The case involved a two-member New York LLC that, in the four or five years it operated, achieved enviable growth and profits. The two members were highly educated individuals with ample business experience.
Apparently for reasons of speed and convenience — they had the financial wherewithal to hire a lawyer, but chose not to — they used LegalZoom to form the LLC including the articles of organization and operating agreement. The latter document reflected a 70/30 ownership split.
Years later the members’ relationship turned bitter, which is when I first got involved in what became a court case and eventually the liquidation and dissolution of what had been a successful business. As in every business divorce, the reasons for the demise of the business were complex and unique but shortcomings in the operating agreement also contributed significantly to the parties’ legal postures and willingness to risk litigation.
You see, the LegalZoom operating agreement for the member-managed LLC had two separate provisions in two separate articles governing management decision-making by the members. The article entitled “Management” provided that in the event of any dispute between members, “final determination shall be made by a vote of the majority of the Members,” i.e, per capita voting, whereas the article entitled “Membership” required a vote of members “holding a majority of the Membership Interests” to approve any action, i.e., pro rata voting.
As you would expect in a battle over governance rights in a two-member LLC, the side claiming 70% ownership argued that the latter article trumped the former, and the other side argued the opposite. The judge in the case — one of the best in the New York Commercial Division — noted that each provision could be read to give way to the other before issuing an interim ruling that left the conundrum unresolved, after which the parties consented to dissolution.
I’m not suggesting that every lawyer-drafted LLC agreement is a model of perfection, but I found it incredible at the time, and still look back in wonderment, that a standard form operating agreement being sold online by a major company to the unknowing public as a more affordable alternative to using a lawyer could suffer from such a fundamental flaw that, in the end, only intensified the parties’ legal conflict.
Just recently I had another opportunity to review a LegalZoom operating agreement for another two-member New York LLC formed about six years after the one I just described. I believe it to be essentially identical to the sample New York form available on LegalZoom’s website currently.
Naturally I first looked at the management provisions. Lo and behold, the “Management” article no longer provides for per capita voting by members. Rather, it provides that all activities or transactions require member approval without specifying the requisite vote, which is left to the provision in the “Membership” article requiring the votes of a majority of the “Voting Interest of the Company.” Unfortunately, nowhere in the agreement could I find any definition of the capitalized term “Voting Interest” although I did find “Ownership Interest” defined as the percentage interest of ownership in the LLC as reflected in the agreement’s Exhibit A identifying the members. Did LegalZoom substitute one drafting glitch for another?
I also observed an arguably better provision in the newer agreement that didn’t appear in the older one, requiring unanimous member approval for specified major decisions such as change in business purpose, merger, amendment of the agreement, etc.
But by and large, the provisions of the newer form of LegalZoom LLC agreement track the default rules of the New York LLC Law, which raises the question, why bother? True, the LLC Law requires that every New York LLC have a written operating agreement within 90 days of formation, however there’s no penalty for non-compliance and the case law applies the “statutory operating agreement,” i.e., the LLC Law’s default rules, whenever there’s no written agreement.
The LegalZoom website offers various levels of service for LLC formation at prices ranging from $149 to $359 plus state filing fees (and, in New York, publication expense which can add over $1,000 depending on the locality). Each service package includes an LLC agreement that the user generates by choosing from a series of options. I haven’t personally gone through the exercise of generating a LegalZoom operating agreement, so I can’t comment on the variety and comprehensiveness of the options offered. But judging from the sample agreement, and knowing how complex and obscure the LLC Law and LLC agreements can be even for experts, it’s hard to imagine that laypersons navigating the LegalZoom website can possibly walk away with an agreement that meets the long-term, ever shifting needs of business partners. For instance:
- Does the LegalZoom form provide a solution when a member stops contributing his or her services, or refuses to contribute additional capital, or refuses to co-guarantee a lease or line of credit? Not that I saw.
- Does the LegalZoom form provide for distributions for taxes on phantom income? Not that I saw.
- Does the LegalZoom form address the members’ duties and job responsibilities, or protect against freeze-out of a minority member? Not that I saw.
- Does the LegalZoom form include a tiebreaker mechanism when there’s an even number of voting members? Not that I saw.
- Does the LegalZoom form offer any workable buy-sell solutions for various trigger events including death, disability and retirement? Not that I saw.
- Does the LegalZoom form include alternative dispute resolution provisions such as mediation and arbitration? Not that I saw.
I could go on, but you get the idea.
In good times when business partners get along well and pull together, the LLC agreement sits unnoticed in a filing cabinet. The true test of an LLC agreement is when times get tough and the members’ interests diverge.
Call me biased because I’m a lawyer. Call me jaundiced because my stock-in-trade is dysfunctional business relationships. I still say to anyone contemplating the formation of a new business entity with partners, you’re better off spending the money up front for 5 to 10 hours of a qualified lawyer’s time — someone who can ask the right questions and provide the right drafting solutions in a well-planned, comprehensive operating agreement — than buying a $149 form agreement that provides no solutions when problems arise or, worse yet, adds fuel to the fire when they do.