Comments (0)

By John Cunningham, January 21, 2012 10:58 am

As I mentioned in my first post in this blog on the subject of best practices in forming LLCs (published on January 16, 2012), it seems to me that authors of LLC formbooks and practice manuals worth their salt ought not merely to propose to their readers the practices these authors favor for use in forming LLCs or even to recommend these practices for this use.  Rather, they should provide their readers with what they believe to reflect LLC formation best practices; and they should explain to their readers why they believe them to be best practices. 

The reason, obviously, is that this is what, if they reflect on the matter, readers clearly want.  Obviously, if you ask these readers whether, in forming LLCs for their clients, they want do so as well as they reasonably can–i.e., at a high level of competence–their answer (even if they have not previously focused expressly on the question) will be a resounding yes.   But this means that what they want from such a book is not merely recommended or even clearly sound practices.  Rather; they want best practices. 

But validly classifying specific LLC formation practices specifically as best practices is no easy task.  This is because, in almost all cases, the best LLC lawyers and law firms—i.e., the ones most likely to be using the best LLC formation practices—cloak these practices (and all of their other legal practices) in secrecy.  In my experience, they almost never disclose them in any detail in law journal articles, in practice manuals, in CLE outlines or in any other source.

So what can be done by a person such as myself–a person intent on writing the best possible LLC formbooks and practice manuals—to overcome this cloak of law firm secrecy? 

Above all:

• We can scour the legal literature in the hope that the best law firms or the most skillful LLC formation lawyers have disclosed their secrets in these sources (even though we know in advance they probably haven’t done so);
• We can test our own considered ideas about best practices by seeking evaluation of them by other LLC lawyers we believe are forming LLCs for their clients with a high degree of competence; and
• We can test our ideas in blogs like this one and elsewhere on the Internet and in other public media–e.g., bar seminars–in the hope of receiving useful feedback from the community of LLC formation lawyers. 

Indeed, if we want to write good books about LLC formation practice, we must do all these things. 

The reason, obviously, is that this is what readers want.  Clearly, if you ask these readers whether, in forming LLCs for their clients, they want do so as well as they reasonably can–i.e., at a high level of competence–their answer (even if they have not previously focused expressly on the yes) will be a resounding yes.   But this means that what they want from such a book is not merely recommended or even clearly sound practices.  Rather; they want best practices. 

But validly classifying specific LLC formation practices specifically as best practices is no easy task.  This is because, in almost all cases, the best LLC lawyers and law firms—i.e., the ones most likely to be using the best LLC formation practices—cloak these practices (and all of their other legal practices) in secrecy.  In my experience, they almost never disclose them in any detail in law journal articles, in practice manuals, in CLE outlines or in any other source.

So what can be done by a person such as myself–a person intent on writing the best possible LLC formbooks and practice manuals—to overcome this cloak of law firm secrecy? 

Above all:

• We can scour the legal literature in the hope that the best law firms or the most skillful LLC formation lawyers have disclosed their secrets in these sources (even though we know in advance they probably haven’t done so);
• We can test our ideas about best practices by seeking their review by other LLC lawyers we believe are forming LLCs for their clients with a high degree of competence; and
• We can publish these ideas in books and in blogs like this one in the hope of receiving useful feedback from the community of LLC formation lawyers. 

Indeed, if we want to write good books, we must do these things. 

The reason, obviously, is that this is what readers want.  Clearly, if you ask these readers whether, in forming LLCs for their clients, they want do so as well as they reasonably can–i.e., at a high level of competence–their answer (even if they have not previously focused expressly on the yes) will be a resounding yes.   But this means that what they want from such a book is not merely recommended or even clearly sound practices.  Rather; they want best practices. 

But validly classifying specific LLC formation practices specifically as best practices is no easy task.  This is because, in almost all cases, the best LLC lawyers and law firms—i.e., the ones most likely to be using the best LLC formation practices—cloak these practices (and all of their other legal practices) in secrecy.  In my experience, they almost never disclose them in any detail in law journal articles, in practice manuals, in CLE outlines or in any other source.

