While limited liability companies (LLCs) are a relatively new type of business entity, they now make up over two-thirds of all newly-formed companies on an annual basis. Persons involved in Arizona-based LLCs have for many years operated under certain legal parameters, the most notable of which is the Arizona Limited Liability Company Act. The first iteration of this act was adopted in 1992.
In 2018, Arizona adopted a new version of the Arizona Limited Liability Company Act (the “New LLC Act”) modeled after the Revised Uniform Limited Liability Company Act. The goal of the New LLC Act was to bring Arizona’s LLC legal regime up-to-speed with significant statutory and common law advances made by other states in this area.
On September 1, 2019, the New LLC Act became applicable to LLCs formed after that date. As of September 1, 2020, the New LLC Act is in full effect and the 1992 LLC act has been effectively repealed. The New LLC Act now governs all Arizona LLCs.
This article highlights some of the key differences between the two acts and identifies several areas of the New LLC Act that should prompt business leaders to undertake a close analysis of their corporate governance documents, practices, and general framework. Undertaking this analysis will help LLCs comply with the requirements of the New LLC Act and reduce unintended negative consequences to operations going forward.
I. Avoiding Certain Default Provisions Under the New LLC Act.
The New LLC Act contains default provisions that apply if the LLC in question has not adopted a valid operating agreement or if there is a valid operating agreement, but it is silent regarding issues otherwise covered by the New LLC Act’s default provisions. The non-exhaustive list of items that can be changed by an LLC’s operating agreement—and an exhaustive list of items that cannot be changed by an LLC’s operating agreement—are found at A.R.S. § 29-3105.
Some of the default provisions that could cause the most trouble for LLC members and/or managers relate to voting, fiduciary duties, pre-dissolution distributions, and contributions.
The New LLC Act contains a default provision providing that, even in the case of a manager-managed LLC, the unanimous vote of all members may be required in certain circumstances, including to:
1. Adopt, amend, amend and restate or revoke an operating agreement, or authorize a transaction, agreement or action on behalf of the limited liability company that is unrelated to its purpose or business as stated in an operating agreement or that otherwise violates an operating agreement;
2. Issue an interest in the limited liability company to any person; and
3. Authorize an amendment to the articles of organization that changes the status of the limited liability company from or to one in which management is vested in a manager or managers to or from one in which management is reserved to the members.
See generally A.R.S. § 29-3407. Accordingly, LLC members—especially LLC managers of manager-managed LLCs—should analyze whether their respective LLCs’ operating agreements contain provisions that override the New LLC Act’s default unanimous voting rules.
B. Fiduciary Duties.
In a sea change in Arizona LLC law, the New LLC Act imposes default fiduciary duties onto LLC members and managers unless otherwise stated in the LLC’s operating agreement. See A.R.S. § 29-3409. Specifically, unless otherwise stated in an operating agreement, a member of a member-managed LLC owes the company and other members, inter alia, duties of loyalty and care and an obligation of good faith and fair dealing. See A.R.S. § 29-3409(A)–(C). Similarly, a manager of a manager-managed LLC owes the LLC and its members, inter alia, duties of loyalty and care and an obligation of good faith and fair dealing. See A.R.S. § 29-3409(J)–(L).
Many single-member LLCs operate using only articles of organization. The lack of an operating agreement in such entities is unlikely to be material given the lack of potential adverse parties. However, the New LLC Act’s imposition of default fiduciary duties does impact the governance structures of multi-member LLCs that do not have a valid operating agreement. Specifically, the change may result in more multi-member LLCs deciding to develop and adopt formal operating agreements that explicitly expand, limit, or eliminate certain fiduciary duties (e.g., the duties of loyalty and care). Notably, the New LLC Act does not allow the obligation of good faith and fair dealing to be modified or eliminated via operating agreement modification.
Whether modifications to fiduciary duties are made through operating agreements, how they are made, and whether members and managers act in accordance with the revised duties are all likely to generate significant breach of fiduciary duty-related litigation—both direct and derivative in nature.
The New LLC Act’s default rule on pre-dissolution distributions requires that they be made in equal shares among members, regardless of ownership percentage. See A.R.S. § 29-3404(a). This could have significant financial and tax ramifications to members, especially majority members. Importantly, this default rule can be effectively replaced by providing for a different distribution procedure in the LLC’s operating agreement. With that said, there are certain other distribution-related default rules imposed by the New LLC Act that may not be so altered. See A.R.S. § 29-3105(C)(13) (“An operating agreement may not: . . . reduce or eliminate the restrictions on distributions under Section 29-3405.A.”).
