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.
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.
Three Short Takes: (1) Exclusive Nature of Florida Charging Order Precludes Garnishment; (2) Tricky Signature Block on Contract Personally Obligates Georgia LLC's Manager; (3) Idaho Clarifies That Veil-Piercing Claims Are Equitable
We have a roundup this week of three recent LLC cases.
1. Charging Order. A dispute between two members of a Florida LLC resulted in litigation, in which the trial court ultimately awarded one member a $41,409 judgment against the other member. After an appeal that affirmed the judgment, and on the prevailing member’s motion, the trial court issued a writ of garnishment in favor of the prevailing member. The LLC as garnishee indicated that it was indebted to the losing member in an amount in excess of the judgment, and that it had funds in that amount in its possession. The court then ordered the LLC to pay the judgment amount to the prevailing member, under the writ of garnishment against the member’s distributions from the LLC.
The losing member appealed the garnishment order, contending that the Florida LLC Act’s charging order provisions barred the garnishment. Young v. Levy, 140 So.3d 1109 (Fla. Dist. Ct. App. June 18, 2014).
Florida’s LLC charging order statute states:
Except as provided in subsections (6) and (7), a charging order is the sole and exclusive remedy by which a judgment creditor of a member or member’s assignee may satisfy a judgment from the judgment debtor’s interest in a limited liability company or rights to distributions from the limited liability company.
Fla. Stat. § 608.433(5). The member that won the garnishment order argued that the LLC’s distributions were “profits” or “dividends” subject to a writ of garnishment and thus exempt from Section 608.433(5). However, Section 608.433(5) refers to the judgment debtor’s “interest” in the LLC, and the Florida LLC Act defines a member’s interest to include the profits and losses of the LLC. Fla. Stat. § 608.402(23). The court accordingly relied on the “sole and exclusive remedy” language of Section 608.433(5) and reversed the garnishment order. Young, 140 So.3d at 1112.
This is not a surprising result, but it’s always good to see an appellate court interpret a statute in a straightforward way. Exclusive does mean exclusive.
2. Personal Liability. A Georgia LLC entered into four written contracts with an advertising agency, for print and Internet advertising. The LLC did not pay the full amount of the agency’s invoices, and the agency sued both the LLC and its manager for the balance. The trial court found in favor of the agency and awarded judgment against the LLC, and against its manager, for damages, attorneys’ fees, and interest.
The manager appealed, contending that he was not a party to the contracts and signed them only in his representative capacity. Buffa v. Yellowbook Sales & Distrib. Co., No. A14A0209, 2014 WL 2766746 (Ga. Ct. App. June 19, 2014).
The four agreements showed that they were with the LLC, but they also had language that implicated the manager. Clause 15F of each agreement stated: “The signer of this agreement does, by his execution personally and individually undertake and assume the full performance thereof including payments of amounts due thereunder.” Id. at *1.
Additionally, the signature block of each contract stated: “This Is an Advertising Contract Between Yellow Book and [printed company name] and [signature] Authorized Signature Individually and for the Company (Read Clause 15F on reverse side).” The court reviewed the language and signature blocks and concluded that the manager was clearly a party to the contracts and therefore liable to pay amounts owing. Id. at *2.
The court also rejected the manager’s argument that he was at most obligated as a guarantor of the LLC’s obligations and therefore was not liable because his guaranty did not satisfy the Statute of Frauds. “Since the language employed in the Yellowbook advertising contracts reflects that Buffa agreed to undertake a primary obligation to perform under the contract, we need not address his arguments regarding the Statute of Frauds.” Id. at *3 n.3. The Court of Appeals therefore affirmed the trial court.
We often hear the maxim, caveat emptor, or buyer beware. This case illustrates the maxim that signers of contracts, even when signing for an LLC, must beware of language in the contract or in the signature block that may unexpectedly saddle the manager with personal liability for the LLC’s obligations.
3. Equity and Veil-Piercing Claims. The Idaho Supreme Court ruled earlier this summer on a breach of contract lawsuit that involved multiple claims, including several veil-piercing claims. Wandering Trails, LLC v. Big Bite Excavation, Inc., 329 P.3d 368 (Idaho June 18, 2014). The court’s discussion of the issues and the facts is lengthy, but one part of the opinion stands out because it resolves an unclear issue in Idaho law.
Idaho law is fairly clear on the basic rule: To pierce the veil of an Idaho LLC and impose personal liability on the LLC’s members or managers, the claimant must show that the LLC is the alter ego of the members, i.e., that there is a unity of interest and ownership to a degree that separate personalities of the LLC and members do not exist, and that if the acts complained of were to be treated as only the acts of the LLC, an inequitable result would follow. Id. at 376.
The court pointed out, however, that Idaho law is not clear whether veil-piercing claims are issues at law or at equity. Id. at 373. The significance is that if veil piercing is an equitable claim, then the trial judge must decide whether to pierce the veil. If it is not an equitable claim, the jury will decide whether the veil is to be pierced. “This Court’s opinions have been unclear regarding whether veil-piercing claims present a question for the jury or whether they are equitable issues to be tried by the court.” Id.
The court reviewed prior decisions, pointed out the inconsistencies, and concluded: “To clarify, we hold that issues of alter ego and veil-piercing claims are equitable questions….In these cases, the trial court is responsible for determining factual issues that exist with respect to this equitable remedy and for fashioning the equitable remedy.” Id. The court noted that a court may empanel an advisory jury on factual questions relevant to piercing the veil, but is not required to do so.
The court’s ruling on this issue is not surprising, because piercing the veil is universally recognized as an equitable remedy. “The doctrine of piercing the corporate veil is equitable in nature.” 1 William Meade Fletcher, Fletcher Cyclopedia of the Law of Corporations § 41.25, at 162 (rev. vol. 2006) (footnote omitted). What is perhaps surprising was the confusion in prior Idaho law, which Wandering Trails has now straightened out.
Massachusetts Court Pierces the Veil of Single-Member LLC Because of Its Failure to Maintain Business Records
Piercing the veil is a long-standing equitable remedy that can allow a claimant against a corporation to also assert the claim against a shareholder, under limited circumstances that usually involve some degree of wrongdoing or abuse of the corporate form. With the advent of LLCs, most states have also applied their existing law about veil piercing to LLCs. State laws about veil piercing vary quite a bit from state to state, and anomalous decisions crop up from time to time.
An outlier decision on veil-piercing was handed down earlier this year by the Massachusetts Appellate Division, in Kosanovich v. 80 Worcester Street Associates, LLC, No. 201201 CV 001748, 2014 WL 2565959 (Mass. App. Div. May 28, 2014). The court pierced the veil of a single-member LLC based on only one factor: the LLC’s failure to maintain business records.
Background. Milan Kosanovich entered into a purchase agreement to buy a condominium from 80 Worcester Street Associates, LLC (WSA). Jeffrey Feuerman was WSA’s manager and sole member, and signed the purchase agreement and a supplemental contract on behalf of WSA. One of the agreements required WSA to repair any defects in the condominium for up to one year after closing.
During the following year Kosanovich complained of numerous defects, and Feuerman responded to some but not all of the complaints. Kosanovich was not satisfied and later sued WSA and Feuerman for breach of contract, breach of an implied warranty of habitability, and violations of the Massachusetts Consumer Protection Act. A jury was waived, and at trial the judge ruled in favor of Kosanovich on his claims for breach of contract and breach of an implied warranty of habitability, and awarded him $9,000 in damages. The judge pierced WSA’s LLC veil and found Feuerman personally liable for the damages award. Id. at *2.
Appellate Division. The court first reviewed the basic veil-piercing rule: the corporate or LLC veil should only be pierced in rare situations, and only “for the defeat of fraud or wrong, or the remedying of injustice.” Id. at *2 (quoting Hanson v. Bradley, 10 N.E.2d 259, 264 (Mass. 1937)). The court should examine 12 factors in light of all the circumstances to determine if veil piercing is justified:
(1) common ownership,
(2) pervasive control,
(3) confused intermingling of business assets,
(4) thin capitalization,
(5) nonobservance of corporate formalities,
(6) absence of corporate or LLC records,
(7) no payment of dividends or distributions,
(8) insolvency at the time of the litigated transaction,
(9) siphoning away of corporation's funds by dominant shareholder or member,
(10) nonfunctioning of managers, or officers and directors,
(11) use of the corporation or LLC for transactions of the dominant shareholders or members, and
(12) use of the corporation or LLC in promoting fraud.
