Basics of NJ Operating Agreements
"Essential Guide to NJ Operating Agreements: What Every Business Owner Needs to be Aware of" as this article is designed to be part of a series of blogs explaining Operating Agreements as it relates to the New Jersey Limited Liability Company (LLC) structure.
So what is an NJ LLC Operating agreement and why is it important? Well, a limited liability company may be managed by its members or by the appointed managers of the LLC and the LLC, subject to any limitations set forth in writing in the operating agreement, has the power to (a) acquire, hold, lease or transfer property, and otherwise carry on any business; (b) sue or be sued in the company’s name; (c) make contracts, borrow money, issue notes, secure any company obligations by granting a security interest in the company’s property or otherwise; (d) lend money; (e) establish pension benefit plans and trusts for the benefit of members and employees; (f) make and perform all contracts and agreements necessary or convenient to the conduct of company business; (g) elect one or more members or nonmembers to be managers; (h) and pay pension benefits, profit shares, and other compensation to members and employees of the company.
42:2B-33.2
It goes on to make clear that the members of the LLC are the "owners" which is also referred to as the "members" of the business. The NJ LLC Law, if there is no operating agreement in place, will act as the default operational guide for the members of the LLC. In other words, the LLC Law will direct how the members should run the business if that choice is left up to the law.
Clearly then , having a detailed operating agreement is the better option. I want to reiterate how important this is. If there are no terms agreed to by the members of the LLC regarding the types of decisions that must be made by the vote of the members, then the LLC Law, at its discretion, will provide the rules by which members of the LLC should run the LLC. This is not ideal because it does not take into account the best interests of the members. Maybe the LLC Law provides that any decision must be made by a majority vote of all members, but two of the members have a partnership agreement in place that requires the two of them together, regardless of each member’s voting interest, to have the right to sign checks, make bank deposits, pay bills and the like. It would be an unfortunate event if this issue were to come up and the parties in question did not have a specific provision in their operating agreement. In such an event, the best case scenario is that each member will have to hire an attorney to strongly argue for their respective position. The worst case scenario is that the members of an LLC must pay for unnecessary litigation over an issue that they thought was covered.
It is not enough for one member to believe that another member of the LLC is abiding by the terms of an oral agreement. The oral agreement is fine if that is what the members decide, but there needs to be a formal, written agreement that clearly states the duties of the parties to the LLC, the division of assets, how profits are allocated, when capital contributions are required and who has the final authority to control the business. The operating agreement acts as the company’s bylaws, an avenue for the settlement of disputes and a mechanism to ensure that the managers and members of an LLC carry out their respective roles in the business.
Core Elements of an NJ Operating Agreement
An NJ operating agreement should contain a few fundamental components that thus perform a number of essential roles in the overall structure of the business. The most basic parts of an NJ operating agreement will include the following:
The NJ LLC member names and information will always be present an NJ operating agreement, as should any additional members that may join the enterprise in the future. This is essential because all members and/or the business will need to be able to identify the ownership interests of each member.
The management structure of the NJ LLC is another essential element of an NJ operating agreement, as members have a choice on whether one or more of them will manage the day-to-day operations of the business, or whether the members will allow for a different entity or person to handle the operations. Depending on how many members there are, the process of determining management can become unwieldy. Without a detailed NJ operating agreement outlining how many members will actively participate in the management of the business, an operating agreement can prove to be vital in keeping the business running smoothly and in avoiding disputes.
Another fundamental piece of an NJ operating agreement will be the splitting of profits and losses among all members that hold equity in the business. This is of course because members must agree in advance as to their compensation, as well as how the business will be split in the event one or more of the members decides to sell their membership interest.
