LLC's Creditors Have Standing to Sue Members for Unlawful Distributions
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
Ohio LLC Shields Privacy of Litigation Plaintiffs
Parties to litigation normally cannot keep their identities out of the public eye--plaintiffs and defendants are named in the complaint that starts a lawsuit. Complaints are public documents that are filed with the court. But a group of allegedly defrauded investors in Ohio recently used a limited liability company to bring a securities fraud lawsuit while keeping their names out of the court records.
The events that led to this lawsuit are sadly reminiscent of the Bernie Madoff debacle. Fair Finance Co. is an Ohio loan company founded in 1934. The company was owned by the Fair family and sold investment certificates to Ohio residents for a generation, including to members of Ohio’s Amish community. In 2002 wealthy Indianapolis investor Timothy Durham took control of the company.
In November 2009 the FBI raided Fair Finance’s offices and seized computers and records. Federal investigators suspected that Fair Finance was being operated as a Ponzi scheme, according to court records. The ongoing investigation has not yet resulted in any charges or arrests, but the company and its eight Ohio offices have been closed since November 24, 2009.
On December 21, a lawsuit was filed by a group of Ohio residents against Fair Finance and several other defendants, including Timothy Durham. In their complaint the plaintiffs seek rescission and damages for breach of contract, securities fraud, and negligent misrepresentation.
The lawsuit was brought by 16 plaintiffs. Two are trusts, 13 are individuals, and one is Fair Recovery, LLC. Fair Recovery is an Ohio LLC that was formed on December 10, 2009. According to the complaint, Fair Recovery is pursing the claims of 20 individual investors, all of whom are members of the LLC. The LLC members invested a total of $1,360,000 in Fair Finance.
Under Ohio’s LLC Act, an LLC is formed by filing Articles of Organization, and according to Fair Recovery’s Articles of Organization, its purpose is “to engage in any lawful act or activity.” The Articles are not required to disclose the LLC’s members, and Fair Recovery did not disclose its members' identities.
According to local newspaper reports, some members of the local Amish community invested with Fair Finance and have claims against it. The articles point out that the Amish faith discourages its members from settling disputes in court, and speculate that Fair Recovery was formed to press the legal action on behalf of Amish investors and to keep their names out of the public record. The law firm representing Fair Recovery and the other plaintiffs declined to say whether any are Amish.
This is a rather novel use of an LLC. Apparently Fair Recovery has no other business, and was formed simply to press the claims of its members in the litigation against Fair Finance. Using such an entity would not normally confer any benefit in litigation, so it appears that the only added value it provides is protection of the privacy of its members.
It remains to be seen how well the LLC will hold up as a privacy shield. For one thing, the identity of Fair Recovery’s members will probably become the subject of pretrial discovery procedures. For example, the defendants will be entitled to depose the Fair Recovery members to investigate the details of their claims. But pretrial discovery information is not usually filed with the court, so the identity of the Fair Recovery claimants presumably will be kept out of the court records prior to trial. The trial itself should be open to the public, but it may or may not be necessary at trial for testimony to identify the Fair Recovery members. Fair Finance must know, of course, who its investors are. It can probably determine easily who the Fair Recovery plaintiffs are, and could disclose that information if it chose to do so.
A First -- New York Applies De Facto Corporation Doctrine to LLCs
New York’s highest court, the Court of Appeals, held last month that the doctrine of de facto corporations applies to LLCs. In re Hausman, No. 08854, 2009 NY LEXIS 4145 (Dec. 1, 2009). “De facto corporations” is an equitable doctrine that can be applicable when founders have attempted to form a corporation but failed to fully comply with the statutory requirements. The New York court is apparently the first appellate court in the nation to resolve this issue.
It sometimes happens that founders of a corporation or LLC to enter into contracts, incur debts or take other actions on behalf of the entity before its formation. But if an agent enters into a contract on behalf of a non-existent entity, under agency law the other party to the contract will usually be able to hold the agent personally liable. The de facto corporation doctrine can permit judicial recognition of the entity’s existence, thereby avoiding personal liability of the agent.
In most states, including New York, an LLC begins to exist when its articles of organization or certificate of formation are filed with the appropriate state agency. E.g., N.Y. Ltd. Liab. Co. Law § 203. But occasionally founders jump the gun and act on behalf of the LLC before the filing is made, sometimes by mistake and sometimes knowing that the articles were not yet filed.
When creditors later claim that the founders are personally liable for contracts entered into before the LLC existed, the founders may defend on the grounds that a de facto corporation existed. There are also other situations, such as in Hausman, where the effectiveness of a conveyance or some other action will depend on whether the LLC existed at the time of the action, and the de facto corporation doctrine may then come into play.
