Limited Liability Companies – Combining The Best Of Two Worlds

Leading commentators have summarized the LLC as ‘a non-corporate business [form] that provides its members with limited liability and allows them to participate actively in the entity’s management.’

Limited liability companies or LLCs, have been a popular form of business for some time now. An LLC offers two main benefits – flexible tax planning and limited liability.

Corporate formalities:

LLCs are intended to be treated as a non-corporate form of business. This means that LLCs do not have to comply with typical corporate formalities like instituting a board of directors, provide for voting rights, conduct meetings, etc. LLCs are also free to tailor their capital needs with a greater degree of flexibility. LLCs can be suitable for many businesses, from a garage-based start-up to a sophisticated joint venture business structure.

Limited liability:

LLCs are regulated by LLC statutes as enacted by each state. LLC statutes generally provide the members of the LLC with a corporate-like limited liability shield. The language of this shield differs from state to state. Essentially, the liability of the member of an LLC is restricted to the amount that he has invested in the enterprise. California law is the most explicit in this explanation, and clearly states that the personal liability of the members of the LLC is similar to the personal liability of the shareholders in a corporation. However, this protection is not absolute. It is subject to certain exemptions which can be broadly categorized as follows:

• False or defective formation of the entity;
• Wrongful conduct by a member;
• Abuse of the shield;
• Capital-related obligations imposed by the LLC statute.

Led by Delaware, the LLC statutes of a few states go beyond the traditional shield of limited liability, and permit LLCs to internally compartmentalize their assets and create individual shields. Under this, the assets of one branch of business can be protected from claims arising out of another branch of business. This is another example of the extreme flexibility offered by LLC statutes.

Management:

Governance and management of a LLC can broadly be divided into the following three areas:

• Right of members to bind the management;
• Power of members and management to bind the LLC to third parties; and
• Rights of members and managers to information pertaining to the LLC.

Management of an LLC can be in one of two forms– management by members or management by managers. Almost all LLC statutes provide for both parallel forms of management, and the LLC has the choice to choose between them. In stark contrast to corporate law, the default rule in most LLC statutes (regarding the form of management) is decentralized management by the members. Under these statutes, in a member-managed LLC, a member has the power to bind the LLC, similar to the general provisions of a partnership. In the event that the LLC breaks up and neither party has an operating agreement to evidence the form of management, the default rule of the LLC statute will apply (regardless of practical or economic considerations). From a practical standpoint, it is important to choose the form of management and to state it in the operating agreement to prevent a future conflict.

Dissolution:

The most common ways in which an LLC is dissolved are (1) upon expiration of a specified term; (2) upon occurrence of a specified event; (3) with consent of the members; and (4) in an LLC that has only one member, the termination of that member’s membership.

In addition, many statutes provide for administrative dissolution for LLCs (on failure to file required reports), and for dissolution by court order (under limited circumstances). The common causes of dissolution of a partnership such as death, bankruptcy or resignation of an individual partner should ideally be dealt with in the operating agreement of the LLC.

Structuring an enterprise as an LLC has several tax-planning benefits as well, which will be dealt with in a later article.

Corporate Governance And Management Of Corporations

State corporate laws place the responsibility of managing the corporation upon its board of directors. The primary advantage of the corporate form of business is that it enables shareholders to share in the benefits, while at the same time limiting their personal liability.

State corporate laws generally provide 2 important protections for the board in managing the daily affairs of the corporation.

The first is the benefit of ‘business judgment presumption’. In the event of litigation arising out of a business decision, the court will assume that the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the corporation. Essentially, this means that the court will trust and uphold the decision of the board, unless the plaintiff to the suit is able to prove that the directors were grossly negligent in keeping themselves informed of all material facts.

The second protection provided to the board is known as ‘demand futility’. The principle of demand futility exists to protect the central importance of the Board in the management of the corporation and to prevent meritless lawsuits. Demand futility acts as a safety valve, allowing only the right level of policing.

For instance when a shareholder intends to file a derivative shareholder suit for and against the corporation, the shareholder needs to make a claim/demand upon the directors to prosecurte the claim, or alternatively show why a demand was not made (‘demand was futile’). When a shareholder makes a claim against a corporation which is accepted by the board, then the litigation regarding the claim is controlled by the board. Alternatively, a shareholder can claim that demand was futile, if he can prove that at the time of filing of the suit, the board could not have acted impartially upon the demand. Thus, if the majority of the directors were interested in the transaction sought to be litigated, then it could be argued that the board could not have acted impartially upon the demand.

