|Essential Elements of an Operating Agreement for a Law Firm Organized as an LLC
byEdward W. Feldman
1. Law firms organized as LLCs need operating agreements.
The 1990s brought an explosion in the use of limited liability companies. Illinois is no exception to the national trend, especially in the wake of the 1998 amendments to the Illinois Limited Liability Company Act, 805 ILCS 180/1-1 et seq (LLC Act).
Many law firms have adopted the LLC structure. This is not surprising. Lawyers have long organized their firms under the partnership structure, and the law governing partnerships is well-developed. Lawyers as a class are slow to change. We like familiarity. The LLC offers many partnership-like attributes that may seem attractive to lawyers who had previously avoided incorporation. While offering limitation on non-professional liability similar to those offered by incorporation, the LLC structure permits a law firm to be taxed on a partnership basis along with the flexibility to manage and operate the business in a partnership-like manner.
At the heart of the LLC Act is the operating agreement, which functions as a sort of constitution for the entity that allows the owners (formally called members in the LLC context), with limited exceptions, to define their relations with each other and with third parties and to prescribe rules for operation and management of the entity.
Failure of a law firm that decides to organize as an LLC to have a well-drafted operating agreement is a trap for the unwary, as it can lead to unintended and unfortunate consequences. If there is no operating agreement or if it is silent on a key term, the LLC Act will dictate the result, and can produce unpleasant surprises.
Consider the following scenario. Lawyers A, B and C reorganize their partnership as an LLC. Now known as ABC LLC. Over time, C becomes less and less productive. He produces neither one-third of the business nor one-third of the billable hours, and his annual compensation has been reduced accordingly. Having an over-inflated ego, he demands to be paid one-third of the firms profits. In the absence of an operating agreement, the LLC Act dictates that C is entitled to distributions equal to those made to A and B. Moreover, once he becomes entitled to a distribution, he assumes the legal status of a creditor of the LLC, which means he may have some priorities in the event of a dissolution. An operating agreement could have been crafted to dictate a fairer result.
The potential for surprise is increased by the fact that the LLC is still in its infancy and the body of case law governing LLCs is small. It is minute with respect to law firms organized as LLCs. While there is reason to believe that courts will eventually adopt rules similar to those applied to small, closely held corporations or partnerships, the LLC Act itself changes some of those rules, and there is no guarantee that courts will not fashion new rules.
The purpose of this article is to highlight certain important issues that a law firm should address in an operating agreement, so that the firm will not be left to the default provisions of the LLC Act or the vagaries of litigation if a lawyer chooses to leave the firm, or if another dispute arises. This article is not intended to be a comprehensive or detailed overview of the entire LLC Act. Rather, it is targeted to those issues of greatest concern to orderly law firm governance.
Whos going to manage the firm?
The LLC Act recognizes two forms of management structure for an LLC, member-managed and manager-managed. These two structures are analogous to a general partnership on the one hand, and a limited partnership or corporation on the other. LLCs are automatically member-managed unless the Articles of Organization designate the LLC as manager-managed.
In a member-managed LLC, the default provision of the LLC Act provides that, like general partners, each member has equal rights in the management and conduct of the companys business, and with certain important enumerated exceptions discussed below, matters relating to the business of the company may be decided by a majority of the members. Note that this default is a per capita rather than per capital provision. It is one-person-one-vote, not one-ownership-share-one vote. Thus, if a member-managed firm has four members, and member A, the largest rainmaker, has a 50% interest in the LLC, and the other three have 50% of the ownership divided among them, the other three can control most management decisions under the head-count default provision of the LLC Act. The rainmaker might not like such a structure. The operating agreement can contain provisions to address that. [The terms per capital and per capita were used in the detailed and informative discussion of LLCs in Murdock, Limited Liability Companies in the Decade of the 1990s: Legislative and Case Law Developments and Their Implications for the Future, 56 The Business Lawyer 499 (Feb. 2001)]
In a manager-managed LLC, each manager has equal rights in the management and conduct of the companys business, and (subject again to certain significant exceptions), any matter relating to the business of the company may be exclusively decided by the manager or, if there is more than one manager, by a majority of the managers. The manager(s) is elected (or removed) by a majority vote of the members. He or she does not have to be a member. The managers are, therefore, analogous to general partners in a limited partnership, managing partners in some general partnerships, or the officers of a corporation.