Hausman was a probate proceeding. Lena Hausman’s will left real estate to her son and daughter and to the children of two predeceased sons. Before her death, the son and daughter executed articles of organization and prepared an operating agreement for a New York LLC. Lena Hausman then deeded the real estate to the son and daughter’s LLC, but the articles of organization for the new LLC were not filed with the New York Department of State until 14 days later.
Lena Hausman died seven months later and her will was admitted to probate. In the probate proceedings, the children of the predeceased sons claimed that the real estate should pass by will because Lena’s deed did not convey the real estate to a valid LLC. They pointed out that the LLC did not exist at the time of the deed. The probate court concluded that the deed to the LLC was valid because the LLC was a de facto corporation when the deed was executed.
The Court of Appeals held that the de facto corporation doctrine is applicable to LLCs. “The statutory schemes of the Business Corporation Law and the Limited Liability Company Law are very similar, and we see no principled reason why the de facto corporation doctrine should not apply to both corporations and limited liability companies.” Hausman at *3. The court cited to no other authority, but implicitly recognized that the equitable considerations which support the doctrine for corporations apply to LLCs as well.
The Court of Appeals pointed out that the de facto corporation doctrine requires (1) a law under which the entity might be formed, (2) an attempt to form the entity, and (3) an exercise of the entity’s powers thereafter. Under the facts in Hausman, the court concluded that the second prong was not satisfied¾even though the doctrine was applicable, no de facto LLC existed because there had been no attempt to file the articles of organization until weeks after the deed conveying the real estate was executed.
It is worth noting that many other states have abolished the doctrine of de facto corporations. See, e.g., Equipto Div. Aurora Equip. Co. v. Yarmouth, 134 Wn.2d 356, 367, 950 P.2d 451 (1998). Many of those states have adopted variations of the Model Business Corporation Act, which is intended to abolish the de facto corporation doctrine. See Model Bus. Corp. Act §§ 2.03, 2.04 (2008). Presumably the states that have abolished the de facto corporation doctrine would not apply it to LLCs.
Utah's Conflicting Remedies - LLC Statute vs. Common Law
Members of an LLC are at loggerheads and one sues the other. The plaintiff decides that the remedies in the state LLC Act are inadequate. The plaintiff instead asks the court for damages under the common law, for repudiation of the LLC’s operating agreement and for breach of contract rather than for dissolution and an accounting under the LLC Act. That was the situation in OLP, L.L.C. v. Burningham, 2009 UT 75, 2009 WL 4406148 (Utah Dec. 4, 2009). The defendant in turn claimed that the plaintiff’s claims for repudiation and breach of contract were not allowable because the remedies under Utah’s LLC Act are exclusive. The court found otherwise and allowed the plaintiff’s contract claims.
Richard Wilson and Wayne Burningham formed OLP, L.L.C. as a Utah limited liability company, to purchase and operate an anti-reflective optical lens coating machine. They agreed to share equal control and ownership of OLP, and initially contributed equal amounts of capital. They agreed that Intermountain Coatings, a company owned by Burningham, would use the lens coating machine.
Acrimony between Wilson and Burningham soon reared its ugly head. They disagreed over how profits should be divided between OLP and Intermountain Coatings, and over whether the funds provided by Intermountain Coatings to OLP should be classified as a loan or as a capital contribution from Burningham.
Wilson eventually filed suit against Burningham and Intermountain Coatings for breach of fiduciary duty, repudiation of the contract, and breach of contract, and for an accounting of OLP’s expenses, revenues, profits, and losses. Burningham counterclaimed for dissolution of OLP. Burningham argued that in winding up OLP’s business, the members’ ownership interests should be determined and distributed according to each member’s capital account as provided in the LLC Act. Burningham’s theory was that Wilson’s claims should be resolved under the LLC Act’s dissolution procedures because those procedures are the exclusive remedy for claims between members.
The court pointed out that the LLC Act does not contain any explicit authorization or denial of common law claims, and examined a number of provisions in the LLC Act which imply that common law claims between members continue to apply. The court found that analogous partnership law allows common law claims between partners, without limiting remedies to equitable remedies. The court held that Utah’s LLC Act does not preclude common law claims between LLC members, such as claims for breach of contract, and that the remedies for such claims include equitable relief such as an accounting as well as damages.
