LLCs allow investors to invest in businesses without fear of liability for harms caused by the LLCs’ activities, but there are exceptions. Case in point: the Montana Supreme Court recently had to decide whether to allow a claim that an LLC member should be liable for the LLC’s obligations on two vehicle service contracts. The Supreme Court held that the member was not liable, even though the member had benefited from the LLC’s contracts, had made some payments on the contracts on behalf of the LLC, and had brought suit in his own name to recover the vehicle being serviced. Weaver v. Tri-County Implement, Inc., 311 P.3d 808 (Mont. Oct. 22, 2013).
C.R. Weaver was one of two members of Mikart Transport, LLC, a Montana member-managed LLC. Mikart entered into agreements with Tri-County Implement, Inc. for service on a Freightliner truck and a Volvo semi-truck. Tri-County carried out the work but was not fully paid, so it asserted a lien and refused to release the Volvo.
Weaver sued Tri-County in his own name for fraud and for return of the Volvo. Tri-County counterclaimed against Weaver and asserted third-party complaints against Mikart and the other member, demanding payment for the work on the two vehicles. Tri-County moved for summary judgment on its claims and the trial court found in its favor on all counts. Judgment for the amount due to Tri-County and for an additional $21,180 in attorneys’ fees was entered against Mikart, the other member, and Weaver. Weaver appealed the trial court’s imposition of personal liability. Id. at 810.
All state LLC statutes provide that LLC members and managers are not liable for the debts and obligations of their LLC simply because they are members or managers, and that is where the Weaver court began. The court quoted Section 35-8-304(1) of the Montana LLC Act:
[A] person who is a member or manager, or both, of a limited liability company is not liable, solely by reason of being a member or manager, or both, under a judgment, decree or order of a court, or in any other manner, for a debt, obligation, or liability of the limited liability company, whether arising in contract, tort, or otherwise or for the acts or omissions of any other member, manager, agent, or employee of the limited liability company.
The court recognized that an LLC’s liability shield is a corollary of its status as a separate legal entity, distinct from its members and with obligations separate from those of its members. Weaver, 311 P.3d at 811. But the liability shield for members and managers is status-based, and certain acts or omissions of a member may go beyond the shield. “[T]his liability shield is not absolute and does not provide immunity to a member for his own wrongful conduct.” Id.
Applying those rules to Weaver’s appeal, the court found that Weaver’s liability would depend on whether he personally breached a contract obligation or committed a tort with regard to Tri-County. Id. at 812. The trial court had relied on the facts that (a) the Volvo that Mikart had hired Tri-County to service was owned by Weaver, (b) Weaver had personally made some payments to Tri-County but had failed to make others, and (c) Weaver personally brought the legal action against Tri-County to recover the Volvo. The Supreme Court, however, found those facts insufficient.
On the contract prong of the analysis, the agreements for the work performed on the two trucks were solely between Tri-County and Mikart. Weaver never guaranteed payment or made any other promises to Tri-County. Without an agreement between Weaver and Tri-County, Weaver could not be liable for breach of contract. Against that bedrock principle, it was immaterial that Weaver owned the Volvo, sued Tri-County personally, or made some partial payments on the amount Mikart owed to Tri-County. To conflate Mikart’s failure to pay its debts with Weaver’s failure to pay Mikart’s debts “would eviscerate the protection afforded by Montana’s Limited Liability Company Act and render the LLC business form superfluous.” Id.
On the tort analysis, the court found that the allegation that Mikart may be unable to pay its debts did not, by itself, establish wrongful conduct that would impose liability on Weaver. There was no fraud or other tortious conduct. (A tort is an actionable, civil wrong, such as fraud, breach of a fiduciary duty, or negligently causing an auto accident.)
The court concluded that there was no basis for holding Weaver liable for Mikart’s obligations to Tri-County, and reversed the judgment against Weaver. Id.
Comment. If hard cases sometimes result in bad law, then Weaver must be the inverse, an example of an easy case making good law. It’s satisfying to see a court march through a weak argument and systematically deconstruct it to reach the right result.
Tri-County’s argument in its brief to the Supreme Court focused mainly on Weaver’s close connection to Mikart, and on the litany of facts: Weaver paid part of what Mikart owed to Tri-County, Weaver owned the Volvo that Mikart contracted with Tri-County to repair, and Weaver personally filed the lawsuit to recover the Volvo. Appellees’ Brief at 10-13. But no legal argument was asserted to show how the facts led to a cause of action: not a promise by Weaver, not wrongdoing on Weaver’s part, not unjust enrichment to Weaver, not piercing the veil.
Although the opinion does not discuss it, one other well-recognized route by which claimants against an LLC can sometimes also pursue their claim against an LLC’s members or managers is by piercing the veil of the LLC. I have written about LLC veil-piercing cases several times; a collection of those posts is available here. (The Montana courts apparently have not ruled definitively on the applicability of veil-piercing to LLCs. See White v. Longley, 244 P.3d 753, 280 n.2 (Mont. 2010).)
Massachusetts Court Disregards Contribution of Services When Calculating Members' Votes Because LLC's Records Didn't Specify Value of the Services
Members of a Massachusetts LLC can file a derivative lawsuit on behalf of the LLC only if a majority of the members other than the defendant approve the lawsuit. Unless the LLC’s operating agreement provides otherwise, the members’ votes are determined by the value of their contributions as shown in the records of the LLC.
Last month the Massachusetts Appeals Court ruled on a dispute over calculation of the members’ votes on an LLC’s derivative lawsuit. The court refused to include one member’s affirmative vote because his contribution consisted of services for which neither the operating agreement nor the LLC’s records specified a value, notwithstanding that the operating agreement gave him a 31.29% interest in the LLC. Williams v. Charles, 996 N.E.2d 475 (Mass. App. Ct. Oct. 3, 2013). As a result there were not enough votes to authorize the derivative claims, which were dismissed.
Background. Brent Williams and several others were members of Frowmica, LLC, a Massachusetts LLC. The lawsuit began when Williams and another member sued a member-manager of Frowmica for breach of fiduciary duties, misappropriation, conversion, and freeze-out. The claims were made derivatively, on behalf of Frowmica.
The trial court determined that the plaintiffs lacked a majority because they had contributed only 42.5% of the total contributions, and dismissed the derivative claims for lack of standing. The issue on appeal was whether Williams’ contribution to Frowmica, which was in the form of services rather than cash, should be included in calculating the votes in favor of the derivative suit. Id. at 476.
The relevant portion of Massachusetts’ LLC Act states:
Except as otherwise provided in a written operating agreement, suit on behalf of the limited liability company may be brought in the name of the limited liability company by:
(a) any member or members of a limited liability company, whether or not the operating agreement vests management of the limited liability company in one or more managers, who are authorized to sue by the vote of members who own more than fifty percent of the unreturned contributions to the limited liability company determined in accordance with section twenty-nine; provided, however, that in determining the vote so required, the vote of any member who has an interest in the outcome of the suit that is adverse to the interest of the limited liability company shall be excluded[.]
Mass. Gen. Laws ch. 156C, § 56. The Frowmica operating agreement did not address how the members could authorize the LLC’s lawsuit, so the court had to apply Section 56 and determine the unreturned contributions in accordance with Section 29.
Section 29 provides a default rule that profits and losses of an LLC are to be allocated “on the basis of the agreed value as stated in the records of the limited liability company of the contributions of each member to the extent they have been received by the limited liability company and have not been returned.” Mass. Gen. Laws ch. 156C, § 29(a).
Section 2(3) of the LLC Act includes services rendered and obligations to perform services in the definition of contribution. The court agreed with the plaintiffs’ contention that neither Frowmica’s operating agreement nor the statute required that contributions be in cash or property, and that Williams had contributed services to Frowmica.
But the court pointed out that neither Frowmica’s operating agreement nor its other records identified a value for Williams’ contribution of services. Exhibit A to the LLC’s operating agreement showed each member’s initial cash contribution and the member’s percentage interest in the LLC. A cash contribution amount is listed for every member except Williams, for whom a zero is shown. But each member, including Williams, is shown with a percentage interest. Williams’ percentage interest is the second largest, at 31.29%.
The plaintiffs argued that Williams’ 31.29% interest in Frowmica reflected the agreed value of his service contributions to the LLC. That would appear to be a compelling argument, except that Section 20(c) of the LLC Act says that a member may be admitted and may receive an interest in an LLC without making a contribution. The court therefore refused to draw the inference that Williams’ 31.29% interest in the LLC represented the agreed value of his contribution, since he could have received his interest for no contribution. Williams, 996 N.E.2d at 479-80. The court was also unpersuaded by the plaintiffs’ arguments, that the operating agreement’s provisions that called for allocations of profits and losses and for voting on other issues to be determined by the members’ percentage interests, supported voting by percentage interests on deciding to bring a derivative suit. Id. at 480.
Comment. The lesson of this case for lawyers is to cover all of the possible voting situations in an LLC’s operating agreement. Massachusetts’ LLC Act provides for great flexibility in member voting. An operating agreement may grant all members, identified members, or classes of members the right to vote on any matter. Voting may be on a per capita, number, financial interest, class group, or any other basis. Mass. Gen. Laws ch. 156C, § 21(b).
