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Delaware Series LLC
The Delaware Protected Series LLC is a business structure that draws attention and curiosity from many business owners. While the formation of a Protected Series LLC may not be for every company, it can be very beneficial for others. Corporate law professor Larry Ribstein encapsulates the use of the Series LLC well in his book, Rise of the Uncorporation, stating that “using commonly managed and operated LLCs presents a risk that the courts will pierce the veil and attribute the liabilities of one of the commonly managed firms to the ‘sister’ LLC. A Protected Series LLC statute effectively instructs the courts to keep the liabilities separate as long as the members have followed the formalities and record-keeping rules.”
What is a Delaware Protected Series LLC?
The Delaware Protected Series LLC is similar to a traditional LLC with divisions. Each protected series designated by the company may have assets associated with it that are not associated with other protected series therein. This provides for internal asset segregation. As a result, one protected series within the LLC may be insulated from the debts and liabilities of all other protected series of the LLC. It is no more expensive than a traditional LLC to maintain because it is filed as one entity and requires just one franchise tax payment in the state of Delaware. All of the protected series are created through a private operating agreement, not required to be listed with the Division of Corporations. Private record keeping is essential to maintain this asset segregation.
How to Form a Delaware Protected Series LLC
To form a Delaware Protected Series LLC, it only requires (1) the $90 payment to the Delaware Division of Corporations and (2) filing of the standard one-page Certificate of Formation naming the registered agent with (3) an extra paragraph in the Certificate of Formation to notice others that the LLC has the right to create protected series.
Regardless of how many protected business units (i.e., series) you would like to have as part of the LLC, no additional filing fees are required in Delaware. The names of the protected business units below the protected series LLC organization are only created by private operating agreement, not on the states’ records. Also, the names of the members of the Protected Series LLC and the members of its protected business units are not filed with the Delaware Division of Corporations. Upon filing the Certificate of Formation, it is very important to sign a detailed Operating Agreement especially drafted to be used for the Protected Series LLC.
Protected Series LLC Definition & Origin
- Protected Series LLC Definition
While different states will have different precise definitions of a protected series LLC, there is an overarching, general definition that they all share. It is a hybrid of 1) an LLC with internal divisions and 2) multiple LLC subsidiaries owned by a common parent LLC. It has features of each. Often it is set up to be a ‘mothership’ LLC that has the option of setting up as many ‘daughter’ protected series as the members see fit. While these materials will refer to the separate divisions of the protected series LLC as ‘protected series’ (both singular and plural), they are also often referred to as ‘cell(s)’.
First the Protected Series LLC is like a single LLC with divisions, because the enabling legislation for the protected series LLC does not say whether it is one or more entities under state law, therefore many consider it is only one ‘entity’ under state law. In the traditional LLC context a division of an LLC is a glorified ‘doing business as’ or d/b/a within an LLC. With divisions, each separate division is legally connected to the entity without any liability separation. Although the operations are conducted through different ‘departments’, each is just an extension of the traditional LLC. In a protected series LLC, each protected series is part of the LLC, not a separately filed LLC. The protected series LLC therefore does not need to register individual cells or ‘qualify’ the cells in foreign states after qualifying the Protected Series LLC as a whole. Only the protected series LLC as a whole is on the official public record. However, this does not apply to Illinois, where each series must file a Certificate of Designation that sets forth the series name and its managers or members. This is also different in Missouri, where the Articles of Organization must contain information on every series and must be amended if a series is added or removed, and Montana, which requires inclusion of series operating agreements in the Articles of Organization. When the protected series LLC or cells therein do business or when it takes title to properties, the name is listed as ‘ABC Capital LLC, protected series 1’. It never loses the name of the LLC filed with the Delaware Secretary of State. Additionally, the protected series LLC has only one Delaware ‘annual report fee’ regardless of how many protected series it contains. Interestingly, the protected series LLC does not have its own chapter in the Delaware code, like limited partnerships, instead, most of the provisions are packed in just one ‘magical’ section of the Delaware LLC Act, 6 Del. C. Section 18-215. Therefore at its core all of the other Delaware LLC Act provisions apply to the protected series, but there are a number of innovations that allow this entity to multiply internally to have an unlimited number of tentacles, each with a separate purpose and separate assets and liabilities. This is like a blank check from the Secretary of State, empowering you to create as many entity-like cells under this one umbrella without any additional state filings.
