LLC Law Blog

Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason #9

The 1948 movie “The Treasure of the Sierra Madre” starring Humphrey Bogart contained these famous words:

“Badges? We ain’t got no badges! We don’t need no badges!  I don’t have to show you any stinking badges!”

When I read new Arizona Revised Statutes  Section 29-3410 it makes me think:

“LLC records? We ain’t got no LLC records! We don’t need no LLC records!  I don’t have to show you any stinking LLC records!”

If you’ve been following my articles about the new Arizona Limited Liability Company Act that is effective September 1, 2019, you know I call the law the Arizona liability act because it creates many new ways members, managers and the company can sue each other.  Section 29-3410 is one of the new statues that is baffling and that creates new grounds for lawsuits.

New Section 29-3410.A requires all Arizona LLCs to maintain the following records:

1. a current list of the full name and last known address of each member and manager.

2. a copy of the Articles of Organization and all amendments to the Articles of Organization.

3. a copy of all current and prior written operating agreements and amendments to all current and prior written operating agreements.

4. any record of a member’s obligation to make a capital contribution to the company.

5. a copy of the company’s federal, state and local income tax returns and reports, if any, for the three most recent years.

6. a copy of the company’s financial statements, if any, for the three most recent years.

The records all Arizona LLCs must maintain under new law Section 29-3410.A are the same records all Arizona LLCs must maintain under current LLC law.  See Arizona Revised Statutes Section 29-607.

The problem with Section 29-3410 is that it contains a long list of new requirements that deal with whether or not the company must disclose any required records.  Section 29-3410 states:

B. During regular business hours and at a reasonable location specified by the limited liability company, a member or manager may inspect and copy the records described in subsection A of this Section and any other company record regarding the activities, affairs, financial condition and other circumstances of the company as is just and reasonable if all of the following apply:

1. the member or manager seeks the records for a purpose reasonably related to the rights and duties of the member or manager under the operating agreement or this Chapter.

2. the member or manager makes a demand in a record received by the company describing with reasonable particularity the records sought and the purpose for seeking the records.

3. the records sought are directly connected to the member’s or manager’s purpose.

C. not later than ten days after receiving a demand pursuant to subsection B, paragraph 2 of this Section, the limited liability company shall inform in a record the member or manager that made the demand of:

1. the records that the company will make available in response to the demand and when and where the company will make the records available.  The time and location may not be unreasonable under the circumstances.

2. the reasons for declining if the company declines to provide any demanded records.

D. Whenever this Chapter or the operating agreement provides for a member or manager to vote on or give or withhold consent to a matter, before the vote is cast or consent is given or withheld, the limited liability company, without demand, shall provide the member or manager with all information that is known to the company and all records in the company’s possession that are material to the member’s or manager’s decision except to the extent the company reasonably believes that the member or manager already knows the information or is in possession of the records.

E. To the extent that some or all of a limited liability company’s records are maintained by a member or manager, the member or manager shall make those records available to the company as necessary for the company to satisfy its obligations pursuant to this Section.

K. In addition to any restriction or condition stated in its operating agreement, a limited liability company may impose reasonable restrictions and conditions on access to and use of information to be furnished and records to be made available under this Section, 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 reasonableness.

L. If a dispute arises regarding a member’s or manager’s right under this Section to obtain information or inspect or copy a record, 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, the court may award the successful party reasonable expenses, including reasonable attorney fees and costs.

Current vs. Future Arizona LLC Records Law

Under current law members are entitled to get copies of the records.  There is no procedures that allow the LLC to refuse to give records to members.  New Arizona LLC law creates an elaborate process that must be satisfied before a member can get required records.  Here are some of the potential problems created by Section 29-3410:

• LLC has two members, Homer Simpson and Ned Flanders.  Each owns 50% of the LLC.  Ned sends Homer an email that he wants copies of the records the company must maintain.  Here are some of the problems that arise:

1. Neither Homer nor Ned is obligated to maintain the records.  The company is required to maintain the records, but it cannot do so unless somebody acts on its behalf.

2. Did Ned make a demand in a record received by the company describing with reasonable particularity the records sought and the purpose for seeking the records?

3. How does Ned make the demand for copies of records and who does he give the demand to?

4. Who determines if Ned’s purpose is a proper purpose?

5. Is Ned’s purpose reasonably related to his rights and duties as a member?

6. Are the records sought by Ned directly connected to his purpose?

7. Who determines if the records sought are directly connected to the member’s purpose in making the request?

8. If Ned sues to enforce his rights under Section 29-3410 who does he sue?

9. Does Homer have any personal liability for the company’s failure to satisfy its obligations under Section 29-3410?

• What if Homer owns 90% of the LLC and Ned owns 10%?  Do the answers to the above questions change?

Section 29-3410.L encourages litigation over records requests by expressly authorizing the prevailing party in a lawsuit to enforce Section 29-3410 to collect attorneys fees and costs from the losing party.