The Frowmica operating agreement called for profit and loss allocations to be made in proportion to the members’ percentage interests, and it called for voting by percentage interests in determining whether to challenge the manager’s performance. In hindsight, a similar provision could have been added to specify that member voting on whether to bring a derivative suit would be in proportion to the members’ percentage interests. Alternatively, a catch-all provision could have been added, to provide that member voting would be in proportion to the percentage interests in the case of any member decision not otherwise enumerated in the operating agreement.
Wyoming’s new LLC Act in 2010 changed the standard for veil-piercing claims by eliminating any consideration of an LLC’s failure to observe formalities relating to its activities or management. That sounds like a big change, but it didn’t affect the result in American Action Network, Inc. v. Cater America, LLC, No. 12-1972 (RC), 2013 WL 5428857 (D.D.C. Sept. 30, 2013).
This case was a breach of contract action. American Action Network, Inc. (AAN) hired Cater America, LLC, a Colorado LLC, to organize a Lynyrd Skynyrd concert during the 2012 Republican National Convention in Tampa, Florida. AAN claimed that it paid $150,000 to Cater as a refundable ticket deposit and that it loaned another $200,000 to Cater. The concert was cancelled on account of weather.
Cater claimed the $150,000 was payment for services it performed, and refused to repay either amount. AAN brought a breach of contract action against Cater, and also against Cater’s sole member, Robert Jennings, on an alter ego or veil-piercing theory. Jennings moved to dismiss the veil-piercing claim on grounds that AAN’s complaint failed to state a claim, under Federal Rule of Civil Procedure 12(b)(6). (A motion under Rule 12(b)(6) tests whether the facts alleged in the complaint, if proved true at trial, could support relief under the applicable law.)
Choice of Law. The court first had to decide which state’s law applied. Jennings claimed that Wyoming law governed the veil-piercing claim. AAN argued that Wyoming law did not apply, but took no position as to which state’s law should apply. Id. at *6. The court assumed, without deciding, that Wyoming law applied. It did so because under its analysis AAN’s veil-piercing claim survived even if Jennings’ contention that Wyoming law applied was correct.
’Tis a passing strange result for more than one reason. First, according to the court the parties did not substantively analyze the proper choice of law issue. Even odder is the fact that Cater was a Colorado LLC, formed under Colorado’s LLC statute in 2008, yet the court applied Wyoming law.
Generally the law of the state of formation of a corporation or LLC will govern veil-piercing claims. See, e.g., Howell Contractors, Inc. v. Berling, No. 2010-CA-001755-MR, 2012 WL 5371838 (Ky. Ct. App. 2012). I blogged about Howell, here. The court in Howell cited several federal cases in support of the rule that the law of an entity’s state of formation governs veil-piercing issues.
Piercing the Veil. The court pointed out that Wyoming has previously applied the equitable doctrine of piercing the veil to LLCs. E.g., Gasstop Two, LLC v. Seatwo, LLC, 225 P.3d 1072 (Wyo. 2010) (veil-piercing factors lie in four categories: fraud, inadequate capitalization, failure to observe company formalities, and intermingling of LLC’s and member’s business and finances).
The Wyoming LLC Act was substantially amended effective July 1, 2010, however, and the revisions touched on the veil-piercing issue. The relevant portion of the LLC Act now reads:
The failure of a limited liability company to observe any particular formalities relating to the exercise of its powers or management of its activities is not a ground for imposing liability on the members or managers for the debts, obligations or other liabilities of the company.
Wyo. Stat. Ann. § 17-29-304(b) (emphasis added). Subparagraph (b) is new – the prior Act made no reference to the LLC’s observance of any particular formalities.
The court determined that this new subsection merely precludes consideration of one factor in a veil-piercing analysis, and quoted approvingly a commentator’s analysis of Section 17-29-304(b): “other categories…, including fraud, inadequate capitalization, and intermingling the business and finances of a company and its member, remain as grounds for piercing the LLC veil”). Cater, 2013 WL 5428857, at *9 (quoting Dale W. Cottam et al., The 2010 Wyoming Limited Liability Company Act: A Uniform Recipe with Wyoming “Home Cooking”, 11 Wyo. L. Rev. 49, 63-64 (2011)).
Based on its determination that the remaining veil-piercing factors continue to be applicable, the court concluded that AAN’s complaint alleged sufficient facts to adequately plead a veil-piercing claim (although the court never set forth AAN’s specific allegations). Jennings’ motion to dismiss AAN’s claims against him was therefore dismissed. Id. That claim will now go to trial.
Comment. The court expressed hesitancy “to conclusively interpret a Wyoming state law as a matter of first impression where the parties have not provided briefing analyzing the statute’s text and where it is not even clear that Wyoming law would apply.” Id. Nonetheless, it’s hard to imagine a Wyoming court taking a different view of Section 17-29-304(b).
Wyoming’s statutory removal of informality from the factors used to determine whether an LLC’s veil should be pierced is a good change. LLCs are often operated informally, and the lack of any particular formalities in an LLC’s management or exercise of its powers rarely if ever would be a serious factor in causing harm or injustice to an LLC’s creditor or contractual counter-party.
Debt and equity are normally viewed as distinctly different financing methods – stock versus bonds, for example. In closely held companies the boundaries can be unclear, though, as a recent decision of the Ohio Court of Appeals demonstrated. Germano v. Beaujean, No. WD-12-032, 2013 WL 4790315 (Ohio Ct. App. Aug. 30, 2013).
Background. Christopher Germano and John Beaujean formed an Ohio LLC in 2007 to operate a pizza restaurant franchise. They agreed that Germano would arrange financing for the venture, Beaujean would provide on-site supervision for the restaurant and not charge a management fee, and they would share ownership equally. There was no written LLC agreement.
The parties originally intended to finance the company with bank financing, but later decided that Germano would loan his own funds directly to the LLC. Germano therefore provided a five-year, interest-only loan of $280,000 to the LLC for start-up costs, and the business commenced.
All went well for several years, but in 2010 Beaujean caused the LLC to begin paying himself a management fee, retroactive from the beginning of the business, and to begin paying a bookkeeping fee to a restaurant supply company he owned. He also transferred funds from the LLC’s bank account to a separate account that only he could access.
When Germano learned what Beaujean had done he sued for conversion, breach of fiduciary duty, and breach of the statutory duty of good faith and fair dealing. Beaujean denied the allegations and asked for a determination that he was the only member of the LLC with management authority because Germano’s $280,000 loan did not constitute a capital contribution.
The trial court found that Beaujean was not authorized to charge a management fee or bookkeeping fees, or to transfer the LLC’s funds to a separate bank account. He was ordered to repay all of the management fees and the bookkeeping fees in excess of a reasonable hourly charge.
The trial court also denied Beaujean’s counterclaim that Germano’s $280,000 loan did not constitute a capital contribution, and declared that the two owners each owned 50% of the LLC. Id. at *2.
The Capital Contribution. The Court of Appeals first examined the Ohio LLC Act:
The contributions of a member may be made in cash, property, services rendered, a promissory note, or any other binding obligation to contribute cash or property or to perform services; by providing any other benefit to the limited liability company; or by any combination of these.
Ohio Rev. Code § 1705.09(A) (emphasis added).
Consistent with the statute, the court took a broad view of what was a contribution. The court’s decision turned on two points: Germano did obtain financing for the venture, and the parties had agreed at the time the LLC was formed that Germano’s financing services were a sufficient contribution to the company. Germano, 2013 WL 4790315, at *4. The court found that Germano’s loan benefited the LLC, and under Section 1705.09(A) that benefit constituted a contribution to capital. Id.
The court consequently affirmed the trial court’s ruling that Germano’s financing services, i.e., his loan, constituted a capital contribution and that the two members shared equally in management. Id. at *6.
Comment. The court’s application of Section 1705.09(A) to Germano’s loan, and its finding that the loan was a benefit to the LLC and therefore was a capital contribution, are straightforward as far as they go. The court dropped the ball, however, in jumping from there to its conclusion that the two members shared management 50-50, with no further analysis other than its reliance on the parties’ original oral agreement that they would each be 50% owners.
The court ignored Section 1705.24 of the LLC Act:
Unless otherwise provided in writing in the operating agreement, the management of a limited liability company shall be vested in its members in proportion to their contributions to the capital of the company, as adjusted from time to time to properly reflect any additional contributions or withdrawals by the members.
Ohio Rev. Code § 1705.24 (emphasis added).
Beaujean and Germano had no written LLC operating agreement, so their oral agreement about sharing management 50-50 was ineffective. Under the statute, their management was to be shared “in proportion to their contributions to the capital of the company,” as adjusted from time to time. The determination of their respective management authority therefore could be made only by examining the value of their capital contributions, but the Germano court made no such assessment.
As a side note, there is an interesting interplay between Section 1705.24 and Section 1705.081 of Ohio’s LLC Act, but it doesn’t change the applicability of Section 1705.24. The issue is that Section 1705.081 provides that an LLC’s operating agreement governs the relations between members, except for certain listed statutory requirements. The list of statutory requirements that cannot be overridden by an LLC agreement does not include Section 1705.24. Also, the LLC Act defines an operating agreement to include written and oral agreements. Thus, Beaujean and Germano’s oral operating agreement about sharing management 50-50 would have controlled, except for Section 1705.24’s specific requirement for a written operating agreement.
