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.
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.
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.
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.
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.
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.
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’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.
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.