The limited liability company (LLC) is often applauded for its flexibility and for the lack of statutory formalities required, such as bylaws and annual meetings. But, this freedom can be a double-edged sword if the LLC members simply rely on the default state law provisions to provide the operating rules for the company. Recent changes to the LLC laws in California and Florida highlight the importance of drafting an operating agreement that govern the company’s operations and specifies right and responsibilities of the members.
Most states require only minimal information, such as the name of the company and its registered agent, on the articles of organization. The details regarding the structure and operation of the LLC are left to the members. Ideally, the members adopt a written an operating agreement. This agreement, which is binding upon the members once it is signed, should specify:
- how the LLC will be managed —by its members or by managers (who may or may not be members)
- how the management team will be selected
- how key business decisions will be made
- what actions require a vote by the members (and what percentage is required for approval)
- what are the duties and responsibilities of the members
- how are profits and losses allocated among the members
- what is the procedure for transferring ownership interests or bringing in additional members
- what triggers the disassociation of a member
- what events (if any) will trigger dissolution of the company
Failing to adopt an LLC operating agreement Is no one's “default” but your own
Every state has provisions governing limited liability companies. A number of states adopt provisions of the Revised Uniform Limited Liability Company Act (“RULLCA”) or its predecessor the Uniform Limited Liability Act, although each state has its own peculiarities. While only business attorneys relish wading through the nuances of the state statutes, every business owner must know one critical fact: state statutes establish the default provisions for an LLC.
If the LLC members do not adopt an operating agreement, or if the agreement fails to cover every essential area, then the default provisions of the state LLC law kick-in. These provisions will control how the LLC is structured and operates. And, when (not "if") the law changes, the LLC may find itself operating under rules that the members did not envision when the company was created. For these reasons, a comprehensive operating agreement is a practical necessity—even if it is not a legal requirement in the formation state.
As an example, consider the LLC’s management structure. In general, an LLC can be managed by all of its members or the members can vest management power in one or more “managers.” In many states, an LLC is not required to state its management structure in its articles of formation. And, even in states that require a declaration, the scope of authority and responsibilities do not need to be enumerated. In most states, the default form of management is “member-managed,” which means all the members must agree on all the business decisions. It also means that all members have the authority to bind the LLC by entering into contracts with third-parties. The LLC operating agreement can override the default presumptions by affirmatively stating the form of management and specifying the scope of authority of the management team. Addressing these issues in the operating agreement ensures that the company is managed the way the members wish it to be.
Suppose, you are fine with the default provisions. Why bother to draft (or have an attorney draft) an operating agreement. Smaller businesses often fall into this way of thinking. One reason to draft an agreement is to "future-proof" your company. Recent changes in California and Florida law illustrate what can happen when LLC members took the path of least resistance in drafting their operating agreements.
Florida’s old LLC statute permitted “managing members,” a hybrid of member-managed & manager-managed. The new statute, which applies to newly formed LLCs and will apply to all existing LLCs after December 31, 2014, eliminates “managing-member-managed” LLCs. Any existing LLC with that form of management will find itself governed that the default “member-managed” provision unless it amends its operating agreement.
California LLCs may also find their management changed by amendment to the LLC law that took effect at the beginning of this year. The new law imposes new restrictions on the authority of LLC managers: decisions that are outside the normal course of business now require unanimous approval of all the members. California LLCs can avoid these restrictions by adopting (or amending) an operating agreement that enumerates the authority of the managers and describes what is considered an extraordinary transaction.
Stay on top of law changes by proactively reviewing your operating agreement
Management of the company is only one area where state default provisions can conflict with the LLC members’ vision of how their company should operate. The only way to guarantee that LLC functions as the members want is to adopt an operating agreement that covers all the essential areas, from management to financial. The operating agreement should also be reviewed on an annual basis to ensure that it still reflects the member’s wishes and addresses all areas where the members want to override the default provisions of state law. It may be advisable to consult with a business attorney who is well-versed in the state law that governs the LLC because subtle changes that a layperson might overlook can have a significant impact on the company’s operations and the members’ responsibilities.