- The LLC law of all 50 states recognizes LLCs as contractual in nature.
- The contract that governs the LLC is called an operating agreement, and every LLC needs one.
- Founders that want to preserve flexibility and create predictable consequences should form LLCs in states that respect freedom of contract.
LLC law may seem esoteric, a dry discussion that would only interest attorneys and legal scholars. That is not the case. A business founder’s understanding of LLC law has practical implications, and misunderstanding creates a legal risk to the founder and the LLC.
Without a solid understanding of the contractual nature of LLCs, founders make critical mistakes. The most common mistake—and one encouraged by misinformation on the internet—is to assume that filing a formation document (called a certificate of formation, articles of organization, or similar term) is sufficient to form an LLC that will meet their business objectives.
Founders that do not understand the contractual nature of LLCs often assume that, because the state accepted their two-page informational form, the LLC is properly formed. But without a valid operating agreement, these founders are left with a patchwork of state-law provisions that are simply guesses at what the founders actually want. These provisions make assumptions about LLC governance and decision-making, financial consequences, and the rights and duties of the owners.
Founders that do not recognize LLCs as creatures of contract are unaware of the problems resulting from forming and operating an LLC without having a contract (operating agreement) in place. When a dispute arises—whether from a co-owner, a creditor, or an outside party—the missed planning opportunities become apparent. Business litigation attorneys all have war stories of expensive legal battles resulting from failure to properly form a business and clarify operational matters. Misunderstandings of LLC law helps keep these attorneys in business.
An LLC is a Creature of Contract
An LLC is a hybrid business entity with roots in both partnership and corporate law. LLCs came to America in 1977 when Hamilton Brothers—a small oil that had grown weary of having to form LLCs in international jurisdictions—convinced the Wyoming legislature to enact the first American LLC statute.
Like the legislation to follow it in the remaining 49 states, the Wyoming LLC act characterized the LLC as a hybrid business entity that combined the best features of corporations and partnerships. The hybrid nature of the LLC has implications for LLC formation. Like a corporation, an LLC is technically formed when the LLC files a document with the state. But like a partnership, the internal operations of the LLC are primarily a matter of agreement among the LLC owners and the LLC itself.
The agreement between the parties—called an operating agreement—is analogous to the partnership agreement used to govern a general partnership. It allows the owners to specify how the LLC will be managed, how and whether LLC interests may be transferred, how profits will be distributed, the duties that the owners owe to each other and the LLC, and other essential matters.
State LLC Acts Assume the LLC Will Have an Operating Agreement
The contractual nature of LLCs is reflected in state LLC acts. State LLC acts anticipate that each LLC will have an operating agreement that governs the operation of the LLC, the economic and governance rights of the parties, the duties that co-owners owe to each other, and other critical legal matters.
Because state LLC acts recognize the importance of an operating agreement, they defer to it. Except in limited cases (discussed below), a valid operating agreement is the law of the LLC. Consider the following selections from the LLC acts of popular U.S. LLC jurisdictions:
- Delaware – “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”1
- California – “It is the policy of this title and this state to give maximum effect to the principles of freedom of contract and to the enforceability of operating agreements.”2
- Florida – “It is the intent of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.”3
- Nevada – An operating agreement “must be interpreted and construed to give the maximum effect to the principle of freedom of contract and enforceability.”4
- Texas – An operating agreement “governs: (1) the relations among members, managers, and officers of the company, assignees of membership interests in the company, and the company itself; and (2) other internal affairs of the company.”5
This language—like similar language in other state LLC acts—refers to “contracts,” “limited liability company agreements,” and “company agreements.” These are all variations of the term used to refer to the operating agreement. The state LLC acts assume that the LLC will have an operating agreement that will govern the operation of the LLC, and they defer to that agreement in most issues relating to LLC governance and operation.
Non-Waivable Provisions of State LLC Law
As the selections above indicate, state legislatures went out of their way to clarify that LLCs are governed by their operating agreement and that the state LLC act should be interpreted in a way that respects the terms of the operating agreement as primary.
If the LLC does not have an operating agreement, the state LLC acts provide a set of default provisions that apply to help fill in the gaps. These provisions operate in much the same way as the state intestacy laws govern what happens when someone dies without a valid will: They are legislative guesses about what people that fail to plan properly may have wanted. Without an operating agreement, the owners at least have the state provisions to fall back on. But those provisions are not likely to match any specific owner’s planning objectives, and they miss important business and strategic planning opportunities.
The selections above indicate that the state law will generally defer to the provisions of the LLC operating agreement. If a valid operating agreement covers a specific topic, that operating agreement is the law as it relates to that topic. The operating agreement trumps the fallback provisions of the state act. But this is not always true. Some states provide a list of rules that will control, even if the operating agreement provides otherwise. These provisions are called non-waivable provisions because the operating agreement cannot eliminate them.
While the list of non-waivable provisions in state statutes that include them is usually short, it can be longer depending on state law. States with business-friendly LLC acts—including Delaware, Texas, and Nevada—favor complete freedom of contract and allow the owners to structure the LLC as they wish. The LLC acts of other states—like California—claim to respect freedom of contract, but include many restraints that stop owners from setting up the LLC as they wish.
Before forming an LLC, it is important to review the non-waivable provisions of the jurisdiction to be sure that state law does not limit the operating agreement’s ability to structure the deal. If state law conflicts with the owners’ objectives, the LLC can be formed in a different jurisdiction that respects freedom of contract between the LLC owners and managers.