Clarity, operating agreements and Delaware LLCs

By Paul Sponaugle Tuesday, August 31, 2010

I recently stumbled upon an article that I found absolutely fascinating, considering my line of work.  In the July 7, 2010 edition of Masuda Funai’s Business Update, Stephen Proctor asks,"Is a limited liability company bound by its own operating agreement?”

Now let’s think about this.  How could the LLC not be bound by its own agreement?  I mean, it is the operating agreement, after all, that sets the guidelines for management and ownership of the LLC. However, after reading further I found the real issue at hand is whether or not the LLC itself be required to sign the agreement, and if not, is the LLC really bound to it.  There are state statutes that unsuccessfully define “parties” to the agreement, or even bind the LLC as an entity separate from its members.   So what does that really mean and does it even matter?  Well, as you’re about to read, failure to clearly define such terms allowed the managing member of a Wisconsin LLC misappropriate funds and there was nothing the LLC could do about.  What you’ll also find in the article is how once again Delaware sets the bar for all things corporate.  See the excerpt of Proctor’s article below:

 

One of the early cases dealing with this issue held that a Wisconsin limited liability company that did not sign the operating agreement was not bound by it. (Bubbles & Bleach, LLC v. Becker No. 97 C 1320, 1997 WL 285938 (N.D. IL May 23, 1997) In Bubbles & Bleach, the limited liability company brought suit in Illinois federal court against the managing member for misappropriation of funds. The managing member moved to dismiss the Illinois federal case. The operating agreement included an arbitration clause that required arbitration in Wisconsin under Wisconsin law. The operating agreement was binding on the "parties" to the agreement, but the term "parties" was not defined. Further, Wisconsin defined an operating agreement as an agreement among the members. The court found that there was no indication that Wisconsin intended to bind the limited liability company as an entity distinct from its members. So the limited liability company was not bound by the arbitration provision in the operating agreement.

Delaware takes a completely opposite approach. In 2002, Delaware amended its limited liability company law to provide explicitly:

"A limited liability company is not required to execute its limited liability company agreement. A limited liability company is bound by its limited liability company agreement whether or not the limited liability company executes the limited liability company agreement." (Delaware Limited Liability Company Act Section 18-101, as amended by 73 Delaware Laws, c. 295, Sections 1 and 2)

(As an aside, Delaware’s defined term is "limited liability company agreement," but it can be referred to as an operating agreement, so the references are to the same agreement.)

It might have seemed that Delaware, considered a bellwether in these matters, would have settled this issue. But, as a recent Illinois case illustrates, the issue is far from settled. (Trover v. 419 OCR, Inc. 921 N.E. 2d 1249, Illinois Appellate Court, Fifth District, January 12, 2010).

Trover was a member of Far Oaks Development Group, LLC (FODG). Trover and the other members of FODG authorized the managing member, Halloran, to transfer land held by FODG to 419 OCR, Inc. (419 OCR, Inc. was owned by Halloran and Macaluso who were also members of FODG.) But Trover alleged that the agreement transferring the land included an oral promise by Halloran and Mancuso, representing 419 OCR, Inc., to pay FODG, in addition to the estimated price of the land to be sold, an additional sum of money to be determined as the land was developed and sold. Although the land was developed and sold at a profit, no additional funds were paid to FODG. The litigation by Trover was based on a derivative action on behalf of FODG alleging breach of contract and fraud.

Halloran and Macaluso sought to compel arbitration under the operating agreement of FODG. The trial court denied the motion to compel arbitration and the defendants appealed.

The court acknowledged that the arbitration provision in the operating agreement was broadly worded. In this case, some of the claims involved defendants (such as 419 OCR, Inc.) who were not members of FODG and were not parties to the operating agreement. Clearly, with respect to these defendants, arbitration could not be compelled. But the more interesting question was whether the limited liability company itself was considered a party to and bound by the terms of the operating agreement that created the limited liability company.

 

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