The New LLC Act provides that a member’s obligation to make a financial contribution to the LLC is not enforceable unless it is in writing. See generally A.R.S. § 29-3403. This express written requirement makes it difficult to enforce prior contribution commitments from a member, which will be to the detriment of the LLC’s other members. If a member’s obligation to contribute to an LLC is in writing, it will not be excused by death, disability, and/or termination. Id.
II. Record Keeping Responsibilities, Member Access to Records, and Disputes Related to the Same.
Under the New LLC Act, an LLC is required to maintain the records listed in A.R.S. § 29-3410(A). Upon an LLC member’s proper request for access to records under A.R.S. § 29-3410(B), an LLC must make these records available for inspection and copying during regular business hours and at a reasonable location specified by the LLC. Managers in manager-managed LLCs may also have duties to respond to a records request. See A.R.S. § 29-3410(E). Which records a member may access and/or copy, and the way in which these records may be presented to the requesting member, can be restricted or enlarged (e.g., requiring electronic production, as opposed to in-person inspection) in the LLC’s operating agreement pursuant to A.R.S. § 29-3410(K). In addition to operating agreement-related restrictions or enlargements of inspection rights, a LLC may impose reasonable extra-operating agreement restrictions and conditions on access to and use of information to be furnished and records to be made available under A.R.S. § 29-3410(A), including designating information and records confidential and imposing nondisclosure and safeguarding obligations on the recipient. In a dispute concerning the reasonableness of a restriction under this subsection, the company has the burden of proving its reasonableness. A.R.S. § 29-3410(K).
For members or managers running LLCs, it is important to note that A.R.S. § 29-3410(L) permits an award of reasonable expenses, including attorneys’ fees and costs, to the successful party in a dispute arising from a member’s or manager’s right to obtain information or inspect or copy a record under A.R.S. § 29-3410, or regarding whether any restriction imposed by the limited liability company on a member's or manager's right to obtain, inspect, copy or use any such information or record is unreasonable.
III. Indemnification and Reimbursement of Members.
Unlike the old LLC act, the New LLC Act provides a framework for indemnification of LLC managers and members and reimbursement of advanced defense costs. See generally A.R.S. § 29-3408(A), (B).
The New LLC Act requires an LLC to indemnify a member or manager against a claim or demand if both of the following apply:
1. The claim or liability exists by reason of the person’s present or former capacity as a member or manager; and
2. The claim or liability did not arise out of the person’s breach of the operating agreement or of A.R.S. § 29-3405 (distribution rules), A.R.S. § 29-3407 (management rules), or A.R.S. § 29-3409 (fiduciary duties), in each case as modified by the operating agreement.
See generally A.R.S. § 29-3408(B).
The New LLC Act requires an LLC to reimburse a member (present or former) of a member-managed LLC or manager of a manager-managed LLC for any payment previously made by the member or manager if: “payment made by the member or manager in the course of the member’s or manager’s activities on behalf of the company if the member or manager complied with Sections 29-3405, 29-3407 and 29-3409, in each case as modified by the operating agreement, in making the payment.” A.R.S. § 29-3408(A). Notably, the statute does not entitle a member of a manager-managed LLC to reimbursement.
Additionally, the New LLC Act provides that an LLC may reimburse a member (present or former) of a manager-managed LLC for: “any payment and with respect to any claim, demand, debt, obligation or other liability, except that the approval of all members, after disclosure of all material facts, is required to reimburse . . . a person with respect to any act, omission or transaction by the person that constitutes a violation of the operating agreement or Section 29-3405, 29-3407 or 29-3409, in each case as modified by the operating agreement.” A.R.S. § 29-3408(C).
IV. Dissociation of a Member.
LLC members retain the right to dissociate (aka “withdraw”) at any time under the New LLC Act. See A.R.S. § 29-3601(A) (“A person has the power to dissociate as a member at any time, rightfully or wrongfully, by withdrawing as a member by express will under Section 29-3602, paragraph 1.” Members may also be involuntarily dissociated if and when, inter alia:
1. An event stated in the operating agreement as causing the person’s dissociation occurs;
2. The person is expelled as a member pursuant to the operating agreement;
3. The person is expelled as a member by the affirmative vote or consent of all the other members if any of the following applies:
o It is unlawful to carry on the LLC’s activities and affairs with the person as a member
o There has been a transfer of all of the person’s transferable interest in the company other than either:
- A transfer for security purposes.
- A charging order in effect under A.R.S. § 29-3503.
