Forming a Limited Liability Corporation: Where? by William H

Spring 2004 Corporate Regulatory Report

Forming a limited liability corporation: where? By William H. Behr

In the last decade, the limited liability company (“LLC”) has rapidly become a common feature of the corporate practitioner’s craft. The reasons for its popularity are clear. The LLC form affords investors the limitations on liability offered by a corporation combined with the tax benefits of a partnership. In addition, this flexible form can easily be molded into an organization that accurately reflects the most complex relationships among entrepreneurs.

Despite this popularity, a surprising number of corporate attorneys do not have a ready answer for what may be the first question they need to address when they or their clients decide to create a new LLC. Where should the LLC be created? For New York practitioners this question can usually be restated as follows: Should the proposed LLC be formed in New York or Delaware?

The answer depends on your client. Generally, the New York Limited Liability Company Law (the “NY LLC Law”) offers more protections to minority interest holders than the Delaware Limited Liability Company Act (the “Delaware LLC Act”). On the other hand, the Delaware LLC Act offers management and the majority interest holders more flexibility in terms of structuring the organization and governance of the LLC. Therefore, if your clients will be the majority holders in a new venture, the Delaware LLC Act is probably better suited to their needs. If your clients will hold less than half of the equity in, and will not dominate the management of the new enterprise, then he or she will most likely be better served by forming the LLC in New York.

In addition to the minority - majority “bias” of the two jurisdictions, there may be other factors your clients are curious about. In particular, a client may be sensitive to the cost of creating an LLC and the relative burden of complying with the “corporate” formalities in the two states. The cost of forming and maintaining an LLC in good standing in each state varies slightly. The Delaware Secretary of State charges from $120 to $160 to file a certificate of formation. In Delaware the counties will also impose a filing fee (typically $20) and a non-state resident will need to provide for an agent of service of process at a cost of approximately $240 per annum. In New York, the fee to file articles of organization is in excess of $200. However, publication requirements are likely to add an additional $1,000 to $3,000 expense.1

Some differences also exist with respect to the amount of “red tape” imposed by the two statutes. The NY LLC Law requires more attention be paid to the formalities of corporate bureaucracy2 than the Delaware LLC Act, unless counsel drafts an operating agreement that specifically exempts the LLC from such requirements. These differences, however, are far less important than the relative bias of the Delaware LLC Act in favor of the management and the NY LLC Law’s minority interest protections. A careful draftsperson can limit the number of meetings, procedures and notices imposed on the operation of a New York LLC through the LLC’s operating agreement. However, as we discuss below, he or she cannot avoid the imposition by the New York statute of dissenters’ rights or the rules regarding interested party transactions. Likewise, spending a few hundred dollars more or less to form an LLC in the appropriate jurisdiction is a small price to pay for the continued flexibility of operation or protection from overreaching that the correct statute will provide.

Under the Delaware LLC Act, members of an LLC have virtually unfettered discretion in drafting the agreement that governs the relationship between the members of a limited liability company, their rights and obligations with respect to each other and the LLC, and the governance of the LLC. (In Delaware, this agreement is referred to as a limited liability company agreement. In New York, it is called an operating agreement.) Under the Delaware LLC Act, statutory default provisions, if they exist at all, control in the absence of language in an LLC agreement. New York, by comparison, imposes a variety of statutory provisions that cannot be waived—the effect of which is that the NY LLC Law provides the

less sophisticated or the less powerful joint venturers with more protection from overreaching or coercive managers and business partners. For example, the NY LLC Law imposes minimum standards with respect to (i) the fiduciary duty of the management of an LLC, (ii) the approval of transactions with interested parties, (iii) limits on indemnification an LLC may provide its managers or members and (iv) dissenter’s rights. The Delaware LLC Act has no such limitations.

NY LLC Law Delaware LLC Act

Standard of Care: No corresponding provision.

Section 409(a) “A manager shall perform his or her duties as a manager . . . in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances.”

Interested Party Transactions: No corresponding provision.

Section 411 Imposes limits on interested party transactions similar to that imposed by corporate statutes. This section requires a vote of disinterested managers to approve contracts or transactions between an LLC and a manager or an entity in which the manager has a significant interest.

Limits on Indemnification: No corresponding provision.

Section 420 “ . . . no indemnification may be made to or on behalf of any member, manager or other person if a judgment . . . establishes (a) that his or her acts were committed in bad faith or were the result of active and deliberate dishonesty . . . or (b) that he or she personally gained in fact a financial profit or other advantage to which he or she was not legally entitled.”

Dissenters Rights: No corresponding provision.

Section 1005 In the event of a merger or consolidation, this section provides members with dissenters rights (the right of former members that did not vote in favor of a merger or consolidation to elect a cash payment) substantially similar to those often provided under corporation laws.

Choosing the appropriate jurisdiction for formation of an LLC can have some profound consequences on the operation of a business venture. From the corporate practitioner’s perspective, we think the choice is relatively clear: If your client will be a minority interest holder, choose New York. If your client will hold the majority interest and is likely to dominate the management of the entity, choose Delaware. And, once you have picked a jurisdiction, you can begin the real work of crafting an agreement that will meet your clients needs.

1 In addition, Delaware imposes an annual entity tax of $200 and New York levies a fee of $100 per member per year. 2 The NY LLC Law imposes numerous detailed default rules regarding, among other things, the need for annual meetings, meeting procedures, quorums and notice, all of which may be waived in the LLC’s operating agreement. The Delaware LLC Act generally does not provide such default requirements.

This article is for general guidance only and does not contain definitive legal advice. Contact us at [email protected].