LLC Law Monitor : Northwest Limited Liability Company Lawyer & Attorney : Doug Batey : Stoel Rives Law Firm : LLC Formation, Tax Liability

LLCs are sufficiently new that issues of first impression continue to come up in various states. One of those issues is whether common law fiduciary duties apply to LLCs, when the state statute is silent or unclear. That was the situation in Wisconsin, when the defendants in a case before the U.S. District Court for the Eastern District of Wisconsin contended that common law fiduciary duties do not apply to Wisconsin LLCs and that they therefore owed no fiduciary duties to the plaintiff. Executive Ctr. III, LLC v. Meieran, No. 10-CV-263-JPS, 2011 WL 4704274 (E.D. Wis. Oct. 4, 2011).

The dispute arose out of the plaintiff’s $1.2 million purchase of an office building from BRIC Executive, LLC. In connection with the sale, BRIC agreed to lease office space back from the plaintiff (Executive Center). But BRIC defaulted on its lease obligations almost immediately and made no rent payments. Executive Center sued BRIC on the lease and obtained a judgment for $152,000, but BRIC was insolvent and never paid on the judgment.

Executive Center then investigated and learned that the defendants, part owners of BRIC, had been paid $400,000 by BRIC immediately after the closing of the real estate sale. BRIC paid the $400,000 to the defendants in order to redeem their part ownership in BRIC, under an agreement made by BRIC and the defendants 11 months before Executive Center’s real estate purchase.

Executive Center next sued the defendants in federal court, challenging the $400,000 transfer from BRIC to the defendants and seeking an award of damages. (The case was filed in federal court on the basis of diversity jurisdiction; no federal law issues were involved.) Executive Center claimed that by accepting the $400,000, the defendants (1) violated portions of Wisconsin’s Uniform Fraudulent Transfer Act; (2) breached a fiduciary duty they owed to the plaintiff; and (3) benefited from an inequitable preference. Id. at *2.

After pretrial discovery the defendants moved for summary judgment on all of Executive Center’s claims. The court granted summary judgment to the defendants on the fraudulent transfer claim and on the inequitable preference claim, but denied summary judgment on the fiduciary duty claim.

The gist of Executive Center’s fiduciary duty claim was that the defendants breached fiduciary duties they owed to Executive Center, a BRIC creditor, when they accepted BRIC’s payment of $400,000 at a time when BRIC was insolvent. The defendants argued that “common law fiduciary duties do not apply to Wisconsin LLCs because LLCs are purely statutory creatures that have their duties defined entirely by statute.” Id. at *7 (citing Gottsacker v. Monnier, 697 N.W.2d 436, 447 (Wis. 2005)). The defendants also pointed out that Wisconsin’s LLC Act does not expressly state that common law fiduciary duties apply to LLCs, other than referring to the Act’s incorporation of veil-piercing principles. Id.

The District Court distinguished Gottsacker, however, pointing out that its only discussion of the applicability of common law fiduciary duties to LLCs was in one Justice’s concurring opinion. The court then examined precedent from other jurisdictions, finding it persuasive: “In fact, there is growing consensus that common law fiduciary duties should apply to the operations of LLCs.” Id. at *8 (citing seven cases from Indiana, Kentucky, California, Connecticut, and Idaho). The court also looked to the policy supported by fiduciary duty rules. “Fiduciary duties exist to protect people who are affected by the actions of those who control businesses. Therefore, it would not make any sense if the expectation for a business to act fairly were to be different simply due to the business owners’ choice of form – an LLC, in this case.” Id. at *9 (citation omitted). The court concluded that common law fiduciary duties apply to Wisconsin LLCs. Id.

The court next considered whether any duties were owed to Executive Center in particular. (Executive Center was a creditor of BRIC, not a member.) Under Wisconsin case law, the defendants would owe a fiduciary duty to Executive Center if (a) BRIC was insolvent at the time of the $400,000 transfer, and (b) BRIC had ceased to act as a going concern. The court had already found that BRIC was insolvent at the time of the transfer, and defendants had conceded that there was an issue of fact regarding whether BRIC was no longer a going concern at the time of the transfer. The court therefore found that genuine issues of material fact remained, and denied defendants’ summary judgment motion on the fiduciary duty claim, which meant that the issue could go to trial.

This case is a nice example of a court resolving a question left unanswered by the state’s LLC Act. (I have written about this issue before, in connection with the Idaho case cited by the Executive Center opinion, here.) It’s also not a surprising result – it’s difficult to imagine a court finding that fiduciary duties do not in general apply to LLCs.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Business acquirors sometimes give the acquired company’s management financial incentives to enhance the acquired company’s value. These are often structured as bonus compensation for achieving defined milestones, and sometimes include equity in the acquired company or in the buyer.