The court rejected Burningham’s argument that dissolution is the sole remedy for wrongdoing between the members as being inconsistent with the jury’s finding that he had repudiated and abandoned the operating agreement. As the court said: “When one party effectively extinguishes a business agreement, whether it be a partnership agreement or a limited liability agreement, that party cannot rely on the agreement (or the default provisions of the LLC Act that supplement the agreement) to protect itself from the harm its actions have occasioned.” OLP, 2009 UT 75, ¶ 21.
The OLP decision is consistent with the approach of many courts to the rights and remedies of LLC members. For example, earlier this year I blogged on a New York decision which found that LLC members have a common law right to an equitable accounting, even though not explicitly authorized in the statute, here. I also described Idaho’s first case on fiduciary duties of LLC members, which found that fiduciary duties existed between managing members even though no such right was described in Idaho’s LLC Act, here. Courts generally seem to be reluctant to rule out common law rights of recovery or to exclude equitable remedies, in the absence of an explicit bar in their state’s LLC Act.
Confusion Over LLC Units
LLC operating agreements often use the term “units” to describe member rights in the LLC. It is convenient to have a word like “units” to label the members’ rights, and “units” is widely used. But “units” has no uniform definition or generally accepted meaning when applied to LLCs.
Andrew Immerman recently authored an article that examines the inherent ambiguity and the confusion that often results from using units to describe LLC member rights. L. Andrew Immerman, Is There Any Such Thing as an LLC Unit?, 11 No. 4 Bus. Entities 20 (July/Aug. 2009), 2009 WL 2563091. The article is a good review of how and why the units terminology is used and misunderstood. It provides examples of the mistaken conclusions that business people can reach when they ignore the differences between shares of stock in a corporation and the rights of a member in an LLC.
Immerman ascribes this confusion to three principal causes. First, business people and sometimes lawyers often think of an LLC as essentially similar to a corporation. Second, the state laws that authorize LLCs do not expressly authorize the issuance of LLC units or define an LLC unit. Third, LLC members are taxed differently than shareholders. LLC taxation can cause units in the same LLC to unexpectedly provide different benefits to their owners, unlike shares of stock, which are usually interchangeable.
There is no concept of “units” in the various state LLC statutes. For example, Washington’s LLC Act makes no reference to units, and simply defines a member’s LLC interest as personal property comprising the member’s share of the profits and losses of an LLC, and the right to receive distributions of the LLC’s assets. Wash. Rev. Code §§ 25.15.005(6), 25.15.245(1).
Delaware’s LLC Act likewise makes no reference to units, and has an almost identical definition of a member’s LLC interest. Del. Code Ann. tit. 6, §§ 18-101(8), 18-701. And neither NCCUSL’s Revised Uniform Limited Liability Act nor the Revised Prototype Limited Liability Company Act from the American Bar Association uses that terminology.
LLCs are distinct from corporations in a number of ways. One major difference is that an LLC is much more a creature of contract than is a corporation. LLC member rights are normally defined by the members’ operating agreement, and only secondarily by the LLC Act. Members are parties to the operating agreement, whereas corporate shareholders hold shares of stock but need not be parties to any contract. Most of a shareholder’s rights will generally be defined by the applicable corporate statute, while an LLC member’s rights will be defined by the terms of the operating agreement. A potential investor in an LLC cannot know what rights the holder of a unit will have without a careful examination of the operating agreement.
Another difference between LLCs and corporations is that the rights associated with ownership of a share of stock are not normally divided. If a share of stock is sold, the rights to receive dividends, to vote, and to receive corporate information will usually all go with the share of stock. Transfer of a member’s interest in an LLC, on the other hand, will convey the right to receive profits, losses and distributions, but it will not necessarily carry with it the right to vote and participate in management of the LLC. All the members must approve the transferee’s admission as a member and participation in management, or the operating agreement may provide for the transferee’s admission as a member. E.g., Wash. Rev. Code §§ 25.15.250, 25.15.260; Del. Code Ann. tit. 6, §§ 18-702, 18-703.
LLCs are taxed as partnerships (absent an election to be taxed as a corporation), so items of profit and loss are allocated directly to the members. The LLC is not a taxpayer. Corporations, in contrast, are taxpaying entities and do not pass profits or losses through to shareholders. (One exception: a corporation can make a Subchapter S election, in which case its shareholders will each be allocated their proportionate share of the corporation’s profits and losses. An S corporation, however, can have only one class of stock and cannot have nonresident aliens or certain types of entities as shareholders.)