Feuerman did not dispute that he had sole ownership and pervasive control of WSA, which according to the court is not enough to pierce the veil, standing alone. But the trial judge had also found that WSA’s records did not exist or were improperly kept. The only document submitted by Feuerman at trial was WSA’s certificate of formation. Feuerman admitted that he ran the business out of his house and his car and that he had no bookkeeping records, tax records or returns, checkbook, or records of payments to subcontractors. As he said, “it was a bit informal.” Id.
That was enough to pierce the veil, said the court. “Feuerman’s failure to maintain or produce records hindered the court’s ability to establish the twelve factors, including intermingling of assets, thin capitalization, and insolvency…. Feuerman’s failure to maintain business records coupled with his sole ownership and pervasive control of WSA supported the [trial] judge’s decision to pierce the corporate veil.” Id. at *3.
Comment. The court’s decision seems inconsistent with the basic rules the court itself cited. As the court said, piercing the veil is intended to remedy fraud, wrong, or injustice. But there was no evidence of any of those. One would have thought the burden of proof would have been on the party claiming that the LLC’s veil should be pierced. The court’s reliance on Feuerman’s inadequate record-keeping effectively placed on his shoulders the burden to prove that he was innocent of violating any of the other 12 factors.
Lawyers of course routinely advise their clients to adhere to the various formalities of running a business in the form of a corporation or LLC, and to maintain and keep adequate business and organizational records. This decision drastically underscores the need to follow the formalities and keep good records.
Standing is a legal doctrine that focuses on, among other things, whether a potential plaintiff is the right party to bring a lawsuit. The claimant must be the real party in interest, i.e., it must benefit directly if the action is successful.
A trial court’s dismissal for lack of standing of an LLC member’s claims against the other members was recently reversed in part by the Kentucky Court of Appeals. The Court of Appeals’ examination of the claims nicely contrasts those that gave the plaintiff standing with other claims where standing was lacking. Chou v. Chilton, No. 2009-CA-002198-MR, 2014 WL 2154087 (Ky. Ct. App. May 23, 2014).
Background. Ram.Chou Construction, LLC (RC LLC) was formed by Li An Chou and Richard, Mark, and William Chilton. The Chiltons owned and operated a separate company focused on large-scale public construction projects. Chou, born in China and raised in Taiwan, had operated several import and export businesses but was unfamiliar with the construction industry.
RC LLC was formed to qualify as a Minority Business Enterprise (MBE), so that it could obtain preferences when bidding on public construction projects. Chou had a 51% member interest in order to qualify the LLC as an MBE. Chou was responsible for obtaining MBE certification, and the Chiltons promised to teach Chou the construction business.
RC LLC had some success bidding on construction projects, but problems arose. According to Chou’s complaint, the Chiltons caused RC LLC to use the employees, equipment, accounting department, and payroll services of the Chiltons’ other construction company. The Chiltons also transferred funds between the two companies without authorization or documentation.
Eventually RC LLC lost its MBE certification because it lacked documentation to show that it was a separate entity and not merely a conduit for the Chiltons’ other construction company. At that point the Chiltons terminated Chou and moved RC LLC’s funds to their main construction company.
Chou then filed a lawsuit in his own name against the Chiltons, claiming fraud, breach of fiduciary duty, breach of the duty of good faith and fair dealing, and misappropriation of funds. He also asked the court for a dissolution of RC LLC and an accounting, and for an award of punitive damages. The trial court determined that RC LLC was the real party in interest and that Chou as an individual lacked standing, and accordingly dismissed his complaint.
Court of Appeals. Referring to court rules and prior case law, the court summarized the standing rule as follows: a lawsuit must be prosecuted in the name of the real party in interest, which is the party that will be entitled to the benefits of the suit if successful, i.e., to “the fruits of the litigation.” Id. at *3 (quoting Taylor v. Hurst, 216 S.W. 95 (Ky. Ct. App. 1919)). The court then reviewed each of Chou’s claims.
Dissolution – Standing. The Kentucky LLC Act authorizes the court to dissolve an LLC “in a proceeding by a member if it is established that it is not reasonably practicable to carry on the business of the limited liability company in conformity with the operating agreement.” Ky. Rev. Stat. Ann. § 275.290(1) (emphasis added). Chou was a member and was authorized by the statute to seek the LLC’s dissolution, so he was therefore the real party in interest and had standing. Chou, 2014 WL 2154087, at *3.
Accounting – Standing. A dissolved LLC must be wound up and liquidated, and its net assets must be collected and either liquidated or distributed in kind. Ky. Rev. Stat. Ann. § 275.300(2). Thus an accounting would be “the natural next required step in the dissolution of the company.” Chou, 2014 WL 2154087, at *3. Because Chou had standing to seek a dissolution, he had standing to seek an accounting as well.
Breach of Fiduciary Duty – No Standing. Earlier Kentucky case law established that managing members of an LLC owe a fiduciary duty to the other LLC members. Patmon v. Hobbs, 280 S.W.3d 589, 595 (Ky. Ct. App. 2009). But the Chiltons were not RC LLC’s managing members – the operating agreement established Chou as the only managing member. Because the Chiltons were not managing members they owed no fiduciary duties to Chou, so he had no standing to assert the fiduciary duty claim. Chou, 2014 WL 2154087, at *4.
Misappropriation – No Standing. The funds and business opportunities that Chou claimed were misappropriated belonged to RC LLC, not to Chou. Any recovery for their misappropriation would belong to the LLC and not to Chou, so he had no standing to assert this claim. The fact that he might benefit indirectly from a recovery by the LLC was not adequate to give him standing to assert the claim. Id.
Fraud and Breach of the Covenant of Good Faith and Fair Dealing – Standing. Under earlier Kentucky case law, there is an implied covenant of good faith and fair dealing in every contract. Chou claimed that the Chiltons breached the implied covenant in the LLC’s operating agreement. As a party to the contract, Chou would be entitled to any recovery for the Chiltons’ breach of the contract. The operating agreement also provided that any member could sue the other members for fraud, so Chou would be entitled to any recovery on his fraud claim. He was therefore the real party in interest and had standing to assert claims for fraud and for breach of the implied covenant of good faith and fair dealing. Id.
Punitive Damages – Standing. The court referenced earlier Kentucky case law for the rule that a claim for punitive damages cannot survive if there is no underlying claim for compensatory damages. The court had already held that Chou had standing for his claims for compensation for fraud and for breach of the implied covenant of good faith and fair dealing, so he also had standing to seek punitive damages. Id.
The Dissent. Judge Thompson’s dissent from the majority’s holding that Chou had no standing for his fiduciary duty claims points out three problems with the majority opinion.
First, Chou’s complaint alleged that Chou’s appointment as managing member of RC LLC was only a formality done for qualifying RC LLC as an MBE, and that in reality the Chiltons managed the LLC and acted on its behalf. As the majority noted, “[a] breach of fiduciary duty generally occurs between a principle [sic] and an agent.” Id. at *4. The Chiltons acted as agents for RC LLC and so owed the members fiduciary duties.
Second, the majority ignored Section 275.170 of the Kentucky LLC Act, which extends fiduciary duties to members as well as managers:
(2) The duty of loyalty applicable to each member and manager shall be to account to the limited liability company and hold as trustee for it any profit or benefit derived by that person without the consent of more than one-half (1/2) by number of the disinterested managers, or a majority-in-interest of the members from:
(b) Any use by the member or manager of its property, including, but not limited to, confidential or proprietary information of the limited liability company or other matters entrusted to the person as a result of his or her status as manager or member.
Ky. Rev. Stat. Ann. § 275.170(2) (emphasis added).
Third, the dissent pointed out that the Patmon opinion, which the majority relied on, referred to the duties of managing members because the defendant was the managing member of the LLC, but Patmon did not exclude members from fiduciary duties.
Michigan LLC Is Not Obligated to Pay Withdrawing Member for Its Interest - Operating Agreement Allowed Member to Sell Its Interest, Subject to LLC's Right of First Refusal
Many state LLC statutes limit an LLC member’s ability to withdraw from the LLC, or require payment to the withdrawing member under some circumstances. Michigan’s statute, for example, says that an LLC member can withdraw only as provided by the LLC’s operating agreement, and that if the operating agreement is silent on a withdrawal distribution, the withdrawing member must be paid the fair value of its interest. Mich. Comp. Laws §§ 450.4509(1), 450.4305.
In a recent case before the U.S. Court of Appeals for the Sixth Circuit, an LLC member that withdrew from a Michigan LLC contended that it should be paid the fair value of its interest. Bellwether Cmty. Credit Union v. CUSO Dev. Co., LLC, No. 13-1853, 2014 WL 1887559 (6th Cir. May 12, 2014). The Court of Appeals upheld the district court’s ruling that the LLC had no obligation to make a withdrawal distribution to the withdrawing member, because the operating agreement’s procedures for a withdrawing member complied with the statute.
