If you engage in LLC practice long enough, you will eventually be asked to draft an operating agreement that effectively gives continuing control of the LLC to the “dead hand” of the patriarch or matriarch in control of the LLC after his or her death. Some of the issues in this drafting challenge are addressed in the attached post by Peter Mahler in his wonderful blawg called “Business Divorce.”
Category: Operating agreements
LLC operating agreements are primarily tools to define and enforce the rights and duties of LLC members and managers with respect to their LLCs. These agreements should also be effective pre-formation teaching tools that will help prospective members and managers decide whether to join LLCs, and they should be effective post-formation users’ manuals that guide LLC members and managers in operating their LLCs.
In order to accomplish any of these goals, operating agreements must be written in plain English, and they must avoid legalisms. The latest American Bar Association Journal contains an excellent article by Bryan Garner, the leading U.S. expert on legal prose style, in which he lists the 12 legalisms he hates most. In my experience, many LLC lawyers make constant use of these legalisms in drafting operating agreements. They shouldn’t.
To read Bryan’s article, click here.
If you’re drafting an operating agreement to maximize the chance that you can attract a highly competent manager to manage the LLC in question or if you’re drafting or reviewing a draft of an operating agreement on behalf of a prospective manager, you need to know a lot about advancement and indemnification provisions in operating agreements and about the hidden issues in these provisions. If you don’t already possess this knowledge, here is an excellent place to start.
Here’s a practice issue I ran into this morning:
Clients for whom you’ve written LLC operating agreements sometimes ask you to amend them. These amendments often take the form of a one- or two-page amendment document with signature blocks for all existing members and for any new ones who are coming on board.
But the greater the number of amendments and the greater the complexity of individual amendments, the more you should be thinking about offering to prepare for your client an “amended and restated” operating agreement—i.e., a revised agreement that integrates into a single, clean revision of the operating agreement all existing amendments to the agreement and any new ones the client is planning. This will make it much easier for the members and for third parties to understand the agreement; they won’t have to flip back and forth among the agreement itself and one or more potentially complicated amendment documents in order to do so.
And drafting the amended and restated agreement might be a nice fee for you.
Lexology is a blawg published by the Association of Corporate Counsel. It is a good source for updates about business law statutory and case law developments both in the U.S. and abroad. I follow it because occasionally it has worthwhile posts about LLC issues. For a current Lexology post on the issue whether LLCs need written operating agreements, click here. The attached post also has a link to an interesting post about California’s new LLC act.
The post under the above link states that only five states—namely, California, Delaware, Maine, Missouri and New York—require operating agreements. I find this interesting, but the fact is that while Delaware does require that LLCs have operating agreements, it doesn’t require that they be written. Thus, I’m a bit skeptical about the above statement as to the other four states mentioned in it.
The obvious reason why clients who are members of multi-member LLCs should have written operating agreements is to provide a secure basis for resolving internal disputes. However, my view (reflected in the New Hampshire Revised Limited Liability Company Act) is that while most smaller multi-member LLCs don’t have written operating agreements, many of these LLCs do have oral or implied operating agreements. I think state LLC acts should respect these agreements despite the obvious risk that they may be difficult or impossible to prove.
Most LLC formations of multi-member LLCs have at least a few unusual features that require special legal attention, and the parties you represent in these formations will often have unique personal needs and interests with respect to their LLC. Tailoring operating agreements to address these realities can take substantial legal work and thus can result in substantial legal fees. But many clients who refuse to authorize this work and to pay these fees will eventually be very sorry that they didn’t.
For an excellent post illustrating these points, read the most recent post in Peter Mahler’s superb blawg entitled New York Business Divorce.
The above subject is excellently addressed in the attached current blog post by Peter Mahler on the basis of a recent decision by a New York appeals court. The post discusses, among other things, an article I wrote in the New Hampshire Business Review in 2012 on the rationale of the New Hampshire legislature for amending New Hampshire’s LLC statute to permit oral and implied operating agreements.
