Introduction

Tennessee business lawyers are increasingly looking to Delaware when organizing their clients’ limited liability companies (LLCs). Delaware has long afforded business lawyers the advantages of an extensive body of corporate and business organization jurisprudence. In addition, the Delaware LLC Act¹ arguably enjoys several advantages over the Tennessee LLC Act² as currently drafted, including:

• greater simplicity and flexibility in LLC formation and management;

• more user-friendly statutory default rules that reflect changes to the federal income tax laws enacted since the original adoption of LLC legislation;

• greater latitude and certainty in limiting the fiduciary duties and expanding the indemnification rights of the management teams of LLCs; and

• availability of single-member LLCs.

Statutory simplicity in LLC organization and governance

The Tennessee and Delaware LLC Acts embody two different philosophies. The Tennessee LLC Act is a lengthy and sometimes laboriously detailed “cradle-to-the-grave” statutory blueprint for the creation, operation and dissolution of LLCs. The Delaware LLC Act provides shorter and simpler guidelines for the organization and functioning of LLCs, with business lawyers and their clients left to work out the details of LLC management and operation on a case-by-case basis. Although the wealth of detail in the Tennessee LLC Act might be advantageous in certain circumstances, currently it is often a hindrance because, as discussed below, many of the Tennessee LLC Act’s default rules were adopted to address tax issues that no longer exist. Therefore, a lawyer who wants to avoid these outdated rules must go through the tedious exercise of identifying which default rules she wants to avoid and then drafting around them.

A good example of the different philosophies of the Tennessee and Delaware LLC Acts is found in the contrast between their approaches to entity formation. Under the Tennessee LLC Act, an LLC comes into existence upon the filing of “articles of organization.”³ Tenn. Code Ann. §48-205-101 includes 16 numbered paragraphs describing what may and must be included in articles of organization. In Delaware, the analogue of “articles of organization” is the “certificate of formation.”⁴ Del. L. §18-201 provides that the certificate of formation need include only two things: (i) the LLC’s name, and (ii) its registered agent and office. It may include “any other matters the members decide to include.”⁵

The other constitutional document of an LLC is the agreement among its members. In Tennessee this is styled the “operating agreement” and must be in writing to be enforceable.⁶ Tenn. Code Ann. §48-206-101 sets forth additional operating agreement requirements in seven numbered paragraphs.

In contrast, Delaware permits the members’ “LLC agreement” to be either written or oral.⁷ The LLC agreement is effective whenever the members stipulate.⁸ There are no specific statutory requirements as to the content of the agreement. It may contain whatever the members deem relevant to the “affairs of [the LLC] and the conduct of its business.”⁹

Another example of the contrasting philosophies of the two LLC Acts is found in their provisions dealing with LLC governance. The Tennessee LLC Act includes a detailed and often complex LLC governance regime covering four different chapters and 33 different numbered sections.¹⁰ These sections describe bifurcated management and governance rules that turn on whether the LLC is “board-managed” or “member-managed.” Management authority in a board-managed LLC in Tennessee is generally vested in a central board of governors analogous to the traditional corporate board of directors. The governance of a member-managed LLC is akin to that of a general partnership under the Uniform Partnership Act. Its members enjoy management and agency rights similar to those of general partners in a general partnership.” Absent a contrary agreement among the members in a written operating agreement, the Tennessee LLC Acts default rule provides that ultimate management authority is exercised by a per capita majority of the members.¹²

This dichotomy of board- and member-managed LLCs spawns additional complexity in the Tennessee LLC Act, because certain other provisions of the Act provide for different results depending on whether the LLC is board- or member-managed.¹³ Further, with a board-managed LLC, certain decisions still require member approval.¹⁴

The Delaware LLC Act adopts a more streamlined approach to LLC governance, resulting in significantly greater statutory simplicity. The Delaware LLC Act deals with governance in a single subchapter containing only seven different sections. The Delaware default rule is that holders of 50 percent of the profits interest in an LLC exercise management authority.¹⁵ However, members may designate managers who may in turn delegate duties to agents, officers or employees.¹⁶ Despite the statutory economy, the Delaware LLC Act permits business lawyers to create LLCs that look and operate like traditional general partnerships or corporations with boards and officers. Creative lawyers and clients also have the freedom to create hybrid LLCs that include elements of both.



