Thursday, November 19, 2015

What is an LLC Operating Agreement, Anyway? (Contract Is King Micro-Symposium)

I so appreciate the opportunity to be a part of this micro-symposium, in which we can explore important issues at the intersection of contract law and fiduciary duties in the fastest growing form of business entity in the United States: limited liability companies (LLCs).  Today, I contribute some foundational information relating to, but not directly responding to, the micro-symposium questions.  These observations come from a panel discussion at the 2015 ABA LLC Institute in Washington, DC in which I was a participant.  I blogged from the Institute last week and promised this post in that first post.

The session at the Institute that I feature in today's post explored the legal and practical nature of an operating agreement (a/k/a, a limited liability company agreement).  Since the operating agreement is the typical locus of private ordering in the LLC form, its status under LLC and other law should be of interest to us.  Among other things, understanding the operating agreement may better enable us to understand when it is a valid, binding, and enforceable obligation among the parties.  That's an issue I have been exploring in some of my work.  But there is more in the legal status of the operating agreement than meets the eye . . . .

The operating agreement panel discussion at the LLC Institute was organized and facilitated by Bob Keatinge.  He began the discussion by offering many views about what an operating agreement is or can be, based on its contents and operation.  Among the documents--contracts and instruments--on his list:

  • an entity constitution (like articles of incorporation);
  • a business plan;
  • a grant of authority and consent to action;
  • a disclosure document memorializing or making disclosures of facts to members, a memorialization of intentions and aspirations of the parties;
  • an encumbrance or option on property to be contributed by, distributed to, or held for the LLC by, members;
  • an employment agreement for managers;
  • an election as to which default statutory provisions apply;
  • a power of attorney; and 
  • numerous other agreements and instruments, depending on context.

I hadn't really thought about the number of distinct functions an operating agreement may serve.  It is, at its core, an agreement that addresses both governance (management and control) and finance. But it's more than that.  Optimally, it binds together the firm and its internal constituents for purposes of organizing and sustaining a legal structure for their business, but it can and does do much other work.

Ann Conaway followed Bob's introduction with a summary of the ways in which operating agreements are statutorily defined and constituted (legally required elements and components of an operating agreement), and Kelley Bender continued along a similar theme by addressing the law relating to amendments to operating agreements and related points.  Key topics in this part of the session included requirements (and lack of requirements) of a writing, potential parties to an operating agreement, interactions between/among (and effects of) multiple documents that together may constitute an operating agreement, the articles/certificates of organization as a potential part of the operating agreement, the truth or fallacy of judicial (and other) observations that an LLC does not have an operating agreement, and the possibility that an operating agreement may be amended by majority (or other less-than-unanimous) consent.  And I know I am missing things from that list . . . .

Then, Jessica Liou and I briefly "debated" whether an operating agreement is a common law contract.  I argued against contract status; she argued for it.  (Neither argument necessarily represented our actual positions on the question or the embedded issues.)  We shared some possible ramifications of the status of an operating agreement as a contract (relating to bankruptcy law questions being debated in recent judicial opinions and the analysis of other, non-bankruptcy legal questions) at the conclusion of the debate.

Beth Fenton batted clean-up, before Bob closed out the program.  She shared observations about issues at the intersection of veil piercing and operating agreements.  Specifically, Beth described common attributes of LLC veil piercing cases and how the drafting of operating agreements may affect a court's analysis in veil piercing cases.

The entirety of the program was significant for me in a number of respects.  Honestly, there wasn't much "new news" in the panel presentations.  But the cumulation of all of this information about operating agreements in a single discussion was powerful.  Apropos of the theme of this micro-symposium, a major takeaway for me related to the relationship between the legal nature of the LLC operating agreement, the contractual focus of LLC law, and notions of fiduciary duty, good faith, and fair dealing in the LLC.  I will pick up on that theme in a separate post.

https://lawprofessors.typepad.com/business_law/2015/11/what-is-an-llc-operating-agreement-anyway-.html

Business Associations, Joan Heminway, LLCs | Permalink

Comments

Hi Joan, I was wondering if you might elaborate on your comment that there was discussion about "interactions between/among (and effects of) multiple documents that together may constitute an operating agreement." This is something that I've considered in the context of family businesses, because family law arrangements can have important implications for how a business is to be governed and how its assets will be distributed. Thanks, Ben

