Critical Distinctions Between Texas and Delaware LLC Law
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Texas is becoming an increasingly popular destination for businesses choosing to form an LLC. In this recorded program, we will highlight some meaningful differences between Texas and Delaware business entity law and demonstrate how practitioners must be wary of these key differences through a study of relevant statutes and cases. Join Byron F. Egan, Partner, Jackson Walker L.L.P. and author of Egan on Entities, a CSC® publication, as we discuss some of the distinctive aspects of LLC laws, including certain fundamental provisions of Texas Business Organizations Code (BOC) and the Delaware Limited Liability Company Act, as well as relevant Texas and Delaware cases.
The topics to be discussed include:
- Differences in the courts structures between Texas and Delaware
- Texas and Delaware fiduciary duties, applicable cases and relevant statutes
- Dissimilarities as they apply to mergers and acquisitions
- Entity formation and implications of federal and state taxes
Anu: Hello, everyone, and welcome to today's webinar, "Critical Distinctions Between Texas and Delaware LLC Law." My name is Anu Shah and I will be your moderator. Joining us today is Byron Egan. Byron is engaged in a corporate partnership limited liability company, securities mergers and acquisitions and financing practice. Byron has extensive experience in business entity formation and governance matters. M&A and financing transaction is a wide variety of industries including energy, entertainment, financial, insurance, restaurants and technology. And with that let's welcome Byron.
Byron: Good morning. As a Texas lawyer I have a visceral preference for Texas law as I am more familiar with it and know that our Texas statutes are clear and cutting-edge. But increasingly, our clients are dealing with Delaware entities which requires us to be familiar with Delaware law and how it differs from Texas law.
Sometimes we have formed a Texas entity for a local startup company and it seeks venture capital or private equity funding. Many investors that are from elsewhere are unfamiliar with Texas law or perhaps they think it's like the jungle at night, it's a dangerous place to be. And our clients are more interested in their money that in the virtues of Texas law.
The institutional investors often have portfolio companies that are Delaware entities and believe that they can gain efficiency in governance that can come from having the same law applicable to all of them in the same governing documents. If we are not at home with Delaware law, the investors will ask our clients to hire lawyers who are.
The good news is that today you will have an opportunity to learn for yourself how Delaware LLC law compares with Texas LLC law. Our program focuses on LLCs because in Texas we're forming LLCs at a rate of 7.5 LLCs for every corporation formed. Delaware is also making more LLCs than corporations, although its ratio is less skewed towards LLCs. Delaware is making around twice as many LLCs as it does corporations. Now, there are more LLCs in both Texas and Delaware than corporations.
Even though the LLC is a relatively new critter, it came to Texas in 1991 and to Delaware a few years afterwards. So we have five business entities to choose from in Texas and in Delaware. The corporation which we've had since the beginning of time, the general partnership, the limited partnership, the limited liability partnership, and the limited liability company and various species of those entities.
The corporation's principal virtue is limitation of investor liability, the general partnership involves joint and several liability on behalf of the partners and therefore has limited utility in the world of investments. The limited partnership which involves having a general partner which is liable for all the partnership obligations and a group of limited partners who have no liability to speak of.
The limited liability partnership is a species of general partnership in which the liability of partners is very limited. Then we have the limited liability company which is the focus of our discussion today, but we're going to discuss other entities for comparison and because courts and LLC law cases they refer to precedent regarding other entities.
I mentioned earlier that we're making LLCs at a 7.5 to 1 ratio over corporations in Texas. And displayed here on the screen is the statistic from the Delaware, excuse me, from the Texas Secretary of State that talks about the 167,957 LLCs formed in Texas in 2017 compared with 22,319 corporations. And you can see that nonprofits and limited partnerships are much less formed.
And there are the statistics that we now have about three times more LLCs than corporations in Texas. Delaware, you can see that, again, we're having more LLCs by long shot than corporations being formed and they now have many more LLCs and corporations.
Taxes are a big factor. They're not a big . . . okay, first of all, we're going to talk about the statutory law. The Texas business organizations code was enacted by the Texas Legislature in 2003 and I'm going to refer to it as the TBOC or the Code. By the way, you'll see various sites that EGAN ON ENTITIES sections such as and such and so and so. That is, those are references to the second edition of EGAN ON ENTITIES which is being published by CSC LexisNexis and will be available in March. It will have more information about each of the topics we're discussing today.
So the business organizations code became effective for new entities formed in Texas after January 1, 2006. After January 1, 2010 the TBOC governs all Texas entities. The TBOC was an attempt to codify the existing statutory law in Texas. So it codified what we call the source law, the existing statutes. It was not intended at that point to make any significant change into substantive law, but the TBOC has been amended in every legislative session since 2006 in response to cases and other state statutory changes. The result is constant updating of the code and it morphs to reflect what's going on in the business and legal world.
The TBOC is organized in a hub-and-spoke approach. The hub provisions are definitions, they are formation rules, how to make filings with the Secretary of State, availability of information, and other kinds of provisions that are applicable to all business entities with various variations for each kind of entity. So the code is going to apply to corporations, partnerships, LLCs, and other entities, nonprofit corporations.
The spoke provisions deal with the particular kind of entities, so the for-profit corporations are in one set of spoke provisions. Another deals with nonprofit corporations and another deals with partnerships and yet another deals with limited liability companies. The LLC spoke provisions are found in TBOC Title 1, Chapter 1, sections 101.101, etc. And then the hub provisions are principally in Title 1, Chapters 1-2.
