Lobbying Affiliate: MML&K Government Solutions

An Operating Agreement Should Be Drafted To Protect Minority Investors

November 11, 2015

Conflict may arise in a limited liability company if LLC managers breach their fiduciary duty by acts such as misappropriating funds or self-dealing.

Entrepreneur magazine reports that the limited liability company continues to gain popularity in the United States with regard to new business formations. The advantage of forming a limited liability company is that the LLC provides the limited liability protections of a corporation but has the operational flexibility of a partnership form of business. Moreover, unlike a traditional corporation, LLCs are not taxed as a separate business entity. Profits and losses are passed through the business to each LLC member who reports profits and loses on their own federal income tax returns.

In this state, as noted by the Kentucky Bar Association, the LLC has now "become the entity of choice for holding investment assets or operating closely-held businesses." In 2013, the Kentucky Secretary of State reported that 17,335 LLCs were organized in Kentucky. By comparison, 3,987 corporations and 196 partnerships were organized in 2013.

According to the KBA, if several individuals are considering setting up an LLC, one issue which should be addressed is the fiduciary duty owed by those who will manage the LLC. Broadly speaking, a fiduciary is someone who is entrusted with the management and protection of another's property. Typically, a fiduciary duty is defined as being one of good faith and fair dealing. Under the Kentucky Limited Liability Company Act, managing members of LLCs have a duty to act in the interests of the company and are said to owe a duty of fairness and loyalty to the company.

The KLLCA permits an operating agreement to be written which expands or restricts-within reason-the fiduciary duties owed by those managing the LLC. The KBA observes that, in today's LLC, it is typical that some members are active in management while others are "passive investors." As a result, and in conjunction with the ever-increasing number of LLCs being formed in Kentucky, this creates the potential for conflict between those who are active in the LLC's management and those who are not. Typical breach of fiduciary duty claims would involve: (1) misappropriating company funds; (2) the unauthorized personal use of company property; or (3) self-dealing acts by LLC managers such as appropriating a business opportunity properly belonging to the LLC.

Protecting minority investors

The American Bar Association notes that operating agreements are frequently not as precise as they should be when describing the duties that LLC managers owe to non-managing or minority LLC members. In addition, operating agreements often do not spell out the consequences of an LLC manager's breach of duty.

The KBA advises that non-managing LLC members, and those with minority interests, will benefit greatly by having an operating agreement drawn up which is specifically geared toward protecting their interests. In this regard, the KBA suggests that the operating agreement should be drafted to include the following:

•· Limitations on the rights of management and controlling members by imposing "super-majority" voting requirements on issues such as how to handle mergers, asset sales and the admission of new members.

•· Prohibitions on self-dealing transactions between managing members and the LLC.

•· Specific standards for the removal and replacement of management.

•· Comprehensive and detailed guidelines for the LLC's operation.

•· A provision specifying the fiduciary duties which LLC managers and controlling interest members owe to minority members.

Consult an attorney

Those who are considering forming a business should consult an attorney experienced in business formation. An experienced Kentucky attorney can draft an operating agreement that will protect the interests of minority and non-management LLC members.

Keywords: LLC

Lexington, KYLouisville, KYFrankfort, KY: MML&K Government SolutionsWashington, D.C.