Drafting LLC Operating Agreements: Beware of Statutory “Default” Rules BUSINESS LAW STATE BAR

BUSINESS LAW
STATE BAR
CONVENTION PREVIEW
The Business Law Section is pleased to
be hosting Harold A. (“Hal”) Hadden, of the
Denver, Colorado firm of Hadden, Morgan &
Forman, P.C. Mr. Hadden, who will lead off
the afternoon session with a discussion of the
issues facing companies being investigated in
the highly charged corporate compliance environment following the fraud scandals that
have rocked the corporate and accounting professions nationally in recent years.
Sarbanes-Oxley Legislation;
Corporate Fraud
Mr. Hadden has substantial experience
with national cases involving SarbanesOxley where significant allegations of corporate fraud were at stake. The Section is truly
fortunate to be able to offer his perspectives
on these very important issues at the upcoming Convention.
In addition to examining corporate
criminal enforcement issues on the national
level, the Section’s Friday afternoon session
will include a panel discussion on white collar criminal enforcement in Arizona. This
program will be moderated by Lee Stein of
Fennemore Craig.
Mr. Stein will be joined by a distinguished panel consisting of Paul Charlton,
the United States Attorney for the District of
Arizona; Donald E. Conrad, Chief Counsel,
Criminal Division, Arizona Attorney
General’s Office; and a representative of the
Phoenix Division of the Federal Bureau of
Investigation.
In addition, Mr. Stein will be joined by
two other criminal defense attorneys in private practice in Arizona, Doug Behm, of
Jennings, Strouss & Salmon, P.L.C., and
Tom Henze, of Gallagher & Kennedy, P.A.
The panel will address federal and state
criminal law enforcement issues, overview
and impact of Sarbanes-Oxley, practical considerations when representing a corporate
client who is the subject of a criminal investigation, and ethical issues.
We are very excited about our programming for the upcoming State Bar
Convention, and hope that you will join us
on Friday, June 13, at The Phoenician.
Drafting LLC Operating Agreements:
Beware of Statutory “Default” Rules
By Kathleen Giancana
Perhaps the most important chapter in a
basic primer on “How to Draft Arizona
Limited Liability Company Operating
Agreements” would provide an outline of
the default rules contained in the Arizona
Limited Liability Company Act, A.R.S. §§
29-601 – 29-857 (the “Act”). What is a
default rule and why is an understanding of
the default rules important?
The Act basically contains three types of
provisions. First, it provides instructions on
how to form a limited liability company (an
“LLC”), how to amend the articles of
organization, what fees are required, etc.
Second, it contains various mandatory rules
governing Arizona LLCs that cannot be
changed by agreement of the members.1
Finally, it contains various default rules that
essentially create an operating agreement
for LLCs that do not have one, or resolve
matters upon which an existing operating
agreement is silent.
A default rule is a statutory provision that
governs the operation of an LLC unless an
operating agreement provides otherwise.
Some of the default rules are surprising.
For example, the default rule on member
voting provides that each member is entitled to one vote, regardless of percentage
interests. A.R.S. § 29-681.E. Thus, if the
percentage interests of A, B, and C in an
LLC are 85%, 10%, and 5%, respectively,
B and C voting together can control any
vote requiring a majority vote unless the
operating agreement provides otherwise.
A capable practitioner is likely to include
provisions dealing with most matters covered by the default rules. But unless the
drafter of an operating agreement has a
checklist of these rules, either written down
or in his head, he runs the risk of unintended consequences that may result from failing to address one or more of these matters.
Knowledge of the default rules is also useful in answering the common client question: “Why do I need an operating agreement?” In most cases, clients will not be
satisfied with the manner in which the
default rules would govern the operation of
their LLC. A brief description of those rules
will persuade them of the benefits of having an operating agreement.
Statutory Model Operating
Agreement
Most LLCs represented by legal counsel
have an operating agreement. The “model”
operating agreement resulting from the
default rules in the Act appears to have
been designed to protect and anticipate the
needs of unsophisticated joint venturers
who do not have legal advice in structuring
their LLC arrangement.
