The Importance of a Well Drafted Operating Agreement Following the Enactment of the New North Carolina LLC Act

July 15, 2015

On January 1, 2014, the North Carolina General Assembly enacted the new North Carolina Limited Liability Company Act under Chapter 57D of the North Carolina General Statutes (the “New LLC Act”) and repealed the former LLC Act codified in Chapter 57C of the General Statutes (the “Old LLC Act”).  Given that the new legislation replaces the Old LLC Act, it should be noted that the provisions of the New LLC Act apply to limited liability companies formed prior to the January 1, 2014 effective date.

The underlying public policy objective of the New LLC Act is predicated on giving “maximum effect to the principle of freedom of contract and the enforceability of operating agreements” (N.C.G.S. 57D-10-01).  This stated policy objective is realized by providing a flexible framework through which enterprising parties can organize and operate their respective businesses as they deem appropriate with minimum statutory restrictions.

The New LLC Act makes it clear that, except for certain limited default rules which cannot be overridden (which are primarily procedural in nature such as the right to bring derivative actions and the right to inspect company records), the operating agreement agreed to by the LLC owners will supersede the default rules of the Act and control the respective rights and obligations of the owners and the manner in which the business of the LLC is to be governed.  This article is not intended to be an exhaustive treatise on the content and implications of the New LLC Act, but instead aims to highlight a few of the reasons (i) new LLC owners should consider drafting a comprehensive written operating agreement that properly articulates the business relationship to be conducted through their newly formed LLC and (ii) existing LLC owners should consider updating their current operating agreements.

1.     Require a Written Operating Agreement

First, in contrast to the Old LLC Act, which required an operating agreement to be in writing in order to override or modify the default rules, the New LLC Act makes it clear that the operating agreement can be written, oral or implied.  While this approach certainly provides flexibility with respect to the form that the operating agreement can take, there are inherent dangers in relying upon a non-written operating agreement to dictate the operation of the LLC and the rights and duties of its owners.  Failure to reduce the terms of the business relationship to writing at the inception of the LLC may lead to incongruent understandings among the owners as to the nature of the terms and may overlook important issues, thereby increasing the likelihood of disputes between the owners when unanticipated events subsequently arise.

In the event there is a dispute among the LLC owners, it will be very difficult (and likely expensive should litigation ensue) for disagreeing parties to prove the terms of an agreement that was derived orally or through implication, or that did not require all amendments to the operating agreement to be consented to in writing.  As such, it is good practice that the LLC owners require that their operating agreement, and any and all amendments to the operating agreement, be in written form.  Otherwise, in the event a dispute arises as to the agreed upon terms of the operating agreement, one LLC member could argue that the original written operating agreement had been amended orally or by implication.

2.     Consider Modifying the Default Rules of the New LLC Act

Absent a well-drafted operating agreement, the business relationships of the LLC owners will be subject to the default rules of the New LLC Act which can lead to unanticipated results inconsistent with the expectations of the parties.  For instance, Section 57D-3-20(b) of the New LLC Act provides that, absent an agreement to the contrary, each member of the LLC will be a manager and each manager is allotted one vote irrespective of the relative amounts of capital contributed by the various members.  Majority of votes cast will dictate the action of the company.  As such, two minority members who each only contributed 10% of the capital to the LLC could effectively outvote the majority member and control the decision-making of the LLC, even though the majority member provided 80% of the capital.  Therefore, it would be wise for majority owners to craft a written operating agreement which supplants this default rule granting equal management rights to the members regardless of their relative economic interests.

Another default rule of the New LLC Act which may merit modification by LLC owners is found in Sections 57D-4-01 and 57D-4-03 and essentially provides that the members’ distribution rights will be based upon the their relative “contribution amounts” to the LLC.  A member’s “contribution amount” equals the fair market value of the capital, services “or other direct or indirect benefits” contributed, or promised to be contributed, to the LLC.   While the Old LLC Act required that the members agree to the fair market value of noncash contributions to the LLC in order to establish the “contribution amount”, the New LLC Act does not require an agreement among the members as to the value of such noncash contributions.

