LLC Law Monitor : Northwest Limited Liability Company Lawyer & Attorney : Doug Batey : Stoel Rives Law Firm : LLC Formation, Tax Liability

Charles McSwain, a 53% member of Hawks Prairie Casino, LLC, a Washington LLC, filed a voluntary Chapter 11 bankruptcy petition in 2007. Hawks Prairie operates a gambling casino in Thurston County, Washington.

Background. The President of Hawks Prairie, Tryna Norberg, knew of McSwain’s bankruptcy filing and continued to treat him as a voting member of the LLC until early 2009, when McSwain called on her to resign and threatened to call a meeting to appoint a new President. Shortly thereafter Hawks Prairie informed McSwain that he was dissociated from the LLC, and after that he received no further member communications from the LLC.

Several months later McSwain filed his plan of reorganization. The plan provided that upon its confirmation by the court, all of McSwain’s rights and interests in the LLC, as they existed immediately prior to the bankruptcy filing, would be automatically reinstated. That would restore his member voting rights and give him majority control of the LLC.

Norberg objected to confirmation on the grounds that full reinstatement of McSwain’s member interest was inconsistent with the LLC’s Operating Agreement and Washington law, and that under Bankruptcy Code Section 365(c)(1) McSwain was precluded from assuming the voting and other management rights of a member. Norberg sought a declaration that McSwain no longer possessed any management rights in the LLC, and that his interests in the LLC were solely those of an assignee, i.e., he had only the right to share in profits, losses, and distributions. Norberg v. Hawks Prairie Casino, LLC (In re McSwain), No. 07-43338, 2011 Bankr. LEXIS 3921, at *2 (Bankr. W.D. Wash. Oct. 6, 2011).

Washington’s LLC Act provides that an LLC member is dissociated, ceases to be a member, and takes on the status of an assignee upon the member’s insolvency or bankruptcy, unless the LLC agreement provides otherwise or the members all consent in writing. RCW 25.15.130(1)(d). (Many other states have similar provisions. E.g., Del. Code Ann. tit. 6, § 18-304.)

The Hawks Prairie Operating Agreement was clear: A member that files a voluntary bankruptcy is dissociated and treated as an assignee rather than as a member, unless all other members consent or 70% of the initial members consent. McSwain, 2011 Bankr. LEXIS 3921, at *7-8. Washington’s LLC Act therefore barred McSwain from being readmitted as a member without the requisite member vote, which was not forthcoming.

Bankruptcy Code. The Bankruptcy Code gives a bankruptcy trustee, or the debtor in possession in a Chapter 11 case (as in McSwain),the authority to assume, assign, or reject the executory contracts of the debtor, subject to several limitations. 11 U.S.C. § 365. The issue before the court was whether Bankruptcy Code Section 365(c)(1) prevented McSwain from assuming all his rights as a member. That section is concise:

(c)        The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if–

(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and

 (B) such party does not consent to such assumption or assignment[.]

11 U.S.C. § 365(c)(1).

The Ninth Circuit has ruled that this section “by its terms bars a debtor in possession from assuming an executory contract without the nondebtor’s consent where applicable law precludes assignment of the contract to a third party.” Perlman v. Catapult Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747, 750 (9th Cir. 1999). (In Catapult, the Ninth Circuit joined the Third and Eleventh Circuits in a circuit split on whether Section 365(c)(1) applies to an assumption by the debtor even if a third-party assignment is not contemplated – Catapult concluding that it does.)

Court’s Analysis. The McSwain court concluded that the LLC’s Operating Agreement was an executory contract, and that applicable nonbankruptcy law, i.e., Washington’s LLC Act, forbids its assignment. The court interpreted Catapult as imposing a third requirement: “assignment must be forbidden [by applicable nonbankruptcy law] because the identity of the nondebtor party is material.” McSwain, 2011 Bankr. LEXIS 3921, at *21. The court went on to say: “It is certainly possible that the identity of Hawks Prairie’s other members is material, such that McSwain could not assume the contract.” Id. at *22.

