When entering into an LLC operating agreement, there are many important factors and issues that must be taken into consideration. Because under Delaware law, LLCs are “creatures of contract,” and if a dispute between the members ultimately arises, the Court will look to this agreement to determine the rights and powers conferred upon each party.

Below is a Top 10 list highlighting very important terms that any LLC operating agreement should have.

1) Members’ Respective Economic Interests. What percentage ownership does each member own? How will members be compensated? What rights are the members afforded by virtue of their respective membership interests?

2) Corporate governance.  An OA generally contemplates the formation of a “board” or “board of managers”, how managers or managing members are selected, and who has rights to appoint them.  In addition, the powers of managers or managing members must be explicitly set forth.

3) Corporate Officers.  What are the powers of the officers, and how are they appointed by the board. Also their compensation, or the manner in which their compensation is determined, can be detailing in the OA.

4) Non-Competition Clause.  If you do not want your fellow member(s) to compete with the company, then this is very important.  Recent case law has suggested that without restrictive terms in the OA, a member may potentially compete.  See Touch of Italy v. Salumeria and Pasticceria, LLC v. Bascio, C.A.No.8602-VCG (Del. Ch. Jan. 13, 2014) (for a link to article discussing this case click here).

5) Books and Records demands.  Whether and to what extent each member or partner may review and inspect the LLC’s books and records (i.e. financial documentation, board meeting minutes, etc.) should be detailed in the OA.  Of note, parties can contract away their rights to seek such inspection.

6) Arbitration/Forum Selection Clauses.  Which laws govern any disputes arising between members? Where must suit be brought? Mandatory arbitration or not?

7) Withdrawal of members.  The LLC Act does not allow for a member to unilaterally withdraw unless that right is set forth in the OA.  This can be very significant if/when a member wants to disassociate from the company.

8) Fiduciary duties.  LLCs are given broad rights to specify what fiduciary duties managers or managing members owe to the company or other members.  However, an operating agreement cannot “eliminate the implied contractual covenant of good faith and fair dealing.” 6 Del. C. § 18-1101(c).

9) Tax Issues.  Will an investment in the LLC cause a member to be subject to income or estate taxes in the state where the LLC does business? Will the passive loss or at risk rules apply to an investment in the LLC? Who will file taxes and when will filings be made?

10) Dissolution.  Every LLC operating agreement should specify under what scenarios the company can dissolve.  In addition, parties can negotiate whether members can seek an involuntary dissolution from the Court.

Carl D. Neff is a lawyer with the law firm of Fox Rothschild LLP.  Carl is admitted in the State of Delaware and regularly practices before the Delaware Court of Chancery, with an emphasis on shareholder disputes. You can reach Carl at (302) 622-4272 or at cneff@foxrothschild.com.

In the matter of Paul v. Delaware Coastal Anesthesia, C.A. No. 7084-VCG (Del. Ch. May 29, 2012), the Court of Chancery examined whether the language of an LLC agreement prescribed the sole manner by which the company’s members could vote their shares, preempting the statutory default, which favors action by written consent, as found in the Delaware Limited Liability Company Act (the “Act”).

Background

Plaintiff Dr. Leena Paul was a shareholder and member of Delaware Coastal Anesthesia, LLC (the “LLC”) from at least June 5, 2007 to August 17, 2011. The LLC members comprised the Plaintiff and the three individual Defendants.  Dr. Paul and the individual Defendants each owned 25% of the LLC.

The LLC’s operating agreement (the “Operating Agreement”) provides that a member of the LLC can be terminated without cause “at any time upon ninety (90) days written notice by . . . the Company acting by vote of seventy-five percent (75%) of the holders of the Company’s Shares.”  On April 25, 2011, the three individual Defendants, representing 75% of the shares, voted or agreed by written consent to terminate Dr. Paul’s membership in the LLC. The individual Defendants then sent Dr. Paul written notice of her termination.

Analysis

Dr. Paul asserted that the individual Defendants breached the Operating Agreement because that agreement does not allow the LLC members to vote by written consent.  She argues that the Operating Agreement only allows members to vote their shares at a member meeting.  Dr. Paul specifically points to Section 7.8, which addresses “Notice of Meetings”, and Section 7.12, which addresses “Voting of Membership Shares”. 

The Defendants, on the other hand, asserted that their action by written consent is effective under § 18-302 of the Act, which provides:  

Unless otherwise provided in a limited liability company agreement, on any matter that is to be voted on, consented to  or approved by members, the members may take such action without a meeting, without prior notice and without a vote if consented to, in writing or by electronic transmission, by members having not less than the minimum number of votes that would be necessary to  authorize or take such action at a meeting at which all members  entitled to vote thereon were present and voted.

6 Del. C. 18-302.

The issue before the Court was whether the Operating Agreement “otherwise provided” for the manner in which votes must be taken, thus preempting the statute.  In making its determination, the Court noted that Delaware law provides that LLCs are contractual in nature and that an LLC’s members have wide latitude to craft the members’ rights and obligations.  The Act, on the other hand, exists as a “gap filler,” supplying terms not fully explicated in an LLC agreement.

Through interpretation of the language of the Operating Agreement, the Court found that the operating agreement did not so “otherwise provide” the manner in which votes were to be taken, and thus held that the Defendants were not precluded from voting by written consent.  Accordingly, the Court found in favor of the Defendants in holding that the vote by written consent of 75% of the LLC’s members to terminate Dr. Paul was valid under the Operating Agreement.

Conclusion

This case is important in that it reinforces the notion of contractual freedom in connection with operating agreements of limited liability companies, and further makes clear that agreements must provide that “gap filler” provisions of the LLC Act do not apply if the intent is to preclude their application to the terms of the operating agreement.

In August 2010, Delaware enacted several amendments to the Delaware General Corporation Law (“DGCL”) in connection with nonstock corporations.  Prior to these 2010 amendments, the DGCL lacked a comprehensive approach to nonstock corporations.  Today, there are between 15,000 and 20,000 nonstock corporations registered in Delaware, many of which are not-for-profit corporations, organized to comply with Section 501(c)(3) of the Internal Revenue Code.  Additionally, many nonstock corporations registered in Delaware are “for-profit” business entities.

As part of a comprehensive revision of the DGCL to clarify its applicability to nonstock corporations generally, Section 114 was added to the DGCL in August 2010 to provide further clarity of the rules governing nonstock corporations.  Notable revisions that have been made through these 2010 amendments are as follows:

  • The provisions of the DGCL that address stockholders and boards of directors shall also be equally applicable to the ‘‘members’’ and ‘‘governing bodies’’ of nonstock corporations.
  • Nonstock corporations are now required to have members pursuant to an amendment to Section 102 of the DGCL.  Further, the members are deemed to be whoever is entitled to vote for the election of the corporation’s governing body, if members are not provided for in the corporation’s bylaws of certificate of incorporation.
  • The inclusion of a savings clause in Section 102(a)(4), which provides that neither a nonstock corporation’s existence nor any of its actions will be invalidated by virtue of its failure to have members and where the certificate of incorporation and bylaws are silent regarding the requirements for membership, the persons who are entitled to elect the governing body will be deemed to be the nonstock corporation’s members. 
  • Members of a not-for-profit nonstock corporation cannot take an equity interest in the corporation.

These amendments will help provide guidance and clarity to the governance and management of nonstock corporations that are registered in Delaware, and should be considered by any entity or individual seeking to form a nonstock corporation in this state.