LLC’s Failure to Execute Operating Agreement Opens Legal Trapdoor

While entity distinctness is a bedrock principle of corporate law, it may often appear redundant and unnecessary for a limited liability company (“LLC”) to sign its own operating agreement. That was likely the thinking of the two co-members at the center of the dispute leading to the recent appellate decision from New York, Wythe Berry LLC v. Goldman, 230 A.D.3d 1081 (1^st Dept. 2024). Neither of the members in Wythe bothered to have the LLC they formed execute, or become a party to, the operating agreement that they themselves entered into as members. Unfortunately, for at least one of the members, Wythe’s holding illustrates the danger of omitting the entity’s signature.

The Wythe Decision

Wythe presented your standard closely held entity business divorce. Two individuals formed an LLC to serve as the vehicle through which they developed a hotel; years later, the co-members’ relationship had devolved, one member accusing the other of mismanagement, diversion of company assets, and improper withholding of information. The usual litany of claims for fiduciary breach, access to the books and records, and an equitable accounting, ensued. The claims were asserted both individually and derivatively, on behalf of the LLC, and brought before the American Arbitration Association in accordance with a provision in the LLC’s operating agreement requiring arbitration of disputes. Given the derivative nature of the claims, the LLC was a nominal defendant in the arbitration.

This is where the wrinkle arose. Unlike the members, who had each executed the operating agreement in their individual capacity, the company itself was neither a party nor a signatory to the agreement. Seizing upon this, the LLC, acting through the co-member who was the respondent in the arbitration, commenced a petition in New York state court to stay the arbitration against it pursuant to CPLR §7503(b), which permits a stay application “on the ground that a valid agreement [to arbitrate] was not made.”[1] The LLC argued that there was no valid agreement to arbitrate because the entity, as distinguished from its members, did not sign and hence was not bound by the operating agreement—including the agreement’s arbitration clause. The co-member who initiated the arbitration of course disagreed, arguing that extricating the entity from its members ran against the clear intent of the members to bind the LLC to its operating agreement.

Ruling from the bench, the trial court declined to stay the arbitration.[2] Although it did not issue a written decision explaining its reasons, the trial court was of the view that, signatory status aside, there would be no “benefit…to hav[ing] an arbitration adjudicating the rights and obligations of the [co-members] that didn’t include the LLCs through which [the co-members] conducted business.”[3] In so holding, the trial court appeared to consider the LLC, at a minimum, a permissive, if not necessary, party to any member dispute. As such, the court saw no reason not to enforce the arbitration clause against the entity, regardless of whether the entity had assented to the clause by signing the operating agreement.

New York’s appellate division reversed. The appellate court grounded its ruling in the text of New York’s Limited Liability Company Law (the “NY LLC Law”), starting with the statute’s provision that “[a] limited liability company formed under this chapter shall be a separate legal entity.”[4] Based upon this provision, the court concluded that “a nonsignatory LLC is a nonparty to an agreement among its members only.”[5] The court also looked to the NY LLC Law’s definition of operating agreement, which is “any written agreement of the members concerning the business of a limited liability company and the conduct of its affairs.”[6] The court’s interpretation of this definition was that while the operating agreement governs relationships among members, it does not necessarily “govern the relationships between LLCs and their members.”[7] Putting it all together, the First Department held that the NY LLC Law “does not dictate that nonsignatory LLCs are always bound by the terms of their operating agreements.”[8] As applied to the facts in Wythe, this meant staying the arbitration of the derivative claims against the entity because the entity was not a party to and thus not bound by the operating agreement’s arbitration clause.

Other States and the Revised Uniform Limited Liability Company Act

Outside of New York, some state LLC statutes contain provisions dictating that the entity is bound by the operating agreement whether or not it executes it. For instance, Delaware’s Limited Liability Company Act states that “[a] limited liability company…is not required to execute its limited liability company agreement,” and that the LLC “is bound by its limited liability company agreement whether or not the limited liability company….executes the limited liability company agreement.”[9] Like Delaware, Virginia’s LLC Act provides that “[a] limited liability company is bound by its operating agreement whether or not the limited liability company executes the operating agreement.”[10] The NY LLC Law, by contrast, contains no such provision, instead only defining the operating agreement as “any written agreement of the members concerning the business of a limited liability company and the conduct of its affairs,”[11] a point of distinction noted by New York’s appellate division in reaching its decision in Wythe.

The Revised Uniform Limited Liability Company Act (the “Uniform Act”) is a model statute designed to bring clarity and stability to areas of state LLC laws. It too explicitly addresses the enforceability of the operating agreement by and against the entity. Per the Uniform Act, “[a] limited liability company is bound by and may enforce the operating agreement, whether or not the company has itself manifested assent to the operating agreement.”[12] By removing the necessity of “manifest assent,” the Uniform Act assures members that the LLC is bound by and may enforce the operating agreement even where the LLC is neither a party nor signatory to that agreement. Thus far, 19 states and the District of Columbia have adopted the Uniform Act—i.e., Alabama, Arizona, Arkansas, California, Connecticut, Florida, Idaho, Illinois, Iowa, Minnesota, Nebraska, New Jersey, North Dakota, Pennsylvania, South Dakota, Utah, Vermont, Washington, and Wyoming. New York has not.

