by George Benaur
Many people are forming limited liability companies (LLCs) without fully understanding the legal importance of having a good LLC operating agreement or the reasons for keeping corporate records as part of operating the company. This scenario is all too common – a couple of partners decide to engage on a business venture and immediately launch an LLC without adequately negotiating the terms of the LLC operating agreement, and sometimes without even executing an LLC operating agreement at all. After forming the company, the partners focus on trying to get deals in place and to generate revenue, and as they do so, they do not keep adequate records (or any records). Then, at some point, they have a dispute and try to backtrack in order to try to resolve it. They each have conflicting versions of what the real “deal” was for the business.
Avoiding this problematic scenario begins with negotiating, drafting and executing a good written LLC operating agreement. Having such a written agreement can definitely save costs down the road and protect the members’ interests. The LLC Operating Agreement is needed in order to clearly provide for the internal operations of the company. Although New Jersey law governing LLCs does recognize oral operating agreements in some instances, it is always advisable to have a written operating agreement. An oral agreement leaves too many issues open in case of a dispute.
Relying on a “form” LLC operating agreement generally does not work. Every company is different, so it is not advisable to use one form for all situations. A properly structured LLC Operating Agreement needs to deal with a broad range of issues, including but not limited to:
- Identify the members and their membership interests
- Record whether the members contributed any capital to form the company
- Who and how will manage the company
- How corporate decisions will be made?
- How will profits be divided and distributed?
- Can new members get in? Can original members get out?
- Who will be responsible for the tax matters of the LLC?
- Other issues specific to the company
In addition to having an LLC Operating Agreement, LLC members need to keep proper records for the company, regardless of the size of the business. These records are important not only to document the path of decisions and corporate actions (by keeping track of minutes of meetings and corporate resolutions), but also to strengthen the chances of the members having protection from potential personal liability in the future.
Just like a corporation, the limited liability company is considered to be a separate legal entity from its members, and generally speaking, the LLC members are insulated from the liabilities of the company. In order for this protection from personal liability to be effective and actually stand up in court, however, it is important to clearly distinguish the acts of the company from the acts of the individual members.
Here is a common example. An LLC was formed by an individual and incurred a debt to one its vendors who then brought a collection suit against both the LLC and the individual owner. The vendor argues that the corporation is a mere sham and is really just an alter ego of the individual owner, so the individual owner should be personally responsible for the LLC’s debt. When analyzing potential personal liability in this type of case, the courts look to whether the company has really operated separate from the owner(s). The factors courts consider in whether to impose personal liability on the owner (under the doctrine known as “piercing the corporate veil”) include: failure to observe corporate formalities; gross undercapitalization; non-payment of dividends; day-to-day involvement of the directors, officers and personnel; insolvency; siphoning of corporate funds by the dominant shareholder; non-functioning of other officers or directors; and absence of corporate records. In some cases, people try to go back and re-create the corporate records, but this is really not advisable and can actually strengthen the case against the individuals by providing the additional argument that they have engaged in fraud (which is another reason for potential personal liability in the veil piercing doctrine).
The bottom line is that people forming companies need to understand that they do need to properly document both their agreement as to how the company will operate and then also comply with the legal requirements for operating the company. Although it may seem like an unnecessary layer of paperwork, keeping proper corporate records is extremely important to help avoid disputes and to insulate the owners from personal liability.