Thursday, October 31, 2013

Why Do Members Need LLC Operating Agreements? Part I of III

On October 23rd, I participated in a panel discussion relating to the LLC operating agreements.  This was a webinar on drafting LLC agreements conducted by Financial Poise, a provider of CLEs and informational webinars for accredited investors, executives, and their legal and financial advisors.  Preparation for the webinar made me think about the main differences between LLCs and corporations.  So, I’ve decided to share my thoughts on what these differences are and what should go into an operating agreement in a series of posts.   

I think of an LLC as a hybrid between a corporation and a partnership.  Consequently, an LLC operating agreement is a hybrid between, on one hand, the corporate bylaws, charter and a shareholders agreement and on the other hand, a partnership agreement.

Internal affairs of a corporation are largely governed according to state statutes.  For example, in Delaware the relevant statute is called the Delaware General Corporation Law, and in New York it is called the Business Corporation Law.  This is not the case for LLCs.  It is actually the opposite.  The LLC state statutes provide default provisions that govern in the absence of corresponding provisions in the LLC’s operating agreements.  So, in a sense, these are gap fillers, and in most cases, can be overridden by contract.  Although registered with the state authorities, LLC internal affairs are governed by contract, which is called an “LLC agreement” or an “operating agreement”.  

This is the reason why most jurisdictions require LLCs to have an operating agreement, although not all of these jurisdictions require it to be in writing (for example, in California and Delaware members can have an oral agreement, which in my opinion, is a recipe for disaster).   In New York, Section 417 of the New York LLCLaw requires members to adopt a written agreement that is not inconsistent with the law or the LLC’s articles of organization.  Note that according to Section 417, even sole member LLCs should have a written operating agreement.  The NY law is silent about the consequences of not adopting an operating agreement, and since operating agreements are not public documents, I assume it is difficult to police.

Below are some illustrations of how LLC statutes typically work. For example, Section 402 of NY LLC Law says that unless provided in operating agreement otherwise, each member votes in proportion to its share of current profits of the LLC. Also, unless provided in operating agreement otherwise, a majority vote of all members is required for admission of new members, issuance of new LLC interests, approval of indebtedness other than in ordinary course, amendment to the articles of organization or operating agreement, approval of dissolution, or sale of all or substantially all assets of the LLC. Section 403 of NY LLC Law says that except as set forth in the operating agreement, LLC shall hold annual meetings. Sections 503 and 504 of NY LLC Law, respectively, say that unless otherwise provided in the operating agreement, each member is allocated profits, losses and receives distributions of available cash on the basis of the value of any contributions made.  As you can see, an operating agreement can alter many of the provisions of the NY LLC Law.

This is why we see such a variety of LLC structures. Some LLCs resemble corporations. Their members are called shareholders, there is a board of directors, and the LLCs authorize and issue shares instead of membership interests. Other LLCs do not have shares at all, but rather their membership interest is expressed in percentages. Members may be passive investors, the LLC may be managed by members or by one or several managers, and profits and losses may be allocated disproportionately to the members’ percentage interests or the value of their contributions.  There may be a priority waterfall with respect to allocations of profits and losses, distributions of available cash, and also distributions in the case of dissolution.

Since this post is already getting to be too long, in the next post, I’ll go over the core provisions that each LLC Agreement should have or members should at least consider including.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Wednesday, October 30, 2013

NYC Conflicts of Interest Law Impedes Growth of Teacher-Led Education Startups

New York City's Ethics Law, Chapter 68 is also referred to as the Conflicts of Interest Law.  It applies to all city employees and contains rules regarding gifts, part-time jobs in other sectors, volunteer activities, post-City employment, use of confidential information and ownership interests in company that do business with the City.  In particular, the Law does not allow public employees to incur financial gain derived from the operation of their own business separate from their public job if it involves selling products or services to the City.

This Law also applies to all NYC public school teachers and prohibits them from selling to schools or entering into any Department of Education-sponsored challenges, such as the Gap App Challenge while they are employed by the City as teachers and for a full year thereafter.

Although the Law makes sense, it is now viewed by some as an impediment to innovation in education, as it makes it difficult for teachers to form education startups if such startups aim to sell their products or services to the DOE.  The Law therefore gives non-teacher founders an advantage as they can freely sell products to NYC district schools and get vendor contracts with the DOE.

The consequences for violating the Conflicts of Interest Law may be severe.  According to the NYC Conflicts of Interest Board (the "Board"), the punishment can include any of the following:
  • You may be suspended for some period or fired; 
  • You may be fined by the Board up to $25,000 per violation; 
  • The Board can recommend to your agency that you be suspended or fired;
  • The Board can also disgorge any money you gained by violating the law; 
  • It is also a misdemeanor that the District Attorney's office may prosecute; 
  • Upon conviction, you may be fined and sent to jail and lose your City job; 
  • The Board may also void any contract or transaction that violates the Conflicts of Interest Law.
Mary Jo Madda recently wrote at length about the Conflicts of Interest Law and how to deal with potential conflict of interest situations in case of educational startups in her article "Arrested Development for Teacher-Led Startups" that you can find here.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Thursday, October 24, 2013

FINRA Funding Portal Rules

On October 23rd, FINRA proposed rules and forms relating to the funding portals, referred to as the Funding Portal Rules.  Once finalized and adopted, these rules will govern the SEC-registered funding portals that will also have to become members of FINRA pursuant to the JOBS Act.  

The public comment period ends on February 3, 2014, shortly after the end of the commenting period on the newly proposed SEC rules implementing the crowdfunding provisions of the JOBS Act.

Happy reading!

The SEC Releases the Long-Awaited Crowdfunding Rules

On October 23rd, the SEC voted unanimously to propose rules implementing the crowdfunding portion of the JOBS Act.  The comment period is 90 days.  The proposing rule release is over 500 long (!), but I anticipate there to be many many comments and commenters.  For those who want a brief synopsis, refer to the SEC press release.

The press release highlighted the following:

Under the proposed rules:
  • A company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.
  • Investors, over the course of a 12-month period, would be permitted to invest up to: $2,000 or 5 percent of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000.
  • 10 percent of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000. During the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding.
Certain companies would not be eligible to use the crowdfunding exemption. Ineligible companies include non-U.S. companies, companies that already are SEC reporting companies, certain investment companies, companies that are disqualified under the proposed disqualification rules, companies that have failed to comply with the annual reporting requirements in the proposed rules, and companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Companies resorting to crowdfunding would be required to provide the following information:
  • Information about officers and directors as well as owners of 20 percent or more of the company.
  • A description of the company’s business and the use of proceeds from the offering.
  • The price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount.
  • Certain related-party transactions.
  • A description of the financial condition of the company.
  • Financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor.
These companies will also have to file an annual report with the SEC and provide it to investors.

Crowdfunding transactions will take place only through an SEC-registered intermediary, either a broker-dealer or a funding portal. 

The proposed rules would require these intermediaries to:
  • Provide investors with educational materials.
  • Take measures to reduce the risk of fraud.
  • Make available information about the issuer and the offering.
  • Provide communication channels to permit discussions about offerings on the platform.
  • Facilitate the offer and sale of crowdfunded securities.
The proposed rules would prohibit funding portals from:
  • Offering investment advice or making recommendations.
  • Soliciting purchases, sales or offers to buy securities offered or displayed on its website.
  • Imposing certain restrictions on compensating people for solicitations.
  • Holding, possessing, or handling investor funds or securities.
Yes, this is a lot to read, to discuss, to digest and comment on!  Happy reading, everyone!  

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.