PREVENTING PROBLEMS IN PARTNERSHIP/OPERATING AGREEMENTS.

Whether it be a small business owned with family, with friends, or with strict business partners, none of us go into business hoping for litigation.  The Operating Agreement for a limited liability company (“LLC”) and the Bylaws for a corporation each respectively govern the internal relations amongst the business owners and with the business.  The freedom to contract under the statutes governing both LLCs and corporations provides entrepreneurs with several options to consider for inclusion in the Operating Agreement or Bylaws and manners to prevent problems between owners.  Ensuring that you have a properly drafted internal governing document can be paramount in avoiding the time, stress and financial capital that is often expanded in business divorces.

The Operating Agreement details the relations among the members as members and between the members and the LLC, the rights and duties of any manager of the LLC, the activities of the LLC and the conduct of those activities, and the means and conditions for amending the Operating Agreement.  The Operating Agreement is the manner in which the LLC may:

·         Modify or eliminate the duty to refrain from competing with the company;

·         Modify or eliminate the duty to refrain from dealing with the company in the conduct or winding up of the company’s business as or on behalf of a party having an interest adverse to the company;

·         Identify specific types or categories of activities that do not violate the duty of loyalty;

·         Alter the duty of care, except to authorize intentional misconduct or knowing violation of law;

·         Alter any other fiduciary duty, including eliminating particular aspects of that duty;

·         Prescribe the standards by which to measure the performance of the contractual obligation of good faith and fair dealing; and

·         Specify the method by which a specific act or transaction that would otherwise violate the duty of loyalty may be authorized or ratified by one or more disinterested and independent persons after full disclosure of all material facts.

The Operating Agreement may not, however:

·         Vary the LLC’s capacity to sue or be sued in its own name;

·         Vary the law that the law of formation governs the internal affairs of the LLC;

·         Unreasonably restrict the duties and rights to information and records from the LLC;

·         Unreasonably restrict the right of a member to maintain an action on their behalf or derivatively on behalf of the LLC; or

·         Restrict the right to approve a merger, conversion, or domestication under Section 1014 to a member that will have personal liability with respect to a surviving, converted or domesticate organization.

While the complexities between what is necessary or merely helpful vary when dealing with a multi-member LLC versus a single-member LLC, adequate consideration at formation needs to be given to both.  Because the Operating Agreement will be governing the respective relationships by and among members and managers, the Operating Agreement needs to consider the business purposes of the LLC, consider transfer restrictions on membership interests, detail where members and managers meetings will be held, and the authority of the officers and/or managers.  Even with a single-member LLC, reverting to a more simplistic Operating Agreement may be inappropriate if there are plans for expansion of members.  Thus, in addition to considering where the LLC is now, you should always give consideration to the long-term goals of the LLC as well to eliminate the need for substantially modifying the Operating Agreement if expansion is successful.  

In the corporate context, the Bylaws (or the Articles of Incorporation) must also state whether there is an applicable Shareholders Agreement.  A Shareholder Agreement is valid for 10 years, unless otherwise stated, and must be conspicuously noted on the front or back of each outstanding stock certificate.  The Shareholder Agreement may also, even if it is inconsistent with one or more provisions of the Model Business Act:

·         Eliminate the board of directors or restrict the discretion or powers of the board of directors;

·         Govern the authorization or making of distributions;

·         Establish who shall be directors or officers;

·         Set forth the exercise or division of voting power;

·         Require dissolution of the corporation at the request of one or more of the shareholders upon the occurrence of a specified event; or

·         Otherwise govern the exercise of the corporate powers or management of the business and affairs of the corporation among the shareholders, directors and the corporation.

A Shareholders Agreement is especially applicable in a closely held corporation to ensure that no shareholder can unilaterally bring an outsider into the ownership circle and to provide rules to follow if the shareholders part ways.  In the LLC context, the same transfer restrictions are typically encompassed in the Operating Agreement.  Typically, a Shareholders Agreement or Operating Agreement will include some or all of the following transfer restrictions:

·         Prohibiting the transfer of shares or membership interests by sale, assignment, gift, pledge, or any manner prohibited by the Agreement and nullifying any attempt to transfer in contradiction to the Agreement;

·         Providing a right of first refusal to the non-selling member or stockholder to avoid the judicial reluctance to enforce absolute restraints on alienation of property.  This provision permits a member or shareholder to transfer their interest or shares to a third-party after first offering the bona fide third-party offer to purchase to the non-selling member or stockholder and the non-selling owner fails to exercise the right of first refusal; and

·         Permitting the purchase of the stock or membership interest if one of the owners files for bankruptcy, dies or is divorced.  The purchase price for the stock or membership interest is typically defined in the Shareholders Agreement or Operating Agreement and is often via an appraisal or other pre-determined formula based on cash flow, revenue, or book value.  If the owners do not exercise the option to purchase upon one of the triggering events, the Shareholders Agreement or Operating Agreement will often provide that the transferred stock or membership interest will no longer bear voting rights and will only be entitled to the economic benefits of ownership.

In the closely-held context, both agreements help ensure that the entity and ownership of the entity are as contemplated by the owners.  While many of the provisions may seem unnecessary or overly complex during inception when the owners are agreeable and working together, the agreements help govern the parties when the relationship deteriorates and provide a roadmap during the business dissolution.

While the process of setting up these documents and agreements are lengthy and may seem unnecessary if you are working with a friend or family in the long run it is creating a strong foundation should it ever be tested. Work now with a good legal advisor is a big step toward keeping yourself out of court for business litigation.