Legal Mistakes to Avoid in Business Agreements

What goes into an Operating Agreement

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An operating agreement is the document that sets forth the rights and obligations of the members of a Limited Liability Company.  Section 417 of the New York Limited Liability Company Law provides that

“the members of a limited liability company shall adopt a written operating agreement that contains any provisions not inconsistent with law or its articles of organization relating to (i) the business of the limited liability company, (ii) the conduct of its affairs and (iii) the rights, powers, preferences, limitations or responsibilities of its members, managers, employees or agents, as the case may be.”

If you decide not to enter into an operating agreement, the default laws of New York will apply and they may not be what you want or need.   The default rules may leave you with no options in many common situations.   Unfortunately, countless small businesses owners do not bother to enter into one and the negative consequences are plenty.

There are many forms out there and most cover the very basic requirements, but I found that there are certain subjects that are often overlooked or not given the necessary attention at all.

Deadlock between 50/50 partners

Many small businesses consist of two equal owners.  What are you supposed to do if you cannot agree on a certain business matter that requires the approval of both business owners?  The New York Limited Liability Company law default rules have no answer for this scenario.  Lacking other possibilities, many disgruntled owners will try to seek judicial dissolution of the LLC (Section 702).   But a deadlock alone is not necessarily grounds for judicial dissolution in New York.  Thus, it is a good idea to address this situation in your operating agreement.

Great care should be taken in describing what constitutes a deadlock (just any issue or just major issues that required unanimous approval?) and what procedure should be followed in case such deadlock occurs.

Buy Sell Provisions in case of Deadlock

One approach is to provide for some sort of buy sell mechanism.  When a deadlock occurs, one of the business owners buys out the other one.  In order to decide who buys and who sells, one could provide that one owner offers to purchase the interest of the other owner and names a price.  The other owner then has the choice to either accept the price or decide to purchase for that price.  While this provides an incentive to name a realistic price, it can get  problematic when the parties don’t have the same financial resources. And it is surely a very stressful and somewhat unpredictable procedure.

Deadlock Tie Breakers

The operating agreement could provide that a third person will be called upon to make a decision.  Some trusted business advisor or some arbitrator from one of those arbitration associations.  However, what third person is really qualified to make decisions about your business.  Also, sometimes there is no right or wrong decision, it is just that the owners have different goals and interests.  How can a third person decide what is the right decision?

Duties of the LLC Members

The managing members of a New York limited liability company have certain fiduciary duties towards the LLC and the other members.  But the law is very generic and it is unclear what that will really be in any given situation (see Section 409).   So it is a good idea to spell out what members are expected to do and not to do.

  • Members could be restricted from competing with the LLC.
  • Each member should be obliged to keep all LLC business confidential.
  • Members could be prohibited from entering into transactions with the LLC on their own behalf.
  • If the LLC members are creating intellectual property on behalf of the LLC (software, designs, innovative methods of doing anything), the LLC Operating Agreement should set forth that all such intellectual property has to be immediately assigned to the LLC and is not and will not be the property of the individual LLC members.
  • Members could be required to provide certain minimum services for the LLC.

Withdrawal

Think you can just walk away when you had enough?  No, you cannot. Under New York Limited Liability Company law, you can only withdraw under the circumstances provided for in the operating Agreement (Section 507).  If you have no operating agreement or don’t provide for withdrawal options, you are out of luck.  So you may want to build in rules to apply when a business owner wants to leave.  One way is to have a so called “right of first refusal”.  If you find someone who is willing to buy your share of the business, you first have to offer it to the other business owner on the same terms and conditions.  Only if the remaining business owner declines can you go and sell it to the third person.  But obviously this requires you to find a third person, which can be difficult.

Transfers

If you don’t state anything, the New York default rules apply and membership in an LLC can be sold and assigned.   But if that happens, only the economic rights transfer, not management, voting or other rights that are attached to being a full member (Section 603).  The buyer of the membership is entitled to the distributions and allocation of profits and losses to which the seller would have been entitled.  Nothing more.  You might want to provide for a different solution.   One mentioned above is the “right of first refusal”.  You could also provide that transfers among members are ok or transfers to family of the member for estate planning purposes.

Expulsion

The New York Limited Liability Company law states nothing about throwing out a member for misconduct.  Even if a member totally misbehaves, there is nothing you can do, unless you provide for it in advance in the operating agreement.  Drafting for this is tricky though, since it opens the possibility for abuse by the majority members or a situation where everybody is walking on eggshells for fear of triggering an expulsion event.

You will have to decide what procedure to be followed; a vote of the majority? unanimous consent?  What is the triggering event?  What kind of conduct will be grave enough to justify kicking out an owner.

What are the consequences of expulsion?  There could be a forced buy out upon predetermined terms or a valuation of the misbehaving owner’s membership interest.  Alternatively, the member could just be excluded from any further voting or management rights.

Amendments

Especially if you are a minority member, you have to make sure that amendments require the consent of all members.  Or that there is an operating agreement in place at all.  If you don’t have an operating agreement at all, Section 402(c) allows the majority members to amend, adopt, restate or revoke an operating agreement.  There have been cases where a court saw nothing wrong with two majority members adopting an operating agreement two years after the LLC’s formation without the signature of the third minority member.

Valuation of the Membership Interest

If the operating agreement has provisions that have a mandatory buy-out as a consequence, there must be a way to value the membership interest of the selling member.  This is a minefield for mistakes and disasters waiting to happen.  For example, some operating agreements state that the value of a membership interest is as stated in some exhibit and that such an exhibit must be updated on an annual basis.  Of course, more often than not, nobody cares to update it on an annual basis and when the value is needed a dispute arises.