Seven Critical Mistakes Real Estate LLCs Make (and How to Avoid Them) — Mistake #2: Skimping on the Formation and Operating Documents
LLCs are known and loved as a relatively simple business form. You can start and operate them without a lot of advance planning. But taking shortcuts at the outset can lead to big problems later.
Which brings us to…
MISTAKE #2: Skimping on the Formation and Operating Documents
Prevention is the best medicine.
In this case, “prevention” is taking the time to properly plan and customize your entity operating documents. The medicinal benefits of this prevention can be measured by the dollars saved in avoiding future litigation claims, which can be substantial and sometimes threatening to the very existence of the company.
Prevention is best achieved through customizing your operating documents to fit your objectives. Every hour of time spent drafting and clarifying the Operating Agreement could save multiples of those hours in litigation. And on those occasions where litigation is unavoidable, your position will be much stronger with well-drafted entity documents.
Good news: the law allows for tremendous flexibility and customization in the structuring of LLCs.
California Revised Uniform Limited Liability Company Act
California’s revised LLC Act (“RULLCA”) became effective January 1, 2014. Most of my comments in this series of articles are geared toward California LLCs governed by RULLCA. Many LLCs, including some operating in California, choose to be governed by Delaware law instead. Delaware law is generally regarded as more manager-friendly and laissez-faire. I’ll cover the differences between California and Delaware LLC law in a future post.
RULLCA provides a lot of vanilla “default” rules for LLC operations, and they will automatically apply to any California LLC unless the LLC’s Operating Agreement specifies otherwise. But RULLCA also allows for customization — almost all of the “default rules” can be altered by the Operating Agreement. Take advantage of this flexibility.
Make sure you participate in the “customization” task and arm your attorney with the details and business objectives that matter. Read the draft Operating Agreement before it goes live. Are the parties’ rights and duties clear? If something doesn’t make sense to you, chances are it won’t make much sense to a jury either. Aim for clarity and avoid pointless legalese.
Manager’s Fiduciary Duties Can be Modified
LLC managers take note — the Operating Agreement can modify fiduciary duties owed to members.
Managers of California LLCs owe certain duties to members:
- Loyalty (limiting adverse interests to / competition with the LLC and misappropriation of the LLC’s opportunities)
- Care (prohibiting gross negligence, recklessness, intentional misconduct, or criminal violations)
- Good Faith & Fair Dealing (preventing acts frustrating members’ benefit of the bargain)
These duties can’t be eliminated, but can be modified through the Operating Agreement or amendments with the members’ informed consent (and as long as the modifications are not “manifestly unreasonable”).
Examples:
- Identify specific activities (such as “sometimes competing” or “potentially competing” ventures) that, by agreement, don’t violate fiduciary duties.
- Specify the number or percentage of members needed to authorize or ratify any specific transaction that raises fiduciary duty issues.
- Prescribe standards by which the duty of good faith and fair dealing should be measured.
- Describe the manner of management required. Is the “manager” job full-time, part-time, or no-specific-time? Is the manager free to engage in other business unrelated to the LLC?
So, take advantage of this flexibility, and clarify the managerial expectations.
Member Rights and Duties Can Also be Modified
Under California RULLCA’s “default” rules, members have a right to consent/vote on issues such as:
- manager removal
- sale/lease of LLC assets
- financing transactions and hypothecation of LLC property (using it as security for a loan)
- admission of new members
- acts outside the ordinary course of business
But the Operating Agreement can modify most of these rights with the members’ consent.
(Note for LLC members: If you intend to be an “active” investor and exert influence on intra-entity matters, you probably don’t want to agree to limiting too many of your default rights, and you probably want to avoid Delaware LLCs altogether.)
Manager Removal
Of all the member rights noted above, “manager removal” is probably the most frequent source of litigation.
Under RULLCA’s default provisions, members may remove a manager with or without cause, and without notice by a simple majority member vote. As such, with many small LLCs in particular, the manager can be sacked with ruthless speed and efficiency.
Many Operating Agreements modify that default rule to require one or more of the following:
- notice
- good cause (usually some form of default or breach of the Operating Agreement)
- super-majority vote
In fact, the Operating Agreement might even be able to eliminate manager removal altogether. (This hasn’t been tested yet in any published California appellate decision that I know of, but the statutory language may allow it.)
