Module 3: Effects of State Law on Governing Agreements

Overview

Earlier, we briefly referred to how state and, to a lesser extent, federal laws can affect the contents of business governing agreements. In this module, we will take a closer look at how state laws influence the drafting of corporate bylaws, LLC operating agreements and partnership agreements.

Governing agreements are contracts. For most contracts among private parties, freedom of contract means that, aside from establishing fundamental guidance for their validity (such as the need for an offer, acceptance and consideration) and providing for basic fairness (such as consumer warranty protections), legislatures and courts leave writing the particulars of the agreement to the parties. Even if a contract is illegal or contrary to public policy, the remedy is not generally to change the agreement's content but rather to invalidate part or all of the contract.   

Because legally-created business entities exist based on state laws allowing them to exist, state involvement and regulation limits freedom of contract. State business laws try to strike a balance between the freedom to create a governing agreement that best matches the needs of the business against the need for companies to comply with fundamental legal safeguards. Every state has its own laws for business governance. For business people creating a new company, understanding what these laws are and their effects on the governing agreement are early strategic issues to consider.

State laws pertaining to governing agreements break down into two broad areas of concern. The first is which statutes to apply, based on the form of the business. Corporations, LLC's and partnerships each have their own sets of applicable laws. The second is whether the applicable rules impose affirmative or negative requirements (or both) to the agreement's content. We will address, below, each of the three types of governing agreements considering the state laws applicable to them.

Laws Affecting Corporate Bylaws

State laws govern the creation and operation of corporations. The variations among state corporation laws can be burdensome for a corporation’s incorporators, shareholders and directors alike, particularly when the corporation does business outside the state of its creation. One way that companies have tried to promote uniformity has been to favor Delaware state law: for many years, based on Delaware’s reputation for having favorable corporation laws, incorporators would choose to create companies in Delaware even if did business in other states.

Today Delaware law faces competition in the form of the American Bar Association’s Model Business Corporation Act.[1] Since its promulgation in 1950, about half the states have adopted the MBCA in its entirety and the rest have adopted parts of it. [2] Over time, Delaware’s corporation law and the MBCA have steadily moved closer in their effects, as both the Delaware legislature and the drafters of the Model Act have borrowed features from each other.[3] We will confine ourselves to examining the Model Act.

As the foundation for many state laws, the MBCA contains several “gap-filler” provisions that take effect unless the corporation’s bylaws supersede them. These default provisions take affirmative or negative forms: either imposing requirements, such as mandating the existence of a board of directors or restricting what the corporation can do (such as precluding the corporation from making loans to directors or officers of the business[4]). When creating a corporation, the incorporators should have a firm grasp of the state’s corporation laws, so they can customize the bylaws to avoid default provisions they do not want.

Here are some of the bylaws-related default terms of the Model Act:[5]

·     ·          Bylaws are required.[6] It is the responsibility of the board of directors to adopt the initial bylaws, and the board has the default power to change or repeal the bylaws. Like many Model Act provisions, this one lets the corporation change the defaults by writing different terms in the bylaws; the only restriction being that parts of the bylaws that do not mirror the state’s corporation act must not be illegal under state or federal laws or contrary to the articles of incorporation.

 ·         Meeting requirements.[7] The law requires annual meetings for the shareholders. Special meetings are optional and can be called for by the board of directors, by the company president or by shareholders holding at least five percent of voting shares, unless the bylaws change that proportion. Another default rule is that shareholders can participate in meetings by conference call (which, presumably, includes e-conferencing platforms) instead of in person. Similar default provisions exist for the board of directors.[8]

 ·         Notice requirements.[9] The law specifies a period of 10 to 50 days’ notice to shareholders in advance of special meetings. It also identifies the acceptable forms of notice, including electronic means. Note here that no provision exists for the bylaws to substitute a different notice period, suggesting that such a deviation could be subject to legal challenge.

 ·         Voting rights and procedures.[10] The statutory default is for shareholders to have one vote per shareholder, and for shareholders to cast their votes in person. Bylaws can expand on these minimums by providing for different classes of shares and allowing for more ways to vote, such as by mail, by proxy or through electronic means, or cumulative voting for directors.

 ·        Quorum requirements.[11] If the bylaws do not state otherwise, the presence of 10 percent of shareholders having voting rights is enough to establish a quorum at a meeting. For meetings of the board of directors, a quorum consists of a minimum of one third of the directors unless the bylaws direct otherwise.[12]

 ·         Director qualifications.[13] The corporation must have a board of directors.[14] The bylaws can include requirements or restrictions on who may become a member of the board of directors. Unless the articles of incorporation or bylaws state otherwise, the law prohibits requiring directors to be shareholders or residents of the corporation’s state of incorporation.

 ·         Director removals and vacancies.[15] If the bylaws do not contain procedures for removing elected directors, the statute provides for such removal under various circumstances. The statutory default requires the vote of two-thirds of the shareholders to remove a director. The statute also considers whether the corporation uses cumulative voting or allocates director positions among different classes of shares. Unless the bylaws or articles of incorporation specify a different procedure, director vacancies or new director positions can be filled by a majority vote of directors present at a meeting even if they do not constitute a quorum.[16]

 ·         Committees.[17] The statutory guidance for whether the board of directors can create committees is a good example of a legal restriction on what the corporation and its shareholders can agree to: committees are allowed only if the articles of incorporation or bylaws provide for them. Even when the bylaws authorize them, the statutes mostly govern what they cannot do (such as amending or repealing the bylaws, acquiring or merging with another company, distributing assets or voluntarily dissolving the corporation).