Second the protected series LLC organizational structure can be like a parent with wholly-owned-subsidiaries, because each cell is allowed to contract in its own name, sue and be sued in its own name, obtain separate tax ID numbers, and even make separate tax elections (‘Check the box’ elections on IRS form 8832 or 2553), so one cell could be a partnership, another an s-corp, and another a c-corp.
There is also another way a protected series LLC is unlike either of the two above, which is what makes it so compelling to some who cannot afford to pay and maintain multiple LLCs. The Delaware protected series LLC enables operations to be managed under one roof. It enables new protected series to be opened without additional filings or fees with the Delaware Secretary of State. The founding members associated with the parent company can generally designate members associated with one or more cells and membership interests to only apply to a particular cell. Therefore to use a simple example, ABC Capital LLC can be a one member LLC with Able Adams as a member. It could have Ben Burns be a single member on ABC Capital LLC, protected series 1; with Christopher Curtis as the member on protected series 2; David Downing on protected series 3; and Elizabeth Emery as the member of protected series 4. Therefore that example is NOT a parent-child relationship, because it is more akin to 5 separately filed LLC’s under one roof. For various reasons, we do not suggest this diversity of ownership, because it is unwieldy and runs a high potential for conflict.
The above example is extreme, but it illustrates that the cell members typically own not only a founding membership interest in the company, but also a membership interest in the cells. Therefore in the ‘cascade of power’ the power does not necessarily flow down from the top. Instead each cell is in many respects autonomous, depending how the protected series LLC agreement and cell operating agreements are written.
- Protected Series LLC Origin
To understand the unique purpose of a protected series LLC and its advantages compared to a traditional LLC, corporation, or partnership, it is important to understand the context in which the protected series LLC was developed. It was started as special interest legislation of the mutual fund industry, which wanted to have protections and benefits of multiple LLCs contained in a single entity. The SEC securities attorneys for the mutual fund industry are largely responsible for the enactment of the protected series LLC. The mutual fund industry was tired of having the expense and hassle of filing separate SEC filings for each class of funds under the mutual fund company’s umbrella. Their solution was to create an LLC that would be like a potential cell company which could have daughter funds all within one SEC filing. However these companies were concerned about liability separateness and the right of each fund to be managed independently. Their solution was to add provisions which allow each class of funds to sue and be sued in their own name and to contract in the name of each fund. This concept was not foreign to the law, since the statutory trust already had the ‘protected series’ feature. Around the same time, since some funds were run as limited partnerships, the protected series language was also added to that section of the code.
Since few people use statutory trust series or limited partnerships series for small businesses, those series sections have garnered little attention. They are still used mainly for the investment and asset holding community. However the LLC has grown significantly in popularity, eclipsing the traditional corporation as the business structure of choice for small business owners. The business community has become comfortable with the ‘traditional LLC’ (which is the term I use to call an LLC without the ‘protected series’ feature), so much so that there is a demand for many LLCs simply to hold particular assets or business operations. Sometimes the administrative burdens and incremented costs of maintaining separate entities becomes too much. When the entrepreneur needs a solution to reduce costs the protected series LLC is one vehicle that has multiple self-contained entity-like protected series within it. This helps to control costs and streamline some administrative burdens.
Basic Protected Series LLC Agreement Structure
- Operating Agreements
The Delaware LLC Act provides for “maximum flexibility” and “freedom of contract” with regard to the LLC Operating Agreement. In the majority of protected series LLC Operating Agreements, the Agreement provides for a top-level membership known as “Founders” and a second tier of members called “separate series members” for the purpose of this information we are referring to these as separate cell members. We suggest that these top-level founding members be the same people as the second tier members for a “mirror-image” of ownership to prevent problems with rogue members owning slivers of interest of one cell, but not others, who may be more prone to litigating against the other members and therefore tying up all the assets of the LLC in a litigation that should be limited to particular assets. While it is theoretically possible to remove the unrelated protected series from the lawsuit if they are not properly tied to the dispute, as a practical matter, even the cost of such a motion is burdensome and the outcome is uncertain.
In a traditional LLC, as well as a protected series LLC, any changes to the Operating Agreement are accomplished through amendments. While these are usually in writing and executed by every member of an LLC, it is possible that the cell Operating Agreement contains different provisions for amendment by supermajority of founders plus members associated with a cell or it can require unanimous consent. Some agreements also provide for simple majority. Delaware’s maximum deference to freedom of contract given to the protected series LLC Operating Agreements provides LLCs with the flexibility to choose whatever amendment procedure they believe is best at the outset.