In a recent Ohio case the buyer of a company’s assets provided incentive compensation to the company’s management, based on the profits of a division of the company. The employee was later terminated, and claimed the company had entered into a partnership with him and then breached its fiduciary obligations.

Although the contract never referred to a “partnership,” the court held that the incentive compensation provisions created a partnership between the buyer and its employee. Rhodes v. Paragon Molding, Ltd., No. 24491, 2011 Ohio App. LEXIS 3553 (Ohio Ct. App. Aug. 26, 2011). And once the court determined that a partnership existed, the door was opened to the former employee’s claims of breach of fiduciary duty.

Huntin’ Buddy Industries was a seller of turkey and duck calls designed by Roy Rhodes, one of its owners. In 2004 Huntin’ Buddy sold its assets to Paragon Molding, Ltd., an Ohio LLC. As part of the acquisition, Rhodes entered into a five-year employment agreement with Paragon. In the asset sale agreement Rhodes was given profit-sharing rights based on the “Roy Rhodes Championship Call division” (Division).

Fifteen months after the acquisition, Paragon terminated Rhodes’ employment and contended that his profit-sharing rights in the Division were also terminated. Rhodes sued, claiming that the profit-sharing provisions in the asset purchase agreement had created a partnership between Rhodes and either Paragon or its executive officers, and that Paragon and its principal officers had breached their fiduciary obligations to him. The trial court ruled on summary judgment that no such partnership or fiduciary duty existed.

The Court of Appeals first stated the Ohio partnership rule:

A partnership exists when there is (1) an express or implied contract between the parties; (2) the sharing of profits and losses; (3) mutuality of agency; (4) mutuality of control; (5) co‑ownership of the business and of the property used for partnership purposes or acquired with partnership funds.

Id.at **7 (quoting Grendell v. Ohio EPA, 146 Ohio App.3d 1, 764 N.E.2d 1067 (2001)).

The court pointed out that the parties had no express partnership agreement, and then examined the relevant provisions of the Huntin’ Buddy asset purchase agreement. The salient terms were:

1.         “Rhodes will maintain 35% of the value of the [Division].”

2.         “Should [the Division] be sold, Roy Rhodes will be entitled to 35% of the net purchase price related to the [Division].”

3.         “Should [Paragon] be sold as an entirety including [the Division], Roy Rhodes will be entitled to 35% of the net value of the [Division] only.”

4.         “Should any profits be distributed from the [Division], Roy Rhodes will be entitled to 35% of said profits after taxes.”

Id.at **10.

The court’s analysis focused on the co-ownership requirement. The agreement did not say that Rhodes “owns” 35% of the Division. But, said the court, the language “Rhodes will maintain 35% of the value” of the Division meant that the parties intended for Rhodes to retain ownership of 35% of the Division. That interpretation was also supported by the clause that Rhodes is entitled to 35% of distributions of Division profits.

There was also a deposition in the case that may have been the final nail in the coffin of Paragon’s argument. One of Paragon’s owners agreed in his testimony that Rhodes “owned thirty-five percent” of the Division. The Court of Appeals noted that “even the owner of Paragon intended for Rhodes to retain a thirty-five percent ownership interest” in the Division. Id. at **12.

So the court found that an implied partnership had been created. “Accordingly, this evidence supports a conclusion that an implied partnership existed between Rhodes and Paragon such that Rhodes was entitled to ownership of thirty-five percent of the company itself, thirty-five percent of any profit distribution instituted by the company, and thirty-five percent of the net profits generated during the sale of the company.” Id. at **12-13.

Partners in a partnership owe each other fiduciary duties, id. at **7-8, and the court found ample evidence in the record to create a genuine issue regarding whether Paragon had breached its fiduciary duties. For example, Paragon purported to strip Rhodes of his 35% interest when it terminated his employment, and Rhodes was excluded from any involvement in or information about the Division. Result: The Court of Appeals reversed the trial court’s summary judgment dismissing Rhodes’ fiduciary duty claims, and sent the case back for a trial on Rhodes’ fiduciary duty claims.