Delaware LLCs are formed under and governed by the Delaware Limited Liability Company Act, which we abbreviate as the DLLCA.
Taxes are important. They're not the subject of our program but you need to know about them. Before the Tax Cuts and Jobs Act of 2017, corporations had a choice of being a C corporation whose tax rates were 15% to 35% and then the shareholders were taxed on dividends and rate of 20% plus a 3.8% unearned income Medicare contribution tax, a net investment income tax on the lesser of various amounts.
On the other hand, partnerships and LLCs could be flow-through entities with no entity level tax. I said could be because the Internal Revenue Code has what they call check-the-box regulations thereunder that allow an entity, particularly an LLC, to elect whether it wants to be taxed as a corporation or as a partnership. Most LLCs today are going to be organized to where they'll be taxed as partnerships and therefore they'll be flow-thru entities with no entity level tax.
The tax will be at the owner level at individual rates which range up to 37% plus the 3.8% Medicare contribution tax on self-employment income. Noncorporate investors in businesses other than specified service businesses like law firms and accounting firms can deduct it through partnerships and LLCs, can deduct approximately 20% of their business income subject to certain limits that basically keep it in smaller entities.
The taxes margin tax is a critical thing. It was enacted in 2006. Before 2006 LLCs were subject to a franchise tax which was an effect of 2% income tax on LLCs, but general limited partnerships were not subject to the franchise tax. In 2006, the margin tax was enacted in Texas and it in effect makes any entity that has limited liability, that includes a corporation, a limited liability partnership, a limited partnership or an LLC subject to the margin tax. The result is that it's now no more advantageous to be a limited partnership than an LLC.
William Safire once said that what's the difference in a corporation and an LLC is the personality that you can get the limited liability of a corporation through an LLC and the flexibility and the camaraderie of a partnership in an LLC. But from a tax standpoint, an LLC can be taxed for federal purposes as a partnership, but it is subject to the Texas margin tax. And they say it's not an income tax, but when you get through it it's the gross receipts of the entity after deductions for compensation or cost of goods sold resided that the base may not exceed 70% of revenues. And then it's a portion to Texas based on gross receipts and aggregate gross receipts.
The tax rate for 2017 and '18 is 0.75% with an exception for certain retail and wholesale business which pay at a 0.375% rate. So the margin taxes change the calculation for entity selection but not necessarily the result. The LLC has become more attractive because it can elect to be taxed as a corporation or a partnership for federal income tax purposes. The disadvantage is that there are uncertainties as to how an LLC will be treated for the purposes of federal self-employment taxes. And that can reduce its desirability in certain situations. And those situations, some accountants prefer to use the S corporation. Lawyers tend to prefer the LLC taxed as a partnership.
The Delaware has a corporate income tax rate of 8.7% which is a bit high. However, the Delaware General Corporation law exempts a corporation that merely has a corporate office in the state of Delaware and is not doing business within the state and the corporation whose activities within the state are confined to the maintenance and management of their intangible investments.
The state income tax does not apply at the entity level to an LLC unless it's elected to be taxed as a corporation for federal income tax. Rather LLC members in Delaware or our partnerships' partners are going to be generally subject to the Delaware personal income tax with a high marginal rate of 6.6%. However, non-resident individual members of an LLC or a partnership are only taxable on their entity income attributable to sources in Delaware, thus many out-of-state corporations, LLCs and partnerships they're non-residents in Delaware and do not have any income for business in Delaware, can avoid material Delaware income tax liability.
LLCs and partnerships are called by the courts alternative entities. And that is to distinguish them from corporations which were the traditional entities and which are largely governed by statute and in a common law. But in the case of an LLC or a partnership, the courts apply contractarian approach in considering their governing documents and measuring fiduciary duties and their governing purposes. In other words, the Delaware statutes say that the principle of freedom of contract is inherent in matters dealing with LLCs and partnerships, thus you have a great deal of flexibility to shape your entity in Delaware by contract.
Texas LLC and partnership statutes allow modification but not an elimination of common law fiduciary duties, but now allow limitation of governing personal liabilities to the extent permitted by corporations except for breaches of duty of, that is, they allow elimination for breaches of the duty of care but not for the duty of loyalty, so in your LLC documents you can essentially eliminate the liability of their governing persons or breaches of the duty of care but not for the duty of loyalty.
Delaware allows partnership and LLC Agreements to eliminate all fiduciary duties, but one cannot be "coy" in the wording and cannot eliminate the duty of good faith and fair dealing, thus full-frontal nudity is important in Delaware. If you're going to eliminate fiduciary duties by contract, you need to be very expressed and explicit in doing so and if you're not sufficiently clear then a court will imply that you have adopted the common law fiduciary duties with the minor modifications to be made in your contract, big difference. So in Delaware it's very important that you use the right word, the difference in the right word and the almost right word can be the difference of lightning bolt and lightning bug.
The fiduciary duties of general partners are the highest recognized by law and they include the duty of care. That's essentially acting as a reasonably prudent person would do in making a business decision for the entity. The duty of loyalty requires that the individual or entity act loyally to the entity which means that you're going to put the interests of the entity ahead of your personal interests.
The duty of candor is a subset of the duty of loyalty and it basically says, "If you're communicating with your members, you need to be candid, you need to tell the whole truth and nothing but the truth," and it's almost like the securities laws relating to disclosure. You cannot be fraudulent, you cannot be misleading, you must tell fully and fairly what you're trying to tell.
