Thursday, April 17, 2008

Restrictive Covenants Among LLC Members

You've heard of buy-sell agreements among shareholders of closely held corporations. In the case of LLCs, the operating agreement is typically the place one finds restrictions upon transfer of LLC member interests. But why have them? A small business is much like a marriage. And one carefully chooses a spouse. If a member of your LLC is allowed to sell out to anyone of the member's choosing making the buyer of a member of your ownership group, that's a problem for the remaining members. They may be stuck to continue the business with a stranger or, worse, a disruptive individual they never would have freely chose to hook up with. This problem is magnified for LLCs that are managed collectively by the managers as opposed to having named managers who control the operation of the LLC. Any new member automatically becomes a member of the management team.

When a group of entrepreneurs trust each other implicitly at the start of a new business venture, they may think restrictive covenants among the members are unnecessary as one of their fellow members is not going to screw the LLC over by selling out. But consider the following: divorce, death, and bankruptcy. Forces beyond the control of a member may force him or her to sell. Best to plan for these eventualities on the front end so that the LLC may continue in business with the least disruption as possible should one of these events befall a member.

Another difference between corporate shareholder buy-sells and LLC restrictive covenants found in LLC operating agreements. For tax reasons, the LLC is typically the buyer of the LLC units of the departing member. Link. In shareholder buy-sell agreements, the shareholders typically purchase the stock of the departing shareholder individually.

Middle ground option. You the LLC members wish to prevent any individual LLC member from transferring his or her membership in the LLC outside of the current ownership group but you are reluctant to bind the LLC to mandatory purchase of an LLC interest upon the withdrawal, death, financial insolvency of a member. It's a legitimate concern. For an LLC whose business is thinly capitalized, the extra burden of buying out a departing member may well force the LLC into liquidation. Is there another option? Yes, forbid withdrawal or other transfer of member LLC interests. What happens upon the insolvency or death of the member? In these cases, the creditor or heirs of deceased member (as the case may be) only take the right to distributions held by the member but may not vote the LLC membership interest or otherwise exercise any rights of members. Here is a sample LLC operating agreement with restrictive covenants (see article VII). See also Online LLC Operating Agreement Form.

Wednesday, April 16, 2008

Fiduciary Duties of LLC Members

At common law, partners owe each other a fiduciary duty of loyalty and good faith. "A fiduciary has a duty to act primarily for the client's benefit in matters connected with the undertaking and not for the fiduciary's own personal interest." Link. "Loyalty" can be a nebulous concept to pin down but, with certainty, one can say that a partner is forbidden from competing against the partnership through an outside business venture and from converting partnership business opportunities to the partner's individual benefit. But limited liability companies are hybrids, not exactly partnerships nor corporations. What fiduciary duties, if any, do LLC members owe to each other? Can these be modified in a written operating agreement.

This variance from state to state on the topic but my general sense of the law prevailing in most states is that managers (be they members or not) owe a fiduciary duty of loyalty to the LLC; however, non-managing members owe no such duty. Further, the fiduciary duty of managers to the LLC can be altered by the operating agreement. The following is an overview of selected state LLC statutes on this subjective to present a better feel for how this shakes out.

California. Section 17153 of the California Corporations Code provides: "The fiduciary duties a manager owes to the limited liability company and to its members are those of a partner to a partnership and to the partners of the partnership." Link. See Section 16404(b) of the California Corporations Code for the specifics of fiduciary duties of partners under California law. "The fiduciary duties of a manager to the limited liability company and to the members of the limited liability company may only be modified in a written operating agreement with the informed consent of the members." Link.

Florida. "[E]ach manager and managing member shall owe a duty of loyalty and a duty of care to the limited liability company and all of the members of the limited liability company." Florida Stat. Section 608.4225(1). Section 608.4225 goes on in great detail relative to the specifics of the "duty of loyalty and duty of care". Under Section 608.423(2)(b), the LLC operating agreement may not "Eliminate the duty of loyalty under s. 608.4225, but the agreement may" change a few other elements of other duties owed by managers to the LLC.

Texas. " Texas law governing LLCs does not specifically address whether manager or member fiduciary duties exist or expressly define them. Therefore the existence of such a duty may be a question of fact dependent upon the unique circumstances of each case and determined by case law. The relationships of managers and members to a limited liability company are generally assumed to be fiduciary in nature." Web site of Tipton Jones, a Texas law firm. Although the Texas LLC Act punts on the issue of defining fiduciary duties for managers, it clearly states that any such duty can be modified by the LLC operating agreement: "The company agreement of a limited liability company may expand or restrict any duties, including fiduciary duties, and related liabilities that a member, manager, officer, or other person has to the company or to a member or manager of the company." Texas Business Organizations Code, Section 101.401.

