Bylaws and Operating Agreements – An Overview
There are a few key documents that every business and organization should have in place to help ensure their longevity. One of those documents is a set of bylaws or an operating agreement.
A Bylaw is essentially a contract put in place by a corporation to help govern the internal operations of the company. Membership rights (and responsibilities) are often the focus of the bylaws, as well as the duties of the corporate officers – such as how frequently board meetings should be held, how many directors are needed to form the board etc. Bylaws also cover voting procedures and how amendments to the bylaws can occur .
The articles of incorporation and bylaws of a corporation generally outline how the corporation is managed, and the rights and obligations of the corporation and its members. Operating agreements are very similar to bylaws, and in effect provide the same level of information.
However, because operating agreements are for limited liability companies (LLCs), they forgo some of the more formalized considerations of bylaws. Members of LLCs have much more discretion over the contents of their operating agreement. There aren’t any requirements that outline what needs to be included in an operating agreement, unlike that of bylaws, which are, by necessity, much more formal.
Bylaws and Operating Agreements – The Differences
Bylaws and operating agreements are used for the same purpose – to control the activities of the members and stakeholders of organizations – but are different in how they are structured and when they are legally required. Some organizations are required to have bylaws in place by law, but no business entity is required to have a formal operating agreement in place unless its particular state law requires it. The terms of bylaws and operating agreements are similar in many cases, but their functions and legal requirements are not. Bylaws do not only apply to corporations (companies with shared stocks) but also to nonprofits. While bylaws are not typically required for other types of entities (such as LLCs, partnerships and franchises), some corporations are legally required to have bylaws prepared, like C corporations. Unlike bylaws, which can be required by the laws of the state where the business is based, operating agreements are not required for businesses that are set up as sole proprietorships.
When to Use Bylaws
The decision to use bylaws rather than an operating agreement is often a difficult one. While it is always clear when to use one or the other, it is sometimes difficult to determine when you should use bylaws. Over the years, I have seen bylaws used appropriately as well as bylaws used interchangeably with operating agreements, so much so that the distinction is baffling at times.
As a general rule, bylaws are used by corporations and associations, while partnerships and limited liability companies (LLCs) typically use operating agreements. By default, unincorporated associations will look to partnership laws in their state for guidance on how to operate. While some states do have specific statutes governing the operation of non-profits and other unincorporated associations, most of these statutes are of limited application and do not address some of the more substantive issues to be considered.
In addition, since by-laws require both owners and shareholders to vote on certain issues, it may not be appropriate or necessary to have bylaws in an organization that is fairly small with just a few members. On the other hand, if the organization has issued shares of stock, anyone who has shares must get the rights normally associated with shareholders.
In short, bylaws are usually most appropriate in the following types of organizations:
As noted above, bylaws are generally unnecessary in the following types of organizations:
When to Use an Operating Agreement
Operating agreements are optional for corporations but not for LLCs. An LLC must adopt an operating agreement to govern the running of the business, and the members (owners) of the LLC decide the terms of the agreement. The agreement can be detailed or less formal than a corporation’s bylaws. Operating agreements for LLCs provide the members with flexibility. If steps are not taken to protect the interest of the members, the terms of the business operation will be determined by the laws of that jurisdiction.
An operating agreement is more than just a typical contract between the members. LLCs are registered with the state, which gives them certain protections under the laws of the state of their incorporation. Since most states do not have specific statutory protections and guidelines in place to protect the interest of members of an LLC, the operating agreement will serve to supplement those gaps.
The operating agreement can set certain restrictions, such as the following:
Having the above-mentioned restrictions set forth in an operating agreement embodies the parties’ intent and prevents one member from unilaterally altering the business for personal gain.
