SEC Limits the Use of Series LLCs for Broker-Dealers
The SEC recently took the wind out of the sails of broker-dealers hoping to use series LLCs for multiple broker-dealers within one LLC. In a letter dated September 1, 2009, the SEC staff advised the Financial Industry Regulatory Authority (FINRA) that the proposed series LLC structure would not pass muster under the SEC’s net capital rule, its customer protection rule, and its financial reporting rule.
FINRA proposed, for example, that an LLC would have two series, one to operate a retail broker-dealer and one to operate an institutional broker-dealer. The LLC, and not either series, would register with the LLC.
The LLC itself would have no business operations. Instead, each series would operate a separate brokerage and would have separate assets and liabilities. The liabilities of one series would not be enforceable against the assets of the other series or the overall LLC, but the assets and liabilities of the two series would be aggregated on the LLC’s consolidated financial statement, which is filed periodically with the SEC. (For a description of how series LLCs work, see my previous post, here.)
The SEC’s staff pointed out that partitioning each series’ assets and liabilities within the LLC would be inconsistent with applying the net capital rule at the LLC level. Reporting the LLC’s financials on a consolidated basis would greatly impair the SEC’s and FINRA’s ability to supervise the LLC’s financial position, since the SEC would not be able to determine the financial position of the LLC and each series without substantial effort.
The staff pointed out other problems regarding customer reserve accounts and equal treatment of customers in the event of a liquidation proceeding. The bottom line was that the idea of having the LLC be the regulated entity while yet having each series be treated as separate, independent entities for purposes of their assets and liabilities, is inconsistent with the SEC’s regulations.
Series LLCs have a place in the business world. But at least in this case, asking regulators to ignore the inherent inconsistency between regulating only the overall LLC, while disregarding the separate liability shield of each series within the LLC, was simply a bridge too far.
Former LLC Member: Why Does My K-1 Show All This Income?
An LLC member, Mr. Smith, sells his member interest and terminates all connections with the LLC. The sale agreement ends Smith’s rights in the LLC. Smith moves on and doesn’t think much more about the LLC. Many months later, Smith receives a Schedule K-1 from the LLC. >
Schedule K-1 is the form an LLC uses to inform each member of the member’s share of income, losses, deductions, credits and so on. Like almost all LLCs, Smith’s former LLC is taxed as a partnership for federal income tax purposes, and the LLC’s income and losses for each tax year are allocated to its members. The members then each pay taxes on their share of the LLC’s income for that year, or use the losses to shelter other income. (The ability to use losses to shelter other income is subject to various limitations. See my prior post on passive income loss limitations, here.)
Smith is shocked to see that the K-1 shows a whopping allocation of income to him for the last year of his membership in the LLC. He realizes that that income will have to be reported on his own personal tax return and will substantially increase his tax bill, and he didn’t receive any cash distribution from the LLC to cover those extra taxes. Based on what he knows about the LLC’s operations and finances towards the end of his involvement with it, he doesn’t understand how or why so much income was allocated to him. What does he do?
Naturally Smith starts asking questions. He requests copies of the LLC’s financial records so his CPA can evaluate the correctness of the LLC’s allocations. The LLC, however, points out that Smith is no longer a member, so its operating agreement gives him no right to see the records. The LLC also notes that the state LLC Act only allows members, not former members, to access LLC records. In short, he is politely told to go roll his hoop.
The plaintiffs in Abdalla v. Qadorh-Zidan, 913 N.E.2d 280 (Ind. Ct. App. Sept. 10, 2009), were faced with this situation. The Qadorh-Zidans (Zidans) and the Abdallas had formed five LLCs to own and operate apartment properties. Later the Abdallas filed a lawsuit against the Zidans alleging breach of fiduciary duty and usurpation of corporate opportunities. That suit was resolved through a settlement that included a buyout – the Zidans sold their membership interests in the LLCs to the Abdallas in August 2006.