Fiduciary duty, standard of conduct and indemnification rights of members and managers

The Tennessee LLC Act’s bifurcated rules for member- and board-managed LLCs carry forward with respect to the standard of conduct imposed on the LLC’s management team. The standard of conduct for governors thus follows closely the analogous standard for directors in a corporation.¹⁷ A governor of a board-managed LLC must discharge his duties:

… in good faith, in a manner the governor reasonably believes to be in the best interests of the LLC and with the care an ordinarily prudent person in a like position would exercise under similar circumstances.¹⁸

Compare the analogous provision for corporate directors at Tenn. Code Ann. §48-18-301 (a):

A director shall discharge all duties as a director, including duties as a member of a committee:

(1) In good faith;

(2) With the care an ordinarily prudent person in a like position would exercise under similar circumstances; and

(3) In a manner the director reasonably believes to be in the best interests of the corporation.

Similarly, the fiduciary duty of a member in a member-managed LLC mirrors the fiduciary duty owed by general partners under the Uniform Partnership Act.¹⁹ Each member in a member-managed LLC must:

… account to the LLC for any benefit, and hold as trustee for it any profits derived by the member without the consent of the other members from any transaction connected with the formation, conduct, or liquidation of the LLC or from any use by the member of its property including, but not limited to, confidential or proprietary information of the LLC or other matters entrusted to the member as a result of such person’s status as a member.²⁰

Each general partner in a partnership must:

… account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property.²¹

The Tennessee LLC Act imposes an additional standard of conduct on members that is virtually identical to the standard for governors in a board-managed LLC.²² Tenn. Code Ann. §48-240-102(b) requires each member of a member-managed LLC to:

… discharge such member’s duties as a member, including all duties as a member of a committee:

(1) In good faith;

(2) With the care an ordinarily prudent person in a like position would exercise under similar circumstances; and

(3) In a manner the member reasonably believes to be in the best interest of the LLC.²³

Although the Tennessee LLC Act includes a detailed formulation of the rules relating to member/manager/governor conduct, the members may deviate from these statutory rules within certain limits. Specifically, members may adopt a different standard of conduct provided that it is not “manifestly unreasonable.”²⁴ Note in Tenn. Code Ann. §48-240-102, Subsections (a) and (b), relating to members of a member-managed LLC, that the fiduciary duty owed by members differs from the standard of conduct imposed on them. Tenn. Code Ann. §48-240-102(g) permits reformulation of a member’s standard of conduct but says nothing about permissible deviations from the member’s statutory fiduciary duty. Presumably, this statutory fiduciary duty of members therefore cannot be altered or waived. However, note further that Tenn. Code Ann. §48-240-103, dealing with member conflict of interest transactions, also allows members to define their standard of conduct in conflict transactions, provided again that such definition is not manifestly unreasonable. Whether Tenn. Code Ann. §48-240-103’s separate mandate regarding member conflict transactions chips away at §48-240-102(a)’s statutory fiduciary duty for members is not clear.

The Tennessee LLC Act’s incorporation of the Tennessee Business Corporation Act’s and Uniform Partnership Act’s concepts regarding standard of conduct and fiduciary duty affords practitioners certain advantages. First, the statutory formulations of these concepts in the Tennessee LLC Act should be known quantities to lawyers, clients and judges familiar with these analogous provisions in Tennessee’s other business organization acts. Any cases interpreting the analogous sections of these other acts will therefore presumably be of benefit in analyzing the comparable provisions of the Tennessee LLC Act. Of course, if the members of an LLC deviate from the statutory formulation of the standard of conduct and fiduciary duty rules in their operating agreement, the comparable corporate or partnership statutes and any related case law will be of more limited utility, depending on the extent of the deviation.

