Further Notes on the Ohio Revised LLC Act, R.C. 1706
Ohio has enacted a Revised Limited Liability Company Act as Chapter 1706 of the Revised Code, which entirely supersedes the current statute, Chapter 1705, as of January 1, 2022. The new law will apply to all LLCs in Ohio, not just LLCs formed after the effective date. At that time, Chapter 1705 is repealed.
The Revised LLC Act, Chapter 1706, is organized differently from the current LLC Act, Chapter 1705, and has a more permissive and flexible approach to LLC organization. The Revised LLC Act is not just a revision of the existing LLC Act – it’s based on the “Prototype LLC Act” drafted by a committee of the American Bar Association, and is structured differently from the current LLC Act.
Earlier I wrote a post that looked at how the Revised LLC Act approaches LLC indemnification. Here are a few broader observations on the new Revised LLC Act:
No Fire Drill
The new law does not press us into making mandatory changes for existing companies by the end of the year — so, phew! Existing operating agreement terms will continue to function as written, with comprehensive, well-written agreements being least affected by the new law. Any operating agreement provision enforceable under the current LLC Act is also enforceable under the Revised LLC Act.
No Safety Net
The Revised LLC Act does change the significance of the operating agreement, or the way the operating agreement will be interpreted. The current LLC Act regularly establishes default rules that control “unless otherwise provided in the operating agreement,” and that can serve to some degree as a functional operating agreement; it also acts as a safety net for poorly written or incomplete operating agreement terms. The Revised LLC Act prefers to state simply that a company “may” establish various provisions in company operating agreements, without providing default rules. As a result, operating agreements that fail to address basic issues will no longer find a safety net in the statutory language. LLCs should no longer try to operate “under the statute” while they work on an operating agreement.
In a way, the new act encourages innovation in designing organizational governance and rights. In the 1990s, with the enactment of the LLC Act, Ohio lawyers developed model operating agreements that were widely adopted, and the language and structure of those models have become familiar to practitioners. The Revised LLC Act encourages companies to go beyond those conventions and structures by naming some of the varied rights and powers that a company can assume through its operating agreement. As a lawyer, I enjoy working with clients to articulate different governance structures in an operating agreement, and the new law is an opportunity for companies that have outgrown their operating agreements to rethink management in a new light. On the other hand, we can expect negotiations among members and their counsel to become more involved as we discuss different approaches and work toward an agreement. Lawyers can expect their work product to be scrutinized more closely. Lawyers may also have to address fee expectations with clients as drafting, reviewing, and revising operating agreements could require more time and work.
Another way of thinking of the new law is that it is not going to let a court come in and save you from unfair, absurd, or stupid results arising from unfortunate language in your operating agreement, so careful, comprehensible drafting is more important than before.
The Revised LLC Law does contain mandatory provisions. The ones that affect the relationship between members are mostly in the dissociation, dissolution, and merger/conversion sections. Most of the mandated provisions have to do with formalities of filing with the secretary of state and regulations for foreign LLCs.
No Love
Section 1706.06 states that the statute is meant to give “maximum effect to the principles of freedom of contract and to the enforceability of operating agreements.” It then goes on to say that the statute controls over “principles of law and equity,” and that the statute is not meant to be “strictly construed” under common law rules. These provisions are meant to ensure that fiduciary duty case law will not apply to Ohio LLCs. In practice, this opens the door for operating agreements to create strong imbalances between the rights of majority/management and minority members. Default standards of duty for members and managers are established in 1706.31 and 1706.311 (which are the same as the default standards in the current LLC Act), but 1706.08(B) allows operating agreements to reduce standards to a bare “implied covenant of good faith and fair dealing.” The potential for scripting unforgiving provisions in an operating agreement is reinforced by 1706.08(4) and (5), which invite provisions creating penalties against members who breach terms of the agreement, including flat-out forfeiture of membership interests.
