Understanding LLC Operating Agreements in the State of New Jersey

The Essentials of a New Jersey LLC Operating Agreement

An LLC Operating Agreement is essentially the road map of how the LLC is to operate and be governed. While the New Jersey Limited Liability Company Act (the "Act") provides statutory default provisions that govern the LLC, a written Operating Agreement is a fundamental document for setting forth the rules and regulations and governing the rights and responsibilities of the members and managers.
As the Act is designed to be flexible, and many of the statutes governing LLCs are permissive and not mandatory, the members have the flexibility to override almost every provision in the Act. As such, every LLC should have a carefully drafted Operating Agreement that reflects the business intentions of its members and complies with the reasonable legal requirements of the Act.
The Operating Agreement is particularly important because it helps the members of the LLC plan for common but very important future contingencies of the LLC, including, without limitation:
Given the many complexities addressing the governance and authority of members and managers, among other operating and financial economic issues, we highlight the following additional considerations regarding an LLC Operating Agreement:
In general, an LLC Operating Agreement may be entered into by all members and/or managers of the LLC. However , an LLC may adopt an Operating Agreement at various times in its organizational development. In other words, an LLC may enter into an Operating Agreement at the time of formation or at any other time in the future.
Case law has held that a company organized as an LLC "may act in conformance with the [Operating Agreement], regardless of whether it is adopted at the time of formation or at any time thereafter." In the companion case, the prior owners of the LLC were entitled to protection under the written agreement, even if they were not signatories to the agreement. Therefore, it is of utmost importance that existing and future members and/or managers understand that: (i) a written or oral agreement requiring mutual consent of all members or managers will probably be enforceable even if it is not in writing; however, (ii) if no formal Operating Agreement exists and there are not any restrictions on transferring membership interest, a member can assign a membership interest without consent from other members.
The Act’s flexibility, along with decisions interpreting and implementing the Act, are designed to allow members the freedom to define and decide issues as they arise. A careful drafting of the Operating Agreement eliminates future surprises and misunderstandings, and curtails the need for costly litigation.

What Constitutes a New Jersey LLC Operating Agreement

An Operating Agreement is the cornerstone of a successful Limited Liability Company (LLC) and it is particularly important for entrepreneurs in New Jersey. While an Operating Agreement is not required under NJ LLC law, it can play a very significant role in avoiding potential liability to the members for excessive exposure in case of a lawsuit. Even more importantly, it can help limit exposure to creditors in case of bankruptcy of the company or one of it’s members. Members and management of a New Jersey LLC should be familiar with the following key elements of a typical Operating Agreement and how they may affect their LLC.

1. Balance of Control

Since an LLC is a hybrid business structure, a company can elect to be managed by the members or appoint one or more managers to manage it. If members decide to appoint a manager, their interest in the company should be clearly reflected in Operating Agreement by designating voting and non-voting members and managers. This is especially important when there are different distributions of profit shares and cash.

2. Profit and Loss Sharing

In most cases, the distribution of profits should be in proportion to the ownership of each member but customarily, each LLC should have a provisions in the Operating Agreement that states that the distribution of profits and losses will be at the discretion of the managers, as long as members do not receive less than their tax basis. As a general rule, any distributions less than the tax basis amount will be taxed as ordinary income to the members.

3. Transfer of Ownership Interests

It’s essential for LLC members to anticipate the future and to consider what may happen if an existing member leaves the company. Members can preclude unwanted transfers by including a "right of first refusal" clause in the Operating Agreement. A careful cross purchase provision can ensure stability and continuity of management of the company in case of a member departure.

4. Management and Board Structure

There should be a reference to a Board of Managers and Manager managed LLCs as well as the number of managers in the company. A Board of Managers may consist of a combination of member and/or non-member managers. The Board will typically have the authority to make decisions regarding the management of the LLC and members will have to ratify Board decisions. The terms of management appointments should be detailed in terms of length of service, procedure for re-appointments, replacement of Managers and compensation.