KEYTLaw’s Operating Agreement Eliminates Section 29-3410 Duties

The Operating Agreement we prepare for all of our multi-member LLCs contains language that eliminates all of the troubling duties in Section 29-3410.  If your Arizona LLC wants to be subject to the duties levied in Section 29-3410 we will modify the Operating Agreement to make Section 29-3410 applicable to the LLC and its members.

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Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason #8

Yes Dorothy, beginning September 1, 2019, Arizona manager managed LLCs will no longer be in Kansas limited liability company land.  Instead they will be in liability company land, a new environment in which a manager of an Arizona manager managed LLC can be sued for violating one or more of the fiduciary duties the new Arizona Revised Limited Liability Company Act (ALLCA) levies on managers of manager managed Arizona LLCs..  When ALLCA becomes effective all managers of manager managed Arizona LLCs will have numerous new duties the violation of which will give members and the company causes of action to sue managers.  This is why I call ALLCA the Arizona liability company act.

What are the New Manager Duties under ALLCA?

Arizona Revised Statutes Section 29-3409 levies the following new fiduciary duties on all managers of Arizona LLCs that are manager managed. ALLCA is applies to all Arizona LLCs formed after August 31, 2019, and all Arizona LLCs after August 31, 2020.  Section 29-3409 states:

I. A manager of a manager-managed limited liability company owes to the company and the members the duties of loyalty and care stated in subsections j and k of this Section.

J. The fiduciary duty of loyalty of a manager in a manager-managed limited liability company includes the following duties:

1. to account to the company and hold as trustee for the company any property, profit or benefit derived by the manager to which the manager is not entitled:

(a) in the conduct or winding up of the company’s activities and affairs.

(b) from a use by the manager of the company’s property.

(c) from the appropriation of a company opportunity.

2. to refrain from dealing with the company in the conduct or winding up of the company’s activities and affairs as or on behalf of a person having an interest adverse to the company.

3. to refrain from competing with the company in the conduct of the company’s activities and affairs before the dissolution of the company.

4. to disclose to each of the other members and managers who are considering or voting on a decision or transaction regarding the company or one or more of the members’ interests in the company both of the following:

(a) any material conflict of interest on the part of the disclosing manager with respect to the decision or transaction.

(b) if a material conflict of interest exists, all material facts relating to the decision or transaction that are within the disclosing manager’s knowledge and not known or reasonably available to the affected members or managers.

K. The duty of care of a manager of a manager-managed limited liability company in the conduct or winding up of the company’s activities and affairs is to refrain from engaging in grossly negligent or reckless conduct or willful or intentional misconduct.

L. A manager shall discharge the duties and obligations under this Chapter or under the operating agreement and exercise any right consistently with the contractual obligation of good faith and fair dealing.

Q. In a manager-managed limited liability company, a member does not have any fiduciary duty to the company or to any other member solely by reason of being a member.

R. A conflict of interest is material if the conflict would reasonably be expected to affect a member’s or manager’s judgment regarding the decision or transaction under consideration.

Does Anybody in Arizona Understand the New Duties in Section 29-3409?

Probably not!  Imagine you are the manager of an Arizona manager managed LLC that is governed by ALLCA, which means you are subject to all of the duties set forth in Section 29-3409.  Would you know you are subject to the duties levied in Section 29-3409?  If you did know about the duties levied on managers would you know how to protect yourself and avoid liability by “doing the right thing?”  I wouldn’t and I’ve formed 9,300+ LLCs and been advising LLC clients about Arizona LLC law since 1992 when Arizona adopted its current LLC law.  I’m an LLC lawyer and I don’t know what the new duties mean or how to comply with them in the operation of an LLC.

Here is a short list of some of the questions all managers of an Arizona manager managed LLC need to ask and know the answer to:

• What is the duty of loyalty?
• How does a manager satisfy the duty of loyalty?
• What is the duty of care?
• How does a manager satisfy the duty of care?
• When would a manager’s actions cause the company to act on behalf of a person having an interest adverse to the company?
• When does the managers actions constitute competing with the company?
• When the members are voting on an issue when does a manager have a conflict of interest that requires the manager to disclose all material facts to the members?
• If disclosure of material facts is required, must the manager prepare a written disclosure document and give it to the members before they vote on the issue?  Hint:  Yes if the manager wants to be able to prove he or she satisfied the disclosure requirement.
• What is grossly negligent conduct?
• What is reckless conduct?
• What is willful misconduct?
• What is intentional misconduct?
• What is the contractual obligation of good faith?
• What is the contractual obligation of fair dealing?

When you know the answers to the above questions only then can you act in ways that will satisfy your fiduciary duties as a manager and avoid liability for failing to satisfy a duty.

People or companies that are managers of manager managed LLCs need to be aware of the potential liabilities the managers have under Section 29-3409.  There is good news, however, a well drafted ALLCA compliant Operating Agreement can eliminate or modify all of the duties that apply to managers in Section 29-3409 except

Warning for Managers of Manager Managed Arizona LLCs

If you or your company will be the manager of an Arizona manager managed LLC you should not accept the job unless all the members of the LLC sign an Operating Agreement that eliminates or modifies the manager’s duties under Section 29-3409.