Determining the value to the LLC of Germano’s loan would not be easy. It’s not the amount of the loan itself, because the loan must be repaid. Likewise, determining the value to the LLC of Beaujean’s management services, which the court saw as his contribution to capital, would be problematic. For one thing, the value of his services would increase over time, as he continued to manage the restaurant without compensation, so under Section 1705.24 his share of management authority would be adjusted and gradually would increase.
Two recent bankruptcy cases illustrate the courts’ inconsistent treatment of member rights in LLC operating agreements. In one case a bankruptcy court enforced a member’s right to receive an assignment of the other member’s equity in an LLC. In the other case the court ignored state LLC law and the debtor’s LLC agreement in order to allow the trustee to assert management rights in the debtor’s LLC.
Case 1: Assignment of Member’s Interest. A provision in an LLC agreement that resulted in a member’s conveyance of its LLC interest was enforced by the Arizona Bankruptcy Court in In re Strata Title, LLC, No. 12-24242, 2013 WL 2456399 (Bankr. D. Ariz. June 6, 2013). The debtor, Strata Title, LLC, was one of two 50% members of Tempe Tower, LLC. The other member was Pure Country Tower, LLC.
Schedule 1 of Tempe Tower’s operating agreement provided that if Pure Country’s $850,000 capital contribution was not returned to it by February 23, 2013, Strata’s member interest in Tempe Tower would be transferred to Pure Country. Pure Country would then be the sole member of the LLC. Id. at *1.
The language in Schedule 1 used an interesting drafting technique: “[I]n the event that [Pure Country] does not receive 100% of its initial Capital Contribution … on or before February 23, 2013 … [the owner of Strata Title] hereby irrevocably assigns his and the entire right, title and interest of Strata Title, LLC in [Tempe Tower] to [Pure Country].” Id. (emphasis added). The phrase “hereby irrevocably assigns” would normally mean that the assignment is effective on the date of the operating agreement, but the agreement is also clear that the assignment doesn’t actually occur unless and until the capital contribution has not been returned to Pure Country by February 23, 2013.
Pure Country looked to the “hereby irrevocably assigns” language and contended that Strata’s member interest in Tempe Tower did not become property of the bankruptcy estate, because the member interest was assigned to Pure Country on the date of the operating agreement, before Strata’s bankruptcy petition was filed. The court rejected that argument, pointing out that the assignment would be of no effect if the $850,000 were paid to Pure Country before the February 23, 2013 deadline. The assignment was therefore not absolute, and Strata’s member interest in Tempe Tower at the date of filing of the bankruptcy petition became part of the bankruptcy estate. Id. at *3.
Pure Country also sought a determination that Pure Country held a perfected security interest in Strata’s member interest in Tempe Tower, and asked for stay relief so it could foreclose on Strata’s member interest. In the alternative it asked for stay relief to compel Strata to transfer the member interest to Pure Country. The court said it would look to state law to determine the parties’ rights under the operating agreement, and to the Bankruptcy Code to determine how those rights should be treated in the bankruptcy.
The court concluded that Pure Country did not have a perfected security interest in Strata’s membership in Tempe Tower. Even if Schedule 1 created a security interest in the member interest, Pure Country had not filed a UCC financing statement to perfect its lien, and the only other grounds for perfection, control of investment property, were not applicable because the LLC interests were not “investment property” as defined in Article 9 of the UCC. Id. at *4.
The last string in Pure Country’s bow was its request that the court give it relief from stay and order Strata to transfer its Tempe Tower member interest to Pure Country in accordance with Schedule 1. The court phrased the issue as: “Does the Debtor still hold a property interest in the membership interests under the terms of the Operating Agreement?” Id.
Section 544 of the Bankruptcy Code gives the debtor the right to avoid unperfected liens, but it does not give the debtor any power to expand the scope of its contractual property rights. The debtor’s membership interests are subject to the constraints of the LLC’s operating agreement and state law. Id.
The court referred to the Arizona LLC Act, which empowers an LLC’s operating agreement to govern the relations between the members and the LLC, and to define the rights, duties and powers of the members. Ariz. Rev. Stat. § 29-682. Schedule 1 of the operating agreement limited Strata’s rights in Tempe Tower:
Under terms of the Operating Agreement, the Debtor’s membership interests in Tempe Tower could only remain property of the Debtor if it paid $850,000 to pure Country by February 23, 2013. Having failed to do so, the Debtor ceased to own any membership interests in Tempe Tower as of February 24, 2013.
The automatic stay did not prevent this outcome because § 362 does not alter existing rights in a contract. … (“The mere running of time on contractual rights is not an act of a creditor within the meaning of Section 362(a).”)
Strata, 2013 WL 2456399, at *5 (quoting In re Pridham, 31 B.R. 497, 499 (Bankr. E. D. Cal. 1983)). The court recognized Pure Country’s rights to the member interest and lifted the stay to the extent any further acts by Pure Country were necessary to obtain possession and control of Strata’s membership interests.
Case 2: Transfer of Management Rights. Last month the Nevada Bankruptcy Court dismissed as unauthorized a bankruptcy filing that had been filed on an LLC’s behalf by its sole member. The sole member had previously filed her own Chapter 7 bankruptcy, and her bankruptcy trustee claimed that he had succeeded to all her rights in the LLC, including management rights and the right to decide whether the LLC should file for bankruptcy. Her trustee had not authorized the LLC’s bankruptcy filing and successfully requested the court to dismiss it. In re B & M Land & Livestock, LLC, No. BK-N-13-50543-BTB, 2013 WL 5182611 (Bankr. D. Nev. Sept. 10, 2013).
In 2010 Marsha Raj filed a Chapter 7 bankruptcy petition. She was the sole member of B & M Land and Livestock, LLC, and indicated in her filing that the LLC was an asset of her estate. In 2013, Raj filed a Chapter 11 petition on behalf of B & M, without notifying her bankruptcy trustee. When the trustee learned of B & M’s bankruptcy filing, he moved to dismiss it on the grounds that Raj was not authorized to file B & M’s bankruptcy.
The issue in the case was the impact of Nevada’s LLC Act:
Unless otherwise provided in the articles or operating agreement, a transferee of a member’s interest has no right to participate in the management of the business and affairs of the company or to become a member unless a majority in interest of the other members approve the transfer.
Nev. Rev. Stat § 86.351(1). This provision is similar to many other state LLC Acts, and clearly provides that a transferee of an LLC member’s interest will not have any management rights unless the operating agreement or articles of formation allow it, or a majority in interest of the other members consent. It reflects the “pick your partner” principle, which is inherent in LLC statutes as well as partnership law.
Section 541(a)(1) of the Bankruptcy Code provides that the estate of the bankrupt includes “all legal or equitable interests of the debtor in property as of the commencement of the case.” If a debtor is a member of an LLC, this section in effect makes the bankruptcy trustee a transferee of the debtor’s member interest.
The court relied on prior case law and interpreted Section 541 to mean that the trustee acquired not only the member’s economic interest, but also the member’s management rights. “In obtaining the debtor’s rights, the trustee is not a mere assignee, but steps into a debtor’s shoes as to all rights, including the rights to control a single-member LLC.” B & M, 2013 WL 5182611, at *4.
Conflicting state law does not matter, said the court, opining that Section 541 “trumps any conflicting analysis or rules in state law relating to the control of LLCs or partnerships.” Id. at *5. The court granted the trustee’s motion to dismiss the LLC’s bankruptcy on grounds the debtor did not have authority to file the LLC’s bankruptcy. Id.
Comment. These two cases are inconsistent in their approach to state law control of LLC member rights. Strata looked to state law to determine the parties’ rights under the operating agreement; B & M expressly disregarded state law to reach the result that was most convenient for the trustee’s administration of the debtor’s assets. If there is any justification for disregarding state law it is that last point: it’s hard to imagine an effective administration of a Chapter 7 bankruptcy where a significant asset of the debtor is its member interest in a valuable single-member LLC that the trustee cannot control.
Although B & M involved a single-member LLC, the court’s analysis is not limited and would seem to apply to multiple-member LLCs. If that were so, a bankruptcy debtor who owned a majority LLC interest could find the bankruptcy trustee controlling the LLC, against the wishes and to the detriment of the other members. The court did note in passing that its rule might be limited in the case of LLCs providing professional services, which under state law can usually be owned and managed only by professionals licensed in that discipline.
One bankruptcy case involving a debtor’s interest in a single-member LLC reached the same result as B & M, but the court there observed that in a multi-member LLC the result would be different. “Where a single member files bankruptcy while the other members of a multi-member LLC do not, … the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of the contributions to which that member would otherwise be entitled.” In re Albright, 291 B.R. 538, 540 n.7 (Bankr. D. Colo. 2003).
