Reviewing LLC Documents for
New or Existing Clients

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

This case study has been adapted from PPC’s Guide to Limited Liability Companies, 11th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II and Gregory A. Porcaro, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ((800) 323-8724;  ppc.thomson.com).

Practitioners will frequently be asked to review organizational documents for new or existing limited liability company (LLC) clients. When reviewing these documents, the nature of the client’s business, the relationships among the business’s owners and the owners’ short-term and long-term goals, should always be kept in mind. Practitioners have an opportunity to make a significant contribution to the drafting exercise because of their familiarity with their clients and their clients’ businesses.

The basic LLC documents a practitioner will be asked to review are the articles of organization and the operating agreement. To the extent these documents fail to address certain issues that may arise in the LLC’s operation it may be necessary to review other documents, including buy/sell agreements, capital contribution agreements, guarantee or indemnification agreements or supplemental operating agreements. All of these agreements, taken together, control the LLC’s operations. Most LLCs will have only articles of organization and an operating agreement. All of the provisions essential to the LLC’s operation can and should, as a practical matter, be contained in these two documents whenever possible.

A review of the LLC’s organizational documents should address the LLC’s relationship with its members, its operations, its capital structure, its management structure, and tax and economic issues. In this discussion, the articles of organization are assumed to provide only the minimal information required by statute, leaving all other details to be addressed in the operating agreement.

Getting Started

Practitioners need certain information to begin a review of an LLC’s articles of organization and operating agreement. First, they should make sure they understand the client’s goals. The slant of the practitioner’s review may be different, depending on whether the client is an individual who intends to manage the LLC or a passive nonmanaging member. Practitioners should also make sure they understand the specific relationships the members intend the documents to convey. For example, is it important for each member to participate in management? Is the LLC being formed for estate planning purposes? Should a member have the right to withdraw from the LLC at any time and receive the fair value of his or her interest?

Major Areas to Consider

The articles of organization and the operating agreement should attempt to address all of the anticipated issues that may face the LLC during its existence. This is particularly important given the lack of judicial precedent for LLCs. These include both structural and operational issues, as well as economic issues such as the allocation of income and distributions. The issues to be covered can be broadly classified as those dealing with:

1. Start-up and formation;

2. Management;

3. Member relations (admissions, withdrawals, etc.);

4. Economic issues (income allocation, distributions, etc.);

5. Tax issues;

6. Dissolution; and

7. Legal issues (amendment of agreement, etc.).

Each of these issues requires careful consideration, since, once in place, the operating agreement and the articles of organization may be difficult to amend.

Practice tip: One important section of the operating agreement that practitioners should consider using is a “Definitions” section. Consolidating the definition of terms used in the operating agreement eliminates the need for cross-referencing and provides one section that contains specific definitions used throughout the agreement. The “Definitions” section can contain as many or as few definitions as desired. However, terms used throughout the agreement, or terms for which a specific and detailed definition is desired, should be included. If a definitions section is used, the definitions should be clear, concise and understandable. If possible, the practitioner should review the appropriate state statute to see whether there are pertinent definitions included in the law.

Effect of State Law

Practitioners involved in the organization of an LLC must be well versed in the provisions of the LLC statute for the state of the LLC’s organization. An analysis of the statute itself usually is necessary. The analysis will provide practitioners with information concerning the statutory limits on formation, operation, merger and dissolution of LLCs, and the extent to which these provisions can be altered or amended by provisions in the articles of organization or operating agreement.

All LLC statutes provide statutory defaults that govern the LLC in the absence of any contrary provision in the articles of organization or the operating agreement. However, relying on the default provisions to achieve certain objectives can be dangerous, since the provisions of a state LLC statute may be changed with little or no notice by the legislature. Additionally, there is no guarantee that the members will agree to revise the operating agreement when the statute changes, and members may attempt to obtain preferential treatment in one or more areas in exchange for their agreement to sign the revised operating agreement. Further, such defaults tend to be fairly broad, making it undesirable to rely on the default provisions when the LLC wants to restrict member or manager actions or options. While reliance on statutory defaults may be an easy way to avoid a lengthy document, it is probably not wise to depend on the default provisions to ensure the goals and objectives of the LLC members are achieved.

Adoption and Amendment of the Operating Agreement

Under most state LLC statutes, the operating agreement must be adopted by the unanimous consent of the members. Once adopted, the operating agreement is usually binding on all future members. Because of the unanimous consent requirement, many LLCs adopt an operating agreement immediately on the issuance of the articles of organization, when there are few members.

Many state LLC statutes also require unanimous consent of the members to amend the operating agreement or articles of organization. Generally, this limit can be lowered in the operating agreement. Many states have adopted savings clauses to provide limited liability for LLC members even if the strict formalities of the state statute are not met. The consent requirements to amend the operating agreement and articles of organization are topics that should be addressed in reviewing the documents.

There is uncertainty as to the consequences of failing to comply formally with the state requirements for the creation of an LLC. To the extent creditors reasonably believed they were dealing with individuals who were personally liable, they may have a right to pursue those members. However, creditors who would have had the same rights against the LLC as they expected should not be able to pursue the members individually, absent fraud or other intentional wrongful acts.

The better course of action, obviously, is to comply formally with the LLC formation requirements and have a detailed, executed operating agreement. Many states have adopted savings clauses to provide limited liability for LLC members even if the strict formalities of the state statute are not met. However, it is not smart to rely on the benevolence of a judge to rule in favor of limited liability.