- Members Associated with Company or Protected Series
One of the primary benefits of having a protected series LLC is the ability to have different members for different protected series, and the possibility of having members who are only associated with the company generally and not the cells, or members that are only associated with a cell and not the company generally. This flexibility of membership can be used for a variety of purposes, although a more simple structure may be advisable in most cases (see Section II.A)
Protected Series LLC Evolution
- Different Applications
In Delaware, and the handful of other states that have protected series LLC statutes, these internal liability shields will most likely be respected, as they will be supported by both Delaware case law and the Delaware statutes themselves. Exporting the cells to a non-series jurisdiction is prone to a risk that the non-series state court would not regard the separate protected series and impute joint and several liabilities. An out-of-state judge may decide not to import Delaware law for matters that are outside the scope of the ‘internal affairs doctrine’. Based on conflict of laws principles, the judge could decide that empowering members of the protected series LLC to establish cell protections without new additional filings with the secretary of state is a violation of public policy in that state and decide not to follow it, even though the U.S. Constitutional precedents suggest the cell protection should be honored, based on a whole host of doctrines such as full faith and credit, equal protection, substantive due process, and the personhood status granted to entities.
In any case, the odds of being ‘the first patient on the table’ are low, like playing the lottery, and will likely also give the vast majority of protected series LLC owners the opportunity to transfer property out of a protected series if there is a wave of negative case law from non-series states. The trend at the moment is in favor of the protected series LLC. A few states have adopted protected series LLC acts recently. Many view the California Franchise Tax Board (‘FTB’) ruling as a positive development (requiring a franchise tax from each protected series within an LLC as though it were a separate LLC). While the FTB ruling in California may impose additional fees, the ruling also recognizes the protected series as though they were separate LLCs (at least for tax purposes). This would make it easier for a defendant to make the argument that separate protected series should also be separate for liability reasons; otherwise, California is taxing a privilege it is not affording. Additionally, the Uniform Law Committee is now drafting protected series provisions to add to the Uniform LLC Act.
Finally, an important point to keep in mind when thinking about possible taxation and legal issues of the protected series LLC is that many of these decisions rely on the different protected series being completely separate from each other. This means that each protected series would have separate records and an objective method to determine which assets and liabilities are in which protected series. Creating this visible separation is vital to being able to have the different protected series be considered as distinct legal entities.
Currently, it is unclear how some court systems will handle protected series LLCs. In states where the protected series is, by statute, a separate legal entity, it seems obvious that the state court system would recognize it as such. In other state courts or in Federal Court, this would lead to an uncertain outcome because they would not have protected series LLC provisions as part of the law that they are applying. However, the protected series LLC does present an interesting question about service of process. If a protected series is to be sued, is it necessary to serve the protected series itself, or is serving the parent LLC sufficient, or required? Additionally, is service on a cell enough to satisfy service on the parent LLC, or is it necessary to serve the parent itself? Currently, the whole protected series LLC has one Registered Agent, which is listed on the protected series LLC Certificate of Formation, meaning that there is only one Agent to receive service. The protected series LLC still has a few kinks to iron out with respect to the courts, although it is likely that future rulings of the Delaware Chancery Court will begin to set precedent as the protected series LLC becomes a more widespread entity structure.
In 2010, after a number of states had already adopted protected series LLC provisions, the IRS noticed that it posed a problem for taxpayers. While it had already been settled that the traditional LLC could elect to be taxed in a variety of ways through ‘check the box’ regulations, it was uncertain whether the protected series would qualify as distinct legal entities who could elect their treatment for tax purposes, or if they would have to assume the tax classification of the company generally and be taxed as an individual entity or if the whole protected series LLC, including the cells and the company, would be taxed as a single entity. Consequently, the IRS issued a private letter ruling, which states that different cells are allowed to choose their own treatment for tax purposes, based on their individual businesses and membership structures (disregarded entity, partnership, C-Corp, or S-Corp). Thus, a cell can elect how it is to be treated for Federal Income Tax as a business entity that is distinct from the other cells of the same LLC.
In 2010, the IRS circulated a proposed revenue rule to provide taxpayers guidance on the series LLC (2010-22793). In it the IRS said it deemed the separate series to be separate taxable entities. This gave the series LLC a great deal more certainty about how to file returns. However, this may require filing an additional partnership tax return (1065) for each additional series. Some considered an advantage of the series to be the ability to file a single consolidated return. However, it appears now that this is not the preferred method, to date the IRS still has not finalized that proposed revenue ruling.