Unfortunately, one of the challenges the Tennessee LLC Act poses for business lawyers is advising LLC clients how far they may go in deviating from the statutory standard of conduct and fiduciary duty. When is a reformulation of these statutory rules “manifestly unreasonable”? There are no Tennessee cases interpreting this language, so the lawyer is thrown on her own devices in counseling a client as to what this language does and does not permit. Conservative lawyers will assume (and advise their clients) that each step away from the strict language of the statutory rules is one step closer to manifest unreasonableness. Therefore, any material liberalization of the statutory standards in the parties’ agreement may pose a serious risk that such agreement will be unenforceable if challenged.

In contrast, Delaware imposes no restrictions on the parties’ ability to articulate a standard of conduct for members and managers by private agreement. In fact, the Delaware LLC Act includes no statutory definition of these standard or duties, nor does it even state whether such duties or standards exist. Del. L. 18-1101(c)(2) simply provides that the common law duties (whatever they may be) of a member or manager may be expanded or restricted, without limitation, by the members in the LLC agreement. Delaware lawmakers underscore the primacy of the members’ agreement by articulating an express legislative policy in favor of freedom of contract at Del. L. 10-1111(a). That provision goes further to provide that, in interpreting LLC agreements, the rule of strict construction of rules in derogation of common law will not apply. The drafters of the Delaware LLC Act therefore intended LLC owners to have maximum flexibility to define by private agreement their obligations and responsibilities to each other without regard to common law principles that might conflict with those private goals.

Delaware continues this emphasis on enforcing the parties’ private agreement in the indemnification provisions of the Delaware LLC Act. Del. L. 18-100 provides that the only limits on the LLC’s power to indemnify a manager, member or other person are those (if any) set forth in the LLC agreement. Again, this provision must be read in conjunction with Delaware’s overarching legislative policy of giving precedence to the parties’ freedom to contract.

Although the Tennessee LLC Act permits LLCs to go beyond the statutory mandatory indemnification of members, managers and governors, Tenn. Code Ann. §48-243-101(i)(1) imposes outer limits for permissive indemnification. These limits are borrowed from the Tennessee Business Corporation Act and do not permit indemnification:

… if a judgment or other final adjudication adverse to the responsible person or officer establishes such person’s liability:

(A) For any breach of the duty of loyalty to the LLC or its members;

(B) For acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; or

(C) Under §48-237-101.

More user-friendly default rules

Prior to Jan. 1, 1997, the IRS used a four-part test to determine whether unincorporated entities (like LLCs or partnerships) would be taxed as partnerships or as corporations. To receive partnership tax treatment, an LLC had to lack at least two of four corporate attributes. These four corporate characteristics included (i) limited liability, (ii) continuity of life, (iii) centralized management, and (iv) free transferability of interests. The Tennessee LLC Act was drafted to ensure that properly formed Tennessee LLCs would always lack at least two of these four characteristics, so as to ensure that they would receive the desired partnership tax treatment.

However, effective Jan. 1, 1997, the IRS discarded the traditional four-factor analysis in favor of the so-called “check-the-box” entity classification rules. Under the check-the-box regulations, a domestic unincorporated entity with at least two owners — like a Tennessee LLC — will be taxed as a partnership unless it affirmatively elects to be taxed as a corporation.

The check-the-box rules have freed business lawyers to focus their efforts on creating LLCs that accomplish their clients’ business objectives instead of having to worry about complying with arbitrary and esoteric tax rules. As a result, business lawyers can create what some commentators have called “super pass-through LLCs” that possess many traditional corporate characteristics yet receive partnership pass-through tax treatment.²⁵

Unfortunately, the default rules in the Tennessee LLC Act have not yet been updated to reflect these sea changes in the federal tax laws. As a result, when organizing a Tennessee LLC, lawyers must identify which of these outdated rules they want to avoid and draft around them. In contrast, the Delaware LLC Act has been “cleaned up” to eliminate tax-related statutory anachronisms. Therefore, the Delaware LLC Act’s default rules are more likely to reflect LLC owners’ desires since the adoption of the check-the-box regulations.

