Can a Court Rewrite Your LLC Agreement? You Might Be Surprised.

What do you do if you never put a limited liability company operating agreement on paper?  In some cases, the answer may be decided against your wishes by a court. I was recently speaking with a small business owner who ran into trouble with the other member of his limited liability company.  The two had formed the LLC six years ago by filing with the Commonwealth but never put an operating agreement on paper.  However, he indicated that they had an oral agreement on a variety of things that would normally be in an operating agreement - how the LLC is managed, how the profits and losses are divided, how to buyout a member who leaves, etc.  Now he wanted to use some of those agreements to resolve the conflict.

In Massachusetts (as well as many other states), a written operating agreement is not required; members can have an oral agreement on how their company is structured and operated.  But that flexibility can bring risk.  Here's why.

States have a common law concept called the "statute of frauds".  (For those of you who eyes are immediately starting to glaze over at the sight of technical legal talk, you can skip to the paragraph that begins "So what does this mean for your company?" to understand the practical implications.) State laws vary, but generally the statute of frauds states that certain contracts must be in writing and signed if you are going to enforce them.  In addition to other things, this common law principal includes any contract that cannot by its terms be performed within a year.  Note that an agreement that happens to take more than a year is not automatically subject unless the agreement specifically states that it will take more than a year.  If so, the contract is not automatically void, but one party can raise the statute of frauds in order to have the contract voided.  Remember that this is a complex topic because there are some exceptions, but as a general principal, long-term unwritten agreements carry some uncertainty.

This issue became much more relevant to LLCs last year when the Delaware Chancery Court ruled that an oral LLC agreement was subject to the statute of frauds.  In Olson v. Halvorsen, C.A. No. 1884-VCL (Del. Ch. Dec. 22, 2008), a hedge fund founder who was removed by the other members demanded that the court enforce a multi-year earnout agreement that was included in their unsigned draft of an LLC agreement - an earnout worth well over $100 million!  The court held that because the earnout was to be paid over the course of six years, it falls within the statute of frauds and was therefore unenforceable.  The former hedge fund manager's claim for the payout was rejected.

The applicability of this case in Delaware adds some uncertainty to the operating agreements of LLCs formed there.  Other states, including Massachusetts, have yet to decide this issue definitively, but the Delaware courts often serve as a model for other courts when they are facing corporate and LLC issues.  So this decision may eventually have implications for your agreement.

So what does this mean for your company? If your LLC is operating under an oral operating agreement, many of the provisions with respect to management and such may be enforceable because they can be performed within a year.  However, as the court decided in Delaware, if you have an oral agreement with the other members that entitles you to some benefit that extends beyond one year, you may lose that right in a dispute.  For example, if the members agree that if you were to be hit by a bus tomorrow, the other members would buy back your membership interest with installment payments over five years, the other members might be able to successfully void that provision upon your untimely demise under the statute of frauds.

So here are some tips with respect to operating agreements in light of this case law:

1. Put your LLC operating agreement in writing.  Operating Agreements do not have to be fancy.  You can write the provisions of your agreement in any way that expresses the true intent of the parties.  Working with a lawyer may help save a tremendous amount of agony since they have experience in drafting agreements that will be enforceable.  But don't get caught up in the formalities - just get it in writing.
2. Make sure everyone signs the agreement.  A critical element of the statute of frauds is that the agreement must be signed by the person against whom it will be enforced.  As in the Olson case described above, the members wrote out the provisions of an agreement, but the courts did not enforce it because the parties never signed it.  I have dealt with other situations where clients "forget" to sign a document.  It may be easily overlooked a the end of a negotiation, a critical issue to protecting your rights.
3. Revisit your agreement periodically.  Companies that have been operating for several years might be surprised by what is in their operating agreements because the needs of the members and the company may change over time.  This is even more important if you are operating with an oral agreement.  After a few years, the members may have very different recollections of your agreement, which may lead to messy disputes down the road.  I would recommend that you take a fresh look at your agreement annually when you have an annual meeting.

New Model Startup Docs Give Entrepreneurs a Head Start - Do You Still Need a Lawyer?