In the fall of 2007 the Zidans received tax returns and K-1 Schedules from the LLCs for the tax year ending on the date of the buyout. The Zidans alleged discrepancies in the K-1s and requested accounting information and records from the LLCs for the time period when they were members. The Abdallas refused, so the Zidans filed a complaint alleging breach of fiduciary duty and seeking declaratory relief to inspect the books and records of the LLCs for the period when they were members. The Zidans sought discovery of the requested information, which was stayed pending a summary judgment motion by the Abdallas. The trial court’s denial of the Abdallas’ motion was appealed.
The Abdallas contended that any fiduciary duties owed to the Zidans terminated when they ceased being members of the LLCs, because the Zidans no longer had any rights under the operating agreements and because their settlement agreement in the first lawsuit included a relinquishment of all of the Zidans’ rights as members. The Zidans maintained that fiduciary duties should remain intact with respect to the resolution of pre-separation business, and that therefore the fiduciary relationship covered the preparation of the tax return which was completed after the Zidans sold out.
The court held that the Abdallas owed a fiduciary duty to the Zidans regarding the preparation of tax returns for the period during which the Zidans were members of the LLCs. Abdalla, 913 N.E.2d at 286. As the court said, “To hold otherwise would give the Abdallas the freedom to allocate tax burdens to the Zidans and retain tax benefits for themselves without allowing the Zidans any recourse to verify or rectify this allocation.” Id.
The court reached a similar result on the question of whether the Zidans had a right of access to the LLCs’ books. Although the Indiana LLC Act only gives members the right to access an LLC’s records, Ind. Code § 23-18-4-8(b), the court held that the Zidans, as former members, had a right to access the records covering the time period while they were still members of the LLCs. Abdalla, 913 N.E.2d at 287.
Many state LLC Acts, like Indiana’s, do not address what inspection rights former LLC members have. For example, the LLC Acts of Washington, Oregon and Delaware are silent on inspection rights for former members. There’s no reason why state statutes can’t address this issue, though. The Illinois LLC Act, for example, provides that former members have a right of access for a proper purpose to LLC records pertaining to the period when they were members. 805 Ill. Comp. Stat. 180/10-15. The Revised Uniform Limited Liability Company Act and the Uniform Limited Partnership Act also have comparable provisions giving former members limited access rights.
When the Zidans resolved their first dispute with the Abdallas through a buyout of the Zidans’ interests in the LLCs, they apparently did not consider the inevitable entanglement resulting from the tax flow-through treatment of the LLCs. In an LLC buyout there will usually be a time lag from the buyout to the computation and allocation of the LLC’s profits and losses, and the distribution of the Schedule K-1s.
There’s a moral here. A member selling its interest in an LLC should consider adding provisions to the buyout agreement for later access to the LLC’s accounting records and for consultation with the LLC’s manager or CPA over the tax allocations and the preparation of tax returns, for the period when the seller was a member. The seller should also consider provisions for notice, access to records and consultation regarding any later amendment to the LLC’s previously filed tax returns, or any IRS contact with the LLC or tax audit for the period before the buyout. These provisions can help the former member avoid unpleasant tax-related surprises, and can give the former member the tools necessary to investigate unexpected tax allocations.
Connecticut Orders LLC Dissolution and Winding Up - Member Acrimony Prevents LLC from Carrying On Its Business
It’s a classic fact pattern that is all too familiar to many business lawyers. Two good friends decide to start a business. In their enthusiasm they create a 50/50 ownership structure and launch the business. Later, things change. One starts devoting more time to the business. Or maybe the business develops a commercial relationship with a separate company owned by one of the friends, which benefits only that one. Their business relationship becomes asymmetrical. Their views of how each should be compensated or how the business should be conducted diverge.