In the event, though, the court concluded it need not determine whether the identity of the members other than McSwain was material. Instead it decided the case on the grounds of an implied waiver by Norberg. From the beginning Norberg was fully aware of McSwain’s bankruptcy and knew that McSwain could be treated as an assignee under the Operating Agreement. She nonetheless permitted McSwain to exercise all the rights of a full member, including attending management meetings and voting on major transactions. Norberg had sent the members multiple emails, letters, and minutes of meetings that referred to McSwain as a member. The court concluded that by her actions Norberg impliedly waived her right to enforce the Operating Agreement’s dissociation provisions against McSwain. Id. at *24. Under the confirmed plan of reorganization, McSwain was therefore entitled to exercise his full membership rights in the LLC, including voting and management rights. Id. at *30.

Comments. The court’s waiver analysis is unexceptional and clearly seems to be the right result. The court’s discussion in dicta of the applicability of the Catapult rule, however, focuses on the identity of the other members in the LLC, and conjectures that if the LLC had a large number of passive members, their identity would not be material and McSwain would then be able to assume his rights as a member. Id. at *22-23.

Catapult, on the other hand, relied on the policy of the nonbankruptcy law that restricts assignment, not on the degree to which the policy applied to the facts of the specific case. Catapult describes Section 365(c)(1) as stating “a carefully crafted exception to the broad rule – where applicable law does not merely recite a general ban on assignment, but instead more specifically ‘excuses a party … from accepting performance from or rendering performance to an entity’ different from the one with which the party originally contracted, the applicable law prevails…. Only if the law prohibits assignment on the rationale that the identity of the contracting party is material to the agreement will subsection (c)(1) rescue it.” Catapult, 165 F.3d at 752.

The dissociation provisions of the LLC Act fit that description well. They preserve the economic rights of the dissociated member, but prevent the dissociated member from interfering in the management of the LLC. This is consistent with the “know your partner” principle, which is reflected in multiple provisions of most state LLC Acts, such as limitations on assignment and the rules on charging orders.

McSwain reached the right result because of Norberg’s implied waiver. But McSwain’s focus on the specific facts of the LLC and its members, rather than the rationale of the nonbankruptcy law that prohibits assignment, is inconsistent with Catapult and should not be relied on.

Given the increasing use of LLCs in business organizations, it seems likely that disputes over the interaction between Bankruptcy Code Section 365(c)(1) and the dissociation provisions of state LLC Acts will continue to arise as LLC members have occasion to file Chapter 11 bankruptcies. There will be further developments.

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LLC organizers sometimes refer to themselves loosely as “partners” during the preliminary stages of a development project, before they get around to forming their limited liability company, but those words can come back to haunt them. Say, for example, that during the pre-formation phase, one of the organizers signs a contract in his own name, intending that the LLC carry out the contract. The LLC is formed, but then the project doesn’t go forward, the parties fall out, and the organizer that signed the contract can’t pay. In that case the creditor on the contract may seek payment from both the contract signer and the other organizer, on the theory that the organizers were partners and therefore were both liable.

The Lawsuit. That scenario played out in Lentz Engineering, L.C. v. Brown, No. 14-10-00610-CV, 2011 Tex. App. LEXIS 7723 (Tex. App. Sept. 27, 2011). William Wilkins and Alden Brown were planning to purchase and develop a real estate project. Wilkins entered into a contract to purchase the property, and Brown and Wilkins met with an attorney in February 2005 and agreed to form a Texas LLC to carry out the development. In March Brown gave Wilkins $400,000 to purchase the property, and Wilkins acquired the real estate in April. One day later, the attorney filed articles of organization for the LLC, which identified Brown and Wilkins as the LLC’s managers.

