RULLCA Keeps on Truckin' - Minnesota Gets on Board

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.

North Carolina Sorts Out Consequences of LLC Charging Orders

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.

N.C. Gen. Stat. § 57C-5-03. (Many states have LLC charging order statutes that are almost identical. E.g., New York, N.Y. Ltd. Liab. Co. Law § 607; Washington, Wash. Rev. Code § 25.15.255.)

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.

Alabama Legislature Passes New LLC Act

The Alabama legislature last month passed a comprehensive revision to Alabama’s limited liability company statute. The bill was enrolled and forwarded to Governor Bentley on March 4, 2014, and the Governor is expected to sign it into law shortly.

The new act, the Alabama Limited Liability Company Law of 2014, will be effective January 1, 2015 for LLCs formed thereafter. It will not be effective until January 1, 2017 for LLCs formed under the current statute, although they can elect to be covered by the new act beginning January 1, 2015.

The 2014 Act was drafted by a committee of the Alabama Law Institute, a volunteer-operated legislative agency. The 2014 Act is not based on any one uniform law and is unique to Alabama, but on reading the Act it is clear that many provisions were based on elements of the Revised Uniform Limited Liability Company Act, the ABA’s Revised Prototype Limited Liability Company Act, and the LLC Acts of Delaware and Colorado. The Alabama Law Institute has published the 2014 Act with commentary from the drafting committee, here

Some of the noteworthy features of the 2014 Act are:

Oral Operating Agreement. The current LLC Act defines an operating agreement as a written agreement of the members or managers that governs the affairs of an LLC. Ala. Code § 10-12-2. The 2014 Act provides that an operating agreement (now called a limited liability company agreement) may be “written, oral or implied.” 2014 Act § 10A-5A-1.02(k). This change means that an oral or even an implied agreement of the members will now be adequate to override most of the default rules in the statute. (A few may only be overridden by a written LLC agreement.)

Non-Profit Purpose. The 2014 Act clarifies that an LLC need not have a business purpose and may even be a non-profit organization: “A limited liability company may carry on any lawful activity, whether or not for profit.” 2014 Act § 10A-5A-1.04(c).

Management. The 2014 Act moves away from a publicly defined management structure that is either member-managed or manager-managed. Under the current Act, an LLC’s articles of organization must indicate if the LLC is manager-managed – if not, the LLC is managed by its members. Ala. Code § 10-12-10(a)(8). (Articles of organization are filed with a probate judge of the county in which the initial registered office of the LLC is located.)

The 2014 Act, in contrast, does not require that the certificate of formation (the new name for the formation document) indicate anything about the management of the LLC. 2014 Act § 10A-5A-10.01. Instead it specifies that an LLC agreement may provide for the LLC’s activities to be under the direction and oversight of (a) the members, (b) one or more managers, or (c) such other governance structure as is provided in the LLC agreement. 2014 Act § 10A-5A-4.07. If the LLC agreement does not specify, the LLC is managed by its members.

The 2014 Act also does away with the current Act’s statutory apparent authority for managers and managing members, for “apparently carrying on in the usual way” the business and affairs of the LLC. Ala. Code § 10-12-21. Instead, a member’s or manager’s authority to bind the LLC will be governed by the LLC agreement and the law of agency.

Conversions. The 2014 Act provides a new tool that will be useful in many types of business transactions, by authorizing one-step conversions between LLCs and other types of entities such as limited partnerships and corporations, either intra-state or interstate. The converting entity becomes a different type of entity, but is in all other respects the same entity. The converting entity owns the same property and is subject to the same liabilities after the conversion, and any lawsuits by or against the entity continue.

Washington state recently changed its LLC Act to authorize LLC conversions, with an amendment similar to the 2014 Act’s conversion provisions. Like the Washington amendment, the 2014 Act requires that all members of an LLC consent to the plan of conversion. For more information about conversions, see my post on the Washington amendment, here.

Series LLCs. The 2014 Act authorizes a new type of Alabama LLC – series LLCs. 2014 Act § 10A-5A-11.01.

A series LLC can be used to segregate the LLC’s assets and liabilities into separate cells or pods, each of which is called a series. Each series can own its assets separately from the assets of the LLC or any other series of the LLC. Each series can incur liabilities that are enforceable only against the assets of that series, have its own members and managers, and enter into contracts and sue and be sued in its own name. It is in effect an entity within an entity.

My informal survey shows that Alabama has become the twelfth state to approve series LLCs. Missouri was the most recent, when it amended its LLC Act last year to authorize series LLCs. For more information on series LLCs, see my post on Missouri’s adoption of series LLCs, here.

Comment. As I read through Alabama’s new LLC Act I was impressed by the progressive and thoughtful approach that was apparent in the large policy choices reflected in the Act, and by the careful and detailed treatment of a number of issues that are sometimes troublesome in LLC Acts. I commend the committee of the Alabama Law Institute that drafted the 2014 Act and the comments, the new Act’s sponsor, Representative DeMarco, and the Alabama legislature for a good piece of work.

New York's Appellate Division Applies Corporate Derivative-Suit Rules to LLCs

Bernie Madoff’s Ponzi scheme has resulted in hundreds of lawsuits. Two of those cases, recent rulings from the Appellate Division of New York’s Supreme Court, have shed light on New York’s derivative-suit rules for LLCs. Hecht v. Andover Assocs. Mgmt. Corp., 979 N.Y.S.2d 650 (App. Div. Feb. 5, 2014); Sacher v. Beacon Assocs. Mgmt. Corp., 980 N.Y.S.2d 121 (App. Div. Feb. 5, 2014). See Sacher v. Beacon Assocs. Mgmt. Corp., 979 N.Y.S.2d 653 (App. Div. Feb. 5, 2014).

The facts in Hecht and Sacher were similar. In each case an investment-fund LLC incurred large losses from investments in Madoff’s firm, and the LLC’s member(s) sued the managing member, the manager’s principals, an investment consultant, and the LLC’s independent auditor.

The Appellate Division opinions in these two cases dealt only with the members’ negligence claims against the auditors. The members’ claims were asserted derivatively, on behalf of the LLC. In each case the auditor moved for dismissal of the complaint on grounds that the members had no standing, because they had not demanded that the LLC assert the claim against the auditor before they brought their suit. E.g., Hecht, 979 N.Y.S.2dat 652. The trial court denied the auditors’ motions for dismissal.

