3 Dangers of Not Understanding Your LLC Operating Agreement

Think you can sign your LLC Operating Agreement, put it in a drawer, and then forget it?

No chance.

Think of your Operating Agreement as the foundation of your business…the playbook for your company.

Need to know what happens if a member leaves or dies? Operating Agreement. What everyone’s roles and responsibilities are?  Operating Agreement.  Resolving disputes among members?  Operating Agreement.

So you can see how if you referred to your Operating Agreement and it didn’t address these situations, or it stated the opposite of what you thought or wanted, it could be a big problem.

“My attorney prepared my Operating Agreement and he/she knows what it says so I’m sure it’s fine.”

Even if we assume your Operating Agreement hasn’t needed to be updated since your attorney first drafted it, your attorney does not make the day to day decisions regarding your business to ensure you are complying with the Operating Agreement.  So let’s a look at some possible dangers of not knowing what your Operating Agreement says:

There Are Requirements Not Being Met.

Your Operating Agreement may outline what happens if capital calls are not made, if there are terms you thought applied but were not written in the Operating Agreement, or how disputes are resolved.

Let’s take a look at a case that highlights this:

Wisner vs. SB Indiana LLC.  In this case, money needed to be raised for the LLC and the Operating Agreement explicitly permitted the manager to make capital calls. A member failed to make his capital contribution and as a result his ownership interest was diluted to zero.  The member sued claiming the dilution of his interest was oppressive.  The court ruled in favor of the manager because the reduction of a member’s interest who did not contribute to a capital call was clearly authorized in the Operating Agreement.  Apparently, the member failed to read the Operating Agreement to understand what would happen if he did not make the capital call.

Your Oral And Other Written Agreements May Not Matter.

Have you had discussions or emails where you agree on terms that are different from what is in the Operating Agreement?  Don’t assume these other agreements are going to hold up in court.

Operating Agreements  usually have language that state that the Operating Agreement supersedes any other agreements that are not explicitly incorporated into the Operating Agreement.

Here’s a case demonstrating this:

Copacia vs. Ginzinger.  A LLC was formed with two equal members to start a development. Member 1 contributed personal funds for the operating expenses and development costs of the LLC, and both Members agreed Member 2 would repay Member 1 50% of the costs and expenses. When Member 2 failed to repay, Member 1 filed a lawsuit seeking his 50% share.  However, the Operating Agreement restricted Member 1’s remedy to a “reallocation of the members’ sharing ratio.” Therefore, Member 1 could not force Member 2 to pay him money, he was only entitled to a greater ownership interest in the LLC (which might be worthless if the real estate deal goes south). Here, the verbal agreements were not incorporated into the Operating Agreement and the court upheld the terms of the Operating Agreement.

Your Rights May Be Restricted.

The previous case also points out how your rights can be limited when there is a dispute. Member 1 had no idea he couldn’t recoup his money, and his only option was to receive a greater ownership interest in a possibly defunct LLC.

The following illustrates how a member’s rights can be limited:

Altobelli vs. Hartmann. Plaintiff-Lawyer sued his law firm that terminated him after he accepted a position as coach of a college football team.  The firm’s Operating Agreement stated any “dispute, controversy, or claim… between the firm and any current or former principal… shall be solely and conclusively resolved by arbitration.” Although the Plaintiff sued the firm leaders and not the law firm itself, the court ruled that an LLC can only act through individuals, and therefore this dispute had to be resolved by arbitration. The Plaintiff was also unable to get a jury trial which may have given him a greater chance of success than arbitration.

Bottom Line:  Make sure your Operating Agreement is specifically tailored to meet the needs of your business, and you understand your rights and obligations under the Agreement.  The courts recognize the importance of Operating Agreements and you should too.  Otherwise, your dispute will ultimately be very costly when lawyers and courts get involved. 

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