There are some situations where federal regulation provides shareholders with an advisory vote in addition to corporate law and the corporation’s documents. For e.g., the new ‘Say on Pay’ rules require public companies to provide shareholders with an advisory vote regarding the compensation of its most highly-compensated executives. Advisory votes are important because they give shareholders a chance to voice their opinion. Although these votes are beneficial in maintaining a healthy dialogue between the corporation and its shareholders, the corporation can still choose to ignore the shareholders vote if it believes that an alternate proposal is in the best interests of the corporation.

A certain degree of tension and conflict between the shareholders and the management is healthy, and would encourage good governance of the corporation. However, for the peaceful functioning of the corporation, it is necessary that a delicate balance between these (sometimes conflicting) interests be preserved. The board is and should be the final word on management and governance of the corporation – the purpose of a corporate enterprise is passive investment by shareholders while the management runs the show. However, boards need to keep in mind that shareholders have legitimate interests in the governance of the corporation and should be provided with some kind of mechanism to express their concerns to the board. This could be achieved by encouraging shareholders proposals or by providing shareholders with greater voting rights. A corporation that does not adequately address shareholder concerns could open itself up to a host of problems, including proxy battles, hostile acquisitions, or poor stock performance.

Incorporating a Company in Delaware

Corporate law is regulated by each state, in the United States. This means that while there is no ‘federal corporations law’, each state has its own corporate law code (many modeled upon the Model General Commercial Code).

What is the significance of the state of incorporation?

A company can establish its headquarters, and do business in any state (not restricted to the state of incorporation). The importance of the state of incorporation lies in the fact that it establishes the legal domicile of the corporation. Based on the ‘internal affairs doctrine’, the law of the state of incorporation generally governs how disputes between directors/officers of the Corporation and shareholders are resolved.

Delaware as the first choice

Delaware is neither a populous nor geographically large state. However, it is the state of incorporation for fifty-seven percent of U.S. public companies and for fifty-nine percent of Fortune 500 companies. Delaware began to acquire its present status in the early 20th century, by adopting a corporate law code aimed at attracting and retaining more incorporations. Due to the large number of companies incorporated in Delaware, and the consequent litigation generated by them, Delaware’s corporate law plays a central role in establishing corporate governance norms for publicly traded corporations in the US.

Why incorporate in Delaware?

Established system of judge-made law:

The corporate law of Delaware is known as the Delaware General Corporate Law or ‘DGCL’ and contains extensive provisions regarding the formation, conduct and dissolution of a corporation. However, even the DGCL is limited in its provisions and interpretations. Several vital concepts in corporate law are governed by common law, i.e., judge-made law. These include fiduciary duties of directors, officers and controlling shareholders of the corporation both in conducting the daily business of the corporation, as well as in dealing with particular circumstances like mergers or proxy contests. Delaware courts deal with a massive amount of corporate litigation on a daily basis, which has led to the establishment of a sound corporate jurisprudence. Outside of Delaware, corporate law cases generally constitute only a tiny portion of a judge’s typical case-load.

A sound court system:

The Delaware Chancery court is a uniquely established court with limited jurisdiction. It has a docket of primarily corporate cases. These cases are heard by judges who are experts in corporate law, as opposed to juries. Court decisions are published in case-law reporters and are commercially available, providing valuable guidance to practitioners.

Reduced transaction costs:

Corporate lawyers develop an early familiarity with the extensive corporate case law laid down by the courts of Delaware. This reduces transactional costs and enables corporations incorporated in Delaware to plan with some foresight and knowledge. Delaware does not charge income tax to corporations incorporated within the State, which have their business/headquarters and operations outside the state.

There is some argument among scholars and practitioners that Delaware is losing its sheen as the corporate law giant. However, for the foreseeable future, it is unlikely that any other state will overtake Delaware as the favored place of incorporation for sizable companies.

Arbitration as an Alternative Dispute Resolution Mechanism

Soaring litigation costs, possible delays and the dangers and disadvantages in dealing with an unfamiliar jurisdiction are some of the reasons that have led to the development of innovative dispute resolution mechanisms in commercial contracts.

Arbitration has evolved as one of the most popular along the various alternate dispute resolution mechanisms for several reasons. Arbitration clauses are generally favored by courts – in the sense that courts usually give effect to arbitration clauses, unless there are good reasons for another interpretation. Unlike court proceedings, arbitral proceedings can be concluded behind closed walls. This benefit of confidentiality is important to parties, especially in cases where IP secrets or a great deal of monetary damages are involved, and the parties to the dispute would prefer to keep it out of media glare. But perhaps the most important advantage offered by arbitration is the use of technically-qualified arbitrators. Commercial disputes today require the services of experts in the field, and it is a massive advantage if the dispute resolving authority is itself composed of experts.