Under the default rules, each member is
treated equally with respect to voting, distributions, allocations of taxable income,
etc. The only exception is that distributions
are made in proportion to capital contributions, but only until all capital contributions
have been repaid. A.R.S. § 29-703.B. For
example, if the contributions to an LLC
made by A and B are $750,000 and
$250,000, respectively, the first $1,000,000
of distributions will be made 75% to A and
25% to B, but all further distributions will
be made to A and B equally. Thus, the Act
does not reflect the concept of “percentage
interests,” common to many operating
agreements, where the interests of A and B
in all operating and liquidating distributions
might be 75% and 25%, respectively, even
after capital contributions have been repaid.
It is important to note in the following
discussion of the default rules that, unless
otherwise stated, all of the rules can be
modified by an operating agreement.
Capital Contributions
Services as Capital Contribution. Under
the Act, the term “capital contribution”
includes services. The value of a contribution of services is the fair market value of
the services at the time they are rendered.
A.R.S. §§ 29-601.3, 29-703.C.1. Assume,
for example, that A contributes $1,000,000
to an LLC and B only contributes services.
Many operating agreements would provide
that A was to receive a return of his
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May 2003 • The Arizona Business Lawyer
Drafting Limited Liability Company Operating Agreements: Beware of Statutory “Default” Rules
$1,000,000 contribution before any amount
was distributed to B. Under the default
rules, however, it would be necessary to
determine the value of B’s services. Initial
distributions to A and B would be made on
a pro rata basis as if B had contributed cash
in an amount equal to the fair market value
of those services (which arguably would be
worth $1,000,000 if B received a 50% interest). If this is not the intended result, the
operating agreement should specifically
provide that the provision of services is not
treated as a capital contribution.
The capital contribution default rule also
creates a lurking tax problem. In general, if
one member gives up any part of his right
to be repaid his capital contribution in favor
of another member as compensation for
services, the services member has upfront
income in an amount equal to the value of
his right to the other members’ capital contributions. Treas. Reg. § 1.721-1(b)(1);
Rev. Proc. 93-27, 1993-2 C.B. 343. In the
example above, B may have a right to a
portion of A’s $1,000,000 contribution
under the default rules if he has already performed the services for which he is receiving the capital contribution at the time A
contributes the $1,000,000. This could
cause the receipt of the interest to be immediately taxable to B.2 Thus, an operating
agreement should specifically provide that
the provision of services is not treated as a
capital contribution or, if it is intended that
capital contribution credit be given for services, the tax consequences of the provision
should be carefully analyzed and explained
to the members prior to their execution of
the operating agreement.
Value of Capital Contributions. Unless
an operating agreement provides otherwise,
the value of capital contributions is determined as follows: (a) the value of services
is the fair market value of the services at
the time they are rendered, (b) the value of
property other than cash is the fair market
value of the property at the time it is transferred to the LLC, (c) the value of the “use
of property” is the fair market value of such
use when the LLC enjoyed the possession
or use, and (d) the value of other non-cash
contributions is zero. A.R.S. § 29703.C. As
in the case of services, if the value to the
LLC of the use of a member’s property is
not intended to be treated as a capital contribution, this needs to be specifically stated
in the operating agreement.
Consent to Capital
Contributions. Under the
default rules, the consent
of all members is necessary to fix or modify the
amount of capital contributions required to be
made by the members, or
to release a member from
an obligation to make a
capital contribution.
A.R.S. §§ 29701.B,
29702.C. Thus, even in a
“manager managed”
LLC, the manager cannot require additional
capital contributions to be made by the
members unless the operating agreement
specifically provides him with that power.