New Jersey LLC Operating Agreement Legal Requirements

In New Jersey, while the business structure and composition of ownership is flexible, there are several legal formalities with which New Jersey limited liability companies (LLCs) must comply upon formation. The most "formal" requirement is that the LLC must adopt an Operating Agreement within 90 days of formation. This is required by New Jersey law regardless of whether the LLC has chosen to be taxed as a partnership or as a corporation for tax purposes. Additionally, an LLC organized in New Jersey must continuously maintain a registered office in New Jersey. See N.J.S.A. 42:2C-35(a) and (b); N.J.S.A. 42:2C-11.
LLC Operating Agreements generally outline the ownership interest of the respective members, the management of the entity, and the powers and authority of the members and managers. There are other topics that can be included in Operating Agreements, such as an explanation of what happens upon a business dissolution, what happens upon the death of a member, a mechanism for selling a member’s interest in the business, capital contribution clauses, and/or buy-out/membership transfer provisions. It should be noted that an Operating Agreement is similar to a traditional partnership agreement because the interests of the members of an LLC, for both tax and liability purposes, are derived from the interests of the partners of a general or limited partnership. See N.J.S.A. 42:2C-11. Member interest in an LLC is non-transferable, similar to partnership interests in a traditional partnership, unless the consent of all the other members is obtained. N.J.S.A. 42:2C-46 and -47; Innes v. Arl Holdings, LLC, 418 N.J. Super. 163, 168 (Ch. Div. 2010).

Constructing an LLC Operating Agreement in NJ

When faced with the task of drafting an LLC operating agreement, some entrepreneurs rely on templates or other tools to assist them. A variety of fees and services are offered by legal service providers, with costs generally correlating to the number of members, the number of pages in the operating agreement, and areas of flexibility built into the operating agreement (i.e. should members have the right to modify the operating agreement?). Some service providers offer "free" operating agreement templates, but these templates should be used with caution as the "free" clauses do not necessarily meet statutory requirements or other best practices for New Jersey operating agreements.
One final tip is to compare the terms of the operating agreement with the requirements of New Jersey’s Limited Liability Company Act. The statute provides default terms that apply when the terms of the operating agreement don’t specify a different term. Entrepreneurs should take care to identify, in writing, what it is the members have agreed to, as opposed to what the statute requires.

Common Errors to Avoid in New Jersey LLC Operating Agreements

Common Mistakes in New Jersey LLC Operating Agreements
When setting up an LLC (Limited Liability Company) in New Jersey, one key task is the proper drafting of an operating agreement. We see many mistakes in New Jersey LLC operating agreements including the following:
Not including an agreement or not having a written agreement which defers into the default statutes of a New Jersey limited liability company. While the statute known as the New Jersey Limited Liability Company Act is fairly comprehensive, it does not cover all issues and therefore having a written agreement is recommended. For example, the New Jersey statute says that a member has contributions when they join an LLC but really offers little in the way of what each member’s rights and obligations are and what happens to contributions. As discussed elsewhere on this blog, contributions and members’ rights are very important and should be addressed in any written agreement. Failing to review and update the agreement after each stage of growth of the LLC. As LLCs grow and change, the existing operating agreement may no longer address important issues. For example, as members come and go and as the financial landscape of the company evolves, the planned tax treatment may need to be changed and should certainly be reviewed with outside professionals. Another scenario is when the company grows and the majority owners sell to the public via an initial public offering ("IPO"). In this case the company would probably need to be converted to a corporation from an LLC and new shareholders and directors will enter the picture. Therefore , the agreement should be updated as the business evolves. Not clearly defining the day-to-day management of the LLC. Whether the members of an LLC all take an active role or not and whether the management roles are shared or not can have far reaching implications and should be put in writing prior to starting the LLC. Incomplete capital contribution and distribution provisions. When planning a new business it is important to understand the various types of contributions that members will make and whether these contributions have a dollar value. Further, how profits and distributions will be made to the members and what happens to the various contributions should the company dissolve, become insolvent, sell its shares or go public should be addressed in the agreement. Lack of change of control provisions. Depending on the entity’s needs and structure, there may be a need to define who can own a membership interest and when that interest may be transferred. This is especially important if there are multiple tiers to the ownership structure such as in some hedge funds, venture capital funds and private equity funds. Failing to make sure the operating agreement is consistent with the articles of organization. This is a minor point but should not be overlooked.
A properly drafted operating agreement should protect against the long term likelihood of prolonged disagreement and litigation over these and other issues.