Background. Bellwether Community Credit Union was a member of CUSO Development Company, LLC, a Michigan LLC that provided administrative services to financial institutions such as Bellwether. In 2011 Bellwether withdrew from CUSO, as was permitted by CUSO’s operating agreement. Shortly thereafter Bellwether filed suit to recover a withdrawal distribution from the LLC for the fair value of Bellwether’s member interest.
The Michigan LLC Act addresses the right of a withdrawing member to receive a distribution:
If a provision in an operating agreement permits withdrawal but is silent on an additional withdrawal distribution, a member withdrawing in accordance with the operating agreement is entitled to receive as a distribution, within a reasonable time after withdrawal, the fair value of the member's interest in the limited liability company as of the date of withdrawal based upon the member's share of distributions as determined under section 303.
Mich. Comp. Laws § 450.4305 (emphasis added). Bellwether contended that because CUSO’s operating agreement was “silent on an additional withdrawal distribution,” Bellwether was entitled to the fair value of its member interest.
CUSO argued that its operating agreement was neither silent nor ambiguous on the distribution rights of withdrawing members. The operating agreement provided CUSO with a right of first refusal: The withdrawing member was required to specify a price for its interest. The LLC or, if it declined, the other members then had the right to purchase the interest for the specified price. If neither the LLC nor the other members purchased the withdrawing member’s interest, then the withdrawing member had the right to sell its interest to a third party at the specified price (or a higher price) for 90 days.
Bellwether offered its interest to CUSO and the members for $655,223, but there were no takers. Bellwether did not attempt to find a third party buyer and instead filed suit.
Court’s Analysis. The court characterized the right of first refusal as “a detailed process for a withdrawing member to follow, which clearly contemplated a discretionary withdrawal distribution if [CUSO] exercised its right of first refusal to purchase shares back from a dissociating member.” Bellwether, 2014 WL 1887559, at *4.
The court pointed out that if CUSO had exercised its option to buy back Bellwether’s interest, its payment to Bellwether would have qualified as a withdrawal distribution. “Distribution” is defined by Michigan’s LLC Act as “a direct or indirect transfer of money … by a limited liability company to … its members … in respect of the members' membership interests.” Mich. Comp. Laws § 450.4102(2)(g).
The court’s conclusion was that although the operating agreement did not give a withdrawing member an absolute right to a distribution, it was not “silent” on the issue. The operating agreement provided a mechanism for Bellwether to receive a withdrawal distribution, if CUSO exercised its right to purchase Bellwether’s member interest. The fact that CUSO did not exercise its purchase right did not make the operating agreement silent on the withdrawal distribution. Bellwether, 2014 WL 1887559, at *4.
Bellwether raised other arguments that relied on parol evidence, but the court found the language of the operating agreement to be clear and unambiguous and therefore rejected extrinsic evidence. Id. at *5. Bellwether also argued that equitable principles should be applied to interpret and modify the operating agreement’s provisions. The court rejected that argument by referring to Michigan law: “The Michigan Supreme Court has explained that principles of equity alone do not serve as a basis for ignoring express contractual provisions under the guise of interpretation.” Id. at *6.
The court accordingly affirmed the district court’s order granting summary judgment for CUSO.
Comment. The result in Bellwether appears consistent with the statute and the CUSO operating agreement. But the case illuminates a strange corner of LLC law.
The origins of “withdrawal” apparently lie in the early concept of a partnership as an aggregation of partners rather than an entity. A partner could remove itself from the group and cause the dissolution of the partnership. But LLCs are different.
An LLC member has no liability for the debts of the LLC and usually will have no obligations under the LLC’s operating agreement. In many manager-managed LLCs the members will have no management authority. Withdrawal therefore does not seem to accomplish much, unless it results in the member being cashed out. And under most LLC operating agreements, a withdrawing member is not entitled to receive any withdrawal distribution.
The answer may lie in the fact that LLCs are taxed as partnerships, and in some cases an LLC member may receive allocations of profit from the LLC that increase the member’s federal income tax bill, with no cash distributions to cover the members’ increased tax liability. Withdrawal could be used to bring an end to that unpleasant scenario, albeit at the cost of forfeiting the value of the member’s interest.
Amendment to LLC Agreement Tightens Indemnification But Cannot Remove LLC's Obligation to Indemnify Against Prior Lawsuit
LLC operating agreements sometimes indemnify members, managers, and employees against claims and lawsuits. And like any other agreement, LLC operating agreements can be amended. In a recent Delaware Court of Chancery case, an amendment to an LLC’s operating agreement narrowed the indemnification provisions in a way that precluded an employee’s claim for indemnification against a prior lawsuit. The employee objected that the amendment could not take away his right to be indemnified, and the court agreed. Branin v. Stein Roe Inv. Counsel, LLC, C.A. No. 8481-VCN, 2014 WL 2961084 (Del. Ch. June 30, 2014).
Background. Francis Branin was owner and CEO of a wealth management firm that provided investment counseling and asset management services for high-net-worth individuals. In 2000 his firm was sold, and in 2002 Branin resigned and joined Stein Roe Investment Counsel, LLC (Stein LLC). Later that year Branin’s former company sued him in New York for soliciting his former clients, claiming that he breached an implied covenant that New York law imposed on the seller of a business. That litigation dragged on for ten years, but Branin defended successfully and all claims against him were eventually dismissed.
When Branin joined Stein LLC, its operating agreement contained a broad indemnification clause (the First Version):
To the full extent permitted by applicable law, each Member, Manager or employee of the Company shall be entitled to indemnification from the Company for any loss, damage or claim by reason of any act or omission performed or omitted by such Person in good faith on behalf of the Company and, as applicable, in a manner reasonably believed to be within the scope of the authority conferred on it by this Agreement ….
Id. at *2. This language fairly clearly applied to the lawsuit against Branin and obligated Stein LLC to defend Branin or to cover his defense costs.
A few months after Branin was sued by his former employer, however, Stein LLC amended the indemnification clause to exclude claims for damage incurred by reason of the indemnified party’s “breach of any agreement, express or implied, entered into by such Person with one or more outside parties prior to such Person’s association with the Company” (the Second Version). Id. at *3 (emphasis omitted). The former employer claimed in the New York litigation that Branin breached an implied covenant, so the revised indemnification, if applicable to Branin, would exclude him from its coverage.
When Branin later requested Stein LLC to indemnify him for his New York litigation expenses, the company refused. Branin then filed suit in Delaware seeking indemnification for his attorneys’ fees and costs, which over ten years amounted to more than $3 million.
Court’s Analysis. The principal question in the case was whether Branin had a right to indemnification under the First Version and whether it was superseded by the Second Version. The court first looked to the Delaware LLC Act, which broadly authorizes LLCs to indemnify managers, members, or other persons, subject to standards and restrictions set forth in the LLC agreement. Del. Code Ann. tit. 6, § 18-108. The court then reviewed the language of the First Version and straightforwardly determined that it gave Branin a right to indemnification.
The more complex question was whether the Second Version applied to Branin and superseded the First Version. The court began by examining the policies justifying indemnification. Entities indemnify employees, officers, or directors to encourage them to work for or serve the entity. In this case the First Version was in place when Branin went to work for Stein LLC, and the company benefited from his services. The court then examined several corporate indemnification cases and determined that they generally measured the obligations of the indemnifying company at the time of the events giving rise to the claim or when the lawsuit involving the claim was filed. The court also emphasized the “to the full extent permitted by applicable law” language in the First Version.
The court determined that the First Version created an enforceable right in Branin to be indemnified, which vested when the lawsuit against him was filed. Because Branin’s right was vested it could not be defeated by the Second Version’s later amendment to the indemnification clause.
Stein LLC also argued that Branin was not entitled to indemnification because he was sued in his own personal capacity, not because of actions on behalf of Stein LLC. The court rejected that argument, finding that there was an adequate nexus or causal connection between the New York litigation and Branin’s position with Stein LLC. Branin was an employee of Stein LLC, Stein benefited from the clients who followed Branin when he joined Stein, and the New York litigation involved claims that Branin had improperly solicited the clients of his former company.
The court concluded that the plain meaning of the First Version gave Branin a right to indemnification for the New York lawsuit, and that his right vested and was not rescinded by the Second Version. Branin was not granted judgment on his pleadings, though, because the court determined that there were material factual issues remaining concerning whether he acted in good faith and in a manner he reasonably believed to be within the scope of his authority, as required by the operating agreement. Branin,2014 WL 2961084, at *10.
