The Rules Are Changing for Operating Agreements

August 27, 2012

New Hampshire’s current LLC act (which I’ll call the “Old Act”) provides that an agreement among the members of an LLC about their rights and duties as members (an “operating agreement”) won’t be legally binding unless it’s in writing; and the Old Act provides that except as set forth in its operating agreement, an LLC will be governed by the “default” rules of the Old Act — whether its members want these rules or not.

The rule in the New Act is quite different. It provides that not only written operating agreements but also oral and implied operating agreements are binding on the members.

Already I hear a disruptive reader saying, “Tell someone who cares.” But believe me, this change between the Old and New Acts has big practical implications.

Why did the committee that drafted the New Act include this change? Our reasoning, and our overall goal as a committee, was to revise the Old Act to make it as user-friendly as possible for New Hampshire small businesses.

You see, many New Hampshire small-business LLCs don’t have written operating agreements but do have “handshake” agreements and agreements reflected in how they do business. Some of these agreements deal only with issues of profit-sharing and voting, but many also deal with other important things, such as the “fiduciary” expectations of the members about their duty to work hard for the LLC and not to compete against it.

The best reason for continuing the Old Act’s rule that only written operating agreements are valid is to obtain certainty about the terms of LLC deals. The contents of written operating agreements are usually easy to prove. The contents of oral and implied operating agreements can be difficult to prove.
However, to the extent their contents can be proved, oral and implied operating agreements deserve to be enforced just as much as written ones. In fact, not to enforce them would be to trample on the expectations of LLC members unaware of the Old Act’s writing requirement.

An example: In Year 1, John and Mary form JM LLC, under the Old Act. John contributes $50,000 to JM and Mary contributes $10,000. However, they agree that because Mary will contribute far more time and expertise to JM than John, they will split JM’s profits 50/50.

Thanks to Mary’s efforts, JM is very profitable, and over a period of years, it distributes hundreds of thousands of dollars to John and Mary under the 50/50 rule. However, in Year 10, John and Mary have a terminal falling out. John sues Mary in the Merrimack County Superior Court. He claims that the above 50/50 deal wasn’t valid because it wasn’t in writing.

The default rule under the Old Act is to split distributions based upon capital contributions, so in this case that would be 83.3 percent to John and the balance to Mary. On this basis, John asks the court to order Mary to return to the LLC all of the “excess” distributions she received from JM — amounting, as I’ve mentioned, to hundreds of thousands of dollars.

Under the Old Act, John might well win on this claim. Under the New Act, if the court believes Mary on the 50/50 issue, he’ll lose.

The fundamental question here is this: Which is more important for LLC members — certainty about their LLC deal or a chance to prove their case? The New Act drafting committee and the New Hampshire Legislature chose the latter option. Were they right? Time will tell.

But whichever answer you think is right, here’s a key lesson for you if you’re a member of a New Hampshire LLC formed under the Old Act: Under the New Act, effective as of January 1, 2014, any written operating agreement among you and your co-members will no longer necessarily define your LLC deal, since any member can come along and claim that oral and implied commitments are part of the deal. So if you care about your LLC, make sure it has a written operating agreement, and make sure that this agreement provides that oral and implied agreements about your LLC don’t count.