So what can be done by a person such as myself–a person intent on writing the best possible LLC formbooks and practice manuals—to overcome this cloak of law firm secrecy? 

Above all:

• We can scour the legal literature in the hope that the best law firms or the most skillful LLC formation lawyers have disclosed their secrets in these sources (even though we know in advance they probably haven’t done so);
• We can test our ideas about best practices by seeking their review by other LLC lawyers we believe are forming LLCs for their clients with a high degree of competence; and
• We can publish these ideas in books and in blogs like this one in the hope of receiving useful feedback from the community of LLC formation lawyers. 

Indeed, if we want to write good books, we must do these things.

Comments (0)

By John Cunningham, January 18, 2012 8:09 pm

For purposes of LLC formation practice, I propose (subject to your comments as a reader of this blog) to define “best practices” as follows in quotes:

“A best practice in forming LLCs means a method of performing a particular task in the formation that meets each of these four tests:

1. It produces an optimal result.
2. It produces this result at least as reliably as any alternative method.
3. It is not inferior to any alternative method in any significant respect.
4. It is superior to all alternative methods in one or more respects.

What constitutes an “optimal result” in performing a particular task varies, of course, depending on the task in question.

In theory, there may be two or more methods of performing the task, both or all of which produce an optimal result. However, in this circumstance, one method may be better than the others because it is easier to learn, easier to implement or faster to implement than the other methods.

EXAMPLE. A key task in any LLC formation is non-tax choice of entity—i.e., the analytical process of choosing between LLCs and other types of business organizations for a business start-up on non-tax grounds (such as the strength of their liability shields, their ability to confer statutory charging order protections, or the legal and other costs of their formation and operation).

In my experience, the best method for doing non-tax choice of entity is, briefly, the following three-step method.

1. Determine which types of business organizations are available to the business start-up client in question under applicable state law. For example, the state-law business organizations available to an individual forming a single-owner business are, in most or all states, (i) sole proprietorships, (ii) single-shareholder corporations and (iii) single-member LLCs. To perform this step, you must, of course, have a complete list of potentially relevant state-law business organizations.
2. Identify the non-tax advantages and disadvantages of each of these organizations for your client. To perform this step, you must, of course, have a complete list of potentially relevant non-tax advantages and disadvantages. In the example, the obvious chief non-tax advantage of LLCs and single-shareholder corporations over sole proprietorships is that they provide liability shields, while sole proprietorships do not.
3. Choose among these organizations for your client by netting these advantages and disadvantages. In the example, the chief non-tax advantage of a single-member LLC over a single-shareholder corporation for most individuals forming single-owner businesses is the greater informality and flexibility of single-member LLCs, particularly with respect to their management structure.

In my experience, the above three-step method is the only method for doing non-tax choice of entity that will yield an optimal result. Thus, there is no need to compare this method with alternative methods before characterizing it as the non-tax choice of entity “best practice.”

It is true that, in seminars and other forums, lawyers sometimes suggest that non-tax choice of entity and tax choice of entity cannot be analytically separated in an LLC formation and thus must be done simultaneously. In my view, this position is manifestly wrong, since the factors relevant in non-tax and tax choice of entity are entirely different from one another. Thus, the two methods should never be mixed. Rather, you should apply each of the two methods processes independently of the other and should then reconcile any difference in outcome.

Comments (0)

By John Cunningham, January 16, 2012 1:00 pm

I’m currently preparing a third edition of Drafting Limited Liability Company Operating Agreements, my Wolters Kluwer LLC formbook and practice manual. The purpose of the Third Edition is to comprehensively and systematically implement in the book the concept of LLC formation best practices.

As you no doubt know, “best practices” is a concept in wide use in medicine, manufacturing and other non-legal fields, but not in the law. It is a concept that I want to be express, pervasive and unifying in my book.