The fiduciary duties of managers of an LLC are analogous to those of corporate directors, absent some contractual definition or limitation of those duties. The fiduciary duties of managers thus would include the duties of care, loyalty and candor and they're discussed more fully later.
Unlike the TBOC, Delaware statutes governing partnerships and LLCs provide that their policy is to give maximum effect to the principle of freedom of contract at the entity agreements. Delaware statutes allow the elimination of fiduciary duties, but they do not allow the elimination of the contractual duty of good faith and fair dealing.
Several recent Delaware cases involving limited partnership reorganizations elaborate on what I just said, that you can eliminate fiduciary duties, but you have to be very expressed at how you do it and you must not be able to eliminate the duty of good faith and fair dealing, which is not fiduciary but contractual in nature. In these cases, the general partner of the limited partnership or an affiliate was a survivor or acquiring partner in a reorganization of the partnership, usually by a merger.
The cases can be viewed as a roadmap to the wording pitfalls and alternatives to be considered when structuring M&A transactions involving LLCs, as well as partnerships. And four of these cases, the Delaware Supreme Court gave effect to the elimination of the contractual fiduciary duties and their replacement with a provision authorizing related party transactions where a conflicts committee of independent directors of the general partner in good faith determined that the transactions were in the best interest of the partnership.
But what in these cases the partnership agreement did was expressly eliminate all fiduciary duties of the general partner and all other partners and then replaced those with a provision that allowed authorized related party transactions where the conflicts committee of independent directors of the general partner which was usually either an LLC or managed by managers or a corporation in good faith determined that the transactions were in the best interest of the partnership. So you have eliminated fiduciary duties and then you've said you're going to have a conflicts committee of independent directors to make a decision, and if they make a decision, then that's going to be binding all the limited partners and there is no fiduciary governor involved.
Two other decisions applied the implied covenant of good faith and fair dealing which cannot be eliminated to hold for the plaintiff. The Gerber case held that a fairness opinion was inadequate to support a transaction with the general partner because it only covered the fairness of the entire transaction rather than fairness to the limited partners.
So what the partnership agreement did was say there are no fiduciary duties, they're eliminated and that a transaction is presumed fair, conclusively presumed to be fair if a fairness opinion from a reputable investment banker express that the transaction is fair from a financial point of view to the partnership, a traditional fairness opinion. And if that's the case, then the fiduciary duties of the general partner are not applicable.
Otherwise, if the transaction was subject to fiduciary duties, then the Delaware courts would use the entire fairness standard in measuring the conduct of the general partner and would say that the test is that the burden of proof is on the general partner to prove that the affiliated party transaction was both substantively fair from a fair price standpoint. The price is fair and the process was fair. So in that case, it might involve an auction of the partnership interests to find out what the third parties would bid or some other process for determining that, in fact, the directors had used a good process to determine that, in fact, the transaction was fair and to the best interests of the partnership.
In that case, in the Gerber case, the banker negotiated a fairness opinion that simply said that the entire transaction is fair to the partnership, and the price is fair. The court said, "That's not good enough because the real beneficiary of that fairness opinion is the limited partner." And by simply talking about the partnership as a whole it was not dealing with the split between the general partner and the limited partners hence that opinion did not satisfy the duty of good faith and fair dealing.
You know, it's a contractarian doctrine, so what the court is saying it's not fiduciary, but rather, if the parties had thought about the issue and negotiated a proper agreement, they would've required that the fairness opinion be addressed to the limited partners which it wasn't and it's a very big judgment for the plaintiff. The Dieckman versus Regency GP LP case held its facts surrounding a director's appointment to and service on a special committee demonstrate a lack of respect for director independence requirement in the partnership agreement and that the failure to disclose the director conflict was such a fundamental disclosure failure hence to negate the approval by the unaffiliated limited partners.
I asked a general, Chief Justice Leo E. Strine at an ABA meeting about that decision and at a big meeting, big audience and I said, "Leo, this looks like a duty of candor case that you're dealing with the disclosure of the directors and that's a duty of candor case." He replied back, "No, you mischaracterize the facts," that, in fact, what happened was the directors were directors of an affiliate of the general partner up until, in one case, two days after the process of the special committee began. And then immediately after the transaction closed, they went back on the board of the affiliated company.
So in effect their independence was rented for a very short period of time and it was as if the parties had always intended that the independence would be for a very short period of time. The court said that that is such a grievous behavior that it breaches the covenant of good faith and fair dealing. Hence you may successfully word your elimination of fiduciary duties in your contract but a court will find that certain behavior violates the duty of good faith and fair dealing and you don't have a buy.
In the seventh decision, Vice Chancellor Laster in the El Paso Pipeline Partners case, that was a derivative case in which the Vice Chancellor awarded $171 million to the plaintiff, the limited partners, because he found that a conflicts committee of the board of the general partner did not, in fact, believe that the transaction was in the best interest of the partnership.
So in that case, you had, again, elimination of fiduciary duties and a good, well-crafted partnership agreement provision that said, "Fiduciary duties are eliminated, but in place thereof we're going to have a conflicts committee of independent directors of the general partner. And if they're independent, then their determination is conclusive if they determine that the transaction is the best interest of the partnership."
The court said that the special committee, in fact, did not act in good faith because in approving the transaction it focused on whether the transaction would increase the distributions to the limited partners rather than the total valuation of the transaction which the court felt was unfair. And the court in essence said that because the independent directors were simply going through the motions, they were trying to approve a transaction that they thought the general partner wanted and they focused on what the general partner was focused on, they weren't doing their job and therefore they weren't acting in good faith.