The Appellate Division found that in each case the members’ complaint had pleaded with sufficient particularity that making demand upon the LLC’s managing member, to assert the claim against the auditor, was excused because the managing member’s self-interest showed that the demand would have been futile. Each LLC’s managing member had a direct financial interest in the auditor’s issuance of clean audit opinions, in the form of continued higher fees for maintaining the investment with Madoff and in inflated fees based on a percentage of the LLC’s fictitious profits. Id.

The Appellate Division therefore affirmed the trial court’s denial of the auditors’ motions for dismissal, and allowed the claims against the auditors to go forward.

New York law on derivative suits is not as clear for LLCs as it is for corporations. The Business Corporation Law (BCL) spells out when, how, and by whom a derivative suit may be brought on behalf of a corporation. N.Y. Bus. Corp. Law § 626. New York’s LLC Act, in contrast, makes no provision for derivative suits for LLCs.

New York’s Court of Appeals has held, however, that members of a New York LLC may bring a derivative suit on behalf of an LLC, even though there are no provisions governing such suits in the LLC Act. Tzolis v. Wolff, 884 N.E.2d 1005, 1005 (N.Y. 2008). But the Tzolis court went no further: “What limitation on the right of LLC members to sue derivatively may exist is a question not before us today. We do not, however, hold or suggest that there are none.” Id. at 1010.

The court in Hecht and Sacher recognized that the BCL’s demand requirement and futility exemption applied to LLCs, albeit without much analysis other than a citation to Tzolis and to two pre-Tzolis New York cases on derivative suits for corporations. The two older cases dealt with the demand requirement in a shareholder derivative suit. Bansbach v. Zinn, 801 N.E.2d 395 (N.Y. 2003); Marx v. Akers, 666 N.E.2d 1034 (N.Y. 1996).

Hecht and Sacher’s matter-of-fact application to LLCs of the BCL’s demand requirement suggests that the New York courts will likely apply the full panoply of corporate derivative suit rules to LLCs. E.g., the plaintiff must be a shareholder at the time of bringing the suit and have been a shareholder at the time of the actions complained of; the derivative suit may not be compromised or settled without the approval of the court; and the court may award attorneys’ fees to a successful plaintiff. N.Y. Bus. Corp. Law § 626.

The Hecht and Sacher decisions are also consistent with rulings on LLC derivative-suit issues by trial courts in a number of post-Tzolis cases. Peter Mahler has described several such rulings in his New York Business Divorce blog post, here.

New Jersey Amends LLC Charging Order Rules - Foreclosure Is No Longer Available to a Member's Judgment Creditor

 

New Jersey Governor Chris Christie signed into law in January an amendment to the New Jersey LLC Act that eliminates foreclosure of a member’s LLC interest from the remedies available to a member’s judgment creditor. New Jersey Bill A4023. The Act continues to allow a judgment creditor to obtain a charging order, which is now a creditor’s sole remedy against a member’s LLC interest.

Background. State LLC Acts almost uniformly give an LLC member’s judgment creditor the right to obtain a charging order, which mandates that any distributions by the LLC that would otherwise go to the member be paid instead to the creditor. A charging order standing alone, however, will provide no benefit to a creditor if the LLC makes no distributions to its members.

Some state LLC Acts go further and allow a judgment creditor to foreclose on the member’s LLC interest, at least under some circumstances. E.g., Cal. Corp. Code § 17705.03. Foreclosure allows the creditor to sell the member’s interest outright, and the purchaser of the interest then acquires all of the member’s economic interest.

A creditor’s rights under a charging order are limited to satisfaction of the debt – once the judgment debtor’s obligation is satisfied, the charging order is extinguished. Foreclosure, on the other hand, results in a permanent transfer of the debtor’s economic interest. But even if foreclosure is allowed, the purchaser typically will not receive the member’s non-economic rights, such as management participation and voting, unless the operating agreement or a vote of the other members admits the purchaser as a member.

The New Jersey Statute. Prior to 2012, the New Jersey LLC Act authorized charging orders but excluded foreclosures: “A court order charging the limited liability company interest of a member pursuant to this section shall be the sole remedy of a judgment creditor, who shall have no right … to seek an order of the court requiring a foreclosure sale of the limited liability company interest.” Former N.J. Stat. Ann. § 42:2B-45 (2004). Many other states likewise narrowly limit the charging order remedy. E.g., Del. Code Ann. tit. 6, § 18-703.

In 2012 New Jersey adopted the Revised Uniform Limited Liability Company Act (RULLCA). RULLCA is a uniform law recommended by the National Conference of Commissioners on Uniform State Laws (NCCUSL). Consistent with RULLCA’s more flexible approach, New Jersey’s 2012 Act allowed foreclosure upon a showing that distributions under a charging order would not pay the judgment debt within a reasonable time. Former N.J. Stat. Ann. § 42:2C-43 (2012).

Once a state adopts a comprehensive, uniform statute such as RULLCA, there is usually some resistance to incremental changes. For one thing, such changes undercut the state-to-state uniformity that is a goal of laws recommended by NCCUSL. Nonetheless, in 2013 the New Jersey Business and Industry Association, and lawyers from the Real Property Trust and Estate Law Section of the New Jersey State Bar Association, supported an amendment that removed the foreclosure remedy for judgment creditors of LLC members. New Jersey Bill A4023 (Bill). The Bill restores the pre-2012 language with only minor changes:

A court order charging the transferable interest of a member pursuant to this section shall be the sole remedy of a judgment creditor, who shall have no right under 42:2C-1 et seq. or any other State law to interfere with the management or force dissolution of a limited liability company or to seek an order of the court requiring a foreclosure sale of the transferable interest.

Bill, § 6.

The principal reason the trusts and estates lawyers supported the change was (drum roll please) to restore certain estate and gift tax benefits. New Jersey State Bar Association, Capitol Report (Jan. 13, 2014). As explained by the Capitol Report, the estate and gift tax laws are based on the fair market value of transferred property, and restrictions on transfer reduce the fair market value of a member’s LLC interest and therefore reduce estate and gift taxes. Allowing foreclosure removes a transfer restriction and is therefore a factor tending to increase the interest’s fair market value and the estate and gift taxes. The Capitol Report also alludes to the reduced asset protection of LLCs if creditor foreclosure is allowed.