The court didn’t discuss what type of entity Paragon was, so the result presumably would have been the same if Paragon had been a corporation instead of an LLC. But Paragon’s LLC status may have affected the phraseology used by the drafter of the incentive compensation language. The clause on distributions of profits in particular sounded like it could have come from a partnership or LLC operating agreement: “Should any profits be distributed from the [Division], Roy Rhodes will be entitled to 35% of said profits after taxes.” Although this clause does not directly refer to ownership of the Division, it satisfies part of the definition of a partnership and provides additional support for the court’s conclusion.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Last year the New York Appellate Division ruled that LLC organizers are fiduciaries of the investors they solicit to be members, and that as such they have a duty to disclose their self-dealing. Roni LLC v. Arfa, 903 N.Y.S.2d 352 (App. Div. 2010). I reported on the case, here.

The Roni decision was critiqued by New York lawyer Peter Mahler, who blogs on New York business law, here, and by law professor Larry Ribstein, here. To oversimplify a bit, the gist of the criticism is that the rule of the old corporate cases, on which the Roni court relied, (a) has been made unnecessary by the disclosure rules of federal and state securities laws, and (b) should not apply to LLCs because the contractual nature of the relationship between LLC members allows them to allocate risks and define duties inter se, which is not characteristic of corporations.

Roni has since been appealed to New York’s highest court, the New York Court of Appeals. Oral arguments in the case were heard by the court on November 15, 2011, and yesterday Peter Mahler blogged on the briefing and the oral arguments, here. His article is a fascinating review of the oral arguments before the high court. The judges’ questions apparently ranged widely from “Why should LLCs be treated differently?” to concerns over line-drawing and the reach of the Roni rule articulated by the Appellate Division.

So now we wait for the high court’s decision, which Peter Mahler predicts will likely be in the early months of next year. One can hope, if the Appellate Division ruling is upheld, that the court will provide some guidance on the scope of the Roni duty to disclose.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Judge Karas thoroughly dissects the plaintiff’s derivative and other claims in Cordts-Auth v. Crunk, LLC, No. 09-CV-8017, 2011 U.S. Dist. LEXIS 109600 (S.D.N.Y. Sept. 27, 2011). The opinion usefully sheds light on some of the corners of New York law on LLC derivative suits.

Plaintiff Renate Cordts-Auth filed suit on September 18, 2009, asserting: 

●         derivative claims for breach of fiduciary duty, tortious interference with contract,   and legal malpractice;

●         a direct claim for breach of contract; and

●         equitable claims for an accounting, access to records, and a declaratory judgment that she was a member of Crunk, LLC at the time of the claimed wrongdoing.

The defendants moved to dismiss the lawsuit, and for purposes of the dismissal motions the court assumed the truth of the following facts, as asserted in the complaint.

Background.  Cordts-Auth was a long-time employee of Sidney Frank Importing Company (SFIC), and also assisted its owner Sidney Frank in the operation of Crunk, LLC, a New York limited liability company. In 2005 Cordts-Auth was granted Performance Units in Crunk as consideration for her services. Her interest in the Performance Units was limited to the company’s post-grant-date appreciation, based on an appraisal at the time of grant.

Sidney Frank, the CEO of SFIC and Crunk, died in 2006. His daughter Catherine Halstead (Halstead) became Chairwoman of SFIC and manager and principal executive of Crunk. Her husband, Peter Halstead, became an advisor to Crunk’s management, including Cordts-Auth. Two months later, Peter informed Cordts-Auth that Halstead intended to devalue Crunk’s Performance Units and issue new units, to restructure Crunk and re-launch the company with new investors, and to defraud Crunk’s existing investors.

Cordts-Auth informed Halstead of her objections to the restructuring in February, 2007. Shortly thereafter she was removed by Halstead from her positions at SFIC and Crunk. A month later Cordts-Auth, SFIC, and Crunk entered into a separation agreement, under which Cordts-Auth agreed to resign from her positions with the companies and was paid $2 million.

Three weeks after execution of the separation agreement, Halstead wrote to Cordts-Auth. Halstead informed her that Crunk had lost $1.5 million in 2006, that Crunk had been projected to lose its remaining cash investments during the upcoming fiscal year, and that Crunk had been sold to Solvi Brands, LLC as of February 28, 2007, nine days before the date of the separation agreement. Cordts-Auth was informed that she would receive nothing for her Performance Units because the Crunk sale proceeds were less than the minimum required for the Performance Units to have any value. Two months later Crunk was dissolved.

In February 2009 Cordts-Auth requested from the re-launched Crunk an accounting of Crunk’s sale proceeds. In March 2009 she demanded a copy of the sale agreement between Crunk and Solvi, and the identities of all former interest-holders in Crunk and all current interest-holders in Solvi. Her requests were rejected and she filed the lawsuit several months later.

