Changes to Business Entity Law Move Pennsylvania Toward ‘Freedom of Contract’ Rule

February 27, 2017Alerts Corporate Alert

Pennsylvania is moving toward the “freedom of contract” rule – as followed by Delaware – with the adoption of Act 170, a law that substantially revised laws applicable to partnerships and limited liability companies.

Passed by the Pennsylvania legislature in November 2016, the new law went into effect on Feb. 21, 2017 for all new entities (those filed on or after that date) and will go into effect no later than April 1, 2017 for all existing entities. Existing entities may be subject to the law sooner if they amend their agreement and elect to be covered by it.

The changes to the law are significant and may warrant revisions or amendments to your entity’s partnership agreement or operating agreement. For ease of discussion in this article, the term “agreement” refers to both partnership agreements and operating agreements.

Altering Fiduciary Duties

Act 170 allows an entity to eliminate or alter fiduciary and managerial duties, subject to certain limitations. A fiduciary duty is an obligation to act in the best interest of another party.

First, an agreement can alter the duty of loyalty and outline specific activities that do not violate the duty of loyalty so long as such revisions are not “manifestly unreasonable.” For example, an entity can eliminate the duty of loyalty with respect to competing with the entity or appropriating a company opportunity. Additionally, an entity can alter the duty of loyalty with respect to (a) using the company’s property for personal gain, (b) engaging in self-dealing, and (c) conducting the company’s activities for personal gain.

Similarly, the duty of care can be altered (but not eliminated) and other fiduciary duties may be revised or eliminated in an agreement so long as doing so would not be manifestly unreasonable.

The manifestly unreasonable standard is a substantial burden for claimants to overcome such that a term will be deemed manifestly unreasonable only if, in light of the entity’s purposes, activities and affairs, it is readily apparent that (i) the objective of the term is unreasonable, or (ii) the term is an unreasonable means to achieve the objective. Additionally, Pennsylvania law now explicitly permits the agreement to provide for indemnification and/or exculpation of its members/partners (as applicable), regarding breaches of the duty of care except for conduct that constitutes recklessness, willful misconduct or a knowing violation of the law.

Act 170 also eliminates the previous rule of “statutory apparent authority” for members and managers of a limited liability company, which means that the entity may not be bound by the actions of its members or managers.  However, it is likely that an entity could still be held liable for the actions of its members or managers under agency theory.  For proof of such authority, entities may file a certificate of authority with the Commonwealth of Pennsylvania outlining the authority of a person to conduct certain matters on behalf of the entity, such as the ability to transfer real property and enter into other transactions. In that case, a filed certificate of authority is of record to demonstrate such authority, which may obviate the need to prepare an agreement.

As such, it is advisable that parties ensure that all representatives of an entity with which they are conducting business have the authority to conduct such business in order to protect their interests.

Transferability of Interest in Partnership or LLC

Finally, Act 170 modifies the law regarding the transferability of an interest in a partnership or limited liability company in its differentiation of a “Transferable Interest” versus other types of interests in an entity.  Act 170 defines a “Transferable Interest” as the right to receive distributions from the applicable entity, regardless of whether a person remains a member/partner, but does not include any voting or management rights.  In order to transfer broader rights, consent of all members/partners or a provision in the agreement would have to permit such transfer. 

As a result, a judgment creditor may only get a lien on a debtor’s Transferable Interest but may have no right to vote, for example, as to the timing or amount of distributions of the applicable entity.  Act 170 provides that any lien on a Transferable Interest would not cover any amount constituting reasonable compensation for present or past service or payments made in the ordinary course of business under a bona fide retirement plan or other benefits program.

Consequently, existing Pennsylvania entities may wish to review their agreements to determine if revisions need to be made in lights of these and other changes in the law contained in Act 170. It is also imperative for new entities to be well-versed in Act 170's changes in order to determine what should be, and perhaps what cannot be, included in their operating agreement or partnership agreement.