Saturday, April 12, 2008

LLC Managers

Limited Liability Companies (LLCs) come in two basic varieties: (a) those managed collectively by the LLC members and (b) those managed by "managers" who are appointed by the LLC members. To complicate matters, LLC members can also be LLC managers. Let's take the common example of an LLC set up to own and operate an apartment complex. The owners of the LLC (i.e., the members) do not wish to handle leasing, maintenance, rent collection and all the other details that go with operating an apartment complex. Thus, they will hire a management company to run the operations of the LLC that owns the apartment complex. This post will walk through the legal paperwork necessary to set up this arrangement.

First step is filing articles of organization with the state of your choice. See California LLC articles of organization (scroll down to page 3) and Florida articles of organization. This page has links to the articles of organization for most states. You'll notice that in Florida, the managers must be named in the articles of organization. In California, as with most states, the LLC organizer merely checks a box indicating whether the LLC shall be managed collectively by the LLC members or by managers. In most states your LLC charter is issued the same day that it is filed with the appropriate state office. OK, now you have an official legal entity--an LLC. The next step is an LLC operating agreement. Prior posts on this blog discuss its contents so I'll not belabor the point. But in relation to managers, one issue is important to cover in the operating agreement: the division of responsibility between the LLC members and the managers. Is there a dollar cutoff for transactions the members must approve? Are there certain sorts of contracts that the members wish to reserve for approval (i.e., any contract with a duration over one year)? Without any boundaries set forth in the operating agreement, the power of managers to bind the LLC to transactions is theoretically limitless. I also think it is important for the operating agreement, in the case of managers, to set forth the grounds and mechanism for firing the managers.

The next step is appointment of the managers and setting compensation. This can be done in the operating agreement or a separate resolution of the LLC members. Either way, the specific management contract that is to be entered into between the management company (or individuals) and the LLC should be included and approved by the members. I'd attach the management contract as an exhibit. Here is an extensive LLC property management contract from the ABA. Make sure the management contract tracks any restrictions on the authority of the managers to bind the LLC contained in the operating agreement. Third parties dealing the LLC managers for any sizable transaction will certainly ask for a copy of the management contract but might neglect to ask for the LLC operating agreement. Putting restrictions on manager authority both places does the best job of putting third parties on notice of these restrictions. Other things to go in the management contract include the duties of the managers, compensation for services, and grounds for termination. Although it would be unusual in a property management contract, confidentiality agreements for business information of the LLC (such as customer lists) are often found in management contracts.

The last formality is execution of the LLC management agreement. One other potential requirement occurs for an LLC organized under the laws of one state (say California) but owning property or otherwise operating in another state (say Nevada). In this example, the California LLC would need to register as a foreign LLC in Nevada.

Thursday, April 10, 2008

Removal of LLC member

Single member LLCs are really sole proprietorships for which the law gives limited liability protection traditionally enjoyed by corporations. An LLC with two or more members is, at its core, a business marriage. And we know marriages can, and often do, go bad. The best course of action is to plan for a potential breakup. Amicable LLC breakups are easy enough to draft for in an LLC operating agreement. Either one member withdraws (see below article on member withdraw) or the members mutually agree to dissolve their LLC. What if there is no agreement between the members? Then we are faced with a contested business divorce and it can get ugly. When there are just two members, each with 50% ownership interest, there really is no way to resolve the issue. There is no majority owner with voting power to oust the minority. Dissolution based upon management deadlock is the ultimate resolution of the impasse unless the two members can agree on a course of action.

The most common situation I encounter involving a desire to remove a member is one where a member does not live up to his or her commitments to provide money or services to the LLC. See post on the topic. It is common for state LLC laws to prohibit removal of a member unless there is a written LLC operating agreement that specifically provides for removal. I should back up and emphasize the importance of your operating agreement specifically detailing what cash payments and services are to be provided by each member. A written operating agreement that leaves out these provisions is fatally defective.

You're first option, assuming the operating agreement plainly states that the member is to provide money or a service, is to sue the member for breach of contract. It's difficult to continue in business with a person who you had to sue in order to force him or her to live up to their commitments. The logical resolution of the problem is removal of the deadbeat member. And that is a sticky wicket to negotiate. First, the operating agreement must provide for removal under these circumstances. Second issue, can the moving members gather sufficient votes to remove the member? Here is the rub. Operating agreements commonly provide for removal of a member only upon a supermajority vote is required. Supermajority is generally anywhere from 60 to 90 percent. If the member you are trying to remove holds at least 41% of the ownership in the LLC, under some LLC operating agreements, you cannot remove him or her even if they have failed to provide the required capital contribution or services.

