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Seven Critical Mistakes Real Estate LLCs Make (and How to Avoid Them) — Mistake #3: Ignoring Member Rights and Duties

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California law is more protective of LLC members than other jurisdictions.

If LLC governance in other jurisdictions (like Delaware) seems like a dictatorship, then in California LLCs function more like a democracy (at least by default).

Managers who ignore membership rights do so at their own peril.

MISTAKE #3: Ignoring Member Rights and Duties

Under California law, some LLC member rights can’t be eliminated in the Operating Agreement.  Those rights include access to books and records, the ability to seek judicial dissolution, and the right to maintain a class action or derivative action.

Other member rights (such as the right to distributions) can be customized in the Operating Agreement.  Understanding member rights can prevent litigation, and increase the odds of success in unavoidable litigation.

Access to Information / Books & Records

Members have broad inspection rights as long as their request is reasonably related to their membership interest.  They are entitled to:

  • the Operating Agreement, Articles, and amendments
  • names and addresses of all members and holders of transferable interests
  • information regarding contributions and share of profit/loss for all members
  • name and address of manager(s)
  • tax information and financial statements for past six years
  • books and records regarding the LLC’s internal affairs for the past four years

Note the emphasized last bullet.  This is very different from Delaware law, which tends to allow LLCs to hold internal information closer to the vest.  Under California law, do “books and records” include all internal emails?  I’m not aware of a case on point … yet.

So, for managers: As long as a member’s request for information is “reasonably related” to the membership interest (which, in most cases, it probably is), provide them the information.  If you don’t, the member can sue to obtain the information and will be entitled to attorney fees if the court finds your refusal to provide the information was unjustified.  And if the member can’t afford to prosecute an action, the member can request the State Attorney General to do so.  This is the type of attention most LLC managers don’t want.

Derivative Actions

The member’s right to sue derivatively (on behalf of the LLC to enforce LLC rights, even when the manager refuses to do so) is an important tool when used correctly.

Members are sometimes surprised to learn that they have no direct interest in property owned by the LLC.  They own a part of the LLC, not the LLC’s property.

I’ve seen many cases where a disgruntled LLC member, in his own name, will sue the LLC and its manager over the handling of the LLC’s business, claiming damages in the form of reduced (or no) distributions.  Courts often dismiss those cases, holding that the individual member has no standing to sue for harm to the LLC, and that such a claim must be brought derivatively if at all.

To sue derivatively, the member must first show that he demanded the manager to take action on behalf of the LLC and the manager refused, or that the demand would have been futile.  Establishing “futility” is an increasingly difficult task given the trend in recent appellate decisions, so members should generally make a well-documented demand on the manager before suing derivatively.

Distributions and Contributions

Most of the member rights to distributions and contributions are customized in the Operating Agreement.  But there are some general booby traps to stay alert for.

A distribution is not allowed if it would render the LLC unable to pay its debts as they become due, or if it would render the LLC’s total assets less than total liabilities (including preferred rights).

Any manager who consents to an improper distribution is personally liable to the LLC for the portion of the distribution that was improper.  The same is true for a member who receives a wrongful distribution, if the member has knowledge of the facts that make the distribution wrongful.

On top of the simple “pay it back” remedy described above, just think of the dangerous potential “alter ego” ramifications of an improper distribution.  Member distributions that render the LLC unable to meet known obligations doesn’t exactly strengthen the “corporate veil.”

Contributions are almost entirely governed by the Operating Agreement.  Keep in mind that the obligation to make a contribution is generally not excused by death, disability, or inability.  (In the case of member death, the representatives of the member’s estate can generally make the required contribution.)  The failure to make a contribution — even in these circumstances — is commonly a ground for “dissociation.”  (More on dissociation below…)

Also, the LLC is not alone in its right to enforce a required member contribution.  A third party claimant against the LLC may exercise the same right.

Dissociation (Withdrawal)

The California Revised Uniform Limited Liability Company Act (“RULLCA”) has some default provisions regarding dissociation, and these are often modified/supplemented by the Operating Agreement.  Grounds for forcing the dissociation of a member usually involve some type of breach or default under the Operating Agreement (such as the failure to make required contributions).  A member can voluntarily elect to dissociate at any time, but may be liable for breach of the Operating Agreement for doing so.

A dissociated member does not cut the cord with the LLC completely.

Instead, a dissociated member becomes a legal “transferee” of his own interest, with no voting or managerial rights (only an interest in the future distributions).  The LLC is not required to make an immediate payout or “redemption” of the dissociated member’s interest (unless stated otherwise in the Operating Agreement) — the dissociated member must wait for distributions in due course, and any damages caused by a “wrongful dissociation” (such as missed contributions) can be offset against the distribution.

Lesson

Whether you are an LLC manager or member, stay aware of member rights and duties.  And conduct yourself accordingly.  Doing so might keep you out of the courtroom.

 

Next post in series … MISTAKE #4: Stepping into “Alter Ego” Liability

Prior posts in this series:

MISTAKE #1: Choosing the Wrong Business Partners

MISTAKE #2: Skimping on the Formation and Operating Documents

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