For example, the dissolution rules under the Tennessee LLC Act closely resemble the analogous rules under the Uniform Partnership Act as adopted in Tennessee.²⁶ A number of events (including, among other things, the death, retirement, withdrawal, bankruptcy or insanity of a member) trigger LLC dissolution under the Tennessee LLC Act.²⁷ If such a dissolution event occurs, to avoid liquidation and winding up of the LLC, all (or pursuant to the articles, a majority in interest) of the remaining members must elect to continue its business and existence.²⁸ It is possible to eliminate some or all of these dissolution events, but that requires an affirmative election to do so in the LLC’s articles of organization or operating agreement.²⁹

The dissolution provisions under the Delaware LLC Act are exactly the opposite of those in the Tennessee LLC Act. §18-801 of the Delaware LLC Act provides that these traditional dissolution events (i.e., a member’s death or withdrawal) do not cause a dissolution of the LLC unless the members agree in writing within 90 days after the event to dissolve the LLC. In fact, if no time for an LLC’s dissolution is specified in its LLC agreement, a Delaware LLC has perpetual existence.³⁰

The Tennessee LLC Act’s provisions relating to the assignability of membership interests were also drafted to address tax concerns that no longer exist under the check-the-box regulations. The general rule under the Tennessee LLC Act is that unanimous approval is required for transfers of governance rights in an LLC.³¹ By electing to do so in the articles of organization or operating agreement, members may reduce that required approval percentage, but not below a majority in interest.³² Members may further specify in the articles or operating agreement that the right to approve a transfer of governance rights is limited to governor members (in board-managed LLCs) or eliminated with respect to transfers of governance rights associated with specified membership interests constituting less than 80 percent of the aggregate governance rights.³³ These rules are intended to address issues relating to free transferability of interests under the old entity classification rules and certain IRS revenue rulings applying those rules in various factual circumstances. These rules could be simplified and liberalized considerably to reflect the new check-the-box regime.

For example, under the Delaware Act a member’s membership interest is freely transferable in whole or part.³⁴ A transferee cannot participate in LLC management unless approved by all non-transferring members. However, the members are free to deviate from the regime by specifying in the LLC agreement any other procedure for approval of the transferee’s right to participate in LLC management.³⁵

A number of other provisions in the 1995 amendments to the Tennessee LLC Act were in response to IRS Review Procedure 95-10. Rev. Proc. 95-10 specified the conditions under which the IRS would consider a ruling that an LLC be classified as a partnership for federal tax purposes. For example, consider the definition of “majority in interest” at Tenn. Code Ann. §48-201-101(23):

“Majority in interest” means any group of members who, as of the date of a dissolution event described in §48-245-101 (a) or other date of a determination, collectively own membership interests with financial rights that entitle the group of members to receive collectively not less than a majority of all present and future distributions from profits, and not less than a majority of all distributions of capital of the LLC. Unless otherwise provided in the articles or operating agreement, the determination of the estimated future distributions shall be made by the chief manager.

This definition is particularly troublesome since the issue of what comprises a majority in interest of the members (an important threshold determination for purposes of a number of different approvals required under the Tennessee LLC Act) devolves into a question of fact to be determined empirically by the chief manager.



Availability of single-member LLCs

One of the most significant advantages of the Delaware LLC Act is that it permits single-member LLCs. See Del. L. §18-101(6). In contrast, §48-205-101(6) of the Tennessee LLC Act requires Tennessee LLCs to have at least two members.³⁶

Tennessee’s two-member requirement creates a number of difficulties for business lawyers. Most obviously, how does the lawyer organize a business with a single owner as a Tennessee LLC? In the past, the lawyer in this situation has been forced either to use a family member or spouse as a nominal second member, organize a single shareholder S corporation to act as a second member, or simply abandon the LLC format and use instead an S corporation if the owner desired limited liability.