Disputes over managerial removal and authority can get very messy, with multiple parties claiming the authority to speak for and make decisions on behalf of the entity. The Operating Agreement should provide a clear procedural framework for how “contested” managerial removals are dealt with and how they impact the LLC’s operations until the dispute is resolved.
Securities
LLC managers and members frequently under-appreciate their duties and liabilities under California and federal securities laws.
Under California law, LLC interests are presumed to be a security unless all members are actively engaged in management. Outside of sole one-member/manager LLCs, the “unless” is rarely fulfilled. Exercising normal member rights like voting and receiving information is not considered “active engagement in management” for purposes of the securities laws.
Under federal law, the outcome is mostly the same. LLC interests qualify as “investment contracts” subject to securities laws to the extent they envision “profits derived solely from the efforts of others.”
Bottom line: Assume securities regulations apply and talk to a lawyer about available exemptions (there are many) and how to best document compliance with those exemptions.
Also, in the securities context disclosures regarding the “risk of loss” became critically important, and should appear in multiple locations (Operating Agreement, Subscription Agreement, other stand-alone investment documents).
Attorney Fee Clauses
Attorney fee recovery clauses in Operating Agreements don’t start litigation, but they can make litigation much worse.
They can become the “tail that wags the dog” and prevent settlement. It’s hard to settle a dispute where the claimed damages are $100,000 if there is an attorney fee clause and each side has spent more than that amount in litigation and preparing the case for trial.
I like attorney fee clauses in some agreements, like contracts between a business and a third party — an “outsider” to the entity. But in intra-entity agreements like an LLC Operating Agreement, I’m not a big fan. Most intra-LLC disputes are like “civil wars” between formerly close business partners. Adding attorney fee recovery raises the stakes steeply and can sometimes ensure that the litigation loser suffers financial ruin.
If your Operating Agreement has an attorney fee clause, be clear on its scope. Some attorney fee clauses apply narrowly to only disputes seeking to “enforce” the terms of the Operating Agreement. Other clauses apply broadly to all disputes “arising from” the Operating Agreement or the parties’ relationship. If you’re going to include an attorney fee clause in the Operating Agreement for a new LLC, be sure to think through the most likely potential litigation scenarios and outcomes, and pick the clause with the “right fit.”
Alternative Dispute Resolution
Many Operating Agreements include provisions requiring binding arbitration of disputes.
Arbitration takes place outside of court, but the arbitrator’s decision can generally be enforced in court.
The supposed benefits of arbitration are greater speed, reduced cost, and finality (no appeals). In general, these benefits are true much of the time, but not always. The main advantage of arbitration is you get a single private arbitrator who is dedicated to your case and whose calendar can be reserved for your case with a high degree of certainty. In our public courts, by contrast, cases are subjected to many hurdles and delays with calendaring and courtroom availability, much of which has been exacerbated by the recent courtroom budget problems. Time is money, and the cost of litigation can often be measured by the time it takes a case to get to trial.
But one of arbitration’s positives (finality / generally no right to appeal) is also one of its worst negatives. Arbitrators are human and, like judges, they sometimes make mistakes. Arbitration clauses can be written to include a limited right of appeal. Or better yet, parties can choose to implement “judicial reference” instead of arbitration. In judicial reference, the parties can have a private judge appointed to adjudicate their case, with many of the scheduling benefits associated with arbitration, but also with tighter rules of evidence and an automatic right of appeal. Parties might also want to limit the right of appeal to only awards above a certain monetary threshold, so that time and resources are funneled to appeals only where the stakes justify the extra time and expense.
Lesson
Don’t skimp on your basic LLC documents. Take advantage of the customization opportunities allowed by California law. Set expectations and guidelines as clearly as possible.
Next post in series … MISTAKE #3: Ignoring Member Rights and Duties
Prior post in series:
MISTAKE #1: Choosing the Wrong Business Partners
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[…] Skimping on the Formation and Operating Documents — Prevention really is the best medicine. Many disputes can be avoided by taking the time on the front-end to customize your Operating Agreement to make it understandable. Evaluate the specific facts of your LLC and envision what types of problems might arise. Pay close attention to the provisions that tend to be the focal point of disputes — managerial authority and member voting rights. […]
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