Operating Agreement Can Eliminate or Modify Some Section 29-3409 Duties

One reason your Arizona member managed LLC needs an ALLCA compliant Operating Agreement is to have it eliminate or modify the fiduciary duties set forth in Section 29-3409.  The general rule of Section 29-3105.A.3 of ALLCA is “in the event of a conflict between a provision of the operating agreement and this Chapter, the provision of the operating agreement governs” except an Operating Agreement may not:

• eliminate the contractual obligation of good faith and fair dealing or the duty to refrain from willful or intentional misconduct under Section 29-3409, or

• limit or eliminate a person’s liability for any violation of the contractual obligation of good faith and fair dealing or conduct involving willful or intentional misconduct.

KEYTLaw’s Operating Agreement Can Eliminate or Modify Fiduciary Duties

The Operating Agreement we prepare for all of our multi-member LLCs contains language that eliminates all of the manager’s duties levied in Section 29-3409.  Our Operating Agreements do not eliminate or modify the contractual obligation of good faith and fair dealing or the duty to refrain from conduct involving willful or intentional misconduct.  If your manager managed Arizona LLC wants its managers to be subject to the fiduciary duties levied in Section 29-3409 we will modify the Operating Agreement to make Section 29-3409 applicable to the LLC and its managers.

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Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason #7

Forrest Gump’s mother used to tell him “Life is like a box of chocolates. You never know what you’re gonna get.”  This statement applies to Section 29-3409 of the new Arizona Limited Liability Company Act (ALLCA) effective September 1, 2019.  Members who are subject to Section 29-3409 will NEVER know what they get under this statute until they win or lose a law suit for breach of one or more of the new duties levied on members of member managed Arizona LLCs.  This new law imposes fiduciary duties for the first time on members of all member managed Arizona LLCs.

Instead of calling the ALLCA by its full legal name, I frequently refer to ALLCA as the Arizona Liability Company Act because of the many fiduciary duties the new law levies on members of member managed Arizona LLCs.  New duties means new potential liabilities imposed on members that can cause them to be named as defendants in lawsuits and to be liable for attorneys’ fees and damages.

Fortunately most of the new fiduciary duties levied on members and managers of Arizona LLCs under ALLCA can be eliminated or modified by a well drafted Operating Agreement.  Members of Arizona LLCs that hire a competent Arizona LLC attorney will be able to sign an ALLCA compliant Operating Agreement.  Unfortunately it will be the unsuspecting members of member managed multi-member Arizona LLCs that lack an ALLCA compliant Operating Agreement that will be subject to the new fiduciary duties.  These new duties levied on members and mangers are a litigation attorney’s dream because they will have many new reasons to sue members of multi-member Arizona LLCs that are member managed.

Current Arizona LLC Law

Current Arizona LLC does not impose any fiduciary duties on members of an Arizona LLC.  The Arizona Court of Appeals case called TM2008 Investments, Inc., vs. ProCon Capital Corp. involves a dispute among the two members of Doveland Developments, LLC, a company formed to buy land and develop it into homes.  ProCon Capital sued TM2008 Investments for breach of a fiduciary duty called the implied covenant of good faith and fair dealing.  The issue before the Arizona Court of Appeals was whether or not Arizona’s limited liability company law provides that a member of an Arizona LLC owes a fiduciary duty to the other members of the LLC.  The court said:

“We decline in this case to mechanically apply fiduciary duty principles from the law of closely-held corporations or partnerships to a limited liability company created under Arizona law. The legislature did not explicitly outline any such duties for members of an LLC; instead, the LLC Act allows the members of an LLC to not only create an operating agreement, but also delineate in that agreement the duties members owe one another.”

The times they are a changing.  The drafters of ALLCA decided to change drastically Arizona LLC law by adding language in ALLCA that expressly creates new fiduciary duties on members of member managed Arizona LLCs.

Definition of Fiduciary Duty

Cornell Law School’s Wex Legal Dictionary defines “fiduciary duty” as follows:

A fiduciary duty is the highest standard of care.  The person who has a fiduciary duty is called the fiduciary, and the person to whom he owes the duty, is typically referred to as the principal or the beneficiary. If an individual breaches the fiduciary duties, he or she would need to account for the ill-gotten profit. His or her beneficiaries are entitled to damages, even if they suffered no harm.

Fiduciary duties exist to encourage specialization and induce people to enter into a fiduciary relationship.  By imposing these duties, the law reduces the risk of abuse of a beneficiary by the fiduciary.  As a result, potential beneficiaries can have greater confidence in seeking out a fiduciary.

New Arizona Revised Statute Section 29-3409

New Arizona Revised Statutes Section 29-3409 levies the following fiduciary duties on members of member managed Arizona LLCs formed after August 31, 2019, and members of all Arizona member managed LLCs after August 31, 2010:

A. A member of a member-managed limited liability company owes to the company and the other members the duties of loyalty and care . . .

