Unlike corporations, which are not required by law to have stockholders agreements (no matter how advisable that may be for its owners), limited liability companies formed in New York are required to have a written operating agreement. The requirement for a written agreement puts New York in a distinct minority of states – while several require operating agreements, most that do permit them to be written, oral or implied.
As the agreement of a limited liability company is required to be entered into before, at the time of or within ninety days after the filing of the articles of organization, the company is necessarily newly formed, and its owners may not want to invest significant time, effort and expense in drafting a lengthy operating agreement when they may be unsure of the viability of the business. As a result, we are often asked by clients to prepare a “simple” operating agreement. But how “simple” can a simple operating agreement be, and is entering into such an agreement advisable?
To start with, the New York Limited Liability Company Law (the “LLCL”) does not provide much detail as to what an operating agreement consists of. Section 102 of the LLCL defines an operating agreement as “any written agreement of the members concerning the business of a limited liability company and the conduct of its affairs and complying with section four hundred seventeen of this chapter.” Section 417 provides just a general guide for what should be in an operating agreement: “the members of a limited liability company shall adopt a written operating agreement that contains any provisions not inconsistent with law or its articles of organization relating to (i) the business of the limited liability company, (ii) the conduct of its affairs and (iii) the rights, powers, preferences, limitations or responsibilities of its members, managers, employees or agents, as the case may be.”
The simplest operating agreement would be one that provided the names, addresses, and the value of initial capital contributions of each of the members and incorporated by reference the default provisions of the LLCL. As a one page document, such an agreement would certainly satisfy a client looking for an inexpensive operating agreement. But would it work?
Operating agreements generally deal with three types of issues, namely management of the company, transfers of interests in the company, and financial/tax issues. As discussed below, the default provisions of the LLCL deal with these issues, but not in a way that is necessarily expected or desirable.
A limited liability company can be managed by one or more managers (if the company’s articles of organization so provide) or by the members themselves. As we are drafting with simplicity as the goal, the company will presumably be member managed, so that we don’t have to deal with how managers are elected and removed and what issues, if any, need to be approved by the members. Assuming our client wants all decisions to be made by a simple majority vote based on the members’ respective ownership, then our simple agreement does the job. Section 402(a) of the LLCL provides, “Except as provided in the operating agreement, in managing the affairs of the limited liability company, electing managers or voting on any other matter that requires the vote at a meeting of the members pursuant to this chapter, the articles of organization or the operating agreement, each member of a limited liability company shall vote in proportion to such member’s share of the current profits of the limited liability company …”, and Section 402(f) states, “Whenever any action is to be taken under this chapter by the members or a class of members, it shall, except as otherwise required or specified by this chapter or the articles of organization or the operating agreement as permitted by this chapter, be authorized by a majority in interest of the members’ votes cast at a meeting of members by members or such class of members entitled to vote thereon.” In other words, the default is majority approval, voting by ownership (not per capita, or one vote per member).
As a technical aside, note that the vote is by a majority of the votes cast as a meeting. If a majority owner is present at a meeting (thereby providing a quorum), but abstains from voting on a matter, that matter could still be approved by a majority of the votes cast, even if such votes were not a majority of the outstanding membership interests.
While the default voting provisions may work, there is one customary management-related provision that is missing from our simple agreement – namely a provision requiring the indemnification of members with respect to claims arising out of the operations of the company. While Section 420 of the LLCL provides that a limited liability company may indemnify and hold harmless members, the LLCL does not require it to do so. As a result, if, for example, a member signs a contract on behalf of the company and then finds himself named in a suit by the other party as a result of having done so, he will be forced to count on the good will of his fellow members with regard to any defense and settlement costs (note that the Business Corporation Law authorizes a court to award indemnification if a corporation fails to do so; there is no corresponding right in the LLCL).
Transfers of Interests
Most business owners are familiar with the ownership and transfer of shares of corporate stock. Absent unusual circumstances, the transfer of a share of stock conveys both the right to vote such share and the financial rights associated with it, such as the right to a pro-rata share of dividends payable by the corporation. The LLCL, however, contains a trap for the unwary, and use of our simple agreement may result in unintended consequences.