Comment. Indemnification clauses are often viewed as technical boilerplate. Sometimes they are written in text so dense and turgid that you would think the drafter was being paid by the word with a bonus for unintelligibility. Which is a shame, because the basic concept is fairly simple: indemnification is a way of shifting risk from one party to another. LLC indemnification clauses like the First Version in Branin reflect a business commitment from an LLC to its managers, members, and employees. The commitment is that if are they working for the LLC or acting on its behalf and as a result are sued by a third party, the LLC will defend them, cover the cost of the lawsuit, and pay any award of damages. As the Branin court discussed, such a promise is an inducement to get people to serve in those positions.
Against that backdrop, the result in the Branin case makes perfect sense. An employee goes to work for an LLC whose operating agreement broadly indemnifies employees against third party claims. Later the employee is sued for activities on behalf of the LLC, and rightfully expects the LLC to indemnify him. The LLC, then faced with upholding its promise, amends the operating agreement to renege on its promise and take away its indemnification? Too clever by half, and the Chancery Court opinion in Branin rather thoroughly rejects that ploy.
Utah LLC Is Not Bound by 99-Year Lease Because Its Manager Had Neither Actual Nor Apparent Authority
Suppose you enter into a signed contract with a limited liability company. The contract is signed by the LLC’s manager. Later the LLC’s other manager tells you that the manager that signed the lease was not authorized to do so. He tells you that the LLC is not bound by the contract and does not intend to honor it. Can the LLC get away with that?
Sometimes the answer is yes, it can. That scenario was before the Utah Court of Appeals last month in Zions Gate R. V. Resort, LLC v. Oliphant, 326 P.3d 118 (Utah Ct. App. May 1, 2014).
Darcy Sorpold, a member and manager of Zions Gate R. V. Resort, LLC, signed a 99-year lease on behalf of the LLC. The lease conveyed rights to a recreational-vehicle pad and lot to Michael Oliphant, as payment for work performed by Oliphant.
Eighteen months later Zions Gate brought suit to evict Oliphant, claiming that Oliphant was a tenant at will because the lease was invalid. Zions Gate argued that the lease was invalid because Sorpold had no authority to enter into the lease without the consent of the LLC’s other manager. Both parties moved for summary judgment, and the trial court granted summary judgment in favor of Oliphant to enforce the lease. Id. at 120.
No Actual Authority. Zions Gate argued that Sorpold had no actual authority to bind the LLC because of the interplay between the LLC’s articles of organization and Section 802 of the Utah Limited Liability Company Act. The LLC’s articles of organization plainly stated that the agreement, approval or consent of both managers was required to act on behalf of the LLC.
Section 802 states that the act of an LLC’s manager for “apparently carrying on in the ordinary course of the company business” binds the LLC “unless the manager had no authority to act for the company in the particular matter and the lack of authority was expressly described in the articles of organization.” Utah Code Ann. § 48-2c-802(2)(c). The court found that the LLC’s articles of organization expressly described Sorpold’s lack of authority to act unilaterally on behalf of the LLC, and that under Section 802 Sorpold therefore had no authority to bind Zions Gate to the lease. Zions Gate, 326 P.3d at 121-22.
No Apparent Authority. The court went on to consider Oliphant’s argument that Sorpold had apparent authority to enter into the lease on behalf of the LLC. Oliphant contended that he had reasonably believed that Sorpold had authority to enter into the lease, and that he had changed his position in reliance on that appearance of authority.
The court described the common-law agency rule of apparent authority: “Apparent authority exists where the conduct of the principal causes a third party to reasonably believe that someone has authority to act on the principal’s behalf, and the third party relies on this appearance of authority and will suffer loss if an agency relationship is not found.” Id. at 122 (quoting Hale v. Big H Constr., Inc., 288 P.3d 1046, 1061 (Utah Ct. App. 2012)).
Zions Gate argued that Oliphant had notice of the limitation on Sorpold’s authority because of Section 121 of the Utah LLC Act. Section 121 states that filed articles of organization constitute notice to third parties of all statements in the articles of organization that are expressly permitted to be set forth in articles of organization by Section 403(4) of the LLC Act. Utah Code Ann. § 48-2c-121(1). And Section 403(4) of the LLC Act provides that an LLC’s articles of organization may contain a statement of the limitations on the managers’ authority to bind the LLC. Utah Code Ann. § 48-2c-403(4)(b).
The court found that Oliphant was deemed to have had notice of the limitations on Sorpold’s authority under Sections 121 and 403 of the LLC Act, could not have reasonably believed that Sorpold had authority to act, and could not have reasonably relied on Sorpold’s authority. Sorpold therefore did not have the apparent authority to bind the LLC. Zions Gate, 326 P.3d at 122.
Oliphant argued that it was unreasonable and unrealistic to expect people entering into agreements with LLCs to acquire and read their articles of organization. But the court pointed out that the statute’s imputed notice provision is clear, and the state’s division of corporations is required to make all required filings available for inspection and copying by any member of the public upon the payment of a reasonable fee. The court also referred to the limits on its role: “And while Oliphant may believe the law imposes an unrealistic burden on those doing business with LLCs, it is not the prerogative of this court to question the wisdom of the statutory scheme enacted by the legislature.” Id. at 123.
Ratification. Oliphant argued that Zions Gate had ratified Sorpold’s execution of the lease by failing to timely object. The court acknowledged that a principal may impliedly or expressly ratify an agreement made by an unauthorized agent, but cautioned that the knowledge of Sorpold could not be imputed to Zions Gate to demonstrate the LLC’s knowledge of the facts. The record was not clear when Zions Gate learned that Sorpold had entered into the lease, so summary judgment could not be rendered on that issue. The court therefore reversed the trial court’s grant of summary judgment and remanded the case back to the trial court for trial on whether Zions Gate had ratified the lease.
Comment. Zions Gate is a nice illustration of the complexities that can be involved when the lack of authority of an LLC’s manager is raised as a defense to an agreement. The LLC’s agreement will be enforced if the manager had either actual or apparent authority. But even if there was no actual or apparent authority, the agreement may be enforceable if the LLC has ratified the agreement either expressly or impliedly by simply waiting too long to disaffirm it.
Zions Gate also shows the powerful ability of an LLC to put third parties on imputed notice of provisions in the LLC’s articles of organization that limit the authority of managers. Such provisions can protect the LLC in the event a manager exceeds his or her authority and purports to commit the LLC to an ill-advised contract.
Recent Rulings On Personal Liability: Manager of Montana LLC Is Shielded, Owner of Louisiana LLC Is Not
The liability shield of LLCs is a fundamental attribute that investors, members, and managers routinely rely on. But sometimes an LLC’s shield is porous and fails to protect a member or manager. A pair of recent cases show how claimants against an LLC can sometimes impose personal liability on an LLC’s member or manager.
Montana – Signature Problems, But No Personal Liability. Aspen Trails Associates, LLC did business under the assumed name Windermere Real Estate – Helena. Aspen entered into equipment leases with Empire Office Machines, Inc., and later entered into a letter agreement with Empire that replaced and revised the leases. The letter agreement indicated that it was with Empire and “Windermere,” but the signature lines had no indication that Windermere’s manager or the Empire signatory were signing on behalf of their entities.
Aspen later defaulted on the letter agreement, and Empire sued both Aspen and the Aspen manager that signed the letter agreement. Empire obtained a judgment against Aspen, but Aspen’s manager moved for summary judgment on grounds that Empire’s contract was with Aspen and not with the manager. The trial court ruled in favor of the manager on his motion for summary judgment, and Empire appealed. Empire Office Machs., Inc. v. Aspen Trails Assocs. LLC, 322 P.3d 424 (Mont. Apr. 8, 2014).
Empire argued that Aspen’s manager was personally liable on the letter agreement because (a) it did not indicate that the manager was acting in an agency capacity, and (b) the letter agreement’s reference to “Windermere” did not identify Aspen as the principal.
The court, however, found that Empire had notice that the manager was acting as Aspen’s agent because of the long-term business relationship between Aspen and Empire, which included the two leases that were replaced by the letter agreement and lease payments by Aspen that were sometimes made by “Windermere” or “Windermere of Helena.” Id. at 425-426.
Relying on the long-term business relationship, and the fact that the letter agreement was drafted by Empire and any ambiguity in it must therefore be interpreted against Empire, the court concluded that Empire had reason to know that Aspen was the manager’s principal. The court accordingly affirmed the trial court’s ruling that the manager was not personally liable on the letter agreement. Id. at 428.
Louisiana – Member’s Personal Tort Liability. Allen Lenard was the owner, sole member, and licensed contractor of Pinnacle Homes, L.L.C., a home construction company. Pinnacle entered into a contract and built a home for Jennifer Nunez, but the completed home was below the base flood elevation required under federal and state law.