Comment. The idea that the impact on estate and gift taxes is a reason to eliminate the foreclosure remedy from an LLC charging order statute seems a bit like the idea that the tail should wag the dog. Not that I’m against reducing taxes, but the impacts of this change on creditors and on the asset-protection feature of LLCs are important and deserve more consideration than they apparently received here.

 

LLC and Corporate Conversion Bill Goes Forward in Washington Legislature

Finance and restructuring transactions sometimes require that an LLC be redomiciled in a different state, or changed into a corporation or limited partnership. Under Washington law these changes require two or three indirect steps involving formation of a new entity and either a merger or a transfer of assets and a dissolution. A bill has been introduced in the Washington Legislature that would streamline and simplify this process by allowing direct, one-step conversions between LLCs, corporations, and limited partnerships.

Senate Bill 5999, sponsored by Senators Pedersen, O’Ban, Kline, and Fain, would amend Washington’s Limited Liability Company Act and the Business Corporation Act. The amendments would allow conversions between Washington LLCs, corporations, and limited partnerships. The Bill would also allow entities formed under the laws of another state to convert into Washington LLCs and corporations. (Washington’s Uniform Limited Partnership Act already allows conversions. RCW 25.10.756. But without the changes in SB 5999, conversions of Washington LPs can only occur to and from entities in other states.)

Procedures. The conversion procedures are fairly simple. If the converting entity is a Washington LLC, its members must unanimously approve a plan of conversion, and the LLC must then file articles of conversion with the Washington Secretary of State. The organization it converts into must comply with its governing statute, which will usually entail filing a certificate of conversion under that statute.

A similar process is used when the converting entity is a Washington corporation. Unanimous shareholder approval of a plan of conversion is required except when the corporation converts to a foreign corporation. In that case the approval requirements are the same as those for a corporate merger, and the shareholders will have dissenters’ rights if the terms of their shares after the conversion are not at least as favorable as before the conversion.

As an additional protective feature, if LLC members or corporate shareholders will have personal liability as members or shareholders of the converted organization, they must also sign a separate written consent to their personal liability.

When a foreign entity converts to a Washington LLC or corporation, it must file articles of conversion (and also a certificate of formation if it is becoming an LLC) with the Secretary of State.

Result of Conversion. The Bill is clear: an organization that has been converted is for all purposes the same entity that existed before the conversion. The title to all real estate and other property remains vested and unimpaired in the converted organization. All debts and liabilities remain as obligations of the converted organization. Any lawsuit by or against the converting organization continues as if the conversion had not occurred. The conversion does not dissolve the LLC or corporation.

Legislative Status. The Bill has been voted on and passed by the Washington Senate, 48 to 0. The House Judiciary Committee had a hearing yesterday morning, at which I testified in favor of the Bill. We now wait to see what action the Judiciary Committee will take, and whether the Bill will go to the House and be voted on. Keep your fingers crossed.

Comment. This is a good Bill that will be welcomed by corporate lawyers, investors, lenders, and others involved in a variety of transactions. It provides for a cheaper and easier method of changing an entity’s type, its state of formation, or both. It is highly protective of minorities. It also leaves in place the existing methods for changing the type of an entity, such as mergers, which will continue to be used when unanimous member or shareholder approval cannot be obtained. In that case dissenters’ rights will apply.

Thanks are due to the members of the Washington State Bar Association’s Corporate Act Revision Committee, and the Bar’s LLC Law Committee. The two committees collaborated on drafting the bill.

I also commend the Senators who sponsored the Bill, especially Senator Jamie Pedersen, who testified in favor of the Bill at the hearings of the Senate Law and Justice Committee and the House Judiciary Committee.

Illinois's the Place to Be - LLC Managers Are Not Liable for Fraudulent Statements on Behalf of LLC

 LLC law in most states is clear on the proposition that an LLC manager who acts on behalf of an LLC does not automatically become personally liable for the LLC’s obligations. Most states are also clear that the rule is different for torts – they don’t allow an LLC to shield a manager from tort liability even if the manager’s tort occurs while acting on behalf of the LLC. The Appellate Court of Illinois, however, has taken the opposite tack, shielding an LLC manager from personal liability for fraudulent statements made on behalf of the LLC. Dass v. Yale, No. 1-12-2520, 2013 WL 6800983 (Ill. App. Ct. Dec. 20, 2013).

The dispute in the case began when Wolcott LLC sold the plaintiffs a condominium that turned out to have problems with its sewer lines and drainage system. The plaintiffs sued Wolcott for their damages, and later amended their complaint to add claims against Craig Yale, Wolcott’s managing member. The amended complaint added numerous allegations of fraudulent statements by Yale.

The trial court dismissed the claims against Yale, on the grounds that the Illinois LLC Act shielded Yale from liability for fraudulent statements made as manager of the LLC. The relevant portion of the LLC Act states:

Sec. 10-10. Liability of members and managers.
(a) Except as otherwise provided in subsection (d) of this Section, the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager.     . . .

 (d) All or specified members of a limited liability company are liable in their capacity as members for all or specified debts, obligations, or liabilities of the company if:

(1) a provision to that effect is contained in the articles of organization; and

(2) a member so liable has consented in writing to the adoption of the provision or to be bound by the provision.

805 Ill. Comp. Stat. § 180/10-10. The Appellate Court affirmed the trial court, also relying on Section 180/10-10.

The plaintiffs’ argument was that Section 10-10 does not exempt LLC managers from personal liability for torts or fraud that they committed, even if they were acting in their capacity as managers. Their position was that Section 10-10 shields members and managers from being liable merely because the LLC is liable, but does not shield managers who actually commit a tort while acting on behalf of the LLC. Dass, 2013 WL 6800983, at *7.

Unconvinced, the Appellate Court found three reasons for shielding LLC managers from liability for their fraudulent statements. First, the court looked to what it called “the plain language” of the LLC Act:

Thus, “[s]ection 10-10 clearly indicates that a member or manager of an LLC is not personally liable for debts the company incurs unless each of the provisions in subsection (d) is met.” Here, there is no claim that Yale is liable under subsection (d), so Yale is not personally liable for the tort claim against Wolcott.

Id. at *8 (citation omitted) (quoting Puleo v. Topel, 856 N.E.2d 1152, 1156 (Ill. App. Ct. 2006)).