Legal Specifications for NJ Operating Agreements
While there is no express mandate under New Jersey law that a limited liability company be required to have an operating agreement, any LLC will almost always benefit from one. N.J.S.A. 42:2C-11 provides: If a limited liability company is formed without an operating agreement, or if its operating agreement does not expressly provide for a particular matter, the following rules apply: (a) The management of the limited liability company shall be vested in its members in the following manner: (1) Each member shall have equal rights in the management and conduct of the business of a member-managed limited liability company. (2) Matters shall be decided at a meeting of the members by a majority of the members entitled to vote, unless the operating agreement requires a greater percentage approval of members. (b) Except as provided in the operating agreement, each member shall devote such time and attention to the business of the limited liability company as may reasonably be necessary to perform his duties. Here, the majority of the statute (N.J.S.A. 42:2C-11) sets out default provisions that could apply in the absence of an operating agreement. There are other similarly default provisions that would apply unless the operating agreement specified something different. In addition, N.J.S.A. 42:2C-16 makes clear that the statute governing LLCs in New Jersey will trump the operating agreement if there is a conflict between the two: ("An operating agreement shall control the relations among the members and the relations between the members and a manager as among themselves, subject to any restrictions contained in the articles or an operating agreement. In the case of a conflict between the provisions of the articles or an operating agreement and the provisions of this act, the provisions of the articles and the operating agreement shall control, except to the extent that the articles or operating agreement do any of the following:… (3) Eliminate the duties of loyalty or care, except as permitted in section 12 [N.J.S.A. 42:2C-12]. An operating agreement shall not eliminate the duty of good faith, nor may it provide for a standard of conduct for a member or manager that is less than the minimum standard of conduct provided in this act.").
Advantages of Possessing an Operating Agreement in NJ
An operating agreement is a foundational document your New Jersey limited liability company needs if you want to ensure your business operates according to its rules and terms. While you are not required by state statute to have an operating agreement, it is a necessary tool to help you protect yourself from liability from creditors and plaintiffs. Beyond that, the agreement can also serve as a formal framework for the business, describing what its purpose will be, how it should handle finances, and how members should share in the profits and losses of the business.
First, beyond the protection an operating agreement affords to its members, it also benefits your LLC in other ways. Having a written agreement will better protect the company’s status as a limited liability company because the agreement demonstrates that the members intended to run the business as an LLC in compliance with required formalities. This proves crucial in the event of litigation. If a member attempts to use the LLC to avoid personal liability as part of a lawsuit against the LLC, and the plaintiff is able to show that the LLC was not being run as intended, the court will most likely allow that plaintiff to "pierce the corporate veil" and hold the members personally liable. It will find that the company was not operating as an LLC, due to the members’ failure to maintain that distinction through their actions.
Second, as an essential element of your business, an operating agreement will help determine how the company will operate on a daily basis. For instance, it can describe the operating decisions the company should make, such as how it should handle income generated by the company, what types of activities or investments it may make, how membership interests may be assigned or sold, how to remove a member or acquire more members, how to amend the agreement, and what to do if the company fails to meet its expectations.
Pitfalls to Evade
Many business owners do not involve legal counsel to draft or review the operating agreement. While a properly drafted one may be compliant with the law, it is important to note that the agreement does not have to comply with the default provisions in the NJ LLC Act. As long as the language of the operating agreement satisfies Title 42, the default statutory provisions may be overridden by the language in the operating agreement.
In addition , the agreement must be clearly and properly drafted to avoid ambiguity and prevent future disputes. Seemingly small errors can have a significant impact on the meaning of the agreement. Even if an LLC chooses to follow the statutory provisions, having a poorly worded agreement will lead to confusion among the members preparing the tax returns and drafting annual reports required with the Division of Revenue.
Finally, even if an operating agreement was drafted in the past, it should be amended or restated when a new member joins or upon any major change. It should also be carefully reviewed to make sure it is still relevant, especially if it has not been utilized.
Composing an NJ Operating Agreement
DRAFTING AN NJ OPERATING AGREEMENT
The drafting process should include a thorough discussion among you, other members and your legal counsel. Consideration should be given as to whether you will draft an operating agreement by using available templates or by preparing an NJ operating agreement.
USE OF A TEMPLATE
Samples of operating agreements for reference purposes are available from many websites. In many cases, the use of a template without legal guidance is not a good idea, because an operating agreement is a document that establishes equal rights among members. Even the most experienced practitioners seek out a legal review before handing the document over for signature by the members. Legal counsel can offer a great deal of financial and organizational protections to the members, particularly in cases where members approach the table with differing understandings and expectations. An NJ operating agreement will help you and your company to a far greater degree than a document that you simply put in a drawer somewhere.
