Most small businesses choose to operate as corporations or limited liability companies (LLCs) as opposed to sole proprietorships or partnerships for a variety of reasons, the most important being the liability protection afforded by corporations and LLCs for their owners. Between the two of them, LLCs are the entity of choice for small businesses by a wide margin because of their flexibility and ease of operation. In Pennsylvania, business owners often form an LLC themselves on the Pennsylvania Department of State (DOS) website by choosing a name, entering the requisite information, and paying the filing fee. Although the process appears straightforward, the do-it-yourself approach has some avoidable landmines that we have noticed in the Clinic.
First, the PA DOS website does not mention that the party forming an LLC should consider filing a Certificate of Authority. Although this is an optional step, it is usually beneficial to file a Certificate of Authority. This document states the authority, or limitation on the authority, of members of the LLC to enter into transactions on behalf of the company and legally bind the company. Landlords and lenders often request proof of an LLC member’s authority to sign documents on behalf of the company—the Certificate of Authority provides such proof. It is possible to file a Certificate of Authority after formation, but doing so requires an additional filing fee ($75), whereas there is no charge if an Authority Addendum is included at the time of formation.
Second and more important, the DOS webpage for forming an LLC in Pennsylvania does not suggest an Operating Agreement. This is an important document that companies should consider, particularly when there are multiple members. An Operating Agreement, among other things, describes the relationship between the members of an LLC and between the members and the company; defines the rights and duties of the members; and states the means of approving the entity’s transactions. Unlike the Certificate of Authority, there is no standard form available for an Operating Agreement; this document is typically drafted by an attorney depending on the needs of the LLC and its members.
Having an Operating Agreement in place can be very helpful, especially if the members of an LLC reach a stalemate. To illustrate this situation, we return to our Pasta Delites hypothetical from previous posts. Mary and Marty have had great success with their Italian restaurant, M&M’s Pasta Delites. The restaurant has become very popular in Central Pennsylvania and has gained the attention of a prominent New York restaurateur, Madeline, who has asked to meet the owners of the restaurant. Madeline attended a meeting with all the members of the LLC that own the restaurant, Mary, Marty, and Uncle Mo. During the meeting, Madeline told the three owners that she was very impressed by the restaurant and expressed her desire to join forces with them. Madeline made them an offer—she would buy the restaurant for $5 million and then help Mary and Marty to open a new restaurant in a different location. Mary, Marty, and Uncle Mo would reap a big profit on the sale, and Mary and Marty would also have the opportunity to open a new restaurant. Mary and Marty were thrilled with this offer and were ready to accept it immediately. However, Uncle Mo was hesitant—he was convinced that they could obtain a higher price for their restaurant. The three members were unable to resolve the issue and approached the Clinic for legal advice.
There is a common assumption that the “majority rules” with most organizational decisions. Unfortunately for Mary and Marty, that is not the case. For activities that arise in the ordinary course of business, differences between members can be resolved by a decision of the majority of the members. It must be noted that this is a majority of the members (i.e., by headcount), not a majority in interest (i.e., by percentage ownership). For a restaurant, activities in the “ordinary course of business” would be activities such as the menu, hours of operations and contracts with vendors.
On the other hand, for activities outside the ordinary course of business, actions can only be taken with the unanimous consent of all members. Therefore, in our hypothetical, all three owners of the LLC-owner would have to consent to selling the restaurant. Mary and Marty cannot override Uncle Mo on this issue unless their Operating Agreement specifically provides for it.
Moreover, in the absence of a detailed Operating Agreement, Mary and Marty would not be able to expel Uncle Mo from the company. This is only possible under very narrow circumstances, such as if the member to be “dissociated” wilfully and materially breaches his duties under the relevant statute. Even then, the members cannot vote to dissociate another member by themselves; they must rely upon a court to order dissociation, if it deems dissociation to be an appropriate remedy.
However, requesting a court to dissociate a member of an LLC is not a commonly used remedy because it is inevitably expensive and unpredictable. The members of an LLC could avoid this by covering a “deadlock” and other important topics in an Operating Agreement.
We have encountered situations at the Clinic where the members of an LLC reached an impasse and there was no way to resolve the deadlock because there was no guidance in an Operating Agreement. Here, the members of an LLC may not have any realistic choice other than dissolution if they cannot negotiate a resolution of their differences. That being said, it is worth noting that these deadlock situations do not occur in single-member LLCs because there is only one decision-maker.
As the Pennsylvania DOS website suggests, due to the legal complexities involved in starting a business, “it is advisable to seek legal counsel before filing to assure that all legal consequences receive proper consideration.” Based on the many DIY-LLCs that we have seen in the Clinic, it appears that this advice is often disregarded.
This post was written by Riya Anchi, a third-year law student at Penn State Law and a member of its Entrepreneur Assistance Clinic.