The Limited Liability Company Operating Agreement and the Statute of Frauds

An LLC’s operating agreement plays basically the same role as a partnership agreement or corporate bylaws. It sets out the basic rules of how the company will be governed. The operating agreement’s chief legal significance is that it provides the vehicle by which the parties exercise their broad power to modify the default statutory rules. The extent of that power, however, varies from state to state. As we have seen, the Delaware statute prioritizes freedom of contract and contains few mandatory rules that cannot be modified in the operating agreement. In contrast, the ULLCA (2006) lists no fewer than 15 provisions that may not be varied by agreement. In addition, the ULLCA (2006)’s drafters expressly rejected “the ultra-contractarian notion that fiduciary duty within a business organization is merely a set of default rules and seeks instead to balance the virtues of ‘freedom of contract’ against the dangers that inescapably exist when some persons have power over the interests of others.”[1] 

In most states, a unanimous vote is required both to adopt and amend the operating agreement.[2] The latter rule is a default rule, however, and may be modified in the operating agreement.[3]

In a majority of states, the operating agreement may be written or oral, although some states require a written agreement. In many of those states in which oral agreements are allowed, however, the Statute of Frauds potentially applies to LLC operating agreements.[4] In Olson v. Halvorsen, for example, the court explained that the LLC operating agreement’s provision for retirement of a founding member “requires the remaining members to act to maintain the retired member’s economic interest, prevents the remaining members from taking actions to reduce the retired member’s economic interest, and prevents [one of the founders] from withdrawing a certain percentage of his funds unless he relinquishes his veto rights, all for a period of time well beyond one year.” The court further explained that:

These obligations and restrictions affect how [the founders] choose to run and structure their business over a multi-year period and rise above the mere payment of money over time. Moreover, most of the payments [the founders] would be required to make [to a retired founder] could not be calculated until more than one year after an event occurs triggering the alleged payment obligation.[5]

The Statute of Frauds therefore applied and the oral agreement was unenforceable.

The Delaware legislature subsequently amended the state’s LLC statute, however, by adopting § 18-101(7):

A limited liability company agreement is not subject to any statute of frauds (including § 2714 of this title).

Professor Kleinberger explains:

It is thus theoretically possible for a Delaware limited liability company to assert that under an oral term of the company's operating agreement, a member has transferred to the company title to land, or vice versa. (Delaware enacted this statute to negate a decision of the Delaware Supreme Court applying the one-year provision of the statute of frauds to operating agreements. Olson v. Halvorsen, 986 A.2d 1150, 1161 (Del. 2009). However, a good NOM/WMO provision should cover this problem.)[6]

He further explains that:

A “no oral modification” (NOM) provision amounts to a statute of frauds adopted by private agreement. Both the phrase and its acronym are misnomers; if the provision is properly drafted, it precludes implied-in-fact modification as well. A better acronym would be WMO—written modifications only.[7]

Colorado and Illinois have adopted statutes similar to Delaware’s, which likewise preclude the statute of frauds from applying to LLC operating agreements.[8] Other states, however, continue to apply the statute of frauds to LLCs in appropriate cases.[9]

The degree of formality required with respect to LLC operating agreements involves difficult tradeoffs:

As a matter of policy, there is something to be said for permitting oral operating agreements to the extent a writing requirement can frustrate the parties' expectations. On the other hand, permitting oral operating agreements can significantly increase litigation costs because of the need to prove the oral statements that comprise the agreement. Furthermore, oral agreements make it difficult for new members to ascertain the terms of the firm they are entering. Even if the initial agreement is in writing, allowing its oral modification creates equivalent problems.[10]