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Oct. 26 — Limited liability companies may want to take a second look at the agreements that govern their operations after a Delaware court ruling, corporate governance attorneys told Bloomberg BNA.
The Delaware Chancery Court said in Obeid v. Hogan that an LLC couldn't appoint a non-director to a special litigation committee because it had opted for a “corporate-style governance structure” and shown its desire to be covered by corporate law, rather than LLC law (133 CARE, 7/12/16).
Under state law, only directors can serve on a corporation's special committees.
LLCs are the most common type of private company in the U.S. They typically are governed by their operating agreements, which provide flexibility in how they manage their internal affairs. Being governed as a public company can hinder that flexibility. According to the Delaware Division of Corporations' 2015 annual report, there were 128,042 LLCs formed last year in the state, compared to 38,288 corporations.
There is perennial debate about whether corporate principles are “bleeding” into LLCs' operating agreements, Lawrence Hamermesh, a corporate governance professor at Widener University's Delaware Law School in Wilmington, told Bloomberg BNA Oct. 24. The problem in this case was that the LLC agreement adopted a corporate model, but didn’t clarify when corporate principles should apply, Hamermesh said.
Some LLCs may want to consider redrafting their agreements in light of the decision, Hamermesh said. For example, they may want to rethink using phrases like “board of directors” in an LLC agreement. “What does it mean?” he asked. “Why use these terms ambiguously if an LLC doesn’t want the corporate law structure to apply?”
LLCs also may adopt blanket clauses that prevent courts from treating them like corporations, Louis Hering, a Wilmington-based partner at Morris, Nichols, Arsht & Tunnell LLP told Bloomberg BNA. Hering, who focuses on the organization and structuring of Delaware alternative entities, also said in an Oct. 25 interview that LLCs may revise their agreements to add specific provisions that allow the delegation of tasks in certain circumstances.
In Obeid, the chancery court concluded that a former federal judge couldn't be appointed to a special litigation committee to investigate and decide whether to pursue derivative claims on behalf of Gemini Real Estate Advisors LLC and Gemini Equity Partners LLC.
The LLCs filed an appeal to the Delaware Supreme Court but have since voluntarily dismissed it.
This isn't the first time Delaware courts have applied corporate law to alternative entities. However, Hering said, Obeid goes beyond the specific circumstances addressed by those courts. If having corporate-like traits in an LLC operating agreement is enough to bring in every aspect of corporate law, then the ruling could be “troubling” for LLCs with similar features, he said.
The Obeid court rejected the defendants' argument that an LLC has authority under Section 18-407 of Delaware's Limited Liability Company Act to delegate tasks to individuals that aren't directors or members.
Corporate law practitioners have long considered Section 18-407 to be “quite permissive” in what LLCs may delegate to non-members, Melissa Stubenberg, a Wilmington-based director at Richards, Layton & Finger PA, said Oct. 20 during a discussion of Obeid at an American Bar Association panel in Arlington, Va. Stubenberg advises Delaware LLCs and partnerships.
Stubenberg warned that LLCs looking to amend their operating agreements in response to the ruling may be left with more questions. The LLC structure provides contractual freedom, but attorneys can't draft LLC pacts to accommodate every contingency or a specific judicial ruling, she said. “From my perspective, what has me concerned are things I'm not thinking about when drafting such provisions.”
It's a “two-edged sword,” Hering told Bloomberg BNA. LLCs that broadly adopt provisions that prevent the Delaware General Corporation Law from applying must be concerned about unintended consequences, he said.
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