B. The fiduciary duty of loyalty of a member in a member-managed limited liability company includes the following duties:

1. to account to the company and hold as trustee for the company any property, profit or benefit derived by the member to which the member is not entitled:

(a) in the conduct or winding up of the company’s activities and affairs.

(b) from a use by the member of the company’s property.

(c) from the appropriation of a company opportunity.

2. to refrain from dealing with the company in the conduct or winding up of the company’s activities and affairs as or on behalf of a person having an interest adverse to the company.

3. to refrain from competing with the company in the conduct of the company’s activities and affairs before the dissolution of the company.

4. to disclose to each of the other members that are considering or voting on a decision or transaction regarding the company or one or more of the members’ interests in the company both of the following:

(a) any material conflict of interest on the part of the disclosing member with respect to the decision or transaction.

(b) if a material conflict of interest exists, all material facts relating to the decision or transaction that are within the disclosing member’s knowledge and not known or reasonably available to the affected members.

C. The duty of care of a member of a member-managed limited liability company in the conduct or winding up of the company’s activities and affairs is to refrain from engaging in grossly negligent or reckless conduct or willful or intentional misconduct.

D. A member shall discharge the duties and obligations under this Chapter or under the operating agreement and exercise any right consistently with the contractual obligation of good faith and fair dealing.  [Author’s comment: Section 29-3105.C.5 says that an Operating Agreement cannot limit or eliminate a person’s liability for any violation of the contractual obligation of good faith and fair dealing.]

Section 29-3409 inflicts seven new duties on members of member managed LLCs.  This means ALLCA creates seven new ways a member can be sued by another member or the LLC.  Now do you see why I call ALLCA the Arizona liability company act?

Welcome to the New Age of Arizona LLC Law Uncertainty

It’s 2021 and you are a member of a three member Arizona LLC that is member managed.  You are subject to Section 29-3409.  Anybody can read this statute, but until an Arizona appellate court rules on the duties levied on members in this statute nobody has a clue what the statute means or how a member must act to avoid liability under the statute.  Consider the following questions every member will have about Section 29-3409:

• What is the duty of loyalty?
• How does a member satisfy the duty of loyalty?
• What is the duty of care?
• How does a member satisfy the duty of care?
• When does a member get property, profit or benefit to which the member is not entitled?
• When must a member refrain from dealing with the company as or on behalf of a person having an interest adverse to the company?
• When does a member’s activities constitute competing with the company?
• When the members are voting on an issue when does a member have a material conflict of interest with respect to the decision or transaction?
• If the members are voting and a member has a material conflict of interest, how does the member with a conflict know if a fact is a material fact relating to the decision or transaction that are within the disclosing member’s knowledge and not known or reasonably available to the affected members.
• All knowledgeable attorneys will advise members of an Arizona member managed LLC that if the member has any material conflicts of interest with respect to an issue the members are voting on the only way that the member can protect himself or herself is by preparing a written document that discloses all material facts, give the document to all the other members and get a receipt signed by all the other members in which they acknowledge getting the written disclosure document at a specified date and time.
• What is the contractual obligation of good faith and fair dealing?  How does a member satisfy this requirement?

How Do Members of a Member Managed Arizona LLC Eliminate or Modify Section 29-3409?

The Section 29-3409 problem is only a problem for member managed Arizona LLCs that are not single member LLCs and LLCs owned by a solely by a married couple.  The member / members of these types of Arizona LLCs are not going to sue themselves or hold themselves liable for violating any duties in Section 29-3409.

The Section 29-3409 problem only exists for member managed multi-member Arizona LLCs other than a two member LLC owned by a married couple. My recommendation is that multi-member Arizona LLCs eliminate or modify member duties set forth in Section 29-3409.  Here are two ways a member managed multi-member Arizona LLC can eliminate or modify the duties levied on members:

1. Form a manager managed LLC or amend the Articles of Organization of a member managed LLC to change it to a manager managed LLC.  The duties imposed on members by Section 29-3409 apply to members only when the LLC is member managed.  Warning: Although the members of an Arizona manager managed LLC are not liable for duties under Section 29-3409 all managers of a manager managed Arizona LLC will have similar fiduciary duties under Section 29-3409.

2. Have the members of a manager managed Arizona LLC adopt an Operating Agreement that eliminates unwanted duties in Section 29-3409 or that modifies the duties to make them acceptable to the members.  Note: Section 29-3105.C.5 prohibits an Operating Agreement from limiting or eliminating a person’s liability for any violation of the contractual obligation of good faith and fair dealing.

Operating Agreement Can Eliminate or Modify Some Section 29-3409 Duties

One reason your Arizona member managed LLC needs an ALLCA compliant Operating Agreement is to have it eliminate or modify the fiduciary duties set forth in Section 29-3409.  The general rule of Section 29-3105.A.3 of ALLCA is “in the event of a conflict between a provision of the operating agreement and this Chapter, the provision of the operating agreement governs” except an Operating Agreement may not:

• eliminate the contractual obligation of good faith and fair dealing or the duty to refrain from willful or intentional misconduct under Section 29-3409, or

• limit or eliminate a person’s liability for any violation of the contractual obligation of good faith and fair dealing or conduct involving willful or intentional misconduct.