Startup companies just got new tools to make the formation process a little easier.  With the help of the law firm Wilson Sonsini Goodrich and Rosati (if you are a California startup, you have undoubtedly heard of them), TheFunded.com offered up this week its contribution to the recent and growing trend of publishing early stage documents for startups and emerging companies with publication of the following form documents:

• Bylaws
• Certificate of Incorporation
• Initial Stockholder Consent
• Invention Assignment Agreement
• Restricted Stock Purchase Agreement
• Indemnification Agreement
• Initial Board Consent
• Action by Incorporator
• Plain Preferred Term Sheet

These are the basic documents used by startup companies to get their ventures off the ground.  The Certificate of Incorporation is the only document that is filed publicly with the state, the others govern internal matters within the company.

This is not the first set of legal documents to be released, but most of the other forms have been in the early stage equity investment area.  Wilson Sonsini itself published a term sheet generator for each stage venture investment deals, TechStars published a set of model early stage investment documents earlier this year, and of course, there are also the National Venture Capital Association forms for early stage venture investments that have been out for several years.  In fact, other firms and organizations have released form documents in an effort to make the process of formation early stage financing easier, cheaper, and more efficient.  Wait, did someone accuse lawyers of being inefficient?

So startup lawyers are now expendable?

Don't jump to conclusions too soon.  These documents can give you a sense of what is involved in formation and also provide a baseline for your final agreements.  However, there are still many things here that you should discuss with your attorney.  There is no such thing as a one-size-fits-all set of formation documents.  Each company will have individual needs based on the structure of the organization, the people involved, etc.  For example, you should at least consider the following:

1. These documents assume that your startup is incorporating in Delaware and is located in California.  State laws of formation differ and your state may have different requirements that will have an impact on the documents.
2. These documents are founder-friendly in that they give a lot of control to the entrepreneurs who form the company.  That is great for the entrepreneurs but may become problematic if you have other investors or third parties involved who want to share in that control.
3. You may need to consider an additional agreement for the founders to cover other contingencies that affect their relationship.  Remember that everyone is happy to be in business together at the beginning.  But a little planning up front will help to resolve disputes later.
4. If you sign a restricted stock agreement, you will likely (in almost all circumstance) file an 83(b) election.  This must be filed at the time you sign or within 30 days in order to enjoy the benefit of recognizing tax on the value of the shares of the fair market value (which should be $0.00 at the time of grant because they are given at fair market value).  The alternative is that you will be taxed at each stage of vesting - if the company increases in value, you could be stuck with a tax bill each time without any liquidity (i.e. no cash is paid to you at vesting from the stock).

The bottom line is that forms like these give some more power to entrepreneurs in taking control over the formation process.  And because they come from reputable organizations, you can have a piece of mind that you might not find with other online sources.  But with this new control comes the responsibility to make sure that you understand what you are getting into.   A good startup attorney can walk you through the pros and cons of these documents so that you can feel confident that you are setting up a strong organization.

Massachusetts Data Privacy Regulations Get Delayed ... Again

For those of you stressing over the changes to personal information policies and procedures required by the pending Massachusetts data security regulations, you can breathe a sigh of relief... sort of.  The deadline for implementing the new policies has been pushed back - for the third time.  Now the new regulations will take effect on March 1, 2010 (rather than in January), and some of the more controversial aspects of the law have been watered down to make the requirements more palatable to small businesses. If you are a business owner who is not aware of the upcoming changes, you need to take a look.  The far-reaching regulations are a response by lawmakers to the highly-publicized security breaches at TJX, The Boston Globe, and others where thousands of social security numbers, credit card numbers, and other personal information were carelessly unsecured.  As described by Mass High Tech:

The Massachusetts regulations, first promulgated last fall based on a legislative directive, will go further than any other state by requiring any company that handles state residents’ sensitive data to take measures to protect it. Measures include encryption and extend to ensuring that all third-party IT service providers adequately protect sensitive data — a clause that drew criticism from business owners as an onerous requirement.

Specifically, the revisions to the data security regulations moderate the specific requirements to make them more consistent with the federal privacy requirements under the Gramm-Leach-Bliley Act.  The new Massachusetts privacy regulations apply to any business - yes, even outside of Massachusetts - engaged in commerce that collects and retains personal information of Massachusetts residents in connection with the provision of goods and services.  While these regulations will apply to all businesses regardless of size, the new revisions make clear that the regulations will apply a risk-based approach based on the size and scope of each business. (i.e., smaller businesses storing small amounts of information will be required to take different actions than would a large company with much more information and resources).

