Why A Well Written Attorney Prepared California LLC Operating Agreement is Essential
Why A Well Written Attorney Prepared California LLC Operating Agreement is Essential
|Prepared By: Melissa C. Marsh, Los Angeles Business And LLC Attorney
Written: March 2009
Pursuant to California Corporation's Code §17050(a), every California limited liability company (LLC) is required to have an Operating Agreement that governs how the members will deal with their LLC ownership interests, and other important company matters. Next to the Articles of Organization, the LLC Operating Agreement is the most important document to a California LLC.
A California LLC Operating Agreement serves to: (1) preserve or strengthen the members personal limited liability protection to safeguard the personal assets of the LLC members and/or managers; (2) set forth the operating rules and procedures to limit financial and management misunderstandings, and (3) ensure the members get the primary benefit of operating as LLC – the flexibility to establish your own operating and governance procedures., as opposed to the stringent rules that govern California Corporations.
Asset Protection – Personal Limited Liability Protection
One of the main reasons individuals opt to form a California LLC over a partnership is the personal limited liability protection afforded to the LLC members, but not to general partners. Having a well written Limited Liability Company Operating Agreement is the first step to ensuring the courts will respect your LLC and the personal limited liability protections it provides to its members. This is particularly important with any single member LLC, where without the formality of an LLC Operating Agreement, the LLC will look a lot like a sole proprietorship and the courts will be more apt to consider the LLC the simple "Alter Ego" of the sole member, as opposed to its own separate entity. Having a formal well written operating agreement lends credibility to the separate existence of the LLC.
California Corporations Code, section 17101(b) provides in part, as to an LLC:
(b) A member of a limited liability company shall be subject to liability under the common law governing alter ego liability, and shall also be personally liable under a judgment of a court or for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, under the same or similar circumstances and to the same extent as a shareholder of a corporation may be personally liable for any debt, obligation, or liability of the corporation; except that the failure to hold meetings of members or managers or the failure to observe formalities pertaining to the calling or conduct of meetings shall not be considered a factor tending to establish that a member or the members have alter ego or personal liability for any debt, obligation, or liability of the limited liability company where the articles of organization or operating agreement do not expressly require the holding of meetings of members or managers.
It is therefore ultra important that members of a limited liability company, not only properly form the LLC and prepare a well written comprehensive LLC Operating Agreement, but also maintain the LLC with all the formalities typically observed by a California corporation (e.g., annual and special minutes of meetings of the members, resolutions of the members and managers, proper documentation of loans to or from the LLC, and no comingling of personal and company funds, etc...)
If you are a member of a multi-member limited liability company, the lack of a comprehensive well written Operating Agreement signed by all of the members substantially increases the risk of future disputes involving the company's management and the rights and obligations of the members. A well drafted LLC Operating Agreement can set forth the rules each member must follow, reduce the potential for misunderstandings, limit the possibility for unintended consequences, and when a disagreement does materialize it can provide methods to resolve the dispute without the need for costly and emotionally draining litigation. Unfortunately, as a business attorney for over 10 years, I have seen too many disputes involving the members of an LLC that could have been either completely avoided, or at least resolved, by a well drafted LLC Operating Agreement, but instead led to costly litigation and in some cases the demise of the LLC.
Every business needs a set of rules to govern itself. With a corporation, it is the bylaws and hopefully a buy-sell agreement. With a partnership, it is a partnership agreement. With an LLC, it is the Operating Agreement. Although California Corporation's code provides certain default rules and procedures when an LLC Operating Agreement remains silent on a particular issue, it is not wise to rely on them, especially in light of the LLC's primary benefit—its flexibility in terms of management, profit distribution and the allocation of profit and losses without regard to membership interest. If you don't need flexible management or profit/distribution rules, then you are probably better off with a California corporation which affords better tax treatment to most California businesses.
If you still desire to form an LLC with a generic online form operating agreement, then consider the following. California Corporate Code §17156 provides "except as otherwise provided in the articles of organization, or the [LLC] operating agreement, if the members of an LLC have appointed more than one manager, decisions of the managers shall be made by majority vote if at a meeting, or by unanimous written consent." While this may not sound so bad, it can be. What if there are certain decisions the members expected would only be made by unanimous vote such as the sale of some, or all, of the LLC's assets, or acquisition of a large amount of debt? Absent a well drafted LLC Operating Agreement that provides terms requiring a super majority vote, or a unanimous decision, a simple majority can basically change the entire direction of the LLC and expose all of the members to additional risk.