In a series of posts in this blog, I will be presenting, as succinctly as I can, my key thoughts on the subject of LLC formation best practices as I develop them in drafting and revising the Third Edition. I’ll be very grateful for any comments you may have on these posts.

Comments (2)

By John Cunningham, March 3, 2011 10:06 am

What criteria should you apply in evaluating your state’s LLC act?

This is a trick question, since, as a practical matter, you should evaluate your Act on the basis of three quite separate sets of criteria.

A few points by way of background:

• First, we know from IRS filing information and other sources that in most or all states, about one third of all LLCs are formed as single-member LLCs by individuals; and we know that these individuals have little or no knowledge of LLC law, are not represented by lawyers with LLC competence, and in most cases do not adopt operating agreements for their LLCs.  I’ll refer to these individuals here as “unsophisticated individuals.”
• Second, we know from the same sources that in most or all states, most other LLCs are formed by just two or three individuals and that these individuals, too, are unsophisticated and generally do not adopt operating agreements.
• Third, the above sources make clear by implication that in most states (Delaware may be an exception), only a very small proportion of LLC founders (perhaps less than five percent) are “sophisticated” individuals and entities—i.e., individuals and entities that possess a solid knowledge of LLC law or whose lawyers possess this knowledge.

In my view, the above considerations lead remorselessly to the following four conclusions:

1. LLC acts should be drafted primarily to meet the needs of unsophisticated members whose LLCs have no written operating agreements.  This is not a matter of conservatism or liberalism; it is a simple matter of fairness.  Unsophisticated individuals don’t have the knowledge or the money to protect themselves in forming LLCs.  So the state has to help them.  Sophisticated individuals do possess this knowledge.  They don’t need the state’s help (except as I’ll explain below).
2. LLC acts should contain all of the mandatory and default provisions necessary to provide unsophisticated individuals who are forming single-member LLCs with a sound “off-the-shelf” operating agreement—i.e., an operating agreement whose provisions, taken as a whole, will work for more such individuals than any alternative set.
3. Similarly, LLC acts should contain all of the mandatory and default provisions necessary to constitute a sound “off-the-shell” operating agreement for unsophisticated individuals forming multi-member LLCs.
4. Finally, LLC acts should provide permissive provisions that endow sophisticated individuals with maximum contractual freedom to tailor their operating agreements to meet their needs and interests.  In practice, this means that these acts should contain all of the “flexibility” provisions of the Delaware Limited Liability Company Act—provisions that the Delaware corporate bar has diligently and skillfully developed over a period of almost 20 years.

What does all this mean as to the actual provisions that LLC acts should contain?  In subsequent posts, I’ll present my views about these provisions as applicable to (i) unsophisticated individuals forming single-member LLCs; (ii) unsophisticated individuals forming multi-member LLCs; and (iii) sophisticated individuals and entities.

Comments (2)

By John Cunningham, February 13, 2011 9:49 am

All human beings, including even LLC lawyers and their LLC formation clients, are by nature aesthetic animals.  They are hungry for beauty, and they look for beauty in whatever they behold.  And if they find it, they are more receptive to its non-aesthetic contents than they might otherwise be. 

In the case of LLC formation clients, “what they behold” includes operating agreements.  So what can you do to make the operating agreements you draft for your clients more beautiful?  Below are some tips.  (I’ve sought to implement all of these tips in the operating agreements you can access by clicking on the “LLC Forms” button in the top navigation bar of this blog.)

1)     Formality and dignity.  Beauty is inherently formal and dignified.  Think of a Bach fugue or a Cezanne landscape.  So start your operating agreements with a title page that states the title of the agreement and its date.  This title page will give a formality and dignity to the agreement that will support its aesthetic pleasingness.