LLC members generally want the LLC’s allocations to be respected for tax purposes. This is a matter of predictability and being able to accurately assess and plan for the economic benefits and tax consequences of their LLC investment. For the LLC’s allocations of profit and loss to be respected for federal income tax purposes, the allocations in the operating agreement must comply with a set of complicated Treasury regulations intended to ensure that the allocations have “substantial economic effect.” I.R.C. § 704(b)(2). One of those requirements is that a capital account be maintained for each member. A member’s capital account is increased by the member’s contributions to the LLC’s capital, by profits allocated to the member, and by LLC liabilities assumed by the member, and decreased by distributions paid and losses allocated to the member, and by liabilities of the member assumed by the LLC.
The regulations also require, when the LLC is dissolved and its assets liquidated, that liquidating distributions be made to the members in accordance with the positive balances in their capital accounts. This is a key requirement of the allocation regulations, and has the effect of truing up the final, liquidating distributions with the effects of the LLC’s history. All the prior member capital contributions, distributions to members, and allocations of profits and losses would have impacted each member’s capital account in ways that may have varied from member to member.
Assuming the LLC’s operating agreement complies with these rules, the result is that on liquidation one member may receive substantially more or less per unit than another member receives per unit. A corollary is that at any point in the life of the LLC, one member’s unit may be worth more or less than a different member’s unit. One might try to define “unit” in the operating agreement to take capital account variations into effect, but then the definition would likely not work well for attributes such as voting and establishing percentages for profit and loss allocations.
In corporations it’s different and much simpler. At any given time the corporation’s capital per share is the same amount for all outstanding shares of common stock. If a corporation is dissolved and liquidated, the liquidating distributions per share of common stock will be the same amount for all the shares. “Holders of corporate stock need not worry about capital accounts, and the superficial resemblance of LLC units to corporate stock may create the impression that LLC members can safely ignore the concept as well. It can be perilous, however, to ignore LLC capital accounts.” Immerman, supra, at 62.
In all states LLCs now lead corporations in formations of new business entities. For many business people LLCs are relatively new and sometimes perplexing. Their lawyer or the other parties may present them with operating agreements that describe their interests as “units.” They may be familiar with corporations, but should not be misled by the surface similarities and assume that those units are comparable to shares of stock. The operating agreement should be read and analyzed carefully. The ways in which units are handled in the agreement needs to be thoroughly understood. Because many of the results of a member’s investment will depend on the tax treatment of allocations and capital accounts, an experienced tax advisor should usually be consulted.
The Beneficial Ownership Bill Just Won't Go Away
The Incorporation Transparency and Law Enforcement Assistance Act, S. 569 (the Bill), is still alive. Two weeks ago the Senate Committee on Homeland Security and Governmental Affairs held a hearing on the Bill, on November 5 (the Hearing). The list of witnesses and their prepared testimonies are available, here. The Committee’s previous hearing on the Bill was on June 18, 2009.
The principal purpose of the Bill is to require the states to change their laws to mandate that organizers of LLCs and corporations provide each state with lists of the “beneficial owners” of the entity being formed, during the formation process and annually thereafter. Each beneficial owner must be identified by name and address. For more details, see my previous blog on this Bill, Big Brother Wants to Crack Open Your LLC.
The Bill’s definition of “beneficial owner” is awe inspiring in its scope and ambiguity. A beneficial owner is defined as an individual “who has a level of control that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct the corporation or limited liability company.”
Only human beings are included in the definition of beneficial owner, so multiple levels of ownership will have to be traced. If an LLC or corporation is a member of an LLC, for example, the ownership will have to be followed up to the individuals at the top of the ownership structure.
In many cases it will be unclear which individuals have the ability, as a practical matter, directly or indirectly, to direct the affairs of an LLC with multiple levels of ownership. And if an organizer knowingly omits the name of an individual that is later determined to somehow have the practical ability to directly or indirectly control the entity, that organizer may be fined up to $10,000 and sent to jail for up to three years.
This is a bad bill. It is one more example of the federal government attempting to federalize an area of commerce traditionally handled by the states. It would be an invasion of the privacy of millions of legitimate business people. The bureaucrats promoting this Bill disregard the legitimate commercial interests many business people have in not disclosing their ownership of a business.
The Bill is justified by organizations such as the Treasury Department, the Justice Department, and the Federal Law Enforcement Officers Association as being helpful in investigations of crimes such as money laundering and wire fraud. The testimony skates briefly over the fact that LLCs and corporations can act only through their human agents, officers, and employees. For example, to open a bank account an LLC must have a person appear on its behalf at the bank and identify himself or herself to the bank’s satisfaction. LLCs and corporations are required to have registered agents in their state of formation and every state in which they do business. The records of an LLC, including its ownership records, may be searched if a judge issues a search warrant on probable cause.