So, what does this mean for you?

If you are a business owner who collects the first name or initial and last name of a Massachusetts resident in combination with that resident's (a) Social Security number, (b) drivers license or state issued identification card number, or (c) financial account number or credit or debit card number, you must comply with the new regulations by March, 2010.  That includes, at a minimum:

1. creating a comprehensive information security program for safeguarding against "reasonably foreseeable internal and external risks to the security, confidentiality, and/or integrity" of the personal information, including employee training and education;
2. encrypting all data and files containing the personal information to the extent "technically feasible" and maintaining "reasonably up-to-date" firewall protection and operating system security patches; and
3. taking "reasonable steps" to select and retain third-party service providers that are capable of maintaining appropriate security measures consistent with these regulations and any applicable federal regulations.

The steps that were originally included as required actions are now offered as guidance to comply with the regulations, but whether a company is ultimately in compliance will be determined on a case-by-case basis.  In any event, all businesses should take a look at their data security procedures to make sure they are up to date.

Are you concerned about how the new regulations will affect you?  What do you see as the biggest challenges to comply?

"The paradigm has changed" for the billable hour

As a follow up to my previous post about how the economic environment is affecting law firm economic models, and the Wall Street Journal brings one more example:  companies the likes of Pfizer, Cisco, and American Express are demanding that law firms ditch the billable hour structure in favor of flat-fee contracts.

Companies have long complained that legal fees are inflated by a business model in which law firms have high-priced junior lawyers who must be kept busy billing for work that could be handled more efficiently. With the recession, companies have the leverage to force changes, say some lawyers at both client companies and law firms.

And while this shift is welcomed by the companies, the law firms are facing new challenges:

The shift could further squeeze earnings at top law firms. The past 18 months have been brutal for some big law firms as work that hinges on vibrant credit markets, such as deal making, has flat-lined.

In fact, as reported on Above the Law, some law firms, in addition to the seemingly endless list that have laid off attorneys over the past year, are now turning to pay cuts for associates that are still employed.  One law firm in Boston is cutting associate salaries by as much as 35%.

It certainly gives some business owners new leverage in the relationship with their lawyers.  But is this new power reserved only for the biggest companies?  How has the economy affected the way you work with your lawyer?

Not too big to fail: the end of BigLaw?

Recessions typically force businesses to tighten their belts and make some temporary changes as they wait out the storm.  But doesn't this one seem different?   Doesn't it feel as though it is reaching formerly untouchable sectors of the economy and encouraging a willingness to completely rethink the way things have always been done? One such example is big law firms.  Check out Douglas McCollam tearing down the current big law firm model in the WSJ:

At bottom, what’s in question is the whole economic edifice of the modern American law firm. Like the pharaohs of old, big firms are enamored of constructing pyramids with an ever-widening base of associates and nonequity partners toiling on behalf of a narrowing band of equity partners at the top. Increasing a firm’s “leverage”—as expressed through the billable hour, one of the most pernicious creations in the annals of commerce—has been the key metric driving profitability at big law firms over the last generation.

Along with the growth and "hubris" that has created international legal institutions that rival the size of some of their larger clients came excess:  now junior associates in Boston and other major cities are making $160k to start, plus bonus, and are often billed out at $300 - $500 per hour -- rates which used to be reserved for partners -- making million dollar partner salaries commonplace.

I am certainly not suggesting that the big law firms are going away.  However, businesses are rethinking the model in light of this deep recession and what they want out of their relationships with their lawyers.  There will certainly be some changes going forward.

This is particularly pertinent to startups and small businesses.  Jason Mendelson, co-founder and Managing Director of Foundry Group, has written extensively and convincingly of the effect on startup companies from a venture capitalist's perspective in an entire series of blog posts called Law Firm 2.0.  These are definitely worth a read; there are a lot of lawyers out there - myself included - who are seeking new ways to accomplish our clients's goals from their perspective, not the lawyers's.

What do you think?  What would you most like to see from your lawyer?

UPDATE:  It seems McCollam's Op-Ed and the discussion about Law Firm 2.0 has struck a nerve.  Is there actually a big difference of opinion here?  Having worked at big law firms, I have seen a variety of views.  Few were in favor of maintaining the status quo, but each had a different perspective for "fixing" things depending on where they sat on the pyramid.

What do you see as the real debate, and where do you see the fault line?