Change Is Coming

All good things must come to an end, including my time with Stoel Rives LLP. I joined this firm in 1980, and at the end of this month I’m retiring. I thank Stoel Rives and my colleagues for a truly wonderful 34 years, and now I’m looking forward to new adventures.

I started this blog under the aegis of Stoel Rives in May, 2009. It has been well received and has substantial readership. Quite a number of posts have been reprinted in publications of the ABA and the Washington State Bar Association. And I have learned a ton about LLC law, analyzing appellate opinions, the vagaries of state legislation, and about writing.

Although I will be leaving LLC Law Monitor behind, the blog is going to continue. My colleagues Lori Le Cheminant, Brant Norquist, and Todd Friedman are going to take up the pen and carry LLC Law Monitor forward. I am confident their talents and energies will showcase insightful analyses of developing LLC law, and I encourage you to continue following LLC Law Monitor in 2015.

I thank my partners at Stoel Rives for supporting my efforts with the blog. I also want to thank Francis Pileggi of Delaware Corporate & Commercial Litigation Blog; Peter Mahler of New York Business Divorce; Thomas Rutledge, Chair of the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities; and John Cunningham, author of the Aspen treatise, Drafting Limited Liability Company Operating Agreements. Their writings and their personal encouragement and ideas have been inspiring and invaluable.

Adios. I will miss it all.

 

Glitch in Maine LLC Act Prevents Administratively Dissolved LLC from Bringing Suit

Administrative dissolution is an enforcement tool that many states use to ensure that LLCs pay their annual fees and file their annual reports. An LLC that fails to pay its annual fee or file its annual report is given notice of the dissolution. If it complies with the payment and other requirements it will then be reinstated, although after the statutory period (typically three or five years) it loses the ability to be reinstated.

Administratively dissolved LLCs normally have the power to defend themselves in litigation and to initiate lawsuits to enforce their rights, but last month a quirk in Maine’s LLC Act prevented an LLC from suing to enforce its rights. Beaudry v. Harding, No. Cum-14-150, 2014 WL 5861051 (Me. Nov. 13, 2014).

Background.  Paul Beaudry was one of two members of Northern Maine Transport, LLC, a Maine limited liability company (NMT). In 2010 attorney Alan Harding represented NMT in a lawsuit against an insurance company on a fire insurance policy. NMT and the insurance company settled the lawsuit.

Beaudry later claimed that NMT was injured by Harding’s legal malpractice in the lawsuit over NMT’s fire insurance. In 2012 Beaudry filed a malpractice suit against Harding, asserting claims both individually and derivatively on behalf of NMT.

Harding defended Beaudry’s derivative claim on behalf of NMT because NMT had been administratively dissolved in 2009 and therefore could not prosecute suits on its own behalf, and defended Beaudry’s claim in his own name because the harm alleged – loss of NMT’s insurance proceeds – was not an injury personal to Beaudry. Id. at *1. Harding filed a motion for summary judgment, and the trial court granted his motion and dismissed both counts of Beaudry’s suit.

Supreme Court.  Beaudry argued that the Maine LLC Act allows a dissolved LLC to prosecute claims to collect its assets. Id. at *2. Consistent with Beaudry’s argument, Section 1596 of the Maine LLC Act states that “[t]he dissolution of a limited liability company does not … [p]revent the commencement of a proceeding by or against the limited liability company in its limited liability company name.” Me. Rev. Stat. Ann. tit. 31, § 1596.2 (emphasis added). (Presumably the phrase “or against” would be interpreted to include the power of the LLC to defend a claim brought against it.)

Harding, on the other hand, pointed to Section 1592: “The administrative dissolution of a limited liability company under this section does not impair: … [t]he right of the limited liability company to defend any action, suit or proceeding in any court of this State.” Me. Rev. Stat. Ann. tit. 31, § 1592.4 (emphasis added). Thus, when referring specifically to administrative dissolution, the statute only refers to defending lawsuits, implying that an administratively dissolved LLC is not authorized to initiate a suit.

Without making any attempt to harmonize the two sections, the court simply jumped to its conclusion:

Reading these sections in relation to the whole statutory scheme, the more specific statute governing the effect of administrative dissolution is controlling. See Butler [v. Killoran], 1998 ME 147, ¶ 11, 714 A.2d 129. Thus, NMT, as an administratively dissolved LLC, is not authorized to prosecute claims; it may only defend claims. To interpret the Act otherwise would be to render subsections of section 1592 superfluous.

 Beaudry, 2014 WL 5861051, at *2.

The court concluded that Beaudry was barred from bringing suit on behalf of NMT because of its administrative dissolution. The court also pointed out in a footnote that Beaudry had conceded that he had not directly suffered any injuries personal to him. The court therefore affirmed the trial court’s grant of summary judgment to Harding. Id. at *3.

Comment.  The Beaudry result is disquieting. The court’s perfunctory analysis refers to Butler v. Killoran for the proposition that “a statute dealing with a subject specifically prevails over another statute dealing with the same subject generally,” but ignores Butler’s maxim that “the two should be harmonized if possible.” Butler v. Killoran, 1998 Me. 147, ¶ 11, 714 A.2d 129, 133 (1998).

The court relied on Section 1592’s reference to the right of an administratively dissolved LLC to defend any action and its omission of a right to prosecute an action. But Section 1592 does not say that an administratively dissolved LLC is barred from initiating a lawsuit. Further, it is often impossible as a practical matter to defend a lawsuit if the defendant is barred from raising counterclaims, which the court’s analysis would appear to prevent.

But the more serious omission is the court’s failure to consider the winding-up requirements of the Maine LLC Act. Sections 1592.3 and 1596.1 mandate that a dissolved LLC, whether administratively dissolved or dissolved by action of the members, must wind up its activities. Section 1596.1.A also makes clear that winding up includes collecting the dissolved LLC’s assets. If an administratively dissolved LLC has a claim against a third party that the third party won’t voluntarily pay, the LLC may have to resort to filing a lawsuit to collect that asset. The Beaudry court’s interpretation will in some cases prevent an administratively dissolved LLC from complying with the statute’s requirement to collect its assets.

