Tips to Avoiding Unnecessary and Costly Disputes Between LLC Members
Two or three friends or associates come up with a good idea for starting an exciting new business venture They decide to go into business together and in doing so form an LLC by filing the Articles of Organization with the Arizona Corporation Commission. They launch the business by hiring employees, leasing an office space, setting up a marketing program and soliciting early sales, but all too often never explore or refine the details of their business relationship by conceiving or executing an Operating Agreement. More often than not, a disagreement arises during the business formation or their early days of operation and the parties realize they should have more explicitly spelled out the terms of their partnership in writing. They didn’t set forth thee LLC’s operational rules and address many of the contingencies which might occur as they move forward. Their recollections may be different regarding what terms they agreed upon, if they agreed upon them at all. They may not have even known the full gamut of terms to address, in their early business launching stage. If discovered early enough and if the parties are conciliatory, they can frequently patch things up and move forward. They realize at this point and hopefully it is not too late, that having a well-drawn and well-crafted operating agreement for a limited liability company is one of the most important steps a new partnership can take to assure its success. It can stabilize the new business launching and will be a critical document if legal disputes arise between LLC members.
What Is an Operating Agreement?
An LLC operating agreement is a contract between the owners of the LLC (called” members” in legalese) that defines the rights and responsibilities of the LLC and its members to each other. It sets forth the rules concerning how an LLC is to be operated, how its profits will be distributed, expulsion or withdrawal of members and a number of other details.
In Arizona such an agreement may be written or oral. Written is highly preferred however because disputes about terms of an oral agreement oftentimes assure litigation and such legal disputes are costly and detract from business profitability. A well-drafted operating agreement:
- Provides a framework for the internal operations of the company.
- Helps to protect the limited liability status of your LLC so you are less apt to be exposed to personal liability for business debts and commitments
- Is helpful in avoiding costly legal disputes
What Are Some of the Essential Terms Which Should Be Covered in the Agreement?
- Basic Information such as LLC name, principal office(s) address(es), purpose of the company, company duration and information regarding members including names and addresses
- Creating a voting method for members.
- The setting of rules for admitting new members
- Setting rules for the transfer of shares
- Creating remedies if a member defaults and fails to pay required capital contribution
- Tax provisions: Taxation as a partnership, S Corporation or C Corporation
- Rules of internal operation/management: manager-managed or member-managed, …
- Rights of Members: Sale of membership interest, withdrawal or expulsion
- Capital Contributions both initial and additional: money, property, knowledge and expertise
- Non-compete provisions
- Buy-Sell Provisions relating to divorce, bankruptcy, etc.
What Happens If Your Limited Liability Company Does Not Have an Operating Agreement?
- In Arizona, like most other states, if an AZ LLC has been formed, but there is no written operator’s agreement, the situation is governed by a default provision in A.R.S. 29-3105B.. A.R.S. which establishes certain general governing rules. In April 2018, Arizona Governor Ducey signed into law SB 1353, which provided for repeal of the existing LLC laws replaced them with the new Arizona Limited Liability Company Act (ALLCA). Starting September 1, 2019, ALLCA applies to all Arizona LLCs formed on or after that date, and on September 1, 2020, Arizona’s current LLC law will expire, and ALLCA will apply to all Arizona LLCs, regardless of their date of formation. In Arizona For information regarding the statutory default rules, if you do not have an operator’s agreement, you are welcome to give us a call at 602 228-0328.
- The new ALLCA was enacted, primarily to govern issues left unaddressed in an AZ LLC’s operating agreement. For example, the 2018 LLC Act adds: Standards for fiduciary duties and duty of good faith and fair dealing; Centralized list of what statutory default rules can, and cannot, be changed in an operating agreement; New default rules for member voting; and Statutory indemnification rights for managers. In particular, owners tend to leave out any clear statement of what fiduciary duties the members and managers owe to the company and one another. Generally, a person in a position of control and trust must act with care and loyalty to those he or she serves.
- Arizona limited liability companies should have a written operator’s agreement to limit the new liability imposed by the default provisions of the new ALLCA law. The default provisions under the old law were not particularly favorable when applied to LLC’s without written operator’s agreements and now things are even worse and dictate more strongly new agreements or amendment of previous agreements..
Common Types of Disputes That Develop that Are Often Prevented/Resolved by Having a Good Operating Agreement; Disputes Which May Threaten the Viability of Your Partnership
- Disputes over terms of the partnership agreement- A good reason to implement a strong, clear operating agreement in the first place
- Disputes over alleged misconduct or malfeasance by one of the partners
- Disputes over non-performing partners and what, if anything, can be done to increase their productivity
- Dispute regarding technology licensing agreements and intellectual property agreements
- Disagreements over business management of the company
- Disagreements over hourly input of partners and/or workload imbalance
- Disagreements concerning resource expenditure and partnership distributions
Recommendations for Avoiding or Mitigating Disputes
Hire a well-qualified legal counsel to draft your documents. This relates to the initial operating agreement and in particular the dispute resolution provisions and consider executing a partnership or LLC Buyout Agreement.
Engage in Direct Negotiation: Address the issue(s) directly with your partner informally. Do so in private, without other staff participation. If you disagree on certain points, table them and see what you can agree upon first. The other pieces may fall into place.
If the dispute is too complicated or too emotional to resolve through direct negotiation, consider seeking the assistance of legal counsel, using alternative dispute resolution or participating in mediation with a well-qualified neutral third-party mediator.
If you would like to speak to a well qualified business attorney on any of the above topics, please give us a call at the Law Offices of William D. Black, (602) 265-2600 or email us at billblack@billblacklaw.com We would be happy to help.