California and Delaware LLCs are Not the Same
Most LLC members don’t give serious thought to the jurisdiction in which their LLC is formed. The general perception is that a California LLC will incur slightly higher business taxes and franchise fees but is convenient for California citizens, while a Delaware LLC has access to a judicial system with expertise in business matters.
Delaware is also correctly perceived as very “freedom of contract” oriented. This point cannot be overstated.
One critical difference between California and Delaware LLCs is a member’s right to inspect books and records.
California: member’s right to inspect LLC books and records cannot be eliminated by the operating agreement
In a California LLC, one of a member’s most significant rights is the ability to inspect the LLC’s books and records. That right is set forth in California Corporations Code section 17704.10. Under section 17704.10(b), any LLC member, manager, or holder of a transferable (economic) interest has the right, upon reasonable request, to inspect and copy during normal business hours any of the records required to be maintained pursuant to section 17701.13(d).
And, significantly, under Corporations Code section 17701.10(d)(2), the LLC’s operating agreement cannot “vary a member’s rights under section 17704.10.”
Delaware: freedom of contract; books and records inspection rights can be waived
In Delaware, however, the law is different as illustrated by a case recently filed by Delaware’s Court of Chancery — Bengson v. Elevate RCM Holdings, LLC.
In Bengson, the court evaluated the operating agreement of Elevate RCM Holdings, LLC (“Elevate”), a Delaware LLC. Elevate indirectly owned Elevate Patient Financial Solutions (“ElevatePFS”), a company that provided revenue cycle management solutions to hospitals, health systems, and healthcare providers.
Plaintiffs Dena and Rick Bengson became members of Elevate in 2023 after ElevatePFS acquired their business. In connection with the acquisition, the Bengsons received cash and membership interests in Elevate. The Bengsons also signed a Joinder Agreement whereby they agreed to become parties to and be bound by Elevate’s Operating Agreement.
The Operating Agreement stated that with certain exceptions “no Member shall be entitled to any information, inspection, examination, demand, or similar access rights, and each Member hereby irrevocably and unconditionally waives” any inspection rights.
After Elevate sold ElevatePFS and distributed proceeds, the Bengsons demanded documentation supporting the distribution amounts. After receiving only a “waterfall summary” the Bengsons informally demanded several categories of information relating to the sale. Elevate denied this informal request. The Bengsons then issued a formal request to inspect Elevate’s books and records. Elevate again denied the request, citing the Operating Agreement’s inspection waiver provisions. The Bengsons sued.
The Delaware Court of Chancery held that the Bengsons waived their right to inspect Elevate’s books and records when they agreed to be bound by the Operating Agreement, and that the Operating Agreement’s inspection waiver provisions were valid and enforceable. The court held that Delaware law “does not expressly prohibit” the waiver of a member’s default inspection rights, and that “sophisticated parties may contractually waive a statutory right in exchange for valuable consideration.”
The court also rejected the Bengsons’ argument that the waiver of inspection rights was barred by public policy and that allowing waiver “would constitute a license for an LLC’s manager to swindle other members with impunity.” The court acknowledged that “inspection rights are important tools for investors” but held that Delaware law expressly intends “to give maximum effect to the principle of freedom of contract.” The court continued:
Accordingly, investors are advised to review contract terms carefully before investing and not to look to the courts to save them from contracts that may appear ill-advised in retrospect.
The court further held that the Operating Agreement’s waiver provisions were sufficiently clear and unequivocal.
Lesson
California and Delaware LLCs are not the same. Among the key differences is that in California, an LLC operating agreement cannot vary the members’ right to inspect the LLC’s books and records. But in Delaware, the principle of freedom of contract prevails and inspection rights can be waived.