Illinois Says LLC Is Not a Joint Venture, So Contractor/Member Can File a Mechanic's Lien Against Its Own LLC
An Illinois contractor cannot file a mechanic’s lien against property it owns or co-owns, including ownership through a joint venture. Is an LLC a joint venture? That was the question before the Illinois Appellate Court last month. A contractor that was a member of an LLC and had worked on the LLC’s property filed a mechanic’s lien against the property for its unpaid fee. The LLC’s lender contended that the mechanic’s lien was invalid because the contractor was a joint venturer and would in effect be placing a lien on its own property. Peabody-Waterside Dev., LLC v. Islands of Waterside, LLC, No. 5-12-0490, 2013 WL 4736714 (Ill. App. Ct. Sept. 3, 2013).
The facts of the case are straightforward. The contractor was one of two 50% members of the LLC, which was attempting to develop real estate in Illinois. The LLC hired the contractor for site preparation and grading work at the property. The contractor performed the work and billed the LLC for $4.5 million. The contractor was unpaid, filed its mechanic’s lien, and later sued the LLC for breach of contract and to foreclose its mechanic’s lien.
At trial the LLC’s bank lender filed a motion to invalidate the contractor’s mechanic’s lien, on grounds the lien was invalid because the contractor had performed the work for its own benefit as a co-owner of the property. (If the bank could not invalidate the contractor’s lien, then the contractor’s claim would have priority over the bank’s secured loan.) The trial court agreed with the bank’s argument and invalidated the lien, although it did enter judgment against the LLC in favor of the contractor for its breach of contract claim. Id. at *2.
The trial court based its lien ruling on Fitzgerald v. Van Buskirk, 306 N.E.2d 76 (Ill. App. Ct. 1974), which had held that a building contractor “acted in the capacity of a joint venturer with the defendants and in such capacity was not a person entitled to a mechanic’s lien.” Id. at 78. The Appellate Court agreed with the Fitzgerald rule, noting that “an owner or co-owner of property may not claim a lien against his or her own property.” Peabody-Waterside, 2013 WL 4736714, at *2 (citing Bonhiver v. State Bank of Clearing, 331 N.E.2d 390, 398 (Ill. App. Ct. 1975)).
But the Appellate Court disagreed with the trial court’s conclusion. The court pointed out that:
- an Illinois LLC is a legal entity distinct from its members (805 Ill. Comp. Stat. 180/5-1(c));
- an LLC member is not a co-owner of the LLC’s property (805 Ill. Comp. Stat. 180/30-1(a));
- a member of an LLC owns only its membership interest in the LLC; and
- sharing in the profits and losses of an LLC does not make the LLC’s members jointly interested or co-owners of the LLC’s property.
Id. at *3. The court differentiated LLCs from joint ventures, which it said are not distinct legal entities. Id.
The court concluded: “Given that [the contractor], as a member of [the LLC], is not jointly interested in the property, nor is it a co-owner of the property, its mechanic’s lien must, therefore, be valid.” Id.
The bank also argued that the contractor, as an LLC member, had waived the LLC’s defenses to its own lien claim and should therefore be ineligible to assert the mechanic’s lien. The court dismissed that argument because the contractor did not control the LLC’s actions alone. The other member’s consent was needed for any action by the LLC, the other member was also the LLC’s managing member, and the two members were separate and unaffiliated. Id. at *4.
The Appellate Court never defined joint ventures, only characterizing them as not being distinct legal entities. Id. at *3. Many lawyers are no better – the term “joint venture” is often used loosely to cover a range of commercial relationships, from strategic alliances to LLCs to short-term or limited-purpose partnerships. One treatise provides a useful characterization:
A “joint venture” is an association of two or more persons to carry on a single enterprise for profit. The legal principles that govern partnerships generally govern joint ventures, because a joint venture essentially is a partnership carried on for a single enterprise.
1 William Meade Fletcher, Fletcher Cyclopedia of the Law of Corporations § 23, at 40 (Carol A. Jones, ed. 2006) (footnote omitted).
Partners are co-owners of partnership property, so Fletcher’s definition is consistent with the court’s assertion in Peabody-Waterside that the parties to a joint venture are co-owners of a joint venture’s property.
Peabody-Waterside very likely would have come out the other way if the contractor had been the LLC’s sole member. The LLC would still be a legal entity distinct from its sole member, and the LLC and not its member would still own the property. But a sole member’s complete control over the LLC would probably be fatal to the member’s mechanic’s lien, given the court’s discussion in Peabody-Waterside of the importance of the two members’ shared control.
Federal Court Determines LLC's Citizenship for Diversity Purposes Differently Depending on Whether Sole Member Is a Trust or Trustee
The federal courts are available to litigants even when no question of federal law is involved, if the controversy is between citizens of different states. For a federal court to have what is referred to as diversity jurisdiction, all adverse parties must be completely diverse in their citizenship. No plaintiff can be a citizen of the same state as any defendant. The federal courts are therefore often required to determine the citizenship of LLCs, corporations, and partnerships, as well as individuals. In a case of first impression, the District Court for the Southern District of New York recently had to determine the citizenship of an LLC whose sole member was the trustee of a trust with numerous beneficiaries. WBCMT 2007-C33 N.Y. Living, LLC v. 1145 Clay Ave. Owner, LLC, No. 13 Civ. 2222(WHP), 2013 WL 4017712 (S.D.N.Y. July 30, 2013).
WBCMT initiated this diversity suit to foreclose on a $133 million mortgage against 36 LLCs, a guarantor, and nine creditors with security interests in the mortgage. WBCMT is an Ohio single-member LLC. Its sole member, according to its operating agreement, is “U.S. Bank National Association, as trustee for the registered holders of Wachovia Bank Commercial Mortgage Trust, commercial mortgage pass-through certificates, series 2007-C33.” Id. at *2.
The defendants moved to dismiss for lack of diversity jurisdiction, contending that WBCMT should be treated as a citizen of every state in which the trustee and any trust beneficiary was a citizen. Given the citizenship of some of the defendants, this would have resulted in a loss of complete diversity and the dismissal of the lawsuit.
An LLC has the citizenship of all its members for purposes of the federal courts’ diversity jurisdiction. Id. at *1. (The rule is different for corporations: a shareholder’s citizenship is irrelevant to the corporation’s citizenship. Cosgrove v. Bartolotta, 150 F.3d 729, 731 (7th Cir. 1998).)
The court noted that under established case law, a trust has the citizenship of both its trustees and its beneficiaries. WBCMT, 2013 WL 4017712, at *1. But in this case the LLC’s sole member was identified in the LLC’s operating agreement as the trustee, not the trust. That raised what the court called an unsettled question of law: “When an LLC – whose sole member is a trustee – brings an action on the basis of diversity jurisdiction, whose citizenship matters?” Id.
The court first discussed the general rule for entities: “Courts must look past an artificial entity to its members in order to determine its citizenship.” Id. at *2. Recognizing the difference between a trust and the trustee of the trust, however, the court looked to the Supreme Court’s decision in Navarro Savings Ass’n v. Lee, 446 U.S. 458 (1980). The Supreme Court in Navarro held that the trustees of a Massachusetts business trust were the real parties in interest for purposes of diversity, and that the court need not look to the citizenship of the business trust’s shareholders. The WBCMT court then briskly concluded that “[when] an LLC’s sole member is a trustee, the LLC’s membership is determined by the citizenship of the trustee alone.” WBCMT, 2013 WL 4017712, at *3. The defendants’ motion to dismiss for lack of subject matter jurisdiction was denied.
Comment. The proposition that the citizenship of an LLC varies depending on whether its member is a trust or a trustee of the trust is premised on the assumption that a trust is an artificial entity, distinct from its trustee. If that proposition were correct, the decision in this case would be consistent with the diversity rules for determining the citizenship of partnerships and LLCs. But that’s a questionable assumption, for two reasons.
First, to characterize a trust as an “artificial entity” for citizenship purposes is inconsistent with the nature of a trust. The law of trusts does not treat a trust as an entity. “(1) [A] trust is a relationship; (2) it is a relationship of a fiduciary character; (3) it is a relationship with respect to property, not one involving merely personal duties; (4) it subjects the person [the trustee] who holds title to the property to duties to deal with it for the benefit of charity or one or more persons, at least one of whom is not the sole trustee; and (5) it arises as a result of a manifestation of an intention to create the relationship.” 1 Austin Wakeman Scott et al., Scott and Ascher on Trusts § 2.1.3, at 36 (5th ed. 2006). A trust’s property is always held by the trustee, for the benefit of the beneficiaries. Id. § 2.1.6.
Second, the LLC’s operating agreement did not list its sole member as simply “U.S. Bank National Association,” but as “U.S. Bank National Association, as trustee for the registered holders….” The bank was not a member in its own right, but in its capacity as trustee of the trust. The trust was therefore bound by the LLC agreement, and in effect was the member. Under that analysis the LLC’s citizenship would have been the citizenship of the trustee and all of the trust’s beneficiaries, there would have been a lack of diversity, and the case would have been dismissed.
A Deal's a Deal - Federal Court Says That Exercising Buyout Option in New York LLC Without Advance Notice Is Not a Breach of Fiduciary Duty
Are fiduciary duties relevant when an LLC member has an option under its operating agreement to buy out another member for a fair-market-value price? For example, must the member give advance warning before exercising its option even if not required by the agreement? One of two members in a New York LLC whose interest was purchased under such an option apparently felt it had been misled and damaged by the other’s silence regarding its intention to exercise the option, in LJL 33rd Street Associates, LLC v. Pitcairn Properties Inc., 725 F.3d 184 (2d Cir. July 31, 2013). The court said no breach of fiduciary duties had occurred – the contract ruled.