Inability to Perform. Under the default
rules, a member is required to perform any
enforceable promise to make a capital contribution, including a promise to perform
services, even if he is unable to perform
because of death, disability, or any other
reason. A.R.S. § 29-702.B. If a member
does not make a required capital contribution or perform required services when due,
he is obligated at the option of the LLC to
contribute cash equal to the value of that
portion of the promised capital contribution
or services that have not been made. This
provision should be taken into account
when representing services members
because, unless the operating agreement
provides otherwise, the estate of a services
member may be monetarily liable if the
member ceases to be able to perform services because of his death or disability.
any vote requiring the approval of a majority of the members or managers requires the
affirmative vote of more than one-half of
the members or managers, respectively, voting on the basis of one vote per member or
manager. A.R.S. § 29-681.E. Thus, if the
percentage interests of the members are not
equal and a vote reflecting the different percentage interests is desired, the
operating agreement must provide that each member has a
percentage vote equal to his
percentage interest.
Actions Requiring
Unanimous Vote. The following actions require the unanimous vote of all members
under the default rules
(whether the LLC is “member
managed” or “manager managed”): (a) adopting or
amending the operating agreement, (b) authorizing a transaction or action
unrelated to the purpose or business as set
forth in the operating agreement, (c) issuing
an LLC interest to any person, (d) approving a plan of merger or consolidation with
or into another business entity, and (e)
changing the status of the LLC from member managed to manager managed or vice
versa. A.R.S. § 29-681.C. Unless an operating agreement contains specific provisions
to the contrary, these default rules may give
a minority member more power than is
intended by the parties. For example, it is
not uncommon for an operating agreement
to fail to address a merger of the LLC into
another entity. If the agreement is silent,
however, the approval of all members is
required, no matter how slight their percentage interest may be.
Actions Requiring a Majority Vote. The
following actions require the approval of a
majority of the members or managers under
the default rules (depending upon whether
the LLC is member managed or manager
managed): (a) resolving business differences, (b) authorizing distributions, (c)
authorizing the repurchase of a member’s
The capital
contribution
rule also
creates a
lurking tax
problem.
Voting
Per Capita Basis. Under the default rules,
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Drafting Limited Liability Company Operating Agreements: Beware of Statutory “Default” Rules
interest, (d) authorizing the filing of a
notice of winding up or articles of termination concerning the LLC,3 and (e) authorizing most amendments to the articles of
organization. A.R.S. § 29-681.D.
the managing member/manager if the LLC
were manager managed. A.R.S. §§
29681.D, 29703.A.
Choice of Manager. A manager of an
LLC does not have to be a member unless
otherwise provided in the operating agreement. A.R.S. § 29-681.B. If an operating
Management
agreement does not provide a manner for
Member Managed versus Manager
designating or electing additional or
Managed. The decision with respect to
replacement managers, on the withdrawal or
whether an LLC should be member manresignation of a manager, management of
aged or manager managed is very important
the limited liability company continues to
if the default rules are not considered carebe vested in the remaining managers, or if
fully. Different default rules apply dependthere are no remaining managers, management is vested in one
or more new managers
to be designated or
elected by a majority
The decision with respect to
of the members. A.R.S.
§ 29-681.B.
whether an LLC should be
member managed or manag-
Distributions
Timing and Amount
of Distributions. If an
operating agreement
if the default rules are not
does not specifically
set forth rules for
considered carefully. Different
determining when distributions to members
default rules apply depending
are to be made and the
amount that is to be
upon the management status
distributed, all distributions must be approved
of the LLC.
by a majority of the
members, if the LLC is
member managed, or
by a majority of the
managers, if the LLC
is manager managed,. A.R.S. §§ 29ing upon the management status of the
681.D.2, 29-703.A. Almost all operating
LLC.4 See, e.g., A.R.S. § 29681.D. Some
LLCs are member managed but have a
agreements deal with the priority of distrimanaging member who has broad managebutions, i.e., how distributions are to be
ment authority. In that situation, many of
allocated among the members. Care should
the default rules will be applied differently
be taken, however, to make sure that the
than they would be if that managing memtiming and amount of distributions is also
ber had been the designated manager in a
addressed; otherwise, at least in the case of
manager-managed LLC. For example, the
a member-managed LLC, a majority vote
timing of distributions would be decided by
will be required each time a distribution is
a majority of the members if the LLC were
to be made.
