Manager Has Authority to Bind Oregon LLC Even With a Known Conflict of Interest
When an LLC manager signs a contract on behalf of the LLC there is usually no question whether the LLC is bound by the manager’s signature. But consider – what’s the result when the manager is an investor and an officer of the other party to the contract, and the LLC members disapprove of the contract and attempt to reject it on grounds that the manager lacked authority to enter into the contract because of the manager’s conflict of interest? The Oregon Court of Appeals was faced with this scenario in Synectic Ventures I, LLC v. EVI Corp., No. A139879, 2011 Ore. App. LEXIS 337 (Or. Ct. App. Mar. 16, 2011).
The Loan. Three LLC investment funds (Synectic) loaned $3 million to EVI Corporation pursuant to a 2003 loan agreement. The loan agreement called for repayment by December 31, 2004, but EVI had the right to convert the debt into equity in the form of EVI stock if it received additional investments of at least $1 million before the December 31 deadline.
Conflict of Interest. The Synectic LLCs were managed by Craig Berkman, at first directly and later through management firms he controlled. Berkman was involved with both parties to the loan. In addition to being Synectic’s manager, Berkman was also the board chairman and treasurer of EVI, and held EVI warrants and stock options.
Amendment. In September 2004, as the year-end due date of the loan approached, Berkman executed an amendment to the loan agreement on behalf of Synectic that extended EVI’s repayment date one year, to December 31, 2005. Berkman also approved the amendment in his capacity as an EVI board member. The Synectic members were unaware of the amendment at the time it was made. Berkman was removed as manager in December 2004, and in 2005 Synectic learned of the amendment and notified EVI that the amendment was not authorized and that EVI was in default on the loan.
EVI raised $1 million in additional investment before December 31, 2005 and converted the loan into equity, thereby avoiding default (if the amendment was binding on Synectic).
Synectic sued EVI to collect on the loan, and EVI defended on grounds that it was not in default under the amended loan. The trial court concluded that the amendment was valid and binding on Synectic and that EVI was therefore not in default.
Authority. The Court of Appeals began with a look at Or. Rev. Stat. § 63.140(2)(a), which provides in part:
Each manager is an agent of the limited liability company for the purpose of its business, and an act of a manager, including the signing of an instrument in the limited liability company's name, for apparently carrying on in the ordinary course the business of the limited liability company, or business of the kind carried on by the limited liability company, binds the limited liability company unless the manager had no authority to act for the limited liability company in the particular matter and the person with whom the manager was dealing knew or had notice that the manager lacked authority.
This section provides for the manager’s apparent authority in the ordinary course of the LLC’s business. Many state LLC acts have similar provisions for managers and members (if the LLC is member managed), e.g., Washington, Utah, and New York. Both the Uniform Partnership Act and the Uniform Limited Partnership Act have similar provisions for the apparent authority of general partners.
Under Or. Rev. Stat. § 63.140(2)(a), if the manager has no authority and the third party has knowledge of the lack of authority, the principal will not be bound. The court therefore reviewed Synectic’s operating agreements to determine Berkman’s authority, and concluded that the agreements gave Berkman the exclusive authority to manage the business of the LLCs and to take action without the consent of the members. The operating agreements also provided that third parties could rely on Berkman’s authority to bind the LLCs without further inquiry. Synectic, 2011 Ore. App. LEXIS 337, at *12-13. Under these provisions it appeared to the court that the amendment was within the authority granted to Berkman in the operating agreements: “As such, at first blush it would appear that Berkman’s act of executing the amendment was within the express authority granted to him in the operating agreements.” Id.
Synectic argued that Berkman’s actual authority was limited by letter agreements Berkman had entered into with some of Synectic’s investors, and by his acts of self-dealing and breach of fiduciary duties. Id. at *13.
The court held that the letter agreements did not limit Berkman’s authority because they were between Berkman and some of the Synectic members, but not with Synectic. If the letter agreements obligated Berkman to those members, any breach was between him and them and did not affect his authority to act for Synectic. Id. at *17.