4. The person is an unincorporated entity that has been dissolved and whose activities and affairs are being wound up;
5. On application by the LLC or a member in a direct action under A.R.S. § 29-3801, the person is expelled as a member by judicial order because the person does any of the following:
o Has engaged or is engaging in wrongful conduct that has affected adversely and materially, or will affect adversely and materially, the company’s activities and affairs.
o Has committed wilfully or persistently, or is committing wilfully or persistently, a material breach of the operating agreement or a duty or obligation under A.R.S. § 29-3409 as modified by the operating agreement.
o Has engaged or is engaging in conduct relating to the company’s activities and affairs that makes it not reasonably practicable to carry on the activities and affairs with the person as a member.
6. The person does any of the following:
o Becomes a debtor in bankruptcy.
o Signs an assignment for the benefit of creditors.
o Seeks, consents to or acquiesces in the appointment of a trustee, receiver, or liquidator of the person or of all or substantially all the person's property.
7. The limited liability company dissolves and completes winding up.
See generally A.R.S. § 29-3602.
V. Dissolution of the LLC.
The New LLC Act expands the default events that trigger dissolution of an LLC to include:
1. An event or circumstance that the operating agreement or articles of organization state causes dissolution.
2. The consent to dissolution is given in a record signed by the number of members specified in the operating agreement or, if none is specified, by a majority in interest of the members and by one or more members that on dissolution of the company and liquidation of its assets would be entitled to receive more than one-half of the value of all assets to be distributed to all members on liquidation.
3. The passage of one hundred eighty consecutive days during which the company has no members unless before the end of the period both of the following occur: (a) Consent to admit at least one specified person as a member is given in a record signed by one or more transferees that on dissolution of the company and liquidation of its assets would be entitled to receive more than one-half of the value of all assets to be distributed to all transferees at the time the consent is to be effective; and (b) At least one person becomes a member in accordance with the consent.
4. On application by a member, the entry by a court of competent jurisdiction of an order dissolving the company on the grounds that any of the following apply:
a. The conduct of all or substantially all of the company's activities and affairs is unlawful.
b. It is not reasonably practicable to carry on the company's activities and affairs in conformity with the articles of organization and the operating agreement.
c. The members or managers are deadlocked in the management of the company and irreparable injury to the company is threatened or being suffered or the activities and affairs of the company cannot be conducted to the advantage of the members because of the deadlock.
d. The managers or those members in control of the company do any of the following:
i. Have acted or are acting in a manner that is illegal or fraudulent with respect to the activities and affairs of the company, causing or threatening a material and adverse effect on the company or the applicant.
ii. Have wilfully or persistently breached the operating agreement or the duty of loyalty under section 29-3409, as modified by the operating agreement, causing or threatening a material and adverse effect on the company or the applicant.
iii. Have wasted, misapplied or diverted substantial assets of the company for purposes not related to the activities and affairs of the company, causing or threatening a material and adverse effect on the company.
5. The signing and filing of a statement of administrative dissolution by the commission under section 29-3708.
See A.R.S. § 29-3701(A).
Of pertinent note for medical marijuana companies is A.R.S. § 29-3701(A)(4)(a). Until the federal laws classifying marijuana as a schedule 1 controlled substance under the Controlled Substances Act (CSA) are changed, A.R.S. § 29-3701(A)(4)(a) may jeopardize companies engaged in medical marijuana businesses. This dissolution problem may be avoided by overriding A.R.S. § 29-3701(A)(4)(a) in the LLC’s operating agreement. See generally A.R.S. § 29-3105(C). However, the question remains as to whether such an overriding provision would be enforceable in light of A.R.S. § 29-3105(A)(2) (“The operating agreement may contain any provision that is not contrary to law.”).
The New LLC Act ushers in important changes to Arizona’s framework governing LLCs and raises many questions for those with altered duties and responsibilities. LLC members and managers should familiarize themselves with the new framework to identify what, if any, corporate work needs to be undertaken to re-position the subject LLC properly, including to mitigate likelihood of future disputes. It is especially important that existing LLCs conduct a review of their respective operating agreements to analyze whether they should be revised to override any of the New LLC Act’s default provisions by which the subject LLC does not wish to be governed. Relatedly, to the extent a multi-member LLC does not currently have a valid operating agreement in place, it should consider implementing one. Galbut Beabeau, P.C.’s attorneys are experienced in the formation and operation of Arizona LLCs and can help with this process.
DISCLAIMER: This article is designed for general information only. The information presented herein does not constitute legal advice or the formation of a lawyer/client relationship.