KEYTLaw’s Operating Agreement Can Eliminate or Modify Fiduciary Duties

The Operating Agreement we prepare for all of our multi-member LLCs contains language that eliminates all of the members’ duties levied in Section 29-3409.  Our Operating Agreements do not eliminate or modify the contractual obligation of good faith and fair dealing or the duty to refrain from conduct involving willful or intentional misconduct.  If your member managed Arizona LLC wants its members to be subject to the fiduciary duties levied in Section 29-3409 we will modify the Operating Agreement to make Section 29-3409 applicable to the LLC and its members.

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Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason #6

New Arizona Limited Liability Company Act (ALLCA) Section 29-3407.C.3 provides:

“a majority of the managers shall decide . . .

(a) matters that are outside the ordinary course of the company’s activities and affairs but within the company’s purpose.

(b) matters on which there exists a known difference among managers.

This is a troubling statute that I recommend be amended or deleted in Arizona LLCs’ Operating Agreements.  The problem with subsection (a) is ALLCA does not define: (i) the ordinary course of the company’s activities, and (ii) the company’s purpose.

If the manager managed LLC does not have an Operating Agreement that defines the ordinary course of the company’s activities or the company’s purpose then subsection (a) is meaningless.  Few LLC Operating Agreements define the LLC’s purpose.

The practical significant of Section 29-3407.C.3(a) is that an LLC manager cannot exercise any power under this subsection unless the LLC has an Operating Agreement that defines the LLC’s ordinary course of activities and/or the company’s purpose, but very few LLCs have an Operating Agreement with that kind of language.

Another problem with Section 29-3407.C.3 is subsection (b), which provides “a majority of the managers shall decide . . . matters on which there exists a known difference among managers.”  This provision could be interpreted to mean that any time the managers differ on a proposed action a majority of the managers can decide to adopt or reject the action despite contrary language in the LLC’s Operating Agreement.  This provision is too broad and potentially dangerous to some of the members.  It should be eliminated by an ALLCA compliant Operating Agreement.

An Arizona LLC’s Operating Agreement should contain language that expressly states what a manager can do and what the manager cannot do without getting approval from the members.  My Operating Agreements contain these types of provisions.

In addition, my ALLCA compliant Operating Agreement deletes Section 29-3407.C.3 and many other problem provisions contained in Arizona’s new ALLCA.

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Recently somebody for whom I formed an Arizona LLC asked me if Arizona’s new LLC act (ALLCA) that is effective 9/1/19 for LLCs formed after 8/31/19 and all Arizona LLCs after 8/31/20 will require Arizona LLCs to adopt an Operating Agreement that contains language that makes the agreement compatible with ALLCA.  The short answer is no.  ALLCA does not require an Arizona LLC to have an Operating Agreement or amend existing Operating Agreements.

As an Arizona LLC attorney who has formed 9,300+ LLCs my answer to the question, even though ALLCA does not require an Arizona LLC to have an ALLCA complaint Operating Agreement is that all Arizona LLCs should have an ALLCA compliant Operating Agreement because it would be extremely foolish and potentially a costly mistake for an Arizona LLC to fail to have an ALLCA compliant Operating Agreement.

I recommend that all Arizona LLCs adopt an Operating Agreement that contains provisions derived from or based on the statutory provisions contained in ALLCA.  Because all of Arizona’s existing LLC statutes will be completely eliminated and replaced by the new ALLCA, all Arizona LLCs need an ALLCA compliant Operating Agreement.  To me it is a no brainer.

New Arizona LLC law means all Arizona LLCs need an Operating Agreement drafted for the new law.  If you are thinking of forming a new Arizona LLC and will not get an ALLCA compliant Operating Agreement, ask yourself WHY?  Don’t you want an agreement drafted for Arizona’s new LLC law now?  Your new Arizona LLC’s Operating Agreement should be ALLCA compliant now so you don’t have to modify the Operating Agreement before September 1, 2020, to make it compliant with Arizona’s new LLC law.

ALLCA Compliant Operating Agreement

What do I mean by an ALLCA compliant Operating Agreement?  I mean an Operating Agreement that has been drafted by an experienced Arizona LLC attorney like me who has studied ALLCA and who has written provisions for the Operating Agreement that take into consideration statutory provisions in the new law.

I invested a lot of time reading and studying Arizona’s new LLC law because I know that all existing and future Arizona LLCs need an Operating Agreement that is drafted specifically for Arizona’s new ALLCA.  My ALLCA compliant Operating Agreements contains 17 pages of new text that addresses Arizona’s new LLC law.

New ALLCA Sections Added to My Operating Agreement

Below is the table of contents for Article 13 of my ALLCA compliant Arizona LLC Operating Agreements.  The table shows the titles of the 28 sections of new provisions in Article 13 that constitute 17 pages of text in my ALLCA compliant Operating Agreement.  A quick review of the 28 new sections I added to my Operating Agreements to make them ALLCA compliant will show you that the new ALLCA has a lot of provisions that affect Arizona LLCs that all Arizona LLCs need to address.

