extent the operating agreement of a member-managed limited liability company expressly relieves a member of a responsibility that the member would otherwise have under this title and imposes the responsibility on one or more other members, the operating agreement also may eliminate or limit any fiduciary duty of the member relieved of the responsibility that would have pertained to the responsibility.
(3) If not manifestly unreasonable, the operating agreement may:
(i) alter the aspects of the duty of loyalty stated under Section 8849.1(b)(1)(i) or (ii) or (2) or 8849.2(b)(1)(i) or (ii) or (2);
(ii) prescribe the standards, if not manifestly unreasonable, by which the performance of the contractual obligation of good faith and fair dealing under section 8849.1(d) or 8849.2(d) is to be measured;
(iii) identify specific types or categories of activities that do not violate the duty of loyalty;
(iv) alter the duty of care; and
(v) alter or eliminate any other fiduciary duty.
(e) Determination of manifest unreasonableness.–The court shall decide as a matter of law whether a term of an operating agreement is manifestly unreasonable under subsection (d)(3). The court:
(1) shall make its determination as of the time the challenged term became part of the operating agreement and by considering only circumstances existing at that time; and
(2) may invalidate the term only if, in light of the purposes, activities and affairs of the limited liability company, it is readily apparent that:
(i) the objective of the term is unreasonable; or
(ii) the term is an unreasonable means to achieve the term’s objective.