 ·         Officers.[18] Just as the law requires bylaws and the existence of a board of directors, it also requires a minimum of four officers: president, vice president, secretary, and treasurer. The bylaws cannot eliminate any of these positions, although a single person can fill multiple roles. The officers, by default, are elected or appointed by the directors to one-year terms. The bylaws can change officer titles, increase the number of officer positions and govern how they are filled and for how long.

 Laws Affecting LLC Operating Agreements

As with corporations, state laws are the source of authority over LLCs and every state has LLC statutes. Unlike corporations, however, there is less pressure among the states to adopt uniform laws governing LLCs or guiding what should go into their operating agreements. Part of why some entrepreneurs choose the LLC form over the corporate form is to take advantage of the comparative freedom that an LLC offers in its management structure and operational flexibility. This means that operating agreements are subject to more content variability compared to corporate bylaws: indeed, as we touched upon in Module One, some states do not require operating agreements at all and others do not require that they be in writing.

For example, consider North Carolina’s definition of the LLC operating agreement. It is defined as “any agreement concerning the LLC or any ownership interest in the LLC to which each interest owner is a party or is otherwise bound as an interest owner.”

It also states:

Subject to other controlling law, the operating agreement may be in any form, including written, oral, or implied, or any combination thereof. The operating agreement may specify the form that the operating agreement must take, in which case any purported amendment to the operating agreement or other agreement expressed in a nonconforming manner will not be deemed to be part of the operating agreement and will not be enforceable to the extent it would be part of the operating agreement if it were in proper form.[19]

Under this statute, for example, it can be challenging not only to identify what the operating agreement must include, but also what constitutes the original operating agreement, whether more than one such agreement exists and what amendments may exist and in what form.

Like the American Bar Association’s Model Business Corporation Act, the Uniform Law Commission- through its National Conference of Commissioners on Uniform State Laws- has created a model set of laws for LLCs, presently in the form of the Revised Uniform Limited Liability Company Act. However, while all states have adopted some or all of the Model Business Corporation Act into their corporation laws, only a handful have adopted the uniform LLC act.[20] Let’s look at its most important provisions:

 ·         No writing requirement.[21] The operating agreement can be oral, implied, or in a record form. Operating agreements consisting of any combination of these forms are also acceptable. “Record form” means that is, “inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form”.

              ·         The operating agreement’s affirmative provisions include establishing the relations among the LLC members and between the members and the company, member management and voting rights, manager rights and responsibilities for LLCs that use managers, the activities of the company and their performance, transferability of member interests and distributions to members upon dissolution of the LLC.[22]

Optional provisions include:

o   specifying if the company will be managed by managers, as opposed to being member-managed,[23]

o   qualification of new members,[24]

o   requiring the approval of a designated third party to amend the agreement,

o   specifying the company’s obligations to transferees of membership interests and dissociated members,[25]

o   non-equal distributions upon dissolution and winding up,[26]

o   precluding the ability of some members to consent to distributions,[27] and

o   authorizing status and activities for members, managers, assets or transferable interests.[28]

·         Restrictions on operating agreement provisions include prohibitions against:

o   eliminating the members’ duty of loyalty and duty of care,

o   modifying the LLCs capacity to sue and be sued under its own name,

o   precluding members from accessing the company’s financial and other records, and

o   attempts to vary the authority of state courts over matters such as filing requirements, dissolution decrees and winding-up requirements.[29]

The main difference between state laws affecting corporations and those affecting LLCs is that corporation laws tend to emphasize gap-filler provisions based on the more formalized corporate bylaw requirements. Compare this to LLCs, which often require more explicit statutory guidance for oral or implied operating agreements or, in some cases, must contemplate the absence of an agreement.

Laws Affecting Partnerships

As the least formal of the three types of governing agreements that we’re covering, partnership agreements tend to have the fewest affirmative requirements under state law. This informality finds its ultimate expression in the lack of any state law requiring the parties to have a partnership agreement. State partnership laws are often like LLC laws in their focus on filling in the particulars that a simple or non-existent agreement does not include.

Every state except for Louisiana has adopted a version of the Uniform Partnership Act, created by the same National Conference of Commissioners on Uniform State Laws.[30] Multiple versions of the Act exist, so partnership law is not exactly the same in the 49 states that have adopted its iterations.[31]

To sample how state partnership law can affect the partnership agreement, we’ll look at Washington’s partnership law, which states: "Except as otherwise provided, the partnership agreement governs relations among the partners and between the partners and the partnership. To the extent the partnership agreement does not otherwise provide, this chapter governs relations among the partners and between the partners and the partnership."[32]

The next subsection of the law contains an assortment of restrictive provisions almost identical to the ones that the Revised Uniform Limited Liability Company Act places on LLCs. The rest of Washington’s partnership act consists mostly of statutes that create a default management and operating structure for the company as though no partnership agreement exists to fill in where there is no agreement or where the agreement does not cover certain elements.

Conclusion

A business governing agreement is, arguably, the most important contract that business owners can enter. Properly written, it serves as a unique combination of rulebook and roadmap for the company to guide its operations in the way that the owners want, as opposed to “one-size-fits-all” generic provisions found in state laws.

Understanding state laws that govern bylaws, operating agreements and partnership agreements is important to consider in advance for two reasons: first, knowing the law is essential to avoiding conflicts between the governing agreement and the law, which, in turn, reduces the potential exposure to legal liability of a business entity and the people behind it. Second, it helps to reveal parts of the governing agreement that the drafters can modify to best match the company’s needs by overriding statutory defaults.

For business people who elect not to engage the services of an attorney when drafting their governing agreement, understanding the potential requirements and pitfalls in the applicable law can also be helpful when drafting an agreement based on a model template or another company’s governing agreement.