Nunez sued Pinnacle and Lenard for violations of Louisiana’s New Home Warranty Act. The trial court found that Pinnacle violated the New Home Warranty Act by not complying with the required elevation standards, and awarded damages of $201,600 for the cost to elevate the home to the proper elevation. The trial court also ruled that Lenard was personally liable for the damages because of his professional negligence in not properly calculating or supervising the grading and fill dirt required to bring the property to the proper elevation. Lenard appealed and the Court of Appeal affirmed the trial court. Nunez v. Pinnacle Homes, L.L.C., 135 So.3d 1283 (La. Ct. App. Apr. 2, 2014).
The Court of Appeal first approved the trial court’s reliance on Section 1320(D) of the Louisiana Limited Liability Company Law, which limits the liability of LLC members and managers but also carves out an exception for fraud or torts:
Nothing in this Chapter shall be construed as being in derogation of any rights which any person may by law have against a member, manager, employee, or agent of a limited liability company because of any fraud practiced upon him, because of any breach of professional duty or other negligent or wrongful act by such person, or in derogation of any right which the limited liability company may have against any such person because of any fraud practiced upon it by him.
La. Rev. Stat. Ann. § 1320(D).
Lenard argued that the trial court improperly found him personally liable merely because he held a contractor’s license. The Court of Appeal, however, referred to the trial court’s findings of fact: “The trial court, however, found personal involvement and inaction by Lenard which it found constituted a ‘breach of professional duty or other negligent or wrongful act.’” Nunez, 135 So.3d at 1289 (quoting trial court findings of fact). The court found no basis to overturn the trial court’s findings of fact, and affirmed the judgment against Lenard.
The majority’s opinion was not clear whether the court was treating the trial court’s findings as a determination that Lenard breached a professional duty, or that Lenard committed an “other negligent or wrongful act.” The dissent by Judge Amy, on the other hand, viewed the trial court as having found that Lenard committed “professional negligence,” that a licensed general contractor is not a “professional” as the term is used in Section 1320(D), and that because Lenard had no separate, non-contractual duty to Nunez, he was not personally liable. The dissent quoted a recent Louisiana Supreme Court decision:
[A] showing of poor workmanship arising out of a contract entered into by the LLC, in and of itself, does not establish a “negligent or wrongful act” under La.R.S. 12: 1320(D). To hold that poor workmanship alone sufficed to establish personal liability would allow the exception in La.R.S. 12:1320(D) to negate the general rule of limited liability in La.R.S. 12:1320(B).
Id. at 1291 (quoting Ogea v. Merritt, 130 So.3d 888, 905 (La. Dec. 10, 2013)).
Comment. These two cases are examples of situations that can lead to personal liability for an LLC member or manager that is carrying out the company’s business. Empire shows how informality when signing a contract, or inconsistency between the terms of a contract and the signature, can lead to unexpected personal liability for the individual that signs the contract. Although the manager escaped personal liability in Empire, I have written about similar cases that did not turn out so well for the signatory, here, here, and here.
A manager or member can also be tagged with personal liability when acting for an LLC, if the member’s or manager’s conduct can be characterized as a tort such as fraud, malpractice, or negligence. The more clear-cut cases involve conduct such as fraud or negligence that results in personal injury, such as an LLC’s delivery driver that negligently drives the company’s truck and injures someone. Whether the driver is a member, manager, or simply an employee of the LLC, the driver will be personally liable.
The theory is less clear where the member’s or manager’s conduct simply involves carrying out the LLC’s contract and does not involve a recognized and regulated profession such as medicine, law, or architecture. The dissent in Nunez viewed Lenard as not being a recognized professional, saw his conduct as simply carrying out the LLC’s performance of the contract in a way that resulted in a defective product, and would have applied the liability shield of Section 1320(B).
For an example of a case similar to Nunez with a similar result, see my post on a South Carolina case, here. For an example of an outlier from New Jersey that shielded an LLC manager from liability for his fraudulent statements on behalf of the LLC, see my post here.
Kentucky Finds Sole Member Not Personally Liable on Lease That LLC Entered into While Administratively Dissolved
Administrative dissolution is a remedy that states use to enforce their annual-fee and annual-report requirements for LLCs. The dissolved LLC must wind up and liquidate its business, but can be reinstated if it pays the back fees and files its report. The reinstatement will then relate back and take effect as of the date of the dissolution. If the LLC waits too long, typically three or five years, it can no longer be reinstated.
Administrative dissolution is common. It often happens by inadvertence, and when an LLC’s management learns of the problem it will usually act quickly to reinstate the LLC if there is still time to do so. In those cases the unplanned dissolution results in no change to the LLC’s operations, since management is at first unaware of the problem and then fixes it as soon as possible.
This common scenario played out in a recent Kentucky case. A Kentucky LLC was administratively dissolved and later entered into a real estate lease. The LLC subsequently defaulted on its lease, and the landlord sued both the LLC and its single member. Shortly after the lawsuit was filed, the LLC applied for and was granted reinstatement by the Kentucky Secretary of State.
The landlord’s theory was that the single member was liable either because the dissolution stripped her of her statutory immunity as a member, or because she was an agent and lacked authority to act for the LLC. The trial court and the Court of Appeals found that the LLC’s member was not personally liable on the LLC’s lease, and the Supreme Court affirmed in a lengthy and detailed opinion. Pannell v. Shannon, 425 S.W.3d 58 (Ky. March 20, 2014).
Member Liability. The Kentucky LLC Act provides that an LLC’s member or manager is not personally liable for the LLC’s obligations merely by reason of being a member or manager. Ky. Rev. Stat. Ann. § 275.150(1). (All state LLC statutes have a similar provision.) The landlord, however, pointed out that Section 275.300(2) requires a dissolved LLC to not carry on any business except that appropriate to wind up and liquidate its business and affairs, and argued that an LLC member that violates that prohibition loses its limited liability protection even if the LLC is later reinstated.
When an LLC is reinstated after administrative dissolution, “the reinstatement shall relate back to and take effect as of the effective date of the administrative dissolution, and the limited liability company shall resume carrying on business as if the administrative dissolution had never occurred.” Ky. Rev. Stat. Ann. § 275.295(3)(c) (repealed in 2011, but in force when the events in this case occurred). Reinstatement literally undoes the dissolution. Pannell, 425 S.W.3d at 68.
The landlord argued that the word “resume” in the statute implies that the LLC had to have ceased doing business while administratively dissolved. The court acknowledged that “resume” appears to create some ambiguity, but read “resume” in context as a reference to the retroactive nature of reinstatement. The court also supported its interpretation with an analysis of subsequent statutory revisions which clarified that an LLC’s dissolution does not take away the limited liability protection of an LLC member or agent, using the in pari materia canon of construction. Id. at 70-72. (In pari materia refers to the principle of statutory construction that if a subsequent statute on the same subject clarifies language in a prior statute, the court may be guided by the legislative clarification.)
The court found that it would be illogical to enforce the winding-up-only limits on a dissolved LLC if the LLC was not intended to be wound up, as would be the case with an administratively dissolved LLC whose owners and management were unaware that it had been dissolved. And if the LLC were strictly barred from taking any non-winding-up activities, it would be prevented from filing the paperwork to end the administrative dissolution, a classic catch-22. Id. at 74.
The court also emphasized the LLC Act’s strong preference for limited personal liability, positing that an LLC’s liability shield for members should not be lost through an LLC’s failure to pay a $15 annual fee or submit an annual report. The court found this conclusion to be consistent with the general rule in most jurisdictions that LLC members are not personally liable for actions taken during a period of dissolution followed by reinstatement. Id. at 76.
Agent Liability. The court saw this as a two-part issue: did Ann Shannon, the LLC’s only member and its only manager, have personal liability (1) by reason of merely being an agent of the dissolved LLC, or (2) because she acted as an agent without authority?
After distinguishing several cases from other jurisdictions, the court concluded that “[t]he retroactivity of the reinstatement statute, when read with the provision making the company exist even after dissolution and the statutes creating immunity for agents, makes an agent immune if personal liability is alleged solely because the agent is an agent.” Id. at 80.
The landlord contended that Shannon lacked the authority to act on behalf of the LLC because it did not exist when she executed the lease on behalf of the LLC. But the LLC Act is clear: “A dissolved limited liability company shall continue its existence...” Ky. Rev. Stat. Ann. § 275.300(2). The landlord contended that the statute’s limit on acts other than winding-up activities limited Shannon’s authority, but the court again pointed out that if that were true, the LLC would not be able to seek reinstatement, because an LLC can only act through an agent. Pannell, 425 S.W.3d at 83.