Now, the case was appealed in the Delaware Supreme Court and the Supreme Court said Vice Chancellor finding a facts was correct and therefore the substitution of the court's judgment was appropriate, but the Supreme Court reversed because of standing. This was a derivative action and the transaction that was being challenged was a merger and the partnership merged with an unaffiliated entity before the lawsuit was finally adjudicated.
And Supreme Court held that the plaintiffs to have standing under the statute had to be a limited partners both at the time of the action that was being complained of and at the time that it was finally resolved. And since the merger occurred before the final adjudication the plaintiffs had standing and hence their $171 million judgment was reversed.
Nonetheless you can see that even though Delaware allows the elimination of fiduciary duties, there are interpretations of the duty of good faith and fair dealing that make it look an awful lot like a fiduciary duty case in certain circumstances.
Now let's get into the mechanics and vocabulary in Texas and Delaware. We have a little different vocabulary from a partnership or a corporation for an LLC. In Texas the owners of an LLC are called the members and they are analogous to the shareholders in a corporation or the limited partners of a limited partnership. They're the owners of the business.
And the governing persons are called managers. And the managers of an LLC are generally analogous to directors of a corporation and are selected by the members in the same manner as corporate directors are elected by the shareholders. Although unlike most corporations, you don't have to have an election, you could provide a mechanism for an LLC to have perpetual managers who have no annual election and they are elected in a particular fashion. So there is flexibility in how the governance of an LLC is created, so say, these are critters of contract.
Under TBOC any individual corporation, partnership, LLC or other person may become a member or a manager of an LLC, thus it is possible to have an LLC with a corporation as a sole manager just as it is possible to have a leveraged partnership with a sole corporate general partner.
LLCs formed under Delaware law are governed by the Delaware Limited Liability Company Act, the DLLCA. As in Texas the owners of a Delaware LLC are called members and are analogous to the stockholders of a Delaware corporation. The certificate of formation of a Texas LLC is an important document. In Texas an LLC is formed when one or more persons file a certificate of formation with the Texas Secretary of State along with a filing fee.
The initial certificate of formation must contain certain statutory items: the name of the LLC, a statement that it's an LLC, the period of its duration which maybe and typically is perpetual, its purpose which maybe and typically is stated as any lawful purpose for which an LLC may be organized, the address of the initial registered agent, and the name of its registered office, and if the LLC is to have a manager or managers, a statement to that effect and the names and the addresses of the initial manager or managers. Or if the LLC will not have managers, a statement to that effect and the names and addresses of the initial members, the state and address of each organizer and various other information, including if it's to be a professional LLC, a statement to that effect.
An LLC's existence as such begins when the Secretary of State files a certificate of formation. Unless it provides for delayed effectiveness as the statute allows. An LLC may also be formed pursuant to a plan of conversion or merger in which case the certificate of merger must be filed or the certificate of conversion but need not to be filed separately.
An LLC may generally be formed to conduct any lawful business subject to limitations of other statutes which regulate other business like the practice of medicine. Generally, it has all the powers of a Texas corporation or limited partnership subject to any restrictions imposed by statute or governing documents.
The name of an LLC is important in Texas. It must contain words or an abbreviation to designate the nature of the entity. The designation may be any of the following words: limited liability company, limited company or an abbreviation of either phrase. The name must not be the same as a receptively similar to that of any domestic or Texas foreign entity transacted in business. Unless the existing entity has a similar name and consistent in writing.
The TBOC provides that except to the extent otherwise provided to LLCs, certificate of formation or the Company Agreement, the affirmative vote approval or consent of the members is required to amend the certificate of formation.
The Delaware LLC is formed by the filing of an executed certificate of formation with the Secretary of State of Delaware. It must contain the name of the LLC, the address of its registered agent, and the name and address of the agent for service of process and any other matters the members have determined to include. So it's typically a very, very short document. Although some people prefer longer documents for various reasons.
It's formed at the time of its certificate of formation being filed by the Secretary of State.
The Company Agreement is a critical document in Texas. It contains most of the provisions relating to the organization and management of a Texas LLC. It's a contract. It contains the terms coverage securities. The Company Agreement will contain provisions similar to those in a limited partnership agreement or corporate bylaws, differently fairly lengthy.
Under the TBOC the Company Agreement controls the majority of the LLC governance matters and generally trumps the default provisions relating to LLCs. But there are a few things that the TBOC section 101.054, that's a section to remember, provides that may not be waived or modified by Company Agreement.
So in other words, under Texas LLC statutes, the Company Agreement is going to control most of the LLC governance matters and it will trump the provisions in the TBOC except in a few limited circumstances where the statute says that the TBOC may not be waived or modified by the Company Agreement.
For example, the TBOC provides that the Company Agreement or certificate of formation may only be amended by a unanimous member consent, but if either document provides otherwise, such as for amendment by manager consent or consent of a majority of the members, then it may be amended pursuant to its own terms.
But this makes sense because a Company Agreement is a contract and normally a contract cannot be amended unless all of the parties to the contract so agree or unless it provides for a different mechanism for its amendment. So in effect the TBOC is incorporating contract law provisions in this provision that says that the certificate of formation or a Company Agreement may only be amended by a unanimous member consent unless the documents otherwise provide. That makes it very important to have the right words in your Company Agreement.