The Bill appears to be driven in large part by law enforcement’s desire to peer into business records without a warrant and without any need to alert the business that the government is looking at its records.
The proponents of the Bill deprecate its impact on the states. For example, it was asserted in John Ramsey’s prepared testimony at the Hearing, on behalf of the Federal Law Enforcement Officers Association, that “this Bill does not require any state to enact any law with respect to corporations; it merely requires the states to add one more question to their existing incorporation forms and to make the information provided available to law enforcement upon presentation of a legally authorized subpoena or summons.” That is incorrect; the Bill does not contemplate a voluntary process. For the states to make it mandatory on an LLC to disclose its beneficial owners, the states will have to pass laws or adopt regulations.
Mr. Ramsey dismissed the costs on the states, saying “beneficial ownership information can be collected via existing electronic incorporation methods and stored in existing electronic databases.” He should talk to those who would be responsible for complying with the Bill’s requirements. Senator John Ensign testified at the Hearing that the Nevada Secretary of State estimates that its costs for implementing the required systems could reach as high as $10 million, with ongoing annual costs of approximately $1 million.
Kevin Shepherd represented the American Bar Association at the Hearing. He testified:
In our view, the imposition of a federal regulatory regime focused on beneficial ownership information is not workable, would be extremely costly, would impose onerous burdens on state authorities and legitimate businesses, would run counter to formation practices of major countries (including Canada, Mexico, Japan, and China), and will not achieve the laudable goal of assisting federal law enforcement authorities with pursuing and prosecuting criminal activity.
Mr. Shepherd pointed out in his remarks that the United Kingdom has studied and considered this issue. The UK authorities concluded that there were significant disadvantages and no clear benefits to adopting a system requiring up-front disclosure of beneficial ownership of entities, especially since it was unlikely that those engaged in criminal activities would provide true information. Financial Action Task Force Third Mutual Evaluation Report, Anti-Money Laundering and Combating the Financing of Terrorism, The United Kingdom of Great Britain and Northern Ireland at 234.
Jack Blum, a Washington attorney who testified at the Hearing in support of the Bill, conceded that criminals would be able to conceal the identity of the beneficial owners of entities formed for nefarious purposes. It does seem rather unlikely that criminals and fraudsters would worry about complying with a law intended to make it easy to catch them.
American businesses form approximately two million LLCs and corporations each year. These range from small, mom-and-pop businesses to entrepreneurial, venture-capital-funded start-ups to joint ventures between large organizations with complex ownership structures. This Bill would burden all of them with confusing and difficult-to-understand reporting requirements that will provide little or no benefit to law enforcement. The Bill should be rejected.
New York Court Holds Distribution Was Not a Misappropriation
Is it a distribution or a misappropriation when a managing member of an LLC withdraws funds from the LLC for his own use? That was the dispositive issue in Mostel v. Petrycki, 885 N.Y.S.2d 397 (N.Y. Sup. Ct. Sept. 2, 2009). It was dispositive because the answer to that question determined which of two different statutes of limitations applied.
Mostel had a judgment against Fulcrum Global Partners, LLC, a Delaware LLC (Fulcrum), from a prior lawsuit. Fulcrum went out of business and Mostel was unable to recover from Fulcrum on his judgment, so he brought a lawsuit against Petrycki, the founding member and CEO of Fulcrum. Mostel claimed that a $300,000 withdrawal from Fulcrum by Petrycki was a fraudulent conveyance under New York’s Debtor and Creditor Law, N.Y. Debt. & Cred. Law §§ 273, 273-a, 276 and 276-a.
According to Mostel, Petrycki’s withdrawal was a fraudulent conveyance because it was without consideration, and rendered Fulcrum insolvent and without assets to satisfy the judgment against it. If the withdrawal was a fraudulent conveyance, Mostel’s judgment against Fulcrum could reach the $300,000 in Petrycki’s hands.
Petrycki, however, asked for Mostel’s suit against him to be dismissed on grounds that his $300,000 withdrawal was a distribution to him by Fulcrum, and the lawsuit was therefore barred by the three-year statute of limitations in the New York Limited Liability Company Act and the Delaware Limited Liability Company Act.
Mostel riposted that the six-year statute of limitations applicable to the fraudulent conveyance claim should apply. (Mostel’s suit was filed more than three years and less than six years after the withdrawal.) Mostel argued that the $300,000 withdrawal was not a distribution because Petrycki did not have authority to withdraw the funds and had applied them for his personal use.
