Why Do Members Need LLC Operating Agreements and What Should Be Included in Them? Part I of III

Why Do Members Need LLC Operating Agreements and What Should Be Included in Them? Part I of III

 On October 23rd, I participated in a panel discussion relating to the LLC operating agreements. This was a webinar on drafting LLC agreements conducted by Financial Poise, a provider of CLEs and informational webinars for accredited investors, executives, and their legal and financial advisors. Preparation for the webinar made me think about the main differences between LLCs and corporations. So, I’ve decided to share my thoughts on what these differences are and what should go into an operating agreement in a series of posts.

I think of an LLC as a hybrid between a corporation and a partnership. Consequently, an LLC operating agreement is a hybrid between, on one hand, the corporate bylaws, charter and a shareholders agreement and on the other hand, a partnership agreement.

Internal affairs of a corporation are largely governed according to state statutes. For example, in Delaware the relevant statute is called the Delaware General Corporation Law, and in New York it is called the Business Corporation Law. This is not the case for LLCs. It is actually the opposite. The LLC state statutes provide default provisions that govern in the absence of corresponding provisions in the LLC’s operating agreements. So, in a sense, these are gap fillers, and in most cases, can be overridden by contract. Although registered with the state authorities, LLC internal affairs are governed by contract, which is called an “LLC agreement” or an “operating agreement”.

This is the reason why most jurisdictions require LLCs to have an operating agreement, although not all of these jurisdictions require it to be in writing (for example, in California and Delaware members can have an oral agreement, which in my opinion, is a recipe for disaster). In New York, Section 417 of the New York LLCLaw requires members to adopt a written agreement that is not inconsistent with the law or the LLC’s articles of organization. Note that according to Section 417, even sole member LLCs should have a written operating agreement. The NY law is silent about the consequences of not adopting an operating agreement, and since operating agreements are not public documents, I assume it is difficult to police.

Below are some illustrations of how LLC statutes typically work. For example, Section 402 of NY LLC Law says that unless provided in operating agreement otherwise, each member votes in proportion to its share of current profits of the LLC. Also, unless provided in operating agreement otherwise, a majority vote of all members is required for admission of new members, issuance of new LLC interests, approval of indebtedness other than in ordinary course, amendment to the articles of organization or operating agreement, approval of dissolution, or sale of all or substantially all assets of the LLC. Section 403 of NY LLC Law says that except as set forth in the operating agreement, LLC shall hold annual meetings. Sections 503 and 504 of NY LLC Law, respectively, say that unless otherwise provided in the operating agreement, each member is allocated profits, losses and receives distributions of available cash on the basis of the value of any contributions made. As you can see, an operating agreement can alter many of the provisions of the NY LLC Law.

This is why we see such a variety of LLC structures. Some LLCs resemble corporations. Their members are called shareholders, there is a board of directors, and the LLCs authorize and issue shares instead of membership interests. Other LLCs do not have shares at all, but rather their membership interest is expressed in percentages. Members may be passive investors, the LLC may be managed by members or by one or several managers, and profits and losses may be allocated disproportionately to the members’ percentage interests or the value of their contributions. There may be a priority waterfall with respect to allocations of profits and losses, distributions of available cash, and also distributions in the case of dissolution.

In Part II, I’ll go over the core provisions that each LLC Agreement should have or members should at least consider including.

Read more commentary from Arina Shulga on the legal aspects of operating new and growing businesses at Business Law Post.

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