Fiduciary Duties. Synectic’s operating agreements obligated Berkman to carry out his duties in accordance with the standard of conduct specified for LLC managers in the Oregon LLC Act, which includes the duty of care and the duty of loyalty. Or. Rev. Stat. § 63.155. Synectic contended that Berkman’s breaches of those duties without member approval invalidated his execution of the amendment. But before the court considered whether Berkman had breached his fiduciary duties, it examined whether the remedy requested by Synectic would be available even if Berkman had breached his duty.
The court concluded that the language of Or. Rev. Stat. § 63.140(2)(a) controlled: the act of a manager binds the LLC “unless the manager had no authority to act for the limited liability company in the particular matter and the person with whom the manager was dealing knew or had notice that the manager lacked authority.” Berkman had the express authority under the operating agreements to enter into the amendment. Synectic took no action to limit his authority, and the loan extension was within the ordinary course of the LLC’s business. Even if knowledge of Berkman’s self-dealing were imputed to EVI, any inquiry by EVI would only have led to the conclusion that Berkman had authority to execute the amendment. Synectic, 2011 Ore. App. LEXIS 337, at *23-24.
In short, Berkman had actual, unqualified authority under the operating agreements, and his act of executing the amendment therefore was binding on Synectic even if it was a breach of his fiduciary duties.
Conflict of Interest. Synectic also pointed out that under Or. Rev. Stat. § 130(2)-(4), a transaction involving an actual or a potential conflict of interest between a member or a manager and the LLC requires the consent of a majority of the members, unless the operating agreement provides otherwise. The Synectic operating agreements clearly allowed members to have conflicts of interest, but said nothing about actual or potential manager conflicts.
Strangely enough, the court found that Berkman’s alleged conflict between his role as Synectic’s LLC manager and his role as EVI’s board member and treasurer was excused by the Synectic operating agreements. While it is correct that Berkman was a member, Synectic’s allegation was that Berkman had a conflict because of his status as a manager, not as a member.
The court’s opinion says not a word about why the operating agreements’ waivers of member conflicts should apply to Berkman in his capacity as manager. Berkman was acting as Synectic’s manager when he signed the amendment, not as a member. For an operating agreement to allow members to have a conflict of interest is a far cry from allowing a manager to have a conflict of interest – non-managing members are passive and don’t make the management decisions that could be affected by a conflict of interest. Synectic may still be trying to puzzle this one out.
More States Are Considering Low-Profit LLCs
At least 10 state legislatures are considering bills to authorize low-profit limited liability companies (L3Cs) – all introduced in the last two and a half months:
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Arizona; Senate Bill No. 1503 |
Arkansas; Senate Bill No. 5 |
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Hawaii; Senate Bill No. 674 |
Indiana; Senate Bill No. 501 |
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Kentucky; House Bill No. 110 |
Maryland; House Bill No. 552 |
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Montana; House Bill No. 415 |
New York; Senate Bill No. 3011 |
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Oregon; House Bill No. 2745 |
Rhode Island; Senate Bill No. 353 |
These have the potential to more than double the number of states that authorize L3Cs. Currently eight states have authorized L3Cs: Illinois, Louisiana, Maine (effective July 1, 2011), Michigan, North Carolina, Utah, Vermont, and Wyoming.
The L3C is a relatively new type of limited liability company, a hybrid which attempts to combine a charitable purpose with a profit-making motive. An L3C is not a nonprofit and is taxed on its profits like any other LLC. I have previously written about L3Cs, here.
Advocates of L3Cs suggest they will encourage investment by private foundations in L3C enterprises. Typical program-related investments (PRIs) made by private foundations in either for-profit or tax-exempt enterprises include equity investments and loans, on terms more favorable to the recipient than a market rate investment. The purpose of the investment must be to support the foundation’s charitable purpose. L3Cs are promoted as facilitating increased investment by private foundations, because the state statutes apply to L3Cs the Internal Revenue Code requirements for the recipient of a PRI made by a private foundation. IRC § 4944(c). The idea is that because L3Cs automatically apply those standards to L3Cs, private foundations will be more willing to invest in L3Cs.
