Should State Laws Require LLC Operating Agreements to Be inWriting?
A committee of the Washington State Bar Association is currently reviewing the Washington Limited Liability Company Act, RCW ch. 25.15, with an eye toward recommendations for changes to the statute. One of the issues the committee is considering is whether Washington’s LLC Act should continue to require LLC agreements to be in writing. The Washington Act defines a “limited liability company agreement” as a written agreement (or a written statement of a sole member) concerning the affairs or business of the LLC. RCW 25.15.005(5). The result is that only written agreements of the members will control over the default provisions of Washington’s LLC Act.
The state LLC laws vary. Some require that member agreements (often called operating agreements) be in writing, while some allow oral agreements as well as written. Under Delaware’s LLC Act, for example, a limited liability company agreement can be “written, oral or implied.” In contrast, the New York LLC Act defines an operating agreement as a written agreement of the members, much like the Washington definition.
Business lawyers usually have an emphatic answer if asked about oral LLC agreements: “Of course they should be in writing.” That’s generally the right advice to give to a client considering any kind of business investment or transaction more complicated than getting one’s shoes shined at the shoe-shine stand. But some people inevitably will choose to form LLCs with only an oral agreement about matters such as capitalization, profit and loss allocations, distributions, voting control and so on. Should their oral agreement be disregarded if it would yield results different from the default rules under the statute?
Corporations, of course, are in the “put it in writing” camp. All state corporation statutes require that articles of incorporation, the basic charter document, be in writing and be filed with the appropriate state agency to create a corporation. Many state corporate statutes allow shareholder agreements to vary some of the statutory default rules, but those statutes require that the shareholder agreements be in writing and be executed by all the shareholders. E.g., RCW 23B.07.320. The Model Business Corporation Act, which has been adopted in 24 states, takes the same approach by requiring that shareholder agreements be in writing to override statutory default rules. Model Bus. Corp. Act § 7.32 (2002).
Partnership law approaches the issue differently. Partnerships are based on the agreement of the partners, and both the Uniform Partnership Act (UPA), Section 101(7), and the Uniform Limited Partnership Act (ULPA), Section 102(13), provide that partnership agreements can be written, oral or implied. Thirty-six states have adopted the UPA and 15 have adopted the ULPA, including Washington.
The common law concept of a partnership – an association of two or more persons to carry on as co-owners a business for profit – recognizes that partnerships can be formed informally and by oral agreements. Although the formation of a limited partnership also requires the filing of a written certificate with a state agency, the certificate of formation need contain only limited information such as the name and address of the limited partnership, and the name and address of each general partner. The certificate of formation is simply a notice filing and is not usually used to define the rights of the partners.
Even if a state’s LLC Act allows oral LLC agreements, the state’s statute of frauds will apply. A statute of frauds invalidates certain types of agreements unless they are in writing and signed, such as a guaranty of another’s debt or an agreement that by its terms is not to be performed in one year. E.g., RCW 19.36.010.
For example, last year the Delaware Chancery Court ruled that the Delaware statute of frauds applied to the oral limited liability company agreement of a Delaware LLC. Olson v. Halvorsen, No. 1884-VCL, 2008 WL 4661831 (Del. Ch. Oct. 22, 2008). The court accordingly dismissed a claim under the agreement that called for a multiyear earn-out after a member’s retirement, since by its terms that provision of the agreement could not be performed in a year.
Washington’s and New York’s LLC Acts do not invalidate an oral LLC agreement. Instead they simply define the LLC agreement as a written agreement. Many of their statutory rules may be waived or modified by the members’ agreement, if it is in writing. The New York court has held that if the member agreement is not in writing, the LLC exists but the default rules in the statute govern the LLC, rather than conflicting terms in the oral member agreement. Spires v. Casterline, 4 Misc.3d 428, 778 N.Y.S.2d 259 (Sup. Ct. 2004). Presumably an oral agreement that supplements but does not purport to override the defaults of the LLC Act would still be enforceable.
To return to the question, should state law require LLC agreements to be in writing? The policy in favor of requiring written agreements is similar to that behind the statute of frauds – experience teaches that certain types of agreements are so significant that the higher degree of certainty inherent in a writing should be required. In the event of a dispute, permitting oral LLC agreements will increase litigation costs because of the difficulty of proving the oral terms. It will also be more difficult for new members of an LLC to determine the oral terms governing the LLC.
The policy that supports allowing oral LLC agreements is that of not frustrating the expectations of the parties. LLCs are popular for smaller businesses with few members, who often form an LLC with minimal legal formalities. Many states, including Washington and Delaware, have recognized in their statutes the goal of maximizing the enforceability of agreements between members: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” RCW 25.15.800(2). That policy is undermined by not enforcing oral member agreements. Also, it seems anomalous to have a different rule on this point for LLCs than for limited partnerships, since in Washington and most other states the limited partnership agreement can be written or oral. RCW 25.10.010(9).
LLCs are used for a wide range of types and sizes of businesses. Large enterprises normally have legal counsel, accountants and written LLC agreements. Smaller, closely held enterprises sometimes don’t have written agreements. An efficient and flexible LLC statute should work well for the widest range of individuals and groups forming an LLC. To do that it should recognize that some LLCs will be based on oral agreements. The need to prove the terms of an oral agreement in the event of a dispute seems an inadequate reason for automatically disqualifying all oral LLC agreements. On balance, the policy reasons seem to tilt in favor of allowing LLC agreements to be oral as well as written.
When I started writing this post I was on the fence on this issue, but I’ve come to the conclusion that the best approach for the Washington LLC Act is to allow LLC agreements to be oral as well as written. But I recognize that people may differ on this point, and I would welcome any comments or input on this issue. Feel free to comment by clicking on the "Comment" link below.
