The Basics of Bylaws and Operating Agreements
Corporations and limited liability companies ("LLCs") are very important business entity types. Each type of business entity has its own way of operating. For example, do the owners of the corporation (known as shareholders) elect the directors to the board of of directors? Are the directors considered employees of the corporation? With an LLC, is it a member-managed or a manager-managed LLC? These are all questions whose answers depend on the provisions in a business entity’s bylaws or operating agreement.
Bylaws and operating agreements are internal governing documents. In essence, every corporation has bylaws, and every LLC has either a operating agreement or an articles of organization that serves to govern its day-to-day operations. Generally speaking , bylaws for corporations govern the day-to-day operational aspects of corporations, while operating agreements govern the operations of an LLC. Bylaws define the internal structure of the corporation. They generally set forth how many corporate officers there need to be and what those officers are (such as President, Secretary, Vice-President, etc.), how often corporate meetings have to happen, and how these meetings will be conducted. Operating agreements govern how much control each member or manager of the LLC has within the LLC. They govern who can make decisions for the LLC, such as managing the day-to-day affairs and making binding contracts on behalf of the LLC.
The Purpose of Bylaws
Bylaws are internal rules or administrative codes adopted by corporations for their governance and management. Containing the day-to-day and detailed procedural rules for the company’s internal affairs, bylaws govern the rights and responsibilities of directors, officers, and shareholders. In many instances they may not reflect the most current expectations for best practices, but may be amazing in their succinctness.
Specifically, bylaws address the procedures for how the corporation will conduct its business, including rules for meetings, board elections, voting, shareholder benefits, transfers of stock, and the replacement of directors or officers. While bylaws are not a requirement for corporations formed in accordance with the New York Business Corporation Law (the "BCL") designating which state laws apply to them (and therefore not explicitly "required" by New York law), they nonetheless tend to be adopted in most companies for the sake of being organized, flexible and having a uniform operational plan.
Bylaws are primarily a mechanism for controlling the actions of internal parties. A corporation may adopt bylaws that differ from or elaborate on statutory rules without violating those rules.
There is no requirement that the bylaws be filed or recorded with any governmental authority. However, they are an important part of the corporation’s records and are, therefore, required to be kept at its principal place of business or registered office.
The Purpose of Operating Agreements
The purpose of an operating agreement is to provide a formal set of terms for running the business. In LLCs, operating agreements are becoming more common because they set out who owns what percentage of the business, what each member’s responsibilities are, and how the business will be run on a day-to-day basis. An operating agreement also provides the most flexibility in terms of business operation. If a business file as a partnership, it has to follow the rules regarding an LLC or other forms of business listed above in order to change any terms of ownership, membership, or operation of the business.
Main Differences Between Bylaws and Operating Agreements
Bylaws and operating agreements serve different purposes and core business structures. Further, bylaws and operating agreements are not interchangeable, so it’s important to understand when an operating agreement is appropriate (as well as when a buy-sell agreement is required). For example, the operating agreement is a flexible document that can include almost anything you want. In contrast, bylaws spell out the structure of a corporation and how it operates. For business owners, this means bylaws are more rigid than operating agreements.
These are some other key differences between bylaws and operating agreements:
Bylaws apply to corporations (C corporations and S corporations). While bylaws may govern the operations of any type of business, both the Delaware Laws of Corporation (Section 109) and the Pennsylvania Business Corporation Law (Section 1501) state that the shareholders of a corporation shall establish the bylaws for the corporation. Thus, bylaws apply to corporations.
Operating agreements apply to limited liability companies (LLCs). Section 17-101(d) of the Delaware LLC Act states that the "members may adopt a limited liability company agreement, also known as an operating agreement." Section 8962.1(a) of the Pennsylvania Limited Liability Company Law of 2013 also states that the "members of a limited liability company may enter into an operating agreement for the limited liability company." Thus, operating agreements apply to LLCs.
The laws governing corporations (including the Pennsylvania Business Corporation Law and the Delaware General Corporation Law) typically require bylaws. Moreover, most, if not all, states generally require corporations to keep copies of their bylaws at their principal executive office or available on request. Thus, bylaws are required for corporations.
In contrast, the laws governing LLCs (including Pennsylvania Limited Liability Company Law of 2013 and the Delaware Limited Liability Company Act) do not require or make any mention of operating agreements. However, the members of an LLC may adopt an operating agreement and operating agreements are recommended by the IRS and operating agreements should be adopted by LLCs to ensure continuity upon the death or disability of one of the members.
In summary, bylaws are typically required for corporations while operating agreements are recommended (but not required) for limited liability companies.
