A limited liability company is commonly regulated by an operating agreement. An operating agreement is an agreement among the members of the limited liability company that governs the affairs of a limited liability company and the conduct of its business. (Delaware Limited Liability Company Act Section 18-101 and Illinois Limited Liability Company Act Section 15-5). Although an operating agreement need not be in writing, most attorneys who assist clients forming limited liability companies will have a written operating agreement signed by the members.
But is the limited liability company itself required to sign the operating agreement? If not, is the limited liability company bound by the operating agreement? Depending on the jurisdiction, statutes and cases treat this question very differently.
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.
The court called this an "issue of first impression in Illinois." The court cited a 1999 Delaware case (Elf Atochem North America, Inc. v. Jaffari, 727 A.2d 286 (Del. 1999)) which was Delaware's case of first impression on this issue. In Jaffari, the court concluded that a Delaware limited liability company was bound by an arbitration clause in its operating agreement, even though it did not sign the agreement. (Interestingly, the court did not cite or discuss the Delaware statute noted above that explicitly binds a non-signing limited liability company to its own operating agreement.)
But the Illinois court found that Illinois law and the facts required a different result. First, under Illinois law a limited liability company is "a legal entity distinct from its members.” (Illinois Limited Liability Company Act Section 5-1(c)) A limited liability company has the power to sue and to be sued. (Id. at 1-30(1)).
The operating agreement of FODG was among the members, none of whom signed in a way that purported to bind the limited liability company. In addition, the operating agreement provided a procedure to bind the limited liability company, but none of the members followed the procedure. Therefore, the limited liability company was not bound by the arbitration provision in the operating agreement.
At the outset of forming a limited liability company, it is difficult to envision circumstances where the members want the limited liability company to be governed by different provisions than those governing the members in the operating agreement (although, as the Trover case illustrates, facts may develop so that a member may want the limited liability company to avoid the provisions of the operating agreement.) So, conservatively, it seems a good idea to have the limited liability company sign the operating agreement so that the limited liability company is bound by the operating agreement.
This also creates a dilemma. Generally, the members will want an operating agreement in place before creation of the limited liability company. However, a signature by a limited liability company yet to be formed might be challenged. Of course, the limited liability company, through its members or managers, can ratify and sign the operating agreement after the limited liability company has been formed, so this should not be a major problem.
But, in this area also, Delaware has answered the question by statute:
"A limited liability company agreement shall be entered into or otherwise existing either before, after or at the time of the filing of a certificate of formation and, whether entered into or otherwise existing before, after or at the time of such filing, may be made effective as of the formation of the limited liability company or at such other time or date as provided in or reflected by the limited liability company agreement." (Delaware Limited Liability Company Act Section 18-202)
So the issue as to whether a limited liability company is bound by its operating agreement remains and must be considered by persons forming a limited liability company (and their counsel). But forming a limited liability company under Delaware law should avoid this issue entirely.