That’s essentially what happened in Saunders v. Firtel, 978 A.2d 487 (Conn. Sept. 22, 2009). Saunders and Firtel were friends who began a business relationship in the mid-1980s. Saunders joined Firtel as an employee and shareholder in Adco Medical Supplies, Inc. (Adco) in 1986. Saunders held 49% of the stock, Firtel held 51%. Firtel was President and Saunders Vice President, and they agreed that each would receive the same annual salary. In 1999, when things were still going well, Saunders and Firtel formed Barbur Associates, LLC (Barbur), a Connecticut LLC in which each owned a 50% interest. Barbur acquired real estate and leased it to Adco on an oral month-to-month lease.
The stage was now set. By 2004, Saunders had become dissatisfied because he perceived that he was doing most of the work but receiving the same compensation as Firtel. Saunders advised Firtel that the 1986 agreement for equal compensation was no longer acceptable. Firtel responded by firing Saunders from Adco in July 2004, lowering the rent charged by Barbur to Adco, unilaterally authorizing repairs by Barbur to the building Adco rented, and arranging a $5,000 loan from Barbur to Adco. Adco refused to pay Saunders his salary for 2004. Shortly thereafter, Saunders and Firtel ceased having any business or personal relationship, and made accusations against each other of theft, breach of fiduciary duty, self-dealing and other “improper and felonious conduct.” Saunders, 978 A.2d at 500 n.22.
Saunders sued Adco for his unpaid 2004 compensation, and for a decree ordering the dissolution and winding up of Barbur. The trial court found for Saunders on his wage claim and ordered double damages pursuant to Conn. Gen. Stat. § 31-72. The trial court also ordered a dissolution and winding up of Barbur, under Conn. Gen. Stat. §§ 34-207 and 34-208.
The Connecticut LLC Act authorizes the superior court to order dissolution “whenever it is not .jpg)
reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” Conn. Gen. Stat. § 34-207. The LLC Acts of Washington, Delaware, New York and many other states have similar provisions, as does NCCUSL’s Revised Uniform LLC Act. The essence of this test is whether or not the business of the LLC can be carried on in a reasonable way. The court has discretion; this is an equitable proceeding in which factors such as oppression, wrong-doing or deadlock are considered.
The court concluded that “the trial court’s order of dissolution is well supported by the evidence.” Saunders, 978 A.2d at 500. In reaching its conclusion, however, the court simply recited the facts identified above. The court did not examine Barbur’s articles of organization or operating agreement to see if the business was being carried out in conformity with the articles or the operating agreement, or refer to any such examination by the trial court. The two Connecticut cases cited by the court don’t seem particularly relevant, since both involved dissolutions of corporations for deadlock under prior corporate statutes. Those statutes, unlike Connecticut’s LLC Act, allowed dissolution for deadlock or other good and sufficient reasons. The court may have concluded that the various abuses by Firtel and the hostility and lack of cooperation between Firtel and Saunders simply made it impossible for the LLC to carry on any business, but the court’s analysis is conclusory and opaque.
Contract provisions don’t necessarily make disagreements between members go away, but sometimes they can provide helpful mechanisms to mitigate disputes and keep the parties out of court. For example, Saunders and Firtel apparently had no provisions in Barbur’s operating agreement to deal with deadlock. If their operating agreement had had a provision that allowed either party to initiate a buy-out process, they might have avoided litigation. A business person may assume that the initially cordial relationship with a potential business partner will continue indefinitely, but his or her lawyer should ask the hard-edged questions to challenge that assumption and help the parties build some safety nets into their agreement.
Oregon Clarifies LLC Derivative Suit Requirements
The Oregon Court of Appeals has clarified when and how members of an Oregon LLC can maintain a derivative suit in the name of the LLC. Bernards v. Summit Real Estate Mgmt., 229 Or.App. 357, 213 P.3d 1 (July 1, 2009). Oregon’s LLC Act allows member derivative suits, but the court imposed additional pleading requirements on the complaint. The court also found that a requirement in the LLC’s operating agreement of unanimous member approval before commencing any suit in the name of the LLC was subject to the agreement’s standard of care and to the implied duty of good faith and fair dealing.