Posted by: Ben Means | Nov 19, 2015 5:52:33 AM

Great to hear from you, Ben. I wish I had taken more detailed notes (and the video of the program, when it is available on the ABA's website, will give you more), but among the highlighted issues were the possibility that the articles/certificate of organization may constitute or be seen as a component of the operating agreement in contexts where that may or may not be intended or desired (which I called out separately in the post), the effect of integration clauses in one or more of the documents asserted to be part of a multi-document operating agreement, how a judge might handle conflicting provisions in multiple agreements, and (of course) just how one identifies the documents that constitute an LLC's operating agreement when they are not labeled as such. The lack of statutory clarity in this area seems to invite judicial decisions that are contextual and may be seen as opportunistic or goal-oriented. We ultimately may question whether this is a good area for common law rules--i.e., whether, as a matter of law-making, we want to leave this much to the courts.

Does any of that jive with what you are seeing in family businesses? Let me know. I look forward to hearing more.

Posted by: joanheminway | Nov 19, 2015 7:17:55 AM

One theme I heard several times at last week's conference was something to the effect that "several Delaware judges want LLCs to be corporations." I heartily disagree (but am frequently wrong). I think the issue is not some movement to corporate law but instead an attempt to ground the essential nature (quiddity) of the LLC. Specifically -- in Delaware the former Chief Justice seemed to consistently take a purist position that LLCs are creatures of contract, while Chancery kept slipping other notions (like equity) into the mix. I have written about that elsewhere. Now that judicial positions have changed, I think there is a move toward a "not-entirely-a-contract" approach. Those who listened to the contract spiel may believe that this is corpification of the LLC. Those like me who did not buy into the "we are all contractarians" approach see some of this as a breath of fresh air. I will post on SSRN a paper I wrote for an introduction that will be published by Pitt. L. Rev. next year that is my attempt to run some of my thoughts to ground. I hope that my friends who are esteemed commentators on this microsymposium can share their thoughts on this issue. I, at least, think it is a vital one. Thanks.

Posted by: Bill Callison | Nov 19, 2015 7:39:31 AM

So glad you raised this, Bill. In fact, in my discussion on dissolution in the LLC context at the LLC Institute (described in my post last week), I likely was “guilty” of making the observation or characterization you are questioning in your comment. Mea culpa.

I agree with you when you say that “the issue is not some movement to corporate law but instead an attempt to ground the essential nature (quiddity) of the LLC.” But when the judiciary seeks to moor an unmoored concept, it tends to look to the familiar. Some have framed the general law of business entities (for better or for worse) as a spectrum that ranges from partnerships to corporations. Certainly, even where that is not the case, business lawyers (and with them, members of the judiciary deciding business law cases) historically have compared and contrasted the doctrinal rules applicable to corporations and partnerships (including various forms of partnership), as well as general agency law rules and norms, in framing and deciding legal questions governed by state entity law. That way of thinking carries over into and informs the freedom-of-contract debate in LLC law.

Regardless, I think I am mostly with Jeff Lipshaw on this when he says (in his post earlier this week—on Monday—as part of this micro-symposium): “I view all organizational and transactional structures, including corporations, LLCs, and contracts, as models or maps.” So, characterize the trends as you may, but they should create a map for enlightened lawyers and clients. Like so many things, it’s a bit like bumper cars to me. LLC law, more often than other entity law (given its relative youth), bumps into a new question based on the behavior of those who adopt the form to house their businesses. Then, it either backs up and moves on to a new space, or stays stuck there—where it may be less useful as a vehicle. (That may be an awful analogy, but I think you know what I mean.)

Legal scholarship helps the law to move on—or not. In that light, please send me the link to your article when it is available, and I will post on it here in a future week. Again, thanks for your thoughts on this.

Posted by: joanheminway | Nov 19, 2015 8:57:41 AM

Wow. I consider myself a pretty erudite guy but I had to look up "quiddity." I'm pretty sure I agree with Joan (thanks for the shout-out and it's an appropriate point) that I'm really uncomfortable with imputing Aristotelian "final purpose" (i.e. essential nature) to our abstract constructs like corporations and LLCs. For example, I'm not big into the new new thing "benefit corporations" but, as I understand it, those could well be divergence from the widely understood purpose that corporations exist for the benefit of the shareholders. There's nothing writ in stone that says you couldn't have a "freedom corporation" that looks like a corporation but has a "contractual" aspect to the board's fiduciary duties. (Indeed, §102(b)(7) is an ELECTION that pretty much does that!)

