Investors Lose Vital Information When They Skip LLC Agreements

Delaware is a popular state for the formation of limited liability companies due to its well-established business laws. The state is home to approximately 1.5 million active LLCs, with more than 200,000 new LLCs registered each year. But as thousands of new investors flock to Delaware to establish their corporations, they need to pay close attention to the agreements they’re entering.

As the New York Court of Appeals recently recognized in Behler v. Tao, under established Delaware law, LLC members are bound by the company’s limited liability company agreement whether or not they sign that LLC agreement.

Delaware’s Limited Liability Company Act provides the framework for the formation and operation of Delaware LLCs. These LLCs are also governed by contracts referred to as LLC agreements.

The terms of LLC agreements vary widely, and can greatly affect the rights of LLC members. All prospective LLC investors—and particularly minority investors—should carefully review and consider the terms of the applicable LLC agreement prior to investing. If they fail to do so, they run the risk of being bound to unfavorable terms. Below are some key terms minority investors should review carefully that may be present in LLC agreements.

First, prospective investors should review the terms relating to potential amendments to LLC agreements.

In Behler, the New York Court of Appeals held that an investor who didn’t sign a company’s LLC agreement was bound by its terms, including the term that permitted the LLC’s managing member to unilaterally amend the LLC agreement. The investor was also bound by the terms of the company’s amended LLC agreement without his signature, including a merger clause and other terms that served to bar his claims against the LLC’s managing member for breach of an alleged oral agreement.

Second, prospective investors are advised to consider provisions relating to the managing member’s obligations and replacement.

These terms include those relating to the managing member’s duties, the ability of members to remove the manager for bad acts, whether the agreement disclaims fiduciary duties for the managing members or provides additional protections for breaches of the duties of care and loyalty, whether the agreement places any limitations on the manager’s affiliated transactions, whether the agreement provides for remedies such as dissolution for oppression, and whether the agreement contains provisions governing the replacement of the manager.

Third, prospective investors should examine provisions relating to distributions, reserves, any additional capital contributions, and draws. These terms affect when and how members receive money from the LLC, and if they are required to contribute additional capital to the LLC.

Fourth, prospective investors should analyze provisions relating to the purchase, sale, and transfer of their membership interests, as well as dilution upon subsequent investments by other members.

These provisions may include purchase rights, such as rights of first refusal, and the right to transfer membership interest, including for estate planning and upon death. They also may include provisions relating to members’ right to withdraw and abandon their LLC membership interest without liability other than the surrender of their economic interest.

Fifth, investors are recommended to consider whether the LLC agreement contains provisions regarding major decision rights. LLC agreements may provide members, including minority members, with approval rights concerning major decisions such as mergers, changes to the LLC’s business purpose, and replacement of the managing member.

Finally, investors may wish to consider provisions relating to members’ information rights. While Section 18-305 of the LLC Act provides for default rules regarding members’ right to access documents and information regarding the LLC, it also provides that “[t]he rights of a member or manager to obtain or examine information as provided in this section may be expanded or restricted in” the company’s LLC agreement.

Because members are ordinarily bound by Delaware LLC agreements even without their signatures, it is important for investors to seek legal advice prior to investing and carefully review these agreements.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Kerrin Klein is a partner at Olshan Frome Wolosky focused on complex commercial litigation, including securities and corporate governance disputes.

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