With the two-member requirement, another concern relates to LLCs with two members who are both individuals. If one of the members dies, becomes disabled or otherwise withdraws from the LLC, there is no clear procedure under the Tennessee LLC Act for allowing the dissolved single-member LLC to recruit a new second member so as to avoid winding-up and liquidation.

Finally, the Tennessee LLC Act’s two-member requirement precludes using Tennessee LLCs in a holding company structure where a parent company acts as the sole member of subsidiary Tennessee LLCs. Such structures may be particularly useful in larger real estate enterprises.



Conclusion

Many of the benefits of Delaware LLCs can be obtained under the Tennessee LLC Act provided that the lawyer understands the problem areas in the current Tennessee LLC Act and is willing to expend her time (and client’s money) in drafting around them.

However, in certain cases, Tennessee lawyers should strongly consider using Delaware LLCs, including situations where:

• a client wants to use single-member LLCs as subsidiaries in a holding company structure (or otherwise needs a single-member LLC);

• a client needs greater flexibility regarding limiting members’ duties to each other or expanding their indemnification rights and greater certainty regarding enforceability of such provisions is desired; and

• a client or the lawyer wants to deal with a simpler LLC Act and simpler, more traditional management structures.

Notes

1. The Delaware Limited Liability Company Act at Del. L. §18-101 et. seq.

2. The Tennessee Limited Liability Company Act at Tenn. Code Ann. §48-201-101 et. seq.

3. Tenn. Code Ann. §48-203-102(a).

4. Del. L. §18-201.

5. Id.

6. Tenn. Code Ann. §48-206-101(a).

7. Del. L. §18-101(7).

8. Del. L. §18-201(d).

9. Del. L. §18-101(7).

10. Chapters 238 through 241, and Tenn. Code Ann. §§48-238-101 through 48-241-111, of the Tennessee LLC Act.

11. Compare Tenn. Code Ann. §61-1-108 (agency of partners) and Tenn. Code Ann. §48-238-103 (agency of members in a member-managed LLC).

12. Tenn. Code Ann. §48-224-101.

13. For example, Tenn. Code Ann. §48-245-101(c)(2) permits a board-managed LLC to specify that dissolution events apply only to member governors.

14. For example, approval of certain mergers (Tenn. Code Ann. §48-244-102), or sale of all or substantially all the LLCs assets (Tenn. Code Ann. §48-244-201).

15. Del. L. §18-402.

16. Del. L. §18-407.

17. Tenn. Code Ann. §48-239-115(a).

18. Id.

19. Tenn. Code Ann. §61-1-120(a) (fiduciary duty of partners).

20. Tenn. Code Ann. §48-240-102(a).

21. Tenn. Code Ann. §61-1-120(a).

22. Tenn. Code Ann. §48-240-102(b).

23. Id.

24. Tenn. Code Ann. §48-240-102(g).

25. See p. 57, Journal of Limited Liability Companies, Fall, 1996.

26. Compare Tenn. Code Ann. §61-1-130 and Tenn. Code Ann. §48-245-101(a).

27. Tenn. Code Ann. §48-245-101(a)(5).

28. Tenn. Code Ann. §48-245-101(b).

29. Tenn. Code Ann. §48-245-101(c).

30. Del. L. §18-801(a)(1).

31. Tenn. Code Ann. §48-218-102(b)(2)(A).

32. Id.

33. Tenn. Code Ann. §48-218-102(b)(2)(C).

34. Del L. §18-702.

35. Id.

36. Fortunately, the Tennessee LLC Act may soon permit single-member LLCs, as several bills are currently pending in the state legislature that would eliminate the two-member requirement.

Tennessee Bar Journal
May 1999 - Vol. 35, No. 5

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