An Operating Agreement that includes three things is destined to cause problems. My practice is 100% litigation and trial of business and commercial disputes. However, I have had the same conversation with new clients hundreds of times about how they ended up in my office. Many cases that end up in litigation were destined for it from the very beginning.
I do not draft Operating Agreements or contracts. However, I litigate these issues when things go wrong. So, here are the 3 things I have seen repeatedly in Operating Agreements that should be avoided at all costs.
1. A Mandatory Arbitration Clause
The American Arbitration Association and other groups push arbitration as an inexpensive and efficient alternative to litigation in court. I’ve represented clients in numerous arbitrations over the last 20+ years. In my opinion, arbitration is neither inexpensive nor efficient.
Arbitration is prohibitively expensive. It’s usually not much quicker than going to trial in state court. In addition to paying for your lawyers, you must pay fees for the arbitrator’s time. You also have to pay fees to the arbitration company. These are much higher than filing fees in state court. I’ve had it happen where the arbitrator’s fees were more than my fees, and I was doing all the work.
If you want to have the option of arbitration, include an optional provision in the Operating Agreement. However, if arbitration is mandatory, it’s like the Hotel California. You can check-in, but you can never leave. You’re stuck in arbitration and a court will, most times, force you to continue in arbitration.
2. A Forum and Choice of Law Provision in Timbuktu (or worse, Delaware)
Forum and Choice of Law provisions are important. A Forum is where a case must be brought if there is a dispute. Choice of Law is the law that the court will apply to the dispute. Both Forum and Choice of Law should generally be the city and state where the parties are doing business. However, I frequently see contracts and Operating Agreements with a Forum and Choice of Law provision in Delaware when no one has any connection there. I was involved in a case with an Operating Agreement that contained such a provision. A Colorado court enforced it. We ended up litigating a case in the Delaware Chancery Court when neither party had even been to Delaware. This was entirely avoidable. There’s no reason to include it in an Operating Agreement.
3. An Ambiguous or Non-Existent Buy-Out Provision in the Operating Agreement
An Operating Agreement should include a mechanism to value an owner’s interest for a buy-out. Whether it’s a forced buy-out or a voluntary buy-out, a mechanism that provides for a process to value the ownership interest can avoid litigation. I’ve seen Operating Agreements that express the value as a formula, provide a streamlined process for valuation by providing for the pre-selection of a valuation expert, or provide for a process to value the equity outside of litigation. It’s equally important that the mechanism or formula is clear (see an example here of what happens when it isn’t clear).
When an Operating Agreement contains a mandatory arbitration provision, a forum selection provision in a remote location, or a non-existent or ambiguous buy-out provision, the resulting litigation ends up being needlessly costly or complicated. These problems are avoided with a thoughtfully written Operating Agreement.