Legal Requirements and Compliance
The legal requirements for bylaws and operating agreements vary, depending on the jurisdiction of formation and the organizational structure. C-Corporations typically have more stringent requirements. For example, many states mandate that for C-Corporations, bylaws must be kept at the principal place of business. S-Corporations may have slightly relaxed rules. For example, they often need not retain a record of the stockholders and directors. LLC Operating Agreements, on the other hand, can be entirely flexible. Assuming there are no restrictions placed on an LLC operating agreement by statute or regulation, the owners of an LLC can decide exactly what they want. In fact, there is no requirement that an LLC have an operating agreement. Just because the law does not require an LLC to have an operating agreement, however, does not mean that it is not viable or useful to have one.
Consider what can happen when there is not an operating agreement. There are few if any limits to what owners of an LLC can agree to in an operating agreement. There are, however, general operating rules for LLCs. These rules govern each LLC that does not have a written operating agreement. In addition, many of the general operating rules are subject to waiver, and thus can be overridden by the written operating agreement, even if it was not executed correctly. For example, most states provide that if an LLC has an insufficiently narrow purpose or no stated purpose, the purpose provision of the LLC will be interpreted as having unlimited purpose. This can be overridden by the written operating agreement. For those who carefully write their operating agreements, such a rule is helpful. Consider the converse situation when no operating agreement is present. In that case, unless the statute provides a narrower scope, the operating agreement will provide maximum flexibility, risking the exposure to liability of all members, rather than allowing for a narrow operating agreement to be effective. Moreover, without an operating agreement, there will be ambiguity as to whether all members can bind the LLC or whether managers are required to approve material actions. Not having an operating agreement is a dangerous gamble for the owners of an LLC.
So, what can happen when not only an operating agreement is missing, but the general statute governing LLCs is not sufficiently clear? Consider the case of In re Applewood Medical Partners LLC. There, the operating agreement for an LLC was signed by two of its three members, and it purported to bind all members. The other member did not sign the agreement and refused to abide by its terms or amend the operating agreement. The operating agreement did not provide a resolution procedure for a deadlock, and worse yet, the national statute governing LLCs provided few if any default provisions. The result was a Texas state law doctrine that required that the LLC be dissolved. Not only would this reverse the fortunes of the 33% owner who did not sign the agreement, but also the dissolution was due to the actions of the more controlling members. Clearly the uncertainty directly resulted from the failure to have an operating agreement, and absent the absence of a resolution clause or clearer statutes, the operating agreement might have been able to avoid the negative consequences.
The bottom line is that while bylaws, operating agreements and other written governance documents are not required in many jurisdictions, they will help avoid uncertainty and unintended consequences. Better to have them.
Drafting Bylaws and Operating Agreements
When it comes to drafting bylaws or an operating agreement designating the internal operations of a corporation or limited liability company, an experienced business attorney is worth their weight in gold. This is because filing paper work with the Secretary of State to place the business entity into existence is simply the first step.
When it comes to the bylaws of a corporation, or that of an operating agreement for an LLC, these documents will also govern the actions of the principles (officers and members) of the company. Failure to amend these documents prior to taking action may leave the company in jeopardy of claims for breach of fiduciary obligations. Prior to signing any contracts or making business decisions of importance, always consult your business lawyer.
When forming a Delaware corporation on behalf of clients, we make sure to always keep our lawyer eyes open when it comes to the internal operations of the company. Often the bylaws drafted by the secretary of state are deemed "unfit" by our experienced legal teams because they fail to cover issues pertinent to the internal operations of a company. Over the years I have diligently modified the Delaware standard forms (bylaws, articles of incorporation , etc.) so that they cover client legal needs.
Drafting effective bylaws requires experience but it is important to note that presently it is common knowledge that bylaws can provide companies with greater freedoms (to determine the internal operation) but place limits on stockholders and officers of the company when it comes to the protections afforded by statute. It is common practice to shadow the provisions of the Delaware statute when drafting bylaws for Delaware companies.
There are standard provisions that should be included in every bylaw. Over the years about half of Delaware companies we saw utilized Bylaws from the Secretary of State and governmental entities and about half utilized custom drafted bylaws that we drafted. It all depends on the management team.
Remember, no matter what the Bylaws say, Delaware law tends to govern. But when the Bylaws govern, it can prove useful to provide clear parameters under the context of Delaware law – provided that the purposes are lawful and not contrary to public policy.