Analysis.  The court began by reviewing Cordts-Auth’s claims to determine whether they were direct (made in her own right) or derivative (asserted on behalf of the LLC). The court applied New York law because Crunk was a New York LLC. Under New York law, a claim is considered to be derivative if the claim is for wrong done to the LLC. Id. at *15. The court viewed Cordts-Auth’s claims for breach of fiduciary duty, tortious interference, and legal malpractice as claims for injury to the LLC, and therefore characterized them as derivative claims.

Standing.  The court next examined whether Cordts-Auth had standing to maintain the derivative claims. New York law requires that the plaintiff in an LLC derivative suit must have been a member of the LLC both at the time of the offending conduct and at the time the lawsuit is commenced, Id. at *17. (Many states, e.g. Delaware and Washington, have similar requirements.)

Crunk’s operating agreement set forth the requirements for an individual to be admitted as a member. The agreement required that Crunk’s Board determine the nature and amount of the Unit Consideration to be made by the individual, and the Unit Consideration must be received by the LLC. Unit Consideration is defined to be “cash or property” – services are not included. The Board made no such determination in Cordts-Auth’s case, and no Unit Consideration was paid by Cordts-Auth.

Crunk’s operating agreement also required that members holding two-thirds of Crunk’s Class A Units consent in writing to the admission of a member. That never happened. Cordts-Auth pointed out that she was listed on the operating agreement’s exhibit as a member, but the court found that the exhibit did not overcome the operating agreement’s clear membership requirements.

The court concluded that Cordts-Auth never became a member but instead was an assignee, a non-member holder of Performance Units. “Therefore, Plaintiff has failed to adequately plead that she ever attained membership in Crunk, and the Court dismisses her derivative claims on this ground alone.” Id. at *25-26.

Not content to rest on that branch of the analysis, the court also examined Cordts-Auth’s status at the time of filing the lawsuit. Cordts-Auth didn’t dispute the defendants’ contention that she was not a Crunk member when she filed suit, but she asserted that she fell within an equitable exception that applied where the transaction was fraudulent. The court found that although Delaware recognizes the equitable exception, no New York courts had applied a fraud exception to a New York LLC.

But even assuming that New York courts would apply an equitable exception to the continuous ownership requirement, the court found that Cordts-Auth did not fit into the exception. The fraud exception applies if the transaction was fraudulent and the transaction was done merely to eliminate derivative claims. Cordts-Auth alleged that the transaction was fraudulent, but not that its purpose was to eliminate derivative claims. She had no claims pending at the time of the Crunk sale, so eliminating a potential derivative suit was unlikely to have been the motivation for the transaction. Id. at *31.

Another equitable exception can apply if both the acquired company and the surviving company have engaged in wrongful or fraudulent conduct. The court found that Cordts-Auth did not allege any wrongful or fraudulent conduct by Solvi, the surviving company, so this exception did not apply. Cordts-Auth therefore lacked standing to pursue the derivative claims. Id. at *33.

Demand Requirement.  Although the court found that Cordts-Auth did not have standing because she was not a member of Crunk at either of the required times (time of wrongdoing, and time of commencement of suit), it nonetheless proceeded to analyze whether Cordts-Auth had satisfied the demand requirements of a derivative lawsuit, and concluded that she had not.

There are two elements of the demand rule. The first component is procedural. Federal Rule of Civil Procedure 23.1 and the New York Business Corporation Law both require that a complaint which asserts a derivative claim must state with particularity the plaintiff’s efforts to obtain the desired action from the LLC’s managers, and the reasons for not obtaining the action or making the effort. The second component is substantive and addresses whether the demand was adequate to inform the managers of the potential cause of action so they could address the claim.

The defendants also contended that Cordts-Auth had a conflict of interest, because she was asserting on behalf of the LLC its claims against alleged wrongdoers, while at the same time pursuing her own personal claims directly against the LLC. The court dismissed that contention, because Cordts-Auth no longer held any interest in Crunk and would not receive any return as a member from the LLC’s claims.

The court found that Cordts-Auth’s complaint satisfied the particularity requirement, because it had adequate details about her demands and included copies of two demand letters she had sent to the defendants. But the substance of her demand was inadequate because it did not clearly relate to the derivative claims she was seeking to assert. She had demanded documents and information about the Crunk sale but had not mentioned potential causes of action or damages.

Cordts-Auth argued that demand would have been futile, which can excuse a failure to make demand. The court rejected this argument because Cordts-Auth did not fail to make a demand, but rather had made an inadequate demand that was refused by management. “Accordingly, the Court finds that Plaintiff has not satisfied the demand requirement, as required under New York law, and that she therefore may not pursue her derivative claims.” Cordts-Auth, 2011 U.S. Dist. LEXIS 109600, at *48.