In the case where a single protected series is insolvent, would the company generally need to be associated with the petition for bankruptcy or can individual cells file for protection? So far, only one Delaware protected series LLC, Dominion Ventures LLC, has been in bankruptcy court where the company and all of its protected series filed for Chapter 11 and the Court appointed a trustee by consent of all parties. This case started in the Court of Chancery. Going through court-ordered arbitration resulted in no liability except the requirement to produce books and records. Because this business was investing in mobile home parks and could not get more investors or more loans, and because of litigation costs, it has to file for protection. This test ‘case’ shows the competency of the court to handle the unique issues presented by the protected series LLC. The Court of Chancery mediation was appealed by the company and is currently stayed pending a final determination by the bankruptcy court.
These questions are currently being considered by the Uniform Laws Committee. While Delaware’s statute does provide that dissolution of a cell does not affect other cells or the company and that the winding up and dissolution of the company requires the winding up and dissolution of all cells under that company, there still would have to be a consistent precedent for Bankruptcy Court to follow.
The Bankruptcy Court has ruled that ‘[An LLC] is a form of legal entity that has attributes of both a corporation and a partnership…corporations and partnerships are allowed to be debtors, and because an LLC draws its character from both of those…an LLC is similar enough to those entities that it may be a debtor under this code’. Combining the fact that a cell is arguably a legal entity and has characteristics similar to existing entities that are allowed to be debtors (such as LLCs themselves), it would appear that a cell could be a debtor under the Bankruptcy Code. Provided the cell and company as a whole were not cross-collateralizing assets but were treating each other at arm’s length with separate records, than the cell should be regarded and not consolidated into a single bankruptcy estate.
Protected Series LLC Today
- Protected Series LLC in Delaware Versus Other States
The Delaware protected series LLC is the most cutting-edge entity on the market. The protected series LLC is a product of the Delaware legislature, the most highly regarded body for drafting corporate laws. When forming a company, business formers have a choice of jurisdictions. Many knowledgeable entrepreneurs and real estate investors have chosen Delaware because of its low costs, business-friendly courts, innovative laws, developed legal precedent from the Chancery Court, and dependable liability protection.
Keeping beneficial owners’ and managers’ names off of public filings is another benefit of the Delaware protected series LLC. Only the name of the LLC and the Registered Agent’s name are listed with the State of Delaware (not the member’s name). Only the Registered Agent’s information will be filed with the Secretary of State. This provides owners and managers with a large degree of comfort. Only the registered agent must maintain a contract name, email, phone, and address on a contact person for each LLC. However, other states such as Illinois require that each separate cell file a Certificate of Designation naming members or managers, which becomes public record.
Another one of the main advantages that the Delaware protected series LLC has over that protected series LLCs filed elsewhere is the Delaware Court of Chancery, which is a dedicated equity court. Only two other states in the U.S.A. have dedicated equity courts (Tennessee and Mississippi), with a third, New Jersey, having equity divisions in its municipal court system. This has given Delaware one of the highest volumes of precedent for decisions about business disputes. With Delaware’s highly developed case law about LLCs, it is likely that court opinions around the country on the protected series LLC will be based on cases decided in Delaware.
Finally, Delaware protected series LLCs only have to pay one franchise tax for the whole LLC every year, rather than having to pay a separate fee for each cell. This will lower the overhead costs of a protected series LLC compared to opening multiple LLCs. Additionally, Incnow as well as a few other registered agent services, will only charge a single yearly registered agent fee for a protected series LLC, rather than multiple fees for multiple traditional LLCs.
- Names of Managers, Members, and "Cells"
Each cell should draft and execute its own Operating Agreement, which is separate from that of the company generally. While the company’s Operating Agreement can set out names of cells by creating them and some basic provisions, the cells will have their names and purposes in their own Addendums to the company agreement. Each Addendum Agreement will also set out the members and managers of the cell, as it is likely that they will be different from the company generally. However, most states require that the name of the cells contain the name of the company generally, although it is possible that each protected series could file a separate d/b/a.
- Membership Interests - Admission of Members, Creating New Interests, Transfer/Disposition of Interests
Like a traditional LLC, the requirements and procedure for admission of new members, creating new interests in the LLC, and transferring or assigning interests will be set forth in the Operating Agreement of a protected series LLC.
It is unusual to have different provisions for adding members or transferring their interest within the same protected series LLC. Frequently the protected series LLC Operating Agreement requires that all members of the company generally and their particular protected series approve of any new members. In the absence of a provision requiring pre-approval of new members, such interests are freely transferrable. Other transfers are subject to a right of first refusal by the company first, and the protected series members and company members second. Many protected series agreements contain a “supremacy clause” where in the event of a conflict between the protected series agreement and the company agreement, the company agreement controls.
