Why Your LLC Needs an Operating Agreement

There are quite a few reasons your limited liability company (LLC) needs an operating agreement and this blog post does not purport to include all of them.  However, over there years we've seen a number of legal issues arise that could've been resolved quickly and efficiently if the LLC  owners had negotiated and executed an operating agreement.

First, if your LLC doesn't have an operating agreement, the company will be governed by your state's LLC statute (in Utah, the controlling statute is the Utah Revised Limited Liability Company Act, referred to herein as the "Act" - this post only considers the Utah Act, although many state LLC statutes are similar).  There are a few things that the Act doesn't address; furthermore, there are other areas where the LLC owners can, and will probably want to, forego the provisions of the Act in favor of something different.

Authority to Bind the Company

Under the Act, an LLC is member-managed unless the operating agreement expressly states that the LLC is manager-managed.  Therefore, if an LLC has no written operating agreement, it is by default a member-managed LLC.

In a member-managed LLC under the Act, "Each member has equal rights in the management and conduct of the limited liability company's activities and affairs."  That means that whether a member owns 1% or 99%, that member has equal rights in the management of the LLC.

Essentially, if a difference arises among the members as to a matter in the ordinary course of the activities of the LLC, the issue would be decided by a majority vote of the members. Notice that the previous sentence doesn't say "decided by a majority interest of the members." Under the Act, three members owning a total of 3% could technically out-vote two members owning a total of 97%.

Distributions

Similar to the voting issue discussed above, distributions of current LLC profits under the Act is done on a "per capita" or head-count basis.  Therefore, if the LLC has no operating agreement, the members should receive distributions of current profits in equal amounts regardless of ownership percentage.

This rule is a recent change to the Act and will likely come as a surprise to many LLC members - particularly those with significant investment capital invested in privately-held LLCs.

Deadlock Remedies 

An older version of the Act stated that a member may seek judicial dissolution of an LLC if (i) the managers are deadlocked, the members are unable to break the deadlock, irreparable injury to the LLC is threatened or being suffered, and the business of the LLC can no longer be conducted effectively because of the deadlock; or (ii) the members are deadlocked in voting power and the deadlock has continued for a period of at least six months.

First of all, the previous statutory remedy of judicial dissolution is far from efficient.  The process could take years and the members could end up spending tens of thousands (or hundreds of thousands!) of dollars in legal fees. Secondly, the current version of the Act does not explicitly include judicial dissolution as a potential remedy for member or manager deadlock.  The new Act states that a member may seek judicial dissolution if it is no longer "reasonably practical to carry on the business of the [LLC]." Whether or not that includes member or manager deadlock has yet to be determined by the courts.

There are a number of more efficient ways an LLC can overcome deadlock through an operating agreement, such as buy/sell clauses, tiebreaker provisions, etc.  A little foresight and a good attorney can help prevent a lot of future costs and headaches.

These are just a few reasons you'll probably want to talk to an attorney about drafting an operating agreement for your LLC.  At the end of the day, if your LLC has multiple members, an operating agreement is probably a good idea.