Since Fulcrum was a Delaware LLC, the court examined both the Delaware and New York LLC Acts. Both statutes provide that if a member receives a distribution that causes the liabilities of the LLC to exceed its assets, and if the member knew of the resulting insolvency at the time of the distribution, then the member is liable to the LLC for return of the distribution. Both statutes also provide that a member’s liability for receiving a wrongful distribution will end three years after the distribution, unless a lawsuit is brought on the claim before the end of the three years. N.Y. Ltd. Liab. Co. Law § 508; Del. Code Ann. tit. 6, § 18-607. Finding no difference between the two states’ laws, the court said it need not decide which state’s law governed – the result would be the same in either case. Mostel, 885 N.Y.S.2d at 399 n.1.
The New York courts had previously determined that in the case of an LLC distribution which is both wrongful under Section 508 of the LLC Act and a fraudulent conveyance under the Debtor and Creditor Law, the three-year limitations period of the LLC Act overrides the six-year limitations period of the Debtor and Creditor Law. O’Connell v. Shallo, 323 B.R. 101 (S.D.N.Y. 2005). So if the $300,000 withdrawal was a distribution, the three-year limitations period of the LLC Act would apply, and Mostel’s claim would be barred. If it was a misappropriation and therefore not a distribution, Mostel’s suit could go forward.
The New York LLC Act defines “distribution” as “the transfer of property by a limited liability company to one or more of its members in his or her capacity as a member.” N.Y. Ltd. Liab. Co. Law § 102(i). Fulcrum’s Operating Agreement gave all members the right to request a return of their invested capital, subject to the approval of the managing member. The agreement did not provide for any additional procedures when a managing member seeks a return of its own invested capital.
Mostel’s complaint conceded that Petrycki was the managing member and that his $300,000 withdrawal was a return of his capital contribution, so the court rather straightforwardly concluded that the withdrawal was an authorized distribution to Petrycki. The three-year limitations period applied and Mostel’s claim was time-barred. Mostel’s complaint was dismissed.
The lessons from this case? Apart from the obvious, of course – don’t delay filing a lawsuit for so long that a statute of limitations bars the claim – the case underscores the importance of written LLC agreements. It also shows the need for the members to consider carefully the distribution provisions in their agreement. Interim distributions should be authorized by the agreement, and the parties should think about what procedures or approvals will be necessary for different types of distributions. For example, in Fulcrum’s agreement, distributions on request of a member for return of its invested capital were allowed if approved by the managing member, and that provision validated Petrycki’s withdrawal as a distribution.
SEC Limits the Use of Series LLCs for Broker-Dealers
The SEC recently took the wind out of the sails of broker-dealers hoping to use series LLCs for multiple broker-dealers within one LLC. In a letter dated September 1, 2009, the SEC staff advised the Financial Industry Regulatory Authority (FINRA) that the proposed series LLC structure would not pass muster under the SEC’s net capital rule, its customer protection rule, and its financial reporting rule.
FINRA proposed, for example, that an LLC would have two series, one to operate a retail broker-dealer and one to operate an institutional broker-dealer. The LLC, and not either series, would register with the LLC.
The LLC itself would have no business operations. Instead, each series would operate a separate brokerage and would have separate assets and liabilities. The liabilities of one series would not be enforceable against the assets of the other series or the overall LLC, but the assets and liabilities of the two series would be aggregated on the LLC’s consolidated financial statement, which is filed periodically with the SEC. (For a description of how series LLCs work, see my previous post, here.)
The SEC’s staff pointed out that partitioning each series’ assets and liabilities within the LLC would be inconsistent with applying the net capital rule at the LLC level. Reporting the LLC’s financials on a consolidated basis would greatly impair the SEC’s and FINRA’s ability to supervise the LLC’s financial position, since the SEC would not be able to determine the financial position of the LLC and each series without substantial effort.
The staff pointed out other problems regarding customer reserve accounts and equal treatment of customers in the event of a liquidation proceeding. The bottom line was that the idea of having the LLC be the regulated entity while yet having each series be treated as separate, independent entities for purposes of their assets and liabilities, is inconsistent with the SEC’s regulations.
Series LLCs have a place in the business world. But at least in this case, asking regulators to ignore the inherent inconsistency between regulating only the overall LLC, while disregarding the separate liability shield of each series within the LLC, was simply a bridge too far.
Former LLC Member: Why Does My K-1 Show All This Income?
