I mean, who writes this stuff? (III)

I mean, who writes this stuff? (III)

      Recently I did a quick Google search and was able to locate operating agreements that can be downloaded off of the internet for free.  Based on my review, you get exactly what you pay for.  In fact, one of these “free” operating agreements essentially guarantees increased legal fees later on.  But as is said, “You can pay me now or you can pay me later.”

      Keep in mind that an operating agreement defines the relationship amongst the members of an LLC.  Invariably, there will be some dispute between the members of the LLC that must be resolved by reference to the operating agreement and the underlying LLC Act. If the operating agreement does not provide clear resolution, either by dictating an answer or clearly dictating the mechanism by which the dispute will be resolved, there is the recipe for a law suit.

      So let’s just consider just a few of the points of this “free” operating agreement.

1.                  First, with respect to formation of the LLC, this agreement provides:

The Members hereby form a Limited Liability Company (“Company”) subject to the provisions of the Limited Liability Company Act as currently in effect as of this date.  Articles of Organization shall be filed with the Secretary of State.

      Initially, this operating agreement describes a process for the formation of an LLC that is exactly backwards.  An LLC is formed not by agreement of the members, but by the filing of articles of organization with the Secretary of State.  You cannot form an LLC before the articles of organization are filed. That, however, is exactly what this agreement provides.  

2.                  That operating agreement goes on to provide:

1.4  TERM. The Company shall continue for a perpetual period.

(a) Members whose capital interest as defined in Article 2.2 exceeds 50% vote for dissolution; or

(b) Any event which makes it unlawful for the business of the Company to be carried on by the Members; or

(c) The death, resignation, expulsion, bankruptcy, retirement of a Member or the occurrence of any other event that terminates the continued membership of a Member of the Company; or

(d) Any other event causing the dissolution of this Limited Liability Company under the laws of the State of __________.

      Initially, demonstrating a lack of attention to the agreements structure, why is “this Limited Liability Company” utilized in 1.4(d) when the defined term “Company” is already set forth in section 1.1.?

      Evidencing even further lack of attention to both the structure of the document and as well its wording, what is the effect of any of the events set forth in 1.4(a)-(d)? The lead in sentence simply states “The Company shall continue for a perpetual period.” Nowhere is it provided that the perpetual existence shall be qualified by any of 1.4(a)-(d).

      If it is intended that the events set forth in 1.4(a)-(d) shall effect the dissolution of the LLC, it really should have said so.

3.                  Section 3.2 this operating agreement provides that “The Members shall determine and distribute available funds annually or at more frequent intervals as they see fit.”  So the members decide if the distribution will be made.  However, Section 4.2 of the same agreement goes on to provide that the “Members that are not Managers shall take no part whatever in the control, management, direction, or operation of the Company’s affairs.” But isn’t deciding to make a distribution participation in the management of the Company’s affairs? The two provisions are in contrast with one another, especially when it is noted that Section 4.3 affords to the managers the power to make all decisions with respect to “the management or all or any part of the Company’s assets.” Simply put, the drafting is bad in that it is inconsistent.

4.                  The agreement goes on, in Section 4.9, to recite certain documents that must be kept, including a copy of the “Certificate of Formation.”  This is curious in that Section 1.1 calls for the company to file Articles of Organization with the Secretary of State.

5.                  Section 5.1 of this operating agreement provides that a manager shall be entitled to compensation “commensurate with the value of such services.”  The agreement does not address who has the authority to make the determination of a manager’s compensation.  Is it intended that that fall within the authority of the managers as set forth in Section 4.3? Is it actually intended that the managers have the unilateral authority to set their own compensation? However, if it is intended that the members determine the appropriate compensation of the managers, that is nowhere set forth in the agreement.  

6.                  This same agreement, at Section 6.2, goes on to provide:

MEMBER’S ACCOUNTS. The Managers shall maintain separate capital and distribution accounts for each member. Each member’s capital account shall be determined and maintained in the manner set forth in Treasury Regulation 1.704-1(b)(2)(iv) and shall consist of his initial capital contribution increased by:

(a) any additional capital contribution made by him/her;

(b) credit balances transferred from his distribution account to his capital account;

and decreased by:

(a) distributions to him/her in reduction of Company capital;

(b) the Member’s share of Company losses if charged to his/her capital account.

      First, why in the second (b) subparagraph is Member capitalized while member is not otherwise capitalized in this Section 6.2.  Also, what is up with rotating among “his,” “him/her” and “his/her”?

      That aside, what is described in this provision as to how the capital accounts will be maintained is inconsistent with the cited regulation.  It is impossible for the managers to both comply with the cited treasury regulation and the express provisions of this operating agreement.  It must only be assumed person who wrote this agreement does not have an appreciation for the requirements of how capital accounts must be maintained in order that the LLC will satisfy the alternative test for substantial economic.  I am going out on a limb here and will posit that the author of this document would be mystified by the phrase “alternative test for substantial economic effect.”

      As mentioned above, you get you pay for.  Badly written operating agreements are often worse than not having an operating agreement at all.  Failure at the beginning of the relationship that will be an LLC to clearly define the rights and responsibilities of the parties does little more than set up the ultimate litigation.  Repeating myself from prior postings, I am always amazed at the willingness of general practitioners to draft operating agreement.  While nobody will “take a stab” at writing a 401(k) plan, it seems everybody thinks they can write an operating agreement.