Section 6.1 What is an Operating Agreement?
An Operating Agreement is the name given to an agreement between the members and managers of an Arizona LLC that sets forth their rights and obligations with respect to each other and the company. It is the limited liability company equivalent to a partnership’s partnership agreement or a corporation’s stockholder’s agreement. An Operating Agreement governs relations: (i) among the members and the managers, and (ii) between the members and managers and the limited liability company. An Operating Agreement may contain any provision that is not contrary to law and that relates to the business of the LLC, the conduct of its affairs, its rights, duties or powers and the rights, duties or powers of its members, managers, employees or agents. The members and managers may include any provision in an Operating Agreement that suits their purposes as long as the provision is not contrary to applicable law.
Although Arizona LLCs are not required to have an Operating Agreement and oral Operating Agreements are permissible, I strongly recommend that all Arizona LLCs, including single member LLCs, have a written Operating Agreement. Agreements between members, managers and the limited liability company should be reduced to a written instrument. Oral contracts can be legally binding in Arizona, but a prudent person will insist on a written contract. The problem with oral contracts is that it is very difficult to prove the terms and conditions of the oral contract. If the parties to an oral contract become involved in a dispute, each party will have a different view of the terms and conditions of the oral contract and the judge or jury in a lawsuit may have a problem determining whose view of the oral contract is correct.
If you are making an oral contract to purchase a bike for $50, it may not be worth the time or effort to create a written contract. However, if you intend to invest thousands of dollars into a business venture or a limited liability company, the stakes are much higher and the investment in time and money to prepare a written agreement between the members, managers and the company can prevent major problems in the future and resolve disputes that arise among members, managers and the company.
Section 6.2 How is an Arizona LLC Governed if It does not have an Operating Agreement?
To the extent that an Arizona LLC does not have an Operating Agreement or if the company’s existing Operating Agreement is silent with respect to a particular issue, Arizona statutes provide “default” rules that govern Arizona LLCs.
An Arizona limited liability company that does not have an Operating Agreement signed by the members is governed by the Arizona Limited Liability Company Act (the “Act”) found in Chapter 4 of Title 29 of the Arizona Revised Statutes. Arizona limited liability companies that do not have an Operating Agreement must look to the Arizona Limited Liability Company Act to determine the rights and obligations of the members, managers and the company.
The Act provides many provisions that affect members, managers and limited liability companies. However, because the Act does not address many common issues that arise in governing limited liability companies, I advise the owners and prospective owners of all Arizona limited liability companies to adopt a written Operating Agreement, especially if there are or will be multiple members.
Section 6.3 Examples of the Arizona LLC Act’s Default Treatment with Respect to Common LLC Situations When the Members Have Not Signed an Operating Agreement
The paragraphs below in this Section 6.3 discuss how the Arizona Limited Liability Company Act will govern an Arizona limited liability company that does not have an Operating Agreement signed by the members. The discussion includes optional provisions that members can include in an Operating Agreement to obtain a result different from than that provided by the default treatment of Arizona LLC law. The discussion in this Section 6.3 is a discussion of Arizona law as it relates to Operating Agreements in general. It does not discuss the specifics of your company’s Operating Agreement. If you would like to read the actual text of the Arizona Limited Liability Company Act.
a. Set Rules for Admitting New Members: The Act provides that after a limited liability company files its initial articles of organization, a person or entity may be admitted as an additional member only: (i) with the consent of all members, or (ii) after being identified as a member in a written statement certified by each of the managers identified in the initial articles of organization. A.R.S. Section 29-731. Section 29-681 states the affirmative vote, approval or consent of all members is required to issue an interest in the limited liability company to any person unless otherwise provided in an Operating Agreement. The Operating Agreement should contain explicit rules with respect to how and when prospective members can become actual members.
b. Operational Significance: An Operating Agreement can alter the general rule and make it easier or harder to admit new members. For example, an Operating Agreement might: (i) prohibit the manager(s) from identifying new members without the prior consent of all of the members or a majority of the members, or (ii) allow a prospective member to become a member with the consent of a majority of the members or all of the members.
c. Restrict Members from Freely Transferring Their Interests in the Company: The Operating Agreement can prohibit members from transferring or encumbering all or any portion of their interests in the company. The Operating Agreement should contain explicit rules with respect to how and when members can transfer their interests in the company. If the company does not have an Operating Agreement that prohibits members from transferring their interests in the company, the Act provides that a member may assign the member’s interest, in whole or in part at any time. A.R.S. Section 29-732.A. The mere assignment of an interest in an Arizona limited liability company does not entitle the assignee to participate in the management of the business and affairs of the limited liability company or to become or to exercise the rights of a member, unless the assignee is admitted as a member. A.R.S. Section 29-732.A.