One can hope that the Maine legislature will soon correct this situation by amending the Maine LLC Act to explicitly allow all dissolved LLCs, whether or not administratively dissolved, to prosecute and defend claims as part of winding up. That would be consistent with the approach taken by the overwhelming majority of the other states. E.g., Revised Uniform Limited Liability Company Act, §§ 702(b)(2)(c), 705(d), Wash. Rev. Code §§ 25.15.270, .295(2)(a).

NCCUSL Starts Work on a Uniform Series LLC Act – Many Questions Remain

More and more states are embracing series LLCs. With Alabama’s authorization earlier this year, 12 states have now authorized series LLCs. But the states have adopted inconsistent approaches to many of the key aspects of series LLCs. The National Conference of Commissioners on Uniform State Laws (NCCUSL) has therefore mounted an initiative to develop a uniform law for series LLCs and for series in other business entities.

A series LLC is an LLC that, under the authority of its state governing law, has established one or more series. Each series is somewhat like a cell within the LLC. A series will own its assets separately from the assets of the LLC or any other series, and will incur liability that will be enforceable only against the assets of that series. It can have its own members and managers, can enter into contracts, and can sue and be sued. In many respects it is like an entity within an entity. For further background you can see my previous posts on series LLCs, here.

In 2013 NCCUSL formed a Drafting Committee to work on a new statute called the Series of Unincorporated Business Entities Act (Series Act). The committee began its work and released drafts of a proposed Series Act in 2013 and 2014. The committee’s drafts and memos are available on the NCCUSL web site, here.

The first reading of the committee’s Series Act took place at NCCUSL’s 2014 annual meeting in Seattle. The reporter’s introductory note to the next draft, following the annual meeting, stated that “[t]he first reading provoked extensive and spirited discussion, which was at times quite skeptical.” The upshot was that the committee released a new draft Series Act (New Draft) earlier this month, which takes a different approach to several major issues.

The New Draft is a stand-alone act, which by its terms will apply to general partnerships, limited partnerships, and LLCs. The New Draft uses the term “protected series” because “series” is frequently used in other contexts, such as bonds and corporate stock. An entity that has one or more series is called a “series organization.” For example, an LLC that has a protected series would therefore be a series organization.

The New Draft provides a wide range of default rules for the internal affairs of a protected series. Most but not all of the default rules can be overridden by the LLC’s operating agreement, or by the partnership agreement or limited partnership agreement if the protected series is within a partnership or limited partnership.

Open Issues.  The Prefatory Note (Note) that accompanies the New Draft raised ten major issues that are key to the Drafting Committee’s continuing work. It is striking that three of the key issues raise fundamental questions that appear to cast doubt on whether there is a future for series LLCs, or for other types of series organizations.

The Need?  The first question is whether there is a need for series LLCs. The Note states it succinctly: “What business needs does the protected series construct uniquely serve?…[T]he special advantages of protected series remain obscure.” Note at 4.

Conflicts of Laws.  The second question is whether jurisdictions that have not adopted series statutes will respect the internal liability shields of protected series established in other jurisdictions. In other words, will the collection activities of inter-state creditors of a series LLC be limited to the assets of the series, when the law of the creditor’s state does not recognize series LLCs?

Bankruptcy; Article 9.  The third question is, how will the Series Act ensure that other areas of law will accommodate the protected series construct? For example, will the federal Bankruptcy Act respect the internal liability shields of an LLC’s series? If not, the shields are of little value. Another example: Article 9 of the Uniform Commercial Code (UCC) determines where to file financing statements that give notice of liens against a debtor’s assets, but Article 9 has no provisions dealing with series LLCs.

There are other significant issues raised in the Note, but these three are the critical issues. The Note provides no answers. It will be difficult for the drafters of series legislation to tailor a proposed law to meet the needs of businesses if the drafters cannot identify the business needs for series entities. And if the internal liability shields of a protected series will not be respected by other states or by bankruptcy law, the major motivation for series LLCs disappears.

To some extent this is a chicken-and-egg problem. If all the states have series LLC statutes, the internal liability shields of protected series will presumably be recognized nationwide, and it would seem likely that bankruptcy law and the UCC would be amended to deal adequately with protected series. But without changes in those other laws or pressure from businesses lobbying for series LLCs, it’s questionable whether many states will be motivated to bother with the necessary legislation for series LLCs.

NCCUSL’s Drafting Committee for the Series Act appears to have its work cut out for it.

De Facto Dissolution of California LLC Allows LLC’s Creditor to Reach Assets Distributed to Members

An LLC sells its assets and distributes the proceeds to its members. It then goes out of business and leaves creditors holding the bag, unpaid. A creditor has a valid claim against the LLC, but can it assert its claim against the members who received the sale proceeds? That was the question before the court in a decision handed down by the California Court of Appeal last month, in CB Richard Ellis, Inc. v. Terra Nostra Consultants, 178 Cal.Rptr.3d 640 (Cal. Ct. App. Oct. 7, 2014). The court allowed the creditor to assert its claim against the members that received distributions, but only after finding that a de facto dissolution of the LLC had occurred.

The facts of the case were straightforward. CB Richard Ellis, Inc., a real estate broker (CBRE), signed a listing agreement with Jefferson 38, LLC to sell the LLC’s 38-acre real estate parcel. A dispute between CBRE and the LLC over the duration of the listing agreement and CBRE’s performance developed, and the LLC sold the real estate for $11.8 million without help from CBRE. One day after its receipt of the net sale proceeds, the LLC transferred essentially all of the proceeds to its members, without paying any commission to CBRE. Seven months later the LLC filed a certificate of cancellation with the California Secretary of State, indicating that it had been dissolved by a vote of its members.

CBRE arbitrated the dispute in accordance with the listing agreement and obtained a $960,000 judgment against the LLC for its commission, interest, and attorneys’ fees. The LLC had essentially no assets and could not pay, so CBRE later sued the LLC’s members.