member managed, but would be decided by
Priority of Distributions. The default rule
er managed is very important
for the priority of distributions may be surprising to some practitioners. Unless an
operating agreement provides otherwise,
distributions to members are made first in
proportion to capital contributions (cash and
the fair market value of other contributions,
including services and the use of member
property unless the operating agreement
provides otherwise) until each member has
been repaid his capital contributions, then to
the members equally (i.e., not according to
percentage interests). A.R.S. § 29-703.B. In
other words, if A contributes $800,000, B
contributes $200,000, and neither contributes services, the first $1,000,000 is distributed $800,000 to A and $200,000 to B,
and all further distributions are split equally
between them. In many typical arrangements with unequal capital contributions, A
and B would have expected that A and B
had acquired 80% and 20% interests,
respectively, and would been allocated distributions in an 80/20 ratio, even after the
return of capital contributions.5
Distributions on Liquidation. Under the
default rules, distributions on liquidation,
after paying creditors, are made first in satisfaction of certain statutory distribution
requirements to members and former members, then to repay capital contributions, and
then to the members equally (i.e., not
according to percentage interests). A.R.S. §
29-708.
Tax Allocations
Allocation of Profits for Tax Purposes.
Unless the operating agreement provides
otherwise, the allocation of profits (i.e., taxable income and certain other items) for tax
purposes is made in the same manner in
which members share in the amount of distributions that exceed their capital contributions. A.R.S. § 29-709. Thus, if the default
rules also apply for purposes of determining
the allocation of distributions (e.g., if there
is no operating agreement), profits are allocated to the members equally. A.R.S. § 29703.B.
Allocation of Losses for Tax Purposes.
Unless the operating agreement provides
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Drafting Limited Liability Company Operating Agreements: Beware of Statutory “Default” Rules
otherwise, the allocation of losses for tax
purposes is made according to the relative
capital contributions the members have
made, or have promised to make in the
future. A.R.S. § 29-709. Sharing losses in
accordance with capital contributions is
what would be expected because that is how
the members would economically suffer
losses. However, the provision does not
expressly limit the prescribed manner of
allocation to the amount of capital contributions made by each member, or take into
account the fact that the capital contributions may have already been repaid. Thus, if
A contributes $800,000 and B contributes
$200,000, the Act seems to provide that
80% of all tax losses would be allocated to
A, even if A had already been allocated
$800,000 in losses and/or had already
received a distribution of $800,000. As discussed below, however, regardless of the
wording of the default rule, such an allocation would not be respected for tax purposes
unless it were “in accordance with the partners’ interest in the partnership.”
Profits and Loses. The application of the
default rules dealing with profits and losses
are subject to section 704(b) of the Internal
Revenue Code and the Treasury regulations
promulgated thereunder, which govern the
allocation of profits and losses for tax purposes. Under section 704(b), if a partnership
agreement is silent with respect to a partner’s distributive share of the partnership’s
“income, gain, loss, deduction, or credit,”
the partner’s distributive share of such items
is to be determined “in accordance with the
partner’s interest in the partnership.” This
generally means allocations are to reflect
the manner in which the partners have
agreed to share the economic benefit or burden corresponding to the income, gain, loss,
deduction, or credit that is being allocated.
Treas. Reg. § 1.704-1(b)(3)(i). Among the
factors considered are (a) the partners’ relative contributions to the partnership, (b) the
interests of the partners in economic profits
and losses (if different from that in taxable
income or loss), (c) the interests of the partners in cash flow and other non-liquidating
distributions, and (d) the rights of the partners to distributions of capital upon liquidation. Treas. Reg. § 1.704-1(b)(3)(ii).
Transfers of LLC Interests
In General. Unless an operating agreement provides otherwise, an interest in an
LLC may be assigned in whole or in part.
A.R.S. § 29-732.A. The assignee, however,
does not become a member of the LLC
unless all of the members consent to his
admission as a member. A.R.S. §§ 29731.B.2, 29-732.A.
Release of Transferor from Liability.