Operational Significance: Without a provision in an Operating Agreement prohibiting a member from assigning the member’s interest in the company, any member may assign the member’s right to receive profits, losses and distributions of money from the company. Without an Operating Agreement that prohibits unrestricted transfers of membership interests, a member could wake up one day and find that an unwanted or undesirable person or entity has an interest in the company.
d. Right of First Refusal on Transfers of Interests: The Operating Agreement can provide that a member who desires to sell or dispose of the member’s interest in the company must first notify the company and the other members of the terms and conditions of a proposed sale and give the company and other members the option to purchase the interest on the same terms and conditions it is offered to a prospective buyer.
Operational Significance: The right of first refusal is a mechanism that allows the members of a limited liability company to retain control of all ownership interests in the company. For example, if three people form a limited liability company that depends on the members working together closely as a team and if one person wants dispose of his or her interest, the right of first refusal allows the original members to acquire the interests of the departing member and prevent the departing member from transferring his or her interest to a person that might not be compatible with the continuing members or that could create problems for the continuing members.
e. Rights to Purchase the Interest of a Member: Situations may arise (“Triggering Events”) that give the company and its members an option to purchase a member’s interest in the company. Examples of Triggering Events might include: (i) death, (ii) bankruptcy, (iii) insanity or incompetence, (iv) conviction of a felony, (v) involvement in an activity that harms the business or reputation of the company, (vi) failure to make a capital contribution, (vii) termination of employment if employed by the company, (viii) divorce where the inactive spouse obtains the interest of the active spouse in a property settlement, and (ix) a member’s default of any obligation owed by the member to the company.
Operational Significance: A problem member can jeopardize the profitability and/or survivability of a limited liability company. An Operating Agreement that gives the company and members an option to purchase the interest of a problem member allows the members to obtain a “divorce” from the problem member. Would you like to continue to be in business with a member who failed to make a capital contribution, inherited the membership from his deceased father-in-law, was convicted of theft or a violent crime, or was operating a business that competes with the business of the company?
f. Set Rules for Allocation of Profits and Losses: Without an Operating Agreement, profits are allocated among the members according to the manner in which they share in distributions that exceed the repayment of their capital contributions (see the following section), and losses are allocated according to the relative capital contributions that members have made or promised to make in the future. A.R.S. Section 29-709.
Operational Significance: This provision means that if two people form a company and one contributes $100 and the other is to contribute nothing, the two members must then split future profits equally unless they agree in an Operating Agreement to allocate the profits differently. If the members of your company intend to allocate profits other than equally to all members, that agreement must be in writing to be enforceable.
g. Set Rules for Distributions of Money: Without an Operating Agreement, distributions of cash or other property to members must be shared among the members in the following order:
(i) In proportion to the amount of members’ un-returned capital contributions.
(ii) Then equally to the members.
See A.R.S. Section 29-703.B.
Operational Significance: This provision means that if two people form a company and one contributes $100 and the other is to contribute nothing, the member who contributes the $100 is entitled to ALL distributions until the member gets the $100 back. When the money member receives all of the $100, the two members must then split future distributions equally. Most of the time members intend to split the distributions according to a fixed percentage among members from day one despite the fact one or more members has not received distributions of all of their capital. If you do not want to be governed by the general rule, your company needs an Operating Agreement that specifies how profits, losses and distributions will be allocated among the members before and after they receive all their capital contributions.
h. Company Governance Rules: Section 681.D of the Act provides that a company may not take any of the following actions without the affirmative vote, approval or consent of a majority of the members, or if management of the limited liability company is vested in one or more managers, the affirmative vote, approval or consent of the sole manager or a majority of the managers:
(i) Authorize the distribution of cash or property to the members.
(ii) Authorize the company to repurchase all or part of any member’s interest in the company.
(iii) Resolve any difference concerning matters connected with the business of the company.
(iv) Authorize an amendment to the articles of organization, other than an amendment to correct a false or inaccurate statement in the articles.
Operational Significance: The general rule is that the company cannot make distributions of money to members without the proper consent. An Operating Agreement can specify when money can be distributed and the amount of distributions plus address all of the other governance issues set forth above.
i. Restrict the Right of a Member or Manager to Contract with the Company: Except as provided in an Operating Agreement, a member or manager may lend money to and transact other business with a limited liability company and, subject to other 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. Section 29-608.
Operational Significance: Without restrictions in an Operating Agreement, a manger of a company may cause the company to enter into a legally binding agreement with the manager, the manager’s relatives and affiliates, or any person or entity. Members may want to require prior consent of a majority of the members or all of the members before a manager or member may loan money to the company, enter into an agreement with the company, or cause the company to enter into any agreement with a family member or affiliate of a member or manager.
j. Obligate Members to Pay Money to the Company: A member is not obligated to contribute money or property or make a capital contribution to a limited liability company unless the member agrees to do so in a written document signed by the member. A.R.S. Section 29-702.