CONSIDERATION OF LEGAL REPRESENTATION
Consultation with legal counsel can also be important if any of the following factors exist: Representation by legal counsel is strongly suggested before moving forward with your NJ operating agreement. Your attorney may also be able to provide you with a list of templates that can be appropriately utilized. If your legal counsel attempts to remove items from a template that will clearly not apply to your particular situation, that document should be further studied, especially if it is your attorney’s only effort on your behalf during the relationship.
REVIEW OF DOCUMENT
Once drafted, a review of the document with new members will be a good idea, particularly for companies that present complicated issues. The document should also be reviewed after a new member joins the organization, or if there is a fundamental change that affects the ownership or management structure of the company.
Modifying an NJ Operating Agreement
As your NJ LLC grows and evolves, certain circumstances may arise that require you to amend your operating agreement. Perhaps you’ve added a member, changed the management structure or need to address a legal or financial issue that didn’t previously exist (or was not previously addressed). When these types of situations arise, it’s important that you take the steps necessary to amend your operating agreement in accordance with the process outlined by NJ law. As previously noted, the default requirements for your operating agreement is the same as the requirements of the New Jersey Limited Liability Company Act ("NJ LLC Act"). However, the NJ LLC Act does permit an amended operating agreement to supersede the law. N.J.S.A. 42:2C-11(c). In other words, once amended, a revised operating agreement can take precedence over any other conflicting provision in the NJ LLC Act. With that being said, it’s important to understand the formal process by which an operating agreement can be amended. The process begins with the members executing a "recorded amendment." N.J.S.A. 42:2C-11(d). The recorded amendment simply refers to an amendment that is filed with the NJ Division of Revenue. It is important to note that the NJ LLC Act outlines specific rules for who must sign the amendment. Furthermore, it states that the amendment is binding on all members of your company and supersedes the original agreement (see the prior paragraph). N.J.S.A. 42:2C-11(e). Of course, there are circumstances that prevent all of your members from signing your amended operating agreement. In these cases, signing the amendment will be optional for those who weren’t able to sign and the new amendment will not be binding on them. N.J.S.A. 42:2C-11(e) (1). Nevertheless, anyone who doesn’t sign the amendment will be bound by the original operating agreement. Additionally, the NJ LLC Act permits an amendment to be approved even though the amendment will not be binding on all members. N.J.S.A. 42:2C-11(e) (2). Even when your amendment doesn’t specifically require your members’ approval, it’s always recommended that you provide each and every member with a copy of the recorded amendment.
Frequently Raised Questions Regarding NJ Operating Agreements
The following is a compilation of frequently asked questions regarding NJ operating agreements, along with their answers:
Q: Why do I need an operating agreement when New Jersey law provides for default rules?
A: New Jersey law allows you to take a "one size fits all" approach by relying solely on N.J.S.A. 42:2C-1 et. seq. However, these default rules may not be in your best interest. By having a flexible operating agreement that is tailored to your specific needs, you can ensure a better chance of protecting your hard work.
Q: If I am the only member of my LLC, do I still need an operating agreement?
A: Yes, the need for a detailed operating agreement becomes even more important when there is a single member because that member lacks the "checks and balances" that exist when there is more than one member.
Q: Can I amend my operating agreement at any time?
A: While the operating agreement can be amended at any time, this is not the best practice for the long run. Consider including a set period of time, such as every five years , for review and amendment with the members to determine if an amendment is needed.
Q: If I don’t have an operating agreement, can I make one later?
A: Yes, but it may be much more difficult than if the agreement was completed at the inception of the company. An operating agreement, when executed correctly and properly enacted, becomes an integral part of the company and is extremely difficult to change or amend afterwards.
Q: Do I really need to have an LLC?
A: It is generally in your best interest to form an LLC because it can protect your personal assets from any liabilities that may arise from the LLC’s business. In addition, if any one member becomes embroiled in personal legal difficulties, other members’ assets are protected under the provisions of the LLC.
Q: How often should I review my operating agreement to confirm that it accurately reflects our needs, both from a tax and an operational perspective?
A: The operating agreement should be reviewed annually by the members at the same time the appointment of the manager is reviewed. Make revision to the agreement as necessary based on the review.