An LLC member, Mr. Smith, sells his member interest and terminates all connections with the LLC. The sale agreement ends Smith’s rights in the LLC. Smith moves on and doesn’t think much more about the LLC. Many months later, Smith receives a Schedule K-1 from the LLC. >
Schedule K-1 is the form an LLC uses to inform each member of the member’s share of income, losses, deductions, credits and so on. Like almost all LLCs, Smith’s former LLC is taxed as a partnership for federal income tax purposes, and the LLC’s income and losses for each tax year are allocated to its members. The members then each pay taxes on their share of the LLC’s income for that year, or use the losses to shelter other income. (The ability to use losses to shelter other income is subject to various limitations. See my prior post on passive income loss limitations, here.)
Smith is shocked to see that the K-1 shows a whopping allocation of income to him for the last year of his membership in the LLC. He realizes that that income will have to be reported on his own personal tax return and will substantially increase his tax bill, and he didn’t receive any cash distribution from the LLC to cover those extra taxes. Based on what he knows about the LLC’s operations and finances towards the end of his involvement with it, he doesn’t understand how or why so much income was allocated to him. What does he do?
Naturally Smith starts asking questions. He requests copies of the LLC’s financial records so his CPA can evaluate the correctness of the LLC’s allocations. The LLC, however, points out that Smith is no longer a member, so its operating agreement gives him no right to see the records. The LLC also notes that the state LLC Act only allows members, not former members, to access LLC records. In short, he is politely told to go roll his hoop.
The plaintiffs in Abdalla v. Qadorh-Zidan, 913 N.E.2d 280 (Ind. Ct. App. Sept. 10, 2009), were faced with this situation. The Qadorh-Zidans (Zidans) and the Abdallas had formed five LLCs to own and operate apartment properties. Later the Abdallas filed a lawsuit against the Zidans alleging breach of fiduciary duty and usurpation of corporate opportunities. That suit was resolved through a settlement that included a buyout – the Zidans sold their membership interests in the LLCs to the Abdallas in August 2006.
In the fall of 2007 the Zidans received tax returns and K-1 Schedules from the LLCs for the tax year ending on the date of the buyout. The Zidans alleged discrepancies in the K-1s and requested accounting information and records from the LLCs for the time period when they were members. The Abdallas refused, so the Zidans filed a complaint alleging breach of fiduciary duty and seeking declaratory relief to inspect the books and records of the LLCs for the period when they were members. The Zidans sought discovery of the requested information, which was stayed pending a summary judgment motion by the Abdallas. The trial court’s denial of the Abdallas’ motion was appealed.
The Abdallas contended that any fiduciary duties owed to the Zidans terminated when they ceased being members of the LLCs, because the Zidans no longer had any rights under the operating agreements and because their settlement agreement in the first lawsuit included a relinquishment of all of the Zidans’ rights as members. The Zidans maintained that fiduciary duties should remain intact with respect to the resolution of pre-separation business, and that therefore the fiduciary relationship covered the preparation of the tax return which was completed after the Zidans sold out.
The court held that the Abdallas owed a fiduciary duty to the Zidans regarding the preparation of tax returns for the period during which the Zidans were members of the LLCs. Abdalla, 913 N.E.2d at 286. As the court said, “To hold otherwise would give the Abdallas the freedom to allocate tax burdens to the Zidans and retain tax benefits for themselves without allowing the Zidans any recourse to verify or rectify this allocation.” Id.
The court reached a similar result on the question of whether the Zidans had a right of access to the LLCs’ books. Although the Indiana LLC Act only gives members the right to access an LLC’s records, Ind. Code § 23-18-4-8(b), the court held that the Zidans, as former members, had a right to access the records covering the time period while they were still members of the LLCs. Abdalla, 913 N.E.2d at 287.
Many state LLC Acts, like Indiana’s, do not address what inspection rights former LLC members have. For example, the LLC Acts of Washington, Oregon and Delaware are silent on inspection rights for former members. There’s no reason why state statutes can’t address this issue, though. The Illinois LLC Act, for example, provides that former members have a right of access for a proper purpose to LLC records pertaining to the period when they were members. 805 Ill. Comp. Stat. 180/10-15. The Revised Uniform Limited Liability Company Act and the Uniform Limited Partnership Act also have comparable provisions giving former members limited access rights.
When the Zidans resolved their first dispute with the Abdallas through a buyout of the Zidans’ interests in the LLCs, they apparently did not consider the inevitable entanglement resulting from the tax flow-through treatment of the LLCs. In an LLC buyout there will usually be a time lag from the buyout to the computation and allocation of the LLC’s profits and losses, and the distribution of the Schedule K-1s.