A Company Agreement in Texas will ordinarily contain the capital account, other financial and tax provisions found in a typical limited partnership agreement. But the TBOC does not require that the Company Agreement ever be approved or signed by the members or be filed with the Secretary of State, otherwise made a public record.
Nevertheless, I think it's desirable for the members to approve the Company Agreement and express their agreement to be contractually bound by their biased members by signing it. I believe that their signatures should facilitate enforcement of it as a contract, but also help it be categorized as a partnership for federal income tax purposes.
Under TBOC a Company Agreement is enforceable by or against an LLC regardless of whether the LLC has signed or otherwise expressly adopted the Company Agreement.
Under TBOC a member has no right to withdraw and cannot be expelled from the company unless provision therefore is made in the Company Agreement. TBOC however provides that a member who validly exercises a contractual right to withdraw pursuant to the Company Agreement is entitled to receive the fair value as, that's a term not defined in the TBOC and therefore it's up to the courts of the members interest within a reasonable time after withdrawal, unless the Company Agreement otherwise provides. Thus, it is typical in Texas to provide that a member does not have a right to withdraw or if there is a right, exactly what it is and if there is a right to withdraw, then how the member gets paid for his interest if, in fact, he has a right to it. A very important point.
Delaware, their vocabulary is a little bit different, but the concepts are essentially the same. In Delaware, the agreement which we Texans call a Company Agreement is referred to as the LLC Agreement. The Delaware statute defines limited liability company broadly to be the principle governing document of the LLC and to encompass, "Any agreement written or oral or implied of the member or members as to the affairs of a limited liability company or its business."
You'll note the statute specifically contemplates oral LLC Agreements. However, the Delaware courts have said that yes, oral LLC Agreements are actable and enforceable but subject to the statute of frauds, which requires a writing unless it's performable within a year.
A member, manager or assignee of an LLC is bound by the LLC Agreement, whether or not a signatory thereto. Delaware expressly authorizes single member LLCs which is also the case in Texas. An LLC Agreement may be amended as provided therein or like in Texas unanimous approval of the members is required for an amendment of the LLC Agreement.
Management in Texas. The business and affairs of an LLC with managers are to be managed under the direction of its managers who can function as a board of directors and may designate officers and other agents to act on behalf of the LLC, just like in a corporation.
A manager, however, unlike the corporation may be a corporation or other entity as well as an individual. And a corporation director must be an individual. It's possible thus to have an LLC which is managed by a single manager that is a corporation or other entity. That may be useful for fiduciary purposes and contractual purposes.
The certificate of formation or Company Agreement, however, may provide that the management of the business and affairs of the LLC may be reserved to its members. It's called a member managed LLC. Thus an LLC can be organized to be run without managers, just as in the case of a close corporation, or it could be structured to run so that the day-to-day operations are run by managers, but member approval is required for significant actions as in the case of many joint ventures and closely held corporations.
So you can see that in Texas the management of an LLC can be through managers who function like a board of directors or it can be through the members who function as shareholders or you can have some blend as the parties choose.
Company Agreement should specify who has the authority to obligate the LLC contractually or to empower others to do so. It should dictate the way in which managers are members whichever is authorized of as the LLC are to manage the business and Affairs. The Company Agreement just specify how managers are selected, their terms of office, how they may be removed.
TBOC provides that the following are agents of the corporation: any officer or agent who is vested with apparent authority, any manager, any member . . . Texas law provides that an act, including the execution of a document in the name of the LLC, for the purpose of apparently carrying on in the usual way the business of the LLC by any of those people binds the LLC unless the person so acting lacks authority to act for the LLC and you can still provide in your Company Agreement or your LLC Agreement or a third party with whom the LLC is dealing is aware of the actor's lack of authority, thus lenders and others dealing with an LLC can determine with certainty who has authority to bind an LLC by reference to its certificate of formation, Company Agreement and resolutions of its managers or members.
This is just as in the case of a corporation. In routine business transactions where verification of authority is not the norm in business transaction involving corporations, the principles of apparent authority apply in the LLC context. The Delaware provisions relating to management of LLCs are comparable to those in Texas and again defer to the LLC Agreement.
Fiduciary duty is a very important topic. It's subject to much litigation. The TBOC does not address specifically whether manager or member fiduciary or other duties exist or even attempt to define them, but it implicitly recognizes that these duties may exist in statutory provisions which permit them to be expanded or restricted and the liabilities for breach thereof may be limited or eliminated in the Company Agreement.
The duty of managers in a manager managed LLC and members and a member managed LLC to the LLC is generally assumed to be fiduciary in nature and measured by reference of the fiduciary duties of corporate directors in the absence of modification in the Company Agreement. Thus you're going to look to corporate fiduciary duties for LLC manager member fiduciary duties as a starting place, of course, for developing a body of law in the LLC context that's also going to be important.
Fiduciary duties of managers can also be referenced to partnership law or the law of agency. And courts when they're not finding good LLC president for their situation will look back to corporate partnership and agency principles. By analogy to corporate directors, managers would have the duties of obedience, care and loyalty. It should have benefits of the business judgment rule. Much like a corporate director, who in theory, represents all the shareholders of the corporation rather than those who are responsible for the person that's being a director, a manager should be deemed to have a fiduciary duty to all of the members, not just who brung them. Whether members or a fiduciary duty to other members or the LLC will be determined by reference to corporate principles and the absence of contractual provisions and the certificate of formation or Company Agreement which you will typically see these days.
