If you’re going to the chapel to get hitched with a business partner, you need a pre-nuptial agreement. For a limited liability company, the document is officially called an Operating Agreement. For a corporation, the concepts discussed below may be captured in a Shareholders Buy-Sell Agreement.
What is an Operating Agreement? Under Idaho law (§ 30-6-102(15), Idaho Code), an operating agreement is “the agreement … of all the members of a limited liability company … concerning the matters described in section 30-6-110(1), Idaho Code.” Section 30-6-110(1) simply sets forth what an Operating Agreement typically governs and what provisions of the Idaho Limited Liability Company Act cannot be altered by the terms of an Operating Agreement.
In my practice, I refer to Operating Agreements as pre-nuptial agreements because, going into business with another person (or entity) is a lot like getting married. You know: for better or worse, for richer or poorer, in sickness and in health, until death do you part. And, just like in marriage, the honeymoon phase in business eventually wears thin and the limits of the “for better or worse” mantra often get tested.
So, then what? The answer to that question is usually a lot less complicated (and less expensive to sort out), if the business partners have anticipated the “what ifs” of their relationship and drafted a roadmap for navigating through them – i.e., an Operating Agreement.
Just as when two people are contemplating entering into the most basic of all partnerships – marriage – there is no better time than before the honeymoon phase wears off to take the time to have a heart-to-heart business discussion about what each owner expects of the other owner(s): (1) at the beginning of the relationship; (2) during the course of the relationship; and (3) at the end of the relationship – whether that point in time is caused by external circumstances or internal strife. As more than one business owner has learned the hard way, trying to reach a mutual agreement about what’s “fair” is a lot harder at the end of a business relationship when the business partners are not seeing eye-to-eye than at the beginning when they are gazing toward a bright and promising future together.
So, now that we’ve established that you need a written Operating Agreement anytime you get hitched to another person as co-owners of a limited liability company, what do you need to know before entering into such an agreement? Let’s look at a few Idaho Supreme court cases for illustration.
In Lamprecht v. Jordan, LLC, 139 Idaho 182 (Idaho 2003), the Idaho Supreme Court held that an Operating Agreement is essentially a contract and thus standard rules of contract interpretation apply. Significantly in that case, the Court noted that, as with all contracts, an unambiguous Operating Agreement will be enforced according to its plain meaning and that the purpose of interpreting a contract is to determine the intent of the parties to the agreement at the time the contract was entered – not the parties’ intent five years later when the honeymoon phase is over. So, be sure your Operating Agreement looks toward the future and covers the standard life-cycle contingencies. When you consider the fairness of the terms, envision yourself on either side of a specific contingency and decide whether you would consider the terms fair from ether perspective – now and five years down the road.
In Howard v. Perry, 141 Idaho 139 (Idaho 2005), the Supreme Court held that an “integration clause” in an Operating Agreement means that the written agreement is the deal, the whole deal and nothing but the deal. An integration or “merger” clause is one you see in most contracts: “this agreement represents the entire agreement with respect to the subject matter herein”, or something similar. Too often, parties to a contract – Operating Agreements included – tend to think of merger clauses as meaningless mumbo-jumbo. To the contrary, if you and the other party have agreed to a term – orally or in some other writing such as an e-mail – but you don’t include the term in the Operating Agreement, a merger clause basically means you are disavowing any terms that are not expressly included in the Operating Agreement.
Similarly, in High Valley Concrete, LLC v. Sargent, 149 Idaho 423 (Idaho 2010), the Idaho Supreme Court followed the express words of the Operating Agreement and Mr. Sargent was left out in the cold. Although Mr. Sargent testified that he and Mr. Beck agreed to split ownership of High Valley on a 49/51 percent basis, respectively, Exhibit A to the Operating Agreement stated that Mr. Beck owned 100% of the membership interest. Apparently, Mr. Sargent agreed to that alleged misrepresentation of their respective ownership interests in order to allow Mr. Beck to claim 100% of the LLC’s losses on his tax returns. Although, according to Mr. Sargent, the intent of the parties was to amend Exhibit A once the company started turning a profit, that did not occur before the parties split the sheets and Mr. Sargent was stuck with what the Operating Agreement actually stated.
Adding insult to injury, because Mr. Sargent was not listed as a member of the LLC, the Court ruled that Mr. Beck did not owe him a fiduciary duty under the Idaho LLC Act regarding their “agreement”. In addition, because Mr. Sargent did not appear to have been acting under the impression that Mr. Beck was acting in his interest rather than in Mr. Beck’s own interest when he agreed to allow Mr. Beck to claim a 100% interest in the company for tax purposes, Mr. Beck did not owe Mr. Sargent a common law fiduciary duty regarding their agreement.
Beware the balance of power. Just as in a domestic relationship, it’s seldom a good idea for one party to wield more power than the other party to the relationship without some counter-balancing provisions. In Bushi v. Sage Health Care, PLLC, 146 Idaho 764 (Idaho 2009), the Operating Agreement contained a provision that it could be amended with less than the unanimous approval of the members. When Dr. Bushi got cross-wise with the other doctors at Sage Health Care, they used that provision to amend the Operating Agreement to vote Dr. Bushi off the island. Unlike the High Valley Concrete case, however, because Dr. Bushi was a member of the PLLC (“Professional Limited Liability Company”), the Court in Bushi remanded the case to the district court to determine if the doctors’ use of the lopsided amendment provision was a breach of their fiduciary duty to Dr. Bushi. In providing guidance to the district court, the Idaho Supreme Court held that technical compliance with the terms of an Operating Agreement by the other doctors would not serve as a shield against Dr. Bushi’s breach of fiduciary duty claim if the doctors’ conduct was improperly motivated (e.g., to advance their own personal financial interests).
What’s the take away? Approach a business relationship with the same degree of caution and care you would for any “until death do us part” relationship; remember that your Operating Agreement needs to clearly state the whole deal and nothing but the deal; and in business, as in relationships in general, do unto your partners as you would have them do unto you.
Molly O’Leary represents business and telecommunications clients throughout Idaho, and is the Managing Principal of BizCounselor@Law, PLLC. In addition, she is a Past President of the Idaho State Bar and a current member of the Statewide Advisory Counsel for the Idaho Small Business Development Center. You may follow her on Twitter: @BizCounselor.