The plaintiffs (Bernards) were minority members of two member-managed LLCs. Each of the LLCs owned apartment buildings and entered into management contracts with the defendant management company (Summit). Bernards claimed that Summit and one of its officers (McKenna) had embezzled the LLCs’ funds, and demanded that the other members approve lawsuits by the LLCs against Summit and McKenna to recover the funds. (The operating agreements for the LLCs required the unanimous approval of the members to bring legal action in the name of the LLCs.)
The other members refused to approve a lawsuit without giving any reasons for their refusal, even though McKenna had admitted embezzling substantial amounts from the LLCs. Bernards then brought derivative suits against Summit, McKenna and the other members, alleging that the other members had breached their duty to the LLCs by refusing to approve the lawsuits against Summit and McKenna.
Oregon’s LLC Act authorizes derivative proceedings by a member in the name of an LLC. Or. Rev. Stat. § 63.801(1). The statute requires that the complaint allege with particularity either that a demand to file the suit was made of the managers (or members in the case of a member-managed LLC), or why a demand was not made. Or. Rev. Stat. § 63.801(2).
The statute does not explicitly refer to any requirement of wrongdoing by the members that refused to approve the lawsuits. The court nonetheless held that when the members have refused the demand for litigation, the complaint must allege facts showing wrongdoing by the refusing members. Bernards, 229 Or. App. at 364.
The court analogized LLC derivative suits to corporate derivative suits. The court had previously held that Oregon’s almost identical corporate statute required, albeit in a demand-futility case, that the complaint in a shareholder derivative suit plead facts showing wrongful conduct by the directors. The court in Bernards applied the corporate rule, holding that in order to rebut the presumption that the members were exercising their business judgment, the complaint must allege facts showing wrongful conduct by the members.
Section 63.801(2) of Oregon’s LLC Act allows the LLC’s operating agreement to vary the statutory pleading requirements. The court therefore looked to the operating agreements and applied their standard of care as the definition of wrongful conduct—gross negligence, fraud or willful or wanton misconduct.
The other members argued that the operating agreements’ requirement of unanimous member consent trumped the pleading requirements of Or. Rev. Stat. § 63.801(2). The court disagreed and held that the requirement of consent was not equivalent to giving every member the unfettered authority to withhold consent. The right to consent was subject to the express standard of care in the operating agreement and the implied duty of good faith and fair dealing. The court noted that the requirement of unanimous member consent meant that the plaintiffs had to allege facts demonstrating that all of the member defendants refused wrongfully. “[I]f even one of them refused to proceed and had a valid business reason for doing so, the LLCs could not bring legal action against McKenna and Summit.” Bernards, 229 Or. App. at 367-68.
The court concluded that the facts alleged by the plaintiffs were not adequate to demonstrate wrongdoing. Yes, there was a clear right to recover the embezzled funds (one defendant had admitted the embezzlement). Yes, the other members refused to sue when a demand was made. Yes, the other members had not provided an explanation for their refusal. Yes, one member had stated that he would not authorize legal action against McKenna and Summit “no matter how much money they had embezzled.” Bernards, 229 Or. App. at 362. But, said the court, it was not alleged, for example, that the members had refused to provide an explanation, or that they had a personal financial interest in McKenna or Summit, or that they were driven by some personal animus against the plaintiffs. The result was that the court affirmed the trial court’s dismissal of the complaints.
The Bernards opinion is noteworthy not only because it answered an open question under Oregon law, but also because it reasoned by analogy and applied Oregon’s corporate law of derivative actions to LLCs. And the result here was clearly right--why should a minority member be able to sue in the name of the LLC to initiate litigation when the other members have decided that the LLC should abstain, without alleging some facts showing that that there was something wrong with the other members’ decision, such as a conflict of interest? Also noteworthy is that the court applied the business judgment rule, while implicitly recognizing that an LLC’s operating agreement could change the rule for that LLC.