Second, the court disregarded the official comments of the National Conference of Commissioners on Uniform State Laws (NCCUSL) on the comparable language of the 1996 Uniform Limited Liability Company Act (ULLCA). (The plaintiffs had argued that the trial court’s ruling was contrary to the legislative history of Illinois’ LLC Act, because notes to the annotated, published version of the Act referred to the NCCUSL comment.)

The NCCUSL comment states “A member or manager, as an agent of the company, is not liable for the debts, obligations, and liabilities of the company simply because of the agency. A member or manager is responsible for acts or omissions to the extent those acts or omissions would be actionable in contract or tort against the member or manager if that person were acting in an individual capacity.” ULLCA § 303 official cmt. (emphasis added). The court, however, found that the NCCUSL reference in the annotated statutes was added by the publisher and that Illinois had not adopted the comment.

Third, the court looked to the history of the LLC Act. Prior to Illinois’ adoption of the ULLCA in 1998, the LLC Act provided that an LLC manager “shall be personally liable for any act, debt, obligation or liability of the [LLC] or another manager or member to the extent that a director of an Illinois business corporation is liable in analogous circumstances under Illinois law.” Dass, 2013 WL 6800983, at *9 (quoting 805 Ill. Comp. Stat. § 180/10-10 (West 1996)). The court found the removal of the language that explicitly provided for personal liability to be significant: “[w]e presume that by removing the noted statutory language, the legislature meant to shield a member or manager of an LLC from personal liability.” Id.(quoting Puleo, 856 N.E.2d at 1157).

The court noted that in both Puleo (obligations incurred on behalf of LLC after dissolution),and in Carollo v. Irwin, 959 N.E.2d 77 (Ill. App. Ct. 2011) (obligations incurred on behalf of LLC prior to its formation), it had found LLC managers to have more protection from personal liability than officers of corporations. In both cases the LLC managers were found not liable for the LLC’s contractual obligations. The court in Dass saw no reason not to apply the reasoning of those cases to tortious conduct by a manager on behalf of an LLC.

Comment. This is a surprising and puzzling case. It is surprising because it is so far outside the majority view and gives such short shrift to NCCUSL’s comment. It is puzzling because its interpretation of Section 10-10 removes a long-standing common law remedy for injured parties, enabling a tort-feasor to escape liability simply because the tort was committed in the name of an LLC.

A case from the South Carolina Supreme Court is instructive. When faced with the same issue and an identical statute, the South Carolina Supreme Court found that a majority of the states that have examined similar statutory language have concluded that a member or manager is always liable for his or her own torts and cannot rely on his or her status as an LLC member or manager as a shield. 16 Jade St. LLC v. R. Design Constr. Co., LLC, 728 S.E.2d 448, 451 (S.C. 2012). I reviewed the opinion, here.

The South Carolina court recognized that interpreting the LLC Act to shield managers who commit torts in furtherance of the LLC’s activities would remove a traditional common law remedy for injured parties, and pointed out that statutes should not be interpreted to derogate from the common law unless the statute itself clearly shows that to be the intent. Finding no legislative intent to restrict the common law, the court ruled that the statute does not insulate managers from liability for their torts, even if the torts are committed on behalf of the LLC.

The Dass court ignored the Illinois rule that statutes in derogation of the common law will be narrowly construed. “A statute in derogation of the common law cannot be construed as changing the common law beyond what the statutory language expresses or is necessarily implied from what is expressed. … In construing such a statute, a court will not presume that the legislature intended an innovation of the common law further than that which the statutory language specifies or clearly implies.” 100 Roberts Rd. Bus. Condo. Ass’n v. Khalaf, 996 N.E.2d 263, 269 (Ill. App. Ct. 2013) (citation omitted).

The Dass court also failed to note that Section 10-10 says that a manager is not personally liable for the LLC’s debt, obligation, or liability “solely by reason of being or acting as a member or manager.” (Emphasis added). A manager’s commission of a tort adds a separate ground for liability.

States That Cancel Dissolved LLCs Create Problems

LLCs have a natural life cycle. They are formed, they organize, they begin conducting their business. And eventually, eventually all LLCs come to an end – sometimes gracefully, sometimes not.

The end stage for an LLC begins with its dissolution, continues with its winding up, and eventually concludes when the business has been closed down, debts and liabilities satisfied, and any remaining assets distributed to the members. This is sometimes a messy process, with unexpected claims, litigation, overlooked assets, disputes between members, tax surprises, missing records, and other examples of Murphy’s law.

A case last month from Kansas is an example of just such a result, where the LLC’s members had a dispute over whether a payment obligation continued post-dissolution. The case also shows how the Kansas LLC Act’s requirement that dissolved LLCs be terminated can lead to unexpected results. Iron Mound, LLC v. Nueterra Healthcare Mgmt., LLC, 313 P.3d 808 (Kan. Dec. 6, 2013).

Iron Mound and Nueterra were the two members of an LLC formed in 1999 to develop and operate ambulatory surgical centers. Shortly after the LLC’s formation, as allowed by the operating agreement, Nueterra entered into a five-year management agreement with the Manhattan Surgical Center (MSC). The LLC’s operating agreement required that Nueterra pay 20% of its MSC revenues to Iron Mound.

Two years later Iron Mound exercised its right under the operating agreement to dissolve the LLC. After some minor winding-up activities, Iron Mound filed the LLC’s certificate of cancellation under Section 17-7675 of the Kansas LLC Act. At that time the LLC’s only significant company asset was the interest in management fees generated from the MSC management agreement. Id. at 810.

Nueterra continued paying Iron Mound 20% of its revenues from MSC until the management agreement expired in February 2006. MSC exercised its right not to renew the management agreement and invited Nueterra to negotiate a new agreement with different terms. Shortly thereafter MSC and Nueterra entered into a renegotiated management agreement.

Nueterra ceased its payments to Iron Mound when the first management agreement expired, and took the position that it was not obligated to pay Iron Mound any portion of its revenues from the new management agreement. Iron Mound disagreed and filed a breach of contract lawsuit against Nueterra for failing to pay 20% of its revenues from the new MSC management agreement.

The trial court ruled in favor of Nueterra on its motion for summary judgment. The Court of Appeals reversed, finding the payment language in the operating agreement to be ambiguous on whether the parties intended the payment obligations to survive the dissolution of the LLC.

