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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.

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By John Cunningham, October 25, 2010 10:02 am

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.

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By John Cunningham, October 18, 2010 8:52 am

In my view, any LLC operating agreement you draft should be understandable to any reasonably well-educated client on a careful first reading.

The only types of operating agreement provisions to which, in my view, this rule should not apply are provisions:

• That deal with highly technical matters such as federal income taxation; and

• That can only be expressly in a legally adequate way through the use of technical terms (such as the partnership tax term “qualified income offset”).

To comply with the above rule of “maximum intelligibility on the first bounce,” you obviously have to write operating agreements in good American English prose. What constitutes good American English prose is, of course, a subjective judgment.

However, I suspect that many good writers would agree that if an provision in an operating agreement breaches any significant rule of style or usage in either (i) Strunk and White, The Elements of Style, or (ii) Bryan A. Garner, Garner on Modern American Usage, it’s not good American prose. These two books constitute my bible on issues of operating agreement style and usage. I highly recommend them to you.

I’ve tried to capture the most important of the rules in the above two books in an exhibit that is included both in my Aspen book entitled Drafting Limited Liability Company Operating Agreements and in the Wolters Kluwer book I’ve co-authored with Vernon Procter of the Delaware bar entitled Drafting Delaware LLC Agreements. This exhibit contains a list of 20 rules. You can access these rules by clicking here.

But as I’ve indicated, there is an element of subjectivity both in choosing “bibles” of good American style and usage and in choosing the rules in these books that are the most important. Thus, I’ll greatly appreciate your comments on the choices expressed in this blog and in the attached list.

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By John Cunningham, August 19, 2010 6:45 am

For the past several weeks I’ve been hard at work writing a law journal article that seeks to answer the above question under the Massachusetts LLC Act. 

I’ve concluded that in order to be able to form LLCs competently under that act, you need to possess a rather shockingly large amount of business organization law knowledge. 

Specifically, I’ve concluded that in order to handle non-tax choice of entity for your LLC formation clients, you need to know (i) the chief business organization law features of LLCs under the Massachusetts LLC Act and (ii) the similarities and differences among these features and those of all other types of Massachusetts business organizations. 

And I’ve concluded that in order to competently plan, negotiate and draft operating agreements for your clients you need to know:

• The provisions of the Massachusetts LLC Act that are relevant to LLC formation practice (which, by my count, comprise 152 provisions);
• Whether each of these provisions should be characterized as definitional, mandatory, default, non-self-enabling permissive or self-enabling permissive;
• The tactical significance of these characterizations in forming Massachusetts LLCs;
• Massachusetts LLC case law relevant to LLC formations;
• The “gap issues” in Massachusetts LLC law—i.e., the issues on which this law is silent or ambiguous (so that, in the operating agreement, you won’t overlook any of these issues);
• The principal business organization law issues relevant in Massachusetts LLC formations (so that you won’t overlook any of these issues) and the various alternative methods of resolving each of these issues in your clients’ best interest;
• The rules of Massachusetts LLC law that govern Massachusetts LLCs that lack operating agreements (so that you can explain to your clients why they absolutely need to have these agreements); and
• The potential adverse impact of these rules on Massachusetts LLCs and their members.

If the above question is one that you yourself have thought about, I’d be very grateful for your reactions to the above list.  In putting the list together, have I gotten just a bit carried away?

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By John Cunningham, July 24, 2010 8:01 am

The tools you need the most in your LLC formation practice are model operating agreements.  As discussed in the last two posts in this blog, these include general-purpose and special-purpose model agreements. 

What purposes should these model agreements be designed to fulfill?  In my view, they should be designed to provide you with optimum assistance in addressing each of the four main tasks you must perform in forming LLCs. 

1. Issue identification.  They must assist you in identifying with your LLC formation clients all of the legal and tax issues likely to be significant for them in the operating agreements for the LLC they want you to form.
2. Issue resolution.  They must assist you in determining with your clients the best way to resolve each of these issues in the operating agreement in your clients’ best interest.
3. Negotiation.  They must assist you in effectively negotiating these terms on behalf of your clients with the other parties to the formation.
4. Drafting.  They must facilitate your drafting of operating agreements in a manner that accurately and enforceably reflects the outcome of these negotiations.