Provisions for liberally restricting minority rights were permissible before Chapter 1706, and to be sure there are many ongoing enterprises working with tiers of restricted LLC membership interests, but I think the new statutory language encourages or is suggesting a shift in the way companies approach organizational culture as a general matter, and I assume smaller companies will start imposing more restrictions on members. I’m calling this is a culture shift because I think there has been a lingering assumption that LLC members have enjoyed a certain assurance derived from the common law of partnerships that minority members would be treated with a sense of the utmost trust and loyalty, and that they would be covered by a rule of restraint against alienation of their interests. The Revised LLC Act definitively wipes out that assumption, so now, if that’s what you want, you have to put it in your operating agreement. Standards of duty for members and managers will become key terms in any operating agreement. Members joining LLCs are advised to be alert to terms that create unaccustomed or unexpected risks, especially risks of disenfranchisement and forfeiture. A dramatic analogy might be to imagine a change in residential housing law in which the current landlord tenant statute were revised to adopt the rules governing commercial leases – current leases could be enforceable as written, but tenants relying on the protections of residential tenant law would be shocked to understand the full scope of legal landlord rights and the lack of default protection for tenants. Members will have to understand what they’re signing. The message to members who get caught up in the harsh provisions of an operating agreement will be, that sucks for you, but you agreed to it.
RC 1706’s Approach to Authority and Liability
Operating agreements will have to take a detailed approach to describing the scope of authority and duties of members and managers.
Under Section 1706.08(B)(1), a majority of the members are authorized to conduct the business of an LLC in “the ordinary course.” The statute does not give guidance on defining the majority (e.g., majority of persons, or a majority of membership interests?) or “ordinary course.” By default, any activity outside the ordinary course is to be decided by all of the members. This is not a statute that will be helping you resolve any disputes about member authority. The current LLC Act gives default provisions for member-managed and manager-managed companies. The Revised LLC Act does not lay out a distinction between the two flavors of LLC management – it just changes the standard of duty for the members and manager once a “manager” is established for the company. Managers are defined by a designation of managerial duties under 1706.01(O), and a manager by any other name smells as sweet, so companies should be intentional about establishing the process for appointing a manager, to avoid inadvertently creating a “manager” under the statute (e.g., if an organization intending to be managed by members equally appoints a president, have they shifted everyone’s standard of duty under section 1706.01(O)?).
My point is that LLCs without an operating agreement are not going to get any help with goverance from the statute, so organizational authority has to be spelled out. A workable operating agreement should expressly cover the following issues:
Define formalities for admitting members and establishing managers. Consider whether the LLC itself should be a party to the operating agreement.
Define formalities for voting, including express terms for notice rights, determining a quorum, determining a majority, written actions without a meeting, authorizing proxy votes, voting rights for interested members, and any supermajority issues.
Define “ordinary course” for the LLC with sufficient particularity.
Define the standards of duty for members and managers, including competition, confidentiality, business opportunity and business judgment standards.
Transfer restriction terms are still crucial, and will not be subject to objections based on common law restraint on alienation arguments.
Member rights in dissociation and dissolution still have to be addressed in detail, including rights of creditors and assignees. The Revised LLC Law introduces the idea of “dissociation” of members, replacing the withdrawal/expulsion language of the current LLC Law. Note that Section 1706.41(A) states that a person shall not voluntarily dissociate from an LLC, which is a big change from 1705.16, which is a default provision that allows a member to withdraw at any time, but I think the operating agreement can still create an express term for voluntary dissociation under Section 1706.411(A).
The Revised LLC Act also allows for a “statement of authority” under Section 1706.19, which is a public filing with Secretary of State describing the scope of authority for a particular person. The statement of authority is a new concept for LLCs in Ohio, and I’m looking forward to learning more about how to use it. At this point I figure it’s a tool that establishes notice of a person’s limited scope of authority, and could be useful in limiting liability either for or to the person named in the statement. The statute sets up a little game of hot potato with Section 1706.20, which provides a person named in a statement of authority with a chance to publicly file a statement of denial of the statement of authority.
The Revised LLC Act also creates a way of limiting claims following the dissolution of an LLC. Section 1706.474 describes a two-year window for claims commencing with an elective notice of dissolution posted on the website of the company or the Secretary of State. This ability to create final repose for claims post-dissolution is similar to provisions in Ohio’s corporate dissolution law updated in 2013, but the LLC statute does not go so far as to require a tax clearance certificate as a condition of finalizing dissolution (which is the biggest pain in the corporate dissolution requirement).
Series LLCs
The Revised LLC Act introduces an idea new to Ohio LLCs, which is the series LLC. Technically, it’s a way of setting up a bunch of LLCs under one charter entity, but it does not seem very different from setting up a bunch of LLCs under separate charter entities. As with the statement of authority idea, I am sure the drafters of the statute had in mind specific ways of using series LLCs, perhaps in connection with sophisticated real estate or securities structures, and I’m looking forward to learning more about them.