Sunday, June 26, 2011

Small Business Horror Story #1: Shady Partner + Generic Operating Agreement = Disaster

This is a re-post from one of my favorite Business Attorneys (other than myself) Gina Bongiovi out of Las Vegas, Nevada.  She tells a story I have come across all too often.

When I sign a new monthly retainer client, I always conduct what I call a "legal checkup" on the business.  I review the company's formation, licensing, employee or contractor agreements, lease agreements, service agreements, etc. to find ways I can better protect the company and its owners. 

Wait, let me clarify.  I *request* these documents in order to review them.  Often, it takes the owners a while to gather all the information to give me and sometimes they simply ignore my requests, preferring that I instead put out fires.  While I'm great at putting out fires, my real value lies in working proactively - modifying these documents to better protect the company before a fire breaks out.

One particular client was in an LLC with another person.  We'll call them Jack and Bill.*  Jack requested the initial meeting with me, apparently without telling Bill.  Bill walked in during our meeting, demanded to know "who the hell" I was, and threw a fit, yelling at the top of his lungs that "we don't need no &*%$ attorney!"  Following that outburst, I gently asked Jack to send me a copy of the company's operating agreement.  He said it was the one that came with the corporate binder he got when he formed the company and he had no idea where the binder even was.  Seeing the writing on the wall, that this partnership was going to crumble sooner rather than later, I made a more urgent request to see the operating agreement.  And I requested the operating agreement every few days for the next two months with no response.

A month ago, Jack called to say Bill was leaving the company.  I again asked for the operating agreement to make sure Bill's exit was in compliance with its terms.  I also suggested that Bill be removed as a signer on all company bank accounts as soon as humanly possible.  No response.  

Last week Jack called in a panic.  While he was at the bank removing Bill as a signer on the account, Bill was at a different branch, withdrawing $21,000 in cash from the company's checking account.  

Because Bill was still a signer on the account, the bank had no choice but to give him the money.

Because the operating agreement didn't restrict an LLC member's ability to take money out of the account, Bill didn't breach any agreement.

And because Bill pulled the money out in cash, there was no way to stop payment.

Jack's only option would be to file a lawsuit against Bill, hope that he wins, and then hope that he could collect the money.  Of course, a lawsuit would drag on for months and more likely years, tying up company resources in what is probably a losing battle.  Plus, even if Bill lost, he could file bankruptcy and then the company would have lost the original $21,000, plus attorney fees, plus time lost while embroiled in a lawsuit.
Lessons learned:  

1) make sure your operating agreement is thorough and addresses issues like when a member can take money out of the account,

2) if someone leaves the company, remove them from the bank account IMMEDIATELY.  Unless you notify the bank that someone is no longer an owner, the banker has no way of knowing not to give an owner access to company funds. 

* Names have been changed to protect the innocent.

You can read Gina's original post at Shady Partner + Generic Operating Agreement = Disaster

If you have any questions or concerns about any of the above, you can contact me at (800) 730-5691 or The Out-House General Counsel.