The “Unintended” Consequences of Not Having a Written LLC Operating Agreement

December 08, 2020

CONGRATULATIONS!! You have just formed a New York limited liability company to purchase a piece of rental property with your cousin Vinny (no, not that Cousin Vinny) and his good friend Michael. Forming a limited liability company to hold real estate is a smart decision. An LLC gives you limited liability protection from creditors and there are certain tax advantages to such structure, such as pass through treatment for U.S. income tax purposes which generally provides for taxation on profits solely at the member level.

However, while you and your partners made a good decision to hold the property through an LLC, unfortunately, since everyone was so focused on creating the LLC and closing on the real property purchase, you all forgot to put in place your LLC’s governing document, known as an operating agreement.

If you are more familiar with corporations, an operating agreement is essentially a cross between a corporation’s by-laws and a shareholders agreement. A key difference, however, is that shareholder agreements, while strongly recommended (see my article on the benefits of shareholder agreements), are legally optional. On the other hand, written operating agreements not only make good sense, under New York law they are in fact legally required (see, https://www.nysenate.gov/legislation/laws/LLC/417).

Under New York’s Limited Liability Company Law (the “LLC Act”), an operating agreement may contain 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. Moreover, failing to enter into a written operating agreement that clearly and adequately addresses the rights and obligations of its members, will leave the LLC and its members subject to the default provisions of the LLC Act as its governing writing.

Relying solely on the default provisions of the limited liability company law can have unintended, and possibly detrimental, consequences to one or more members. For example, if you, Vinny and his good friend Michael each own a one-third (1/3) membership interest, did you know that Vinny and Michael can adopt an operating agreement without your approval? That’s right, under Section 402(c)(3) of the LLC Act, unless you have an operating agreement that says otherwise, members holding a majority of the membership interests, can adopt an operating agreement without the consent of the other members. This is certainly not a position a minority member would want to find him or herself.

In addition, without an operating agreement that says otherwise, members holding a majority of the membership interests can, among other things, (i) admit new members and issue such person a membership interest in the LLC (which would result in a dilution of your percentage membership interest)[1], (ii) incur indebtedness, and (iii) approve the sale of the LLC’s assets. (see clause (c) of https://www.nysenate.gov/legislation/laws/LLC/402)

Clearly the actions that can be taken by the majority members without the say of minority members are significant and impactful on the LLC’s management and the venture as a whole. Therefore, while you may be eager (or even pressed) to move forward with a venture quickly, it is strongly encouraged that you and your “to be” partners take the time to put in place a well-structured operating agreement that sets forth the parties intentions and provides for agreed rights and protections.

Lyle C. Mahler

Lyle C. Mahler is a Partner in the Corporate and Commercial Finance & Banking Practice Groups of Farrell Fritz, P.C.

[1] Percentage dilution is not always a bad thing if the result does not cause an economic dilution, meaning the value of a member’s share of the enterprise remains the same or is increased notwithstanding that such member’s percentage interest has decreased. For example, assume a 20% membership interest is worth $1,000,000 (i.e. a $5,000,000 enterprise value). If a new investor purchases a 10% interest from the LLC for $1,500,000, the investment results in a dilution to the 20% member, down to 18.18%, however, the $1,500,000 cash infusion increases the total enterprise value of the LLC to $6,500,000, which for the 18.18% member, equates to a value of $1,181,700, or a $181,700 increase over the member’s 20% pre-investment value.

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