Which structure of LLC should a law firm choose?
The answer depends largely on the size and history of the firm. A smaller firm is more likely to prefer the member-managed model, since most small firms already operate on that basis de facto. A larger firm, which may have operated for years with a managing partner or management committee having plenary authority over most day-to-day decisions, may prefer the manager-managed model, with the managing partner or a committee designated as the managers. The larger firm might also want to specify whether the manager(s) must themselves be members.
As a practical matter, however, the operating agreement can render this question largely academic. A firm that does not define itself as manager-managed in its Articles of Organization can still achieve the same result with respect to internal firm management by providing in the operating agreement for designation of a person or committee to whom defined authority is granted. Such provisions can, in a member-managed company, override the LLC Acts default of one-member-one-vote decision-making for most matters.
Since the operating agreement can render member-managed and manager-managed LLCs similar with respect to internal governance, the distinction between the two flavors of LLC has greater significance with respect to third parties. In a member-managed company, each member is, like general partners in a partnership, deemed to have actual and apparent authority to bind the LLC with respect to transactions in the ordinary course of business, unless the member had no authority to act for the company in the particular matter and the person with whom the member was dealing knew or had notice that the member lacked authority.
Not so with a manager-managed LLC. There the presumption is reversed. Members are not deemed to be agents of the LLC solely by virtue of the status as members. Instead, managers are in general so deemed, and their acts generally bind the LLC unless they lacked both actual and apparent authority for the acts in question. Id. 13-5(b)(1). LLCs are liable to third parties for wrongful acts of members or managers acting in the ordinary course of business or with authority of the company. Thus, the question of whether to choose the member-managed or manager-managed model could depend upon whether the law firm wants to limit the scope of the apparent authority of its members to third parties.
Management Issues Must be Addressed in Operating Agreement
Regardless of which type of LLC is chosen, it remains important for the members to define in their operating agreement which management decisions they want to reserve unto themselves, and which they wish to delegate to one or more select individuals (whether members or managers). Moreover, the members need to define how voting will be handled on matters not delegated to managers.
Turning first to voting, the members need to decide whether to keep the head-count default provisions of the LLC Act, to weight the votes by ownership interest, or to combine the two, i.e., by making some types of decisions subject to a majority per capita vote and others subject to a majority per capital vote. If the members opt for the last approach, a logical demarcation of issues may depend upon the gravity of the decision.
Most day-to-day business decisions B whether to hire or fire employees, buy a copier, etc. B can be done on a simple majority head count. Others B such as whether to sign a new lease or merge with another firm B might more fairly be done on a per-ownership basis. The important point for present purposes is that the members should address this issue in their operating agreement rather than leave it to the default provisions of the LLC Act.
Turning now to the types of management decisions that are subject to membership votes, the operating agreement can define those decisions that are delegated to management and those that are reserved to the members as a whole. This gives the members the power to change two default provisions of the LLC Act.
The first is power to make ordinary business decisions. As noted above, the LLC Act automatically gives all members of a member-managed company decision-making power over ordinary business decisions and managers of a manager-managed company such power. The operating agreement of the member-managed company can create a management structure and specify which ordinary business decisions are delegated to such management and removed from the members. Similarly, the operating agreement of the manager-managed company can carve out certain significant business decisions from the jurisdiction of the manager and vest it in the members.
The second default-changing provision concerns power to make extraordinary business decisions. Earlier we said that the LLC Act creates exceptions to decisions that can be made by a majority vote of members or managers. Section 15-1(c) of the LLC Act provides for unanimous consent of members of either flavor of LLC for certain decisions, such as amending the operating agreement, requirements of capital contributions, the making of distributions, merger with another entity, or consent to dissolve the LLC. It is likely that most law firms would not want to require unanimous consent for such matters (e.g., most law firms would permit dissolution on a vote of 2/3 or 3/4 of partners rather than require unanimity). Thus, these are critical issues for the operating agreement to address, both with respect to the number of votes required (majority or super-majority or perhaps even unanimity in some cases) and to how votes are counted (per capita or per capital).