L3Cs have generated a lot of interest in the non-profit and social enterprise community, and a fair amount of commentary is becoming available. The Vermont Law Review sponsored a symposium on L3Cs and other developments in social entrepreneurship in February 2010. (Vermont was the first state to authorize L3Cs.) Articles related to the Symposium were published in a symposium edition of the Vermont Law Review, Symposium, Corporate Creativity: The Vermont L3C and Other Developments in Social Entrepreneurship, 35 Vt. L. Rev. 1 (2010).
Two articles in the symposium edition caught my eye. The first was Program-Related Investments in Practice, 35 Vt. L. Rev. 53 (2010), by Luther M. Ragin, Jr., Chief Investment officer of the F. B. Heron Foundation. Heron has been an active PRI maker since 1997, and at the end of 2009 had $21 million in outstanding PRIs, in 38 separate transactions. Heron’s PRIs were made to a variety of organizations. Most were to non-profits, but 10 were equity or subordinated debt investments in limited partnerships, LLCs, and corporations.
The critical driver for Heron is not the legal form of the organization seeking capital. Heron has found that it can apply the PRI rules and reach positive decisions on PRIs to various types of for-profit entities as well as non-profits, provided the PRI serves a charitable purpose. (The two other PRI tests – no lobbying, and income from the PRI not being a significant purpose of the foundation’s decision to make the investment – must also be satisfied.)
The other article in the Symposium edition that jumped out was The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 275 (2010), by J. William Callison and Allan W. Vestal. The article nicely reviews the law of private foundations and PRIs. It then examines the L3C requirements of the state LLC laws and how they attempt to match the PRI requirements. The article concludes that the statutory form does not match well with the PRI requirements and that private foundations will still need to conduct the same due diligence they would conduct before making a PRI to a non-L3C entity.
The experience of the F. B. Heron Foundation buttresses Callison and Vestal’s analysis. The type of entity, and whether it is a for-profit or a non-profit, play little part in Heron’s decisions about making PRIs.
The article concludes with a discussion of why L3Cs are considered harmful. First, smaller, less well-advised foundations may unduly rely on the L3C status of the recipient when making a PRI rather than on their usual due diligence, resulting in non-compliance with tax requirements and possibly endangering the foundation’s charitable status. Second, in an L3C with profit-seeking participants, where the foundation makes a high-risk, low-return investment vis-à-vis the other investors, there is risk that the foundation may run afoul of the “private benefit” doctrine, which is intended to prevent tax-exempt organizations from conferring private benefit on private participants.
Callison and Vestal’s conclusion is succinct: without changes to federal PRI rules there is little or no value to the L3C structure, the existence of the L3C form is a dangerous trap for the unwary, and the form should be shelved.
The article makes a strong case for the states to stop adopting the L3C form, and for the states that currently authorize the L3C form to revise their LLC laws to delete the L3C authorizations.
Will careful legal analysis and commentary take the wind out of the sails of the L3C movement? It’s hard to say. Popular enthusiasms and fads take on a life of their own. And one of the drivers of the L3C movement is the laudable goal of increasing the flow of private foundation money to ventures with charitable purposes. But that goal appears to be blinding the L3C promoters and some state legislators to the legal realities – L3Cs don’t and won’t accomplish that goal unless and until the federal tax rules are changed, which appears unlikely.
Bill Callison on Olmstead v. FTC and Charging Order Exclusivity
Bill Callison’s article, Charging Order Exclusivity: A Pragmatic Approach to Olmstead v. Federal Trade Commission, recently came out on SSRN and should be available soon in Volume 66 of The Business Lawyer. Callison’s article reviews the Olmstead court’s analysis of charging orders for single-member LLCs and suggests how the court should analyze charging orders for multi-member LLCs.