Background. LJL 33rd Street Associates (LJL) and Pitcairn Properties Inc. (Pitcairn) were the two members of 35-39 West 33rd Street Associates, LLC, a New York LLC (the Company). The Company owned a high-rise luxury apartment complex in Manhattan (the Property). LJL owned 50.01% of the Company, and Pitcairn owned 49.99% and managed the Property.
The Company’s operating agreement gave LJL the option of purchasing Pitcairn’s interest in the Company for its fair market value if Salah Mekkawy ceased to be employed by Pitcairn. Mekkawy was initially the CEO of Pitcairn, but by 2010 his duties had been reduced and he was no longer involved in managing the Property.
In October 2010 the parties discussed Mekkawy’s employment, but LJL’s purchase option was never mentioned. First, Mekkawy told LJL, but not Pitcairn, that he would be leaving Pitcairn. Pitcairn was at the same time considering terminating Mekkawy, and its CEO met with LJL to discuss the termination. LJL indicated at the meeting that it was unhappy with Mekkawy and would not object to his departure from Pitcairn, and that LJL was satisfied with Pitcairn’s management of the Property. Several days later Pitcairn informed LJL that it had terminated Mekkawy’s employment.
During the discussions LJL never mentioned its purchase option and Pitcairn never asked about it. Five days after receiving Pitcairn’s notice of Mekkawy’s termination, LJL formally exercised its purchase option.
The Company’s operating agreement defined the option’s purchase price as the fair market value of the Property (FMV) less the Company’s liabilities, and called for arbitration to determine the FMV if the parties could not agree.
LJL and Pitcairn could not agree on the FMV, and Pitcairn proposed selling the Property or offering it for sale in order to determine its true market price. LJL refused and initiated arbitration. After a hearing the arbitrator entered an award determining the FMV of the Property, but the arbitrator declined to determine the purchase price.
LJL petitioned the New York Supreme Court to confirm the arbitrator’s determination of the FMV and to vacate the arbitrator’s refusal to determine the purchase price. Pitcairn removed the case to federal court and asserted claims that LJL had breached its fiduciary duties and the implied covenant of good faith and fair dealing. Pitcairn also claimed that LJL was estopped from exercising its purchase option because it had misled Pitcairn to believe that it would not exercise its option if Mekkawy were fired.
The district court sustained the arbitrator’s refusal to determine the purchase price on the grounds that the arbitration agreement did not extend to arbitration of the purchase price, and dismissed Pitcairn’s claims of breach of fiduciary duty and the implied covenant of good faith and fair dealing. Pitcairn appealed.
The Court of Appeals. The Court of Appeals first dealt with LJL’s contention that the arbitrator was required by the operating agreement to determine the purchase price for Pitcairn’s member interest, as well as the Property’s FMV. The court pointed out that although the operating agreement expressly provided for arbitration of the FMV, it had no provisions for determining the purchase price. Id. at 192. LJL argued that the purchase price was arbitrable because it was inextricably tied up with the merits of the dispute over the FMV, citing prior case law. The court disagreed, finding the two issues to be analytically distinct. But, said the court, even if the arbitrator had discretion to determine the purchase price, it was not an abuse of his discretion to decline to do so. Id. at 193.
Pitcairn claimed that LJL violated its fiduciary duties by not disclosing its intent to exercise its purchase option, but the court gave short shrift to that argument. The court recited the following facts: (a) LJL’s purchase option was a contract right to purchase Pitcairn’s member interest for a price based on the Property’s FMV; (b) Pitcairn did not contend that LJL ever made false representations about Mekkawy or stated that it would not exercise its option if he were terminated; and (c) Pitcairn never asked whether LJL intended to exercise its option or requested that LJL waive its option. After reciting the facts, the court concluded with no further analysis that LJL had not breached its fiduciary duties as claimed by Pitcairn. Id. at 195.
Pitcairn also claimed that LJL had a fiduciary duty to market the Property to a third party or to seek other offers, to help determine its FMV. The court said no, pointing out that the parties’ operating agreement contemplated a specific arbitration procedure to determine the Property’s FMV, and that no language in the agreement required LJL to participate in what the court characterized as “an illusory auction, deceiving potential purchasers into bidding for a property that was in fact not for sale, for the purpose of helping Pitcairn obtain evidence of value.” Id.
Pitcairn invoked the implied covenant of good faith and fair dealing, but the court found there to be no breach by LJL of the implied covenant. “The mere fact of LJL’s decision to exercise its contractual right, absent bad faith conduct, cannot be deemed a breach of its duty to deal with Pitcairn in good faith.” Id. at 196.
The upshot was that the arbitrator’s determination of the FMV of the Property and his refusal to determine the purchase price of Pitcairn’s member interest were upheld, and Pitcairn’s claims for breach of fiduciary duty and breach of the implied covenant of good faith and fair dealing were rejected.
Comment. LJL 33rd Street is a classic case of sandbagging. (For non-poker players, sandbagging is checking to a raise, sometimes pejoratively called lying in the weeds. In a round of betting, before the bets open, a player can check, meaning that he doesn’t bet but also doesn’t drop out. If someone else opens the betting, the player who checked can then call the bet to stay in the game, or he can raise the bet. It’s sandbagging when a player raises the bet after having checked. It’s viewed askance by some, because checking on the first round can be viewed as implying that one’s hand is weak, while the subsequent raise likely shows to the contrary. Sandbagging is within the rules of the game, unless house rules, such as in a friendly home game, bar it.)
I suspect Pitcairn felt it had been sandbagged by LJL. During their meeting in October, LJL told Pitcairn that it was comfortable with Pitcairn’s management of the Property. That would seem to imply that LJL had no desire to change the status quo, but shortly thereafter LJL exercised its option to buy out Pitcairn, within days of Mekkawy’s termination.
Pitcairn apparently drew the inference from LJL’s assurances about its satisfaction with Pitcairn’s management that LJL would not exercise its option, but Pitcairn had the ability to directly address its doubts or questions by simply asking LJL whether it planned to exercise the option if Mekkawy were terminated. That, coupled with the fact that LJL never made any statements about its option, appears to be the major reason why the court rejected Pitcairn’s claims of breach of fiduciary duty and breach of the implied covenant of good faith and fair dealing.
California’s new LLC Act becomes effective on January 1, 2014. The new act, the Revised Uniform Limited Liability Company Act (RULLCA), will completely replace the current statute, the Beverly-Killea Limited Liability Company Act (Beverly-Killea).
RULLCA was signed into law by Governor Brown in September 2012. The new law is based in large part on NCCUSL’s Revised Uniform Limited Liability Company Act, which has now been adopted in eight states. The passage of RULLCA brings California’s LLC statute more in line with the LLC laws of other states, which should facilitate interstate transactions.
The substance of RULLCA is generally similar to Beverly-Killea, but there are a number of significant changes. I describe some of those below, but my list is not exhaustive.
Operating Agreement. Beverly-Killea defines an operating agreement as any written or oral agreement between an LLC’s members as to the affairs and the conduct of the LLC. Cal. Corp. Code § 17001(ab). RULLCA goes further by allowing an operating agreement to be written, oral, or implied. § 17701.02(s). The significance here is that, subject to the limits of Section 17701.10, an LLC’s operating agreement can override RULLCA’s default provisions.
Manager-managed. In both the old and the new statutes an LLC is member-managed unless the proper steps are taken to establish it as manager-managed, but RULLCA changes the requirements. Under Beverly-Killea an LLC is member-managed unless the articles of organization contain a statement that the LLC is to be managed by one or more managers. §§ 17051(a)(7), 17150. Under RULLCA an LLC is member-managed unless the LLC’s articles of organization and the operating agreement state that it is manager-managed. § 17704.07.
Shelf LLCs. Under Beverly-Killea an LLC exists when its articles of organization are filed, but it is not formed until the members enter into an operating agreement. § 17050. RULLCA, on the other hand, does not require the admission of members in order for an LLC to be formed: “A limited liability company is formed when the Secretary of State has filed the articles of organization.” § 17702.01(d).
Non-economic Member. Beverly-Killea assumes that members have economic rights. For example, its definition of a membership interest includes the member’s economic interest, such as the right to share in profits, losses, and distributions. RULLCA, in contrast, allows an LLC to include members that have no economic interest and make no capital contributions. § 17704.01(d). The NCCUSL comment on this section indicates that the purpose of this provision is to “accommodate business practices and also because a limited liability company need not have a business purpose.” NCCUSL, Revised Uniform Limited Liability Company Act, § 401(e) cmt.
Fiduciary Duties. RULLCA provides a more detailed description of the fiduciary duties of LLC managers and managing members than does Beverly-Killea, and constrains the ability of the operating agreement to eliminate or limit fiduciary duties.