Article 13 Arizona LLC Act Provisions

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Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason #5

New Arizona Limited Liability Company Act (ALLCA) effective September 1, 2019, creates many new grounds for members of Arizona LLCs to sue each other and their company.  I call the new law the Arizona liability company because its creates so many new grounds that members can use to sue each other.

New Arizona Revised Statutes Section 29-3409.B.4 is the new law that for the first time gives a member of an Arizona LLC grounds to sue one or more other members as a result of a vote by the members to cause the company to engage in an action or refrain from engaging in an action. Section 29-3409.B.4 states:

B. The fiduciary duty of loyalty of a member in a member-managed limited liability company includes the following duties:

4. to disclose to each of the other members that are considering or voting on a decision or transaction regarding the company or one or more of the members’ interests in the company both of the following:

(a) any material conflict of interest on the part of the disclosing member with respect to the decision or transaction.

(b) if a material conflict of interest exists, all material facts relating to the decision or transaction that are within the disclosing member’s knowledge and not known or reasonably available to the affected members.

The problem for members of Arizona LLCs under ALLCA is that Section 29-3409.B.4 for the first time creates liability for a member of an Arizona LLC who votes on an issue and fails to disclose that the member has a conflict of interest.

When Does a Conflict of Interest Exist?

The big problem is that the term “conflict of interest” is not defined in the statute and there are no Arizona appellate court cases that shed light on the term because the new ALLCA has not been the subject of any litigation yet.  Nor do we have a clue as to whether an existing conflict of interest is material, because only material conflicts of interest must be disclosed.

Can You Find the Conflict of Interest?

Homer Simpson and Ned Flanders each own 50% of World Wide Widgets, LLC.  They have a meeting to consider if WWW should enter into a contract with ABC, Inc., to hire it to manufacture 1,000 widgets for $100,000.  Consider the following hypothetical situations and ask yourself when does a conflict of interest exist?

1. Homer is the sole owner of ABC, Inc.  Clear conflict of interest and Homer must disclose he owns all of ABC, Inc.
2. Homer owns 50% of ABC, Inc.
3. Homer owns 49% of ABC, Inc.
4 Homer owns 5% of ABC, Inc.
5. Homer’s son is the sole owner of ABC, Inc.
6. Homer’s son owns 50% of ABC, Inc.
7. Homer’s son owns 49% of ABC, Inc.
8 Homer’s son owns 5% of ABC, Inc.
9. Homer’s son-in-law is the sole owner of ABC, Inc.
10. Homer’s son-in-law owns 50% of ABC, Inc.
11. Homer’s son-in-law owns 49% of ABC, Inc.
12 Homer’s son-in-law owns 5% of ABC, Inc.
13. Homer’s brother is the sole owner of ABC, Inc.
14. Homer’s brother  owns 50% of ABC, Inc.
15. Homer’s brother owns 49% of ABC, Inc.
16 Homer’s brother owns 5% of ABC, Inc.
17. Homer’s brother-in-law is the sole owner of ABC, Inc.
18. Homer’s brother-in-law owns 50% of ABC, Inc.
19. Homer’s brother-in-law owns 49% of ABC, Inc.
20 Homer’s brother-in-law owns 5% of ABC, Inc.

Except for the situation where Homer owns 100% of ABC, Inc., I have no clue if any of the other scenarios involve a conflict of interest for Homer or if an existing conflict of interest is material.  Do you?

You can see the practical problem all members of Arizona LLCs will have when they are subject to Section 29-3409.B.4. More often than not a member will not know if a conflict of interest exists or if a conflict of interest is material until a jury rules on the issue years later.  Imagine being in a meeting of members of your LLC and you the members are getting ready to vote on an issue to which you may have a conflict of interest, but you are not sure if you do have a conflict of interest or if there is a conflict if the conflict is material.  There is no place you can get an definitive answer to whether or not you have a conflict of interest and if a conflict is material.

Consequence of a Member Having a Material Conflict of Interest

If a member does have a material conflict of interest the member has a fiduciary duty to disclose the all material facts relating to the decision or transaction that are within the disclosing member’s knowledge and not known or reasonably available to the affected members.  The practical problem for all members who think there are material facts that need to be disclosed is that the only way the member can protect against a future lawsuit for failing to disclose is by delivering a document to all of the other members that contains language that discloses the material facts and get all members to sign a receipt in which they acknowledge receiving the disclosure document.

Verbal disclosures of material conflicts of interest are worthless.  My contracts professor in my first year of law school said that “if it is oral rather than written it’s as if it never happened.”  Oral disclosures are invitations to litigation.  The only way a member can protect against liability under Section 29-3409.B.4 is by giving the other members a written disclosure document before voting and get the members to sign a receipt.

For members who want to eliminate the voting disclosure requirement contained in Section 29-3409.B.4. they must arrange for all members of their LLC to sign an Operating Agreement that eliminates Section 29-3409.B.4.