Generally speaking, most owners of non-publicly traded businesses do not want the equity interests of their company to be freely tradable. Being told by your now former partner that he’s given his 50% interest in your company to your ex-spouse is presumably not good news. However, like the Business Corporation Law, the LLCL does not preclude transfers of membership interests – only a provision in an operating agreement can do so (in fact Section 603(a)(1) clearly states that unless otherwise provided in an operating agreement, “a membership interest is assignable in whole or in part”). So unless the members are prepared to have new unknown and unlimited co-owners, our simple operating agreement is, to put it simply, too simple.
Having said that, it’s not all bad news. Unlike transferring shares of stock, in the absence of a provision to the contrary in the operating agreement, a transfer of an interest in a limited liability company does not, to the (sometimes unfortunate) surprise of many, convey any rights other than economic rights. Section 603(a) goes on to state, “an assignment of a membership interest does not … entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights or powers of a member” and that “the only effect of an assignment of a membership interest is to entitle the assignee to receive, to the extent assigned, the distributions and allocations of profits and losses to which the assignor would be entitled.” Section 604(a) further provides, “Except as provided in the operating agreement, an assignee of a membership interest may not become a member without the vote or written consent of at least a majority in interest of the members, other than the member who assigned or proposes to assign such membership interest.”
What happens to those non-economic rights, such as the right to vote and inspect books and records? They don’t remain with the transferring member – they simply cease to exist. As provided in Section 603(a)(4), “a member ceases to be a member and to have the power to exercise any rights or powers of a member upon assignment of all of his or her membership interest.”
The net effect of all of this is that the original members may end up with some silent partners, which most business owners would find to be less than an ideal situation. The remaining original members could, for example, be working to benefit a competitor, and at the very least could be working to benefit someone who contributes neither effort nor cash to the business. While the operating agreement could address this issue by, for example, prohibiting transfers outside of the existing members or making any transfer subject to a first refusal, our simple agreement will allow transfers of economic rights to anyone the transferee may choose.
Putting aside the default rules of the LLCL, a normal operating agreement deals with a number of transfer scenarios that the simple agreement does not address. A more fulsome operating agreement usually requires the sale of a member’s interest upon his or her death or disability, and may require sale of a member’s interest if that member ceases to render services to the company, whether as the result of retirement, resignation, or termination by the other members for cause or gross cause.
In terms of death or disability, the remaining members usually do not want to be growing the company for the benefit of non-working heirs, and the heirs usually desire a buy out as the income of the deceased member will have ended. As to work related buyouts, many individuals assume that if a member commits a bad act (whether simply not showing up for work or something as drastic as embezzlement), they can simply terminate the wrongdoer. However, while they may be able to cut off compensation to the wrongdoer, he or she remains the owner of their equity in the company and cannot be divested of their ownership without consent. Absent appropriate language in an operating agreement, two members may continue to devote their full time to growing the business, while the third member relaxes at the beach, content to not receive a salary, but awaiting their share of the operating profits and a payday down the road when the business is sold. So long as the relationship of the members remains harmonious, the simple agreement may work, but using it could make getting a business divorce much more painful and expensive than it would otherwise need to be should issues arise.
Another concern that our simple agreement does not address is the effect of having members which are entities. For example, rather than having three individuals as members of a company, the three individuals may desire to hold their interest through their own entities. One reason for doing so would be to facilitate estate planning by transferring interests in the entity-member. The other members would continue to deal with the entity-member, and would not have to deal with the initial owner’s estate planning transferees. However, holding interests in an entity also gives the owner of that entity the right to do something indirectly that he or she couldn’t do directly – namely make transfers of an entire membership interest, including voting rights. If an individual owned a 25% interest in his or her name and then sold it to a third party, as discussed above the transfer would convey only economic rights, without the other rights that come with being a member. If, on the other hand, the individual owned the 25% interest through an entity, the individual could very easily sell the ownership of that entity to a third party. The owner of the 25% interest would not change (the only change would be with respect to the owner of that owner), meaning that since there was no transfer of that interest, there is no loss of any rights associated with that interest upon the transfer of the underlying interest. The other owners would now be dealing with a new full partner, not just a silent one.
One final thought on this issue – without a provision dealing with the death of a member, the surviving members will now have a new partner – the heirs of the deceased member, a situation that no one may be happy with. The survivors will be continuing to devote their efforts to the success of the business, something the heirs may play no role in, and they may resent having to share the fruit of their efforts with someone who makes no contribution. The heirs, on the other hand, will having no voting rights. While this may be reasonable if they own a relatively small portion of the equity, consider the situation where the deceased member owned, for example, 75% of the equity. What 75% owner would want to have a 0% say in how the business is run?
