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.
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