Still not convinced you need an attorney to prepare an LLC Operating Agreement. Then consider this. Absent a well written Operating Agreement, California law provides that the profits and losses of the LLC will be distributed equally amongst its owners, even if each member's investment in the LLC connotes a different distribution allocation. If the members of an LLC do not intend to invest equal amounts, or do not intend to share the profits and losses equally, the LLC Operating Agreement must set forth each member's percentage interest and a description of how profits and losses are to be allocated.
A well drafted attorney prepared LLC Operating Agreement will typically alter the following default rules under California law:
- Voting rights, which otherwise are set by each members' interest in the current profits of the LLC.
- Fiduciary duties (although these can only be limited, not abolished), which if not amended can prohibit the LLC members from engaging in similar types of employment for someone other than the LLC.
- The default rule that permits non-members (such as creditors of a member) to inspect LLC records and books.
- The default rule that a member must give six-months notice before resigning.
- The default rule that an event of dissolution dissolves the LLC, unless all members vote to avoid dissolution (rather than allowing a majority of interests of both capital and profits interests to vote to avoid dissolution).
- The default rule that permits a non-member to vote the proxy of an absent member.
- The priority and proportions of distributions after dissolution. The default, after creditors are paid, is (in order of priority): satisfaction of certain unpaid distributions, the return of member contributions, and finally payments to members in the proportion in which such members share in distributions (which is covered elsewhere in this document).
- Unless the Operating Agreement provides otherwise, the Operating Agreement may only be amended with the unanimous consent of all the members. However, the Operating Agreement can provide for a majority, or super majority, vote of the members to amend the Articles or the Operating Agreement. (California Corporations Code Section 17103(b).
A Well drafted Limited Liability Company Operating Agreement will also provide clauses for:
- the initial members of the LLC;
- the members' percentage interests in the business;
- the allocation of profits and losses among members;
- the capital contributions of members;
- the members' voting power;
- When a super majority approval, or unanimous approval of all the members, is required (typically for major company decisions such as borrowing large amounts of money, entering into major contracts, amending the Articles of Organization, changing the capital structure of the company, hiring or firing people related to members and managers, setting the compensation of key employees, and entering into contracts with related parties or companies affiliated with members or managers).
- the desired management structure -- i.e., whether the LLC is to be managed by its members in a de-centralized fashion ("member-managed") or by some designated group of managers (who may or may not be members as well) in a centralized fashion ("manager-managed");
- in the event that the company will be run by managers (or some subset of the members), the division of responsibility between managers and members, and describe the roles that managers and members are expected to play in operating the business;
- procedures for admitting a new member, for member withdrawal, and for ousting a member;
- rules for holding meetings and taking votes; and
- "buy-sell" provisions to restrict a member's ability to sell, encumber, or transfer their membership interest in the LLC, without first giving the LLC and then its other members the right of first refusal to acquire the membership interest, and to set forth a member's rights and a value on a member's interest in the event the member dies, becomes disabled, divorces, or files for bankruptcy.
The best and easiest time to adopt a well written LLC Operating Agreement is when the company is formed. I have seen too many member disputes that could have been avoided with a properly prepared LLC Operating Agreement. A well written LLC Operating Agreement is like insurance, i.e., if you never need it, you don't miss it, but if you need it and don't have it, you may suffer greatly.
If you would like to retain the services of Melissa C. Marsh to form and organize a California LLC, or to prepare a California LLC Operating Agreement, please call 818-849-5206 or Send us an Email.
California business and LLC lawyer, Melissa C. Marsh, is based in Sherman Oaks and West Hollywood, and serves individuals and businesses throughout Los Angeles County, including: West Hollywood, Miracle Mile, Beverly Hills, Century City, Santa Monica, Burbank, North Hollywood, Valley Village, Toluca Lake, Studio City, Sherman Oaks, Van Nuys, Encino, and Woodland Hills.
© 2009 Melissa C. Marsh. All Rights Reserved.
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