KEYTLaw’s Operating Agreement Eliminates Section 29-3409.B Problem

The Operating Agreement we prepare for all of our multi-member LLCs contains language that eliminates Section 29-3409.B.4.  If your Arizona LLC wants  its members to be subject to the conflict of interest disclosure requirement in Section 29-3409.B.4 we will modify the Operating Agreement to make Section 29-3409.B.4 applicable to the LLC and its members.

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Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason #4

Your Arizona LLC needs an Operating Agreement that eliminates or clarifies new Arizona Revised Statutes Section 29-3407.B that is effective September 1, 2019.  This statute applies to member managed LLCs and states:

In a member-managed limited liability company, the following apply:

1. . . . the management and conduct of the company are vested in the members.

2. within the ordinary course of the company’s activities and affairs, each member has the right to manage and conduct the company’s activities and affairs.

3. . . . a majority in interest of the members shall decide any of the following:

(a) matters that are outside the ordinary course of the company’s activities and affairs but within the company’s purpose.

(b) matters on which there exists a known difference among members.

(c) whether to make an interim distribution before dissolution and winding up.

(d) whether to make an advance to a member or manager under Section 29-3408.C.

The first thing to know about this statute is that without an Operating Agreement that defines how members vote, a majority in interest of the members is determined by counting the number of members (husband and wife are two members) then asking what number is a majority of the total number of members?  See New LLC Law Warning: Beware of Section 29-3404.A, which explains the new law’s definition of majority in interest.  For example, if an Arizona LLC has two members, Homer who owns 90% and Ned & Molly, a married couple, who own 10%, Section 29.3404.A provides that there there are three members so Ned and Molly’s two votes overrule Homer’s one vote.

Subsection 3 of Section 29-3407.B creates a vast amount of uncertainty for the members.  It is a time bomb waiting to explode into litigation.  Here are some of the problems caused by this statute:

1. What matters are outside the ordinary course of the company’s activities?
2. What matters are within the company’s purpose?
3. How does a member know there is a known difference among members?
4. Who determines the answers to questions 1 – 3?
5. If this statute is breached, does the company have liability and can it be a defendant in a lawsuit?
6. What happens with there are an equal number of members and no majority?  Apparently the members are deadlocked indefinitely.

An Arizona LLC that is subject to Section 29-3407.B may want to have a provision in its Operating Agreement that eliminates this statute or modifies it in a way that is understandable and that works in actual practice.

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Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason # 3

Current Arizona LLC law Section 29-681.E provides a default method for determining what constitutes a majority of the members when an LLC lacks an Operating Agreement that defines members’ voting rights.  Current LLC law Section 29-681.E states:

a majority consists of more than one-half of the members

The new Arizona Limited Liability Company Act (ALLCA) contains a bizarre and potentially unfair method for determining which members constitute a majority in interest who have control of the LLC.  ALLCA Section 29-3101.12 states:

“Majority in Interest of the Members” means, at any particular time, one or more Members that hold in the aggregate a majority of the interests in the limited liability company’s profits held at that time by all Members . . . . The Members’ respective interests in the Company’s profits are in proportion to their rights to share in distributions that exceed the repayment of their contributions on dissolution and winding up of the Company.

This troubling statute says that the majority in interest of the members is derived from how the members “share in distributions.”  ALLCA Section 29-3404.A states:

“Any distribution made by a limited liability company . . . must be in equal shares among Members.”

When you apply Section 29-3404.A (equal distributions to members) to Section 29-3101.12 (members’ profits equal how they share distributions) the result is a majority in interest of members of an Arizona under ALLCA is the same as current LLC law Section 29-681.E, i.e., a majority in interest consists of more than one-half of the members.

Multi-member LLCs whose members share profits equally don’t need an ALLCA Operating Agreement that defines how members vote because each member gets one vote.  However, all multi-member LLCs that want a voting method that does not give each member one vote must sign an Operating Agreement that defines the desired voting method.

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Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason # 2

New Arizona Limited Liability Company Act (ALLCA) Section 29-3101.13 effective September 1, 2019, states:

“Manager” means a person that under the Operating Agreement of a Manager-managed limited liability company is responsible, alone or in concert with others, for performing the management functions stated in Section 29-3407, subsection C.

ALLCA Section 29-3105.A.1(b)  states:

The Operating Agreement governs . . . the rights and duties . . . of a person in the capacity of Manager

My interpretation of these two statutes is that under ALLCA the only way a manager of a manager managed LLC can be a manager and have manager power’s is if the LLC has an Operating Agreement and the person or entity is named in that Operating Agreement as a manager.

Conclusion:  When a manager managed LLC becomes subject to the new ALLCA it will not have a manager unless the LLC has an Operating Agreement that names one or more managers.

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Why LLCs Must Have an ALLCA Compliant Operating Agreement: Reason # 1

Arizona’s new LLC law called the Arizona Limited Liability Company Act (ALLCA) effective September 1, 2019, contains many traps for members and managers of Arizona LLCs.  The only way members and managers of Arizona LLCs can protect themselves against ALLCA traps is by signing an Operating Agreement that eliminates ALLCA’s problem provisions.