Substance of Claims.  After holding that Cordts-Auth’s derivative claims failed both because she lacked standing and because she had not satisfied either of the demand requirements (particularity and adequacy), the court then discussed the substance of some of her derivative claims in a long footnote 14. Id. at *48-53. The court didn’t rule on those issues, but expressed its skepticism about their viability.

Cordts-Auth claimed that both Crunk and Solvi breached fiduciary duties that they owed to her. Under New York law, corporations do not owe fiduciary duties to shareholders. Apparently no New York court has addressed the analogous issue for LLCs, but the court found it reasonable to extend the corporate rule to LLCs. Neither Crunk nor Solvi owed fiduciary duties to Cordts-Auth, so there could be no breach of fiduciary duties.

Cordts-Auth claimed that Solvi and the Solvi investors had tortiously interfered with her Crunk operating agreement, by inducing Crunk to sell its assets to Solvi in violation of the operating agreement. The court found it doubtful that Cordts-Auth could demonstrate that the Solvi investors induced the sale of Crunk to Solvi merely by investing in Solvi, and questioned whether the sale constituted a breach of the Crunk operating agreement.

Cordts-Auth also asserted a constructive trust claim, on the theory that her Performance Units were wrongfully transferred, but the court rejected that claim because the Performance Units were not transferred but were canceled when Crunk was dissolved.

Breach of Contract.  Cordts-Auth asserted a direct claim, in her own right, for breach of contract against Crunk and Halstead. She alleged that their failure to give her notice of Crunk’s impending sale to Solvi violated Crunk’s operating agreement.

The court dismissed Cordts-Auth’s breach of contract claim against Crunk because Crunk was not a party to its operating agreement, which is an agreement between the Crunk members. “The plain language of the Crunk Agreement, and common sense, make clear that Crunk was not a party to the Crunk Agreement, and therefore could not have breached it.” Id. at *54.

(A Delaware LLC, in contrast, is bound by its operating agreement and therefore could be in breach of its own operating agreement. “A limited liability company is bound by its limited liability company agreement whether or not the limited liability company executes the limited liability company agreement.” Del. Code Ann. tit. 6 § 18-101(7).)

The court also dismissed Cordts-Auth’s breach of contract claim against Halstead. Cordts-Auth claimed that Halstead was obligated to give a “Drag Along Notice” of the impending Crunk sale. The Drag Along Notice only applied, however, if a majority of the selling Crunk members wished to force a minority to participate in a sale of their member interests. The Crunk sale was an asset sale and not a sale of member interests, so the Drag Along Notice did not apply. Further, Halstead had an optional right, but not an obligation, to give a Drag Along Notice. (No notice was required if Halstead did not exercise her Drag Along Right.) The court dismissed Cordts-Auth’s claim: the Drag Along Notice did not apply to Crunk’s asset sale and Halstead was not obligated to give the notice in any event, so there was no breach.

Accounting, Books and Records, and Declaratory Relief.  Cordts-Auth asked for an accounting of the proceeds from Crunk’s sale. The court dismissed that claim, because a party seeking an accounting must establish the existence of a fiduciary relationship, and Cordts-Auth was not ever a member of Crunk and therefore failed to establish the existence of a fiduciary relationship. Additionally, her accounting claim named only Solvi and Crunk, and as the court previously noted, a New York LLC owes no fiduciary duties to its members.

Cordts-Auth also asked for access to Crunk’s books and records, and a declaratory judgment that she was a member of Crunk at the time of sale. Those claims were dismissed because only LLC members have rights to the LLCs books and records, and the court had already determined that Cordts-Auth had not been and was not a member of Crunk.

Conclusion.  All of Cordts-Auth’s claims were dismissed, and her derivative claims were dismissed on several grounds. The opinion will bear study by any New York practitioner analyzing a client’s potential LLC derivative suit.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Charles McSwain, a 53% member of Hawks Prairie Casino, LLC, a Washington LLC, filed a voluntary Chapter 11 bankruptcy petition in 2007. Hawks Prairie operates a gambling casino in Thurston County, Washington.

Background. The President of Hawks Prairie, Tryna Norberg, knew of McSwain’s bankruptcy filing and continued to treat him as a voting member of the LLC until early 2009, when McSwain called on her to resign and threatened to call a meeting to appoint a new President. Shortly thereafter Hawks Prairie informed McSwain that he was dissociated from the LLC, and after that he received no further member communications from the LLC.