2)     Simplicity.  Though its parts may be complex, beauty in its essence is simple.  So use a clear and simple system for denoting the parts, sections, subsections and sub-subsections of your operating agreements.  Thus, for example, don’t include in the agreement sub-subsections such as “2.7.3.4.”  I see this method of numbering provisions in operating agreements all the time.  It’s not only confusing and irritating.  It’s complicated and it’s ugly.

3)     Tranquility.  Beauty is tranquil.  So use a lot of white space in your agreements.  White space rests the eyes of people studying the provisions of your agreements and enables them to read them tranquilly.

4)     Order and unity.  Beauty has an inner order and unity.  So start each of your operating agreements (after the title page) with a summary of contents and a detailed table of contents, and use headings to clearly denote these parts of the agreement and each other part, including the body of the agreement and each of its exhibits.  And clearly denote the various parts within the agreement’s body—e.g., its statement of the parties, its statement of background, its terms and conditions and its signature blocks.  This will not only help readers navigate the agreement and find what they’re looking for in it; it will give them a sense of the agreement’s beauty.

5)     Variety.  Beauty is enhanced by variety.  So use a beautiful font in the text of the provisions of your operating agreements—this this will generally mean Times New Roman—but vary font types in the agreements depending on whether the words in question in them constitute titles, tables of contents, section headings, or subsection headings.

6)     Prose style.  Use a beautiful prose style.  This means writing your agreements in plain English (even the tax provisions to the extent possible) and avoiding ugly legalisms such as “whereas” and “hereinafter” and “recital.”  In general, if you’re thinking about using a word in your agreement that only lawyers use, don’t use it.

Comments (2)

By John Cunningham, January 11, 2011 8:50 am

In my LLC practice, I often run across LLCs whose ultimate owners hold their LLC memberships through single-member LLCs.  They do this because they think that they are obtaining two significant benefits—greater anonymity as LLC owners and an extra layer of statutory liability protection.

EXAMPLE.  Arthur Able and Bill Baker are equal members of AB, LLC.  AB, LLC, in turn, holds real estate with a fair market value of $1 million.  Arthur holds his AB membership directly in his own name.  Bill holds his through a single-member LLC named “Cosmic Holdings, LLC,” of which he is the sole member.

I think the above ownership structure creates a serious trap for Bill.  One of major benefits of holding property in an LLC is that all U.S. LLC acts except that of Pennsylvania provide LLCs and their members with statutory charging order protections.  (And I understand that Pennsylvania case law provides charging order protections for Pennsylvania LLCs and their members.) 

I will write about charging order protections at greater length in future posts.  However, in essence, LLC statutory charging order provisions provide that if a creditor holds an unsatisfied judgment against a member of a multi-member LLCs on the basis of a claim unrelated to the LLC’s business:

• The creditor may obtain a lien (a “charging order”) against the LLC on the debtor-member’s right to receive distributions of LLC profits, requiring the LLC to distribute to the creditor any LLC profits it would otherwise distribute to the member to the extent of the judgment.
• However, the creditor may not levy on the debtor-member’s voting rights or other management rights in satisfaction of the claim.

In my view, the fact that LLC statutes provide for charging order protections and that corporations do not is the single greatest business organization law advantage of LLCs over corporations.    

To explain:  In the above example, Bill, as noted, holds his ownership in AB through a single-member LLC.  What this means as a practical matter is that if Bill accidentally but negligently runs over and kills a brain surgeon on business unrelated to the LLC and the brain surgeon’s estate obtains a $20 million judgment against him, the estate can levy on his single-member LLC membership; it can obtain Bill’s voting rights; and, by exercising deadlock voting power, it can force the LLC to sell its assets and distribute Bill’s share of the proceeds to the estate.  This is because charging order protections only protect LLC members; they do not protect the members of single-member LLCs that are members of multi-member LLCs.

By contrast, assume that Arthur is the AB member accidentally killing the brain surgeon.  In this situation, charging order protections will enable the estate to obtain a charging order against AB, LLC; but, because Arthur holds his membership in AB directly, the estate cannot obtain Arthur’s voting rights and thus cannot force AB’s dissolution.

