Operating Agreements – the lifeblood of the LLC

  1. The Operating Agreement.

Like any corporate entity concerned with limiting future liability, all LLCs are governed by a constituent document generally referred to as a “limited liability company [operating] agreement.  These agreements are intended to provide for the corporate governance of the LLC and are intended to be specific as to the rights and obligations of its members as well as the purpose and authority of the LLC itself.

The operating agreement offers maximum flexibility to the client subject to general principles of equity. Principals have the option of varying agreement terms to suit their specific deal terms.  But the ability to make operating agreements unique is the reason why sometimes contributions don’t match distributions, the priorities of distribution is ambiguous, even the conditions pursuant to which a member may be admitted or expelled could be specific to the type of business and the role of the member.

Accordingly, unless the practitioner is actually precisely duplicating a prior deal with the same members, and the exact same deal documents, then the practitioner must approach each matter as one of first impression in order to become cognizant of any differences between the deals that the client may deem legally insignificant but could have a material effect on the outcome of the new operating agreement.

A couple caveats, this post:(i) isn’t a treatise on how to draft an operating agreement but hopefully it; it merely recognizes that the LLC business has evolved beyond the single member, single purpose LLC, and may include varying numbers of members with conflicting interests; and (ii) focuses on a few selected methodologies for creating effective operating agreements which feature fundamental requirements of contract (and, to some degree, tax law).

Don’t have time for a treatise anyway; I think my boss wants this posted by next week.

 

  1. How Important is the Operating Agreement

The Operating Agreement is perhaps the lifeblood of the limited liability company or LLC. It’s not that other constituent documents, contracts, agreements, policies and/or procedures entered into and/or adopted by an LLC aren’t critical components of an LLC’s business, but the operating agreement generally governs the LLC’s very ability or authority to even undertake such corporate actions.

There is no doubt that the LLC through statutory law and its own operating agreement offers significant corporate advantages to entities that can avail itself of some very real business, tax, operational and management advantages. Like the traditional limited partnership, an LLC also has the beneficial feature of an extremely useful pass-through income function that may be exploited in a myriad of ways for tax or other business purposes for the benefit of the LLC and its members.

The lack of statutory limitations on LLCs provides the practitioner with an incredible amount of latitude with respect to the operation of the LLC not normally permitted by the traditional corporation. Subject to principles of equity, it could be said that the LLC is the corporation unshackled.  And as the LLC continues to increase in popularity based largely on the freedom it affords participants in complex transactions, operating agreements have had to keep pace, and, therefore have become similarly varied in purpose and complexity.

So the construction of the operating agreement is critical, arguably almost as crucial as the determination of transactional terms between the contracting members.

Unfortunately, the flexibility afforded in the construction of an operating agreement is often the very reason the agreement doesn’t work as intended.  Forced creativity often leads to ambiguity and/or inconsistency. And whether it’s because of unreasonable client demands, professional pressure at work, or, sometimes, just plain old laziness, practitioners may sometimes take license with various sections of an operating agreement governed by laws or statute not superseded by the laws governing LLCs.

Ah, but therein lies the rub.

The question is not whether, but how does the practitioner institutionalize a process pursuant to which he can produce (perhaps a large volume of) LLC operating agreement that are specific, precise and fully satisfactory to his client.

Every agreement is unique but a good method should facilitate a beneficial result for all parties involved. I promise none of it is rocket science.

  1. Treat each Operating Agreement as a New Operating Agreement.

Treat each operating agreement as a new operating agreement. No assumptions. Regardless of whether you’ve worked with a client before, or it’s a new client, get as many as the principals in a meeting at one time to tell you the terms, all the terms.   Deals tend to change sometimes when all the principals meet at the same time with their attorney. I like to start a call with a “what’s new with you?” “what’s new with the business?, have you got any new prospects, partners?” I’ve personally been surprised over the years where a simple personal conversation with a client in an impersonal setting leads to significant changes to how I’ve approached managing the client’s legal affairs on a going-forward basis.

Clients don’t always appreciate the legal significance of new information or future plans. That interview should also include inquiries designed to elicit information the practitioner may believe relevant to the new deal that may not have been pertinent to prior transactions.

Lastly, let’s be honest, attorney’s, when faced with a new task of drafting an operating agreement, will usually seek out in his firm’s files a “similar” document on which to base the new agreement.  This is admittedly easy but sometimes a formula for disaster, especially if you didn’t draft the first agreement.

The obvious changes are easy for the novice attorney.. He compares the material deal terms of the found document to the term sheet of the current deal and proceeds to revise the document appropriately. Generally, this is a simple process. But frequently, when the document seems on point, the practitioner runs the risk of overlooking subtle differences driven by specific deal terms of the prior transaction in the more technical areas of the agreement thereby producing a document inconsistent with the client’s needs.

 

  1. Basic Contract Law

Regardless of the type of governing instrument used by a corporate entity (or the versatility its form may offer), basic contract rules developed over 250 years of jurisprudence always apply, and more importantly, govern. This isn’t always easy to explain to a client, but it’s necessary. The flexibility offered to drafting operating agreements does not obviate those requirements.  So it’s up to the practitioner to advise his client that he is not entitled to a member’s first born child should the member commit a material breach , but to advise him on the potential for injunctions, indemnifications and other damages. Similarly, the LLC must appoint a “Tax Matters Partner” and pay its taxes (and allocate taxable income to the capital accounts of its members). And contributions should match distributions, subject to deal terms, and the priority of allocations, if not properly documented, could lead to violations of state or federal tax laws.

  1. Tax

If you’re not tax counsel, have one at the ready. If your instincts tell you that you don’t fully grasp the tax-related consequences of an operating agreement, don’t guess, seek a consult. .

  1. Leverage the Experience Around You

Simple, if you don’t know or understand and you’ve exhausted your research sources, ASK YOUR COLLEAGUES.   Even if they haven’t experienced the type of agreement, attorney’s collaborating on something unique or spectacular can only result in the best result of the client.

  1. Don’t let the Client off the hook

Stay in constant contact with as many principals as possible. Transactions are fluid and the attorney is must keep the lines of communication open.  More communication will result in less drafts being produced and costs being reduced.