The operating agreement describes the internal and operational rules for the limited liability company (LLC), including defining the rights and duties of the members and the managers of the limited liability company.

It is important to recognize that just as each limited liability company is a unique entity, each operating agreement should be a unique document, addressing the specific issues relevant to its specific limited liability company. Any lawyer who automatically drafts the same form of operating agreement for every limited liability company will not provide effective representation and may even be guilty of legal malpractice.

This article examines the important issues that distinguish operating agreements and discusses how the failure to properly address these issues can result in poorly-drafted, inadequate operating agreements that are not equal to properly-drafted, effective operating agreements.

To begin, as background, every limited liability company should have an operating agreement. Even if a limited liability company has a single member (while not the focus of this article, it should be noted that single member limited liability companies generally are not recommended because they can provide weaker asset protection than multiple member limited liability companies), it should have an operating agreement. Failure to have an operating agreement can support an argument that the limited liability company is a “sham” or otherwise not a valid entity.

Six Key Issues For Proper & Effective LLC

One key issue that distinguishes operating agreements is the basic background facts applicable to the limited liability company for which the operating agreement is being drafted. Each limited liability company has its own name, address, registered agent, registered office, members (names and addresses), and managers (names and addresses), and each operating agreement will be different in including these specific basic background facts for its specific limited liability company. This issue should be the easiest issue (relative to the other five issues described below) to properly cover in each operating agreement.

A second key issue that distinguishes operating agreements is the nature of the limited liability company for which the operating agreement is being drafted. Limited liability companies are created as a matter of state law, and thus there are 51 (including the District of Columbia) different limited liability company laws. The operating agreement should reference and be based on the law of the state in which the limited liability company was formed. Thus, for example, an Illinois limited liability company requires an operating agreement that references and is based on Illinois law, while a Delaware limited liability company requires a different operating agreement that references and is based on Delaware law. In terms of the nature of the limited liability company, besides state of formation, another point that distinguishes operating agreements is whether the limited liability company has been established with Series. A Series limited liability company (which can be advantageous to establish asset protection with respect to multiple assets and liabilities in a single limited liability company entity) requires a very different form of operating agreement than a regular (without Series) limited liability company.

A third key issue that distinguishes operating agreements is the economic terms and conditions in the limited liability company for which the operating agreement is being drafted. The operating agreement for the limited liability company needs to address such economic matters as the amount and timing of capital contributions by members, the allocation of profits and losses and cash flow among members (including whether these allocations change over time), and the percentage interests of members. As these economic matters generally will be resolved differently for each limited liability company, the operating agreement for each limited liability company correspondingly will need to be different.

A fourth key issue that distinguishes operating agreements is the terms and conditions that govern decision-making in the limited liability company for which the operating agreement is being drafted. What decisions can be made solely by the managers of the limited liability company? If there are multiple managers of the limited liability company, how do the managers vote?  What decisions require the consent of the members of the limited liability company? How do the members of the limited liability company vote? As these “decision-making-related” questions will be answered differently for each limited liability company, the operating agreement for each limited liability company correspondingly will need to be different.

A fifth key issue that distinguishes operating agreements is the other (to the extent not covered above) internal and operational rules that apply to the limited liability company for which the operating agreement is being drafted. Such topics as manager elections, manager meetings, manager rights and duties, officers, indemnifications, member meetings, member rights and duties, maintenance of capital accounts, “buy-out” rights on voluntary transfers of membership interests, “buy-out” rights on member death or disability, additional members, and dissolution, need to be addressed in the operating agreement. As these “internal and operational rules” topics will be answered differently for each limited liability company, the operating agreement for each limited liability company correspondingly will need to be different.

