Start-Up Entrepreneur Series: Governance Documents

In the Start-Up Entrepreneur Series, I will be taking a deeper look into some of the most common questions early stage founders face in putting together and operating their new businesses.  

Start-Up Entrepreneur will be published each Wednesday morning until conclusion. For more information, check out www.hoeglaw.com or drop Rick a line at rhoeg@hoeglaw.com.

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The day-to-day operations of a business are dependent on many things: market trends, customer relations, vendor management, the CEOs mood.  But from a legal perspective, the operations of a company (whether a corporation or LLC) are governed at the highest level by the interactions of two or three primary sets of rules set forth in only two or three primary sets of documents.  While we’ll get into the details of what these rules can permit (or prohibit) later in the series, it is important, first, to get an overview of how they generally interact.

The Law – The External Supreme Rule

This category of rule is likely obvious to you.  Just as an individual is not permitted to break the law (without penalty), a corporation or LLC is not permitted to break the law.  The difference is that corporations and LLCs don’t really exist. Not really.

Corporations and LLCs are creatures created entirely out of the law (“legal fictions”).  Their rights, powers, and obligations are established in the law and nowhere else. Because of this, both corporations and LLCs can have their actual existence called into question if they are not careful to follow the law’s various rules.

For instance, as mentioned in our discussion of “corporate formalities” here, state corporation statutes generally require corporations to conduct annual meetings (see here for the relevant Michigan statute).  If a corporation fails to regularly hold those meetings (or fails to abide by a host of other statutory requirements), the state or even one of its own stockholders could challenge its very existence.  If successful, such a challenge could subject the corporation’s stockholders to liability for the debts and obligations of the corporation (which has been deemed not to exist).

Outside of everything else discussed below, then, it is quite important for a corporation or an LLC to, above all else, follow the law.

Certificate (Articles) of Incorporation – The Internal Supreme Rule

While the state of civics education in America might sometimes be put into question, most folks can identify the Constitution of the United States as the “supreme law of the land”.  In practice, “supreme” in such case means that a legislature (federal or local) attempting to draft a law counter to the terms of the Constitution will have such law struck down as unenforceable by the courts.  A corporation’s Certificate of Incorporation is its constitution.

(Note that different states refer to this foundational document by different terms.  A Delaware corporation will be founded by filing a Certificate of Incorporation, while a Michigan corporation will be founded by filing Articles of Incorporation.  Their function is identical (within the parameters set forth under their respective laws).)

Like the U.S. constitution, a corporation’s Certificate of Incorporation may not be contravened.  Attempts to do so, either in adopting bylaws violative of the Certificate, or by attempting to take otherwise unauthorized actions, can be challenged as “ultra vires” or “beyond the powers” of the corporation.  If the corporation has been found to have acted ultra vires, the action in question (or the bylaw adopted) may be rolled back by the courts.

Because of this, like the U.S. constitution, a Certificate of Incorporation generally contains the corporation’s most important governance terms: equity rights, board composition, economic preferences, voting thresholds, and similar.  As the Certificate of Incorporation is generally the most difficult governance document to amend, such rights are the foundation on which the corporation is built.

Bylaws – The Corporation’s Own Laws

Keeping with our U.S. law metaphor, the bylaws of a corporation are equivalent to the laws passed by a legislature to govern day-to-day operations.  They are generally more easily amended than the corporation’s Certificate of Incorporation, and cover items which, while important, are not as critical to the very nature of the corporation and/or its stockholder’s interests therein.  As they are “below” the Certificate of Incorporation in legal power, they are not permitted to contravene any rules set forth in such Certificate.

Topics covered by the bylaws of a corporation generally include items such as: the roles of officers, details surrounding the keeping of books and records, conduct of stockholder and board meetings, and similar day-to-day items.

Though a “lower” form of law than the Certificate of Incorporation, bylaws are still generally considered to be a contractual commitment between the corporation and its stockholders.  Because of this, violations of such bylaws (without going through the appropriate amendment process) may still result in an “ultra vires” roll back.

LLC (Operating) Agreement – Constitution and Laws as One

Though an LLC is initially formed through the filing of a Certificate of Formation, Articles of Organization, or such similarly named document, the filing itself does not traditionally take the same place as a corporation’s Certificate of Incorporation.  Instead,  LLC laws usually specify that the parties forming such an entity are to be bound by the rules of an LLC Agreement (or Operating Agreement) which will be given maximum effect under the laws of the applicable state.

(“Maximum effect” here means, in general, that the state courts will attempt to enforce all provisions found in an LLC Agreement that are not directly violative of the state’s public policy.  In other words, draconian economic terms will be enforced, agreements to allow members to murder each other will not.)

An LLC Agreement, then, does not bear the distinction between “constitution” and “laws” that we see in the corporate form.  Such an agreement generally carries both the “high level” governance terms we see in a Certificate of Incorporation (equity rights, economic preferences, etc.) and also the “low level” day-to-day operations rules we see in corporate bylaws (officer roles, meeting times, etc.)

This is, in some ways, a cleaner approach, but it can leave important terms subject to amendment in unexpected ways if not carefully drafted.

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I hope this brief overview of the types of documents governing the operations of both corporations and LLCs has proven useful to you. As always, if you’d like to discuss please leave a comment down below or contact me at rhoeg@hoeglaw.com.  I’d love to hear your thoughts.

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