Initial Managers and Owners

April 13, 2006

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There are many common elements in an articles of organization, which is a key element in establishing the business entity.

The Corporation. Articles of organization for a corporation usually require that the business owner list the initial management structure (that is, the names and addresses of the initial officers and directors), in addition to the initial owners. State corporation statutes differ as to the number of directors and officers required. The modern view allows the owner to use one director, or waive the board of directors altogether in a small corporation, and to designate such officers, if any, as desired by the owner. Delaware and Nevada follow the modern view.

States following the more traditional view sometimes require a minimum number of directors, even in a small corporation. This number usually is equal to the number of shareholders, but typically no more than three directors are required. These states also require a minimum of two officers (a president and a secretary). In some of these states, the two officer positions must be held by two separate individuals. In others, one individual may assume both roles. If you are forming a corporation in a state other than Delaware or Nevada, check with the state's corporations office before deciding on the management structure for the corporation.

The Statutory Close Corporation. The statutory close corporation can waive the requirement for management by a board of directors and instead assign the duties normally performed by the board to the voting shareholders (or some other group). This is desirable because it simplifies the management structure of the corporation. Note that this must be accomplished in the articles of organization, although the operating agreement will reinforce this arrangement.

The state's usual rules regarding corporate officers (see above) apply to the statutory close corporation.

In addition, a statutory close corporation can forego the requirement for a board of directors, but the waiver must be included in the articles of organization.

However, the articles for a statutory close corporation must:

restrict ownership of the entity to a limited number of shareholders (30 or 50, depending on the state)
subject the ownership interests to a buy-sell agreement
prevent the corporation from making a public offering of its stock

States offer forms for the specialized articles necessary to create a statutory close corporation. The forms include these required provisions.

The LLC. Articles of organization for a limited liability company (LLC) usually only require the listing of the names and addresses of the initial owners of the business. Some states also require that the articles of organization for an LLC indicate its management structure (i.e., whether the LLC will be member-managed or manager-managed). In the latter case, the names and addresses of the initial managers usually must be listed. A manager-managed LLC can facilitate the use of the LLC as an estate planning device.

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Terminology regarding owners and managers differs in an LLC and a corporation.

In a corporation, the owners are called shareholders. A conventional corporation is managed by a board of directors and officers. The officers make all of the day-to-day management decisions.

The officers are hired by the board of directors. The board sets the compensation of the officers and oversees the officers as they perform their duties. The board also makes all of the larger financial decisions, such as whether to issue additional common stock or declare a dividend. Directors usually serve for one-year terms in a small corporation. Initial directors (and officers) usually are named in the articles of organization. Subsequently, directors are elected by the shareholders.

Directors and officers also differ in another important respect. Officers are individual agents of the corporation, while directors must act as a group, through majority vote, at a duly constituted meeting or through a unanimously signed written waiver (see below).

In the statutory close corporation, usually there is no board of directors, and the voting shareholders assume the role of the board.

By contrast, in an LLC, the owners are termed "members." In the event no election is made in the articles of organization to make the LLC manager-managed, the presumption is that the LLC is member-managed. In this case, every owner, or member, is deemed a manager, and thus an individual agent of the LLC. In this respect, the member-managed LLC resembles a general partnership.

In a manager-managed LLC, a select group of members are designated as managers. (Managers also may be selected who are not members). A manager-managed LLC is often desirable for estate planning purposes, or where certain members will be passive investors.

In a manager-managed LLC, the members who are not managers have no management authority. However, provided that they hold voting member interests, the non-manager members still can vote on a limited number of issues, including selection of the managers, amendments to the articles and operating agreement, dissolution of the LLC, etc.

Usually, the LLC can assign its managers titles traditionally associated with officers in a corporation (i.e., president, vice-president, secretary and treasurer). One manager also can be designated a representative for tax matters, as permitted under the Internal Revenue Code. All of these designations are accomplished in the operating agreement.

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In some states, absent a provision to the contrary in the operating agreement for manager-managed LLC, members who are not managers are still deemed to be agents of the LLC, with the power to bind the LLC to contracts. It is therefore wise to provide in the operating agreement that non-manager members are not agents of the LLC. This, of course, is one example of why an operating agreement is desirable.

Furthermore, the law is not always clear when it comes to division of authority within an entity. Some issues must be decided by the owners (i.e., shareholders or members), while other issues are within the control only of the entity's managers.

It is not uncommon for an action to be authorized by the wrong group, thus making it unauthorized. Creditors can capitalize on improper authorizations in two ways. Creditors may be able to invalidate a particular action, such as the withdrawal of funds from the entity by the owners. In addition, improper authorizations can be used to pierce the veil of limited liability.

In a member-managed LLC, every member (i.e., owner) also is a manager. Thus, if all members sign an authorization, its validity cannot be challenged on the grounds that the authorization had to be signed by the managers. The members and managers are one single group.

However, it often is desirable to form a manager-managed LLC and have the LLC issue nonvoting member interests to the non-managers. The voting members should be designated as the managers. In this way, once again, there is a single group (i.e., the voting members/managers). Thus, an authorization unanimously signed by this group is beyond challenge on the grounds that it was authorized by the wrong group.

The articles of organization should note that the LLC is to be manager-managed. The operating agreement then reinforces this fact and divides member interests into two classes: voting and nonvoting.

Therefore, to prevent confusion, it is important in a manager-managed LLC that any non-managers hold nonvoting member interests.

If the non-managers hold voting member interests, confusion may arise because the voting members will have rights to vote on all issues, except management issues. The dividing line between management issues and non-management issues is not always clear under state LLC statutes.

However, if the owners do decide to issue voting member interests to non-managers, it is especially imperative that the state statute be scrutinized to determine the proper lines of authority between the two groups (i.e., the members and the managers).

Similarly, in a statutory close corporation, the articles of organization can create two classes of common stock, voting and nonvoting, waive a board of directors and assign management duties to the voting shareholders. In this way, there is only one group, and the issue of improper authorization should not exist when that one group unanimously signs an authorization.