The New California LLC Law: Highlights for Private Equity and Venture-Backed Companies

Highlights for Private Equity and Venture-Backed Companies

January 9, 2014

With the new California limited liability company law in full force, we have been fielding many questions from clients about how the law impacts their investments. The new law, the California Revised Uniform Limited Liability Company Act, took effect at the start of the year. As a practical matter, the new law will not significantly impact many private equity or venture-backed companies, as many are formed outside California (although more on that below), are organized as corporations, or have governing documents that already address many issues that are created by the new law. Also, for PE investments that are wholly owned by the fund, the new law will have little effect because the fund has full managerial authority over the venture.

Nevertheless, there are several changes in the new law that may require attention, particularly for investors in joint ventures or those holding minority interests. This alert identifies those changes and suggests ways to address them. Keep in mind that parties to existing companies may be unwilling to change their documentation, so as a practical matter they may not be able to address these issues. But for new ventures, new practices may be in order.

  1. Manager Fiduciary Duties. Managers have fiduciary duties under both the old and new law, but the new law describes those duties in greater detail. Funds and investors should pay careful attention to the new definitions, particularly the duty of loyalty and how it affects their ability to undertake competing ventures. Also, in some instances it may be appropriate to modify the duty of care to reflect a business judgment rule standard and other practices of venture-backed companies.
  2. Can the Parties Modify Manager Fiduciary Duties? Assuming the parties wish to modify the statutory fiduciary duties, they will need to proceed cautiously. Under the new law, companies may modify — although not eliminate — the statutory duty of loyalty and duty of care, but only if done with the members’ “informed” consent and if the modified duties meet certain tests of reasonableness. The new law provides little guidance on how to satisfy the informed consent requirement, although modifications that result from negotiation among sophisticated parties should, presumably, meet the informed consent test. Nevertheless, if the parties wish to change the statutory duties, the venture documentation should clearly recite that all parties were aware of the statutory standards and knowingly modified them. The same principles apply to satisfying the reasonableness tests: The new law does not provide meaningful guidance, but sophisticated parties likely will have difficulty showing that a change was not reasonable, especially where the deal documentation recites why the manager duties were changed.
  3. Limiting Manager Liability. The new law allows the LLC, with certain exceptions, to eliminate or limit a manager’s liability for monetary damages. (One of the exceptions is that the company may not limit liability for a breach of the duty of loyalty.) As a result, LLCs may adopt liability limitations akin to those found in ventures operated as corporations.
  4. Member Approval of Sale of the Company. Ventures should pay careful attention to the new default rules on member approvals. A number of company actions require unanimous member approval, including a company sale. The default rule can be modified in the operating agreement, but it needs to be addressed clearly or the company may face unintended results. For example, in some LLCs a board is given full company oversight, except for certain decisions reserved for approval by certain investor members. If a sale of the company is not one of those reserved decisions, the company may need unanimous member approval in order to undertake a sale.
  5. Other Member Approvals. The new law also requires unanimous member approval of amendments to the operating agreement and actions taken “outside the ordinary course.” The former requirement will not likely be an issue in PE and VC deals because amendment provisions are often addressed in detail and, therefore, will likely override the statutory default rules. The requirement of approval for events outside the ordinary course is more troubling, however, because the new law does not indicate what events fall outside the ordinary course. The LLC can avoid the issue entirely by including a provision in the operating agreement that modifies or eliminates these member approval rights; the same is true for approval of a sale of the company (discussed above).
  6. Third-Party Reliance and Internal Governance. Be mindful of the new rules regarding internal versus external governance. Where there is a conflict between the LLC’s articles of organization and operating agreement, the articles trump the operating agreement as to third parties that reasonably rely on the articles, and the operating agreement governs as between the members and managers. To avoid a conflict, limit the content of the articles, although in some ventures it may be appropriate to set forth certain managerial authority — such as the ability to sell a key asset — in the articles.
  7. Lender and Other Third-Party Protections. The parties may now condition amendments to the operating agreement on third-party consent. If this type of provision is included in the operating agreement, an amendment will not be legally effective unless the third party consents. This can be a useful tool for persons who are not parties to the operating agreement but need control rights, such as lenders and persons who hold economic interests in the enterprise but are not members.
  8. Avoid California Law? Some ventures may wish to avoid California law by organizing the LLC under a more freedom of contract friendly jurisdiction, such as Delaware. It remains to be seen, however, whether this will be an effective strategy. The new law provides conflicting guidance on what law governs foreign LLCs operating in California. On the one hand, the new law states that it applies to foreign LLCs registered in California, while another section states that, for a foreign LLC, the law of its jurisdiction of formation governs its “internal affairs.” Arguably, the former is a statement as to when the new law becomes effective and the latter determines how the new law applies to out-of-state LLCs. If this interpretation is correct (although there is no assurance it is), then it would seem that matters such as manager duties and approval of transactions would be “internal affairs” and would be addressed under the laws of the foreign jurisdiction. This is not clear from the statute, however, and is open to interpretation.

Private equity and venture-backed investments organized as California LLCs may want to reexamine customary practices for structuring their entities. Otherwise, new rules under the California Revised Uniform Limited Liability Company Act may provide unwelcome surprises.