The Supreme Court found that the operating agreement showed an unambiguous intent that Iron Mound’s right to 20% of Nueterra’s fees from the MSC management agreement was dependent on its membership in the LLC and on the terms of the operating agreement. Id. at 813-14. The court also found it to be undisputed that the operating agreement had ceased to exist by the time Nueterra entered into the new management agreement with MSC. “[T]hus there was no ‘Company’ to ‘receive’ revenues and no ‘Members’ to whom such revenues would be allocated.” Id. at 814.

The court concluded that Nueterra’s new MSC management agreement could not have been an asset of the LLC because the LLC and its operating agreement had both ceased to exist before Nueterra entered into the new management agreement. Id. The court reversed the Court of Appeals and affirmed the trial court’s grant of summary judgment to Nueterra.

Comment. The Kansas LLC Act requires that a dissolved LLC’s articles of organization be canceled upon the completion of its winding up, by the filing of a certificate of cancellation. Kan. Stat. Ann. § 17-7675. The LLC’s existence as a separate legal entity ceases when the certificate of cancellation is filed, and its winding-up activities may not be carried out thereafter. Kan. Stat. Ann. §§ 17-7673(b), 17-76,118(b). (The court in Iron Mound referred to the filing of the LLC’s certificate of cancellation and recognized that the LLC no longer existed, but never cited the relevant statutes.)

The Supreme Court in Iron Mound was driven to its decision by the statutory termination and non-existence of the LLC. The case likely would have come out differently if the Kansas LLC Act allowed an LLC’s winding up to continue indefinitely. In that event the lack of clarity in the operating agreement’s payment terms for Nueterra’s management agreements presumably would have led the court to reverse the trial court’s summary judgment, resulting in a trial over the intent of the parties.

A thought experiment points out the how the Kansas termination rule can lead to unsatisfactory results. The Kansas statute requires that the certificate of cancellation be filed on completion of winding up, and Iron Mound could have viewed its receipt of the payment stream from Nueterra as part of the winding up. In that case it would have been justified in delaying filing the certificate of cancellation until the contractual relationship between Nueterra and MSC was finally terminated. And that would have meant that neither the operating agreement nor the LLC would have been terminated when the first MSC agreement expired and a new agreement between Nueterra and MSC was put in place. The court would then have had to confront the terms of the operating agreement, likely leading to a trial on the merits.

The Kansas LLC Act’s approach – mandatory termination of the LLC’s existence – is an unnecessary holdover from the common law approach to corporate dissolutions. See 3 Model Business Corporation Act Annotated § 1405 official cmt. (4th ed. 2013). Kansas is not alone in its approach – a number of other state LLC statutes have similar provisions. See, e.g., Delaware, Del. Code Ann. tit. 6, §§ 18-203(a), 18-201(b); New Hampshire, N.H. Rev. Stat. Ann. §§ 304-C:142, 304-C:19 (certificate of cancellation may optionally be filed after completion of winding up).

Many state LLC statutes allow a dissolved LLC’s winding-up process to continue indefinitely, and also provide procedures to cut off claims. Washington, Oregon, and the Revised Uniform Limited Liability Company Act all follow that approach. Indefinite continuation of winding up accommodates unexpected circumstances such as the late-discovered asset or long-lasting contracts.

Sometimes a Lie Is Fraud, But Sometimes a Lie Is Just a Lie

Lies are generally bad, but not all lies result in legal liability. In a recent case in point, a Delaware LLC member allegedly lied about his reasons for withdrawing from the LLC and about his post-withdrawal plans. After his withdrawal he competed against his former LLC, in contradiction of his prior statements. We can infer that the other members were incensed – shortly thereafter the LLC filed suit against the former member, asserting nine different counts. The Delaware Court of Chancery rejected all nine. Touch of Italy Salumeria & Pasticceria, LLC v. Bascio, No. 8602-VCG, 2014 WL 108895 (Del. Ch. Jan. 13, 2014).

Louis Bascio was one of three members of Touch of Italy Salumeria & Pasticceria, LLC, which operated an Italian grocery in Rehoboth Beach, Delaware. In October 2012 Bascio gave notice to the other members that he intended to withdraw from the LLC.

The LLC agreement provided that any member could withdraw from the LLC by giving written notice, in which case the other members had 60 days to elect to purchase the withdrawing member’s interest in the LLC. Bascio represented at the time of his resignation that he was moving to Pennsylvania to establish a new business there. He said he would not take any action that would be adverse to the LLC’s business and that he would not open any competing business in Rehoboth Beach.

The other members did not exercise their purchase option, and Bascio’s resignation was effective in December 2012. Notwithstanding his assurances about not opening a competing business, 10 weeks later Bascio and his brother opened Frank and Louie’s, a competing Italian grocery, on the same block as Touch of Italy. Touch of Italy and its members filed their lawsuit against Bascio in May 2013.

Touch of Italy alleged nine counts against Bascio: conversion, fraudulent misrepresentation, breach of contract, negligent misrepresentation, fraudulent concealment, breach of the implied covenant of good faith and fair dealing, breach of fiduciary duty, prayer for punitive damages, and injunctive relief. In June 2013 Bascio filed a motion to dismiss all claims for failure to state a claim.

As is common in business litigation, the plaintiffs asserted several causes of action based on the same underlying facts. The gist of their allegations was that Bascio “lied about his intention to open a competing Italian grocery in order to deceive the Plaintiffs and to induce their reliance on his misrepresentations, a lie in which [Bascio’s] brother, Frank, participated; and that under cover of this lie, they brought that competing entity into existence.” Id. at *4.

You may be asking yourself, where’s the noncompete? The answer is there was none, as the court repeatedly pointed out. “The Plaintiff’s allegations are best characterized as, in effect, an attempt to replicate the non-compete agreement that the parties failed to include in their LLC agreement; a deficiency that the Plaintiffs, because of changed circumstances, now regret.” Id.

Breach of Contract. The court dismissed the breach of contract claim because Touch of Italy alleged no specific acts of Bascio that would have violated the LLC agreement, either while he was a member or afterwards. The agreement detailed a member’s withdrawal procedure, but withdrawal did not require the consent of other members, and the agreement provided no post-withdrawal restrictions on a former member’s conduct. Id.