CBRE alleged that the LLC had been dissolved, that the members had received distributions of the sale proceeds upon dissolution, and that in accordance with the LLC Act each member was therefore liable to CBRE for the LLC’s commission obligation, up to the amount of the distribution received by each member. A jury trial resulted in a verdict and judgment in favor of CBRE, against each member up to the amount of the member’s distribution. The members appealed on grounds that the jury had been improperly instructed on the law regarding the LLC’s dissolution.

Court of Appeal.  The Court of Appeal first had to determine which version of the California LLC Act to apply. (California adopted the Revised Uniform Limited Liability Company Act, effective January 1, 2014.) The court determined that it would apply the earlier version of the LLC Act, because it was in force at the time the dispute arose. Id. at 644.

CBRE based its claim on Section 17355 of the prior LLC Act, which provides that a cause of action against a dissolved LLC may be enforced, “[i]f any of the assets of the dissolved limited liability company have been distributed to members, against members of the dissolved limited liability company to the extent of the limited liability company assets distributed to them upon dissolution of the limited liability company.” Cal. Corp. Code § 17355(a)(1)(B) (repealed 2014). (Section 17707.07(a)(1) of the new LLC Act is nearly identical.)

The defendants objected to the jury instructions, which in relevant part stated:

Dissolution of a limited liability company occurs when it ceases operating in the ordinary course of its business, with the intention, on the part of its members, not to resume the ordinary course of its business….A limited liability company may continue to do business after it has dissolved for the purpose of winding up its affairs, paying its creditors and distributing its remaining assets. In determining whether a dissolution of Jefferson… occurred, you may consider all evidence bearing on that issue, including; for example, the ordinary business of the limited liability company, the assets of the limited liability company both before and after a distribution, the continuation of the ordinary business and the cessation of its ordinary business activities.

CB Richard Ellis, 178 Cal.Rptr.3d at 645. The Court of Appeal noted that the instruction uses the concept of a “de facto” dissolution, based on all the facts and circumstances rather than the formal dissolution steps taken under the statute.

The defendants contended that the jury instruction was incorrect because dissolution could occur only upon compliance with former Section 17350, which says that an LLC is dissolved upon the first to occur of (a) events specified in the articles of organization or operating agreement; (b) a majority vote of the members; or (c) a judicial decree of dissolution. Cal. Corp. Code § 17350 (repealed 2014). The defendants argued that because the LLC had not been formally dissolved when they received their distributions, former Section 17355 did not apply to the members and CBRE could not assert its claim against them.

The court, however, did not read Section 17350 to say that there are no other potential causes of dissolution, or that the three listed causes of dissolution are the exclusive grounds for dissolution. Finding no relevant legislative history, the court looked to the policy of the statute, which it saw as preventing unjust enrichment of LLC members when the members have received assets the dissolved LLC needs to pay its creditors. The court noted that if the members’ interpretation of the statute were correct, LLCs and their members could avoid the Section 17355 clawback “by the simple expedient of transferring assets out of the company the day before voting to dissolve.” CB Richard Ellis, 178 Cal.Rptr.3d at 647.

The court accordingly held that the jury was correctly instructed. “‘De facto’ dissolution is an acceptable predicate to a claim under former section 17355, subdivision (a)(1)(B).” Id.

Comment.  CB Richard Ellis stands out – most states do not recognize de facto dissolutions of LLCs. The issue doesn’t come up frequently because most states have a prohibition in their LLC laws on distributions to a member at a time when the LLC is insolvent or would be rendered insolvent by the distributions, regardless of whether the LLC has been dissolved. E.g., Cal. Corp. Code § 17704.05; Wash. Rev. Code § 25.15.235; Del. Code Ann. tit. 6, § 18-607. And many, including California, Washington, and Delaware, also require that a member who receives a distribution with knowledge that the LLC was insolvent must return the distribution to the LLC, without reference to whether the LLC is dissolved.

The LLC in CB Richard Ellis was presumably rendered insolvent by the distributions, given that CBRE had asserted a large claim against it. A creditor considering using that provision would have to establish the members’ knowledge of the LLC’s insolvency, of course, and that may be why CBRE did not pursue that avenue.

Washington LLC Member’s Bankruptcy Filing Dissociates the Member and Precludes Its Standing to Maintain Derivative Suit in the Name of the LLC

LLC businesses sometimes fail. When the failure is claimed to have resulted from mismanagement or self-dealing, the LLC’s minority members may want to bring a derivative suit against the manager for breach of fiduciary duties. But there may also be collateral damage – an LLC’s failure will sometimes drag the minority members into financial ruin, in which case they may need to file for bankruptcy protection. (For example, they may have guaranteed the LLC’s bank debt.)

A member’s bankruptcy filing may under state law cause the member’s dissociation, however, and that in turn may eliminate the member’s standing to bring a derivative suit for breaches of fiduciary duty. That was the result in a recent Washington case, Northwest Wholesale, Inc. v. Pac Organic Fruit, LLC, 334 P.3d 63 (Wash. Ct. App. Sept. 4, 2014).

Background.  Harold and Shirley Ostenson and Greg Holzman, Inc. (GHI) formed Pac Organic Fruit, LLC in 1998, to operate a Grant County orchard packing facility. The LLC was owned 49% by the Ostensons and 51% by GHI, which was the sole manager. The Ostensons worked at the plant, which the LLC leased from them. The Ostensons and Greg Holzman guaranteed a million-dollar loan to the LLC.

The parties commenced operating the business, but in 2005 the LLC defaulted on its operating line of credit and on its lease payments to the Ostensons. The Ostensons were fired, and the LLC’s bank foreclosed on the packing facility and the Ostensons’ orchard. In January 2007 the Ostensons filed a chapter 11 bankruptcy.

In May 2007 Northwest Wholesale, Inc., a creditor of the LLC, filed suit in Chelan County against the LLC, GHI, and the Ostensons.  The Ostensons then filed cross-claims against the LLC and derivative claims against GHI, Greg Holzman, and Total Organic, Inc., another Greg Holzman company. The Ostensons’ derivative claims alleged that Holzman and the Holzman entities mismanaged the LLC.