The landlord also took the position that because the LLC was reinstated only after he filed suit, the court’s reading of the statute would have an inequitable result. The court, however, saw reinstatement as being only between the LLC and the state. “[The landlord] cannot be allowed to take advantage of the LLC’s failure to file its report and pay what amounts to a tax to bypass the LLC and hold its owners or agents liable, at least not once the failures have been remedied.” Id. at 84.
The Supreme Court accordingly affirmed the dismissal of the landlord’s claim against the LLC’s sole member.
Comment. You can’t help smiling when you read some opinions, from the sheer pleasure of reading a careful, scholarly, and well-written opinion. This is one. The Shannon opinion not only reaches the right result, but does so by carefully disposing of the several legal theories raised by the landlord. The court’s analysis recognizes
- the primacy of limiting the liability of LLC members and managers,
- that a dissolved LLC continues to exist,
- that the statutory requirement for winding up a dissolved LLC does not apply to an unintentional dissolution such as an administrative dissolution, and
- that dissolution is not a creditor’s-rights issue but is between the LLC and the state (in the case of an administrative dissolution) or between the LLC and the members (in the case of an intentional dissolution).
And a tip of the hat to Thomas E. Rutledge, a Kentucky lawyer and the current chair of the Committee on LLCs, Partnerships and Unincorporated Entities of the Business Law Section of the American Bar Association. Tom has written extensively on LLC law, and his writings are cited several times in the Shannon opinion.
LLC statutes typically require that an LLC have at least one member. A corollary is that the death of an LLC’s only member results in the LLC’s dissolution unless the deceased member’s assignees or heirs vote within a limited time to admit one or more members. In a recent Alabama case an LLC’s manager continued operating the LLC after the death of the sole member, without asking the other three heirs to vote to continue the LLC. Ten years later the three heirs asked the court to enforce the dissolution and require that the LLC be wound up.L.B. Whitfield, III Family LLC v. Whitfield, No. 1110422, 2014 WL 803363 (Ala. Feb. 28, 2014). Notwithstanding the ten-year interval, the Alabama Supreme Court affirmed the trial court’s order that the LLC had been dissolved and that the LLC must wind up its business and distribute its assets.
Background. L.B. Whitfield formed an Alabama LLC in 1998 to hold his shares of stock in a large family business. L.B. was the only member, and he and his son Louie were the managers. When L.B. died in 2000, his will left the residue of his estate, including his interest in the LLC, to Louie and each of Louie’s three sisters in four equal shares. Louie was appointed executor of L.B.’s estate and continued as manager of the LLC.
Over the next ten years Louie and the three sisters accepted distributions from the LLC and in other ways treated the LLC as an ongoing entity. This state of affairs began to unravel in 2010, when a dispute arose between the sisters and the LLC over shares of stock the sisters had transferred to the LLC years earlier. The LLC filed a lawsuit against the three sisters, requesting a declaration from the court that the sisters had no right to reacquire the shares from the LLC.
In the course of the lawsuit the sisters learned that under Alabama law the death of an LLC’s only member will cause the LLC to be dissolved unless the deceased member’s assignees agree in writing within 90 days to continue the business and to admit one or more new members. They then sued for a court order requiring the LLC to wind up its affairs and distribute its assets to the sisters and Louie, on the grounds that it had been dissolved 90 days after L.B.’s death. The trial court so ordered and the LLC appealed to the Alabama Supreme Court.
Equitable Defenses. The LLC asserted the affirmative defenses of res judicata, laches, equitable estoppel, judicial estoppel, and waiver. These defenses all revolved around either the probate of L.B.’s estate or the ten-year period between his death and the sisters’ assertion of their claim that the LLC was dissolved. All were rejected by the Supreme Court.
Res Judicata. The LLC argued that its continuation had been adjudicated in the “Decree of Final Settlement” that the probate court entered for L.B.’s estate, because the sisters could have asserted in the probate that the LLC was dissolved but failed to do so. The Supreme Court rejected that defense because the LLC’s continuation was not a central or even a peripheral issue in the probate, and the mere listing of the LLC as an asset of the estate was not a determination that L.B.’s children had been admitted as members of the LLC. Id. at *6.
Laches. The LLC argued that the sisters’ ten-year delay in seeking a declaration of the LLC’s dissolution prejudiced the LLC. The court first pointed out that the sisters were not seeking to dissolve the LLC but were instead seeking recognition that the LLC had been dissolved shortly after L.B.’s death by operation of Alabama law. Laches is a delay that works a disadvantage to the other party, and the court found that the passage of time had worked no disadvantage to the LLC.
Equitable estoppel requires knowledge of the facts by the party to be estopped, lack of knowledge by the party seeking estoppel, and material harm resulting from the assertion of a claim inconsistent with earlier conduct. The court dismissed this defense, finding that the sisters were not aware that the LLC was dissolved until they consulted counsel following the LLC’s initiation of the lawsuit, that the LLC should have been aware of the law that governed its existence, and that there was no material harm resulting to the LLC.
Judicial estoppel applies when a person takes a position in a legal proceeding that is inconsistent with a position previously asserted. The LLC argued that the sisters’ position seeking enforcement of the LLC’s dissolution was inconsistent with their position in the probate of L.B.’s estate. But the sisters never contended in the probate that the LLC should continue or that they were members of the LLC, and the court saw no basis for judicial estoppel.
Waiver. The LLC argued that the sisters had waived their right to seek dissolution. But the court brushed aside the waiver claim, noting that this defense suffered from essentially the same deficiencies as the other defenses.
Dissolution. The LLC argued that it had not been dissolved because Louie’s actions following L.B.’s death continued the LLC. The court began its analysis by examining the relevant provisions of the Alabama LLC Act.
The Act provides that an individual LLC member ceases to be a member on his or her death, subject to contrary provisions in the LLC’s operating agreement. Ala. Code § 10A-5-6.06(b)(3)(a). There were no such provisions in the LLC’s operating agreement.
The Act also provides that an LLC is dissolved and its affairs shall be wound up
upon occurrence of the first of the following events: … When there is no remaining member, unless … [t]he holders of all the financial rights in the limited liability company agree in writing, within 90 days after the cessation of membership of the last member, to continue the legal existence and business of the limited liability company and to appoint one or more new members.
Ala. Code § 10A-5-7.01. L.B. therefore ceased to be a member on his death, and the sisters claimed that as the heirs of the financial rights in the LLC they had never agreed in writing to continue the business of the LLC.
The LLC contended, however, that Louie had the power to transfer his father’s membership interests to himself and his sisters, under Section 10A-5-6.04(a)(1) of the Act, and that he had done so by opening a bank account for the LLC to receive dividends on its shares of the family business and by working with accountants to open capital accounts for himself and his sisters. Section 10A-5-6.04(a)(1) empowers an estate’s personal representative to exercise the deceased member’s financial rights in order to settle the estate, but the court did not interpret it to authorize the personal representative to participate in management or admit members to the LLC. Whitfield, 2014 WL 803363, at *11. Furthermore, the court did not agree that Louie’s actions amounted to a written agreement by the holders of the financial rights in the LLC.
The court also found that its conclusions were supported by “the inherent nature of limited liability companies and [the] fundamental principles attendant to their formation and the acquisition of membership status in them.” Id. at *12. Those principles are that admission to membership in an LLC is not established by implication or by the actions of third parties, and that membership admission, under the LLC Act, must be evidenced by a written instrument signed by all existing members. Id.
The court accordingly affirmed the trial court’s ruling that the LLC had been dissolved upon L.B.’s death and the trial court’s order that the LLC be wound up, provide an accounting of its assets, and distribute the assets in equal shares to Louie and his sisters.
Comment. This decision is an interesting example of rights being enforced after a long (ten years) period, where the holders of those rights unknowingly let them lie fallow and unenforced.
The decision should also be a good warning for lawyers to keep in mind – when the single member of an LLC dies, there is only a limited period of time in which to take action to avoid the dissolution of the LLC, at least under Alabama law. Alabama law is not an outlier on that point; for example, Washington State (Wash. Rev. Code §§ 25.15.130, .270) and the Revised Uniform Limited Liability Company Act (§§ 602, 701) have similar provisions.
Whitfield is also an example of what can happen when parties launch litigation without full consideration of possible consequences. If the LLC had carefully analyzed its history and the circumstances attendant on the probate of L.B.’s estate, and considered the Alabama LLC Act’s rules on dissociation and dissolution, it might have forgone litigation and negotiated a settlement of the dispute over the shares of stock.
