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CHAPTER 3

The Limited Liability Company Operating Agreement

The third part of the sources of authority trilogy is the LLC’s operating agreement. An operating agreement is a written agreement containing rules and procedures that address such things as meetings of members and managers, officers, quorums, and notice requirements for meetings. While there is no magic number of pages or provisions that an operating agreement must contain, a good operating agreement should be comprehensive.

As long as members and managers are in accord, little attention is paid to the formal requirements and procedures found in the operating agreement; however, the more members, managers, and officers, the greater likelihood of disagreement and the need to resort to the operating agreement.

For example, assume that your LLC has three members and is manager-managed. Historically, each member has worked well with the others. Now, however, one of the members has rebelled. For whatever reason, the member no longer agrees with the other two and refuses to sign consent resolutions or cooperate with LLC decisions. When all members of an LLC agree on all matters, the management of an LLC is simple: most decisions would be made with unanimous consent resolutions without formal meetings. When members disagree and wish to assert their individual rights, the members and managers must turn to the operating agreement to determine the procedures for resolution. In our example, the operating agreement will dictate the rules for calling, noticing, and conducting a meeting.

We must revisit an important difference between corporations and LLCs. That difference is that corporations are always managed by representatives appointed by shareholders, who are not involved in operations. LLCs, as we noted above, can be operated by their members in the manner of a partnership or by an appointed group of managers in the manner of a corporation. This fundamental difference means that whichever election an LLC makes—to be member-managed or manager-managed—will dictate what manner of operating agreement it adopts. As these two types of LLCs will be governed differently, their operating agreements will differ. So, in this chapter, we discuss both member-managed and manager-managed LLCs, and at the end of the chapter are two sample operating agreements. Remember that an LLC can change from one form of management to the other as its needs change.

The following issues concerning members, membership, and their rights are commonly addressed in an operating agreement:

• Authority of the members or managers to fix the location of the LLC’s principal executive office

• Location of members’ meetings (either the LLC’s principal place of business or wherever the managers or members may choose)

• Time for annual members’ meetings, usually designated as the “second Monday of December” or “February 1” or in similar language

• Manner of calling special meetings of the members

• Minimum percentage ownership that can call a membership meeting (typically 10 percent to call a special membership meeting), in order to prevent calling meetings to discuss insubstantial or nuisance matters

• Manner in which members receive notice of meetings (e.g., by a written notice mailed or personally delivered to all members not more than 60 nor less than 10 days before the meeting)

• Minimum quorum required to take a membership vote, usually more than 50 percent of the outstanding percentage interest unless the operating agreement or articles set a higher percentage

• Voting at member meetings, including such issues as cumulative voting, record date, proxies, and election inspectors (all of which are discussed in later chapters)

For a manager-managed LLC, the operating agreement will cover a wider range of topics. It will typically address issues pertaining to the managers or board of managers, including the following:

• Management structure (managers organized as a committee or a board or not at all, typically each manager having one vote, regardless of management structure)

• Powers and authority of the managers

• Number of managers and the qualifications required

• Manner of electing managers and length of terms

• Procedure for filling managerial vacancies

• Procedures for calling regularly scheduled or special meetings of the managers

• Manner in which the board can act without meeting, by written consent or written resolution

• Standard of care that managers must exercise when dealing with the LLC or with each other

Operating agreements may also address optional maintenance matters, including these:

• Restrictions regarding loans to or guarantees of manager or member debts

• Persons authorized to sign LLC checks

• Required records and reports

• Maintenance and inspection of LLC records

• Procedures for amending the operating agreement

As you can see, operating agreements cover a lot of territory. Operating agreements provide technical rules of procedure. Your operating agreement should be tailored to fit your LLC. Because so many provisions of the limited liability company acts can be modified by the operating agreement, you should actively participate in creating your agreement. If you don’t, you could lose flexibility and be burdened by procedural safeguards that you don’t want.

For example, you own more than 50 percent of TonoSilver, LLC and Jane and Joan together own 49 percent. You wish to sell TonoSilver, LLC, but Jane and Joan don’t agree. Over cocktails, you learn from a lawyer friend that under the state statute a sale requires only a majority vote of the members; that statute favors you, since you control a majority. As the lawyer drifts away, she suggests that you check the LLC operating agreement to see if the simple majority requirement has been modified. So you dust off the operating agreement that you acquired when you bought your LLC minute book and you are appalled to learn that your proposed sale of the business requires a two-thirds member approval and not a simple majority. You think, “I would never have agreed to that.” No sale.

This brings us to an important point. How can founders of an LLC ensure that management or ownership will never fall into the hands of incompetent or unwelcome persons? Because LLC ownership is property, it can be passed in a will, sold, or given away, possibly to someone whom the other members would consider undesirable. It is possible for founders to exert control over the manner in which LLC interests are passed to third parties. We cover these issues in Chapter 7: Agreements to Control Ownership and Management.

HOW IS AN OPERATING AGREEMENT MADE EFFECTIVE?

First of all, an operating agreement can become effective only after articles of organization are filed. Until then, there would be no legal entity for the operating agreement to govern. Members can prepare and sign an operating agreement before filing their articles of organization, but the operating agreement will become effective only after the articles are filed. Alternatively, the organizers of the LLC can file the articles of organization and enter into an operating agreement soon thereafter; this is more typical. So, either concurrently with the filing of the articles of organization or soon thereafter, the members of an LLC join to either prepare or review a proposed operating agreement. Once they agree to the operating agreement, they execute it just as they would execute a contract. In the manner of a contract, the operating agreement binds the parties to certain responsibilities to the LLC and to each other.

The operating agreement goes into effect when it is executed by the members. The operating agreement also serves to “admit” members to the LLC—much in the way that partnerships require additional owners to be admitted by the current owners. The sample LLC operating agreements that we have included in this chapter contain clauses that require the current members to approve new members by majority vote. The operating agreement should also serve to document both the amount of the capital contribution of each member and the percentage interest held by each member.

When a new member is admitted into the LLC, that person should execute a copy of the operating agreement (because he or she must necessarily agree to be bound by it), and the amount of his or her capital contribution and percentage interest should be recorded.

HOW DO YOU AMEND YOUR LLC’S OPERATING AGREEMENT?

Generally, under state law the board of managers retains the right to amend or repeal an LLC operating agreement. However, articles of organization or operating agreements can contain optional provisions that require approval by the members to amend all or certain portions of the operating agreement. The sample operating agreements at the end of this chapter require member approval to amend the agreement.