Who can join?
The LLC Act provides that new members may be admitted . . . with unanimous consent of the members. Many law firms, particularly smaller ones, are comfortable with this default provision. Many firms already, at least as a de facto matter, permit any partner to veto the admission of a new partner. However, many other firms would prefer to admit a new member by a vote of the existing members, usually requiring a 2/3 or 3/4 supermajority. The operating agreement can easily address this question.
What happens when someone quits?
The departure of a member is a subject on which the LLC Act departs significantly from partnership law, and it presents a host of issues that should be addressed in the operating agreement. Under partnership law, the withdrawal of a partner (absent an agreement to the contrary) triggers the dissolution of the partnership, with resulting wind-up and accounting duties. In contrast, the LLC Act employs the concept of dissociation when a member withdraws. Withdrawal of a member is not an event causing dissolution of an LLC unless the operating agreement so provides. Instead, a member can dissociate from the LLC by giving notice of her express will to withdraw. This power appears absolute, in the sense that it can be done at any time, rightfully or wrongfully by giving notice.
Rather than cause a winding-up and an accounting, dissociation under the LLC Act requires the LLC to cause the dissociated members distributional interest to be purchased at the fair value [of the interest] determined as of the date of the members dissociation. For most law firms, fair value is not a number that can be determined readily or without controversy. The default provisions of the LLC Act set forth a procedure for the determination, under which the LLC must make a purchase offer within thirty days and provide financial backup. If the parties cannot agree within 120 days, the dissociated member may obtain a judicial determination of fair value.
Obviously, most law firms would not wish such uncertainty, leaving the purchase price to valuation experts and judges. The operating agreement, like many partnership agreements, can fix the terms or standards for purchase of the dissociated members interest. Those provisions will control, and can even eliminate the obligation of an LLC to purchase the dissociated members distributional interest.
The precise terms of the purchase provisions will depend upon the economic judgments and imaginations of the members. At one extreme, the agreement could provide only for pay-out of capital accounts, and nothing else, thereby erecting a significant deterrent to departures, as the dissociated partner would receive nothing for the inventory of receivables and work-in-process left behind. Most firms would probably opt for a formula that would provide some accounting for receivables, work-in-process, assets of the firm, and other factors. For present purposes, the key is that the operating agreement should provide a reasonably clear formula so that the firm can avoid the uncertainty and expense of resolving the issue by litigation.
An important caveat should be noted. In general, the LLC Act does not purport to change the fiduciary duties owed by departing counsel to the firm, its members and to the firms clients. The LLC Act prohibits the operating agreement from eliminating or reducing members fiduciary duties, although it permits an exception to be drawn for certain activities if the terms are not manifestly unreasonable. Whatever the meaning of this opaque term, neither the LLC Act nor the operating agreement affects the rights of the firms clients or the members duties to clients under governing ethical rules. Thus, the usual duties of partners not to solicit clients or employees prior to departure or to steal files in the dead of night will continue to apply in the LLC context. And the clients paramount right to choose its counsel, i.e., whether to leave its business with the firm or move with the departing member, is not diminished.
How does someone get kicked out?
Under the LLC Act, in the absence of an operating agreement addressing the subject, expulsion of a member is difficult. Expulsion is allowed in only four specified situations (which do not include, for example, general incompetence, insubordination or lack of productivity of the member) and requires a unanimous vote of the other members. Expulsion may also be had through judicial determination of wrongful conduct or conduct relating to the companys business that makes it not reasonably practicable to carry on the business with the member. Perhaps the difficulty of obtaining expulsion is as it should be, but many firms may wish to have definitive and controlling provisions concerning expulsion determined by their operating agreement rather than by the LLC Act or by a judge.
