This is the third part of a several part series of articles pertaining to limited liability company operating agreements. This third installment addresses capital calls, covenants not to compete and fiduciary duties.
Many medical practices and other health care enterprises operate as limited liability companies (LLCs), and are, therefore, governed by the LLC’s “operating agreement.” However, the concepts imbedded in such operating agreements are often foreign or confusing to the members of the LLCs. Accordingly, the purpose of this series of articles is to shed some light on those concepts.
Capital Calls
Capital calls refer to the ability of the LLC to request additional capital contributions from its members. Typically, they may be used to fund shortfalls during lean years, or to provide capital for projects that are outside of the scope of a projected budget. Many businesses use capital calls when they are unwilling or unable to obtain traditional financing.
When a capital call is made, the funds are attributed to the member’s capital accounts as additional investments in the business.
LLC operating agreements should address how and when a capital call can be made, if at all, and address the length of any notice period.
The operating agreement should also provide guidelines on how to address a failure to meet the call. For instance, if a member refuses to participate, the participating members could dilute the non-participating member’s ownership interest.
Let’s take for example a three member LLC, where each member has an equal 33.33% interest in the company having initially contributed $10,000 each. Presume that a capital call is made for $30,000, and each member is asked to contribute an additional $10,000. One member refuses to participate, but the other two members make up the shortfall and each contribute $15,000.
If the company has distributed all of its profits and has not incurred any losses, then after the new $30,000 capital call, the participating members will each have $25,000 in their capital accounts, and the non-participating member will have $10,000 in their capital account. Under a standard dilution scenario, the non-participating member’s ownership interest would be reduced from 33.33% to 16.67%, and the participating members would now each have a 41.67% interest.
Alternatively, the operating agreement in the above example could allow for the participating members’ $15,000 contributions to be treated as a loan to the company, and not as added capital.
Covenants Not to Compete
Covenants not to compete are important in operating agreements for several reasons, particularly in industries such as health care where the protection of patient relationships and business goodwill is paramount. These covenants prevent members from engaging in competing activities during the term of their membership, and sometimes for a period after termination of their interest.
Covenants not to compete can also help ensure that departing members do not use confidential information, such as patient lists or business strategies, to compete with the company. There may also be non-solicitation language that prevents departing members from soliciting patients or poaching employees of the LLC.
The LLC operating agreement language should be tailored appropriately such that the restrictions are reasonable in duration and geography; otherwise, the provisions may be unenforceable. As with other covenants not to compete, there may be different terms in the event a member leaves the business voluntarily or involuntarily.
It is important to note that covenants not to compete in operating agreements can generally be broader in scope than similar provisions in employment agreements. Courts generally believe that owners of businesses pose a greater threat to a business, and are more capable of finding alternative employment, than a departing employee.
Fiduciary Duties
Fiduciary duties are crucial in operating agreements because they establish the standards of conduct for LLC members, including their acting in the best interests of the LLC and its members. Fiduciary duties also include the duty of loyalty and the duty of care, protecting the LLC and its members from misconduct or self-serving actions by other members.
Members should be required to treat each other and the company fairly and honestly, and maintain a culture of transparency and accountability. Members should be expected to act in the best interests of the LLC and its members, and not for their own personal interests.
This includes disclosure of conflicts of interest by members, and oftentimes require members to provide the company with information and time for consideration of opportunities before a member can act on the opportunity personally.
Of note, while many states impose fiduciary duties for limited liability companies by statute, Maryland does not. However, in 2020, Maryland’s highest appellate court ruled that fiduciary duties exist as to majority members’ actions towards minority members of an LLC in the case Plank v. Cherneski. Given the importance of fiduciary duties to protecting the company as well as the other members, it is advisable to include specific provisions regarding fiduciary duties in an LLC’s operating agreement.