In states like New York that have either not adopted the Uniform Act, or do not have statutory provisions declaring an LLC bound by its operating agreement, LLC members are in the same position as the one in Wythe when it comes to enforcing the operating agreement against the entity. Indeed, before Illinois adopted the Uniform Act, and before Virgina amended its LLC Act, court decisions from both states reached the same holding as did the appellate division in Wythe. In Trover v. 419 OCR, Inc., 397 Ill. App. 3d 403 (2010), an Illinois appellate court held that an LLC that was not a party to its operating agreement was not bound by the agreement’s arbitration clause.[13] Also, in Mission Residential, LLC v. Triple Net Properties, LLC, 275 Va. 157 (2008), Virginia’s Supreme Court held that that because a “a limited liability company is a legal entity entirely separate and distinct from the shareholders or members who compose it,”[14] it was not bound by an operating agreement to which only its members were parties.

Wythe’s Consequences

In the absence of an express statutory provision binding a non-signatory LLC to the operating agreement, Wythe raises the question of what rules, if any, govern an LLC that does not sign its operating agreement. An entity without an operating agreement, or with an operating agreement that does not address certain topics, is bound by the default requirements of the NY LLC Law.[15] Applying this principle, the court in In re Georgian Backyard LLC, 661 B.R. 102 (Bankr. E.D.N.Y. 2024) adjudicated whether a New York LLC was bound by a member’s decision to bring a bankruptcy petition on the entity’s behalf. As the operating agreement was silent on this issue, the court looked to sections 401 and 412 of the NY LLC Law, which govern the authority of members, as agents of the LLC, to manage and bind the entity.[16] Based on those statutory provisions, the court concluded that a member possessed authority to bring a bankruptcy petition on the LLC’s behalf.[17] This begs the question—if an LLC is bound by the default statutory rules where its operating agreement is silent, then is an LLC that does not execute its operating agreement similarly bound by the default statutory requirements?

Courts have not addressed this precise question. This may be because most decisions concerning the operating agreement binding non-signatory LLCs have been limited to the question of whether the LLC is bound by the operating agreement’s arbitration provision, a topic not encompassed by the default statutes, which typically do no cover forum for suit. However, were a non-signatory LLC in fact governed by the default statutory rules, the consequences of the entity being subject to one set of rules—i.e. the statutory rules—and its members being subject to another—i.e. the operating agreement—could make for some thorny interplay. As an example, while rules in the operating agreement on distributions or profit allocations are binding on the members, members would be hard pressed to enforce these same rules against a non-signatory entity. Under Wythe, such an entity would either be bound by the default statutory rules on profit allocations or distributions—which may be different from and in conflict with those in the operating agreement—or bound by no rules at all. In either scenario, the operating agreement’s rules governing the members are unenforceable against the LLC.

Conclusion: Sign, Seal, and Deliver Your Operating Agreements

Recognizing these potential pitfalls, corporate practitioners tasked with drafting an operating agreement would be wise to start by reviewing the applicable LLC statute in the state under whose laws the entity is organized. If that statute does not contain a provision binding the LLC to the operating agreement, then making the LLC a party and signatory to that agreement guarantees that the same rules governing the members are equally enforceable against the entity. If, however, the state has adopted the Uniform Act, or has an LLC Act with a provision akin to the ones in Delaware or Virginia cited above, then the entity’s failure to sign the operating agreement will not result in the entity being unbound—or being bound by a different set of rules (i.e. the statutory rules) from those binding its members.

Nonetheless, even for entities organized under the laws of such states, statutes are always subject to change. To avoid the whims of the legislature—not to mention that of the courts—the prudent course is for the LLC to be made a party and signatory to its operating agreement. By taking this simple step, corporate draftsmen ensure that any issue as to enforceability is determined up front by the members, leaving no room for the courts to question their clear expression of intent.

[1]N.Y. C.P.L.R. 7503 (b).

[2]Wythe Berry LLC v. Goldman, index no. 655863/2023 (Sup. Ct. N.Y. Cty. Dec. 14, 2023), NYSCEF Doc. No. 34.

[3]Wythe Berry LLC v. Goldman, index no. 655863/2023 (Sup. Ct. N.Y. Cty. Dec. 14, 2023), NYSCEF Doc. No. 34, p.4.

[4]New York Limited Liability Company Law §203 (d).

[5]Wythe, 230 A.D.3d at 1083.

[6]New York Limited Liability Company Law § 102 (u).

[7]Wythe, 230 A.D.3d at 1083 (emphasis added).

[8]Id.

[9]Del. Code Ann. tit. 6, § 18-101 (9).

[10]Va. Code Ann. § 13.1-1023 (A)(1).

[11]New York Limited Liability Company Law § 102 (u) (emphasis added).

[12]Uniform Act, §111(a).

[13]Trover, 397 Ill. App. 3d at 408-409.

[14]Mission Residential, 275 Va. At 161.

[15]In re Georgian Backyard LLC, 661 B.R. 102, 105 (Bankr. E.D.N.Y. 2024) (citing cases).

[16]Georgian, 661 B.r. at 105-107.

[17]Georgian, 661 B.r. at 108-109.

 

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