Limited Liability Companies are rapidly becoming the preferred entity in California due to their flexible management structure and effective liability protection. California’s Revised Uniform Limited Liability Company Act, which became effective on January 1, 2014, made some significant changes to California LLC law. As I discussed here, these revisions should motivate LLC managers and members to revisit and possibly amend their existing operating agreements to ensure that the new law does not inadvertently change the management structure, or the rights and obligations of the members and managers, from what was originally intended by the parties.
One thing that the new Act did not do was add a requirement that LLC operating agreements must be in writing to be enforceable. Under the new Act, as with the old law, an LLC operating agreement may be written or oral. This is also true under the LLC laws of Delaware and many other states.
However, as we all know, just because something is permissible doesn’t necessarily mean it’s advisable. 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.
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, 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 is sufficient funds to buy out the interest of a member under certain defined circumstances? A written LLC operating agreement can define in detail the solutions for all of these events (which likely would not have been the subject of specific conversations in an oral agreement).
In the absence of specific provisions to the contrary in a written or oral operating agreement, the “default” rules of the new 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 now result in a manager-managed LLC becoming a member-managed LLC if the LLC does not have a written operating agreement. Under the old 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 contracts 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 would 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 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.
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.