Washington’s LLC Act limits the time period for filing lawsuits against a dissolved LLC. In 2010 the LLC Act was amended so that the limitations period does not start until the dissolved LLC files a certificate of dissolution with the Secretary of State, and the Court of Appeals recently had to decide whether that change applied retroactively. Houk v. Best Dev. & Constr. Co., No. 31163-5-III, 2014 WL 997225 (Wash. Ct. App. Mar. 13, 2014).
In 2004 William and Janice Houk moved into a new home they purchased from Nicholas & Shahan Development, LLC (NSD). There were multiple defects in their home, and in December 2010 they sued NSD for their damages on theories of breach of contract, breach of warranties, negligence, and violations of Washington’s Consumer Protection Act.
NSD moved for summary judgment dismissing the claims on the grounds that they were time-barred because the lawsuit was filed more than three years after NSD’s dissolution. NSD had been administratively dissolved in October 2006 by the Secretary of State for noncompliance with the LLC Act’s administrative requirements (e.g., not paying the annual fee or not filing an annual report).
The trial court denied NSD’s motion because of a 2010 amendment to the LLC Act that took effect before the Houks filed their lawsuit. The amended LLC Act required (as it does now) that a certificate of dissolution must be filed in order to start the three-year limitations period, and NSD had not filed a certificate of dissolution. Although three years had elapsed since NSD’s dissolution, the trial court applied the new filing requirement retroactively and allowed the Houks’ suit to go forward.
The three-year post-dissolution statute of limitations was added to the LLC Act by an amendment in 2006: “The dissolution of a limited liability company does not take away or impair any remedy available against that limited liability company, its managers, or its members for any right or claim existing, or any liability incurred at any time, whether prior to or after dissolution, unless an action or other proceeding thereon is not commenced within three years after the effective date of dissolution….” Wash. Rev. Code § 25.15.303 (2006) (emphasis added).
Section 303 was again amended in 2010 so that the three-year limitations period only begins to run when and if the dissolved LLC files a certificate of dissolution with the Secretary of State. Wash. Rev. Code § 25.15.303. An LLC can dissolve by a vote of its members and is not required to file a certificate of dissolution, but if it does so, the filed certificate makes the dissolution a matter of public record. Wash. Rev. Code § 273(1).
The Court of Appeals pointed out that statutory amendments are presumed to be prospective “unless there is a legislative intent to apply the statute retroactively or the amendment is clearly curative or remedial.” Houk, 2014 WL 997225, at *1 (emphasis added) (citing Johnson v. Cont’l W., Inc., 99 Wash.2d 555, 559, 663 P.2d 482, 484 (1983)).
The court explained that a statutory amendment is curative if it clarifies or technically corrects an ambiguous statute. Id. at *3. Section 303 had previously been held by the Supreme Court to be unambiguous, so the Court of Appeals found that the amendment was not curative. Id. (citing Chadwick Farms Owners Ass’n v. FHC LLC, 166 Wash.2d 178, 207 P.3d 1251 (2009)).
A statutory amendment is remedial if it relates to practice, procedure, or remedies, and does not affect a substantive right. Id. NSD had a legal right to assert the statute of limitations under the 2006 version of Section 303. The 2010 amendment, if retroactively applied, would have denied NSD the right to assert the statute of limitations as a complete defense. The court accordingly found that the 2010 amendment affected a substantive right and was not remedial.
Having determined that the 2010 amendment was neither curative nor remedial, the court followed the presumption that the statute is prospective, and reversed the trial court and granted summary dismissal of the Houks’ suit.
Comment. For lawyers who work with LLCs, the result in Houk is important less for what it teaches about whether statutory changes are retroactive, and more for its lesson on the importance of certificates of dissolution for dissolved Washington LLCs. The three-year statute of limitations in Wash. Rev. Code § 25.15.303 can be very helpful in a dissolved LLC’s winding up, but under the current LLC Act there is no special limitations period for a dissolved LLC unless it files a certificate of dissolution.
LLC members and managers sometimes decide to dissolve an LLC by simply ignoring its administrative requirements and letting the Secretary of State administratively dissolve the LLC. That works, but the benefits of a reasonably short three-year statute of limitations 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).
Although it played no part in the Houk case, the LLC Act also provides a method for a dissolved LLC to dispose of known claims on an accelerated basis, if the LLC has filed a certificate of dissolution. Wash. Rev. Code § 25.15.298. The LLC can give notice of its dissolution to known claimants, who must then assert claims within 120 days or their claims will be barred. If after receiving the notice a claimant asserts a claim that is then rejected by the LLC, the claimant must sue on the claim within 90 days or the claim will be barred. This “fish or cut bait” process has risks and may not be desirable in particular circumstances, but in some cases it can be a highly useful way to bring matters to a head.
Last week Governor Dayton signed into law House File 977, Minnesota’s Revised Uniform Limited Liability Company Act (the “New Act”), after it was passed unanimously by both houses of the Legislature. The New Act will completely replace the current statute, the Minnesota Limited Liability Company Act.
The New Act will be effective August 1, 2015, and will apply to all LLCs formed thereafter. LLCs formed before that date are not subject to the new statute until January 1, 2018, unless they elect to be governed by the New Act during the transition period. H.F. 977, 88th Leg. § 89 (Minn. 2014) (to be codified at Minn. Stat. § 322C.1204).
The New Act is based in large part (albeit with some variations) on NCCUSL’s Revised Uniform Limited Liability Company Act (RULLCA), which with Minnesota’s enactment has now been adopted in nine states. RULLCA has been criticized by commentators, and early enactments were slow to come. But its momentum appears to be increasing – in the past two years Florida, California, New Jersey, and now Minnesota have enacted RULLCA.
The New Act is a major rewrite of Minnesota’s LLC statute and changes a number of the default rules governing LLCs. Stephen Quinlivan, David Jenson, Jenifer Frohne, and Robert Rominski have prepared a useful summary of the New Act, including a comparison of its key terms with the current statute and with the Delaware LLC Act, here.
Arkansas Supreme Court Rules That Members' Claims Against Other LLC Members Are Direct and Not Derivative and May Proceed
When LLC managers do wrong and members complain that they are being injured, their injuries may be direct or indirect. An example of a direct injury to a member would be if a manager were to wrongly cancel the member’s interest and expel the member from the LLC. An indirect injury to a member would be if the manager were to harm the LLC itself, which would indirectly harm all the members. An example would be if a manager with a conflict of interest were to sell goods to the LLC at inflated prices.
An LLC member with direct claims against a manager may assert the claims directly, by suing in the member’s own name. But if the member’s claim is that the manager injured the LLC and therefore indirectly injured the member (along with the other members), then the member can only sue derivatively, in the name of the LLC. Derivative suits are subject to a number of procedural requirements that do not apply to direct claims, which I have written about here (New York), here (Utah), and here (Georgia).
Determining whether member claims were direct or derivative was a key issue in a recent Arkansas case. The minority members of a bankrupt Arkansas LLC sued the managers and other members on grounds of fraud, breach of duty to disclose company information, and conversion of membership interest. The trial court ruled that the plaintiffs’ claims were derivative and should have been brought in the name of the LLC, and dismissed their claims for lack of standing. But the Arkansas Supreme Court reversed and sent the case back for further proceedings, holding that the plaintiffs had standing because their claims were direct and could be brought in their own names. Muccio v. Hunt, No. CV-11-1273, 2014 WL 346929 (Ark. Jan. 30, 2014).
Background. J.B. Hunt and Tom Muccio formed BioBased Technologies, LLC with the understanding that Hunt would contribute capital and Muccio would primarily contribute his time and expertise as CEO. Muccio later agreed to bring in business consultant Walter Smiley on the strength of Hunt’s and the other defendants’ representations that Smiley would be neutral and objective and would make recommendations consistent with the LLC’s best interests. Smiley later became chairman of the board and subsequently replaced Muccio as CEO. Muccio’s complaint alleged that the defendants’ representations about Smiley were “a boldfaced lie” and that Smiley was brought to the company as part of a larger overall conspiracy to oust Muccio. Id. at *3.
A meeting of the members was held several months after Smiley replaced Muccio as CEO, at which Smiley told the members that the company could not cover its checks and that its bank line-of-credit note had been called. On his recommendation, and the promise that each of the members would have a voice in the reorganization process, the members voted to approve the company’s bankruptcy filing. Smiley did not inform the plaintiffs that at his direction the company’s CFO had moved a considerable amount of cash to a different bank, and that the company’s bank had been ready and willing to extend the note.
The plaintiffs also alleged that documents about the LLC’s reorganization were withheld in order to prevent them from making an offer to purchase the business out of the bankruptcy, that the defendants in effect gave themselves an exclusive option to purchase the company, and that the plaintiffs were excluded from the reorganized company.
