An Ounce of Prevention: Avoiding the Pitfalls of the Poorly Worded Operating Agreement

I enjoy teaching workshops — not only do I get to share a lot of great information, but sometimes the question-and-answer sessions blossom into a whole new mini-workshop of their very own. That happened recently when a client asked me, “Why should I use Anderson versus a local attorney for my asset protection structuring?”

That was a GREAT question.

It’s an especially great one to ask if you’re thinking of entering into business relationships with attorneys in other states. If you’ve heard me say it once, you’ve probably heard me say it a dozen (or a hundred) times: each state’s rules concerning investments, tax strategies, and liabilities are different. It’s one thing to do business locally — and that’s a great thing. It’s quite another to have representation and guidance that’s aware of how different locales handle investing…and that’s why you need to do your homework ahead of time.

What Did I Answer?

The way I always answer that question is straightforward. It sounds like bragging, but it’s not.

“Not to be glib,” I said, “but you should come to us at Anderson because we’re the best at what we do. We specialize in asset protection for real estate investors.”  Unless you find a unique local attorney, you won’t get the kind of counsel we give from simply spending time in your lawyer’s office.

So far, so good. But the questioner was on his toes, and he wanted to keep me on mine.

“Yes,” he said, “I know that. But other attorneys have told me they work with investors, too. So what makes you different?”

 That’s the Heart of the Matter.

And this is a difference that’s worth noting.

At Anderson, we don’t just work with investors; we are investors ourselves, so we understand the complexities of real estate investing better than most. We’re in the trenches, working our own deals. And, yes, some work out very well! But in a nutshell? The difference is that we apply what I like to call “dirt smarts” in our client planning.

“My role as your advisor,” I explained, “is to foresee the possible problems, then look for the solutions to minimize possible pain down the road. Think of it in terms of taking a daily aspirin to prevent headaches. Doing that doesn’t guarantee that you’ll never get a headache — but the aspirin regimen may decrease and even lessen the severity of any future headaches.”

That’s what our guidance and expertise does: it can ward off a whole lot of investment headaches down the road. Just one example shows how this works.

The Plain, Simple, Easy-Peasy Investment Scenario…That Wasn’t

A short time ago, one of my clients decided to partner with three other individuals in an apartment building.  The deal was straightforward.  Each partner would contribute a set amount of money for their membership interest in a newly formed LLC.  My client would receive 16 percent interest for his contribution.  The majority partner in the transaction held 50 percent and would serve as the LLC’s Manager. The majority member had his attorney — reputed to work at “a respectable firm” and familiar with LLCs for real estate transactions — draft the operating agreement. Shortly thereafter, an operating agreement was emailed to each of the members for review and signatures.  My client was willing to sign until I pointed out the numerous flaws in his agreement.  Below are a handful of reasons why signing on to this particular agreement could (and probably would) end in disaster.

Problem #1:  The operating agreement does not define the term “Majority” when referencing decisions reserved to the members.

  • Issue:  What constitutes a “Majority”? Does this refer to a number of members or a certain percentage of ownership?
  • Solution:  Define “Majority” in the agreement in terms of at least a percentage of the membership OR a certain number of members. Assuming the LLC doesn’t admit additional members, my advice would have this agreement define “Majority” as 75 percent of the membership interest, or more than two members, so decisions require the approval of at least three members to be binding.

Problem #2:  The Manager can request the members to contribute additional cash to the Company.

  • Issue: This is unfettered power that, in the wrong circumstances, could be wielded unfairly. Worst case scenario, the Manager could “freeze” any member out of the LLC by making a request for capital and it the member does not have the ability to contribute, his ownership will be negatively affected.
  • Solution:  While the LLC management does want to remain sensitive to the need for capital calls if unexpected expenses arise and the LLC does not have sufficient cash reserves, this decision should be made by the collective membership — not solely by the Manager.

Problem #3:   Any member may transact business with the Company without restriction.

  • Issue:  Once again, this is unfettered power that could prove costly. This gives any member the right to set up multiple business ventures to provide services to the Company, thereby enriching himself at the expense of the other members.
  • Solution:  Restrict related parties from dealing with the Company unless a majority of the members approve.

Problem #4:  The Manager/Management Committee is determined by the members from time to time.

  • Issue:  This vagueness in the operating agreement does address how to elect or remove a Manager from the Management Committee. From all appearances, the initial Manager is appointed for life.
  • Solution:  Include a provision to elect or remove a Manager if necessary. And the provision should make absolutely clear who is entitled to vote on this decision — i.e., the Manager up for removal should not have a vote in the process!

Problem #5:  The Manager is given exclusive control over the Company.

  • Issue:  We’ve talked about various unfettered powers, and this is another one of those. Under this agreement, the Manager could sell or encumber the Company assets without the approval of the rest of the members.
  • Solution:  Put some limits on how much leverage the Manager has. I’d recommend that any sale of Company assets above $8,000, encumbrance of assets, or excessive expenditures above $10,000 should be reserved to a vote of the Members.

Problem #6:  The Manager/Management Committee is required to have at least one annual meeting, but there is no mention of Members being invited.

  • Issue:  This enables the Manager to run the company without reporting to the Members.
  • Solution:  The Manager needs to be required to report to the Members at least quarterly, and Members should be given the option to attend any meetings.

Problem #7:  The Manager can hire any person, as the Manager deems necessary, to assist in running the Company.

  • Issue:  This is where nepotism rears its ugly head. If the Manager hires friends and relatives, he can effectively drain the resources of the LLC for personal and/or family gain.
  • Solution:  The agreement needs to restrict or limit any transaction with a related party unless approved by a majority of the members.

Problem #8:  The Manager can hire any person, as the Manager deems necessary, to assist in running the Company.

…And these were just a few of the problems I pointed out to my client regarding this joint venture operating agreement.

The main reason to adopt an operating agreement is to make sure that you and your co-members have established procedures for how the business is to be run. With a poorly drafted operating agreement —or, as happens in many situations, none at all — Members have no vehicle in place to solve any misunderstandings that come up. That way lies violated expectations, trouble, and even complete company failure.

Your Best Asset Protection:  Pros Who “Slug It Out” Every Day

While this is far from the only reason to get professional guidance from Anderson, it’s a big one. Do yourself and your peace of mind a favor…and don’t settle for less than truly experienced and informed advice for your real estate investment decisions. Give us a quick call for “headache prevention!”

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