Northwest Wholesale was later dismissed from the lawsuit as the result of a settlement, and trial on the Ostensons’ claims commenced in Chelan County in July 2011. The Holzman defendants argued at trial that the Ostensons’ bankruptcy dissociated the Ostensons as members from the LLC under Wash. Rev. Code § 25.15.130(1)(d), and that because they were no longer members they lacked standing to bring the derivative action, under Wash. Rev. Code § 25.15.375. The Ostensons contended that the Holzman defendants consented in the bankruptcy proceeding to the Ostensons’ membership in the LLC and to their derivative action.

The trial court dismissed the Ostensons’ derivative claims against the Holzman defendants, ruling that the Ostensons’ bankruptcy dissociated them as members of the LLC and that under Wash. Rev. Code § 25.15.370 they were therefore precluded from bringing a derivative action. Pac Organic, 334 P.3d at 67.

Court of Appeals.  The court’s analysis of the Ostensons’ standing began with the LLC Act. The LLC Act says that a member may bring an action in the right of an LLC if its managers or managing members have refused to bring the action or if an effort to cause those managers or members to bring the action is not likely to succeed.  Wash. Rev. Code § 25.15370.

The court was willing to assume that GHI, the LLC’s manager, would not authorize suit against itself, its owner, or its related company. Pac Organic, 334 P.3d at 73. But the LLC Act also requires that the plaintiff in a derivative action must be a member of the LLC when the suit is filed, and must have been a member of the LLC at the time of the transaction which is the subject of the complaint. Wash. Rev. Code § 25.15.375.

The court noted that the Ostensons were not members when they filed the derivative action, because they had previously filed for bankruptcy and had thereby become dissociated as members. Under Section 25.15.130(1)(d) of the LLC Act, a member is dissociated if the member files a voluntary petition in bankruptcy, unless the LLC agreement provides otherwise or the other members consent in writing. Upon dissociation, the member ceases to be a member and instead is treated as an assignee, i.e., it holds only the economic rights to share in profits, losses, and distributions associated with its interest in the LLC.  Wash. Rev. Code § 25.15.130(1).

The Ostensons pointed to a written stipulation that the parties had entered into in connection with the Ostensons’ bankruptcy. They contended that the stipulation was a consent by Holzman to the Ostensons’ continued membership in the LLC and to their right to sue derivatively on behalf of the LLC. The stipulation included a general release between the parties but preserved some claims, including claims by the LLC against the Holzman defendants for conversion of the LLC’s assets. The language of the stipulation did not address whether the Ostensons could assert the LLC’s claims, though, and the court found no such consent in the language of the stipulation.

Bankruptcy.  The Ostensons contended that federal bankruptcy law preempted the LLC Act from dissociating them because of their bankruptcy filing. They relied on Bankruptcy Code Section 541(c)(1), which provides that the debtor’s interests in property become part of the bankruptcy estate notwithstanding provisions in nonbankruptcy law that restrict transfer of the interest by the debtor. 11 U.S.C. § 541(c)(1).

The court did not agree. Referring to the principle that a debtor’s property rights are defined by state law, and citing In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr. E.D. Va. 2000), the court found that although the bankruptcy estate acquired all the Ostensons’ interest in the LLC, the bankruptcy estate was itself dissociated by the LLC Act. Pac Organic, 334 P.3d at 77. 

The Ostensons also asserted that Bankruptcy Code Section 365(e) prevented them from being dissociated because of their bankruptcy filing. That section says that the debtor’s rights under an executory contract may not be terminated or modified because of a provision under applicable law or under the contract that is conditioned on the debtor’s commencement of a bankruptcy case. 11 U.S.C. 365(e). This section is often called the anti-ipso facto clause rule.

The court looked to an earlier Washington case concerning the effects on a partnership of a partner’s bankruptcy filing, and found that Section 365(e)’s invalidation of ipso facto provisions did not apply and that the LLC Act’s dissociation of the Ostensons was therefore not preempted. Id. at 79 (citing Finkelstein v. Sec. Props., Inc., 76 Wash.App. 733 (1995)).

The Court of Appeals accordingly affirmed the trial court’s dismissal of the Ostensons’ derivative action on behalf of the LLC.

Comment. The interaction between bankruptcy law and LLCs is complex and sometimes inconsistent from court to court. My description of the court’s bankruptcy analysis hits only the highlights. As the court said: “In resolving this question [of the effect of bankruptcy law] we stumble into an esoteric discussion of partnership law, limited liability company law, the nature of dissociation of a member or partner, economic and noneconomic interests in partnerships and LLCs, and executory contracts. We bounce to and from federal and state law.” Id. at 75.

Washington Court of Appeals Again Rules on 2010 Change to LLC Act’s Three-Year Post-Dissolution Limitations Period

For the second time this year the Washington Court of Appeals has ruled on the Washington LLC Act’s three-year post-dissolution statute of limitations. In both cases there was a dispute over whether a 2010 amendment to the LLC Act should be applied retroactively. The court in the more recent case ruled that the plaintiff’s lawsuit was not time-barred even though more than three years had passed since the defendant LLC’s administrative dissolution, because the LLC had not filed a certificate of dissolution as required by the 2010 change to the LLC Act. Zacks v. Arden Drywall & Texture, Inc., No. 70322-6-I, 2014 WL 3843784 (Wash. Ct. App. Aug. 4, 2014) (unpublished).

Background.  Adam Zacks sued Arden Drywall & Texture LLC on September 17, 2012, for breach of contract and negligence in connection with construction work on a home purchased by Zacks. Arden responded by filing a motion for summary judgment.

Arden had been administratively dissolved by the Washington Secretary of State on September 2, 2008, for failing to file its annual report and pay licensing fees. In its motion Arden contended that the claims against it were time-barred under former Wash. Rev. Code § 25.15.303 (2006). (Prior to 2010, Washington’s LLC Act provided that no lawsuit could be filed against a dissolved LLC after three years from the effective date of dissolution. Former Wash. Rev. Code § 25.15.303 (2006).)

