Business formation attorneys are often asked why it is necessary to do anything more than file a bare minimum certificate of formation (on the brief secretary of state’s form) and leave it at that. Clients are often motivated by a desire to keep things both simple and inexpensive. They suspect that lawyers want to over-complicate projects with lengthy documents in order to collect higher fees. After all, in merry old England (from whence much of our law is derived), lawyers were actually paid by the word—this is true—and solicitors of the day were thus rewarded for creating long documents full of obscure verbiage.
Properly documenting an LLC has nothing to do with this dubious history. First, there are organizational, management, tax, and accounting issues to be dealt with. Secondly, when involved in litigation relating to an LLC, one of the first things a plaintiff’s attorney will demand to see is the company record book with all relevant documentation. If this documentation does not exist or is inadequate, the plaintiff may (at least if the plaintiff is alleging fraud, which is common) seek to pierce the company’s liability barrier. This occurs with exasperating regularity in spite of Texas’ actual fraud rule. For details see our companion web article on Piercing the Veil of an LLC.
LLC Documents Generally
It is not just the quantity of LLC documentation that matters but its quality and sophistication. LLC documents should contain asset protection clauses and provisions from the very beginning of the formation process. At minimum, such documents include:
(1) the certificate of formation (“COF”);
(2) a comprehensive company agreement (also called an operating agreement);
(3) the minutes of the first meeting of members (organizational meeting);
(4) signed and issued membership certificates;
(5) signed consent by the registered agent;
(6) if the LLC is a series company and there are to be registered series, a certificate of registered series.
All of these documents should be organized and kept in a company record book with labeled tabs. A company seal may also be included. Although the seal has no true legal effect in Texas, it adds ceremonial and decorative value to official company documents and is customarily applied to LLC membership certificates.
The Certificate of Formation (COF)
The COF supplies the essential information required by the Business Organizations Code and Secretary of State in order to establish a traditional or series LLC. It may also contain such additional information concerning the business and operations of the company as the initial members may wish to make public. For confidentiality and anonymity reasons, however, the COF should avoid including excessive personal information (the home addresses, for example) of its initial managers. Topics mentioned may include:
Company Name. This would be the official LLC name (not including any assumed names).
Entity Type. The type of entity (a limited liability company) is declared.
Registered Agent, Registered Address, and Initial Mailing Address. Every company must have a registered agent to receive service of process in the event the LLC is sued. This person’s name and physical address (not a post office box) must be specified in the COF. The LLC’s initial mailing address (which may or may not be the same) is also required.
Governing Authority. LLCs may be manager-managed or member-managed. For most business purposes (including real estate investing) the manager-managed format is preferred since lenders and title companies prefer it. One or more initial managers are named.
Company Purpose. The company purpose may be specifically stated although a general statement (“the company is organized for all lawful purposes”) is most common.
Classes of Membership Interest. Our practice is to declare that there will be two classes of members, Class A and Class B, with different rights and powers. This is an asset protection device.
Restrictions on Transfer. It is often considered useful to state publicly in the COF that membership interests in the company are subject to restrictions on transfer.
For Series LLCs. If the company is to be a series LLC, then the COF should include a notice of limitation on liability of individual series as prescribed by Business Organizations Code 101.602. It is recommended that the COF go further and describe the powers and privileges of different types of series (ordinary, protected, and registered) and make it clear that the series may operate independently from one another and from the company at large.
Banking and Depository Accounts. Experience has shown that it can be useful to state expressly that the LLC (and, if a series LLC, its individual series) will have the power to deposit and borrow money. Banks and lenders appreciate such a clause.
Organizer. The name and address of the organizer of the LLC is identified. The current standard under BOC Sec. 101.0515 is that the organizer must be an authorized office, manager, or member of the LLC, which is a more restrictive definition than in the past. Previously, it was common for attorneys to sign as the organizer. With this new standard clients may more frequently be asked to sign the COF themselves.
The Company Agreement
The company agreement (also called the operating agreement) is a private contract between the members that contains rules, regulations, and processes governing company operations and activities. It is similar in many ways to a partnership agreement. The company agreement should not be confused with the minutes of the organizational meeting of members (discussed in the next section). Although the content of these two documents may occasionally overlap, they are conceptually different and are designed to address separate items and issues.