Fraud and Misrepresentation. The court dismissed the fraud and misrepresentation claims because fraud and misrepresentation require that the complainant have relied to its detriment on the alleged lies and omissions. But without an alternative course of action there can be no reliance, and the plaintiffs had no right under the LLC agreement to take any other actions, even had they known Bascio’s intentions. The LLC agreement gave Bascio the right to withdraw, and it did not bar him from competing after his withdrawal. The plaintiffs’ attorney even admitted at oral argument that if Bascio had truthfully described his intent to compete, before his departure, the members could have done nothing other than eventually bring their lawsuit. They could have complained, but as the court said, their bootless objections would have been “legally meaningless.” Id. at *5.

Implied Covenant of Good Faith and Fair Dealing. The implied covenant of good faith and fair dealing applies to all LLC agreements, Del. Code Ann. tit. 6, § 18-1101(c), and is intended to prevent a party from denying its contractual partners the benefit of their bargain based on unanticipated circumstances. Id. at *6. But resignation was provided for in the LLC agreement, and post-resignation conduct such as opening a competing business is not unforeseeable. The court accordingly dismissed the implied covenant claim. The court pointed out that covenants not to compete are commonly used to avoid the consequences of post-termination competition. Touch of Italy, 2014 WL 108895, at *6.

Breach of Fiduciary Duties. The court assumed for purposes of Bascio’s motion to dismiss that he owed fiduciary duties to Touch of Italy and its members during his membership. Touch of Italy contended that Bascio was planning to open a competing business while he was a member, but its complaint had no factual allegations of acts that would support such an intention. And Bascio’s fiduciary duties ceased once he was no longer a member.

Conversion. Touch of Italy alleged that it or one of its members owned all assets of the business, listing several categories such as bank accounts, equipment and inventory, and goodwill, and that Bascio had “exercised dominion and control over certain of the above stated assets to the exclusion” of the plaintiffs. Id. at *7 (emphasis in the original). The court dismissed the claim of conversion because the complaint referred only to categories of property and did not specify precisely what property Bascio was alleged to have converted, and alleged only that Bascio had exerted control over “certain” items within the broad categories of property. Touch of Italy had also failed to demand return of the converted property.

Equity. The court also dismissed Touch of Italy’s requests for punitive damages and for injunctive relief, because they were predicated on the other claims of wrongdoing, all of which were dismissed. The court also noted dismissively that the request for punitive damages was inappropriately pled, because Chancery is a court of equity and therefore cannot award punitive damages. “Traditionally and historically the Court of Chancery as the Equity Court is a court of conscience and will permit only what is just and right with no element of vengeance and therefore will not enforce penalties or forfeitures.” Id. at *8 (quoting Beals v. Wash. Int’l, Inc., 386 A.2d 1156, 1159 (Del. Ch. 1978)).

The court dismissed all claims with prejudice, except that the conversion claim was dismissed without prejudice in order to allow Touch of Italy to amend its complaint to specify the property it alleged was converted.

Comment. The core of the plaintiffs’ complaint was that (a) as Bascio was getting ready to withdraw from Touch of Italy, he lied by telling them that he did not intend to compete after he left the company; and (b) after he left the company he competed. But as the court noted repeatedly, Bascio was not contractually bound not to compete, he complied with the LLC agreement by giving advance notice that he would be leaving the company, and there was no reliance on his misstatements or change of position by the plaintiffs.

The court said it right: sometimes a lie is just a lie and not the basis for a successful lawsuit. Id. at *1.

Owner of Kentucky LLC Cannot Sue for Damage to the LLC

The Kentucky Supreme Court has reminded us in a recent opinion that an LLC, even if it has only one member, is a legal entity that is distinct from its owner. When a single-member LLC is harmed by a third party, therefore, the LLC and not its owner is the proper party to assert the claim for damages. Turner v. Andrew, No. 2011-SC-000614-DG, 2013 WL 6134372 (Ky. Nov. 21, 2013).

The dispute in this case arose from a traffic accident. Billy Andrew owned a dump truck that was being operated by his wholly owned company, Billy Andrew, Jr. Trucking, LLC. An employee of M & W Milling was driving a feed truck that struck and damaged Andrew’s dump truck. Andrew sued M & W and its driver for property damage to Andrew’s dump truck and for loss of income derived from the LLC’s use of the truck.

The trial court ruled on the lost income claim in favor of M & W, on grounds that as the real party in interest, the LLC was the only party that could pursue the claim for lost income. The Court of Appeals reversed the trial court, on the theory that Andrew could pursue the lost business claim in his own name because he was the sole owner of the LLC. Id. at *2.

The Supreme Court began its analysis by examining the Kentucky LLC Act. Section 275.010(2) states that a Kentucky LLC is a legal entity distinct from its members, and Section 275.155 says that an LLC member is not a proper party to a legal proceeding by or against an LLC solely by reason of being a member.

The court then looked to cases across the country with similar LLC statutes: “[such courts] have uniformly recognized the separateness of a limited liability company from its members even where there is only one member.” Id. at *3 (citing cases from Connecticut, Louisiana, Minnesota, and South Dakota).

Turning to Kentucky law, the court referred to its decision in Miller v. Paducah Airport Corp., 551 S.W.2d 241 (Ky. 1977). In Miller the president and sole shareholder of a corporation brought suit in his own name against a landlord under a lease with the corporation. The court there held that the corporation was the real party in interest to the claim on the lease, and that Miller therefore could not bring suit against the landlord. Reasoning by analogy, the Turner court found that Miller and his LLC were not legally interchangeable. “[A]n LLC is not a legal coat that one slips on to protect the owner from liability but then discards or ignores altogether when it is time to pursue a damage claim.” Id.

Andrew argued that the LLC should be disregarded because he was the sole owner of the LLC and because the business was operated from his residence. The court recognized that under some circumstances the separate existence of an LLC may be disregarded under the legal doctrine referred to as “piercing the veil.” Veil piercing scenarios usually involve an LLC’s creditor seeking to pierce the LLC’s veil to reach the assets of its member, or a creditor of an LLC’s sole member seeking to reach the assets of the LLC to satisfy its claim against the member. The court did not see this as one of those cases. Id.  at *4.

The court remanded the case to the trial court with directions to determine if the LLC was conducting the trucking business on the date of the accident, and if so to render judgment in favor of M & W because Andrew personally had no standing to bring the business loss claim in his own name.