Under the default rules, a member who has
assigned all or part of his interest in an LLC
is not released from his liability to the LLC
without the written consent of all members;
this rule applies whether or not the assignee
becomes a member. A.R.S. § 29-732.C. In
other words, if A assigns his entire interest
to B, A remains liable to the LLC for,
among other things, further capital contributions he was required to make (presumably
unless they are made by B).6 It is not
uncommon for operating agreements to fail
to overcome this default provision. In representing an assigning member, therefore, if it
important to examine the operating agreement, and if it does not overcome this
default rule, make sure the assigning member obtains the consent of the other member’s to relieve him of all future liability to
the LLC.
Remaining a Member. The Act provides
that a member who has assigned all of his
interest in an LLC remains a member until
the admission of one or more assignees as a
member, but an operating agreement may
permit the assigning member to remain a
member until all assignees of the member’s
interest have been admitted as members.
A.R.S. §§ 29-732.C., 29-733.2. Thus, if A
assigns half of his interest in an LLC to B
and the other half to C, A ceases to be a
member if either B or C is admitted as a
member, unless the operating agreement
provides otherwise.
Withdrawal of Members
Events of Withdrawal. An event of withdrawal is a circumstance under which a
member ceases to be a member of an LLC,
either voluntarily or involuntarily.
The Act includes both default events of
withdrawal (i.e., those that apply unless the
operating agreement provides otherwise)
and mandatory events or withdrawal. All of
the provisions, even those that are mandatory, can be overridden by the written consent
of all the members at the time of the event.
The default events of withdrawal are as
follows: (a) the member makes an assignment for the benefit of creditors or files a
voluntary petition in bankruptcy, (b) one of
various other bankruptcy-type events occurs
with respect to a member, (c) the member
is adjudicated incompetent, and (d) in the
case of a member that is acting as a member
by virtue of being a trustee of a trust, there
is a termination of the trust (but not merely
the substitution of a new trustee). A.R.S. §
29-733.
The mandatory provisions (which still
can be overridden by the consent of all the
members at the time of the event) are (1)
the death of member, (2) the voluntary
withdrawal of a member, (3) the assignment of all of a member’s interest and
admission of one or more assignees as a
member (but an operating agreement may
permit the assigning member to remain a
member until all the assignees have been
admitted as members), (4) in the case of an
estate, the distribution by the fiduciary of
the estate’s entire interest in the LLC (but
an operating agreement may permit the
estate to remain a member until all distributees have been admitted as members), (5) in
the case of a member that is a partnership,
corporation, or limited liability company,
the termination or dissolution of such entity
(but an operating agreement may allow the
member to remain a member until it ceases
to exist as a legal entity), and (6) the member is expelled as a member pursuant to the
articles of organization or an operating
agreement. A.R.S. § 29-733. It is advisable
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The Arizona Business Lawyer • May 2003
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Drafting Limited Liability Company Operating Agreements: Beware of Statutory “Default” Rules
for an operating agreement to list all of the
mandatory events of default so that the
members are aware of them. In addition, the
operating agreement should either specifically include or exclude the events that constitute events of withdrawal under the
default provisions.
Mandatory Rule. A member of an LLC
always has the power to withdraw from an
LLC and no longer be a member. A.R.S. §
29-734. This is a mandatory provision that
cannot be overridden by an operating agreement. The statutory rationale is presumably
that no one should be forced to be a “partner” with another against his will. However,
the Act provides that if the withdrawal violates an operating agreement, the LLC may
recover damages from the withdrawing
member. A.R.S. §§ 29-707, 29-734. Thus,
if the members are concerned about a member withdrawing, the operating agreement
should include a specific provision stating
that the members agree not to withdraw and
then specifically set forth the desired consequences of an unauthorized withdrawal.
Distributions on Withdrawal. A withdrawn member (or his personal representative) has no right to receive any distributions by reason of his withdrawal from an
LLC but instead has what is referred to as
the “rights of an assignee” during the continuation of the business of the LLC (less
damages if the withdrawal is a breach of the
operating agreement). A.R.S. § 29707. In
other words, unless the operating agreement
provides otherwise, the withdrawn member
has a right to distributions from the LLC, at
the same times and in the same amounts as
he would have had if he had remained a
member, throughout the term of the LLC.