- Distribution of Profits and Losses
Because the company and each cell could have different members and ownership structure, each one could have a different plan for distribution of profits and losses set forth in the Operating Agreement. Many LLCs and cells would default to distribution of profits and losses in proportion to ownership or capital contribution; however, for one reason or another, some LLCs would like different allocations.
- Dispute Resolution
The Operating Agreement often contains a provision that requires protected series or the parent to submit to binding arbitration governed by the rules of the American Arbitration Association in the event of a dispute. Regardless, providing a dispute resolution process in the Operating Agreements for a protected series LLC could save hassle in the event of disputes. One disadvantage of the alternate dispute resolution clauses is that they have probably led to fewer reported cases on the protected series LLC.
- Liability and Fiduciary Duties
Under the Delaware LLC Act, members are not liable for the liabilities of either a protected series or an LLC. However, Delaware and most other states do allow for a member to be designated as liable for the liabilities of the LLC in either the Certificate of Formation or the Operating Agreement, although almost no LLCs choose to do this. Additionally, as the Delaware LLC Act provides, the company generally is not liable for the liabilities incurred by its cells, and protected series are not liable for liabilities incurred by other cells therein, or the company generally. When the rubber hits the road and there is a problem, it is possible that bad facts may make bad law. In the event of fraud, or other limited circumstances, it is possible for a judge to get creative and allow a creditor recourse against all LLC assets. To avoid problems, it is best to keep your LLC free of unscrupulous activities or any activity that may be a lightning rod for liability. The series in general is better suited to “cold assets” that are passive and unlikely to result in injury to a third party. It is also wise and advisable to have (1) a well-crafted Operating Agreement, (2) a history of booking transactions into separate protected series records, and (3) documentation of Agreements between protected series for transactions conducted between protected series.
Regarding the fiduciary duties that members and managers owe to both the LLC and each other, Delaware allows for fiduciary duties to be reduced or heightened in the Operating Agreement. However, members of a cell are subject to the same default fiduciary duties in protected series LLCs as they would be in regular LLCs. It should also be noted that it is possible that a majority of controlling members of one cell may owe duties not only to the minority members of that cell, but possibly other cells, depending on how the protected series is organized. There may be separate cross duties of loyalty and care between cells to look out for. For example, a manager of a protected series LLC may wear many hats as manager of each individual cell and should be aware of conflicts that could arise.
Protected Series LLCs Doing Business in "Non-series" States
When cells do business in non-series states, it is best that they limit their activity and exposure. A majority of cells surveyed are using their cells in more than one state. One idea is to establish a cell of the LLC in each state where you do business and be particularly careful when you use multiple LLCs in any particular state without series provisions with the understanding that should there be a lawsuit, you will need to explain the series concept to a judge that is likely unfamiliar with the concept.
Protected Series LLCs Tomorrow
- Model Protected Series Provisions
Currently, the Uniform Law Commission has a Uniform LLC Act, which every state has adopted in some form. This Uniform LLC Act has no series provisions. However, the Uniform Laws Committee does currently have a “Series of Unincorporated Business Entities” Committee, which “will draft series provisions that can be added to some or all of the uniform unincorporated business organization acts other than the Uniform Statutory Trust Act”, as well as adding series provisions to the USTEA.
- 50 States
Once a Uniform series LLC Act is created and endorsed by the Commission, it is likely that more states will start adopting the protected series LLC. Many states have been waiting for just this endorsement. Other states that are rich in oil and gas reserves have already adopted the legislation because it is a favored method to develop natural gas exploration projects, where each project or different phase of a project is designated into a particular cell.
The states have adopted two approaches to the protected series. In the Delaware model, only one entity is filed. No series needs to be specifically filed or designated with the State of formation. In the Illinois model, each cell must file a certificate of designation and pay a fee for each additional series. All other states with the series LLC have followed the Delaware model except for Illinois, Missouri, and Montana, yet many states have modified it slightly. Therefore if you form a series LLC, it is best to do so in Delaware.
Delaware is not only exporting its series LLCs to other states, but also around the world. In a recent poll of 1,000 series LLCs, 20 percent of the respondents were using their series LLCs outside the United States. Reviewing the names on some series, they appear to be used in solar farms, wind turbines, gas development and primarily by the energy sector. Many are also using the series LLC for global real estate investments.