September 27, 2016

Times Have Changed. Have Your Operating Documents?

Private Client Services Newsletter

Operating documents such as articles of incorporation, bylaws and operating agreements (together, "operating documents") set forth rules and procedures that, along with applicable laws, govern the actions of a legal entity. If an organization's operating documents were prepared a long time ago and have not since been updated, now may be a good time to revisit them. To begin, ask yourself the following questions:

  • Is my organization still doing the same thing as when the operating documents were first prepared?
  • Has the board of directors changed at all?
  • Have any shares of my organization been sold or transferred?

If you answered yes to any one of these questions (or if your operating documents have not been reviewed for some time), please read on.

It is critical that the operating documents be updated to reflect, among other developments, changes in the organization's purposes and intentions, actions by the owners over time and relevant changes in state law. If a corporation or other legal entity fails to comply with the terms of its operating documents, the actions of the legal entity may not be valid and the fiduciaries (i.e., directors, officers, managers, etc.) may face potential liability. Finally, it is important that operating documents are in order in advance of a potential transaction (e.g., for a sale or for estate planning purposes) in order to maximize value and ensure a smooth transaction. What follows is a summary of what should be considered when reviewing your operating documents. The focus is primarily on corporations, both for-profit and nonprofit, though many of the issues raised below also apply to limited liability companies, partnerships and other legal entities.

  • Stated Purposes. The articles of incorporation, bylaws or operating agreement may limit the activities of a corporation to specific purposes. If a corporation plans to conduct (or has already conducted) activities outside the scope of its stated purposes, the articles of incorporation will need to be amended to reflect this change. For example, a nonprofit, section 501(c)(3) corporation may limit its activities to the support of youth development programs in a particular city. If the nonprofit corporation plans to expand its charitable activities to other cities, the organization will need to amend its articles of incorporation and bylaws to reflect this change. If the nonprofit operates outside of its stated purposes, directors and officers may be liable for acting beyond their powers, and the acts of the organization may be void or voidable. A good rule of thumb is to draft a broad purpose statement in the articles of incorporation to allow the organization's mission and activities to evolve over time.
  • Composition of Board of Directors. State law typically requires a corporation to have a minimum number of directors. A corporation's articles of incorporation or bylaws may provide further rules for board composition, including a minimum and/or maximum number of directors. Another issue arises when operating documents require directors to have certain qualifications or affiliations. If a corporation selects more directors than authorized under its operating documents, or if directors do not meet stated qualifications, the acts of the corporation or the votes of certain directors may not be valid. Be sure to confirm that the composition of your organization's board of directors is consistent with the organization's operating documents.
  • Voting and Board Action. State laws vary on permissible methods of voting at meetings of the board of directors. If state law permits voting by telephone conference, email or other forms of technology, the organization's operating documents should authorize such methods. The same goes for notice requirements. Oftentimes it is easier to provide notice of meetings to directors, consistent with state law, via email or other electronic notice method. With voting, board action, and notice, it is critical that the organization comply with the terms of its operating documents and the requirements of state law. Defective notice of a meeting or voting by improper means at a meeting may cause actions taken at such meeting to be invalid or provide a dissenting shareholder grounds to dispute the action taken.
  • Removal of Directors and Officers and Successor Provisions. Operating documents typically set forth the process for the removal of directors and officers and the designation of successors. A common provision is that a director or officer may be removed, with or without cause, by a majority vote of the remaining directors in office. If, in the organization's judgment, the threshold for removing directors or officers should be lower or higher (in each case, consistent with state law), the organization should incorporate such changes into its operating documents.

In addition, in the case of an LLC, the operating agreement may designate a successor manager that is no longer living or affiliated with the company, or a method for designating a successor that is outdated and burdensome (e.g., requiring the policy committee of a law firm to name successor managers). Operating documents should be reviewed every few years to ensure the proper fiduciary line-up is in place and to determine whether changes need to be made to the method for designating new managers.