The TBOC allows the Company Agreement to expand or restrict the duties including fiduciary duties and liabilities of members, managers, officers, other persons to the LLC or to its members or managers.
The statute allows the elimination of liability to the LLC or its owners or members for breaches of fiduciary or other duties of its managers and in the case of an LLC managed by members of those members in a certificate of formation or Company Agreement except for a breach of the duty of loyalty or acts in bad faith or a transaction in which the person received an improper personal benefit or an act for which is a liability provided by statute such as securities laws, thus in effect the duty of loyalty may not be eliminated in an LLC Company Agreement.
They can be restricted, however, and they can be defined, thus it's typical to find in an LLC Agreement provisions that deal with business opportunities. That's where the managers receive a business opportunity and the question is whether that opportunity properly belongs to the LLC. The Company Agreement can define when that happens. We all like to have forms and I've set forth below by an attempt to comply with the Texas statute allowing elimination of liability of managers to a certain extent and the restriction of duties.
So I say, first of all, the agreement is not intended to and doesn't create or impose any fiduciary as a duty. And then we say to the extent permitted by applicable law which means basically the TBOC and applicable federal statutes such as the Securities Acts in the full extent permitted by law we eliminate all duties including fiduciary duties that may be implied by applicable law. And in doing so acknowledge that the duties and obligations of each member or manager are only as expressly set forth in this agreement and no member or manager shall have any liability for any act except as specifically provided in law or this agreement.
Then you say this agreement does not restrict or eliminate the duties and certain situations and you begin to set out . . . notwithstanding anything else in this agreement, the manager shall not permit or cause the company to engage in certain actions without the approval of the outstanding units of the partnership, in other words, owner approval, shareholder approval. There are certain actions you want like amendment of documents to go through the shareholders. Then the members are permitted to have investments and other relationships, that's the affiliate transactions and that's also business opportunities and then you provide limitations on that elimination of fiduciary duty.
So it's not a complete elimination, you're defining to what extent of those duties exist and I believe that under the Texas law that is called "restricting or defining the fiduciary duty of loyalty but not eliminating it." And then that there is a contractual presumption by the company, the actions taken in good faith by the manager shall not violate any fiduciary duties. That's my rendition of what the Texas law would allow.
Such provisions however are subject to intense negotiations and some investors will not agree to the limitations on duties and liabilities for those that control. They will expect that those that are managing their business managing in their best interests and be loyal and careful.
Unlike in Delaware, the common-law duty of good faith and fair dealing does not exist in all contractual relationships, difference in Texas is very low. Rather the duty arises only when a contract creates a special relationship between the parties, a special relationship has been recognized where there's unequal bargaining power between the parties and the risk exists that one or more of the parties may take advantage of the other. The special relationship is generally absent in an employer-employee relationship.
And while there are no Texas cases on point, I believe that the relationship of a manager or a member would be so special that a court would imply in the LLC context that the duty of good faith and fair dealing apply.
Also the TBOC does not include provisions that expressly emphasizes the principle of freedom of contract and enforceability of the LLC Agreements to expand or reduce fiduciary duties. The legislative intent of the TBOC says that there's more latitude to exculpate managers and members for conduct that would otherwise be in breach of fiduciary duty under the TBOC in respect to corporations. Therefore, you've got, in my view, more latitude and dealing with fiduciary duty issues in an LLC than you would in a corporation.
TBOC provides in effect that there is a mechanism for approving affiliate transaction. In short, common-law affiliate transactions were void or voidable unless they were entirely fair to the entity. What we've now done is create by statute, an exception for corporations and LLCs and then if an independent body, board of directors, board of managers, good faith authorizes the transaction by approval of the majority of the disinterested manager members, then the transaction is not void or voidable and if you can't get a disinterested body of directors or managers, then it's approved by the members who have proved it in good faith or the transaction is fair to the LLC at the time it's authorized to prove to ratify it. And that means entirely fair.
In a joint venture the duty of a manager to all members could be an issue since managers often are selected to represent the interests of particular members. The issues can be addressed by structuring the LLC to be managed by the members who could then appoint representatives to act for them, but it's member management and their individuals are doing it and they're designated by the members. In such a situation the members would likely have fiduciary duties analogous to partners, but their representatives would not.
Delaware does not codify manager or member fiduciary duties, but expressly permits the elimination of fiduciary duties. We have the Auriga case in which then Vice Chancellor now Chief Justice Leo E. Strine and finding for minority investors who had challenged the merger of the LLC into an entity controlled by the manager held that the LLC Agreement contractually incorporate a core element of the traditional common law of fiduciary duty of loyalty by providing that the manager could enter into a self-sealing transaction such as the purchase of the LLC only if it proved the terms were fair.
So what you're dealing with is the almost right word was not good enough. They thought they were eliminating fiduciary duties, but by leaving in this concept of fairness, the court held that they had in effect incorporated by reference the common law of fiduciary duties of loyalty or care, etc.
The Supreme Court got that case and in effect held that the Chancellor had correctly interpreted the law and saying that the words in the Company Agreement were sufficient to create fiduciary duties, not eliminate them. But there was wording in the Chancellor's opinion to the effect that there was an implied fiduciary duty and the court said, "No," that was dicta. And later, the Supreme Court . . . well, they did not reserve fiduciary duties were to be implied and left that open but later Chancery Court opinions in effect said that unless you eliminate or modify in your LLC Agreement, then there are going to be common law fiduciary duties. So it gets down to the right words in the Company Agreement to eliminate the liability.