Company agreements are fairly lengthy and should be carefully customized to fit the circumstances (avoid templates). However, all company agreements should contain certain basic provisions including (but not limited to):
Organizational Matters. The formation of the company under the laws of its home state is approved and ratified, and aspects of its basic structure (manager-managed versus member-managed, traditional versus series LLC, etc.) are addressed. The company’s purpose is declared. Provisions relating to the appointment of a registered agent (who is usually named at the organizational meeting) are included.
Initial Members. The rights and duties of members are described as is the process for making initial and additional contributions; the means by which membership interests are held (in percentage terms or as units); representations and warranties of members to one another; limits on members’ authority and liability; the admission of new members; and the issuance of membership certificates. There is also an opportunity to designate classes of membership interests—for instance, Class A and Class B. This can take several forms, but most often Class A members are “regular” members while Class B members have fewer rights. Class B members are defined as persons who gain membership or influence by some coercive means (execution upon a judgment, assignment of a membership interest in satisfaction of a debt, charging order, or contested divorce). Class B members have the right to receive notices and be present at meetings but they cannot vote. This structure attempts to assure that members do not wind up in a disastrous partnership with other members’ creditors or ex-spouses since these persons are usually seeking to dissolve the company or sell off its assets for cash.
Capital Contributions. This section usually establishes a capital account for the members and states the requirements for future contributions (including whether they will be optional or mandatory). It may also address the ability of members to grant loans to the company in addition to contributions.
Restrictions on Sale or Transfer of Membership Interests. Company agreements typically contain a right of first refusal and/or other buy-sell provisions that will apply if a member wishes to sell or assign a membership interest. There may also be provisions that relate to the valuation of such interests. The following is typical language: “No Member may assign, convey, sell, encumber or in any way alienate all or any part of that Member’s Membership Interest without the prior written unanimous consent of all the other Members, which consent may be given or withheld, conditioned or delayed, as the remaining Members may determine in their sole discretion, without any requirement that such consent not be unreasonably withheld.” The goal is usually to give each member a right of first refusal to purchase the interest of every other member. If there are multiple members, then the membership interest to be sold is usually divided pro rata among members choosing to exercise this right. It is also important to address major adverse events such as incapacity, death, or bankruptcy of a member.
Meetings, Quorum, and Voting. The process for annual meetings and the calling of special meetings (including setting the agenda) are described. A quorum is defined as are threshold requirements for company decisions. Most decisions are made by majority vote but major decisions may require either a supermajority or a unanimous vote. The company agreement usually provides that virtual meetings are allowed and certain actions may be taken by signed resolution in lieu of a meeting.
Governing Persons. While the election of governing persons is usually accomplished at the first meeting of members (and is included in the minutes of that meeting), the company agreement goes into detail about who may act as manager as well as a manager’s powers, fiduciary duty, standards of performance, term of office, and process for termination. If the company agreement so provides, an LLC may also elect traditional officers such as a CEO, president, and vice president. LLCs do not have a board of directors as do corporations, but it is possible for an LLC company agreement to provide for a board of managers, although this is less common.
Tax, Accounting, and Banking Matters. Company policies relating to fiscal year, method of accounting, preparation of state and federal tax returns, the maintenance and inspection of company books and records, and rules for the opening of depository accounts are covered in this section. There are two general approaches commonly seen in this area: company agreements that go into minute detail about tax and accounting matters (which can make the document quite long) versus agreements that just cover the minimum and then delegate discretionary authority to the managers to consult with professional advisers and make choices that are in the best interest of the LLC.
Allocations of Profit and Loss, Distributions, and Compensation. Profit and loss are most often allocated to each member in the same percentage as that member’s percentage of ownership in the LLC. The rules for distributions are also discussed in this section as well as whether or not the managers will be compensated with salaries.
Dissolution and Winding up of the Company. Provisions in this area often center around what events shall cause a dissolution of the company as well as how debts will be paid and final distribution of the company’s assets made to members.