Once again, provisions common to many firms partnership agreements can be adapted to the LLC context. Some firms permit expulsion for any reason, with or without cause, upon a super-majority vote, typically three-fourths of the partners. Others permit expulsion only for defined cause, usually by super-majority vote. (This is an area in which the per capital v. per capita voting distinction discussed above can be quite important.) Whatever standards are picked, expulsion is a form of dissociation under Section 35-45 of the LLC Act, and expulsion will trigger the duty of the LLC to purchase the dissociated members distributional interest, as discussed above. The operating agreement can provide a different formula for buy-out of an expelled partner than of a member who dissociates for other reasons.
How is the pie going to be divided?
Perhaps no subject is of greater importance or more likely to sow dissension among partners/members than income-sharing. This returns us to the hypothetical scenario posed at the beginning of this article concerning the unproductive member subsidized by the other members for several years. If the operating agreement does not provide a formula or procedure for income-distribution among members, the LLC Act yields a simple, and often economically irrational, answer: Any distributions made by a limited liability company before its dissolution and winding up must be in equal shares.
To make matters worse (from the perspective of the subsidizing members), a members right to a distribution gives him the status of and . . . entitle[ment] to all remedies available to a creditor of the [LLC] with respect to the distributions.
The operating agreement can override these equality default provisions. While many law firms no doubt operate under and are comfortable with an all-partners-are-equal formula, most would probably opt for a determination correlated with actual contribution to the success of the enterprise. The range of possibilities is obviously wide. Elaborate formulas can be created, factoring in business-generation, realization of billable hours, and so on. More simply, a firm can have the operating agreement provide that compensation decisions will be set on an annual basis by a majority vote of the members (or, perhaps, a super-majority) or by a compensation committee.
Whatever route is chosen, any firm that wants to opt out of the equality provisions of the LLC Act must address this issue in an operating agreement before a serious compensation dispute arises within the firm.
1. Dissolving the club.
In general, dissolution of the LLC will occur and its business will be wound up pursuant to the operating agreement by an event making it unlawful for the business of the LLC to be continued, or by judicial decree under limited circumstances. While dissolution presents many potential questions for treatment in an operating agreement, this article discusses two: the provisions for triggering dissolution, and for management of the winding-up process and resultant distribution of proceeds.
With respect to triggering dissolution, the operating agreement can easily provide for dissolution upon a super-majority vote or for other reasons. Of greater interest and complexity is the process for managing the dissolution process and distributing assets of the LLC. The agreement can provide for the selection of a member or a committee to manage the winding-up process. It also can provide for the procedures for payment of overhead expenses, creditors, and, ultimately, distributions.
A critical economic variable in this process is the treatment of the matters in process on the date of dissolution. It seems clear that the accounts receivable and the actual unbilled work-in-process incurred pre-dissolution would be treated as assets of the dissolved LLC subject to liquidation and distribution. Treatment of the run-off, that is, the post-dissolution fees earned in order to complete those matters (be they cases in litigation or transactions in progress) that existed as of the date of dissolution is more questionable. In the partnership context, a set of judicial rules has evolved under which the run-off is deemed an asset of the dissolved partnership, to which the former partners have rights, but the partner handling each matter is entitled to be paid overhead and other expenses incurred in completing the matter. It is unclear whether courts would apply the same rule to the LLC context, although in other contexts courts have shown a willingness to disregard a corporate form and treat shareholders of small companies like partners.
Law firms can resolve these issues in the operating agreement. No answer is right or perfect, but the operating agreement can and should provide an answer.
Control your destiny.
This article has not tried to provide a comprehensive review of the LLC Act or to address all of the matters that should be covered by an operating agreement. The issues are many and the answers depend upon the economics, cultures and predilections of individual law firms. But one thing is clear. A law firm LLC proceeds without an operating agreement at its own risk. Surely most lawyers would advise a client forming an LLC to adopt an operating agreement. Surely most lawyers would advise a client forming an LLC to adopt an operating agreement. Only then can they control their destiny and avoid the surprises that would await them under the default provisions of the LLC Act.
Edward W. Feldman is a partner at Miller Shakman & Beem, where his commercial litigation practice includes representation of lawyers and law firms in partnership, malpractice and professional responsibility matters. Mr. Feldman thanks his partner, Michael L. Shakman, for his contributions to this article.
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