Limited liability companies (LLCs) and S-corporations are rapidly becoming the preferred entities for business operations in California due to their flexible management structures and effective liability protections. Limited liability companies are governed by California’s Revised Uniform Limited Liability Company Act, which became effective on January 1, 2014. Although an operating agreement of some kind is required, the Act does not require a formal written operating agreement, and it is possible for the operation of the company to be defined by an oral agreement among the members. But if the matter is not discussed, how do you prove that your LLC actually has an operating agreement as required? And how do you enforce the terms of an agreement that was never discussed?
Just because something is permissible does not necessarily mean it is advisable. And even if the proposed terms of an operating agreement are discussed and agreed upon, how do you enforce that oral “agreement” in court if there is a dispute as to its terms? In fact, failure to prepare and execute a comprehensive written LLC operating agreement that accurately and completely documents and defines the relationship between the members of an LLC can lead to unpleasant, time-consuming, and costly conflicts down the road. To avoid these conflicts, it is advisable that every limited liability company have a comprehensive written operating agreement prepared and signed by all of the members.
A Properly Prepared Operating Agreement Defines Crucial Issues Regarding the Operation, Management, Termination, and Dissolution of an LLC
While state LLC laws may establish the rights and obligations of the entity and its members to third parties and taxing authorities, an LLC operating agreement is the controlling contract that sets forth the details of the relationships between the members and each other and the members and the LLC itself. Among other things, the operating agreement defines such core issues as ownership transfers, voting rights, taxation issues, business activities, management structure, and management authority. For example, what happens if the manager dies or becomes disabled? What happens if, in a two-member LLC, the members, who at the beginning of the endeavor were the best of friends, no longer agree on the vision for the company, or can no longer get along with each other but both still want to operate the business? How do you ensure that there are sufficient funds to buy out the interest of a member under certain defined circumstances (such as the death or disability of a member/employee)? A written LLC operating agreement can define in detail the solutions for all these events (which likely would not have been the subject of specific conversations in an oral agreement).
The Operating Agreement Carries Out the Intent of the Members
In the absence of specific provisions to the contrary in a written or oral operating agreement, the “default” rules of the LLC Act will apply, which may be completely different than the parties would have intended if the matter had been properly addressed. For example, one of these default rules can result in a manager-managed LLC becoming a member-managed LLC if the LLC does not have a written operating agreement. Under previous law only the articles of organization were required to designate the LLC as manager managed. Now, if the parties intend the LLC to be manager-managed, both the articles of organization and a written operating agreement must contain that designation. If a matter which would have been important to the parties is not addressed by an oral operating agreement or by the “default” laws, then the resolution of that matter is entirely uncertain, and may be determined by a court after lengthy, expensive proceedings, and the ultimate solution may be one that was never intended.
The “Statute of Frauds” and LLC Operating Agreements
Like many contractual arrangements, LLC operating agreements in California (and many other states) can often be enforceable even if they are the product of oral discussions only and are not in writing and signed by the members. For example, the Delaware LLC Act permits “written, oral, or implied” LLC agreements and generally allows parties to enforce unwritten and unsigned LLC operating agreements. However, “generally” does not mean always.
Contracts in Delaware, as in almost all states including California, are governed by what is known as the “statute of frauds.” This doctrine is intended to prevent fraudulent contracts by placing limits on the enforceability of certain kinds of unwritten or oral agreements. One of those limits applies to contracts that are “not to be performed within one year from the making thereof.” Such a contract must be in writing and signed by the party against whom it is to be enforced. Therefore, a court would not enforce an oral five-year employment contact because, by its very terms, it could not be performed within one year.
California’s Application of the Statute of Frauds
California will likely apply that limitation contained in the statute of frauds to LLC operating agreements if they contain provisions that cannot, or are not to, be performed within one year from the date of their execution. You would not want to be in the position of poor Mr. Olson in the 2009 Delaware Supreme Court case of Olson v. Halvorsen. In that case, a draft but unsigned LLC operating agreement contained an earn-out provision entitling a departing member to an earn-out payment over six years. When Mr. Olson was expelled from the business, he sued to collect on the six annual pay-outs. The court held that since, by definition, the six-year earn-out was not to be performed in one year, the statute of frauds barred the enforcement of the unsigned agreement, and Olson was left without his expected payments, even though it appeared that it was something to which all the parties had agreed. As with Mr. Olson, counting on anticipated rewards embodied in an unwritten or unsigned LLC operating agreement can result in years of hard work and investment being for naught.
Even if an oral or implied LLC operating agreement can theoretically be enforced, the process can be challenging, expensive, and uncertain. The absence of a comprehensive, well-crafted operating agreement can lead to significant confusion and disagreement at crucial junctures in the life of the LLC. It is highly advisable to put your relationship with your business partners in writing, even though it may not be strictly required by the law. Consultation with a seasoned and trusted legal advisor, who can ensure that your limited liability company is properly formed, and that your rights are thoroughly protected, is essential.
Your Westlake Village/Thousand Oaks Firm for LLCs
The Cohen Law Firm in Westlake Village serves the unique needs of business owners. From formation to restructuring, and in an ever-changing legal, regulatory and economic landscape, businesses must constantly evolve to survive. To talk about your business’s goals and challenges or to make an appointment, please call the Cohen Law Firm today at (805) 267-7147 or send an e-mail.
This article has been prepared by Cohen Law Firm for informational purposes only and does not, and is not intended to, constitute legal advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.