Beverly-Killea incorporates by reference the fiduciary duties of a partner in a partnership: “The fiduciary duties a manager owes to the limited liability company and to its members are those of a partner to a partnership and to the partners of the partnership.” § 17153. The members may modify those duties, but only in a written operating agreement with the informed consent of the members. § 17005(d).
RULLCA instead sets out the fiduciary duties of managers and managing members in some detail, and limits or “cabins in” the fiduciary duties to the duty of care and the duty of loyalty. The limits are evident in the introductory sentence: “The fiduciary duties that a member owes to a member-managed [LLC] and the other members of the [LLC] are the duties of loyalty and care under subdivisions (b) and (c).” § 17704.09(a). The duty of loyalty is limited to enumerated activities, and the duty of care is limited to refraining from grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.
RULLCA limits the extent to which the members can modify the managers’ or managing members’ fiduciary duties. Any modification of the fiduciary duties can only be done by a written operating agreement. Neither the duty of care, the duty of loyalty, nor the contractual duty of good faith and fair dealing may be eliminated, and the duty of care may not be unreasonably reduced. § 17701.10.
There is one oddity in RULLCA’s fiduciary duty rules. Section 17704.09 comprehensively defines the fiduciary duties of LLC members and managers and appears to exclude any other fiduciary duties. But Section 17701.10(c)(4) says that an operating agreement may not eliminate “the duty of loyalty, the duty of care, or any other fiduciary duty.” (Emphasis added.) A California court may at some point have to resolve this inconsistency, unless it is first clarified by an amendment to the statute.
Effectiveness. RULLCA’s general rule is that it applies to all LLCs after January 1, 2014: “Except as otherwise specified in this title, this title shall apply to all domestic limited liability companies existing on or after January 1, 2014.” § 17713.04(a).
Sub-paragraph (b) provides that RULLCA applies only to acts or transactions by an LLC or its members or managers occurring, or contracts entered into by the LLC or its members, on or after January 1, 2014. § 17713.04(b). Those acts which take place before that date will be governed by Beverly-Killea. This section appears intended to cover issues such as the authority of a manager, breaches of fiduciary duty, and so on, that relate to actions occurring before RULLCA’s effective date.
There is an unfortunate ambiguity in RULLCA’s transition rules, however. As some commentators have pointed out, (1) sub-paragraph (b) states that Beverly-Killea governs all “contracts entered into by the [LLC] or by the members or managers of the [LLC]” prior to January 1, 2014, and (2) an LLC’s operating agreement is a contract between the members. From this they posit that RULLCA was intended to apply only to operating agreements entered into after January 1, 2014.
That would be a surprising result, given that RULLCA consistently uses the defined term “operating agreement” when it refers to the member agreement that governs an LLC. It would also be a poor result from a public policy standpoint, because then all pre-existing LLCs would continue to be governed indefinitely by Beverly-Killea, unless and until they amend or restate their operating agreement or otherwise opt in to the new statute. That is probably not what the drafters of this section and the legislature intended, but predicting how a California court would resolve the issue is a risky business.
Comment. RULLCA makes a variety of other changes to California’s LLC statute. As the end of the year approaches, California’s business lawyers will be reviewing the new law and attending legal education seminars to bring themselves up to speed on the new Act. I expect many will be alerting their clients about the new law and recommending that they review their operating agreements for consistency with RULLCA.
A Georgia LLC sold its business and agreed in the sale contract not to compete with the buyer for three years. During the noncompetition period the members of the selling LLC, but not the LLC itself, started a competitive business. The buyer sued, the trial court found the members liable for breach of the noncompetition covenant, and the members appealed. The Georgia Court of Appeals reversed, finding that the members were not liable on the noncompetition covenant. Primary Invs., LLC v. Wee Tender Care III, LLC, No. A13A0412, 2013 WL 3665318 (Ga. Ct. App. July 16, 2013).
The case turned on the noncompete clause of the sale agreement: “Until three years after the Closing Date (the ‘Noncompetition Period’), Seller [the selling LLC] agrees that neither Seller nor its agents will, unless acting in accordance with Buyer’s prior written consent … open any child care facility within a ten-mile radius of any Business Locations being sold to the Buyer hereunder.” Id. at *1 (emphasis in original). The selling LLC’s members opened a new childcare facility within 10 miles of one of the sold facilities, and the buyer objected.
The court’s analysis addressed three questions. First, did the seller itself violate the noncompete? The court said no – there was no contention that the selling LLC was involved in opening the new facility, nor that the members were acting as agents on behalf of the selling LLC. The Buyer therefore failed to show any violation of the noncompete clause by the seller. Id. at *2.
Second, were the LLC members parties to the sale agreement? The members were not mentioned by name in the sale agreement, and the member who signed the agreement did so only in a representative capacity, on behalf of the LLC. So the members were not parties to the sale agreement, and “‘[i]t is axiomatic that a person who is not a party to a contract is not bound by its terms.’” Id. at *2 (quoting Kaesemeyer v. Angiogenix, Inc., 278 Ga. App. 434, 437, 629 S.E.2d 22 (2006)).
The third and more subtle question was whether the purchase agreement’s use of the words “its agents,” in the phrase “neither Seller nor its agents,” referred to the members. The plaintiffs pointed out that the Georgia LLC Act makes every LLC manager an agent of the LLC. Ga. Code Ann. § 14-11-301. They argued that because the seller’s members were all managers, they were agents of seller and therefore included individually in the phrase “neither Seller nor its agents,” and that as a result the members were bound individually to the terms of the noncompete clause. Primary Invs., 2013 WL 3665318, at *3.
The court conceded that because the members were managers they were indeed agents of the LLC, but dismissed the plaintiffs’ argument for two reasons. One, the court said that nothing in Georgia’s LLC Act allows a principal (the LLC) to bind its agents (the members) for the LLC’s contractual obligations. Two, under the LLC Act, members and managers of an LLC are not liable, solely by virtue of being a member or manager, for the LLC’s debts, obligations or liabilities. Ga. Code Ann. § 14-11-303. The court referred to earlier Georgia cases holding that an LLC member is separate from the LLC and is not a proper party to a proceeding against the LLC solely by reason of being a member of the LLC. Primary Invs., 2013 WL 3665318, at *3.
The court’s final conclusion was that the phrase “neither Seller nor its agents” in the LLC’s sale agreement did not bind the LLC’s members or managers individually, and it reversed the trial court’s judgment against the members on the liability issue.
Comment. The result in this case appears correct, but the court’s opinion doesn’t fully explain the language that the parties were battling over. Look at it again: “neither Seller nor its agents” will compete. The opinion doesn’t address what was intended by “nor its agents.”
If the reference to the LLC’s agents meant agents acting on behalf of the LLC, it was superfluous. In that case the usual rules of agency law would make the LLC but not the agents liable, which would be the same result as if the reference to agents were deleted.
If we assume that the agreement’s reference to agents had a purpose, it must have been that the LLC was agreeing that it would be liable if it competed, or if any of its agents competed even if they did not do so in a representative capacity. In other words, the agreement could just as well have said “neither Seller nor any Member of Seller” will compete.
That interpretation would not create personal liability for the members who competed in the forbidden zone. As the court pointed out, they were not parties to the agreement. But under that interpretation, their competition would constitute a breach by the LLC of its noncompete agreement.
In the event of proscribed competition by a member, the buyer would be able to raise its claim against the LLC, which should be able to respond out of the sale proceeds. Even if the proceeds had been distributed, claims could be asserted against the members who had received distributions, under the Georgia LLC Act. Ga. Code Ann. § 605.
Senator Carl Levin has reintroduced the Incorporation Transparency and Law Enforcement Assistance Act, S. 1465 (ITLEA), on August 1. This bill would require the states to collect information from organizers of LLCs and corporations about the companies’ direct and indirect individual owners, whether U.S. or foreign residents, and to then provide that information when requested by state and federal agencies.
ITLEA just won’t go away. This bill has been introduced several times before, beginning in 2008 when one of the sponsors was then-Senator Barack Obama. Although ITLEA is supported by a variety of law enforcement agencies, it is opposed by, among others, the American Bar Association, the National Association of Secretaries of State, the National Conference of State Legislatures, the U.S. Chamber of Commerce, a coalition of 17 business organizations including the American Institute of CPAs, law professors, and every corporate lawyer with whom I have discussed it.
Who Are the Owners? The basic idea of ITLEA is that organizers of an LLC would be required to provide the state at the time of formation with the name, address, and passport or driver’s license number of each “beneficial owner” of the LLC. The definition is broad and ambiguous – a beneficial owner is defined as “a natural person who, directly or indirectly –
(i) exercises substantial control over a corporation or limited liability company; or
(ii) has a substantial interest in or receives substantial economic benefits from the assets of a corporation or limited liability company.”
ITLEA § 3. Multiple levels of ownership would have to be traced to find and identify the natural persons who are the ultimate beneficial owners of the LLC.
Foreigners. The bill requires that if a beneficial owner holds neither a U.S. passport nor a state driver’s license, a formation agent must certify that it has obtained the street address and a copy of the foreign passport of the beneficial owner, and that the formation agent has verified the name, address, and identity of the beneficial owner. A formation agent is a person who for compensation “acts on behalf of another person to form, or assist in the formation of,” an LLC. Id. The formation agent must retain the information certified and provide it on request of the listed federal agencies.