Theoretically, a member could unilaterally perform services for the LLC without the consent of the other members and claim to have increased his or her economic rights in the LLC for doing so.  Or, there may be uncertainty among the members as to the nature and extent of the services to be performed.  In addition, the rendering of services beyond what may have been contemplated by the other members may adversely impact such other members from a tax perspective due to the indirect shift in capital to the service provider.

Given that, under the default rules of the New LLC Act, a service providing member’s distribution rights in the LLC will be based on the fair market value of the services rendered (or promised to be rendered) by such member, the members would be wise to have an operating agreement that requires agreement among the members as to the fair market value of the services to be performed. In addition, the operating agreement should clearly describe the specific services to be performed, the scope and duration of such services, and the fair market value to be attributed to such services for purposes of ascertaining such member’s contribution amount to the LLC.

Another issue that LLC owners may wish to address in a written operating agreement is the right of managers to delegate their management responsibilities to others.  While such delegation was prohibited under the Old LLC Act absent an agreement among the members to the contrary, the default rule of the New LLC Act permits the managers to delegate their managerial rights.  Accordingly, if the LLC members’ mutual intent is to preclude management delegation, the operating agreement should clearly state that restriction.

3.     Address New Definitions in the New LLC Act

Another reason LLC owners may wish to revisit their current operating agreement is to account for definitional changes in the New LLC Act that may create confusion or inconsistencies with respect to certain defined terms in the body of the operating agreement.  Although Section 57D-11-03(e) of the New LLC Act provides that references in an existing operating agreement to provisions of the Old LLC Act are deemed to be made to the corresponding provisions of the New LLC Act, there may be instances when the applicable corresponding provision is less than clear.

For instance, references in an existing operating agreement to “membership interests” under the Old LLC Act would presumably refer to “ownership interests” under the New LLC Act.  However, the New LLC Act distinguishes between an “economic interest”, which entitles the interest owner to the “capital, income, losses, credits, and other economic rights and interests” of the company, and the broader “ownership interest”, which includes both economic rights and non-economic rights (such as voting rights, rights to information, rights to bring derivative actions, governance rights, if any, and inspection rights).  These definitional changes can be critical when dealing with transfers of ownership interests in various contexts, such as at death, incident to a divorce, pursuant to a bankruptcy proceeding, or in connection with a gift or voluntary sale.

Under the New LLC Act, a transfer of a “membership interest” would only entitle the transferee to the economic rights associated with that interest unless and until the transferee is fully “admitted” as a member of the LLC pursuant to the terms of the applicable operating agreement.  There may be certain contexts in which the transfer of all rights (economic and non-economic) associated with the ownership interest is desired by the members, and other instances in which a more limited transfer of economic rights only is intended by the members (such as for estate planning or asset protection purposes).  Accordingly, given the definitional changes brought about by the New LLC Act, a review and update of the definitions section in operating agreements drafted under the Old LLC Act may be warranted to ensure conformity with the members’ mutual intent.

4.     Conclusion

The New LLC Act has been lauded for the broad flexibility it provides LLC owners when preparing an operating agreement to capture the terms of their business relationship and the manner in which it should be governed.  While the legislation is predicated on freedom of contract principals with limited prescribed statutory requirements, there are various default rules under the New LLC Act which may require consideration and modification through an operating agreement in order to comport with the members’ mutual intent and minimize disputes down the road.

As such, it is critically important that LLC owners take the time to prepare a comprehensive written operating agreement that properly articulates the business relationship to be conducted through the LLC.  Further, with respect to operating agreements entered into while the Old LLC Act was still in effect, it would be highly advisable to review your existing operating agreement with your legal advisor to determine if updates to your agreement are needed in light of the promulgation of the New LLC Act.