A properly drafted operating agreement can greatly enhance the liability protection. An improperly drafted operating agreement will do the opposite, leaving creditors a superhighway of access to the assets. The issue is how to determine if your operating agreement is properly drafted or not.
Most LLC operating agreements that I review fall into what I refer to as the "online variety". These agreements are simple form documents, mass-produced for the uninformed consumer who mistakenly believes that one LLC is no different than another. In some cases, the operating agreement is nothing more than a restatement of what was filed with the particular state of formation. Given sufficient time, the falsity of the belief that one operating agreement is as good as the other may make itself known – usually in a lawsuit, audit or other inopportune time.
If you want to sleep better at night and have a high degree of asset protection, make sure your operating agreement is drafted by a professional (hey, even if they make a mistake, you have someone to blame and potentially recover against) and make sure your operating agreement has what I believe are "6 essential asset protection clauses".
The following are the first 3 of my 6 essential clauses:
1. Clause to Eliminate Mandatory Distributions
A primary benefit in establishing an LLC is outside creditor protection (i.e. you will not lose your membership interest in the LLC to a judgment creditor). This protection is commonly referred to as "charging order protection". A charging order gives a creditor the right to attach distributions made from the LLC to the charged member. If an investor found himself in this situation, he would undoubtedly decide against taking distributions if he was also forced to pay the creditor with the charging order. Unfortunately, if his operating agreement requires annual distributions for taxes or profits, then his hands are tied and the investor will be forced to issue annual distributions to the benefit of his creditor.
2. Unequal Distribution Clauses
If your operating agreement provides that distributions must be made on a "pro-rata basis", then distributions have to be made to all the members or none. In my charging order example above, this could have ramifications for a LLC with multiple members. If the LLC with a pro-rata clause (which is in almost all online documents) wanted to protect the member being pursued by a creditor with a charging order, protecting the member would mean withholding distributions from all members. To deal with this problem, your operating agreement should provide for non-pro-rata distributions.
3. Poison Pill Clauses
A poison-pill provision gives either the LLC or its members the right to buy out a creditor who is seeking to attach an interest in the LLC, usually for a nominal amount of money. This is especially useful for those states that provide judicial foreclosure as an alternative remedy to the charging order. *See my previous post on the Florida Olmstead decision for a discussion on judicial foreclosure.
Keep in mind this provision should only be used in operating agreements with other members whom you trust. If a credit seeks to attach the interest of a member, the LLC or the other members simply exercise their rights to buy the interest. The creditor gets a nominal amount of money, but the LLC and the other members are protected.
Here’s part two, with 3 additional clauses that I look for in every LLC operating agreement I review.