A.R.S. § 29732.A. A withdrawn member,
however, no longer has a right to vote or
participate in the management of the LLC.
A.R.S. § 29732.A.
Dissolution
Upon Written Consent. Unless the operating agreement provides otherwise, an
LLC is dissolved upon the written consent
of both (a) more than one-half of the mem-
6
bers (voting on a per capita basis), and (b)
one or more members who on dissolution
and liquidation would be entitled to receive
assets valued at more than one-half the
value of all the assets. A.R.S. § 29-781.A.2.
Thus, if the percentage interests of A, B, C,
and D were 40%, 40%, 10%, and 10%,
respectively, a dissolution would have to be
approved by both A and B (who together
would be entitled to more than one-half of
the assets on liquidation), and either C or D
(one of whom would have to approve the
dissolution for there to be a majority per
capita vote).
Need for at Least One Member. Unless
the operating agreement provides otherwise,
an LLC is dissolved upon an event of withdrawal of the last remaining member unless
within 90 days all assignees by written consent agree to admit at least one member.
A.R.S. § 29-781.A.4. This provision allows
a 90-day window to find a new member following what may be an unexpected event of
withdrawal, such as the death of a member.
Involuntary Dissolution. Unless the operating agreement provides otherwise, involuntary judicial dissolution may be decreed
upon application of any member if (a)
members or managers are deadlocked and
irreparable injury is threatened or suffered
or LLC cannot be conducted to advantages
of members, (b) members or managers are
acting in an illegal or fraudulent manner, or
(c) substantial assets are being wasted, misapplied, or diverted.7 A.R.S. § 29-785.A.2.
Transactions Between the
LLC and Its Members
Loans and Other Transactions. Under the
default rules, a member or manager may lend
money to and transact other business with the
LLC, and subject to applicable law, has the
same rights and obligations with respect to
those transactions as a person who is not a
member or manager. A.R.S. § 29-608.
Matters to Which Act Is Silent. The Act
does not contain any specific fiduciary duty
provisions, nor does it address the right of a
member or manager to compete with the
LLC.
Conclusion
The default rules of the Act can result in
unintended consequences if an operating
agreement does not specifically address the
matters to which those rules apply. For this,
and many other reasons, a thorough knowledge of the Act is necessary before drafting
Arizona operating agreements.
Endnotes
1. An example of a mandatory rule is discussed
below under “Withdrawal of Members –
Mandatory Rule.”
2. A discussion of the potential taxation on the
receipt of an LLC interest in exchange for
services is beyond the scope of this article. In
general, however, a services partner is only
taxed on the receipt of a “capital interest,” not
on the receipt of a “profits interest.” A “capital
interest” is an interest that would give the
holder a share of the liquidating proceeds if,
hypothetically, the LLC were liquidated
immediately after the interest was received by
the member. A “profits interest” is an interest
other than a capital interest. See Revenue
Procedure 93-27, 1993-2 C. B. 343.
3. The decision to dissolve, however, is made as
described below in “Dissolution – Upon
Written Consent.”
4. For examples of this distinction see “Voting –
Actions Requiring Majority Vote” and
“Distributions – Timing of Distributions.”
5. For a discussion of how the performance of
services can affect the priority of distributions,
see “Capital Contributions – Services as
Capital Contribution.”
6. This may seem like an unusual provision, but
it makes sense in the context of free assignability of LLC interests. Without this provisions, a member could relieve himself of
future liability by assigning his interest to
someone who may not have the ability to satisfy the liabilities of the assigning member.
7. There is also one mandatory provisions allowing an involuntarily judicial dissolution that
applies if it is not “reasonably practicable to
carry on the limited liability company business in conformity with an operating agreement.” The Arizona Corporation Commission
may also dissolve an LLC under certain circumstances. See A.R.S. § 29-786.A.
May 2003 • The Arizona Business Lawyer