Broad Scope. Prior versions of ITLEA focused only on those controlling an LLC. This version goes further by requiring the identities those who either exercise substantial control or have a substantial interest in or receive substantial economic benefits from the assets of the LLC. The terms “substantial control,” “substantial interest,” and “substantial economic benefits from the assets” are not defined.
Implementation. States receiving funding under the Omnibus Crime Control and Safe Streets Act would be required to implement a data-collection system within three years of ITLEA’s passage. The states would have to require LLC formation applicants to provide the state with beneficial-owner information during the formation process.
Once formed, LLCs would be required to update their beneficial-owner information within 60 days of any change and to file an annual up-to-date list of the beneficial owners. Two years after a state begins requiring beneficial ownership information, all LLCs would be swept into the reporting system and would have to begin reporting annually on their beneficial owners and reporting during the year on changes in their beneficial ownership.
The states would not routinely provide beneficial-owner information to the federal government, but they would have to provide the information in response to a civil or criminal subpoena from any state or federal agency or congressional committee, a written request by a federal agency on behalf of another country, or a written request by the financial crimes arm of the Treasury Department.
Exemptions. Nonprofit entities, public companies, businesses that employ more than 20 full time U.S. employees, companies with more than $5 million in annual gross receipts or sales, and companies with an operating presence in the U.S. are exempt from ITLEA’s reporting requirements.
Penalties. The penalties for noncompliance include civil penalties of up to $10,000 and imprisonment for up to three years. This new version of ITLEA, unlike the prior versions, would also make it a violation to merely disclose the existence of a subpoena, summons, or other request for beneficial ownership information.
Comments. This is a bad bill. It is an example of the federal government attempting to federalize an area of commerce traditionally governed by the states. It reflects a lack of understanding of the complexities of many modern business entities and structures. The bill would be burdensome on states and legitimate businesses, while the purported targets such as money launderers, terrorists, and their ilk would presumably avoid reporting truthfully on their ownership when they create a corporation or LLC to own parts of their criminal enterprises.
ITLEA’s core definitions are ambiguous and poorly drafted. For some complex business structures it would be a mammoth task to attempt to determine the beneficial owners of each entity, fraught with uncertainty because of the poorly written statute.
ITLEA would require the invasion of the privacy of millions of legitimate business people. The privacy of LLC members, investors, lenders, and other contractual parties is important and valuable in the business world. For example, identifying the strategic investors in a high-tech company can reveal valuable insights about the company’s future directions. Although ITLEA does not require disclosure by the states of beneficial owner information, a majority of the states have right-to-know laws that would likely require public disclosure of the beneficial owner information. And once the federal government requires that beneficial owner information be collected, it seems unlikely that the states will change their laws to prevent public disclosure.
The weak justification for ITLEA and its many flaws have been ably analyzed in J. W. Verret, Terrorism Finance, Business Associations, and the “Incorporation Transparency Act,” 70 La. L. Rev. 857 (2010).
A dissolved Tennessee LLC that had distributed all its assets was sued for fraud and breach of contract. The Tennessee LLC Act allows claimants to sue a dissolved LLC, but only “to the extent of its undistributed assets.” The LLC defended the suit on grounds that the plaintiffs had no standing to sue because the LLC had no undistributed assets. The court rejected that defense and allowed the claims against the dissolved LLC to go forward on a theory of successor liability. Croteau v. Nat’l Better Living Ass’n, No. CV 12-200-M-DWM, 2013 WL 3030629 (D. Mont. May 30, 2013).
Carol Croteau and two other plaintiffs were insureds whose claims for comprehensive health benefits had been denied. They sued their insurance company, the broker, the marketer, and others, alleging fraud, breach of contract, unjust enrichment, and RICO violations.
One of the defendants was Albert Cormier Solutions, LLC, a Tennessee LLC (ACS). ACS brought a motion to dismiss the claims against it. Its defense was that it lacked the capacity to be sued because its legal existence had been terminated and its assets distributed prior to the filing of the complaint. Id. at *1.
ACS was administratively dissolved by the Tennessee Secretary of State in 2010, under Section 48-249-605 of the Tennessee LLC Act. In 2011 ACS filed articles of termination with the Secretary of State, under Section 48-249-612. The articles of termination stipulated that all assets had been distributed to creditors and members. Id.
ACS’s defense relied on Section 48-249-611(d):
If the dissolved LLC does not comply with the provisions of subsection (b) [written notice to known claimants] or (c) [notice by publication], then claimants against the LLC not barred by this section may enforce their claims:
(1) Against the dissolved LLC, to the extent of its undistributed assets; or
(2) If the assets have been distributed in liquidation, against a member or holder of financial rights of the dissolved LLC to the extent of the member’s or holder’s pro rata share of the claim, or the LLC assets distributed to the member or holder in liquidation, whichever is less, but a member’s or holder’s total liability for all claims under this section may not exceed the total amount of assets distributed to the member or holder; provided, that a claim may not be enforced against a member or holder of a dissolved LLC who received a distribution in liquidation after three (3) years from the date of the filing of articles of termination.
Tenn. Code Ann. § 48-249-611(d) (emphasis added). ACS argued that because claims against a dissolved LLC can only be enforced to the extent of undistributed assets, and it had none, that therefore there were no enforceable claims against it and the plaintiffs’ complaint must be dismissed.
The court first looked to Federal Rule of Civil Procedure 17(b)(2) to address the choice-of-law issue. That rule provides that a corporation’s capacity to be sued is determined by the state law under which it was organized. ACS was organized as a Tennessee LLC, so the court applied Tennessee law.
The court addressed ACS’s argument by pointing out that Section 48-249-611(d) is phrased in the disjunctive: a claimant against a dissolved LLC that has not given notice to creditors or published notice may proceed either against the dissolved LLC to the extent of its undistributed assets or against the members of the dissolved LLC to the extent of assets distributed to the members. Thus, the claim can be prosecuted against either the LLC or its members, with the members implicitly being treated as successors to the LLC.
The court concluded that “[p]laintiffs’ claims on a theory of successor liability are therefore legally sufficient under § 48-249-611(d)(2) as they are brought within three years of the filing of the filing [sic] of articles terminating the existence of ACS.” Croteau, 2013 WL 3030629, at *2. Note that subsection 611(d)(2) is the paragraph covering the enforceability of claims against the members, not the LLC.
The court pointed out that if pre-trial discovery reveals information that would support claims against ACS’s members, joinder of such members may be required under Federal Rule of Civil Procedure 19(a)(1).
Comment. The result here is clearly right, although the opinion is a little confusing. The court allowed the plaintiffs to proceed with their claims against ACS “on a theory of successor liability,” but the members are the successors to ACS, not the other way around. In effect the court let the case proceed against ACS as a stand-in for the members, which is presumably why it referred to the potential requirement for joinder of the members.
South Carolina’s LLC Act authorizes courts, on request of a judgment creditor, to issue charging orders and to foreclose an LLC member’s interest. Last month South Carolina’s Supreme Court considered for the first time the standards for foreclosure and the relationship between foreclosure and charging orders. The court held that the primary factor in determining whether to order foreclosure of an LLC member’s interest is whether the charging order is likely to result in payment of the debt in a reasonable amount of time. Kriti Ripley, LLC v. Emerald Invs., LLC, No. 27277, 2013 WL 3200596 (S.C. June 26, 2013).
Background. In 2003 Kriti Ripley, LLC and Emerald Investments, LLC formed Ashley River Properties II, LLC. The plan was to develop condominiums and a marina on a piece of property in Charleston, South Carolina. Emerald contributed the property and its permits to Ashley River for its 70% member interest, and Kriti contributed $1.25 million for its 30%. Id. at *1.
Unfortunately, Emerald immediately diverted and misappropriated the funds contributed by Kriti to Ashley River. When Kriti learned of Emerald’s wrongdoing it initiated arbitration pursuant to Ashley River’s operating agreement. That began a long and complex series of legal proceedings between Kriti and Emerald, consisting of two separate arbitrations and five different lawsuits. Id. at *2-3.
Kriti eventually obtained an award of $706,000 against Emerald in arbitration in New York, confirmed the arbitration award in a New York court, and registered the New York judgment in South Carolina. Kriti then filed suit in South Carolina and in 2008 obtained a charging order on Emerald’s interest in Ashley River, in the amount of Kriti’s judgment against Emerald.
By 2011, Kriti’s charging order had yielded no funds towards satisfaction of its judgment, and Kriti filed a motion to foreclose on Emerald’s interest in Ashley River. The trial court viewed foreclosure as a drastic remedy, found that the charging order was sufficient protection for Kriti’s interests, and denied Kriti’s motion to foreclose on Emerald’s interest in Ashley River. Id. at *4-6.
Court’s Analysis. The Supreme Court first examined South Carolina’s statute on LLC charging orders and foreclosures:
(a) On application by a judgment creditor of a member of a limited liability company or of a member’s transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment. The court may appoint a receiver of the share of the distributions due or to become due to the judgment debtor and make all other orders, directions, accounts, and inquiries the judgment debtor might have made or which the circumstances may require to give effect to the charging order.