In short:  Think long and hard before advising your LLC formation clients to hold their memberships in multi-member LLCs through single-member LLCs.  First, your client will thereby lose charging order protections.  Second, as a practical matter, he won’t need a second liability shield; so why bother with a single-member LLC?  Third, in any law suit, the “anonymity” he thinks he will obtain through his single-member LLC will quickly turn out to be worthless.

Comments (0)

By John Cunningham, December 31, 2010 12:05 pm

If your LLC formation practice is like mine, you probably find yourself from time to time having to assist clients in the creation of LLCs that will operate regularly in two different jurisdictions. In this situation, a key threshold question is this: Under which of the two relevant state LLC acts should the LLC be formed; and under which should it be registered as a foreign LLC?

Because I am licensed to practice law both in Massachusetts and in New Hampshire and because my law firm has offices in both states, I regularly address the above question under the Massachusetts and New Hampshire LLC Acts, and I recently published an article in the New Hampshire Bar News comparing the two acts from an LLC formation viewpoint. I realize for many readers of this blog, these two acts won’t be relevant. However, I feel confident that the general guidelines presented in the article may be useful not only to Massachusetts and New Hampshire lawyers but also to readers in other states. You can access the article here.

Comments (1)

By John Cunningham, December 22, 2010 9:13 am

In the last post in this blog, dated November 27, 2010, I discussed the potential business asset protection value for many privately owned companies that presently hold their assets and conduct their business through a single entity of adopting a new two-entity parent/subsidiary structure. In this restructuring, the subsidiary should be a single-member LLC taxable as a “disregarded entity.”

In implementing this restructuring, what should be your goals in drafting the operating agreement between the parent and the single-member LLC? I suggest you should have the two main goals summarized below:

1. You should draft the operating agreement so as to provide the parent company and its owners and relevant employees with a clear and comprehensive statement of the legal and tax structure of the single-member LLC, including, especially, its financial and management structures. This statement will be indispensable to the single-member LLC’s managers in administrating and operating the LLC. It may also be indispensable in dealing with third parties that deal with the single-member LLC, such as federal and state tax auditors and potential lenders.

2. To minimize the risk of veil-piercing, you should make clear in the operating agreement the essential separateness of the parent and the single-member LLC. The operating agreement can do much to accomplish this goal—e.g., by documenting the compliance of the LLC with the anti-veil-piercing “adequate capitalization” requirement and by providing in its management provisions that all day-to-day decisions of the single-member LLC will be made by its own internal managers and not by the parent.

However, it may be also be useful for this anti-veil-piercing purpose to formalize, in the operating agreement or in separate intercompany agreements, all other arrangements between the parent and the single-member LLC—e.g., arrangements, if any, for centralized accounting and marketing.

Comments (0)

By John Cunningham, November 27, 2010 4:17 pm

Protecting business assets through parent/subsidiary structures—overview. As a general rule, business entities that own valuable business assets and conduct business operations that could lead to third-party claims should not conduct these operations directly.

Rather, unless there are significant considerations to the contrary, it should hold these assets directly but should conduct its operations through a wholly owned subsidiary entity, and it should lease, lend or license its assets to this subsidiary. Under a properly structured parent/subsidiary structure of this kind, if the subsidiary’s operations give rise to a third-party claim, the parent, if it has not participated in the subsidiary’s operations, should not be subject to the claim and its assets should not be at risk for the claim.

Companies that decide to create parent/subsidiary structures must choose between two types of entities as their subsidiaries—namely, single-member LLCs and single-shareholder corporations. In most cases, the better choice is single-member LLCs. These entities, like single-shareholder corporations, can provide their parents with a strong statutory liability shield. However, because single-member LLCs are subject to no significant statutory formalities, they are simpler to manage than single-shareholder corporations (which are subject to numerous such formalities) and they face a lesser risk of veil-piercing than single-shareholder corporations.