A sixth key issue that distinguishes operating agreements is the extent to which asset protection is enhanced with respect to the limited liability company for which the operating agreement is being drafted. As the words, “limited liability”, suggest, all limited liability companies provide a certain base level of asset protection (although this base level of asset protection varies significantly from state to state based on different limited liability company laws in different states). However, this base level of asset protection with respect to any limited liability company can be significantly enhanced by the terms of its operating agreement. First, provisions can be added to the operating agreement that can prevent an adverse creditor from ever obtaining a membership interest in the applicable limited liability company, such as “buy-out” rights in connection with potential involuntary transfers of membership interests to creditors, and membership interests being treated as “non-marital” property for purposes of a “marital” creditor in the event of divorce. Second, provisions can be added to the operating agreement that can significantly discourage an adverse creditor from wanting to be a member of the applicable limited liability company, such as “admission” charges for a creditor to acquire a membership interest, additional capital contributions being required for a creditor member, elimination of voting rights for a creditor member, and allocation of “phantom income” (including based on the combined special allocation of income in accordance with Revenue Ruling 77-137 and denial of cash flow distributions) to a creditor member. Third, provisions can be added to the operating agreement that can remove an adverse creditor from being a member of the applicable limited liability company, such as conditions to expel a creditor member. Fourth, miscellaneous other provisions can be added to the operating agreement to enhance the asset protection with respect to the applicable limited liability company, such as waiving any obligation of a member to restore a negative capital account balance and restricting various creditor action. The failure of certain operating agreements to include the above-described provisions, and thereby not enhance the asset protection with respect to the limited liability companies for which these operating agreements are being drafted, may be the biggest reason why there are certain poorly-drafted, inadequate operating agreements.

The above title of this article, “All Operating Agreements Are Not Created Equal”, is not intended to suggest that all operating agreements should have the exact same provisions. As noted from the six key issues described above, operating agreements should not have the exact same provisions because each limited liability company for which the operating agreement is being drafted will address and resolve these issues differently. Instead, the reference that “All Operating Agreements Are Not Created Equal” is intended to highlight the common distinction between properly-drafted, effective operating agreements and poorly-drafted, inadequate operating agreements.

When an operating agreement for a limited liability company covers the six key issues described above in accordance with the understandings of the limited liability company’s members and managers and applicable law (including by significantly enhancing the available asset protection with respect to the limited liability company), such operating agreement is a properly-drafted, effective operating agreement. On the other hand, when an operating agreement for a limited liability company fails to fully cover the six key issues described above in accordance with the understandings of the limited liability company’s members and managers and applicable law (including by failing to enhance the available asset protection with respect to the limited liability company), such operating agreement is a poorly-drafted, inadequate operating agreement. Such poorly-drafted, inadequate operating agreements “are not created equal” with properly-drafted, effective operating agreements and need to be amended to become “equal” with properly-drafted, effective operating agreements.

If you have any question concerning whether your limited liability company does not have a properly drafted, effective operating agreement, and thereby an amendment needs to be made, please discuss this subject with your advisers.

Note – Proper Timing of Limited Liability Company Formations

Besides the above-described problem of having a poorly-drafted, inadequate operating agreement, another possible issue with your limited liability company could be the poor timing of formation of an entity manager or an entity member with respect to your limited liability company. If your limited liability company is intended to be formed with an entity manager, you need to be certain that the entity manager has been formed before your limited liability company is formed. If your limited liability company is intended to be formed with an entity member, you need to be certain that the entity member has been formed before your limited liability company is formed. A common mistake is to send in to the applicable Secretary of State formation documents for both your limited liability company and the entity manager and/or both your limited liability company and the entity member at the same time without clear guidance; as a result, your limited liability company can be improperly formed before the entity manager and/or your limited liability company can be improperly formed before the entity member. While this situation can be corrected and the negative consequences at least somewhat reduced, it will cause additional charges to be incurred and inadvertently raise possible “fraudulent conveyance” concerns (which cannot be avoided). Please be certain that the formation of your limited liability company has been properly timed with the formation of any entity manager or entity member.

If you have any question concerning whether your limited liability company was not properly timely formed after any entity manager or entity member with respect to your limited liability company, and thereby a correction needs to be made, please discuss this subject with your advisers.