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California’s Revised Uniform Limited Liability Company Act (RULCCA) sets out duties owed by managers or members of the LLC.  While managers of manager-managed LLCs and members of member-managed LLCs  both owe a duty of loyalty and care, all members and managers have a contractual obligation of good faith and fair dealing.  However, unless terms are manifestly unreasonable, the LLC’s operating agreement affords the LLC an opportunity to edit these duties and responsibilities.  This includes a modification of the duty of loyalty, duty of care, in addition to good faith and fair dealing.  This begs the question: what is the manifestly unreasonable standard?

The National Conference of Commissioners on Uniform State Laws (NCCUSL) wrote RULLCA, on which California based their RULLCA.  Thus, the NCCUSL’s description and commentary on the manifestly unreasonable standard should be understood by those looking to interpret an LLC’s operating agreement.  This is especially true, given the little to no case law (in the entire nation) dealing with the manifestly unreasonable standard.  According to NCCUSL, the manifestly unreasonable standard is fundamental to RULLCA because it protects an operating agreement.  For example, if the concept of manifestly unreasonable were loosely applied, then the court would be able to alter the members’ agreement, something which RULLCA looks to prohibit.  Furthermore, unlike in the commercial context, here manifestly unreasonable is to be applied to the individual business organization in its’ own context.  Finally, it is important to note that when the manifestly unreasonable standard is used, the court’s determination is based off the date the term was adopted in the LLC’s operating agreement.

According to the NCCUSL, the party claiming that a term is manifestly unreasonable has the burden of proof.  Furthermore, the court can only rule the term is manifestly unreasonable under certain circumstances.  First, the court must first understand the purposes and activities of the LLC.  Then, the court must apply their understanding to the term in question.  The court can only find the term to be manifestly unreasonable if “it is readily apparent that (a) the objective term is unreasonable or (b) the term is an unreasonable means to achieve the provision’s objective.”

The court will obtain their understanding of the purpose/activities of the LLC by weighing factors like the sophistication of the parties, both parties’ interpretation of the manifestly unreasonable standard in addition to the overall bargain.  If the LLC’s operating agreement results in unjust operations, regarding unfair dealing or “a situation outside of the reasonable expectations of the parties in in regard to fiduciary duties,” the court will likely revert the operating agreement to the default fiduciary duties provided in California’s RULLCA.

In Kosanovich v. 80 Worcester Street Associates, LLC, the Massachusetts Appellate Division ruled that a single-member LLC’s veil should be pierced because of poor record keeping.  This case is particularly interesting because it seems inconsistent with previous rules and cases.

Here, the plaintiff bought a condominium from the single-member LLC.  In the agreement between the parties, the LLC was to repair any defects of the condominium within one year of the purchase date.  The LLC then failed to repair some of the defects, and the plaintiff sued for breach of contract and breach of an implied warranty.  The judge not only sided with the plaintiff, but also pierced the veil, holding the member of the LLC personally liable.  On appeal, the court started with the veil-piercing rule which states that the veil should only be pierced to defeat fraud or injustice.  Then, the court listed 12 factors that determine if piercing the LLC’s veil was justified.  These factors include:

• (1) common ownership,
• (2) pervasive control,
• (3) confused intermingling of business assets,
• (4) thin capitalization,
• (5) nonobservance of corporate formalities,
• (6) absence of corporate or LLC records,
• (7) no payment of dividends or distributions,
• (8) insolvency at the time of the litigated transaction,
• (9) siphoning away of corporation’s funds by dominant shareholder or member,
• (10) nonfunctioning of managers, or officers and directors,
• (11) use of the corporation or LLC for transactions of the dominant shareholders or members, and
• (12) use of the corporation or LLC in promoting fraud.

The court noted that when analyzing these factors, the veil-piercing was justified.  In particular, the court looked to the pervasive control and poor record keeping to support the trial court’s decision.  The court suggested that the poor record keeping applied to the other factors, since the LLC member could not provide documents convincing the court otherwise.

This decision seems odd because this case was not regarding fraud or injustice (the reason the court stated that veil-piercing should exist).  Also, the burden of proof in this case seemed to have shifted to the LLC member by suggesting that it was this duty to keep good records to show that the 12 factors weighed in his favor.  Still, one of the ways to prevent a veil piercing is to formally treat the LLC as a business.  This means keeping good books and records, and following the formalities of ordinary businesses.

An LLC’s Operating Agreement can modify basic functions of LLC members or managers.  This includes indemnification clauses which may require the LLC to indemnify members or managers against lawsuits.  In Branin v. Stein Roe Inv. Counsel, a disagreement arose when the LLC amended the indemnification provision.  Unlike the old provision, the new indemnification rules prevented an employee from being indemnified in certain circumstances.  That employee, Francis Branin, filed suit arguing that his original indemnification rights should not be replaced by the new amendment.  The Delaware Court of Chancery agreed.

In this case, Branin was being sued by his former employer for soliciting former clients.  After 10 years of litigation, the charges were eventually dismissed.  In this interim period, the LLC which Branin worked for changed their indemnification clause in the operating agreement.  This second version of the indemnification clause was much more stringent, and would not cover Branin’s $3million legal fees.  The question then became the following: Does the second version of the indemnification preclude the indemnification allowed under the original clause?

The court decided that the first agreement included an enforceable indemnification clause.  Also, after looking to previous cases involving indemnification clauses, the Delaware Court of Chancery ruled that the right to be indemnified vests when the initial lawsuit was filed.  Due to Branin’s right being vested under the first version of the indemnification provision, the second version had no effect.  This shows that LLCs cannot rid their responsibility to indemnify once the provision has been triggered.  Therefore, LLCs should design these types of clauses carefully and not blindly accept a boilerplate indemnification clause which may expose the LLC to more liability than desired.