Comment. Turner  is a good reminder that the liability shield of LLCs is dependent on their separate entity status, and that the separate-entity status of LLCs must be taken into account when claims have to be asserted.

Billy Andrew had some reasons to think he could bring all his claims on the truck accident under his own name. The truck was owned by him and not by the LLC, even though it was used in the LLC’s business. He operated the business out of his home. For federal income tax purposes his LLC was likely a disregarded entity, in which case he simply included the income or losses from the LLC on his own personal tax return. But the legal rules on the separate entity status of LLCs are clear, and it’s the lawyer’s job to make sure that the proper parties are named in filing a lawsuit.

Federal Court Explores Whether a Series LLC's Third-Party Liability is Determined by the Law of Its State of Formation

A series LLC is a type of LLC, authorized by state law, that can be used to segregate an LLC’s assets, liabilities and members into separate cells within the LLC, 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 are enforceable only against the series, have its own members and managers, and enter into contracts and sue and be sued in its own name. In effect it is an entity within an entity.

Series LLCs are a relatively new legal construct, and their use is spreading. Delaware first authorized series LLCs in 1996, and since then ten other states have authorized series LLCs. I have written previously on series LLCs; my posts can be seen here.

One question that lawyers worry about when they consider series LLCs is whether the limits on a series’ liability will stand up in court. The state LLC statutes say that the liabilities of a series may be enforced only against the assets of the series, and not against the assets of the LLC or other series within the LLC. But if a series’ creditor sues it in a state other than the state of the LLC’s formation, the laws in the creditor’s state may make no provision for series LLCs. What result then?

That was the principal question in a case handed down earlier this month from the U.S. Court of Appeals for the Fifth Circuit, in the appeal of a lawsuit from the U.S. District Court for the Eastern District of Louisiana. Alphonse v. Arch Bay Holdings, L.L.C., No. 13-30154, 2013 WL 6490229 (5th Cir. Dec. 11, 2013). The opinion is unpublished and its precedential value is therefore limited, but it’s nonetheless a useful first look at an appellate court’s analysis of a key LLC issue.

The case revolved around the foreclosure of Glenn Alphonse’s home mortgage. Arch Bay Holdings, LLC – Series 2010B (“Series 2010B”), a series in a Delaware series LLC, held the note on Alphonse’s home. Alphonse defaulted on the mortgage, and Series 2010B foreclosed in Louisiana state court.

Alphonse did not contest the foreclosure action, but later brought suit in the U.S. District Court, contending that the foreclosure was fraudulent because it was based on robo-signed supporting documentation. Alphonse’s federal lawsuit was brought against Arch Bay Holdings, LLC, the master LLC for Series 2010B. I.e., Arch Bay was the LLC that contained Series 2010B.

(The Court of Appeals referred to Arch Bay as the “parent company” of Series 2010B, which is inaccurate. “Parent company” means a corporation or LLC that owns all the stock of a corporation or all the member interests of an LLC. An LLC’s series is owned by the series’ members, who may be different from the LLC’s members. The more common and more appropriate terminology is to refer to Arch Bay as the master LLC.)

The trial court dismissed Alphonse’s suit on three grounds. One, a subject-matter-jurisdiction issue, was determined to be erroneous because of an intervening Fifth Circuit decision. Id. at *2. The remaining grounds for the trial court’s dismissal were (a) that Alphonse sued the wrong party, and (b) res judicata.

Arch Bay contended that it was the wrong party because the entity that had foreclosed on Alphonse’s mortgage was not Arch Bay, the master LLC, but Series 2010B. Arch Bay’s argument, which prevailed in the district court, was that Delaware law determines its liability, and under Delaware law, Series 2010B was the real party in interest and was a separate legal entity from Arch Bay. Id. at *1.

Internal Affairs Doctrine. The Court of Appeals first examined Louisiana’s conflict-of-laws statute: “‘The laws of the state or other jurisdiction under which a foreign limited liability company is organized shall govern its organization, its internal affairs, and the liability of its managers and members that arise solely out of their positions as managers and members.’” Id. at *6 (emphasis added) (quoting La. Rev. Stat. § 12:1342).

The district court’s conclusion that the liability of Arch Bay or Series 2010B was determined by the Delaware LLC Act was not accepted as a foregone conclusion by the Court of Appeals. “The district court does not appear to have considered the issue of whether liability as between a third-party plaintiff with respect to a holding company LLC or its Series LLC constitutes internal or external affairs.” Id. at *7.

The Court of Appeals agreed that the law of the state of formation normally determines issues relating to the internal affairs of a corporation or LLC, but pointed out that different conflict-of-laws principles apply where the rights of third parties outside the entity are involved. Id. at *6 (citing First Nat’l City Bank v. Banco Para El Comercio Exterior de Cuba, 462 U.S. 611, 621 (1983)). The court also referred to a 2005 district court’s conclusion, interpreting California’s conflict-of-laws statute, that the internal affairs doctrine “‘does not apply to disputes that include people or entities that are not part of the LLC.’” Id. (quoting Butler v. Adoption Media, LLC, No. C04-0135 PJH, 2005 WL 2077484, at *1 (N.D. Cal. 2005)).

The Court of Appeals concluded that the district court had not developed enough facts and had not adequately considered the internal affairs conflict-of-laws question under Louisiana law. Id. at *7.

Res Judicata. Arch Bay also argued that because Alphonse could have raised the robo-signing issue in the foreclosure action, the legal doctrine of res judicata (the thing has been decided) precluded him from bringing it up in the later lawsuit. Id. at *3. One of the requirements under Louisiana’s res judicata statute, in order for the second lawsuit to be precluded, is that the parties in the two lawsuits must be the same. Whether there is sufficient identity of the parties depends not only on whether the parties are the same person or legal entity, but also on issues such as the degree of control of one by the other, and whether the interests of one were adequately represented by the other in the first lawsuit.

The court concluded that there were not enough facts in the record to determine whether Series 2010B had sufficient identity with Arch Bay for res judicata purposes, and that that issue should in fairness be considered together with the question of whether Series 2010B is a separate legal entity. Id. at *4. The district court’s conclusions were therefore reversed and remanded for further consideration consistent with the Court of Appeals’ opinion.