When drafting an operating agreement, it is important to collect information from every member of the LLC. Even though I am the lead drafting attorney within the firm, we work as a team to draft each and every operating agreement.
Common Errors To Avoid
A number of common mistakes should be avoided when drafting either a set of bylaws or an operating agreement. Without careful attention, it is possible for your organization or business to end up with a document that is counterproductive. This section explicates some of the common pitfalls.
First, be careful not to rely too heavily on a template or to copy another organization’s bylaws or operating agreement. No two businesses or organizations are exactly alike, and therefore each should have their own customized documents tailored to their particular needs and circumstances.
Second, avoid using generic legalese or obfuscating language. What, exactly, does "exhibiting unconscionable behavior" mean in terms of board of director conduct? Can that be illustrated via examples? Similarly, what is meant by "conduct involving abuse of position" by an officer? Defining your terms is a remarkably simple way to avoid misunderstandings.
Third, failing to revisit your documents on a regular basis can be a major pitfall. Generally, bylaws or operating agreements should be reviewed every other year to make sure they still adequately meet the needs and circumstances of the organization or business.
Fourth, don’t forget to include important details in your document based on your own purposes and goals. For instance, the purpose of a non-profit corporation is very important and should not be overlooked. Including purpose clauses in bylaws or operating agreements can add clarity to otherwise vague legal documents.
Fifth, don’t forget to make sure your bylaws or operating agreements are consistent with the law in your particular state. Federal and local law may differ, requiring additional attention to detail.
Real-World Examples and Comparisons
Real-life examples and case studies that highlight the importance and impact of well-drafted bylaws and operating agreements can be found in every sector. For instance, consider a nonprofit organization facing internal strife. The board of directors had a well-structured set of bylaws detailing the process for addressing internal disputes. Thanks to those bylaws, the organization was able to handle the conflict internally, without dragging the issue into the public forum. Contrast this with an organization that did not have bylaws or an alternative means of governing itself, which turned to the courts when faced with a leadership challenge. The ensuing litigation ended up being very public and costly for the organization in terms of both money and reputation.
Similarly, in rural local government, operating agreements can provide a clear benefit when entering into grants or contracts. A county in a remote area of the state was seeking grant funding from a federal agency to improve infrastructure. After receiving the grant, the county was informed that it would need to formally contract with a local Indian tribe in order to proceed. The tribe and the county had previously worked together without any formal agreement when engaging in joint infrastructure project. In this case, well-drafted bylaws governing the funding organization would have allowed the county to proceed without delay or extra documentation. Instead, the project proceeded on a much slower schedule, delaying benefits to rural residents and costing more than anticipated due to the protracted negotiation with the tribe.
Final Thoughts and Best Practices
In conclusion, it is clear that bylaws and operating agreements, while often used interchangeably, can have vastly different implications based on the structure and purposes of an organization. When an organization is an LLC, its primary governance document will be its operating agreement, but that does not remove the need for bylaws entirely. Just as corporations have the ability to use their bylaws to set specific internal rules, so can an LLC use its bylaws to add specificity to its operations. It is important to remember that items that should be included in an operating agreement and/or bylaws are items related to the governance of the members, such as procedures for the appointment of officers and procedures for the calling of and quorum requirements at meetings. Items that should not be included in the bylaws include mandatory provisions under applicable law, such as provisions related to indemnification .
Although there are some clear differences between bylaws and operating agreements, the biggest factor in determining what language a particular document requires will be the type of entity that is being formed or managed. Because bylaws and operating agreements do not carry the same implications for corporations and LLCs, there is no one size fits all approach to drafting these documents. One best practice that applies across the board, however, is to ensure that you have the right choice of entity. Many states require the filing of a certificate of formation for both LLCs and corporations with the applicable Secretary of State. In addition, corporations, except for some professional corporations, and certain LLCs may be required to file copies of their bylaws and operating agreements with their Secretary of State as well.