Well-designed model operating agreements provide you with optimal assistance in  accomplishing all four of these tasks.  In future posts in this blog, I’ll explain how.

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By John Cunningham, July 19, 2010 10:50 am

The words we use to discuss a topic can exercise a subtle tyranny over the way we think about that topic.  And if the topic is one that involves action, these words can exercise a subtle tyranny over how we act in respect of the topic.

This is true with regard to the topic to which this blog is devoted—namely, LLC formation practice.  If you don’t use the right terms in thinking about LLC formation practice, there’s a risk that you won’t properly think about that practice or properly conduct it.

To illustrate:  People sometimes ask me if I can give them a “good LLC form” for, say, an LLC under the Arkansas LLC Act.  

In my view, this question makes no sense.  It’s as if one carpenter were to ask another, “Hey, can you lend me a tool?”  Obviously, the first carpenter’s request will be meaningless unless he specifies the type of tool he wants; and if he can’t do that, he’s a terrible carpenter.

It’s the same with LLC lawyers.  In my last post in this blog, dated July 10, 2010, I expressed the view that there are five quite distinct types of forms that lawyers need in order to be well-equipped for their LLC formation practice.  These are:

• General-purpose model operating agreements;
• Special-purpose model operating agreements;
• Model non-tax plug-in provisions;
• Model tax plug-in provisions; and
• “Miscellaneous” forms.

However, the usual understanding of the term “LLC form” among LLC lawyers—basically, that “forms” mean “general-purpose model operating agreements”—can exercise a subtle tyranny over how they think about their LLC formation practice and how they conduct it.  More specifically, the term may tend to keep them from focusing adequately on the fact that there are many different basic types of LLCs; that each of these LLC types needs its own general-purpose model operating agreement; that there are many specialized types of LLCs; that each of these specialized types of LLCs needs its own special-purpose model operating agreement; that operating agreements based on general-purpose and special-purpose model operating agreements often need substantial tailoring through the use of tax and non-tax plug-in provisions; and that many of these operating agreements need to be accompanied by exhibits in the form of bylaws, agreements with managing members and other specialized forms.

The only way to overcome this subtle tyranny is to get analytical.  To do so, ask yourself these questions:  “Wait a minute, what do I mean by ‘LLC form’?  Is it possible there’s more than one basic type of LLC form?  Is it possible that there are five basic types.”

Because there are.

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By John Cunningham, July 10, 2010 1:23 pm

What forms do you need for your LLC formation practice? 

I addressed this question in my March 23, 2010 post in this blog, but since that date, my thinking about the question has significantly evolved.  My current thinking is that you need five distinct types of forms.  These forms are listed below.  I’ll be grateful for any comments you may have on this list.

1)     General-purpose model operating agreements.  You need general-purpose model operating agreements.  These model agreements should be designed to provide a basis for planning, negotiating and drafting all of the basic types of operating agreements that any LLC formation client is likely to need for any purpose (except the purposes addressed in the special-purpose model operating agreements discussed below). 

The best way to organize general-purpose model operating agreements is on the basis of their three main structural features—namely, (i) their ownership structure, (ii) their management structure and (iii) their federal income tax structure.  If you organize them this way, you will find that there are 10 main types of LLCs (click here for a list of these types); and you will find that you need 28 specific general-purpose model operating agreements.  For a list of these 28 model agreements, click here. 

In the summary and detailed tables of contents after the title page in each general-purpose model operating agreement and in the captions of its provisions, each of these agreements should identify all principal legal and tax issues relevant to the type of LLC for which the agreement is designed.  The tables of contents of the agreement should provide you with a comprehensive issues checklist in handling LLC formations. The provisions of each model agreement should provide you with optimal starting-points for resolving each of these issues. 

For an example of a general-purpose model operating agreement for multi-member LLCs, click on the “forms” button of the top navigation bar of this blog and then click on the button marked “Form 6.2.”

2)     Special-purpose model operating agreements.  Depending on your practice, you probably need one or more types of special-purpose model operating agreements.  These may include, for example, model agreements for (i) husband-wife LLCs; (ii) Delaware series LLCs; (iii) promoter-controlled and investor-controlled investment funds; and (iv) LLCs whose members want short-form operating agreements. 

