Understanding Default Statutory Rules

April 13, 2006

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When forming a limited liability company (LLC) or corporation, care must be taken by all owners to consider all aspects of the business and put agreements in writing.

In certain cases, absent contrary provisions in the articles of organization or operating agreement, state statutes apply default rules. As you may imagine, these default rules are not always desirable.

By default, an LLC is member-managed, and a statutory close corporation is managed by a board of directors. Similarly, the presumption, in both cases, is that all of the owners hold voting interests and divide profits and losses according to their relative ownership interests.

It is often desirable to modify each of these default rules and incorporate them into your articles of organization or operating agreement.

Similarly, in many cases, the state statute simply will provide no rule whatsoever. This invites disputes among the owners and slipshod management of the entity, which could lead to piercing of the veil of limited liability.

For example, state LLC statutes do not cover an extremely important issue--disposition of ownership interests. It usually is desirable to prevent an owner from selling his interest to an outsider.

However, absent a buy-sell agreement, which should be part of the operating agreement, an LLC owner is free to dispose of his interest as he sees fit. While the transferee of an LLC interest cannot become a full-fledged owner with voting rights without the other owners' consent, a transfer to an outsider can still disrupt the entity's operations.

Conversely, in the statutory close corporation, the transferee, in fact, becomes a full-fledged owner without the consent of the other owners. While the statutory close corporation is compelled by state statute to adopt a buy-sell agreement, the actual agreement can take different forms. The owners of the entity control how this is actually executed.

In addition, absent a provision in the operating agreement to the contrary, the parties are free to resolve disputes among themselves by way of a court proceeding. Mediation and arbitration usually are better alternatives to a court proceeding because they are much less expensive and less time consuming. However, mediation and arbitration are consensual. In other words, the parties to the dispute must agree to use mediation and arbitration, in lieu of a court proceeding. The best place to do this is in the operating agreement, which is executed before disputes arise.

Also, state statutes generally allow an LLC or a corporation to indemnify the entity's managers for losses that they incur while carrying out the entity's business. Indemnification is an important adjunct to the use of insurance. The statutes merely authorize the entity to include an indemnification provision in its operating agreement. The operating agreement (or bylaws in a conventional corporation) must take advantage of this opportunity and actually provide for indemnification.

Other issues may be adequately addressed in state statutes, but often it is advantageous to repeat the statutory language in the operating agreement. So, if a state statute is later amended, but the previous statute is written into the agreement, the owners do not have to be concerned that a new, and perhaps unknown, rule now governs the business's affairs. The existing rule in the operating agreement would remain valid.

For example, default rules usually mandate that a conventional corporation hold, at a minimum, annual meetings of shareholders and directors. A waiver of a board of directors in the statutory close corporation, of course, eliminates the need for annual meetings of the board of directors.

LLC statutes are more informal, mandating that certain actions need to be approved by the voting members, and that management decisions be approved by the voting members or the voting managers in a manager-managed LLC. However, usually LLC statutes are silent on the issue as to how frequently either group must meet.

Both the LLC and statutory close corporation (as well as a conventional corporation) can, according to state statutes, take action without formal meetings. Any action that would have been taken at a formal meeting may, instead, be accomplished through the execution of a written document, which is unanimously signed by the particular group that had authority over the issue (e.g., the shareholders or members). The notice requirement for meetings also is automatically waived, simply by way of execution of the document.

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Though this type of waiver is authorized by state statutes, the language from the particular state's statute should be incorporated into the entity's operating agreement. This should eliminate problems that might arise should the statute be amended. The owners of an entity certainly don't want to discover, in the midst of a financial crisis for example, that they were operating under older statutory provisions that had been replaced.

In addition, the incorporation of statutory provisions into an operating agreement gives the owners firm guidance on the rules that govern the entity. As questions arise, the owners are far more likely to refer to the operating agreement, as opposed to the state statute.