Now, the statute was later amended in Delaware to provide unless modified in an LLC of governing document, the common law fiduciary duties would apply to LLCs. Again, contractarian approach, that the bargains manifested in the LLC Agreement to be respected, except that you cannot eliminate the contractual cover of good faith and fair dealing.
An LLC Agreement eliminating fiduciary duties that are permitted by the statute could read as follows, this says, in fact, "Except as expressly provided this agreement, no manager shall have any duties including fiduciary duties and that they're replaced by whatever we provide here, and then provide that nothing shall eliminate the contractual duty of good faith." So they have eliminated fiduciary duties, and then you can put in other contractual mechanisms for approval of transactions.
Provisions in LLC Agreements purporting to limit fiduciary duties need to be explicit and conspicuous, as Vice Chancellor once said, now Chief Justice Strine, "Coyness can lead to unenforceability. Language to the effect that no member shall be liable for any act or omission unless attributable to good faith, fraud, to gross negligence, fraud or willful misconduct provides limited exculpation for management liability, but having used a bad faith limit on exculpation you've been in effect held . . . you have assumed common law fiduciary duties. So there you have an example of somebody trying to limit liability but by using the wrong words in the view of the court are in effect incorporated by reference common law fiduciary duties.
In Delaware, people who control members can be held responsible for fiduciary duty breaches of the member. A legal claim in Delaware exists for aiding and abetting a breach of fiduciary duty, whether arising under statute common law or otherwise.
Both the TBOC and Delaware law permit business combinations. TBOC chapter 10 contains merger provisions that allow an LLC to merge with one or more LLCs or other entities. That is, a corporation, limited liability, partnership, general partnership, joint venture, etc. In effect, in Texas, an LLC can merge with a Billy Goat if the Billy Goat has a statute that so authorizes the merger.
The merger must be pursuant to written plan of merger containing certain provisions and the entities involved must approve the merger by a vote required by the governing laws and governing documents. That you're going to have a merger of two entities, you've got to look at the documents of both entities and the laws governing those entities.
Under the TBOC a merge is affected when the entities file a certificate of merger with the Secretary of State unless the plan of merger provides for delayed effectiveness. Unless the Company Agreement provides them, there are no dissenters' rights in Texas in an LLC merger.
The merger must be approved by a majority of the members unless the certificate of formation or Company Agreement specifies otherwise. The TBOC also authorizes an LLC to convert to another form of entity or convert from another form of entity into an LLC without going through a merger or transfer of assets, and has provisions relating to mechanics of the adoption of the plan of conversion which are owner approval, filings with the Secretary of State and so on very much like a corporation, like, a merger.
But the TBOC allows the Company Agreement to provide whether or not to what extent member approval of sales of all or substantially all the LLC's assets is required. In the absence of a Company Agreement provision, the default of the TBOC is to require member approval for sale of all or substantially all of the assets of the LLC. But you can eliminate that by contract.
Delaware LLC likewise can merge with a Delaware or a foreign LLC corporation or other entities, so again, subject to the provisions of the agreement and the statute. To effect a merger in Delaware, like in Texas, you adopt a plan of mergers setting forth the terms and conditions of the merger and how it's going to be approved if approval is 50% of member of percentage interests unless you provide otherwise in the governing documents and a merger is effective when certificate of merger is filed with the Delaware Secretary of State or delayed effective is provided for. Unlike a Delaware corporation, there are no appraisal rights for a Delaware LLC, no statutory appraisal rights, but you can contractually provide for them and people often do.
In Delaware requirements remember approval of the sale of all or substantially all the assets of an LLC are left to the LLC Agreement. Under Delaware law an LLC corporation may again convert to an LLC by following procedures in the statute which are essentially the same as in Texas.
Indemnification, an important issue. In Texas an LLC may but is not required to indemnify any of its members, managers, or governing persons subject only to the standards or restrictions set forth in the certificate of formation or Company Agreement.
The restrictions on indemnification applicable to for-profit corporations are very specific but are not applicable to Texas LLCs. This approach increases the importance of having long form indemnification in Texas because a simple to the maximum extent permitted by law indemnification provision would not incorporate by reference the statutory regimen for indemnification that's applicable to the Texas corporation and may encompass things that are neither the drafter nor the client foresaw.
I'm worried that this breadth could lead courts to read public policy limits and such a provision if it said to the maximum extent permitted by law that there's just a public policy limits on how far that goes or find that the provision is void for vagueness. The provisions should specify who is entitled to be indemnified for what and under what circumstances, which requires careful thought and drafting. In the book I have sample long form and short form indemnification provisions.
The Delaware Limited Liability Company Act likewise provides and, in a Delaware LLC, has broad power to indemnify and advance costs to its members, managers, and others. And again, in Delaware, as in Texas, to provide for indemnification is not to provide for advancement of defense costs. In Delaware and in Texas indemnification is something that happens after the liability has been incurred and the conduct has been measured, maybe in a lawsuit.
Advancement of expenses is when the member or manager, etc., gets sued and asks the company to assume the cost of defense. In both Texas and Delaware, it's critical if you want advancement to specify when and under what circumstances advancement will be purchased, would be provided. It's incumbent therefore to define what rights are granted by the Delaware LLC.
Capital contributions. In Delaware and in Texas, the contribution of a member to the capital of an LLC may consist of any tangible or intangible benefit to the LLC and it can include a promissory note, services performed, a contract for services to be performed, or other interests in or securities or obligations of another LLC or other entity.