Amended in 2010, the LLC Act now authorizes a dissolved LLC to file an optional certificate of dissolution, and provides that a lawsuit cannot be filed against a dissolved LLC after three years from the date of filing of its certificate of dissolution. Wash. Rev. Code § 25.15.273, 25.15.303. There is no three-year bar on lawsuits against a dissolved LLC if it does not file a certificate of dissolution.

Relying on the 2010 amendment, Zacks argued that because Arden had not filed a certificate of dissolution, the three-year period had not commenced and the lawsuit was not time-barred. Arden riposted that the 2010 amendment to RCW 25.15.303 did not apply retroactively to it. 2014 WL 3843784, at *2. The trial court ruled that Zacks’ claims against Arden were barred, granted Arden’s summary judgment motion, and dismissed Zacks’ claims.

Court of Appeals.  Division 1 of the Court of Appeals reasoned that because a dissolved LLC continues to exist, Arden was still an existing legal entity when the 2010 amendments to the LLC Act took effect. Id. at *4. And when the 2010 amendments took effect, less than two years had passed since Arden’s administrative dissolution. The three-year bar under the old statute therefore had not yet applied to Arden, and when the statutory amendments became effective on June 10, 2010, their new rules became applicable.

The 2010 amendments required that a dissolved LLC file a certificate of dissolution in order to commence a three-year limitations period. Arden had not filed a certificate of dissolution, so the court ruled that Zacks’ lawsuit was not barred and could proceed, reversing the trial court. Id.

Comment.  The Zacks court did not need to address whether the 2010 amendments were retroactive, because it simply applied the amendments to Arden commencing when the amendments became effective. (Even if the amendments had been given retroactive effect, though, it would not have changed the result.)

A different division of the Court of Appeals (Division 3) ruled on a similar case earlier this year, which I wrote about, here. Houk v. Best Dev. & Constr. Co., 179 Wash. App. 908, 322 P.3d 29 (Mar. 13, 2014). The court in Houk reached the opposite conclusion, i.e., that a plaintiff’s lawsuit against an administratively dissolved LLC was barred by the three year post-dissolution statute of limitations. But the different results were driven by different chronologies of the relevant events, and the two opinions are consistent in their reasoning.

In Houk the LLC was administratively dissolved in 2006. More than three years passed before the 2010 amendments to the LLC Act became effective, and the plaintiff filed his lawsuit after the 2010 amendments. The LLC never filed a certificate of dissolution. (Note that in Zacks the LLC’s administrative dissolution occurred only two years before the 2010 amendments became effective.)

Houk found that the 2010 amendments were not retroactive, so claims against the LLC became time-barred on the third anniversary of its dissolution, before the 2010 amendments were effective.

Zacks is another reminder of the importance of filing certificates of dissolution for dissolved Washington LLCs. The three-year statute of limitations in Wash. Rev. Code § 25.15.303 can be hugely useful in cutting off claims as part of a dissolved LLC’s winding up. The benefits of the three-year statute of limitations for all claims are so significant that the certificate of dissolution should almost always be filed. The certificate of dissolution is a simple one-page document, Wash. Rev. Code § 25.15.273, and there is no filing fee, Wash. Admin. Code § 434-130-090(11).

New York LLC Manager’s Apparent Authority Makes LLC’s Real Estate Contract Enforceable in the Absence of Manager’s Actual Authority

A New York LLC entered into a contract to sell real estate and accepted a cash deposit. But shortly before closing the LLC asserted that its manager had no authority to sign the sale contract, tendered back the deposit, and refused to sign the closing documents. The buyers sued to enforce the contract, and the court ruled that the manager had sufficient apparent authority that his signature bound the LLC. Pasquarella v. 1525 William St., LLC, 120 A.D.3d 982 (N.Y. App. Div. Aug. 8, 2014).

Background.  The parties negotiated off and on for two years over the plaintiffs’ purchase of real estate from 1525 William Street, LLC, a New York LLC. The LLC was represented in the negotiations by Zvi Sultan, who indicated he was the sole member and President of the LLC. The LLC was also represented by legal counsel, who acted throughout the negotiations as if Sultan had authority to negotiate on behalf of the LLC. Eventually the sale contract was executed, with Sultan signing on behalf of the LLC as its manager. The LLC’s attorney accepted the plaintiffs’ deposit.

Later the LLC refused to sign the closing documents and attempted to return the deposit, on grounds that Sultan had no authority to sign the sale contract on its behalf. The LLC contended that Sultan sold a controlling interest in the LLC to his son shortly before the sale contract was signed, and that the LLC’s operating agreement provided that a sale of corporate property must be approved by all members. The son had not approved the sale.

The plaintiffs sued to enforce the sale contract and the trial court granted their motion for summary judgment. The LLC appealed on grounds that there was a triable issue of fact whether Sultan lacked apparent authority to contractually bind the LLC. Id. at 983.

Apparent authority exists when (a) a third party reasonably believes, based on the principal’s actions, that the supposed agent has authority to act on the principal’s behalf, (b) the third party relies on the appearance of authority, and (c) the third party will suffer loss if an agency relationship is not found. E.g., Zions Gate R.V. Resort, LLC v. Oliphant, 326 P.3d 118, 122 (Utah Ct. App. 2014).

Appellate Division.  The court emphasized that apparent authority can only be created by words or deeds of the principal. “The agent cannot by his own acts imbue himself with apparent authority.” Pasquarella, 120 A.D.3d at 983 (quoting Hallock v. State, 474 N.E.2d 1178, 1181 (N.Y. 1984)).

Examining the history of the parties’ interactions, the court concluded that the plaintiffs reasonably relied on sufficient actions of the LLC and its authorized agents to establish Sultan’s apparent authority:

  • the prior course of dealing with Sultan in his capacity as President of the LLC,
  • the fact that the LLC’s authorized attorney acted in a manner consistent with Sultan’s authority, and
  • the LLC’s acceptance of the plaintiffs’ deposit.