So while our “simple” agreement can work, it is rare that the members will be agreeable to the application of the default rules of the LLLC with respect to transfers of membership interests. The inability to prohibit even economic transfers (or, as a practical matter, any transfers by a member that is an entity), the inability to remove members under appropriate circumstances, and the loss of voting rights upon the death of a member are all problematic results of using the simple agreement.
The LLCL contains a number of default provisions that will work if our members have a truly simple financial structure in mind, with no obligation to make capital contributions other than the initial contributions upon formation of the company, and all allocations of profits and losses and all distributions being made pro rata based on equity ownership. The LLCL doesn’t require a member to make any capital contributions other than those he or she promised to make. Section 503 provides that “[i]f the operating agreement does not so provide, profits and losses shall be allocated on the basis of the value, as stated in the records of the limited liability company if so stated, of the contributions of each member” and Section 504 states, “[i]f the operating agreement does not so provide, distributions shall be allocated on the basis of the value, as stated in the records of the limited liability company, if so stated, of the contributions of each member.” As a result, our simple agreement will work for situations where the financial and tax understandings are equally simple.
However, if, as is often the case, the members want to require capital contributions beyond those made at formation or provide for preferred returns or allocations or distributions that are not strictly pro-rata, our simple agreement will not suffice.
While the simple agreement may work with respect to contributions and how allocations and distributions are to be made, there is one very important issue that it does not address, namely the making of tax advances. Assuming the limited liability company is taxed as a partnership (which is usually the case), each member will receive a K-1 for his or her share of the company’s profits, regardless of whether they actually receive any distributions from the company (what is known as “phantom income”). The LLCL does not require the making of distributions prior to dissolution; to the contrary, in Section 507 it expressly defers this issue to the operating agreement: “to the extent and at the times or upon the happening of events specified in the operating agreement, a member is entitled to receive distributions from a limited liability company before his or her withdrawal from the limited liability company and before the dissolution and winding up of the limited liability company.”
While presumably each of the members will want to cause the company to distribute at least as much cash as is needed to avoid having reach into their own pocket to pay taxes on the company’s profits, there may be situations where the members don’t cause the company to make tax advances. A legitimate reason may be a prohibition in a (badly negotiated) loan agreement, or because the members truly desire to accumulate cash in the company for working capital or other proper purposes. However, not making tax advances is better known as one of the more typical ways that majority owners can freeze out minority owners, particularly minority owners of lesser means than the majority. By not distributing funds sufficient to pay taxes, the majority can put the minority in a position of having to either pay such taxes out of personal resources or sell their interests to the majority. While maliciously engaging in such tactics may give rise to a lawsuit by the minority owner, the much better approach would be to mandate tax advances in the operating agreement. Our simple agreement, however, is too simple to provide for this.
Finally, our simple agreement does not contain any of the customary tax-related provisions that a more complete agreement would have, such as those dealing with the establishment and maintenance of capital accounts, not requiring members to restore deficits in capital accounts, various regulatory allocations under Section 704 of the Internal Revenue Code (including “qualified income offset,” “minimum gain chargeback” and “partner nonrecourse debt minimum gain chargeback” provisions), and the appointment of a tax matters representative. The ramifications of the absence of these provision is beyond the scope of this article.
So is there such a thing as a “simple” operating agreement? Certainly. The LLCL’s default provisions, particularly majority voting, no obligation to make capital contributions, and pro-rata distributions and allocations, are often components of the comprehensive operating agreements we routinely draft. But does a “simple” operating agreement make sense? That’s an entirely different issue. The ability to make even just economic transfers without consent, the lack of required tax advances, and the loss of voting rights on death are some default provisions that many owners would find problematic. In addition, common business terms such as being required to make additional contributions, preferred or priority returns, prohibitions on or rights of first refusal with respect to transfers, and supermajority voting on significant actions all require an agreement that goes beyond the bare minimum. The answer is to draft an agreement that works both when you sign it and when circumstances change – an agreement that anticipates events that may happen, rather than assuming they won’t. The best time to discuss and negotiate an operating agreement is when the entity is being formed, when the owners are aligned and before differences arise; if agreement on these issues can’t be reach at inception, it’s certainly not going to happen after issues have arisen and the company has grown to be worth fighting over. As the attorneys in our Litigation Practice Group will confirm, simple doesn’t necessarily mean better, and a few dollars spent up front can save many dollars down the road.