In addition, under applicable default statutory rules, the very simple management structures that can be provided for in the operating agreements of single-member LLCs owned by entities is generally much more user-friendly than the default statutory management structure of single-shareholder corporations.
Illustration. To illustrate the parent/subsidiary structure outlined above:

XYZ, Inc. manufactures and sells widgets. Its annual gross sales receipts are $20 million. It owns tools, vehicles and equipment (its “Hard Assets”) worth $5 million; it owns valuable patents, trademarks, copyrights and trade secrets (its “Intellectual Property”); it has average receivables during its fiscal year of about $ 1million; and it maintains in its bank account about $1 million as operating capital.

As long as XYZ’s board is willing to accept the modest additional complexities involved in operating through a subsidiary rather than through XYZ as a single unitary entity, XYZ should restructure itself as follows:

• It should create a single-member LLC (“XYZ Operations”—
which I’ll refer to here simply as “Operations”) to conduct
all of its product design, manufacturing and sales
operations.

• It should lease its hard assets to Operations.

• It should license its Intellectual property to Operations.

• It should lend to Operations the operating cash that
Operations needs.

Finally, in order to document its separateness from Operations and thus to minimize the risk of claims from business activities of Operations, XYZ should formalize all of its significant relations with Operations in written agreements that contain arm’s-length terms. These agreements should include a lease agreement; a licensing agreement; a loan and security agreement; a licensing agreement; and, last but not least, an operating agreement governing the relationship between XYZ as the parent of Operations and Operations as its subsidiary.

The operating agreements of single-member LLCs owned by entities. What should be the goals of the operating agreement between XYZ and XYZ Operations? I will address this question in my next post in this blog.

Comments (1)

By John Cunningham, November 20, 2010 10:54 am

In my experience, there are three—and only three—management structures likely to be useful to individuals who form single-member LLCs. These are (i) management by the individual; (ii) management by the individual together with one or more assistant managers; and (iii) management by a third party. (Needless to say, if you have a different view about this issue, I would be grateful to hear from you in a comment on this post.)

In forming a single-member LLC for an individual, how should you, as an LLC lawyer, choose among these three management structures? The choice will generally be an easy one.

• Single-member LLC whose only manager is its member. If, under your client’s articles of organization or other statutory formation document and under the governing operating agreement, you form your client’s LLC as a “member-managed” single-member LLC, this arguably means as a matter of LLC statutory law that only the member may sign contracts and take other management actions on behalf of the LLC. This, in turn, may mean as a matter of law that if, because of death, illness or other causes, the member is unable to act as the LLC’s manager, no one can so act. In other words, it may mean that the LLC completely lacks continuity of management; and more particular, in the case of the death of an individual who is the member of single-member LLC, it may mean that the LLC may be managed only under the direction of a probate court. .

• Single-member LLC with a member-manager and a non-member assistant manager. Thus, to provide for continuity of management in a single-member LLC whose member is an individual, (i) you should provide in the governing articles of organization or equivalent document (if you are required to state the LLC’s management structure in this document) that the LLC is manager-managed; and (ii) in the LLC’s operating agreement, while appointing the member as the LLC’s member-manager, you should also appoint a third party trusted by the member (who will often be the member’s spouse) as a non-member assistant manager. And you should make clear in the operating agreement the precise circumstances in which this assistant manager will have authority to manage.

• Single-member LLC whose only manager is a non-member manager. However, it may sometimes happen that an individual who is the member of a single-member LLC does not want to manage the LLC. This may occur, for example, if the member holds real property in the LLC and does not want property management responsibilities or liabilities.

In this situation, you should provide in the articles of formation (i) that the LLC is manager-managed; (ii) that the member is a non-manager member; and (iii) that the only manager of the LLC is a specified third- party non-member manager. (But you should also normally provide that the member may replace this manager at will.)