Both the Arizona Legislature and the Arizona Supreme Court have taken recent action that ought to be prompting members of Arizona LLC’s without operating agreements to be immediately drafting them. Indeed, even for those LLC’s that already have an operating agreement, members should be pulling them out and reviewing them in light of the recent developments in the law. Simply stated, the rules have changed. Recent legislation and case law has redefined certain “default rules” that apply to your LLC. Default rules are the laws that will be applied if your LLC does not have an operating agreement or if the operating agreement does not expressly address certain subjects.
One change arising out of the June 25, 2019 Arizona Supreme Court decision in In re Sky Harbor Hotel Properties, LLC, and the New Limited Liability Company Act (the “New LLC Act”), relates to the existence of a fiduciary duty. The Arizona Supreme Court decided that LLC managers and members owe “common law fiduciary duties” to the LLC when they are “serving as agents of the LLC” unless the operating agreement has limited or eliminated those duties. The New LLC Act takes it a step further, stating that if your LLC does not have an operating agreement, or it has an operating agreement that fails to define the duties owed by the manager or members, the default is to create a fiduciary duty to both the LLC and the members.
This is a significant change in Arizona law. An individual owing a fiduciary duty generally must put the interests of those to whom the duty is owed before his or her own personal interest when dealing with matters within the scope of the relationship. A fiduciary duty also includes a duty of loyalty. Thus, for those individuals who are members of more than one multi-member LLC operating in the same industry, the existence of a duty that requires you to put LLC and members’ interests above your own should have you quickly assessing the risks associated with such responsibilities and prompting you to take steps to minimize the possibility of future litigation arising out of such interests. Again, you can eliminate or limit such a duty, but it needs to be spelled out in the LLC’s operating agreement.
Another potentially significant impact under the New LLC Act relates to distributions. The default rule under the New LLC Act is that distributions (other than final distributions) must be made in equal shares to all members. A.R.S. § 29-3404.A. For example, once the new legislation goes into effect, if you own a 75% interest in a two-member LLC but the company has no operating agreement or the operating agreement is silent on how distributions shall be allocated, you will only be entitled to a 50% share of distributions despite your majority ownership interest. Under such a scenario, you will still be allocated and taxed 75% of the LLC’s income despite only receiving 50% of the distribution. If the foregoing is troubling to you, review your operating agreement. If the terms of that agreement are not consistent with what the members agree is fair, amend it.
The above provides only a small sample of the changes created to the default provisions that apply to LLCs under the New LLC Act. Thus, if you are a member of a multi-member LLC and do not currently have an operating agreement, it is recommended that you either create one or make sure all members agree with the new default rules. For those members of LLC’s that have an operating agreement, it is recommended that you check it against the New LLC Act to see if it is silent on any of the default rules and, if it is, discuss with the other members whether the default rules are agreeable or if you need to amend the operating agreement.
For more information on this topic or other litigation law matters, please contact Mr. Olexa.