Self-executing arbitral agreements are the most popular version of arbitral agreements. These agreements contain an arbitral clause that takes effect automatically once a dispute arises. In these circumstances, the statute that applies to the dispute on hand is ‘stayed from operating’ and the arbitral proceedings are considered a trial. The decision reached by the arbitrator is final and binding upon the parties. Another type of arbitral clause is where the arbitral clauses are not contained in the primary agreement between the parties, but are contained in a supplementary agreement or a set of by-laws that the parties agree to abide by. Here the parties would begin arbitration by resorting to the particular instrument that contains that provision for arbitration.

However, parties should take care to ensure that all disputes intended to be decided by arbitration are clearly set out in the arbitral clause. Courts cannot go outside the language of the arbitral clause, without further agreement of the parties. Ideally, an agreement intending to refer disputes arising under it to arbitration should also contain a clause stating that arbitrators have power to decide their own jurisdiction. In the absence of such a clause, and assuming the parties disagree as whether a particular dispute is ‘arbitrable’, then it would be referred to court which would have to decide as to whether the arbitrators have jurisdiction to deal with that particular dispute.

In case of arbitral proceedings involving more than one country, a host of other factors come into play. Enforcement of a foreign arbitral award is more complicated and is subject to either the Geneva Convention on the Execution of Foreign Arbitral Awards 1927, or the more popular Convention on the Recognition and Enforcement of Foreign Arbitral Awards, better known as the New York Convention. The ease/difficulty of enforcing foreign arbitral awards differs from one jurisdiction to another and could be another article in itself!

Taken as whole, arbitration as a dispute resolution mechanism can be an effective tool in avoiding exorbinant court costs and obtaining expedited resolution of disputes.  It is well-worth getting familiar with it.

We’ve Been Sued! A Litigation Guide for Small And Growing Companies During The First 30 Days

The Clock Is Ticking

So it’s happened, you have been served with a complaint, and now you have a lawsuit to defend. Whether this is the long awaited culmination of a drawn out business dispute, or a nasty surprise the company didn’t see coming, the clock is ticking.  Courts take a no nonsense approach with deadlines, and missing one can have dire consequences.

Failing to file a responsive pleading can lead to an entry of default and eventual default judgment being entered against the company.  Which means that you lost the case, or at minimum will have to pay the additional legal expenses of fighting for relief from the judgment, just to get back to square one.

In California, for most claims you generally have 30 days from the time you were served the complaint to file a responsive pleading. Cal. Civ. Proc. Code §412.20. If you’ve been sued in Federal court, you may have as little as 21 days. Fed. Rule Civ. Proc. 12(a)(1).  There are exceptions to these rules, for instance, unlawful detainer claims require a response in only 5 days!  Cal. Civ. Proc. Code 1167, 1167.3.

This is not an exorbitant amount of time considering that during this time the complaint will need to travel through corporate channels, an attorney will have to be hired (if you don’t currently have a litigation attorney you may need to interview several), money will have to be accumulated to pay the attorney’s retainer, corporate documents relevant to the complaint may need to be located and reviewed, and lastly, your attorney will need enough time to prepare the proper responsive pleadings.

Depending on the complexity of the complaint, your attorney may need several days to prepare a responsive pleading. (I’ll discuss the most common responsive pleadings in a future post). Some pleadings like a simple answer may not require extensive research by the attorney and can be completed in several hours.  Others like a demurrer, also known as a motion to dismiss in Federal court, may take several days, and or may need to be filed with additional pleadings like a motion to strike.  These types of responsive pleadings can require a significant amount of legal research and time to draft properly.

In short, the company should start building its defense team and working on its defense strategy within a few days of being served, and in cases where litigation is expected, the company should discuss the case with an attorney even prior to being served.

Small and Growing: A Law Blog for Growing Companies

Welcome to Small and Growing, a California law blog for small to medium sized companies facing the threat of litigation. This blog aims to help explain the legal process when your company is sued or when you are forced to use the courts to enforce your rights.  While litigation can often be avoided with proper planning and a good dose of business sense, even the best planning and business sense cannot stop some litigation.  Inevitably, contracts get broken, disgruntled employees sue, clients refuse to pay, etc.

If you have never been in court or even if you have seen a few lawsuits, this blog is for you.  Use it to get informed, discuss, and ask questions about the often maligned and at times misunderstood world of business litigation– its tactics, purpose, and their ultimate effect on your business.

As an attorney in the Silicon Valley and San Francisco Bay area, I will also attempt to address news about federal, state, and local laws and ordinances that affect litigation for local small and growing businesses.

If you have questions or wish to suggest future topics for the blog, feel free to contact me.