3)     Model non-tax plug-in provisions.  You need a wide variety of model non-tax plug-in provisions that you can copy and paste into operating agreements you are drafting on the basis of general-purpose or special-purpose model operating agreements.  The purpose of these plug-in provisions is to supplement or replace the standard non-tax provisions in these model agreements when these provisions don’t meet your clients’ needs.  Examples of model non-tax plug-in provisions are (i) right-of-first-offer and right-of first-refusal provisions; (ii) drag-along and tag-along provisions; (iii) provisions to eliminate fiduciary duties in Delaware LLC agreements; and (iv) securities law compliance provisions.

4)    Model tax plug-in provisions.  You need various model tax plug-in provisions.  These are individual model provisions or sets of related model provisions on federal and state tax issues that you can copy and paste into general- and special-purpose model operating agreements to meet special tax needs of your clients.  Model tax plug-in provisions include, for example, (i) sets of plug-in provisions under IRC §§ 704(b) and 704(c)(1)(A); (ii) plug-in provisions under Prop. Reg. § 1.1402(a)-2 that will enable your clients to avoid the Self-Employment Tax on their shares of LLC income; and (iii) plug-in provisions for tax matters partners. 

5)     Miscellaneous forms.  You need miscellaneous forms, including (i) forms for articles of organization or similar documents to file with relevant state officials to create LLCs; (ii) bylaws for use by LLCs with corporate management structures; and (iii) documents, in the form of attachments to operating agreements, which set forth the rights and duties of managing members and management committees.

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By John Cunningham, April 26, 2010 9:10 am

In my April 13, 2010 post in this blog, I expressed the view that even though, by definition, the members of single-member LLCs completely dominate their LLCs, written operating agreements can nevertheless provide three valuable benefits to these members—(i) these agreements can trump default rules of the governing LLC act that are adverse to single-member LLCs but that would otherwise govern them; (ii) they can serve as users’ manuals for the members concerning the nature and operation of their LLCs; and (iii) they can provide valuable documentation to potential lenders, tax authorities and other third parties about who is authorized to sign LLC contracts and about other significant LLC legal and tax issues.

In a response to a related post, attorney Thomas Beckett has suggested a fourth important benefit that an operating agreement can provide to the member of a single-member LLC—namely, that it can help to support the member’s position that the member and the member’s LLC are separate and distinct legal persons that exist independently of one another.  This, in turn, can reduce the risk that, on alter ego grounds, a court will pierce the veil of the single-member LLC and hold the member personally liable for claims against the LLC.

I could not agree more with attorney Beckett, and I’m quite grateful for his comment.  I confess that I’m also a bit embarrassed by it.  As he himself points out, the potential value of operating agreements in helping the members of single-member LLCs resist veil-piercing claims is one that I myself have made in my Aspen LLC formbook and practice manual.  I should have mentioned attorney Beckett’s point in the above post.  But I want to at least make three follow-up points that I believe will support Mr. Beckett’s excellent comment:

1)     A few years ago, Professor Robert B. Thompson of Vanderbilt Law School reported in a law journal article extensive case law research showing that the shareholders of single-shareholder corporations are far more at risk of veil-piercing that the shareholders of corporations with two or more shareholders.  The same principle undoubtedly applies to the members of single-member LLCs.  Thus, even more than the members of multi-member LLCs, these members and their lawyers should do all they reasonably can to protect themselves from the risk of veil-piercing.

2)     I know of no case specifically supporting, either directly or by analogy, an argument that the existence of an operating agreement can help the members of single-member LLCs resist veil-piercing.  However, such an agreement certainly can’t hurt.  And it’s one more consideration, even if not a compelling one, for the members of single-member LLCs to pay the modest legal fees that LLC lawyers are likely to charge for a well-designed operating agreement.

3)     I believe the above argument may have particular force in the case of single-member LLCs whose members are entities.  In a forthcoming post, I’ll explain in some detail why I think so.  However, briefly, the reason is that if these entities clearly define in operating agreements the nature of their duties toward their single-member LLCs and if they comply with these duties, I can’t help thinking that a court will give at least some degree of weight to this compliance in a veil-piercing case—notwithstanding that the court and everyone else knows that the member could amend the agreement and terminate these duties in the blink of an eye.

