Practice Pointers in Drafting LLC Operating Agreement

A limited liability company (“LLC”) is a popular business structure for new businesses. LLCs are formed in accordance with state law and have the benefit of providing limited liability protection for its members while being taxed as a partnership or a corporation if an election is made. The exact rules for setting up an LLC vary by state, although the general requirements are quite similar.

One of the key steps in forming your LLC is drafting the LLC’s operating agreement. The operating agreement sets forth the members’ financial, management, and other rights and responsibilities.

Although most members are financially solvent when entering into a new business, there may come a time when a member of the LLC may fall on hard times and need to file a personal bankruptcy. Typically, the filing of a personal bankruptcy by a member of a multi-member LLC will have limited effect on the LLC’s ability to continue operating.

Under most state limited liability laws, a member’s bankruptcy filing causes the member to be disassociated from the LLC. Generally, the consequences of dissassociation are the member’s retention of economic rights but the loss of all non-economic/management rights under the operating agreement.

Depending on how the operating agreement is written, it could have implications on whether a bankruptcy trustee can step into the shoes of the bankrupt member and succeed to its rights under the operating agreement.

If the operating agreement is drafted in a way whereby the bankrupt member has material ongoing obligations under the operating agreement (i.e., duties, ongoing capital contributions or managerial responsibilities), it could help to prevent having to do business with an unknown bankruptcy trustee.

Better yet, the operating agreement can specifically restrict any trustee’s interest to an economic interest only. This will ensure that a third party non-member does not gain control or voting rights to the LLC.

For further information on forming your LLC or unique issues faced by LLCs or their members in bankruptcy, please contact: Lisa Yonka Stevens at [email protected] or 443-569-0795.