And how you can get around it.
The Ohio law governing limited liability companies generally allows the operating agreement to determine how the LLC is operated. The operating agreement governs the relationship between members, the behavior of managers, and how the members get paid. There are a few exceptions to this broad law that might throw a wrench in the works for those of us forming a multi-member LLC.
The operating agreement can’t limit the members’ duty of loyalty.
A duty of loyalty, in general, is the duty of a member or a partner in a business entity to put the interests of the entity ahead of his/her own. The duty of loyalty of a member or a manager to the LLC under Ohio LLC law includes the following:
- Accounting to the LLC of any benefit derived from the LLC’s business, including the appropriation of an LLC business opportunity.
- Refrain from dealing with the LLC’s business on behalf of anyone with an interest adverse to the LLC.
- Refrain from competing with the LLC.
Your operating agreement cannot get rid of these duties. However, the law does allow you to identify specific activities that do not violate the duty of loyalty.
Most people who start LLCs to hold investment property often contemplate doing real estate business in several different LLCs with several different people at the same time. In these situations, it’s extremely important for your operating agreement to lay out what the LLC doesn’t consider to be the appropriation of a business opportunity or competition with the LLC. If not, buying property with someone else or in one’s own personal name might be considered competing with the LLC or appropriating business opportunities. To this end, the operating agreement should state specifically that (a) holding property in a different LLC or (b) buying property outside the LLC does not constitute competition or appropriation of a business opportunity.
The law states that an operating agreement cannot eliminate the duty of loyalty, which suggests that heavy modification is in order. Perhaps one can eliminate a component of the duty of loyalty, like the covenant not to compete, but preserve other factors of the duty of loyalty. We do not have case law addressing this new amended law.
The law allows one more workaround to this restriction. If a member has already acted in a way that might have violated the duty of loyalty, the company can ratify that action, or if a member seeks approval, the company can authorize the action according to the terms of the operating agreement.
The operating agreement can’t limit the members’ duty of care to each other or the LLC.
In a business entity, the duty of care is a member’s duty to exercise good judgment and prudence in the operation of a business. They have to act in the best interest of the company. This is important in a multi-member LLC, where at least one member is not a manager.
Generally, a managing member gets the benefit of the doubt in decisionmaking, but when a manager self-deals, such as by paying himself a salary, the principles of the duty of care get called into question as to whether the salary was a fair one. The non-managing member might have a cause of action against the manager for improperly taking money out of the company.
Ohio law gives us an escape hatch from this inability to get rid of the duty. An operating agreement may prescribe the standards by which the duty is to be measured. Currently
The operating agreement can’t eliminate the obligation of good faith and fair dealing under 1705.281(D). 081(B)(5).
Generally speaking, the obligation of good faith and fair dealing is fairly straightforward – a member or manager can’t intentionally deprive the LLC or other members of rights or benefits that it otherwise would have received. The way around this has always been by contract. By expressly permitting some activities under the operating agreement, we can exclude those actions from being scrutinized under this obligation. For example, a landlord may want to terminate a lease in order to realize the appreciated rental value of the property. If the contract specifically allows it, then the landlord need not worry that his decision to terminate would not be in “good faith.”
The operating agreement can’t “unreasonably” limit the members’ right of access to the company’s books under Section 1705.22. 081(B)(2).
Each member has the right to obtain the following information upon “reasonable demand” from the LLC, as long as it is reasonably related to the member’s membership interest in the company:
- Information regarding the status of the business or financial condition of the LLC;
- Copies of federal, state and local income tax returns;
- A current list of the names and mailing addresses of each member;
- A current list of the names and mailing addresses of each manager, if applicable;
- A copy of the articles of organization and any amendments;
- A copy of the operating agreement and any amendments;
- Information about member’s contributions and the dates when they became members;
- Any “other information regarding the affairs of the company that is just and reasonable.”
The company doesn’t have to disclose any information if the company reasonably believes it is “not in the best interest of the company” or “could damage the company or its business.” Information that is subject to a confidentiality agreement is also exempt.
This section may be problematic if you are a managing an LLC with lots of members who you don’t necessarily want digging through your books. The best way to prevent liability under this section of the law is to get ahead of it – send a quarterly or annual update to all your members with copies of financial statements. Keep your members informed so they don’t have to chase you down for updates.
The operating agreement can’t limit professional liability for licensed professionals operating under the banner of an LLC.081(B)(1).
This section basically requires three things:
- All managers and members of a professional services LLC, like a law firm or doctor’s office, must be licensed.
- The operating agreement and the law can’t restrict the authority of any licensing board from regulating professional conduct of licensed individuals.
- The LLC is prohibited from controlling or dictating the professional judgment normally exercised by individual licensed professionals.
If you ever find yourself drafting or negotiating over an Ohio operating agreement, be sure to keep these restrictions in mind and have the appropriate measures taken by your legal professional.