Even for small LLCs, operating agreements that address all the relevant issues can be lengthy and complex and can cost a lot in legal fees. If your LLC clients complain about the prospect of having to pay those fees, you should be prepared to point out to them all of the definitional, default, non-self-enabling permissive, and self-enabling permissive provisions in your home state LLC act that they may not want to govern their LLC deal but can effectively override only in a written operating agreement.
But of course, in order to provide that analysis, you need to have a thorough knowledge of these provisions. In essence, this requires that you create (i) a comprehensive master table of the provisions of your LLC act governing LLC formations; and (ii) sub-tables for each of the five main categories of those provisions—namely, mandatory provisions and, as noted above, definitional, default, non-self-enabling permissive and self-enabling permissive provisions.
Chapters 34 and 35 of my Wolters Kluwer book contain these tables and sub-tables for, respectively, the Delaware and Massachusetts LLC acts, and I’ve created and will soon be publishing tables under the New Hampshire Revised Limited Liability Company Act in the New Hampshire Bar News. You may find these tables useful as templates in preparing the necessary table and sub-tables under your own act.
A very recent decision by the Delaware Court of Chancery has held, in essence, that when an individual leaves his LLC and tells his former members he won’t compete against them and then does compete against them, the LLC can’t obtain an order prohibiting his competition despite his lie. The lesson is that if you want to obtain a non-compete against a former member of an LLC, you have to be very clear about this in your operating agreement.
A number of bloggers have posted comments on this somewhat shocking decision, but in my view, the best comment is by Doug Batey. You can access this comment here. Doug also provides a link to the decision.
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 “188.8.131.52.” 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.
Many LLC operating agreements, including those drafted by outstanding lawyers and law firms, begin with a section that consists of definitions of key tax and non-tax terms used in the agreement. These definitions often number in the dozens.
I may be a minority of one on this point, but I strongly believe that such a definitional section is exactly the wrong way to start an operating agreement.
Here, in a nutshell, is my thinking on this issue:
1) A primary goal for lawyers in drafting an operating agreement for an LLC should always be to make these agreements as easy as possible for their clients and relevant third parties to understand. (Relevant third parties may include, for example, lenders and, if there is ever a serious dispute among the LLC’s members, a judge or arbitrator.)
2) If the first section of an operating agreement consists of nothing but definitions, clients who review it are likely to be glassy-eyed after reading even a few of these definitions; and this may deter them from reading the rest of the agreement. This deterrent effect on clients will be especially strong to the extent that the definitions in question are of esoteric partnership tax terms such as “partner minimum gain” and “offsettable decrease.”
3) Instead, the definitions in operating agreements should appear in the same sections of these agreements as the terms they define. If you draft operating agreements this way, your clients won’t to have to flip back and forth between your definitional section and the other sections of the agreement in order to understand the meaning of these terms as they arise in these other sections.
4) Thus, for example, any operating agreement you draft should normally contain a section that provides relatively numerous and detailed rules concerning:
• The authorizing and making of interim and liquidating distributions by the LLC; and
• The amount and timing of these distributions.
Under the above drafting rule, you should include your definition of “distribution” in your distribution section. You should not include it in a set of definitional provisions at the beginning of the agreement.
If you’d like an illustration of how I think defined terms should be positioned in operating agreements, click on the button marked “LLC Forms” in the top navigation bar of this blog and then click on “Form 6.2.” For an illustration of how to position the definition of “distributions” in operating agreements, look at Section 5 in that form.
I’m not saying that it is never a good idea to include in an operating agreement a comprehensive list of all of the defined terms in the agreement with citations to the provisions of these agreements where these terms are defined. Rather, at least on rare occasions, such a list may be useful to your clients and their lawyers.
However, in my view, the best way to provide such a list is in a separate exhibit at the end of the agreement—not in a massive and repellant clutter of definitions starting on page 1.