(b) A charging order constitutes a lien on the judgment debtor’s distributional interest. The court may order a foreclosure of a lien on a distributional interest subject to the charging order at any time. A purchaser at the foreclosure sale has the rights of a transferee.
S.C. Code Ann. § 33-44-504(b). The court noted that foreclosures are actions in equity, and therefore the decision to grant or deny foreclosure under Section 504 is equitable. Kriti Ripley, LLC, 2013 WL 3200596, at *7.
In denying Kriti’s motion for foreclosure of the charging order, the trial court had viewed other provisions of the LLC Act as providing alternative remedies, including dissolution and the forced purchase of a member’s interest. The Supreme Court rejected that as a factor in the decision whether to order foreclosure, pointing out that Kriti sought foreclosure as a judgment creditor, not as a member, and that Section 504 provides that charging orders and foreclosure are the exclusive remedies of a judgment creditor. Id.
The Supreme Court also rejected the trial court’s characterization of foreclosure as a drastic remedy. “It is a remedy commonly used around the country when a charging order on a debtor’s interest in an entity alone will not result in payment of a judgment. . . . Moreover, the statute provides no indication that a foreclosure is ‘drastic’ or only to be used in extreme circumstances.” Id. at *8.
The trial court had also considered foreclosure to be a form of forfeiture and therefore disfavored. The Supreme Court differed, describing forfeiture not as a penalty but rather as a remedy for collection of a debt. The member’s interest is not divested without compensation, because the value of the foreclosed interest is applied against the member’s debt. Id.
Having swept the trial court’s considerations from the board, the Supreme Court pointed out that as an equitable matter, the forfeiture decision requires consideration of all the circumstances in the individual case. The court referenced opinions from Georgia and New Jersey, and concluded that the primary and usually determinative factor is whether the judgment creditor will be paid in a reasonable time through distributions via the charging order. Id.
The court’s review of the evidence showed that Kriti had received no payments on its judgment since the grant of its charging order in 2008, that Ashley River could not pay its debts, and that it was unlikely that any distributions would be made in the foreseeable future.
The court also found that Emerald had acted inequitably: “Emerald and Longman have attempted to game the system in order to avoid any consequences for their wrongful acts while at the same time trying to make a profit at Kriti and Ashley River II’s expense. On the other hand … Kriti has repeatedly been found to have acted appropriately.” Id. at *9.
The Supreme Court accordingly reversed the trial court and remanded for the entry of a foreclosure order on Emerald’s interest in Ashley River, without further delay. Id. at *10.
Comment. All state LLC statutes authorize courts to issue charging orders on LLC member interests, to satisfy judgments against the member. But only a minority of the state statutes go further and expressly allow foreclosure of the debtor’s LLC interest, as South Carolina’s Section 504 does.
Some of the statutes that don’t mention foreclosure say that a charging order is the creditor’s exclusive remedy. Others are silent on whether a charging order is the creditor’s only remedy, implying that it is not exclusive.
Delaware, for example, says: “The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or of a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest.” Del. Code Ann. tit. 6, § 18-703(d). Washington’s LLC Act, on the other hand, is silent on exclusivity. Wash. Rev. Code § 25.15.255.
The Kriti case does not address what happens after a judgment creditor forecloses on a debtor’s member interest. Assuming that a judgment creditor successfully forecloses, what then?
The creditor that acquires the debtor’s LLC interest at a foreclosure sale would become a transferee of the debtor’s member interest, but unless the LLC agreement or the other members allow it, the creditor would not be admitted as a member and would not have a member’s right to vote or participate in management. See, e.g., S.C. Code Ann. §§ 33-44-502, -503.
In Kriti this presumably would not be a problem, because Kriti is the only other member and could approve its own admission with regard to the LLC interest acquired from Emerald.
The “show me” state recently joined the ten other states that have approved series LLCs. Missouri Governor Jay Nixon signed House Bill 510 on July 1, 2013, amending the Missouri LLC Act to authorize series LLCs, effective August 28, 2013.
Series LLCs. A Series LLC is a form of LLC that can be used to segregate an LLC’s assets, liabilities and members into separate cells, each of which is referred to as a series. Each series can:
- own its assets separately from the assets of the LLC or any other series,
- incur liabilities that will be enforceable against only the assets of that series,
- have its own members and managers, and
- enter into contracts and sue and be sued in its own name.
LLCs can be useful as a way of reducing filing fees and costs that otherwise would be incurred if multiple LLCs were used. (In most states a series LLC pays only one annual filing fee, in the same amount that an LLC with no series pays.)
For example, real estate holding companies often use multiple LLCs to own their properties, one LLC for each parcel, in order to limit the impacts of claims. By instead using a series LLC, a holding company can use one LLC with multiple series, one series for each parcel. There would then be only one annual filing fee for the LLC.
Other States. Series LLCs were first authorized by Delaware, in 1996. Since then Illinois, Iowa, Kansas, Montana, Nevada, Oklahoma, Tennessee, Texas, and Utah have authorized series LLCs. A series LLC is a particular type of LLC, so the states have authorized series LLCs by simply adding the authorizing language to their existing LLC statutes. I have written previously on series LLCs – my posts can be seen here.
Missouri. The Missouri series LLC statute is similar in many ways to the Delaware statute. Each series and its limitations on liability must be established in the LLC’s operating agreement. Each series must keep separate records that account for its assets separately from the other assets of the LLC and any other series. The certificate of formation (articles of organization in Missouri) must give notice of the limitation on liabilities of a series.
There are some significant differences between the Missouri and Delaware statutes, however. For example, in Missouri the articles of organization (which is a publicly filed document) must separately identify each series, and the name of each series is required to contain the entire name of the LLC and to be distinguishable from the names of the other series set forth in the articles of organization.
Missouri has included a useful provision that clarifies the relationship between the series provisions and the remainder of the LLC Act: “Except as modified in this section, the provisions of this chapter which are generally applicable to limited liability companies and their managers, members, and transferees shall be applicable to each particular series with respect to the operation of such series.” H.B. 510, 97th G.A., 1st Reg. Sess. (Mo. 2013).
Caveat. Series LLCs can provide great organizational and administrative flexibility for complex business structures. But, and it’s a big but, there are many unanswered legal questions about them. Unresolved areas include bankruptcy, liability limitations, security interests, piercing the veil, and taxation.
Some of those issues were discussed in Carol Goforth, The Series LLC, and a Series of Difficult Questions, 60 Ark. L. Rev. 385 (2007). More recently, Harner, Ivey-Crickenberger and Kim have reviewed some of the key bankruptcy issues arising when a series, or the master LLC itself, files for bankruptcy under the U.S. Bankruptcy Code. Michelle Harner, Jennifer Ivey-Crickenberger, and Tae Kim, Series LLCs, What Happens When One Series Fails? Key Considerations and Issues,Bus. L. Today, Feb. 2013.
It’s a risky business for a lawyer to advise a client about a course of action when the relevant law is murky.
Last month North Carolina Governor Pat McCrory signed into law a new LLC Act, which among other things removed the prior law’s authorization of low-profit LLCs, or L3Cs. North Carolina is the first state to authorize L3Cs and then later to delete the authorization. L3Cs have been controversial – promoted by some as a way to increase the flow of capital to socially beneficial enterprises, but criticized by others as a flawed type of LLC that doesn’t achieve its goals.
North Carolina’s current statute authorizes L3Cs, and requires that an L3C’s name contain the words “low-profit limited liability company” or the abbreviation “L3C.” N.C. Gen. Stat. §§ 57C-2-01(d), 55D-20. The new LLC Act deletes all references to L3Cs, except that it modifies Section 55D-20 to allow any L3C formed under the existing statute to continue to use “low-profit limited liability company” or “L3C” in its name. The new LLC Act will become effective January 1, 2014.
An L3C is a relatively new type of LLC, which attempts to combine a charitable purpose with a profit-making motive. It is not a non-profit and is taxed on its profits like any other LLC, but its primary purpose is to significantly further the accomplishment of one or more charitable or educational purposes. Advocates of L3Cs suggest that they will encourage investment by private foundations in L3C enterprises. An L3C is required to refer to itself as a “low-profit limited liability company” or as an “L3C.”
Nine states have authorized L3Cs: Illinois, Louisiana, Maine, Michigan, North Carolina, Rhode Island, Utah, Vermont, and Wyoming. According to InterSector Partners, approximately 850 L3Cs have been formed in these states.
Commentators have raised questions and concerns about L3Cs. I previously discussed articles by law professors and business lawyers questioning the utility and wisdom of L3Cs, here. Also, last year the Business Law Section of the American Bar Association actively opposed L3Cs by sending a letter to the Assistant Minority Leader of the Minnesota House of Representatives, which I wrote about, here. The legislature was considering L3C legislation and the ABA letter urged that it be rejected. The bill was not passed.
It appears that the messages from commentators and the ABA’s Business Law Section are getting through to the states. The momentum for state passage of L3C legislation seems to be weakening – it has been almost two years since Rhode Island, the last state to authorize L3Cs, passed its legislation. North Carolina’s rejection of L3Cs is a step in the right direction, and perhaps a harbinger of more to come.