Posted by: Jeff Lipshaw | Nov 19, 2015 9:23:37 AM

(I'm continuing in a new comment so I don't time out.) "What is a corporation?" or "what is an LLC?" questions remind me of the "what is a security" question in Howey. I've made the argument that we don't really define these things, but conceptualize and then identify the prototype at the core of the concept. So the prototype of a security is a share of common stock, and what we are really doing when we try to classify by way of a Howey like definition is to intuit how close we think the instrument under review matches a share of common stock. We have core or prototypical examples of our concept of a corporation, on one hand, or partnership, on the other, and we make metaphoric extensions. Indeed, that's the LLC issue in a nutshell - is my metaphor on this particular issue an extension from partnership, an extension from corporation, or something else?

Posted by: Jeff Lipshaw | Nov 19, 2015 9:29:54 AM

Amen, Jeff! I am with you on benefit corporations, too. I have been dragged kicking and screaming into that world this year (as you may know/have read) . . . .

Posted by: joanheminway | Nov 19, 2015 9:32:32 AM

One more thought. I never understood Myron Steele's position in the Auriga Capital wars. To my previous point, there's no extant conception of a business form has no aspect of fiduciary relationship as a default matter. So it doesn't surprise me that the overwhelming community expectation (i.e. the basis for a bargain-forcing default rule) is a defeasible fiduciary obligation.

What I don't understand are the paternalistic calls for mandatory fiduciary duties in all forms of organization. When we are talking about Mom and Pop somehow getting hosed because they invested in a hedge fund with a Blackstone like disclaimer, it seems to me we are dealing in suitability of investment issues, not business structure issues.

Posted by: Jeff Lipshaw | Nov 19, 2015 9:40:17 AM

And as long as I'm ranting and raving, the idea of a corporation as a person is a metaphoric extension. When you start to think that the metaphoric extension is actually some kind of "reality" (i.e. the essential purpose of a corporation is to be like a person), you start to do weird things like give it constitutional rights that may or may not be appropriate. (That is, I don't think there's anything writ in stone that says you can't limit corporate activity in the political arena - it's another argument from metaphor.)

Posted by: Jeff Lipshaw | Nov 19, 2015 9:46:33 AM

I too am uncomfortable with essential natures. I think entities are whatever we make them and that this can change over time. I think that others are less so. Hence my comment. Bill

Posted by: Bill Callison | Nov 19, 2015 2:20:16 PM

Right, Bill. And so glad (restating what I said above) that you raised this issue in your initial comment. If the law is static, our job as scholars and commentators is significantly less useful.

Posted by: joanheminway | Nov 19, 2015 3:55:18 PM

Joan, I see that the comment thread has moved on, but I did want to answer your question about family businesses. On further reflection, I think the issue is a bit different—not whether an LLC operating agreement is comprised of multiple documents, but whether the operating agreement can provide definitive guidance regarding ownership, control, and fiduciary obligation, as one might expect. In family businesses, for example, it is not uncommon for children and other passive investors to hold ownership indirectly via trusts. When that is the case, the distribution rules the trust follows and the fiduciary duties owed by the trustee may be of more direct relevance than whatever is contained in the LLC’s operating agreement. I discuss some of this in my Ohio State piece, though I’m not sure I can include a link to it via the comment thread. The topic of conflicting fiduciary duties is also explored by Professor Karen Boxx in her article, “Too Many Tiaras: Conflicting Fiduciary Duties in the Family-Owned Business Context, 49 Hous. L. Rev. 233 (2012). Finally, it’s worth noting that marital agreements can have enormous implications for business ownership.

Posted by: Ben Means | Nov 19, 2015 9:54:50 PM

Thanks for this response to my query, Ben. Yes, the interaction of operating agreements with other agreements and instruments affecting business owners, including those associated with estate planning and potential or actual marital dissolution, is another matter for concern. Integration clauses also can be a problem in that context, if they are not thought through and drafted properly. And thanks also for the reference to your Ohio State piece and the cite to Professor Boxx's article. All great additional information.

Posted by: joanheminway | Nov 19, 2015 10:04:15 PM

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