During the summer Brown became suspicious of Wilkin’s conduct and attempted to recover his money and obtain title to the property. Meanwhile, Wilkins entered into a contract in his own name with Lentz Engineering for engineering services. Lentz performed its work under the contract but was not paid.

Lentz then sued both Wilkins and Brown for breach of contract. Lentz’s theory was that Wilkins was directly liable on the contract, and that Brown was liable because he was partners with Wilkins and was therefore fully liable for the debts of the partnership. Wilkins defaulted on the lawsuit but Brown defended on the ground that he and Wilkins were not partners.

Judicial Admission. Brown’s first difficulty was self-inflicted. Lentz contended that Brown had judicially admitted in a motion for summary judgment that a partnership existed between Brown and Wilkins. For example, Brown’s motion stated: “Although Wilkins and Brown entered into a partnership to acquire the Manvel property, that partnership was not formed until March 2005.” Brown also made other, similar statements in his motion. Id. at *4-5.

The court dismissed the “judicial admission” contention, because Brown had taken a contrary position in other pleadings and even in the same summary judgment motion. To be considered a judicial admission, a party’s statement must be clear, deliberate, and unequivocal, and Brown’s contradictory statements didn’t satisfy that standard.

Partnership Formation. The court then considered the main argument, i.e., whether Brown and Wilkins had formed a partnership. The Texas statute’s definition of a general partnership is similar to that of most states: an association of two or more persons to carry on a business for profit as owners, regardless of whether the persons intend to create a partnership or whether the association is actually called a “partnership.” Tex. Bus. Orgs. Code Ann. § 152.051(b).

Facts and Circumstances. Whether a partnership exists depends on all the facts and circumstances. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *9. The factors considered in determining if a partnership has been created include:

(a)        sharing of profits of the business;
(b)        sharing of losses or liability for claims;
(c)        contributing or agreeing to contribute money or property to the business;
(d)       participating in control of the business; and
(e)        expressing an intent to be partners in the business.

 Tex. Bus. Orgs. Code Ann. § 152.052. Note that the first three factors – sharing profits, losses, and contributions – are present in almost every LLC. The fourth factor, participating in control, is present in all member-managed LLCs and in some manager-managed LLCs. Only the last factor, expressing an intent to be partners, is not present in an LLC.

The court found uncontroverted evidence of only two of the factors, splitting profits and participating in control of the business. There was contradictory evidence about expressions of intent to be partners. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *12-14.

Going the other way, both Wilkins and Brown expressed their intent to form an LLC, they opened a bank account in the name of the LLC, and the Certificate of Organization for the LLC was filed before the date on which Wilkins signed the contract with Lentz Engineering. Id.

The relative timing of filing the Certificate of Organization and signing the contract seems to have carried extra weight with the court:

Although courts have held promoters of a company may be liable on contracts made by other promoters prior to formation of the company as if the promoters were partners, Lentz has not cited any authority to suggest that liability should be imposed on one promoter because of another promoter's conduct after the formation of the company.

Id. at *15. The court concluded that the evidence did not conclusively establish the existence of a partnership and that the trial court’s finding of no partnership was not against the great weight and preponderance of the evidence. The trial court’s ruling in favor of Brown was affirmed.

Lessons Learned. The substantial overlap between an LLC and the five factors listed in the Texas statute is a little scary. New business organizers who refer to each other as partners, before the LLC is created, may rue the day they used that terminology. They may have already discussed and agreed on the first four factors, and if they introduce each other as partners, the stage is set. If one partner signs a contract before the LLC is formed, and then things fall apart and the LLC is not formed, the organizers may find that as partners they are all jointly and severally liable on the contract.

How to avoid this outcome? Expunge the word “partners” from any description of the organizers. One of the great benefits of LLCs is their limited liability; don’t open the door to personal liability by calling yourselves partners.

Organizers should strive to form the LLC early. Any contracts should not be signed until after the LLC is formed, and then they should be signed in the name of the LLC.

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