There’s a moral here. A member selling its interest in an LLC should consider adding provisions to the buyout agreement for later access to the LLC’s accounting records and for consultation with the LLC’s manager or CPA over the tax allocations and the preparation of tax returns, for the period when the seller was a member. The seller should also consider provisions for notice, access to records and consultation regarding any later amendment to the LLC’s previously filed tax returns, or any IRS contact with the LLC or tax audit for the period before the buyout. These provisions can help the former member avoid unpleasant tax-related surprises, and can give the former member the tools necessary to investigate unexpected tax allocations.
Connecticut Orders LLC Dissolution and Winding Up - Member Acrimony Prevents LLC from Carrying On Its Business
It’s a classic fact pattern that is all too familiar to many business lawyers. Two good friends decide to start a business. In their enthusiasm they create a 50/50 ownership structure and launch the business. Later, things change. One starts devoting more time to the business. Or maybe the business develops a commercial relationship with a separate company owned by one of the friends, which benefits only that one. Their business relationship becomes asymmetrical. Their views of how each should be compensated or how the business should be conducted diverge.
That’s essentially what happened in Saunders v. Firtel, 978 A.2d 487 (Conn. Sept. 22, 2009). Saunders and Firtel were friends who began a business relationship in the mid-1980s. Saunders joined Firtel as an employee and shareholder in Adco Medical Supplies, Inc. (Adco) in 1986. Saunders held 49% of the stock, Firtel held 51%. Firtel was President and Saunders Vice President, and they agreed that each would receive the same annual salary. In 1999, when things were still going well, Saunders and Firtel formed Barbur Associates, LLC (Barbur), a Connecticut LLC in which each owned a 50% interest. Barbur acquired real estate and leased it to Adco on an oral month-to-month lease.
The stage was now set. By 2004, Saunders had become dissatisfied because he perceived that he was doing most of the work but receiving the same compensation as Firtel. Saunders advised Firtel that the 1986 agreement for equal compensation was no longer acceptable. Firtel responded by firing Saunders from Adco in July 2004, lowering the rent charged by Barbur to Adco, unilaterally authorizing repairs by Barbur to the building Adco rented, and arranging a $5,000 loan from Barbur to Adco. Adco refused to pay Saunders his salary for 2004. Shortly thereafter, Saunders and Firtel ceased having any business or personal relationship, and made accusations against each other of theft, breach of fiduciary duty, self-dealing and other “improper and felonious conduct.” Saunders, 978 A.2d at 500 n.22.
Saunders sued Adco for his unpaid 2004 compensation, and for a decree ordering the dissolution and winding up of Barbur. The trial court found for Saunders on his wage claim and ordered double damages pursuant to Conn. Gen. Stat. § 31-72. The trial court also ordered a dissolution and winding up of Barbur, under Conn. Gen. Stat. §§ 34-207 and 34-208.
The Connecticut LLC Act authorizes the superior court to order dissolution “whenever it is not .jpg)
reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” Conn. Gen. Stat. § 34-207. The LLC Acts of Washington, Delaware, New York and many other states have similar provisions, as does NCCUSL’s Revised Uniform LLC Act. The essence of this test is whether or not the business of the LLC can be carried on in a reasonable way. The court has discretion; this is an equitable proceeding in which factors such as oppression, wrong-doing or deadlock are considered.
The court concluded that “the trial court’s order of dissolution is well supported by the evidence.” Saunders, 978 A.2d at 500. In reaching its conclusion, however, the court simply recited the facts identified above. The court did not examine Barbur’s articles of organization or operating agreement to see if the business was being carried out in conformity with the articles or the operating agreement, or refer to any such examination by the trial court. The two Connecticut cases cited by the court don’t seem particularly relevant, since both involved dissolutions of corporations for deadlock under prior corporate statutes. Those statutes, unlike Connecticut’s LLC Act, allowed dissolution for deadlock or other good and sufficient reasons. The court may have concluded that the various abuses by Firtel and the hostility and lack of cooperation between Firtel and Saunders simply made it impossible for the LLC to carry on any business, but the court’s analysis is conclusory and opaque.
Contract provisions don’t necessarily make disagreements between members go away, but sometimes they can provide helpful mechanisms to mitigate disputes and keep the parties out of court. For example, Saunders and Firtel apparently had no provisions in Barbur’s operating agreement to deal with deadlock. If their operating agreement had had a provision that allowed either party to initiate a buy-out process, they might have avoided litigation. A business person may assume that the initially cordial relationship with a potential business partner will continue indefinitely, but his or her lawyer should ask the hard-edged questions to challenge that assumption and help the parties build some safety nets into their agreement.
