For businesses organized as limited liability companies (“LLCs”), the operating agreement among the LLC and its members, or owners, is the primary document governing the rights and obligations of the business’ owners and management that also specifies the manner in which the organization operates. As such, an LLC’s operating agreement should be reviewed by its members on an ongoing basis to evaluate its relevance and appropriateness not only when the members look to expand their ownership structure but also as the business progresses through its various life stages. Additionally, business owners should take the time to review the provisions of their operating agreement with counsel whenever there is a significant change in the rules governing the operation of LLCs in the state where their entity is formed.
Recently, the laws governing LLCs formed and/or doing business in New Jersey underwent one such change when the New Jersey legislature enacted its version of the Revised Limited Liability Company Act (the “Revised Act”), which was effective March 18, 2013 for all new LLCs formed after this date and will be effective for all LLCs on April 1, 2014. This article will explore some of the changes found in the Revised Act that impact LLCs.
As a threshold matter, to the extent the members of an LLC do not have in place a written operating agreement, members should make the time investment to think critically about how the business should operate as well as their rights and obligations to each other and then reduce their agreement to writing, especially in view of the new rule changes. Beyond certain baseline parameters and default rules, LLC statutes promote flexibility in the management and operation of the LLC, often deferring to the operating agreement on matters such as ownership rights, management structure, organizational decision-making and dispute resolution, voluntary and involuntary transfers, and valuation considerations. Previously, the law specified that an operating agreement be a written instrument among the parties. Under the Revised Act, the definition is much broader as oral agreements, understandings of the members found in a record, and implied agreements of the members can collectively be considered the LLC’s operating agreement. As a result, more information can now be considered to define the members’ agreement on the business and their respective rights and duties, which may result in unintended consequences for some members when there is no open discussion that results in a written agreement that effectively integrates the parties’ mutual understandings.
The members of an LLC may elect to share in the management responsibilities of their business or they may elect to vest most of the organization’s management responsibilities in a manager or board of managers. Further, the members or the manager(s) may, similar to a corporation, delegate certain managerial responsibilities or authorize officers of the LLC to act for or on behalf of the LLC. While an operating agreement may or may not establish officer appointments (but should set forth the authority to grant such appointments), the Revised Act expands upon the prior statute by providing that the operating agreement governs, among other items, the relations between the members and the LLC, the rights and duties of a person in the capacity of manager, and the conduct of the activities of the LLC. Accordingly, the members, with the input of the manager(s) (if the LLC is manager-managed), should periodically evaluate the decision-making responsibilities set forth in the operating agreement to rationalize what shall be required to constitute an act of the company. For example, agreements often contain a list of major decisions that require either a super-majority or unanimous vote. The members should review this list from time to time and consider whether its parameters and the items included (or not included) on it are still consistent with the business reality of the LLC.
Additionally, the Revised Act permits LLCs to file a statement of authority with the State of New Jersey that sets forth the authority, or the limitations on the authority, of all persons holding a particular position with the company to execute an instrument transferring real estate in the name of the LLC or otherwise bind or act on behalf of the LLC. To the extent a certificate of authority is on file, third parties contracting with a representative of an LLC are presumed to have knowledge of such individual’s authority (or his limitations), irrespective of how this individual is represented to the third party or what the LLC operating agreement says. Therefore, as a matter of good governance, it is incumbent on the members and manager(s) of the LLC to ensure that the operating agreement conforms to any filed and effective statements of authority.
An operating agreement is also an important document in that it memorializes the expectations of the members’ rights and obligations as to each other. As such, it is the primary document the members look to in the event of an offer to purchase either the company or some or all of the membership interests, the voluntary or involuntary (such as upon death, disability, bankruptcy, divorce or upon a showing of cause) withdrawal of a member, or when the members simply cannot agree on a major decision impacting the LLC. Often, these events trigger a buy-out option or a liquidation event, and the members, so as to preserve their value in the enterprise, should be continuously aware of each of these triggering events and the attendant rights of the company and non-affected members. Further, the members should be aware of the various valuation methodologies available in the event a value must be ascribed to affected membership interests.
Beyond the initial considerations regarding members’ rights outlined above, the Revised Act also implements some important changes to New Jersey LLC law that may affect the rights of members under operating agreements drafted in relation to the prior LLC statute. For example, under the Revised Act, New Jersey law now makes clear that a member’s dissociation, or withdrawal, from the LLC does not entitle the member to a distribution upon dissociation. Rather, in the absence of the members’ agreement to the contrary, the dissociating member continues to hold an economic interest but has no right to vote or participate in the management of the LLC. Alternatively, New Jersey law previously provided that, except as otherwise set forth in the operating agreement, a member was entitled to receive the fair value of his membership interest as of the date of his resignation within a reasonable time following such resignation, less all applicable valuation discounts. Therefore, under the Revised Act, if a member’s dissociation is not expressly addressed in the operating agreement, then the dissociated member will remain entitled to his share of future distributions and the subsequent appreciation of his economic interest in the LLC.
Additionally, the Revised Act also now provides for certain minority membership rights, whereby a member can apply for a judicial order of dissolution of the LLC when the manager(s) or the members in control of the LLC have acted in a manner that is oppressive and was, is or will be harmful to the applicant. This provision of the Revised Act grants new statutory rights to minority members that permits the court, on application by the affected member, to examine the interactions of the members and even the written terms of the operating agreement to determine whether the manager(s) or controlling members acted in an oppressive and harmful manner as to the applicant member. Accordingly, while this standard remains subject to further development and interpretation, its mere inclusion in the Revised Act should cause LLC owners to revisit their operating agreements and reconsider whether provisions impacting holders of minority membership interests could be considered by a court as rising to a level of bad faith.
In highlighting only a selection of the several changes brought about as a result of the enactment of the Revised Act, the article stresses the need for the New Jersey LLC to have in place a written operating agreement that is adapted to the new law. Further, the recent rule changes also present the opportunity to evaluate the principal terms of an LLC’s operating agreement with a view towards current business operations and the needs of the business’ owners.
For more information about your operating agreement or any franchise related questions, please e-mail Justin Csik at email@example.com or by phone at 609-896-9060.