An alternative way to draft the operating agreement is that the member up for removal is barred from voting on the motion. Thus, if it takes supermajority for removal, this is determined without inclusion of the ownership interest of the member up for removal. For example, assume ABC LLC has three owners, two of whom (A & B) own 40% and last (C) holding 20%. Further assume ABC LLC has a provision in the operating agreement for removal of an LLC member who fails to provide services upon a 66% vote of members in interest. If the operating agreement excludes the ownership interest of the member up for removal from the calculation, then A and C members could vote to remove member B for failure to pay the required capital contribution. Although A & C together own only 60% of the interest in the LLC, they own 100% when the interest of B (the member up for removal) is not taken into consideration.

The downside of excluding the ownership interest of the member up for removal from the calculation of supermajority? A majority own is likely not to agree to such a provision. By doing so, he or she has agreed to summary mechanism for the majority member's removal from the LLC. Bottom line: if your LLC has more than one member, deal with the issue of removal of a member up front in your LLC operating agreement. The operating agreement should detail (a) the grounds for removal, (b) the actual mechanism for removal, and (c) compensation to the member upon removal for his or her LLC interest.

Friday, April 4, 2008

Planning For Withdrawal of a Member

One of the most important, but often overlooked, elements of an LLC operating agreement is provision for withdrawal of a member. In some states, an LLC member is not allowed to withdraw absent a provision in a written operating agreement specifically allowing for withdrawal. See Texas LLC law and Florida LLC law. In providing for withdrawal of a member from your LLC, two matters should be addressed: (a) the mechanics of withdrawal (when, where, and how notice of withdrawal is given) and (b) compensation to the withdrawing member. Of the two, compensation is the more difficult question. In Florida, if the LLC operating agreement does not specify the amount a withdrawing member is to receive, the withdrawing member is to receive "fair value" for his or her LLC interest. Florida Stat. Section 608.427(2). Sounds nice, the member who leaves gets what's "fair". The problem is that "fair value" is a nebulous term and difficult to arrive at precise calculation for assets that are not publicly traded. Hire five experts to determine fair value of a closely held business interest and you probably will be handed five different valuations. One option is to return the withdrawing member's capital account. Other options are formula's that can work either off of the capital account or the ownership interest. For example, member capital account multiplied by 110%. Or, LLC profits for the prior year multiplied by six and, then, by the member's ownership percentage. Formulas are hard to arrive at but they surely save much headache on the backend.

Thursday, April 3, 2008

What Goes Into An LLC Operating Agreement?

A limited liability company (LLC) is formed by filing articles of organization with a state that issues the charter. The articles are very basic. An LLC operating agreement is an agreement between the members (i.e., owners) of the LLC giving the operational details of the organization. Here is a survey for each state listing whether an operating agreement is required and, also, whether the LLC operating agreement must be in writing.

So your LLC has been formed. You've decided you wish to have a written operating agreement and, now, are faced with determining exactly what goes into the agreement. Let's start with the basic elements.
  • Name all the members.
  • List the initial capital contribution required by each member.
  • List what services, if any, are to be provided by each member
  • Allocation of profits and losses.
As to the initial capital contribution, the best course of action is to state specifically when the contribution must be made by the members and the penalty for failure to make the payment. Same with services: what is the penalty if a member fails to deliver the promised services? Lastly, the all important issue of profits and losses. Most LLC operating agreements state percentages of ownership for each member (sometimes expressed in units) with profits and losses divided according to ownership interest. But this is not required. When profits and losses of an LLC are not allocated based upon the ownership percentage, it is called a "special allocation". Corporations may not make special allocations of profits and losses while partnerships and LLCs can. However, special allocations must meet the substantial economic effect test set forth in IRS regulations. Get advice from a tax professional before attempting a special allocation.

Other recommended topics to be covered in an LLC operating include the following:
  • Expulsion of a member.
  • Admission of a new member.
  • Withdrawal of a member.
  • Death of a member.
  • How LLC member voting is conducted.
  • When the LLC is managed by managers, what matters are reserved for decision by the members.
  • Restrictions upon sale of LLC interests to persons outside of the current ownership group.
  • Restrictions upon LLC members participating in competing business ventures.
The list of topics that can go into an LLC operating agreement is quite expansive but, hopefully, the foregoing has covered the most common topics.

Sample LLC operating agreements: