Major Changes to Business Entity Laws in Pennsylvania Beginning February 21, 2017
Pennsylvania has enacted a comprehensive set of laws (Act 170) modernizing the treatment of unincorporated associations, including limited liability companies, limited partnerships, limited liability partnerships, limited liability limited partnerships and general partnerships, as well as providing certain amendments to the laws governing Pennsylvania business and nonprofit organizations. The principal improvements introduced by Act 170 include enabling entity documents to vary the duties of an entity’s managers, members and partners, clarifying the rights of members to company information, clarifying the status of transferees of members or partners and limiting the remedies of creditors against limited partners and members. Act 170 is applicable to all unincorporated associations formed on or after February 21, 2017, and to all existing entities starting April 1, 2017 (unless existing entities elect to be governed by the Act before April 1). Many of the new provisions of Act 170 are more “management friendly” and therefore potentially appropriate to be reflected in amendments to existing LLC operating agreements and LP agreements, subject to careful planning and drafting.
House Bill 1398 was signed into law on November 21, 2016, as Act 170. Act 170 becomes effective in two stages: February 21, 2017, for unincorporated associations governed by the Act formed on or after February 21, 2017, and April 1, 2017, for unincorporated associations formed before February 21, 2017, unless existing entities elect to be governed by the Act before April 1.
Act 170 primarily amends the Pennsylvania laws governing general partnerships, limited partnerships, limited liability companies and other unincorporated associations, and brings the laws governing unincorporated associations in closer alignment with uniform acts promulgated by the Uniform Law Commission. The Act also enables the creation of nonprofit limited partnerships and nonprofit limited liability companies and expands the liability shield for partners in limited liability partnerships and limited liability limited partnerships.
Among the principal improvements introduced by Act 170 are provisions defining the duties of members and partners, enabling constituent entity documents to vary the duties of an entity’s managers, members and partners, establishing the rights of members to information, clarifying the status of transferees of members or partners, limiting the remedies of creditors of limited partners and members to “charging orders” and adopting provisions addressing derivative actions. A few of the salient provisions of the 2017 amendments are summarized below. There are of course many other changes to the old laws governing unincorporated associations which are beyond the scope of this summary.
1. Duties of Members and Managers of Limited Liability Companies. The Act 170 amendments establish rules for the duties of members of LLCs and for managers of manager-managed LLCs. The new law authorizes the operating agreement to establish the status of an LLC as manager-managed. This is a change from the prior law, which required a provision in the certificate if the LLC were to be manager-managed. Consistent with the approach of the prior law, however, if the status of an LLC as manager-managed is stated in the certificate of organization, the managers will have the same statutory apparent authority as under the prior law. In a member-managed LLC, the operating agreement may be amended only with the affirmative vote or consent of all members unless the operating agreement provides that an amendment may be approved by fewer than all members.
The basic rule is that members of a member-managed LLC owe to the LLC and to the other members of the LLC the duties of loyalty and care. The Act provides guidance as to the scope of the duties. Members also have a contractual obligation of good faith and fair dealing in discharging their duties.
Members of a manager-managed LLC do not have any duties to either the LLC or to the members of the LLC solely by reason of being a member other than the duties of good faith and fair dealing. Managers of manager-managed LLCs owe to the LLC and to its members duties of care and loyalty and contractual obligations of good faith and fair dealing.
Both members and managers may be exonerated from breach of their duties of care, except for any act that constitutes recklessness, willful misconduct or a knowing violation of law.
2. Variation of Rights and Duties of Members and Managers. The LLC operating agreement may govern the rights among members and between members and the LLC, the rights and duties of members or managers and the activities and affairs of the LLC, subject to a series of limitations set forth in section 8815(b) of Title 15. Among the limitations is that the operating agreement may not eliminate the duty of loyalty of members or managers or vary the contractual obligation of good faith and fair dealing, except that, if not “manifestly unreasonable,” the operating agreement may:
- alter certain statutory aspects of the duty of loyalty;
- prescribe standards to measure performance of the contractual duty of good faith and fair dealing;
- identify categories of activities that do not violate the duty of loyalty;
- alter the duty of care; and
- alter or eliminate any other fiduciary duty.
Whether a term of the operating agreement is “manifestly unreasonable” is to be decided by a court as matter of law based upon the circumstances existing at the time the challenged term became part of the operating agreement.
3. Contents of LLC Operating Agreements. The new law sets forth a list of twenty items that an operating agreement may not vary from the statutory provision, including rights of members to approve mergers or other designated fundamental transactions, providing indemnification or exoneration in violation of certain statutory limitations, and varying the statutory-delineated causes of dissolution. But Act 170 does permit the operating agreement to vary a number of other statutory provisions which would otherwise serve as the “default” provisions governing the LLC, such as the method by which a specific act or transaction that would otherwise violate the duty of loyalty may be authorized or ratified by one or more disinterested and independent persons after full disclosure of all material facts, altering various limitations on distributions, and imposing reasonable restrictions on the availability and use of information regarding the LLC’s activities, affairs and financial condition.
4. Distributions. Prior law did not have a test for measuring the legality of distributions and relied instead on the law of fraudulent transfers. Act 170, in contrast, contains distribution tests based on the Model Business Corporation Act (the tests apply to both interim distributions and liquidating distributions). The law essentially provides two tests for measuring a distribution, and a distribution violates the law if after the distribution, the LLC fails either of the tests. One test of the legality of a distribution is whether, after giving effect thereto, the LLC would be insolvent in the equity sense of not being able to pay its debts as they become due in the ordinary course of business. The other test is the so-called balance sheet test, whereby following the distribution, the LLC’s total assets would be less than the sum of its total liabilities, plus the amount that would be needed, if a company were to be dissolved at the time of the distribution, to satisfy preferential rights upon dissolution. The balance sheet test permits unrealized appreciation and depreciation of assets to be considered when measuring the legality of a distribution.
5. Governance Interests and Transferable Interests. With respect to limited liability companies, the Act clarifies that a member may not transfer to another person who is not a member of the LLC, any rights in the LLC other than a “transferable interest.” The partnership laws include corresponding provisions. The term “transferable interest” refers to an economic interest in the LLC to receive distributions. In contrast, a “governance interest” also encompasses the rights to receive or demand access to information, to vote for the election of governors and the right to receive notice of or vote on issues involving the affairs of the entity.
While the rights of a “transferee” are dependent on the language of the operating agreement, Act 170 clearly states that, unless the members of the LLC otherwise agree, the only interest that a person who is not a member of an LLC may receive from a member is a transferable interest, which does not include the rights of the holder of a governance interest. Essentially, a transferee can only obtain an economic interest in the LLC.
Consistent with the limited rights of a transferee, a creditor executing upon the governance interest of a member of an LLC can only obtain the member’s transferable interest, which essentially is limited to the right to receive distributions. Further, Act 170 provides that the exclusive remedy for a person seeking to enforce a judgment against an LLC member’s interest is a charging order. This limitation does not apply to the interest of the sole member of an LLC, whose entire governance interest is subject to execution. Act 170 also permits a non-member, such as a creditor, to have veto rights over amendments to the operating agreement if so provided in the agreement.