Id. at 984.

The court found an alternative basis to support Sultan’s statutory apparent authority, under the New York Limited Liability Company Law:

Unless the articles of organization of a limited liability company provide that management shall be vested in a manager or managers, every member is an agent of the limited liability company for the purpose of its business, and the act of every member, including the execution in the name of the limited liability company of any instrument, for apparently carrying on in the usual way the business of the limited liability company, binds the limited liability company, unless (i) the member so acting has in fact no authority to act for the limited liability company in the particular matter and (ii) the person with whom he or she is dealing has knowledge of the fact that the member has no such authority.

N.Y. Ltd. Liab. Co. Law § 412(a) (emphasis added). Section 412(b) has a similar provision governing manager-managed LLCs, so the court found that under Section 412, Sultan had apparent authority whether he was acting as a member or as a manager.

The LLC failed to offer any evidence that plaintiffs had any knowledge of the limitation on Sultan’s authority resulting from the transfer of his member interest, so the court found that there was no issue of triable fact whether Sultan lacked apparent authority to enter into the sale contract, and affirmed the trial court’s ruling.

Comment.  The legal doctrine of apparent authority is hugely important in the world of business. Consumers and businesses routinely rely on the apparent authority of the other party to a contract, without inquiring into the details of the actual authority of the agent signing the contract.

It would be difficult to function in a modern economy for more than a few hours without interacting with an agent of some kind. The atmosphere is so thick with agents that most people rarely think about them; I willingly hand money to a stranger I meet in a store and carry away goods without questioning whether a sale has occurred.

Paula J. Dalley, A Theory of Agency Law, 72 U. Pitt. L. Rev. 495, 497 (2011).

Pasquarella is an example of a fairly routine application of apparent authority, so much so that it’s a little surprising that the LLC asserted Sultan’s lack of actual authority as a reason for not enforcing the sale contract. The doctrine of apparent authority is by its nature always fact-specific, but the facts here seemed to fairly clearly support Sultan’s apparent authority.

The court also relied on Sultan’s statutory apparent authority under Section 412 of the New York Limited Liability Company Law. If that section applies in a particular case, the court in theory need not even examine the facts supporting apparent authority, other than (a) was the purported agent a member or manager of the LLC, (b) was the action by the purported agent taken “for apparently carrying on in the usual way the business of the limited liability company,” and (c) did the other party have any knowledge that the member or manager in fact had no authority.

In one respect the Pasquarella court’s analysis was deficient, because it did not address whether the real estate sale contract was for the purpose of “apparently carrying on in the usual way” the business of the LLC. The LLC’s business is not described in the opinion, but a sale contract for a parcel of real property would usually be considered outside the ordinary course, unless the LLC routinely sold real estate.

 

Washington Court of Appeals Clarifies That Fraud Need Not Be Pleaded with Particularity to Support Veil-Piercing Claim

The Washington Court of Appeals had to decide earlier this year whether the plaintiff’s complaint in an LLC veil-piercing case was adequate, in Landstar Inway, Inc. v. Samrow, 181 Wn. App. 109, 325 P.3d 327 (May 6, 2014). The plaintiff alleged that the veil should be pierced because the LLC member used the LLC form to commit fraud. The LLC member moved to dismiss the claim against him on grounds that the complaint lacked sufficient detail. The court held that the strict pleading requirements for a fraud claim do not apply to a veil-piercing claim based on fraud allegations.

A brief review of the pleading requirements for a complaint is in order. A complaint is the document that a plaintiff files in court to begin a lawsuit. It must contain a statement of the plaintiff’s claim showing that the plaintiff is entitled to relief from the defendant, and a demand for judgment for the relief requested. In most cases the relief requested will be an award of damages, i.e., money from the defendant to compensate the plaintiff.

The rules of court govern the requirements for a complaint. Washington’s court rules for civil cases, like those of most states, are based on the Federal Rules of Civil Procedure. In most cases the complaint must provide only “a short and plain statement of the claim showing that the pleader is entitled to relief.” Wash. R. Civ. P. 8(a). This is often referred to as “notice pleading,” meaning that the complaint is only required to have sufficient detail to put the defendant on reasonable notice of the claim. The expectation is that the parties will be able to learn additional details, if necessary, during the discovery phase of the proceedings.

The pleading rules are stricter for some types of allegations, however, including claims of fraud:

“In all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally.” Wash. R. Civ. P. 9(b) (emphasis added). A complaint that alleges fraud but fails to plead the elements of fraud and the detailed circumstances constituting the fraud may face dismissal.

Background. Frank Samrow and Terry Walker formed Oasis Pilot Car Service LLC to provide pilot car dispatching services to trucking companies. Truckers hauling tall cargo loads in Washington are required to have a pilot car escort. The pilot car has an attached, vertical survey pole, higher than the load, and precedes the truck to ensure safe passage under overpasses and bridges.

Oasis entered into a master agreement in 2009 with Landstar Inway, Inc. to provide pilot car services. Later that year Oasis responded to a request from Landstar by dispatching Phil Kent to escort a truck with a tall load from the Canadian border through Washington.

Kent’s pilot car passed under a freeway overpass near Lakewood that Kent believed had been safely cleared, but the truck’s load struck the bottom of the overpass, damaging both the load and the overpass. Landstar eventually paid the owner of the load and the Washington Department of transportation for their damages, and then tendered its indemnity claim to Oasis under the master agreement. The master agreement required Oasis to maintain vehicle liability insurance, but Samrow’s insurance company rejected Landstar’s claim because the insurance was on his personal vehicle.

Landstar then sued Oasis, Samrow, and Kent’s company, CJ Car Pilot, Inc., for negligence, breach of contract, and breach of indemnity. Samrow moved for summary judgment dismissing him from the lawsuit, on grounds that any liability ran to Oasis and not to Samrow personally. The trial court granted Samrow’s summary judgment motion, ruling that the undisputed facts did not justify piercing the LLC’s veil or imposing personal liability on Samrow, and Landstar appealed. Landstar, 181 Wn.App, at 119.