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By John Cunningham, April 13, 2010 3:57 pm

In my last post, I summarized a number of arguments sometimes made by lawyers and legal scholars and even by clients for the proposition that single-member LLCs don’t need operating agreements.

All of those arguments are plausible.  However, for most single-member LLCs, the arguments for the opposite position are stronger.  In this post, I’ll briefly state these arguments as applicable to single-member LLCs whose members are individuals; but essentially the same arguments apply to single-member LLCs whose members are entities.

1)     The need for written operating agreements to trump LLC statutory provisions that are inappropriate for single-member LLCs whose members are individuals.  LLC acts are written primarily for multi-member LLCs, and many of their mandatory and default provisions are inappropriate for single-member LLCs whose members are individuals.  These include, for example, the mandatory provision in almost all LLC acts that LLCs cannot exist as legal persons unless they have at least one member; the default provision in almost all acts that LLCs are managed by their members; and the default provisions in most or all acts that members shall be dissociated (i.e., their memberships shall terminate) if they become bankrupt or incompetent or if they assign their entire LLC interest to other persons.

In subsequent posts, I will explain why these and other typical LLC statutory provisions can do fatal damage to single-member LLCs whose members are individuals.  For now, suffice it to say that the only fail-safe means to avoid this damage is through written operating agreements.

2)     The need for written operating agreements as users’ manuals.  Operating agreements for single-member LLCs whose members are individuals can, if they are comprehensive, well-organized and written in plain English, serve as invaluable “users’ manuals” providing these members with a clear idea of the nature of their LLCs before they form them and with practical operating instructions once they have launched them.  In my experience, clients don’t like to have to think of their LLCs as black boxes; they want to understand them and they want to know how to administrate them.  For this, they need well-designed written operating agreements.

3)     The need for written LLCs in dealings with third parties.  Operating agreements can greatly facilitate relations between, on the one hand, an LLC and the individual who is its member; and, on the other, third parties such as banks, parties to business transactions with the LLC and tax authorities.  All of these third parties are likely from time to time to ask individuals who are members of single-member LLCs for legally valid documentation concerning, for example, the identities of persons with authority to bind their LLCs and concerning the tax and financial structures of these LLCs.  Written operating agreements provide this documentation.

In short, drafting written operating agreements for your single-member LLC clients isn’t just good business for you as an LLC lawyer; these agreements can also provide invaluable legal and tax tools to your clients.

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By John Cunningham, April 5, 2010 11:38 am

There are currently about 9 million U.S. LLCs in good standing.  IRS filing statistics suggest that about 3 million of them are single-member LLCs.  Perhaps 95% of these single-member LLCs are owned by individuals and 5% by entities.

Do these LLCs need operating agreements?  Indeed, does the concept of operating agreements for single-member LLCs even make sense?

These questions are important, since, among other considerations, if single-member LLC operating agreements really are legally meaningful and of practical utility to clients, they should constitute a legitimate and profitable little line of business for LLC lawyers.  In my view, it’s legitimate for lawyers to charge between $500 and $1,000 for drafting operating agreements for single-member LLCs owned by individuals and significantly more for those owned by entities.  But obviously, if single-member LLCs aren’t legally meaningful, then charging clients for drafting them would be unethical.

It’s often argued by reputable LLC lawyers and scholars that operating agreements for single-member LLCs don’t make sense.  This is because, by definition, the members of single-member LLCs totally dominate their LLCs.  Thus, arguably, there can be no meaningful offer and acceptance between a single-member LLC and its member and thus no legally meaningful contract between them.

Furthermore, even assuming that single-member LLC operating agreements can somehow be legally valid, what possible purpose can they serve?  Stated otherwise:  Who ever heard of a shareholder agreement between a single-shareholder LLC and its owner?  So why might single-member LLCs need operating agreements?

I believe that the above arguments, though plausible, are wrong, and I believe that most single-member LLCs need operating agreements.  In my next post, I’ll explain why.