Sometimes, new business owners are leery of forming a California Limited Liability Company (“California LLC”) as opposed to a California corporation or California partnership because they are daunted by the need for an operating agreement. Most good operating agreements are 20-40 pages long (depending upon the complexity of the structure).

As we recently discussed, while it is wise to have a formal custom-drafted California operating agreement, the California Corporation Code does not require it. A California operating agreement can be oral or implied from the conduct of the members of the California LLC. See Cal. Corp. Code § 17101.2(s). For various issues that the members did not consider, the statute provides various “default” provisions.

Example: In Re Kite Ranch, LLC

A good example of what facts and behavior a court will look to in determining if an oral agreement exists is the case of In re Kite Ranch, LLC, 234 P. 3d 351 (Wyo Sup. Ct. 2010). The California LLC Statute is based on the Revised Uniform Limited Liability Company Act which has be enacted in Wyoming. See here. Thus, a Wyoming case can be persuasive and instructive to a court in California.

Kite Ranch involved a Wyoming cattle ranch. In 2001, three partners wanted to buy the Ranch and they approached a fourth colleague (Powell) about providing $300,000 towards the purchase price of $1.1 million. The parties secured a loan for most of the remainder of the purchase price. The bank required the borrowers to form a business entity as a condition of the loan. The parties formed an LLC under Wyoming law. However, the members did not execute an operating agreement.

The ranch successfully operated as a cattle ranch over the next few years. During that time, approximately $220,000 of Powell’s equity contribution was returned. In 2006, however, problems arose and the loan fell into default. Litigation followed.

Among the issues for the court to resolve was whether Kite Ranch LLC had an operating agreement and whether certain acts and conduct of the LLC members changed the “default” provisions under the Wyoming LLC statute. With respect to both, the Wyoming Supreme Court answered in the affirmative.

What Facts Demonstrate an Oral Operating Agreement?

In reviewing the facts of the case, the court held that the Kite Ranch, LLC did, in fact, have an operating agreement based initially on certain pre-formation agreements supported by later oral agreements and their collective course of conduct during the first several years of operation. The court held this based on several facts, including:

• The members had signed pre-formation agreements/documents which were subsequently followed;
• All members signed and agreed to the loan commitment letter;
• All members signed the documents authorizing the loan;
• The bank loan was made in the manner contemplated by the pre-formation agreements/documents;
• The capital contributions followed what had been agreed in the loan commitment letter and related documents;
• The articles of organization followed the initial capitalization structure;
• The LLC’s tax returns followed the initial capitalization structure;
• Profits and losses were allocated, without objection, pursuant to the initial capitalization structure;
• The agreed-upon member operated the ranch with the full knowledge and agreement of all the members;
• Informal meetings were periodically held to discuss management of the ranch and the LLC; and
• Almost immediately after purchasing the ranch, the members had the LLC start repaying Powell’s capital contribution of $300,000 reflecting the member’s agreement that Powell was to be a minority equity holder whose equity would be returned as quickly as possible

Based on the foregoing, the court held that the Kite Ranch, LLC had an operating agreement.

Oral/Course-of-Conduct Can Change the Statutory “Default” Provisions

As noted, the Kite Ranch LLC members returned to Powell almost $220,000 of his initial $300,000 capital contribution. One argument in the case was that Powell received too much reimbursement and that his allocation of profits should have been limited per the default provisions in the statute. However, the court held that this oral/course-of-conduct operating agreement was sufficient to vary the “default” provisions of the Wyoming LLC statute. The “default” provision in the statute states that profits and losses are to be allocated based on the value of ongoing contributions, unless changed by the operating agreement. See Wyo. Stat. Ann. § 17-15-119. In Kite Ranch, the court held that the members had varied the “default” provisions of the statute by oral agreement and by conduct — the members clearly agreed and acted for several years to allocate profits and losses on the basis of the initial capital contributions, not the ongoing and continuing contributions. Thus, the “paydown” of Powell’s $300,000 was upheld.

Call San Diego Corporate Law Today

Whether a court will find an oral operating agreement exists and under what conditions will depend on the unique facts of the case. However, as Kite Ranch and other cases show, the best practice is to have some sort of written operating agreement. At minimum, it helps avoid long and costly litigation.

If you need or just want more information about LLC formation, articles of organization and California LLC operating agreements, contact Michael J. Leonard, Esq., of San Diego Corporate Law. Contact Mr. Leonard by email or by calling (858) 483-9200.

You Might Also Like:

California LLCs

Avoid LLC Pitfalls

Doing Business In California – Foreign Corporations

Various Corporate Forms Compared