Court of Appeals. The court began its review of Washington’s LLC veil-piercing law by referring to Chadwick Farms Owners Association v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009), and Section 25.15.060 of the Washington LLC Act. To succeed in piercing the veil of an LLC, a plaintiff must prove that the LLC form was used to violate or evade a duty and that the LLC form should be disregarded to prevent loss to an innocent party. Abuse of the corporate form must be shown to establish that the LLC was used to violate or evade a duty, and that typically involves some type of fraud, misrepresentation, or manipulation of the LLC to the member’s benefit and the creditor’s detriment. Landstar, 181 Wn.App. at 123.

Landstar alleged that Samrow abused the corporate form by fraudulently concealing the fact that Oasis dispatched pilot car operators instead of providing pilot car services of its own, and by fraudulently misrepresenting his own personal insurance as Oasis’, to satisfy Oasis’s insurance obligation under the master agreement. But Samrow argued that the court should reject Landstar’s veil-piercing claim because it was based on fraud, and Landstar failed to plead the elements of fraud and the factual circumstances with the particularity required by Civil Rule 9(b).

The court pointed out that it was faced with an issue of first impression: “There is no Washington case addressing whether a party must satisfy the pleading requirements of CR 9(b) in seeking to disregard a corporate form.” Id. at 125. The court looked to the federal courts because they have addressed the issue, but found no unanimity there.

Washington law is clear that piercing the veil is an equitable remedy and not a separate cause of action. If the veil of an LLC is pierced, a member may be held personally liable for the LLC’s underlying tort or breach of contract, but piercing the veil is not a freestanding claim for relief. Id. at 125-26 (citing Truckweld Equip. Co. v. Olson, 26 Wn.App. 638, 643, 618 P.2d 1017 (1980)). From that premise the court reasoned that CR 9(b)’s heightened pleading requirement for claims of fraud should not apply to claims seeking the remedy of piercing the veil, even if the veil-piercing claim is based on fraudulent conduct. The court also noted that its conclusion was consistent with Washington’s commitment to maintaining liberal pleading standards. Id. at 126.

Having rejected Samrow’s contention that Landstar’s complaint failed to satisfy the CR 9(b) heightened pleading requirement, the court went on to the merits of Samrow’s summary judgment motion. The court reversed the trial court’s grant of summary judgment on the veil-piercing claim because it found that material issues of fact remained to be resolved at trial.

Comment. Landstar is significant because it resolved an open question about the pleading requirements for a complaint that seeks to pierce the veil of an LLC, where the veil-piercing request is predicated on fraudulent acts or statements. The court made clear that the normal “notice pleading” rules apply in such a case, unlike the stricter requirements for pleading a direct claim of fraud.

South Carolina Supreme Court Invalidates LLC Operating Agreement’s Repurchase Right After Charging Order Foreclosure

Many LLC operating agreements contain transfer restrictions on LLC member interests. Those restrictions sometimes include the LLC’s right to repurchase the interest if a member makes a transfer in violation of the operating agreement. What’s the result if such a repurchase right applies to a transfer resulting from the foreclosure of a charging order by a member’s judgment creditor? The South Carolina Supreme Court earlier this month ruled that a foreclosure sale was valid and trumped the operating agreement’s repurchase right, and that the repurchase right could not be enforced. Levy v. Carolinian, LLC, No. 27442, 2014 WL 4347503 (S.C. Sept. 3, 2014).

Background. Shaul and Meir Levy obtained a $2.5 million judgment against Bhupendra Patel, a member of Carolinian, LLC, a South Carolina LLC. The Levys later obtained a charging order against Patel’s interest in the LLC, and subsequently foreclosed the lien of the charging order.

Following the foreclosure sale, the LLC asserted that it was entitled under the operating agreement to purchase Patel’s interest from the Levys. Section 11.1 barred the members from voluntarily or involuntarily selling, transferring, or otherwise conveying their interest without a two-thirds vote of the other members, and declared that any attempted conveyance of a member’s interest without the requisite consent would be null and void. Section 11.2 provided for the repurchase: “If a Member attempts to transfer all of a portion of his Membership Share without obtaining the other Members’ consent as required in Section 11.1, … such Member is deemed to have offered to the Company all of his Member Share….” Id. at *2.

The LLC contended that because Patel’s interest was conveyed without the members’ consent, the Levys were deemed to have offered their interest to the LLC and it was entitled to purchase the interest. The Levys objected that they were not parties to the operating agreement and were not required to obtain any consent to foreclose their statutory charging order.

The Levys filed suit for a declaratory judgment that they were the rightful owners of Patel’s interest. The trial court found that as transferees the Levys became subject to Article 11 of the operating agreement, and that the LLC could therefore force the Levys to sell Patel’s interest to the LLC. Id. 

Supreme Court. The court began by reviewing the South Carolina LLC Act, S.C. Code Ann. § 33-44-101 to -1208 (the Act). The Act provides at Section 504 that:

  • a judgment creditor of an LLC member may obtain from a court a charging order against the member’s distributional interest,
  • a charging order is a lien on the judgment debtor’s distributional interest,
  • the judgment creditor may foreclose its lien,
  • the member’s interest that is subject to the charging order may be redeemed at any time before foreclosure,
  • a purchaser at a foreclosure sale has the rights of a transferee, and
  • this is the exclusive remedy by which a member’s judgment creditor may satisfy a judgment out of the judgment debtor’s distributional interest in the LLC.

The court pointed out that while an LLC is generally free to modify the default provisions of the Act by its operating agreement, the agreement may not restrict the rights of a person “other than a manager, member, and transferee of a member’s distributional interest.” Levy, 2014 WL 4347503, at *3 (quoting S.C. Code Ann. § 33-44-103(b)).

But, said the court, the Levys did not become transferees until after the foreclosure sale, so the LLC’s operating agreement could not restrict their rights by requiring consent of the members before the foreclosure sale. At that time the Levys were merely judgment creditors. The LLC could not invoke the purchase right under Section 11.2 after the foreclosure, because that right was only applicable where consent was not obtained prior to the transfer. The Supreme Court accordingly reversed the trial court: “[W]e further find that Carolinian may not now invoke the provisions of Article 11 to compel the Levys to sell the distributional interest they acquired through the foreclosure sale.” Id. at *4.

