Deadlocked Manager and Deadlocked Members Plus Threatened Irreparable Harm Equals Judicial Dissolution of Solvent LLC
The LLC in In re Metcalf Associates-2000, L.L.C. v. Chambers, 213 P.3d 751 (Kan. Ct. App. 2009), owned real estate encumbered by a loan that was coming due in the near future. The real estate needed to be sold or the loan refinanced, but the LLC’s manager could not act because it was deadlocked internally. The owners of the two 50% voting blocks in the LLC were deadlocked and could not agree on a course of action. Because the LLC was in effect frozen, one group of owners petitioned the court for the dissolution of the LLC and the sale of the real estate. The Kansas Court of Appeals upheld the trial court’s order for dissolution of the LLC.
Many state LLC statutes provide for judicially ordered dissolution if it is not reasonably practicable to carry on the LLC’s business in conformity with the LLC’s operating agreement. E.g., Del. Code Ann. tit. 6, § 18-802. Washington’s LLC Act is similar, but adds “or other circumstances render dissolution equitable.” Wash. Rev. Code § 25.15.275. These statutes emphasize the role of the operating agreement in evaluating whether judicially ordered dissolution is appropriate.
The Kansas statute, by contrast, uses an “irreparable injury” test. Any member owning at least 25% of the outstanding interests in the LLC’s capital or profits and losses may petition the court for dissolution and sale of the LLC’s assets
[i]f the business of the limited liability company is suffering or is threatened with irreparable injury because the members of a limited liability company, or the managers of a limited liability company having more than one manager, are so deadlocked respecting the management of the affairs of the limited liability company that the requisite vote for action cannot be obtained and the members are unable to terminate such deadlock ….
Kan. Stat. Ann. § 17-76,117(b). The approach of the Kansas statute, with its emphasis on deadlock and irreparable injury, comes straight out of the corporate statutes. E.g., Wash. Rev. Code § 23B.14.300(2)(a); Model Bus. Corp. Act § 14.30(2)(i) (2008).
The defendant Michael Chambers argued that a unanimity provision in the LLC’s operating agreement precluded a finding of deadlock. Chambers argued that (a) the LLC’s purpose was to buy office buildings and sell them for a profit; (b) the operating agreement required the unanimous agreement of the members to sell the LLC’s real estate; and (c) therefore there could not be a deadlock because the members had not fulfilled the requirement for unanimous agreement that it was time to sell.
The court, however, recognized that there was a fundamental dispute between Chambers and Patrick Hayes (who controlled the other 50% of the LLC). Hayes wanted to sell the building in a short period of time, and Chambers wanted to acquire the building for himself at a price substantially below its fair market value. The court opined that the LLC’s operating agreement could have been drafted to specifically limit the situations in which the court could declare a deadlock, but held that the unanimity requirement did not preclude a finding of deadlock and application of the statutory remedy for deadlock. Metcalf, 213 P.3d at 757-58.
Chambers also argued that the LLC was not facing irreparable harm because it was a solvent, profitable company with substantial rental income. But the court noted that the LLC had no management because its sole manager was itself deadlocked, and the LLC had no way to sell or refinance its real estate because of the members’ deadlock. The statute allows for judicial dissolution when the LLC is suffering or is threatened with irreparable injury. “By including both the actual suffering of irreparable injury and the mere threat of that injury, the legislature has implicitly rejected Chambers’ argument that a company can’t be dissolved so long as it’s still solvent.” Id. at 759.
So is there any difference in outcome between the approach of the Kansas statute (deadlock plus actual or threatened irreparable harm) and that of the Delaware statute (not reasonably practicable to carry on the LLC’s business in conformity with the LLC’s operating agreement)? The Delaware approach looks to the expectations of the parties under the LLC’s operating agreement, while the Kansas test is independent of the operating agreement. Also, the Delaware approach does not require either deadlock or irreparable harm in order for dissolution to result. All that Delaware requires is that it not be reasonably practicable to carry on the LLC’s business in conformity with the LLC’s operating agreement. The cause is not specified, although in many cases it is likely to be a deadlock between the members.
In Metcalf, the result would likely have been the same under the Delaware statute, since it’s hard to see how the LLC’s business could have been carried on in any manner, let alone in conformity with the operating agreement.
An LLC's Property Is Not the Members' Property
A recent New York case dealt with one of the most fundamental characteristic of LLCs – the LLC as a legal entity. Sealy v. Clifton, LLC, 890 N.Y.S.2d 598, 2009 N.Y.App. Div. LEXIS 9020 (N.Y.App.Div. 2009). One of two LLC members, each owning a 50% interest, asked the trial court to partition the LLC’s real estate. In a partition action, real estate held by joint tenants or tenants in common is divided into portions so that each co-owner is awarded full, individual ownership of a portion of the real estate. The trial court refused to dismiss the partition action, but the Appellate Division reversed and required dismissal by the trial court.
Under state LLC laws, an LLC is a legal entity, in effect a legal person. An LLC can sue and be sued, own property, enter into contracts, and do many of the things that an individual human being can do. E.g. N.Y. Ltd. Liab. Co. Law §§ 203(d), 202.
Since an LLC is a legal person, the property it owns is the property of the LLC, not of the members. The New York LLC Act is clear: “A membership interest in the limited liability company is personal property. A member has no interest in specific property of the limited liability company.” N.Y. Ltd. Liab. Co. Law § 601. Other state LLC laws have similar provisions.
Relying on Section 601, the Sealy court held that the LLC, not its members, owned the real estate. Because the members were not co-owners of the real estate, the partition action had to be dismissed. Sealy, 2009 N.Y.App. Div. LEXIS 9020, at *1. Prior New York law allowed partition actions to be brought only by co-owners.
Perhaps the reasoning of the Sealy plaintiff was: “I am a part owner of the LLC; the LLC owns the real estate, therefore I am a part owner of the real estate.” In other words, something like “I own the box, ergo I own what’s inside the box.” The analogy is not apt, but perhaps it convinced the trial judge, since he refused to throw out the partition request.
That theory breaks down because an LLC is a legal entity, a legal person. The real estate in Sealy was owned by the LLC, not by the members. The only way a member could reach the real estate would be to cause the dissolution and winding up of the LLC. In that process either the real estate would be liquidated and its proceeds distributed to the members, or the real estate could be divided by the LLC and the individual parcels of the real estate distributed in kind to the members. But the member apparently had not pursued dissolution.
The legal personhood of LLCs, like that of corporations, partnerships and other entities, is a legal doctrine thoroughly woven into our legal, business, financial and political systems. It allows the law to treat LLCs as persons for many purposes – but not all. For example, LLCs cannot marry, adopt children, hold public office, or vote in public elections.
Some constitutional rights apply to legal entities. For example, the U.S. Supreme Court last month invalidated a federal ban on corporate expenditures for public communications intended to affect federal elections. The Court held that the First Amendment’s mandate that “Congress shall make no law … abridging the freedom of speech” applies to corporations. Citizens United v. Fed. Election Comm’n, 175 L. Ed. 2d 753 (2010). The Court’s opinion saw corporations as entitled to be heard in the political arena, like individuals. This was a controversial five-to-four decision that overruled prior Supreme Court precedent.
The boundaries of the legal doctrine that treats corporations and LLCs as persons will continue to be mapped and delineated. And as in Citizens United, the boundary may shift from time to time.
LLC's Creditors Have Standing to Sue Members for Unlawful Distributions
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