One of the most potentially damaging ALLCA provisions is Arizona Revised Statutes Section 29-3404.A.  This statute states:

“Any distribution made by a limited liability company before its dissolution and winding up must be in equal shares among Members.”

This statute means that an Arizona LLC taxed as a partnership or S corporation with taxable income of $10,000 in 2021 that is owned 90% by Homer Simpson and 10% by Ned Flanders will:

• Allocate $9,000 of the income to Homer who will pay the tax on that amount.
• Allocate $1,000 of the income to Ned who will pay the tax on that amount.
• Distribute $5,000 to Homer.
• Distribute $5,000 to Ned.

ALLCA Section 29-3404.A causes the $10,000 of income to be distributed equally to each member.

How to Avoid the Section 29-3404.A Problem

Homer and Ned should sign an ALLCA compliant Operating Agreement that eliminates the default problems contained in ALLCA.  Their Operating Agreement should have language in it that eliminates Section 29-3404.A .

FYI:  All of my Operating Agreements eliminate the Section 29-3404.A problem and are 100% ALLCA compliant.  ALLCA compliant means my Operating Agreements are drafted to eliminate many of the inherent problems that ALLCA creates such as Section 29-3404.A .

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New Arizona Limited Liability Company Act (ALLCA) Section 29-3401.E provides that two or more natural persons may own an LLC membership interest as joint tenants with right of survivorship and a married couple may own an LLC membership interest as community property with right of survivorship.  These types of LLC membership interests are created by one of the following methods:

Joint Tenancy with Right of Survivorship

1.  A written Operating Agreement expressly declares that two or more natural persons hold a transferable interest as joint tenants with right of survivorship or in joint tenancy with right of survivorship.

2. A written assignment of a transferable interest to two or more natural persons, who may include one or more assignors if the written assignment is signed by each joint tenant and contains the express written declaration that the joint tenants hold the assigned transferable interest as joint tenants with right of survivorship or in joint tenancy with right of survivorship.

3. It is created in the Articles of Organization if the Articles are signed by each joint tenant and contain the express written declaration that the joint tenants hold the assigned transferable interest as joint tenants with right of survivorship or in joint tenancy with right of survivorship.

Community Property with Right of Survivorship

4. A written Operating Agreement expressly declares that that a married couple holds a transferable interest as community property with right of survivorship.

5. A written assignment of a transferable interest to a married couple, who may include one or both assignor spouses if the written assignment is signed by each spouse and contains the express written declaration that the married couple holds the assigned transferable interest as community property with right of survivorship.

6. It is created in the Articles of Organization if the Articles are signed by each spouse and contains the express written declaration that the married couple holds the membership interest as community property with right of survivorship.

Consequences of the Death of a Member Who Holds a Membership Interest with a Right of Survivorship

If a member who holds a membership interest with a right of survivorship dies, the surviving joint tenant with right of survivorship or surviving spouse who holds a community property right of survivorship does not necessarily become a member of the LLC with respect to the acquired interest.  ALLCA Section 29-3401.H states:

“Each co-owner of a transferable interest, whether the transferable interest is held as tenants in common, joint tenants with right of survivorship, community property or community property with right of survivorship, shall have only the rights of a transferee with respect to the interest, both during the lifetime and following the death of any other co-owner, unless and until the co-owner becomes a member in accordance with subsection C of this Section.”

ALLCA Section 29-3401.C states:

“After formation of a limited liability company, a person becomes a member by any of the following:

1. as provided in the Operating Agreement.
2. as the result of a transaction effective under Article 10 [mergers & conversions] of this Chapter.
3. by agreeing to become a member, with the affirmative vote or consent of all the members.
4. as provided in Section 29-3701.A.3.

Bottom Line

Creating membership interests held jointly by members as joint tenants with right of survivorship or community property with right of survivorship does not happen automatically.  Even under current Arizona LLC you create these types of ownership interests by proper documentation signed by the joint owners or married couple.

I create joint tenancy with right of survivorship membership interests and community property with right of survivorship membership interests by including the proper language in the LLC’s Operating Agreement that is signed by the joint tenants or the married couple.  My Operating Agreements also provide that on the death of a joint tenant or married member the interest of the deceased that is acquired by the survivor is automatically given full membership status.

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Under current Arizona LLC law (Arizona Revised Statutes Section 29-632.A.3) all Arizona LLCs must state in their Articles of Organization “the address of the limited liability company’s known place of business in this state.”  This means all Arizona LLCs must have a place of business in Arizona that is not merely a mailing address.

Beginning September 1, 2019, for Arizona LLCs formed after August 31, 2019, and beginning September 1, 2020, for all Arizona LLCs, Arizona LLC’s Articles of Organization must state the LLC’s principal address, which is the LLC’s mailing address inside or outside of Arizona.  ALLCA Sections 29-3201.B and 29-3102.20. The new ALLCA eliminates the requirement that Arizona LLCs must have a place of business in Arizona.

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