Comment. Levy is not about an attempt to avoid a charging order or an attempt to prevent foreclosure of a charging order, and it’s not a dispute about a pre‑foreclosure redemption. (The operating agreement and the Act both allowed redemption of a member’s interest that is subject to a charging order, but the LLC was unwilling or unable to redeem Patel’s interest prior to the foreclosure.) Levy is about an attempt by an LLC to require in its operating agreement that unwanted acquirors of a member’s interest, on demand by the LLC, must sell back the interest to the LLC (presumably at a fair price, although the opinion never mentions the price that Article 11 apparently describes).

The operating agreement’s buyback is an aspect of the “pick your partner” principle – the idea that, like partners in a partnership, members in an LLC should not be forced to associate and do business with another member they don’t know and don’t want to be associated with. This principle is embodied in the distinction between an LLC member, who will have voting and management rights as well as economic rights, and an assignee (also called a “transferee”) that has only economic rights unless admitted as a member. Consistent with this principle, most LLC statutes only allow an assignee to be admitted as a member on the unanimous vote of the members, or as otherwise allowed by the operating agreement. E.g., S.C. Code Ann. § 33-44-503.

Of course the buyback provision of the Carolinian operating agreement goes further than merely keeping the purchaser at the foreclosure sale out of management. Buying back the purchaser’s interest completely ousts the purchaser from the LLC, so it would not even have economic rights, let alone management rights.

The court’s analysis, however, focused in a literalistic way on the language of the operating agreement. The court’s analysis ran as follows: the Levys did not become transferees until after the foreclosure, consent for the sale was required by the operating agreement before the foreclosure, and therefore the Levys were not bound by the need for consent. But a transferee of a member’s interest takes no less and no more than the economic rights of the transferor. If the transferor’s LLC interest was subject to a repurchase right under certain circumstances before the transfer, then it would continue to be subject to the repurchase right after the transfer. The court ignored this basic principle of property rights. The repurchase right did not affect the rights of a third party; it applied to a transferee, the purchaser at the foreclosure sale.

Dissolution of Connecticut LLC Does Not Automatically Transfer Assets to LLC’s Members

Lawyers sometimes misunderstand the consequences of an LLC’s dissolution. Dissolution does not terminate the existence of an LLC. A dissolved LLC’s members and managers continue to be its members and managers, and must wind up the LLC’s business. The dissolved LLC continues to own its property until it is sold or distributed to the members.

A claim by an LLC’s managing member that the LLC’s dissolution automatically transferred its property was a central issue in a recent accounting malpractice case. Mukon v. Gollnick, 92 A.3d 1052 (Conn. App. Ct. June 24, 2014) (per curiam).

Background. Mark Mukon was the managing member of Sea Pearl Marine, LLC, a Connecticut limited liability company. The LLC purchased a ship’s hull in 2007 in order to construct a complete vessel, and paid Connecticut sales tax on the hull.

Connecticut LLCs must pay an annual $250 filing fee to the state, and in 2009 Mukon asked his accountant how he could avoid paying the annual fee. His accountant advised him that he could avoid the fee by dissolving the LLC, and that the only tax consequences would be capital gains taxes when the vessel was sold. Mukon accordingly dissolved the LLC, and his accountant assisted in filing the dissolution paperwork with the state.

After the dissolution Mukon re-registered the vessel in his own name with the Connecticut Department of Motor Vehicles. Shortly thereafter the Department of Revenue Services audited the transaction, determined that there was no exemption, and assessed use taxes, penalties, and interest, which Mukon paid. (The use tax is complementary to the sales tax, and is assessed when sales tax is not collected.)

Mukon later sued his accountant for malpractice. He claimed that the tax became payable when the vessel was automatically transferred upon the LLC’s dissolution, contrary to the accountant’s advice that the dissolution would not result in any tax liability other than capital gains upon the vessel’s sale. The trial court accepted Mukon’s theory, found that the accountant had committed professional malpractice, and awarded damages to Mukon. The accountant appealed.

Appellate Court. The court’s analysis turned on its review of the Connecticut LLC Act’s dissolution provisions. A dissolved LLC continues to exist but must be wound up. Its managers or managing members must, in the name of the LLC, settle and close the LLC’s business, dispose of and transfer the LLC’s property, discharge its liabilities, and distribute any remaining assets to the LLC’s members. Conn. Gen. Stat. §§ 34-206, 34-208. The court found the statute to be clear: the LLC’s dissolution started a winding-up process, but dissolution alone did not transfer any assets.

The dissolution of a limited liability company does not … result in an automatic transfer of the limited liability company’s assets to one of the individual members. Instead, the dissolution necessitates a prescribed winding-up process, and a member receives the limited liability company’s property if, and only if, the member or manager winding-up the limited liability company has completed the applicable steps established by § 34-208(b) and the assets are distributed in accordance with § 34-210.

Mukon, 92 A.3d at 1055.

Mukon’s malpractice cause of action was predicated on his theory that the use tax became due and payable when the vessel was automatically transferred upon the LLC’s dissolution. The court rejected his theory and therefore reversed the trial court’s malpractice award.

Comment. It seems odd that Mukon hung his whole case on the theory that the LLC’s dissolution transferred the LLC’s property. After all, an LLC’s dissolution initiates the winding-up process, and the statute requires that the LLC’s assets be sold or distributed to the members after all debts and liabilities have been satisfied. In other words, dissolution made the transfer of the boat inevitable, and the transfer resulted in the use tax being assessed. So the accountant’s advice that the dissolution would not result in sales or use taxes appears to have been incorrect.

In any event, the case is a good review of the rules for dissolving and winding up an LLC. It’s also an example of the adage, “penny wise and pound foolish.” $250 a year seems like a modest price to pay to keep an LLC in existence.

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