Several months later McSwain filed his plan of reorganization. The plan provided that upon its confirmation by the court, all of McSwain’s rights and interests in the LLC, as they existed immediately prior to the bankruptcy filing, would be automatically reinstated. That would restore his member voting rights and give him majority control of the LLC.

Norberg objected to confirmation on the grounds that full reinstatement of McSwain’s member interest was inconsistent with the LLC’s Operating Agreement and Washington law, and that under Bankruptcy Code Section 365(c)(1) McSwain was precluded from assuming the voting and other management rights of a member. Norberg sought a declaration that McSwain no longer possessed any management rights in the LLC, and that his interests in the LLC were solely those of an assignee, i.e., he had only the right to share in profits, losses, and distributions. Norberg v. Hawks Prairie Casino, LLC (In re McSwain), No. 07-43338, 2011 Bankr. LEXIS 3921, at *2 (Bankr. W.D. Wash. Oct. 6, 2011).

Washington’s LLC Act provides that an LLC member is dissociated, ceases to be a member, and takes on the status of an assignee upon the member’s insolvency or bankruptcy, unless the LLC agreement provides otherwise or the members all consent in writing. RCW 25.15.130(1)(d). (Many other states have similar provisions. E.g., Del. Code Ann. tit. 6, § 18-304.)

The Hawks Prairie Operating Agreement was clear: A member that files a voluntary bankruptcy is dissociated and treated as an assignee rather than as a member, unless all other members consent or 70% of the initial members consent. McSwain, 2011 Bankr. LEXIS 3921, at *7-8. Washington’s LLC Act therefore barred McSwain from being readmitted as a member without the requisite member vote, which was not forthcoming.

Bankruptcy Code. The Bankruptcy Code gives a bankruptcy trustee, or the debtor in possession in a Chapter 11 case (as in McSwain),the authority to assume, assign, or reject the executory contracts of the debtor, subject to several limitations. 11 U.S.C. § 365. The issue before the court was whether Bankruptcy Code Section 365(c)(1) prevented McSwain from assuming all his rights as a member. That section is concise:

(c)        The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if–

(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and

 (B) such party does not consent to such assumption or assignment[.]

11 U.S.C. § 365(c)(1).

The Ninth Circuit has ruled that this section “by its terms bars a debtor in possession from assuming an executory contract without the nondebtor’s consent where applicable law precludes assignment of the contract to a third party.” Perlman v. Catapult Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747, 750 (9th Cir. 1999). (In Catapult, the Ninth Circuit joined the Third and Eleventh Circuits in a circuit split on whether Section 365(c)(1) applies to an assumption by the debtor even if a third-party assignment is not contemplated – Catapult concluding that it does.)

Court’s Analysis. The McSwain court concluded that the LLC’s Operating Agreement was an executory contract, and that applicable nonbankruptcy law, i.e., Washington’s LLC Act, forbids its assignment. The court interpreted Catapult as imposing a third requirement: “assignment must be forbidden [by applicable nonbankruptcy law] because the identity of the nondebtor party is material.” McSwain, 2011 Bankr. LEXIS 3921, at *21. The court went on to say: “It is certainly possible that the identity of Hawks Prairie’s other members is material, such that McSwain could not assume the contract.” Id. at *22.

In the event, though, the court concluded it need not determine whether the identity of the members other than McSwain was material. Instead it decided the case on the grounds of an implied waiver by Norberg. From the beginning Norberg was fully aware of McSwain’s bankruptcy and knew that McSwain could be treated as an assignee under the Operating Agreement. She nonetheless permitted McSwain to exercise all the rights of a full member, including attending management meetings and voting on major transactions. Norberg had sent the members multiple emails, letters, and minutes of meetings that referred to McSwain as a member. The court concluded that by her actions Norberg impliedly waived her right to enforce the Operating Agreement’s dissociation provisions against McSwain. Id. at *24. Under the confirmed plan of reorganization, McSwain was therefore entitled to exercise his full membership rights in the LLC, including voting and management rights. Id. at *30.

Comments. The court’s waiver analysis is unexceptional and clearly seems to be the right result. The court’s discussion in dicta of the applicability of the Catapult rule, however, focuses on the identity of the other members in the LLC, and conjectures that if the LLC had a large number of passive members, their identity would not be material and McSwain would then be able to assume his rights as a member. Id. at *22-23.