Comment. At one level Alphonse is an unremarkable case – its holding was simply to reverse and remand because the district court had not adequately developed the facts and had not considered the internal/external affairs issue. But the court’s discussion of series LLCs should get a lot of attention, because as far as I know it’s the first available opinion (albeit unpublished) that discusses whether the internal affairs doctrine will apply to the asset protection side of series LLCs.

The asset protection feature of series LLCs is an important part of their attraction, and the state LLC statutes are clear on the point. Delaware’s LLC Act, for example, provides that if certain conditions are met, then

the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the limited liability company generally or any other series thereof, and, unless otherwise provided in the limited liability company agreement, none of the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to the limited liability company generally or any other series thereof shall be enforceable against the assets of such series.

Del. Code tit. 6, § 18-215(b).

The Alphonse court’s discussion does not augur well for the enforceability of the liability limitations of series LLCs, at least when claims are brought in the courts of states other than the 11 that have authorized series LLCs. “[T]he internal-affairs doctrine ‘does not apply to disputes that include people or entities that are not part of the LLC.’” Alphonse, 2013 WL 6490229, at *6 (quoting Butler, 2005 WL 2077484, at *1).

If the internal affairs doctrine does not apply to series LLCs, then presumably the overall entity, meaning the LLC and each series, will be liable for debts incurred by a series.

Delaware Allows LLC Agreement to Waive Members' Right to Judicial Dissolution

Delaware’s LLC statute authorizes the Court of Chancery to dissolve an LLC on application of a member “whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” 6 Del. C. § 18-802. That’s well and good, but what if the LLC agreement says the members have no right to seek a judicial order of dissolution? Is that enforceable?

Last week the Court of Chancery said yes, it is. The court relied on the Delaware Act’s stated policy of maximizing freedom of contract, and ruled that an LLC member had no right to seek a judicial order of dissolution where the LLC agreement waived that right. Huatuco v. Satellite Healthcare, No. 8465-VCG, 2013 WL 6460898 (Del. Ch. Dec. 9, 2013).

Dr. Aibar Huatuco and Satellite Health Care (SHC) formed a Delaware LLC in 2007. Each owned 50% of the LLC, which owned and operated dialysis facilities in California. SHC managed the company and Huatuco was its medical director.

Dissension eventually reared its ugly head. Disputes between Huatuco and SHC arose over several loans to the LLC and loan guarantees by Huatuco, Huatuco’s role as medical director, and the LLC’s replacement of Huatuco as medical director. On April 18, 2013 Huatuco filed a complaint seeking judicial dissolution of the LLC, and SHC later filed a motion to dismiss the complaint for failure to state a claim.

The Statute. The parties agreed that whether Huatuco was entitled to judicial dissolution was governed by the interplay between provisions of the LLC agreement and the Delaware LLC Act’s authorization of judicial dissolution. Id. at *3.Section 18-802 states:

On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.

The Agreement. The LLC agreement specified the events upon which the LLC could be dissolved, such as by a super-majority vote of the members. But the agreement did not mention judicial dissolution – it neither expressly provided nor waived a right to judicial dissolution.

The LLC agreement also contained a disclaimer: “Except as otherwise required by applicable law, the Members shall only have the power to exercise any and all rights expressly granted to the Members pursuant to the terms of this Agreement.” Id.

The Argument. SHC relied on the disclaimer and argued as follows: (a) the parties agreed to forgo any rights not required by law or explicitly granted by the LLC Agreement, (b) judicial dissolution is not a mandatory provision of the LLC Act and the LLC Agreement did not expressly provide a right to seek judicial dissolution, and (c) therefore judicial dissolution was unavailable to Huatuco. Id. at *4. Huatuco riposted that the disclaimer was being taken out of context, because it was embedded in a paragraph dealing with the members’ economic rights and therefore only applied to economic rights.

The court disagreed with Huatuco’s interpretation. The paragraph in question was captioned “Other Member Rights,” implying it was not necessarily limited to economic rights. More importantly, the disclaimer referred to “any and all rights” granted to the members under the Agreement, which would include other rights such as a right to seek judicial dissolution. The court therefore interpreted the disclaimer to mean that the members rejected all default rights under the LLC Act unless explicitly provided for in the LLC agreement. Id.

The court also pointed out that judicial dissolution is not a mandatory provision of Delaware law, citing R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, No. 3803-CC, 2008 WL 3846318 (Del. Ch. 2008) (upholding members’ waiver in LLC agreement of rights to seek judicial dissolution). The court explained that permitting waiver of judicial dissolution in an LLC agreement is consistent with the LLC Act’s broad policy of freedom of contract. “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” 6 Del. C. § 18-1101(b).

Huatuco argued that as a matter of public policy the court should not deprive him of the right to ask a court for dissolution where no alternative exit options are available. The court dismissed that argument because he had some limited remedies under the agreement and because “[p]ermitting judicial dissolution where the parties have agreed to forgo that remedy in the LLC Agreement would … change in a fundamental way the relationship for which these parties bargained.” Huatuco, 2013 WL 6460898, at *6.

The court concluded that Huatuco had no right to seek a dissolution under Section 18-802, because a right to judicial dissolution is not required by law and was validly excluded by his LLC agreement. His case was dismissed.

Comment. Huatuco is consistent with R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC and is not a groundbreaking case. But these two cases exalt the principle of maximizing freedom of contract to new heights. Both focus on giving the parties the benefit of their bargain, but they ignore the key language in Section 18-802:

On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.

6 Del. C. § 18-802 (emphasis added). Judicial dissolution is a remedy that is intended to carry out the purpose of the LLC agreement, not change it.

The need for a non-waivable judicial dissolution remedy has been recognized by the National Conference of Commissioners on Uniform State Laws (NCCUSL), in both the Revised Uniform Limited Liability Company Act (RULLCA) and the Uniform Limited Partnership Act (ULPA). (RULLCA has been adopted in eight states and ULPA has been adopted in 18 states.)

Instead of leaving the issue for later judicial interpretation, RULLCA and ULPA list their provisions that may not be waived by a limited partnership or LLC agreement, and both provide that an LLC agreement may not vary the power of a court to grant dissolution under the conditions specified in the statute. ULPA § 110(b)(9); RULLCA § 110(c)(7).

NCCUSL’s clear rules on non-waivability contrast favorably with the Delaware approach, which results in some uncertainty about the law until the courts resolve which sections in the LLC Act are waivable and which are not.

Montana Court Explores the Boundaries of LLC's Liability Shield

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.