  • Entity Duration. Although less commonly used today, organizations can be established to exist for only a specified duration of time (e.g., 20 years). When the specified duration expires, the organization will cease to exist—the provision giving effect to this cessation is called a "sunset provision." However, if the intention today is that the organization continue indefinitely until purposefully dissolved or cancelled by the directors or owners, the operating documents should be reviewed to determine whether they include a sunset provision, and if so, that the necessary corporate documents are amended before the provision takes effect.
  • Transfer Restrictions. In the case of for-profit organizations, if the shareholders, members or partners intend for the company to remain within the family or within a certain group of existing owners, then the owners should ensure that restrictions on transfer of interests and other protections are in place. In particular, careful consideration should be given as to what occurs when an owner dies, retires or divorces, for example, including the price at which an owner (or his or her estate) will be redeemed, and whether the other owners will be given a right of first refusal in the event an owner desires to transfer or sell his or her interest in the company. If such provisions are already in place, they should be reviewed periodically to determine whether the provisions continue to reflect the current intention of the owners.
  • Changes in Ownership and Operations. Many changes can occur throughout a year—for example, the death of an owner, the gift or other transfer of an owner's interest in the company, the issuance of additional shares, units, interests, etc. or a change for tax purposes including different tax allocations—that affect the terms and structure of operating documents. It is quite common that operating documents are not amended to reflect these important changes. When reviewing documents, consider the following: Are the owners in the company and the current ownership shares/percentages accurate? Are the appropriate number of shares, units, interests, etc. authorized under your operating documents? Have there been non-pro rata capital contributions that affect the ownership percentages? Does the allocation of distributions, profits and losses reflect the agreement and practice of the owners of the company?
  • Indemnification. State laws typically specify some default level of indemnity protection for a broad class of individuals, such as an organization's directors, officers, employees or agents. These state laws are usually expressly subordinate to an organization's operating documents. If your operating documents are silent on indemnification or don't expressly override the often broad indemnity protections afforded under applicable state laws, then your organization may be exposed to more risk than intended or directors may receive less protection than intended.
  • Related Party Transactions. A related party transaction can be defined as a business deal between two or more related parties who are engaged in a relationship prior to consummation of the deal. These transactions are subject to state laws concerning conflicts of interest, among other laws, and, in the case of publicly-traded companies, federal securities laws.

Here is an example: Unbeknownst to your organization's board of directors, a key manager of your organization owns a significant portion of another entity and such entity enters into a material contract with your organization. This transaction presents a potential conflict of interest which may cause the transaction to be void or voidable under the laws of some states. However, this transaction can be "authorized" under the laws of some states if legally required protocol is followed and disclosures are made. One question to ask about your operating documents is whether they include procedures for discovering and disclosing related party transactions.

  • Dissolution. Circumstances, whether voluntary or involuntary, may arise that cause the need for dissolution of your organization. It is common for organizations either not to include a dissolution clause in their operating documents or to omit important procedural details from the clause. If your organization's operating documents lack a dissolution clause or contain incomplete procedural provisions, your organization's board and officers may have difficulty agreeing on how to handle your organization's affairs in the event of a dissolution. Some things to consider are whether your operating documents specify events the occurrence of which would cause dissolution (e.g., death of a shareholder, financial crisis) and whether your operating documents specify how assets and liabilities are to be divided in the event of dissolution.
  • Changes in State Law. Finally, operating documents may need to be updated to incorporate changes in state law. Changes in state law with respect to corporations, partnerships, LLCs, trusts or other entities may require the organization to revisit and update its organizing documents on a regular basis. In addition, state statutory default provisions can conflict with the organization's intentions of how the organization should operate; documents should be reviewed periodically to make sure that undesired default provisions have been overridden by the terms of the operating documents.

As this overview demonstrates, there are a number of reasons to review and revisit an organization's operating documents. If you have not reviewed the operating documents for your organization recently, now is an excellent time to do so.

*Declan Tansey also contributed to this Newsletter. Mr. Tansey is admitted only in Virginia; practicing law in the District of Columbia during the pendency of his application for admission to the DC Bar and under the supervision of lawyers of the firm who are members in good standing of the DC Bar.

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