Limited liability companies (“LLC”) have been a popular type of business entity for Illinois entrepreneurs since the Illinois Limited Liability Company Act (“Illinois LLC Act”) (805 ILCS 180) was originally enacted in 1993. When forming your LLC, it is important to have a written agreement with your business partner(s). This blog entry will focus on the type of written agreement applicable to LLCs, the Operating Agreement.
When many entrepreneurs or co-owners start a business, they are often unsure of what type of corporate governance documents are required. When forming an LLC, there are two important documents: 1) the charter document and 2) the internal governance document. The charter document is called a Certificate of Formation and the internal governance document is called the Operating Agreement. The Operating Agreement is a confidential agreement with your business partner(s) and you are not required to file the Agreement with the State of Illinois or any other governmental agency or office. The Operating Agreement should lay out the basic operating procedures for the company and will help the company avoid litigation that might result from future business disputes.
Although Operating Agreements are not required under Illinois law, they are arguably one of the most important documents to protect your company. The type of provisions contained in an Operating Agreement are important in controlling the structure of the company and the relationship between owners of an LLC, who are called members. In Illinois, if members fail to create an Operating Agreement, the LLC defaults to the rules in the Illinois LLC Act. These default rules may not be attuned to your company’s business strategy. For instance, in Illinois the default rule is that distributions must be made in equal shares to all members. This would not make sense for a company where the members agreed that the distributional interests are not equal.
Operating Agreements generally contain important provisions including how business decisions should be made (both routine day-to-day decisions and large decisions, such as selling the business or how to allow in new members), specifying how the losses and profits are distributed, the percentage of business ownership, the responsibilities of each member and how to handle liabilities in case of dissolution. The Operating Agreement should also address how to proceed with the exit of a member by death, disability, resignation or termination for cause. If a member decides to leave the company and no Operating Agreement is in place such an exit might cause a bevy of problems for the company, including the possibility of an expensive and time consuming lawsuit. Failure to have an Operating Agreement can open up your company to financial risk and unforeseen circumstances.
As mentioned previously, the Illinois LLC Act governs the organization and operation of LLCs in Illinois. If a company does not have an Operating Agreement, the company will, by default, operate according to this Act. Recently, the Illinois legislature amended the act through Illinois House Bill 4361, which was signed into law effective July 1, 2017 and significantly revises the Illinois LLC Act. Business owners should be aware of these changes because they alter how an LLC may operate. For instance, unless the Operating Agreement provides that the LLC is to be managed by a manager(s), the default management structure is now “member-managed.”
The revised Illinois LLC Act also now permits oral and implied Operating Agreements. The Illinois LLC Act now provides that the Operating Agreement is enforceable “whether or not there is a writing signed or record authenticated by a party against whom enforcement is sought, even if the agreement is not capable of performance within one year of its making” (making it exempt from the Illinois Statute of Frauds). The best practice is still to have a written Operating Agreement; in the absence of a written Operating Agreement any issue between members is open to court interpretation. Another major change to the Act provides for the elimination/waiver of fiduciary duties. An Operating Agreement, if it contains “clear and unambiguous” language, can “restrict or eliminate a fiduciary duty” for members and “identify specific types or categories of activities that do not violate any fiduciary duty.” Although the duty of care still cannot be eliminated, the duty can now be altered in the Operating Agreement except to allow for intentional misconduct or knowing violation of law. This change may serve to protect members from claims by other members as the revised Illinois LLC Act allows the Operating Agreement to include the types of categories or activities that do not constitute a violation of the member’s fiduciary duty.
The aforementioned changes are not exhaustive and we encourage owners of LLCs to consult with their attorney regarding the revisions to the Illinois LLC Act. Even if your company already has an Operating Agreement in place, these revisions may make amendments to your current agreement necessary (i.e. if your company wishes to take advantage of the ability to eliminate or restrict fiduciary duties). The preparation of a proper Operating Agreement is crucial to the operation of your company and can result in unforeseen consequences if not drafted properly. The information in this article is for informational purposes only and does not constitute formal legal advice. Call Roberts McGivney Zagotta LLC to discuss your company’s Operating Agreement.