(To view this article as published in the August 2010 edition of the Massachusetts Lawyers Journal, please click here)
When you’re forming an LLC for Massachusetts clients, any of five powerful factors may require you to form it under the Delaware Limited Liability Company Act, 6 Del. C. § 18-101 et seq. (the “Delaware Act”) rather than under the Massachusetts Limited Liability Company Act (the “Massachusetts Act”). This may be so even though the LLC will operate primarily or entirely in Massachusetts—and even though many key provisions of the Massachusetts Act are the same as or closely similar to provisions of the Delaware Act and are obviously derived from them.
However, as discussed at the end of this article, forming Delaware LLCs can involve significant hazards for Massachusetts clients and their lawyers.
The five factors potentially requiring the use of the Delaware Act are these:
- Sophisticated investors. Many sophisticated investors and lenders, both U.S. and foreign, and their professional advisers, including especially their lawyers, are familiar with the Delaware Act and feel comfortable working with Delaware LLCs. However, many of them are unfamiliar with the Massachusetts Act and thus are reluctant to do business with Massachusetts LLCs. If, now or in the future, your Massachusetts LLC formation clients will be dealing with sophisticated U.S. or foreign investors or lenders, you may have to form their LLCs under the Delaware Act.
- “Everybody’s second choice.” The non-Massachusetts members of a multi-member LLC will often want the LLC to be formed under the LLC act of their home jurisdiction, not under the Massachusetts Act. However, the Delaware Act is widely regarded as the preeminent U.S. LLC act. Thus, the normal compromise will be the Delaware Act. As the saying goes, “Everyone’s second choice is Delaware.”
- The Delaware courts. The Delaware Court of Chancery and the Delaware Supreme Court are widely viewed as the best U.S. business courts, and they process LLC litigation and other business litigation faster than the courts of most or all other U.S. jurisdictions. The availability of the Delaware courts to handle Delaware LLC internal disputes, especially disputes involving high financial stakes, is a major reason for choosing to form LLCs for Massachusetts clients under the Delaware Act rather than the Massachusetts Act.
- Specific Delaware Act provisions. The Delaware Act contains numerous provisions that can be highly useful to particular clients but for which there is no corresponding provision in the Massachusetts Act. For example:
• Section 18-1101(b). The cardinal provision of the Delaware Act is § 18-1101(b), which provides that “`i`t is the policy of this `Act` to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements `the Delaware term for operating agreements`.” This provision gives LLC promoters, members, managers and others with significant LLC stakes a high degree of confidence that the courts will enforce even the most unusual and creative terms of their LLC agreement, including terms that may appear to judges and other third parties to be oppressive.
• Sections 18-101(7) (seventh sentence) and 18-302(e). Delaware Act § 18-101(7) (seventh sentence) provides that persons that are not parties to LLC agreements may nevertheless have rights under them. Under Delaware Act § 18-302(e), an LLC agreement may provide that the parties to the agreement may not amend it except with the approval of a third party. These two sections can provide crucial benefits to LLC promoters and others that have substantial stakes in LLCs but that do not want the potential risks and burdens of LLC membership.
• Section 18-404(d) (second sentence). Delaware Act § 18-404(d) (second sentence) provides in effect that under specified circumstances, an LLC agreement may authorize actions by managers (including even actions by a single manager in a multi-manager LLC) without a meeting, without prior notice and without a vote. This provision, too, can provide powerful protections and benefits to LLC promoters and others, including lenders, that have important LLC stakes.
• Series LLCs. Delaware Act § 18-215 provides for “series” LLCs. Series under § 18-215 function like single-member LLC subsidiaries of parent LLCs. However, no separate filing or franchise tax is required in order to establish a series, and each series is statutorily insulated from claims not only against other series but even, amazingly, from claims against the parent.
- Delaware case law. While there are as yet very few broadly significant Massachusetts LLC cases, there is an extensive body of Delaware LLC case law, and this body of law is growing rapidly. In addition, in deciding Delaware LLC claims, the Delaware courts routinely apply the vast body of Delaware corporate and limited partnership cases.
The leading Delaware LLC case is Elf Atochem North America, Inc. v. Jaffari, 727 A.2d 286 (Del. 1999). Among other things, this case resoundingly reinforces the plain meaning of Delaware Act § 18-1101(b) (the “freedom-of-contract” provision noted above). Furthermore, it holds that even seemingly mandatory Delaware Act provisions normally must be construed as non-mandatory unless they are intended to protect third parties. This holding constitutes a uniquely powerful weapon in drafting LLC agreements to protect LLC promoters and others with significant LLC stakes.
However, use of the Delaware Act can involve significant hazards.
- The complexity of the Delaware Act. The Delaware Act is the lengthiest and most complex of U.S. LLC acts, and it contains many pitfalls for lawyers unfamiliar with it. For example, it contains several key provisions that appear on their face to be merely permissive provisions but that are probably best construed as default provisions—i.e., as provisions that will govern an LLC as if they were mandatory provisions unless the LLC agreement expressly alters them. See, e.g., Delaware Act §18-601 (concerning interim distributions); and Delaware Act §18-402 (third sentence) (concerning manager removals). Thus, you shouldn't form Delaware LLCs unless either (i) you yourself possess substantial Delaware Act expertise; or (ii) you associate yourself with another lawyer who possesses it.
- Delaware litigation of internal LLC disputes. Delaware LLCs and their managers are subject under the Delaware Act to Delaware service of process. See Delaware Act § 18-104(a) (requiring Delaware LLCs to have Delaware registered agents and offices); § 18-109(a) (providing that serving as a Delaware manager constitutes consent to Delaware service of process). Excellent as the Delaware courts may be, your LLC clients and the members and managers of their LLCs may not want to face the risk of defending Delaware lawsuits.
- Exposure of non-Delaware lawyers to Delaware long-arm jurisdiction. Under a Delaware Court of Chancery decision called Sample v. Morgan, 935 A.2d 1046 (Del. Ch. 2007), non-Delaware lawyers, even if they have only the most minimal Delaware contacts, may be subject to the long-arm jurisdiction of the Delaware courts in malpractice claims and other claims relating to Delaware LLCs.
To sum up: There are many situations in which you may owe it to your Massachusetts LLC formation clients to form LLCs for them under the Delaware Act. But doing so may involve significant risks not only for them but also for you.