Catapult, on the other hand, relied on the policy of the nonbankruptcy law that restricts assignment, not on the degree to which the policy applied to the facts of the specific case. Catapult describes Section 365(c)(1) as stating “a carefully crafted exception to the broad rule – where applicable law does not merely recite a general ban on assignment, but instead more specifically ‘excuses a party … from accepting performance from or rendering performance to an entity’ different from the one with which the party originally contracted, the applicable law prevails…. Only if the law prohibits assignment on the rationale that the identity of the contracting party is material to the agreement will subsection (c)(1) rescue it.” Catapult, 165 F.3d at 752.

The dissociation provisions of the LLC Act fit that description well. They preserve the economic rights of the dissociated member, but prevent the dissociated member from interfering in the management of the LLC. This is consistent with the “know your partner” principle, which is reflected in multiple provisions of most state LLC Acts, such as limitations on assignment and the rules on charging orders.

McSwain reached the right result because of Norberg’s implied waiver. But McSwain’s focus on the specific facts of the LLC and its members, rather than the rationale of the nonbankruptcy law that prohibits assignment, is inconsistent with Catapult and should not be relied on.

Given the increasing use of LLCs in business organizations, it seems likely that disputes over the interaction between Bankruptcy Code Section 365(c)(1) and the dissociation provisions of state LLC Acts will continue to arise as LLC members have occasion to file Chapter 11 bankruptcies. There will be further developments.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

LLC organizers sometimes refer to themselves loosely as “partners” during the preliminary stages of a development project, before they get around to forming their limited liability company, but those words can come back to haunt them. Say, for example, that during the pre-formation phase, one of the organizers signs a contract in his own name, intending that the LLC carry out the contract. The LLC is formed, but then the project doesn’t go forward, the parties fall out, and the organizer that signed the contract can’t pay. In that case the creditor on the contract may seek payment from both the contract signer and the other organizer, on the theory that the organizers were partners and therefore were both liable.

The Lawsuit. That scenario played out in Lentz Engineering, L.C. v. Brown, No. 14-10-00610-CV, 2011 Tex. App. LEXIS 7723 (Tex. App. Sept. 27, 2011). William Wilkins and Alden Brown were planning to purchase and develop a real estate project. Wilkins entered into a contract to purchase the property, and Brown and Wilkins met with an attorney in February 2005 and agreed to form a Texas LLC to carry out the development. In March Brown gave Wilkins $400,000 to purchase the property, and Wilkins acquired the real estate in April. One day later, the attorney filed articles of organization for the LLC, which identified Brown and Wilkins as the LLC’s managers.

During the summer Brown became suspicious of Wilkin’s conduct and attempted to recover his money and obtain title to the property. Meanwhile, Wilkins entered into a contract in his own name with Lentz Engineering for engineering services. Lentz performed its work under the contract but was not paid.

Lentz then sued both Wilkins and Brown for breach of contract. Lentz’s theory was that Wilkins was directly liable on the contract, and that Brown was liable because he was partners with Wilkins and was therefore fully liable for the debts of the partnership. Wilkins defaulted on the lawsuit but Brown defended on the ground that he and Wilkins were not partners.

Judicial Admission. Brown’s first difficulty was self-inflicted. Lentz contended that Brown had judicially admitted in a motion for summary judgment that a partnership existed between Brown and Wilkins. For example, Brown’s motion stated: “Although Wilkins and Brown entered into a partnership to acquire the Manvel property, that partnership was not formed until March 2005.” Brown also made other, similar statements in his motion. Id. at *4-5.

The court dismissed the “judicial admission” contention, because Brown had taken a contrary position in other pleadings and even in the same summary judgment motion. To be considered a judicial admission, a party’s statement must be clear, deliberate, and unequivocal, and Brown’s contradictory statements didn’t satisfy that standard.

Partnership Formation. The court then considered the main argument, i.e., whether Brown and Wilkins had formed a partnership. The Texas statute’s definition of a general partnership is similar to that of most states: an association of two or more persons to carry on a business for profit as owners, regardless of whether the persons intend to create a partnership or whether the association is actually called a “partnership.” Tex. Bus. Orgs. Code Ann. § 152.051(b).

Facts and Circumstances. Whether a partnership exists depends on all the facts and circumstances. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *9. The factors considered in determining if a partnership has been created include:

(a)        sharing of profits of the business;
(b)        sharing of losses or liability for claims;
(c)        contributing or agreeing to contribute money or property to the business;
(d)       participating in control of the business; and
(e)        expressing an intent to be partners in the business.

 Tex. Bus. Orgs. Code Ann. § 152.052. Note that the first three factors – sharing profits, losses, and contributions – are present in almost every LLC. The fourth factor, participating in control, is present in all member-managed LLCs and in some manager-managed LLCs. Only the last factor, expressing an intent to be partners, is not present in an LLC.