The Company Agreement in Texas or LLC Agreement in Delaware would ordinarily contain provisions relative to who is going to provide what capital under what circumstance, what capital accounts are going to be maintained by the partnership and the allocation of property, profits and losses. Those are going to be comparable to those in a limited partnership agreement and offered or drafted by reference to applicable tax laws.
In both Texas and Delaware, the allocations of profits and losses and distributions of cash or other assets are made to the members in the manner provided in the Company Agreement or the LLC Agreement. A member is not entitled to receive distributions from an LLC prior to its winding up unless specified in the Company Agreement or the LLC Agreement.
The LLC may not make any distribution to members in both states to the extent that immediately afterwards and after giving effect to the distribution, all liabilities of the LLC, other than liabilities to members with respect to their interests and non-recourse liabilities exceed the fair value of the LLCs assets. A member who receives a distribution that is not permitted under this statute has no liability to return the distribution unless the member knew that the distribution was prohibited.
The limitations of the preceding sentence to return the distribution do not apply to payments for reasonable compensation, a compensation for past or present services or reasonable payments made in the ordinary course of business under a retirement plan.
Liability to third party is piercing the corporate veil. The Legislative History of the Texas LLC statute says this article provides except as provided in the regulations, what we call the Company Agreement of the outset, that a member or manager except as provided in the documents, a member or manager is not liable to third parties expresses the legislative intent that limited liabilities to be recognized in other jurisdictions and states a member who is not a proper party to proceeding by or against a limited liability company.
So that is a statement of the legislature that veil piercing is not to be permitted in that other states under the Full Faith and Credit Clause of the U.S. Constitution are supposed to recognize the immunization of members and managers for veil piercing under Texas law.
However, courts have not respected that statement of legislative intent to the extent that I thought they should. And there are some cases that suggest that corporate veil piercing concepts apply to LLCs. The TBOC was amended in 2011 to provide the veil limiting provisions for corporations, also applied to LLCs. So thus, the TBOC provides that, except as provided in the Company Agreement, a member or manager is not liable to third parties for the debts, obligations of the LLC.
Although members are liable for the amount of their capital contributions. Members may participate in the management of an LLC without forfeiting this liability shield but may be liable for their own torts. Since the Texas LLC statutes deal expressly with the liability of members and managers for LLC obligations the "piercing the corporate veil" principle should not apply to LLCs in Texas. Although there're court opinions that suggests to the contrary. As I said the TBOC was amended to clarify that the veil piercing standards in the TBOC are applicable to LLCs and that effectively means that there's no veil piercing for contractual obligations and except in the case of an actual fraud.
Alter ego veil piercing principle similar to those applicable to Delaware corporations, are applicable to Delaware LLCs with the plaintiff having to demonstrate a misuse of the LLC form. So in both states you're having an attempt to limit veil piercing and in both states there is a slight risk of veil piercing. The doctrines of the courts used vary a bit, at least in Texas, we have in effect said that you have to have actual fraud for it to be veil piercing.
An LLC may have various classes of membership interests, the membership interest is personal property and it does not confer upon the member any interest in any specific LLC property. The membership interest may be evidenced by a certificate if the Company Agreement so provides.
The Company Agreement may establish classes of members having expressed relative rights and powers and duties, including voting rights and may establish requirements regarding the voting procedures and requirements for actions including the election of managers and amendment of the Certificate of Formation. The Company Agreement could also provide for different classes of members. And who gets to elect the managers and what percentage, etc.
For securities law purposes an LLC membership is interest is considered a security. Unless otherwise provided in the Company Agreement, a member's interest in an LLC is assignable in whole or in part. With the assignment of a membership interest does not of itself dissolve the LLC or entitle the assignee to participate in the management and affairs of the LLC, or to become, or exercise any of the rights of a member. The assignment entitles the assignee to be allocated income, gain, loss, deduction or credit to the extent that is provided therein.
Until an assignee becomes a member, the assignor continues to be a member and have the power to exercise the rights and powers of a member, except to the extent those powers are assigned. An assignee of a membership interest may become a member if and into the extent the Company Agreements so provides.
Until an assignee is admitted as a member he doesn't have the liability as a member solely as a result of the assignment. So you could see it's very important to contain in the Company Agreement provisions relating to the assignment of interest and admission of individuals as members. The membership interest transfer provisions and the Company Agreement are definitely enforceable winding up in termination.
The TBOC requires that an LLC commence winding up of its affairs and the LLC dissolved upon the occurrence of any of the following events: the expiration of the period fixed for its duration which may be perpetual, the action of the members to dissolve the LLC (in the absence of a specific provision and Certificate of Formation or Company Agreement, the vote will be a majority of the members,) any event specified in the certificate of formation or Company Agreement to cause dissolution.
I think you moved me it a little bit. We talked about mergers of LLCs and other entities that statutory business combinations are permitted. And then Texas has one unique concept that's applicable to LLCs and corporations and that is a divisive merger by which the LLC can merge into itself and create two or more entities in that transaction that would avoid a lot of things. So you could divide an LLC by its merging into itself rather than doing an asset transaction or merging with a third party. There is a lot of nuance to the divisive mergers that we'll have to get into in another CLE program and we've got, as she said, more content here than we have time to cover today, so I will adjourn at this point.
Anu: Well, thank you to everyone who joined us. Byron, thank you very much for this great presentation and we hope to see you all next time.