The Duty of Care of New Hampshire Lawyers in Drafting Operating Agreements For Multi-Member LLCs

John M. Cunningham
Of Counsel, Corporate Department
Published: New Hampshire Bar News
December 15, 2021
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Every year, hundreds of New Hampshire lawyers assist their clients in forming multimember LLCs under the Revised New Hampshire Limited Liability Company Act (the “New Hampshire LLC Act”), and, in so doing, they draft operating agreements for these clients. What are the principal elements of the duty of care with which these lawyers must comply in this drafting? Above all, the answer is that under Rule 1.1 of the New Hampshire Rules of Professional Conduct, they must have all the knowledge and skill to perform this task. If they lack this knowledge and skill, they must not do this drafting.

However, in the paragraphs that follow, I’ll provide a somewhat more detailed overview of the above duty-of-care elements as I understand them. For concreteness, I’ll assume that the lawyer I’m addressing in these paragraphs is Mary Jones, a New Hampshire sole practitioner who holds herself out as a business lawyer and who, at least from time to time, drafts LLC operating agreements for clients forming multi-member LLCs.

Mary’s first duty of care in drafting these agreements is to determine which of the prospective members and managers of the relevant LLCs (collectively, the “participants”) should be her clients in the above drafting, and she must obtain the participants’ agreement as to her determination. Mary has three options in making this determination:

• She may represent only one of the participants;

• She may represent two or more of them in a joint representation if their interests in the LLC in question are substantially aligned and if they sign a written joint representation agreement authorizing the representation; or

• She may represent none of the participants, but only the entity itself.

In this third situation, she must expressly advise the participants that she is representing only the LLC, and that, if the participants want to protect their individual interests in the LLC, they must retain their own lawyers.

However, in my view, of this situation Mary should also advise the participants that her duty in representing the LLC is to draft an operating agreement which will provide a reasonable compromise of the LLC rights and duties of all the participants, and which all the participants will be willing to sign. If she provides them with this advice, obviously her duty of care will be, to the extent possible, to provide the participants with an operating agreement that reflects this compromise.

However, once she has determined who should be her clients in drafting the operating agreement in question, Mary will have a duty in drafting the agreement for any such clients to identify all the legal and tax issues potentially relevant to them to the extent she possesses the necessary expertise. If she lacks that expertise, she must expressly so advise her clients, and she must either refer them to an attorney who possesses this expertise, or she must advise them that she is not competent to make this referral.

The relevant tax expertise she will need in order to handle the relevant multimember LLC tax issues will generally be as follows:

• She will need the expertise required to advise her clients as to which of the three federal tax regimens available to the relevant multi-member LLC under the U.S. Treasury Entity Classification Regulations—namely, Subchapter C, Subchapter K (partnership taxation) or Subchapter S—will be best for their LLC.

• She will need the expertise necessary to identify which specific federal tax issues are likely to be relevant to her clients under each of the above regimens.

• She will need to be able to determine which specific federal tax provisions will be best for her client in order to maximize the annual 20% federal income tax deductions potentially available to them under Internal Revenue Code Section 199A.

• If, as will normally be the case, the federal tax regimen of the multi-member LLC in question will be partnership tax, she will need the expertise necessary in order to determine whether the operating agreement in question should contain the provisions necessary in order to comply with the requirements of Prop. Reg. § 1.1402(a)-2 (the “Prop. Reg.”). The Prop. Reg. is the proposed Internal Revenue Service regulation that may will her clients to realize potentially substantial reductions of the Social Security taxes for which they will otherwise be liable.

In my experience, relatively few New Hampshire business lawyers possess the above tax expertise. It is to be hoped, however, that Mary will possess the legal expertise necessary to competently draft the legal provisions of the operating agreement in question. To draft these legal provisions competently:

• Mary will need, firstly, a comprehensive knowledge of the 310 provisions of the New Hampshire LLC Act generally relevant to the drafting of operating agreements for multi-member LLCs, including a knowledge of whether each of these provisions is a definitional provision, a mandatory provision, a default provision, a nonself-enabling permissive provision, or a self-enabling permissive provision.  This knowledge will often be critical to Mary in determining whether and how to address these provisions in the operating agreement in question. For example, if a default provision in the New Hampshire LLC Act favors her clients, she should generally not make reference to it in negotiating the terms of the agreement, since, if it is not addressed in the agreement, it will automatically apply if all required parties sign the agreement.

• In particular, she must know how to address Section 107 of the New Hampshire LLC Act, which provides that in an operating agreement, the parties to the agreement may increase, reduce, or even eliminate any duties otherwise applicable to the parties under that act.  If, for example, Mary is representing a participant who will be a manager of the LLC in question, it will often be appropriate for her to seek in the relevant operating agreement to reduce or even to eliminate manager duties of care.

Three specific sets of legal provisions of which she must have a comprehensive understanding and which she must know how to draft are the following:

• The first is the set of provisions addressing the duty of loyalty under Section 110 of the New Hampshire LLC Act. Section 110 is among the most complex provisions in that act; among other things, it provides for eight subsidiary duties of loyalty. For many of her clients, it will appropriate for Mary to negotiate the waiver by the members of the relevant LLC of one or more these subsidiary duties. This includes, for example, the duty not to compete against the LLC.

• The second is the set of provisions addressing events of dissociation—i.e., events, such as death, which will terminate a member’s membership rights.  These events and the buyout consequences that should result from them are often the most complex provisions in a multi-member LLC operating agreement. The basic provisions in the New Hampshire LLC Act concerning events of dissociation are set forth in Sections 98 through 102, but these provisions do not address buyout issues and other essential dissociation issues relevant in the operating agreements of most multi-member LLCs.

• The third is the set of provisions addressing the rules that should govern dispute resolution in the operating agreement in question. For LLC members who wish to maintain the privacy of internal LLC disputes, the best dispute resolution methods may well be confidential mediation followed by arbitration.

However, if mediation fails and an LLC matter is subject to arbitration, serious issues may arise for Mary’s clients unless she is able to ensure, through the relevant arbitration provisions, that the arbitrator will be competent and unbiased and that all procedural issues arising in the arbitration will be resolved in a manner that is favorable—or, at a minimum, fair—to her client. These issues will almost certainly not arise for Mary’s clients if the operating agreement in question provides that, if mediation fails, these disputes must be resolved in the Business Docket of the New Hampshire circuit court. But it will often be appropriate for Mary to provide in an operating agreement that some types of LLC internal disputes must be resolved by arbitration and others by litigation.