One of the recurring issues I see in my litigation practice is LLC managers engaging in “questionable conduct” with third parties — outsiders to the LLC.
By “questionable conduct,” I generally mean binding the LLC to transactions and obligations that might be beyond the manager’s authority to enter into without the consent of the majority of the LLC’s members.
LLC operating agreements generally contain some limits on the manager’s authority. Most say something to the effect of: the manager has authority over the LLC’s day to day operations, but LLC member approval is required for extraordinary transactions, like selling the LLC’s property, encumbering the LLC’s property as security for a loan, or dissolving the LLC.
What happens when the LLC manager oversteps his/her authority and makes an “unauthorized” deal with a third party?
One key California statute provides critical guidance.
Corporations Code section 17703.01
In Title 2.6 of the California Corporations Code, otherwise known as the Revised Uniform Limited Liability Company Act (“RULLCA”), section 17703.01 sets forth the ground rules for a manager acting as an “agent” for the LLC in the LLC’s dealings with third parties.
For manager-managed LLCs (as opposed to member-managed LLCs), the members are not agents of the LLC, and cannot “bind or execute any instrument on behalf of” the LLC. (Section 17703.01(b)(1).)
The manager, on the other hand, is an agent of the LLC “for the purpose of its business or affairs,” and the manager’s signature on any instrument on behalf of the LLC will bind the LLC “unless the manager so acting has, in fact, no authority to act for the limited liability company in the particular matter and the person with whom the manager is dealing has actual knowledge of the fact that the manager had no such authority.” (Section 17703.01(b)(2).)
Subdivisions (c) and (d) of the statute shed further light:
(c) No act of a manager … in contravention of a restriction on authority shall bind the limited liability company to persons having actual knowledge of the restriction.
(d) Notwithstanding the provisions of subdivision (c), any note, mortgage, evidence of indebtedness, contract, certificate, statement, conveyance, or other instrument in writing, and any assignment of endorsement thereof, executed or entered into between any limited liability company and any other person, when signed by [the manager], is not invalidated as to the limited liability company by any lack of authority of the signing [manager] in the absence of actual knowledge on the part of the other person that the signing … manager had no authority to execute the same.
(Section 17703.01(c)-(d), emphasis added.)
A manager’s “unauthorized” acts can’t always be invalidated
Thus, under the statute, if a manager engages in an “unauthorized” transaction — say, selling the LLC’s property without member approval — the members cannot automatically invalidate the transaction. To do so, the members would need to prove that the third party buyer had “actual knowledge” that the manager lacked authority to sell the property. This is referred to as a “safe harbor,” and is meant to protect the rights of the third party dealing with an LLC’s manager.
A notable example of how the statute operates was discussed on the Money and Dirt blog post, “Just How Much Power Does Your LLC’s Manager Have?” In the case discussed in that post, the LLC’s manager agreed with a third party that the LLC would provide indemnity — for obligations related solely to the manager’s side projects, which were totally unrelated to the LLC’s business!
Applying section 17157(d) from the Beverly-Killea Act (the predecessor to RULLCA with language very similar to RULLCA section 17703.01), the court held that since the third party lacked “actual knowledge” of any restrictions on the manager’s authority, the indemnity agreement could not be invalidated.
What is “actual knowledge”?
“Actual” knowledge or notice consists of “express information of a fact.” (Civil Code section 18.) Actual knowledge is usually distinguished from “constructive” or “imputed” knowledge, where someone is held to “know” something because their agent knows it or because the fact is contained in a recorded document.
One court of appeal opinion has held that: “Actual notice is notice given directly to, or received personally by, a party.” (Cal. Ins. Guarantee Assn. v. Workers’ Comp. Appeals Bd. (2008) 163 Cal.App.4th 853, 863.) That court further held: “Imputed knowledge is constructive, not actual knowledge.” (Ibid., emphasis added.) Thus, that court held that while an agent’s knowledge is normally imputed to the agent’s principal (see Civil Code section 2332), the principal will not be held to have “actual knowledge” when a statute specifically requires “actual knowledge.”
Other cases seem to hold differently. (See, e.g., Citizens for Covenant Compliance v. Anderson (1995) 12 Cal.4th 345, 355 [holding, as to a recorded instrument, that “constructive notice is the equivalent of actual knowledge; i.e., knowledge of its contents is conclusively presumed”]; City of Anaheim v. Metropolitan Water Dist. of Southern Cal. (1978) 82 Cal.App.3d 763, 771 [holding recordation “is the equivalent of actual notice“]; Watson v. Sutro (1890) 86 Cal. 500, 517 [general rule is that “a principal is bound by the knowledge of his agent;” “There is no difference in this respect between actual and constructive notice“]; Baxter v. Cal. State Teachers’ Retirement System (2017) 18 Cal.App.5th 340, 366 [same]; and Aspen Pictures, Inc. v. Oceanic S.S. Co. (1957) 148 Cal.App.2d 238, 254 [approving jury instruction stating “When the law imputes knowledge, it has the same legal effect as though there was actual knowledge“], emphases added.)
Confused? You are probably not alone.
I would expect courts to further clarify what counts as “actual knowledge” under section 17703.01.
In a manger-managed LLC, only the manager (not any member) is an agent of the LLC with authority to bind the LLC. Third parties dealing with the LLC’s manager are protected by the “safe harbor” provision in section 17703.01.
If a manager oversteps his/her authority and enters into an improper transaction without member approval as required by the LLC’s operating agreement, undoing that transaction is not automatic — the members will need to show that the third party had “actual knowledge” of the manager’s lack of authority. Proving “actual knowledge” by the third party may prove very difficult.
Of course, even if they cannot unwind the transaction, the members may have remedies against the manager for breach of fiduciary duties. But victory on that claim will often ring hollow if the LLC’s main assets or other rights have already been transferred away.