“The Pitfalls of Not Having an LLC Operating Agreement”

An operating agreement is a foundational document that establishes the rights of the owners (“Members”) of limited liability companies (“LLC(s)”), as well as detailing the general financial and internal governance structure of the LLC. As a result, operating agreements often touch on a wide variety of topics, including tax allocations, transfers of ownership interests, and how the LLC will be managed.

Despite their importance, many LLCs do not have written operating agreements. Under Illinois law, when an LLC fails to have a written operating agreement (or alternatively, an operating agreement is silent on a particular issue), the default rules under the Illinois Limited Liability Company Act (the “LLC Act”) apply. This ensures that courts are able to apply universal rules in the case of missing operating agreements or operating agreements that do not address issues that later arise. However, there are significant gaps in the LLC Act, leaving many important issues unaddressed, which can impose adverse consequences on the LLC and its Members.

This is problematic because the default rules in the LLC Act do not always allow for expedient or satisfactory results. To help illustrate the negative consequences that may come from an absent operating agreement, this article will present a hypothetical fact pattern demonstrating how Members of LLCs can be adversely affected by failing to have an operating agreement.

Hypothetical

Members A, B, C, and D agree to form the “Company,” an Illinois limited liability company. The Company operates and conducts all of its business within the state of Illinois. To get the Company’s business up and running, Members A and B individually contribute $4,000 of cash, whereas Members C and D individually contribute $1,000 of cash (for a total contributed capital of $10,000). After two years, the Company’s business is doing very well, and it has generated $1 million of profit each year. As a result, the Members elect to distribute each year’s profits of $1 million based on the percentages of their initial contributions to the Company: Members A and B receive $400,000, as they each contributed 40%, and Members C and D receive $100,000, as they each contributed 10%.

At the beginning of the third year, Member D feels he is owed a greater share of the profits and now feels animosity towards Members A, B, and C. He begins to be rude and disrespectful towards them in all his communications. He stops attending business meetings and does not engage in any managerial capacity of the Company. As a result, Members A, B, and C find it harder to conduct the business of the Company and decide that they want to remove Member D from the Company so that he is no longer a member. However, Member D has no desire to sell his interests in the Company and wants to continue to receive his future share of any profits. The Company does not have an operating agreement.

Removing a Member

Since the Company does not have an operating agreement, Members A, B, and C must rely on the LLC Act to provide guidance on how to remove Member D.

The LLC Act allows for a member to be expelled by a unanimous vote of the other members only if (i) it would be illegal to continue the LLC’s business with that member, or (ii) that member has transferred all or substantially all of their interests in the LLC (subject to minor exceptions). Here, Member D is not acting illegally or subjecting the Company’s business to illegal conduct. Further, it is noted that he does not wish to sell or transfer his membership interests in the Company, and he has not taken any action to do so. As a result, Member D cannot be removed via a unanimous vote of the other members.

Illinois law does allow for a member to be removed from an LLC via judicial intervention, through a process called “dissociation” (a further discussion of this topic follows). As a result, Members A, B and C must now turn to litigation to dissociate Member D. In doing so, they will need to show that Member D did any one of the following three things: (i) engaged in wrongful conduct that adversely and materially affected the Company’s business, (ii) willingly and continuously committed a breach of a duty owed to either the Company or the other members, or (iii) has engaged in conduct relating to the Company’s business that would make it impractical to carry on the business with Member D.

Putting aside any discussion on who will be successful in the hypothetical litigation, the failure to have an operating agreement has directly led all parties to spend greater financial and human resources in resolving this dispute. Apart from the cost of litigating this issue, the Company continues to operate without a managerial individual, and the business may be impacted as a result. Had the parties had entered into an operating agreement, they could have detailed the specific processes for a member’s removal, or at the very least, dispute resolution among the parties. By failing to do so, all the members of the Company must now invest significant human and financial capital to resolve this dispute.

Distributions

Under the LLC Act, all distributions made by an LLC before its dissolution must be made in equal shares.

Although Members A and B individually contributed $4,000 (or 40% of the total contributed capital of the Company), the LLC Act mandates that all voluntary distributions by an LLC must be disbursed in equal amounts. In the hypothetical scenario above, the $1 million profit distributed in both Year One and Year Two should have been split equally, with each member receiving $250,000, as opposed to Members A and B receiving $400,000 and Members C and D receiving $100,000. By the letter of the law, Member D is correct, and both he and Member C are entitled to an additional $300,000 from the prior profits that were distributed to Members A and B.

Although the prior distributions were disbursed in accordance with the plain economics of the initial capital contributions to the Company, the LLC Act is not focused on this. Instead, the LLC Act is focused on the number of members an LLC has as the basis for any distributions. This is a bright-line test, designed to promote uniformity and consistent application by Illinois courts dealing with issues related to distributions.

Members may choose to split distributions according to the initial capital contributions to an LLC, but this need not be the case. Where the parties intend a different result, there is usually an agreement among the parties as to how it will work, which is memorialized in a written operating agreement. By failing to have a written operating agreement, members of LLCs subject themselves to the basic rules of the LLC Act, which requires members to evenly split all distributions made by the LLC.

Member D Remains

What happens if Member D is removed as a member of the Company by an Illinois court? This is called “dissociation.” When a member of an LLC is “dissociated,” the member is no longer a member of that LLC and has no further right to participate in management decisions of the LLC. However, a member’s dissociation does not extinguish the member’s ties to the LLC.

Under the LLC Act, a dissociated member retains the members distributional interest in the LLC, which is now held by the dissociated member as a “transferee.” This means that the dissociated member is still entitled to receive any distributions the member would have received if the member had not dissociated from the LLC. In essence, the dissociated member would no longer need to devote any time, attention, or other resources to the LLC and would still be entitled to an equal share of any future distributions. In our hypothetical, if the Company continues to be profitable at the rate of $1 million per year and a distribution occurs annually, then Member D (even if dissociated) would be entitled to receive $250,000 per year despite having no responsibilities for the Company.

All of the problems described above could be addressed in a well-written operating agreement. For example, an operating agreement could explicitly exclude distributions to those individuals who become dissociated. Another alternative is to require a mandatory buyout of any dissociated member’s interest in the LLC, with the end result being that the dissociated member leaves the LLC with no interests at all and no future rights to any distributions. Whatever the course of action, these methods must be enshrined within an operating agreement to ensure the financial rewards of an LLC remain with the intended parties.

Parting Thoughts

Unlike corporations, LLCS are intended to be guided by contract principles, and the operating agreement is intended to be the controlling contract. Operating agreements are central to the governance and administration of an LLC, both from a business and legal perspective. When an Illinois LLC does not have an operating agreement, it is subject to the standard rules present in the LLC Act. As demonstrated, these rules can often lead to more internal strife and controversy. There are several other statutory rules that have not been discussed in this article, and it is important to have a robust operating agreement to ensure that any potential disputes are handled in the most efficient and effective manner possible.