Background. In Olmstead the FTC won a judgment against Olmstead, and then obtained an order allowing it to execute on Olmstead’s member interest in his single-member Florida LLC, including his right to vote and control the LLC. Olmstead v. FTC, 44 So. 3d 76 (Fla. 2010). By executing on all of Olmstead’s member rights, the FTC could cause the LLC to make distributions, liquidate the LLC, or take other actions.
Florida’s LLC Act gives a judgment creditor of an LLC member the right to obtain a charging order against the member’s LLC interest. Olmstead contended that the charging order remedy was exclusive and provided the only way for a judgment creditor to reach the member-debtor’s interest in the LLC.
A charging order requires that any LLC distributions payable to the member be paid instead to the creditor. Fla. Stat. § 608.433(4). A charging order does not require the LLC to make any specific distributions, so if the FTC were limited to having a charging order, it might not receive distributions or any other value from Olmstead’s rights in the LLC for a very long time. Very, very long.
Olmstead Decision. The Florida Supreme Court pointed out that the LLC Act’s charging order provision was nonexclusive on its face, and ruled that the FTC could execute on Olmstead’s full member interest. “[W]e hold that a court may order a judgment debtor to surrender all right, title, and interest in the debtor’s single-member LLC to satisfy an outstanding judgment.” Olmstead, 44 So. 3d at 83.
The Olmstead decision has received a lot of attention. It reduces the asset-protection usefulness of single-member LLCs, and it is from the highest court of a populous state with large centers of commerce. And many states have LLC acts with charging order provisions that, like Florida’s, lack exclusivity language. E.g., Wash. Rev. Code § 25-15-255; N.Y. Ltd. Liab. Co. Law § 607 (McKinney 2007).
As Callison points out, Olmstead leaves several questions unanswered. Is the court’s holding limited to single-member LLCs, i.e., would the result have been the same if Olmstead’s LLC had other members? How is “single member” interpreted? For example, should an LLC with two spouses as the only members be treated as a single member LLC? If the Olmstead result applies to multiple-member LLCs, to what extent can the members’ operating agreement limit the rules that would otherwise apply to a judgment creditor’s rights?
The Olmstead court saw the charging order as a special remedy, responsive to the basic principle of Section 608.433(1): “Unless otherwise provided in the articles of organization or operating agreement, an assignee of a limited liability company interest may become a member only if all members other than the member assigning the interest consent.” This is the “pick-your-partner” principle, which is integral to partnership and limited partnership law and is a part of most partnership and limited partnership statutes. But because in a single-member LLC no other member’s consent is necessary to admit an assignee as a member, the court saw no need for the charging order to be the only remedy available to the judgment creditor.
The court also examined Florida’s general and limited partnership statutes. Both expressly provide that the charging order on a partnership interest is the judgment creditor’s exclusive remedy. Fla. Stat. §§ 620.8504, § 620.1703. As a matter of statutory interpretation, the presence of exclusivity in the partnership charging order statutes and the lack of such a provision in the LLC Act supported the conclusion that the LLC charging order was not intended by the legislature to be exclusive. Olmstead, 44 So. 3d at 82.
Extrapolation. How should the Florida court rule when a charging order case involves a multi-member LLC? Callison notes that the default rules of Florida’s LLC Act include pick-your-partner principles, and concludes that there should be a rebuttable presumption that charging orders are exclusive. Callison, supra, at 12. He proposes that in single-member LLCs, and in multiple-member LLCs whose operating agreement allows complete transferability of interests, the presumption would be overcome and the charging order would not be the exclusive creditor’s remedy. Id. at 12-13.
Callison also proposes a similar rebuttable presumption for incorporation into LLC statutes, using statutory language such as:
Charging orders are the exclusive remedy by which a member’s judgment creditors can reach the member’s interests in the company; provided, however, that if the judgment creditor can demonstrate that all or any part of the member’s interest in the company can be assigned by the member to a third party without the other members’ consent, then the charging order shall not be an exclusive remedy with respect to such freely assignable interest.
Id. at 20. This is an interesting approach – an attempt to pragmatically balance the policies of implementing “pick your partner” principles against the goal of providing judgment creditors with reasonable remedies.