How to Amend Your Operating Agreement for a New Jersey LLC

Adaptability is a cornerstone of business success, and your Operating Agreement should typically allow for growth. A good Operating Agreement will usually include simple directions to amend the Agreement whenever necessary. For example, a common clause will state that the Agreement can be amended by a unanimous vote of all members. If your members have agreed to make changes to the Agreement the process is straightforward: change the document to reflect those amendments, and have all parties sign and date the new pages. Attach the new papers to the original. You may have to reorganize the pages to fit them back into the binder after your amendments, so keep that in mind when making changes.
If you don’t have unanimous support but all parties agree in principle to the changes, there are options for amending your LLC Operating Agreement without unanimous consent. For example, in a Unit Plan, each member is allocated a certain number of units, which represent an equal fraction of the LLC’s value. Typically, if each member agrees that a new member can purchase a certain percentage of the total units at a certain price and terms, the shares will be distributed proportionately among all other members. This assures that the investment will not dilute any party’s ownership more than necessary as the LLC grows.
An LLC can also follow the protocol in an existing Operating Agreement to allow changes to be made under certain circumstances; e.g., sometimes an LLC agreement may provide for a vote to take place where approval of a certain percentage or majority of the members was given in non-operating circumstances (i.e. sale of assets, admission of new members, removal of existing members, etc.). The right circumstances will be unique to each LLC, but the process will be similar to the procedure of adding a new party under a unit plan. Once the percentage required for the change has been reached, the amendment will become part of the original Operating Agreement. Sometimes, however, an LLC must make changes without the support of all members. In that case, the revisions take effect once a quorum of members has been obtained. Final approval often requires further votes by the group after the quorum has been reached.

Advantages of a Properly Drafted LLC Operating Agreement

An LLC Operating Agreement is not a statutory or essential document in the operation of an LLC. Operating Agreements, however, should be strongly considered and prepared since such agreements set forth each member’s expectations during operation of the company and protect the members and the LLC itself from external disputes.
The most likely reason for litigating an LLC is an internal management dispute involving the managers or members of company. A clear and comprehensive Operating Agreement will eliminate ambiguities, thereby resulting in a clear record of the expectations of the members. If disputes arise about how an LLC is supposed to be managed, and there a failure to resolve such disputes internally, rather than rely on the New Jersey Limited Liability Act (the "Act") or the law in another state where the Company does business on how an internal management dispute is to be resolved, the members can rely on the Operating Agreement as the expression of their intent.
If no Operating Agreement exists , then disputes between the members or between the members and the managers will be addressed by the Act in manner that could be different from expectations of one or more of the parties. For example, the Act provides default rules regarding which members participate in management, if the management structure of the LLC is unclear. If no Operating Agreement exists, the Act also provides default rules regarding the following issues, among other things: (i) the capital contributions of each member (ii) distributions, including whether profits and losses are shared in proportion to capital accounts or allocated on some other basis; and (iii) transfers of membership interest.
If no Operating Agreement exists and a lawsuit must be filed to resolve an internal LLC dispute, the results of any litigation may be contrary to expectations of the members. Therefore, an Operating Agreement sets forth the expectations of the parties in writing, resulting in a better outcome for the company and its members.