Operational Significance: If your company’s cash flow needs require that each member contribute $5,000 to the company for three years to make payments due on the company’s purchase of real property, the members will not be obligated to make the payments unless their obligations are contained in a written document. An Operating Agreement may provide that one or more members are obligated to pay money to the company when it is formed, on specific future dates or if the company lacks cash to pay its debts. This type of provision can prevent an economic disaster during times when the company has cash flow problems or suffers losses. Without a written promise to pay, members sometimes “forget” their obligations to pay money or they may change their minds. The Operating Agreement could provide that a member who defaults on an obligation to pay money to the company could be required to sell the member’s interest in the company to the other members or to the company.
k. Restrict the Company’s Right to Borrow and Loan Money: Section 29-610.A of the Act authorizes an Arizona limited liability company to borrow and lend money to members and others, and these powers are to be broadly construed. A.R.S. Section 29-610.C. Managers of the company have the apparent authority to cause the company to borrow or loan money to or from members and third parties.
Operational Significance: Members may agree in an Operating Agreement on when the company may borrow or loan money, whether loans can involve other members or third parties, the general terms and conditions applicable to a loan (such as the interest rate) and the maximum amount of a loan. It is very common for members to agree in an Operating Agreement that the company may or may not borrow from or lend to other members or that loans involving more than a specified amount cannot be made without the prior approval of a majority of the members or all of the members.
l. Terminate a Member’s Interest in the Company: An Operating Agreement may provide circumstances that give the company an option to expel a member and terminate the member’s entire interest in the company. Without explicit terms and conditions in an Operating Agreement that provide for the expulsion of a member, it may be difficult or impossible to terminate the interest of a problem member.
Operational Significance: Expulsion provisions in an Operating Agreement can be used to oust a problem member from the company. This type of provision is most commonly used in an Operating Agreement in connection with obligations to pay money, but it can also apply in any situation where a member defaults on an obligation owed to the company. If a member is obligated to pay money to the company and fails to do so, an Operating Agreement can provide that the defaulting member forfeits voting and management rights, is liable for damages and that the member’s interest in the company be purchased with the result that the member ceases to be a member.
m. Restrict the Right of a Member to Withdraw from the Company: The Act authorizes a member to withdraw from a limited liability company at any time on mailing or delivering written notice of withdrawal to the other members. A.R.S. Section 29-734. An Operating Agreement can restrict a member’s right to withdraw from the company.
Operational Significance: Usually it is not in the best interest of the company or its members if a member may withdraw as a member at any time. By including a restriction on members’ rights to unilaterally withdraw from membership in the company, the limited liability company may recover from the withdrawing member damages for breach of the Operating Agreement and offset the damages against any amount otherwise distributable to the withdrawing member. A.R.S. Section 29-734.
n. Conclusion: Although an Arizona limited liability company is not required to have a written Operating Agreement, it is in the best interest of multiple-member companies to adopt a comprehensive Operating Agreement that sets forth their rights and obligations with respect to the company. A good Operating Agreement written to comply with Arizona law can prevent future disputes among members and provide certainty with respect to how the company will be governed. A comprehensive Operating Agreement is a complex legal document that should be prepared by an Arizona attorney with substantial experience preparing Operating Agreements for Arizona limited liability companies.
Section 6.5 How to Modify Your Operating Agreement
If the members of your LLC want to make any substantive changes to its Operating Agreement such as deleting or adding text or adding provisions specific to the Company, we can revise the agreement. To make changes to the Operating Agreement or if you want to discuss possible changes, contact KEYTLaw business and contracts attorney Richard C. Keyt at 480-664-7472 (email [email protected]). Ricky can work with the members to answer questions (no charge) and revise the Operating Agreement per the members’ instructions. He charges $275 per hour for the time needed to revise the Operating Agreement with a minimum fee of $275.
Section 6.6 How to Create a Legally Binding Obligation on a Member to Contribute Money or Property to the Company
A member of an Arizona limited liability company is not obligated to make any capital contributions to the company unless the obligation is in writing. The best place to evidence an obligation of a member to contribute money or property to the company is in the Operating Agreement.
Note: Unless you want to obligate a Member to contribute money or property to the Company, you should not require that the Member contribute anything in the Operating Agreement. If a Member becomes obligated to contribute money or property to an Arizona limited liability company and the Member fails to do so, creditors of the Company can get a court order that the Member contribute the money or property. By creating an obligation to contribute money or property to an Arizona limited liability company when it is not necessary, you are creating a situation where the Member may be forced by a creditor of the Company to contribute to the Company when the Company does not have the assets to pay the creditor.
Section 6.7 All Members Need to Sign the Operating Agreement
The best time to get the members to agree on the content of an Operating Agreement is when the company is formed. As time passes, it is less likely that the members will ever sign an Operating Agreement. I strongly recommend that the members of all multi-member Arizona limited liability companies sign a mutually agreeable Operating Agreement.