Legal Considerations and Compliance
In terms of legal requirements, bylaws are most commonly required for corporations, while operating agreements are required for LLCs. Some states have specific provisions that outline the required contents of bylaws and operating agreements, but neither document has to be registered with the state. For example, in California, bylaws must contain information regarding the types of shareholders, rules and procedures for voting, how directors and officers are chosen and removed from office, the powers of shareholders, directors and officers, and how financial reports should be processed. Certain states, such as Colorado, do not require corporations to have bylaws at all. Pennsylvania and New York have no laws requiring LLCs to have operating agreements.
Most states do not have mandatory rules about the content of bylaws or operating agreements , but many stipulate that both documents must include provisions explaining how a corporation or LLC should, respectively, go about winding up business and distributing its assets, which is how a business is dissolved and how outstanding debts are paid off.
Corporations and LLCs are required to maintain their bylaws and operating agreements at their principal place of business but they do not need to file these documents with the state. If a business cannot produce these documents when requested by its members, shareholders or the court, it could incur penalties or negative repercussions. In addition to state-mandated penalties, failure to follow the rules and procedures included in these governing documents could compromise the protection afforded by limited liability against personal liability.
Drafting Effective Bylaws and Operating Agreements
When drafting bylaws and operating agreements, it is essential to consider the specific needs and goals of the business. These documents are not one-size-fits-all solutions, but rather tailored instruments that should reflect the unique circumstances of each entity. To draft effective bylaws and operating agreements, here are some guidelines to follow:
- Thoroughly Understand the Business: Before drafting, take the time to understand the business structure, ownership, and management. This understanding will allow you to tailor the documents to the specific needs of the entity.
- Customize Provisions: While there are common provisions that appear in most bylaws and operating agreements, such as those regarding the board of directors, decision-making, and ownership structure, be sure to customize these provisions to reflect the specifics of your business.
- Anticipate Future Growth: Consider how the business may evolve over time and include provisions that allow for the addition of new owners, employees, or other stakeholders. Having a plan in place for the future will help prevent conflicts and ensure smooth transitions.
- Review Regularly: Bylaws and operating agreements should not be set in stone. Schedule regular reviews to update the documents as needed to reflect changes in the law, the business, or the ownership structure.
Amendments and Updates
Amendments and Updates to Bylaws and Operating Agreements
Different entities have different processes for making amendments. Corporations typically allow amendments during meetings of the board or shareholders of the corporation, while an operating agreement can be modified as a matter of law if the remaining members agree. That said, in both cases, amendments must be made in accordance with the agreement governing the entity.
Why should you consider adopting an updated operating agreement or bylaws? Over time, your business may grow, shrink, or change dramatically. For instance, if the business begins to enter into contracts with other businesses, hiring employees, purchasing physical assets, or obtaining sources of financing, your business may need additional protection in your operating agreement or bylaws to deal with those transitions. Alternatively, if the business is dissolving or eliminating operations that are no longer profitable, its governance documentation may need to address the winding down of affairs.
Additionally, amendments to protect the business from conflicts amongst owners or customers may periodically need to be adopted. For instance, when providing products or services to other businesses, if a customer were to face insolvency or other financial issues, a business’ operating agreement or bylaws may be able to determine how profits or cash flow from that customer can be secured for the benefit of the company to preserve the business’ interests.
When a membership/shareholder conflict requires a buyout of one of the business owners or a potential sale of the business, an operating agreement or bylaws may provide the mechanism through which a business is required to make such changes. Alternatively, if a business was to go into an insolvency or bankruptcy, the documents would determine how the business is wound down or sold.
When amending an operating agreement or bylaws, one must review the current version to determine the applicable amendment requirements. Generally, these include the number of owners necessary to effectuate an amendment, whether notice requirements apply, and the process to provide such notice. In some cases, the entire business may be required to update its agreements due to changes in law.
The Importance of Documentation
Bylaws and operating agreements exist to protect a business and to ensure smooth day-to-day operations. If a business runs into trouble – whether due to legal reasons or an internal conflict – corporate documents can make all the difference. That is why business owners should think carefully about how their bylaws and/or operating agreements are implemented.
For example, when starting a new business , the potential importance of the operating agreement may not seem clear. Many LLC members do not identify the operating agreement as their business’s most important document. But a misunderstanding of how much value an operating agreement can deliver should not stop the members from creating a document that could protect the owners from internal disputes.
The same is true when starting a corporation. Corporate bylaws can help directors and officers manage affairs that otherwise would have the potential for conflict. For the single-member corporation, the corporate bylaws can clarify the process by which a shareholder may make decisions. Even when there is only one shareholder, a written agreement can help ensure the one-person corporation has clear governance rules.