Will the company be a series LLC? If so, there is a whole cluster of provisions that need to be included in the company agreement. These relate to the limitation on liability of series; creation, naming, and governance of series; whether or not the LLC will utilize registered series which require a separate filing with the secretary of state; clauses relating to series record keeping and separation from other series; assumed names for series; and many other similar provisions.
Dispute resolution. Every well-drafted contract should include provisions for alternative dispute resolution. The LLC members should agree to mediate unresolved disputes prior to resorting to litigation or the filing of a complaint with any government agency. If legal action is undertaken without first engaging in mediation then the members should agree to abate or pause such action until mediation is completed.
Community Property Issues. An LLC membership is personal property and presumed to be the community property of both spouses. If there are to be spouses who are not members, then it is prudent to include or attach a “consent by non-member spouses” to the company agreement.
The company agreement should generally be designed to maximize asset protection and will be one of the first documents demanded in discovery if the company is sued, since it is not recorded with the Secretary of State or anywhere else. The plaintiff will want to see (first) if a company agreement exists and (second)if it contains any provisions that may be an impediment to a monetary recovery.
The First Meeting of Members
The organizational meeting should address a whole array of items pertaining to the company’s start-up. Important elements include:
Persons Present. The initial paragraphs of the minutes recite the date and location of the meeting as well as persons present. The attorney who drafted the company’s formation documents is often listed as present and being the one who prepares the minutes.
Certificate of Formation and Certificate of Filing. The members approve and ratify both of these documents as governing documents of the company.
Formation Expenses. Fees and costs expended for formation are often approved and provision may be made for reimbursing those who made these expenditures.
Company Purpose. A general purpose statement is preferred (e.g., “any and all lawful purposes for which a limited liability company may be organized under the Texas Business Organizations Code”). The minutes may go on to state that the company will focus its attention upon a particular business such as investing in real property.
Initial Members and Percentages. The initial members, their respective initial contributions (whether in the form of capital or services rendered), and their respective percentage interests in the company should be specified.
Approval of Company Agreement. The company agreement should be reviewed and approved.
Governing Persons – Election of Managers. One or more managers are designated with the operational authority to manage day-to-day operations. Officers may also be elected if the company agreement so provides. See Tex. Bus. Org. Code sec. 101.251.
Official seal. The company seal should be affixed and approved.
Membership certificates. The form and issuance of membership certificates should be approved.
Organizational expenses. Expenses incurred incident to forming and establishing the LLC should be approved and ratified. Reimbursement for company organizational expenses may also be approved.
Appointment of Registered Agent. The registered agent and registered address should be recited and approved as should the company’s principal place of business.
Assumed Names. These are often recited and approved, if any have yet been obtained.
Series LLC Provisions. Provisions establishing the company as a series LLC are included, along with approval of conveyance of assets into individual series.
Banking and Book Keeping. This section should approve obtaining an EIN, opening an operating account, and check-writing authority.
Conclusion. The concluding paragraphs of the minutes should resolve that the company may commence business, state that members waive notice of the meeting, and approve the minutes. All members sign.
Annual and Special Meetings
For company maintenance purposes, the company should have at least one formal meeting per year—“formal” in the sense that it is reduced to writing and included in the company record book. The basic elements of the annual meeting are review and ratification of the preceding year’s actions by the company, its managers, and officers; specific approval of major decisions; recognition of any unusual events or circumstances not in the company’s ordinary course of business; and election of new managers who will serve in the forthcoming year.
It may also be a good idea to hold special meetings to review and ratify any major decision, approve the purchase or sale of real property, approve a loan to the company, or accept new members. Special meetings addressing such issues may be held anytime. The more documentation clearly reflecting such actions (signed by all members) the better.
LLC documents contain common elements that should be addressed in the case of every new company. However, enterprises vary. Their purposes and members are different. The formation and organizational documents should be carefully drafted to reflect these differences. They should also provide tough protection from creditors and plaintiffs who may seek to pierce the veil and hold individual members personally liable for debts and actions of the company. Ongoing annual and special meetings should be held to preserve and maintain records and the independent legal character of the company. All relevant documents should be organized and contained in the company record book.
Information in this article is proved for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes and any statutes or cases referred to should be checked for updates. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is retained and agrees in writing to do so.
Copyright © 2022 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, http://www.LoneStarLandLaw.com.