The court found uncontroverted evidence of only two of the factors, splitting profits and participating in control of the business. There was contradictory evidence about expressions of intent to be partners. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *12-14.

Going the other way, both Wilkins and Brown expressed their intent to form an LLC, they opened a bank account in the name of the LLC, and the Certificate of Organization for the LLC was filed before the date on which Wilkins signed the contract with Lentz Engineering. Id.

The relative timing of filing the Certificate of Organization and signing the contract seems to have carried extra weight with the court:

Although courts have held promoters of a company may be liable on contracts made by other promoters prior to formation of the company as if the promoters were partners, Lentz has not cited any authority to suggest that liability should be imposed on one promoter because of another promoter's conduct after the formation of the company.

Id. at *15. The court concluded that the evidence did not conclusively establish the existence of a partnership and that the trial court’s finding of no partnership was not against the great weight and preponderance of the evidence. The trial court’s ruling in favor of Brown was affirmed.

Lessons Learned. The substantial overlap between an LLC and the five factors listed in the Texas statute is a little scary. New business organizers who refer to each other as partners, before the LLC is created, may rue the day they used that terminology. They may have already discussed and agreed on the first four factors, and if they introduce each other as partners, the stage is set. If one partner signs a contract before the LLC is formed, and then things fall apart and the LLC is not formed, the organizers may find that as partners they are all jointly and severally liable on the contract.

How to avoid this outcome? Expunge the word “partners” from any description of the organizers. One of the great benefits of LLCs is their limited liability; don’t open the door to personal liability by calling yourselves partners.

Organizers should strive to form the LLC early. Any contracts should not be signed until after the LLC is formed, and then they should be signed in the name of the LLC.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

The common-law rule is that a corporation appearing in court must be represented by an attorney. That’s the rule in Washington and all federal courts. Not surprisingly, earlier this year Washington applied that rule to limited liability companies. Marina Condo. Homeowner’s Ass’n v. Stratford at the Marina, LLC, 161 Wn. App. 249, 263, 254 P.3d 827 (2011).

One might have thought that the Marina decision would have foreclosed the issue, but the plaintiff in Dutch Village Mall, LLC v. Pelletti, 162 Wn. App. 531, 256 P.3d 1251 (July 5, 2011), an LLC with a single member, contended that its sole member should be able to represent it in court.

The Dutch Village LLC owned a shopping mall and sued a tenant. The LLC’s complaint was signed by its sole member, Jay Lei. The defendant moved to strike the complaint on the grounds that it had to be signed by an attorney. The trial court granted the motion and the Court of Appeals accepted review. Lei argued for an exception:

       Lei contends the right to appear pro se belongs to a single-person LLC as much as a person because the single owner is likewise acting solely on his own behalf, making all the decisions and taking all the risks, much like a sole proprietor. Lei contends the separate legal entity status of a single member LLC is a technicality that the court should disregard.

 Id. at 536.

The court rejected Lei’s argument. First, said the court, allowing nonlawyers to conduct litigation creates burdens for the other party and for the court, resulting in poorly drafted pleadings, inadequate presentations of motions, and proceedings that are unduly prolonged and numerous. Id. at 538. (This does seem to reflect a hostility to pro se litigants, even when the litigant is an individual and therefore fully entitled to represent him- or herself.) Additionally, said the court, a lay litigant lacks many of an attorney’s ethical responsibilities. The court referred to the “elaborate and inappropriate claims pleaded by Lei in this case and his refusal to withdraw a moot and pointless motion for default.” Id.

Second, the court was troubled by the inconsistency between disregarding the entity for the member’s convenience (thereby obviating the need for a lawyer in court), and respecting it for other issues (the LLC’s liability shield). For example, if the defendant successfully counterclaimed against the LLC, Lei presumably would be unwilling to disregard the LLC and accept personal liability.

The court also pointed out that a rule allowing single-member LLCs to appear in court without an attorney would likely result in disputes over the LLC’s claim to have only one owner. What if the LLC’s ownership changed in the middle of a lawsuit? Could a plaintiff assign its claim to a single-member LLC, thereby eliminating the need to hire a lawyer to represent it in court?

The court’s refusal to allow the LLC to be represented in court by its single member is unexceptional and consistent with the rules on corporations. It is also consistent with the lawyer licensing system and the body of rules that protect lawyers’ monopoly on legal services. The system is usually justified by the need to protect the public from incompetent or unethical legal representation, but the Dutch Village case shows that the convenience of the courts is also a factor in supporting the rule.

• Email This
• Print
• Comments
• Trackbacks
• Share Link