Fraud. The court recited the rule that a shareholder may bring a derivative action on behalf of a corporation to enforce a right of the corporation when the corporation has failed to do so, citing Arkansas Rule of Civil Procedure 23.1. The court distinguished direct suits as being appropriate “only when the shareholder asserts an injury that is distinct and separate from the harm caused to the corporation.” Id. at *8.
Surprisingly, the court discussed only the rules for corporations, even though BioBased was a limited liability company. The court even referred to BioBased as a “limited liability corporation.” Id. at *1. The court did not discuss Section 1102 of the LLC statute, which governs LLC derivative suits, and appears to have implicitly assumed that the rules for corporations regarding direct and derivative actions automatically apply to LLCs. Later in the opinion, though, the court referred to the Arkansas LLC statute’s provisions governing a member’s right to receive information.
After examining the results of the various misrepresentations made by the defendants, the court concluded that the plaintiffs “suffered a direct injury resulting in the loss of their ownership interest in BioBased. These claims sound in fraud in the inducement and thus are not fraudulent actions that harmed only BioBased.” Id. at *11.
Duty to Disclose. The Arkansas LLC statute requires managers and managing members to “render, to the extent the circumstances render it just and reasonable, true and full information of all things affecting the members to any member.” Ark. Code Ann. § 4-32-405(c) (emphasis added). The court recognized that the members’ statutory rights to information support individual claims by members, and not by the LLC itself. Muccio, 2014 WL 346929, at *12.
Conversion. Conversion is a common law tort for the wrongful possession or disposition of another’s property. The plaintiffs claimed that the defendants exercised dominion over the plaintiffs’ LLC membership interests, and that the defendants converted those interests through their fraudulent misrepresentations. The court concluded that because it had determined that the fraud claim was a direct claim, that similarly the conversion claim was a direct claim. Id. at *13.
Having decided that the claims for fraud, failure to disclose company information, and conversion were all direct claims by the plaintiffs and not derivative claims, the court reversed the trial court’s rulings on those claims and remanded them to the trial court for further proceedings.
Comment. The court’s review of the claims and its analysis show that determining whether claims are direct or derivative can be highly fact-intensive. Fraud claims and conversion claims, for example, can be either direct or derivative, depending on the circumstances. The distinction between direct and derivative claims by LLC members and the procedural barriers for derivative suits are ably discussed in an article by Professor Kleinberger. Daniel S. Kleinberger, Direct Versus Derivative and the Law of Limited Liability Companies, 58 Baylor L. Rev. 63 (2006).
One troubling aspect of the court’s opinion is its easy glissade between limited liability companies, limited liability corporations, and corporations, and its references to cases and court rules on corporations as if they automatically applied to LLCs.
LLCs and corporations are separate and distinct types of entities, formed under different chapters and having different characteristics, and there is no such thing as a “limited liability corporation”:
- Section 4-26-102(1) of the Arkansas Code defines “corporation” as “a corporation for profit subject to the provisions of this chapter [chapter 26], except a foreign corporation.”
- Section 4-32-102(6) of the Arkansas Code defines “limited liability company” as “an organization formed under this chapter [chapter 32].”
The Arkansas court’s terminological confusion is not unique – Professor Kleinberger has referred to this as “a continuing, albeit lessening, phenomenon of judicial confusion as to the nature of, and correct terminology for, limited liability companies.” Id. at 71 n.27.
Courts continue to struggle with the effects of LLC charging orders. In a recent North Carolina case the question was whether the grant of a charging order constituted an assignment of the member’s interest and caused him to lose his management rights while the order was in effect. First Bank v. S & R Grandview, L.L.C., No. COA 13-838, 2014 WL 846671 (N.C. Ct. App. Mar. 4, 2014). The Court of Appeals reversed the trial court, and held that the charging order did not carry out an assignment of the member’s interest and that the member retained his management rights.
The charging order in the case was requested by First Bank because it had obtained a $3.5 million judgment against Donald Rhine. Rhine was a member of S & R Grandview, L.L.C., and the trial court granted First Bank’s motion for a charging order against Rhine’s member interest in the LLC.
The Trial Court. As is customary, the charging order directed the LLC to pay to First Bank any distributions that Rhine would otherwise receive. But the court also concluded that the charging order “effectuate[d] an assignment” of Rhine’s member interest. The court ordered that until First Bank’s judgment was satisfied:
- First Bank was to have the rights of an assignee of Rhine’s membership interest, and the LLC’s members and managers were ordered to treat First Bank as an assignee.
- Rhine was enjoined from exercising any of the rights of a member in the LLC until First Bank’s judgment was satisfied.
- First Bank was not allowed to exercise any rights of a member in the LLC, other than its right under the charging order to receive distributions that would otherwise go to Rhine.
- Rhine’s membership rights (other than his rights to distributions) were to “lie fallow” until First Bank’s judgment was satisfied.
First Bank, 2014 WL 846671, at *1.
Court of Appeals. Rhine argued on appeal that the trial court erred (1) by concluding that the charging order carried out an assignment to First Bank of his membership interest, and (2) by enjoining Rhine from exercising his management rights in the LLC.
The Court of Appeals turned to North Carolina’s LLC Act, as in effect at the time of the charging order. N.C. Gen. Stat. ch. 57C. (North Carolina’s LLC Act was since amended. N.C. Gen. Stat. ch. 57D.) The LLC Act at that time authorized charging orders as follows:
On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the membership interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the membership interest. This Chapter does not deprive any member of the benefit of any exemption laws applicable to his membership interest.
Section 57C-5-03 states that a judgment creditor has only the rights of an assignee of the membership interest, so the court looked to Section 57C-5-02, which describes an assignee’s rights: “An assignment entitles the assignee to receive, to the extent assigned, only the distributions and allocations to which the assignor would be entitled but for the assignment.” The court read the two sections together and found that (a) their plain language gives a judgment creditor only the right to receive distributions the debtor-member would have been entitled to, and only until the judgment is satisfied; and (b) nowhere in those provisions did the legislature mandate an assignment of membership interests through a charging order. First Bank, 2014 WL 846671, at *3.
The last sentence of Section 57C-5-02 also provides that “the pledge of, or granting of a security interest, lien, or other encumbrance in or against, all or any part of the membership interest of a member shall not cause the member to cease to be a member or the secured party to have the power to exercise any rights or powers of a member.” The court viewed a charging order to be an encumbrance that under Section 57C-5-02 would not cause a debtor-member to lose its membership rights. Id. at *4.
The court emphasized that once the judgment is paid, the debtor-member’s interest in the LLC is no longer subject to the charging order, as opposed to an assignment of a member’s LLC membership interest, which is a permanent transfer. Id.
The court found additional support for its conclusions in the new LLC Act, which among other things explicitly states that a charging order is a lien on the judgment debtor’s economic interest. N.C. Gen. Stat. § 57D-5-03(b). Although the new Act did not apply directly to the case, the court found its additional provisions to be clarifications that supported the court’s conclusion. “The subsequent amendment of the charging order statute is strong evidence that the General Assembly intended charging orders under 57C-5-03 to be encumbrances that do not affect a debtor’s managerial interest, contrary to plaintiff’s contention and the trial court’s order.” Id. at *5.
The court accordingly held that under the plain language of Section 57C-5-03, “a charging order does not effectuate an assignment of a debtor’s membership interest in an LLC and does not cause a debtor to cease being a member in an LLC.” The court reversed the trial court’s order enjoining Rhine from exercising his membership rights in the LLC and ordering that his membership rights “lie fallow.” Id. at *6.
Comment. All states have LLC charging order statutes, and they are generally understood to give the judgment creditor only a type of lien on distributions otherwise receivable by the debtor-member. Nonetheless, the claim that a charging order conveys the entire membership interest of an LLC member-debtor periodically comes up and has to be batted down.
For example, in a reversal of their usual positions, a judgment debtor who owned an LLC member interest in an Ohio medical LLC argued in court that a charging order could not be granted against his interest because the charging order would constitute a full assignment of his ownership interest, and would therefore violate Ohio’s statute barring the unauthorized practice of medicine. FirstMerit Bank, N.A. v. Xyran, Ltd.¸ which I discussed, here. (The court did not accept the debtor-member’s argument.)
The courts don’t always get it right. Witness the U.S. District Court’s decision in Meyer v. Christie, a Kansas case I wrote about, here. The court there allowed a judgment creditor to use its charging order to take over management of a single-member LLC by treating the charging order as an assignment of the sole member’s membership.
The First Bank court’s analysis was thorough, and it got the issues right. It should be a useful persuasive precedent for courts in other jurisdictions, particularly in those many states that have similarly worded statutes.