Ohio LLC's Incentive Compensation Creates Partnership With Former Employee
Business acquirors sometimes give the acquired company’s management financial incentives to enhance the acquired company’s value. These are often structured as bonus compensation for achieving defined milestones, and sometimes include equity in the acquired company or in the buyer.
In a recent Ohio case the buyer of a company’s assets provided incentive compensation to the company’s management, based on the profits of a division of the company. The employee was later terminated, and claimed the company had entered into a partnership with him and then breached its fiduciary obligations.
Although the contract never referred to a “partnership,” the court held that the incentive compensation provisions created a partnership between the buyer and its employee. Rhodes v. Paragon Molding, Ltd., No. 24491, 2011 Ohio App. LEXIS 3553 (Ohio Ct. App. Aug. 26, 2011). And once the court determined that a partnership existed, the door was opened to the former employee’s claims of breach of fiduciary duty.
Huntin’ Buddy Industries was a seller of turkey and duck calls designed by Roy Rhodes, one of its owners. In 2004 Huntin’ Buddy sold its assets to Paragon Molding, Ltd., an Ohio LLC. As part of the acquisition, Rhodes entered into a five-year employment agreement with Paragon. In the asset sale agreement Rhodes was given profit-sharing rights based on the “Roy Rhodes Championship Call division” (Division).
Fifteen months after the acquisition, Paragon terminated Rhodes’ employment and contended that his profit-sharing rights in the Division were also terminated. Rhodes sued, claiming that the profit-sharing provisions in the asset purchase agreement had created a partnership between Rhodes and either Paragon or its executive officers, and that Paragon and its principal officers had breached their fiduciary obligations to him. The trial court ruled on summary judgment that no such partnership or fiduciary duty existed.
The Court of Appeals first stated the Ohio partnership rule:
A partnership exists when there is (1) an express or implied contract between the parties; (2) the sharing of profits and losses; (3) mutuality of agency; (4) mutuality of control; (5) co‑ownership of the business and of the property used for partnership purposes or acquired with partnership funds.
Id.at **7 (quoting Grendell v. Ohio EPA, 146 Ohio App.3d 1, 764 N.E.2d 1067 (2001)).
The court pointed out that the parties had no express partnership agreement, and then examined the relevant provisions of the Huntin’ Buddy asset purchase agreement. The salient terms were:
1. “Rhodes will maintain 35% of the value of the [Division].”
2. “Should [the Division] be sold, Roy Rhodes will be entitled to 35% of the net purchase price related to the [Division].”
3. “Should [Paragon] be sold as an entirety including [the Division], Roy Rhodes will be entitled to 35% of the net value of the [Division] only.”
4. “Should any profits be distributed from the [Division], Roy Rhodes will be entitled to 35% of said profits after taxes.”
Id.at **10.
The court’s analysis focused on the co-ownership requirement. The agreement did not say that Rhodes “owns” 35% of the Division. But, said the court, the language “Rhodes will maintain 35% of the value” of the Division meant that the parties intended for Rhodes to retain ownership of 35% of the Division. That interpretation was also supported by the clause that Rhodes is entitled to 35% of distributions of Division profits.
There was also a deposition in the case that may have been the final nail in the coffin of Paragon’s argument. One of Paragon’s owners agreed in his testimony that Rhodes “owned thirty-five percent” of the Division. The Court of Appeals noted that “even the owner of Paragon intended for Rhodes to retain a thirty-five percent ownership interest” in the Division. Id. at **12.
So the court found that an implied partnership had been created. “Accordingly, this evidence supports a conclusion that an implied partnership existed between Rhodes and Paragon such that Rhodes was entitled to ownership of thirty-five percent of the company itself, thirty-five percent of any profit distribution instituted by the company, and thirty-five percent of the net profits generated during the sale of the company.” Id. at **12-13.
Partners in a partnership owe each other fiduciary duties, id. at **7-8, and the court found ample evidence in the record to create a genuine issue regarding whether Paragon had breached its fiduciary duties. For example, Paragon purported to strip Rhodes of his 35% interest when it terminated his employment, and Rhodes was excluded from any involvement in or information about the Division. Result: The Court of Appeals reversed the trial court’s summary judgment dismissing Rhodes’ fiduciary duty claims, and sent the case back for a trial on Rhodes’ fiduciary duty claims.
The court didn’t discuss what type of entity Paragon was, so the result presumably would have been the same if Paragon had been a corporation instead of an LLC. But Paragon’s LLC status may have affected the phraseology used by the drafter of the incentive compensation language. The clause on distributions of profits in particular sounded like it could have come from a partnership or LLC operating agreement: “Should any profits be distributed from the [Division], Roy Rhodes will be entitled to 35% of said profits after taxes.” Although this clause does not directly refer to ownership of the Division, it satisfies part of the definition of a partnership and provides additional support for the court’s conclusion.
Kansas Court Broadens Charging Order Against Single-Member LLC
Judgment creditors of LLC members usually have the right under state law to obtain a charging order against a member’s LLC interest. A charging order mandates that any distributions by the LLC that would otherwise be made to the member be paid instead to the creditor. The charging order provides no benefit, though, if no distributions are made to the LLC’s members. And if the judgment debtor is the only member of the LLC, it’s unlikely that he or she will cause the LLC to make distributions, since those would have to go to the creditor.
The U.S. District Court in Kansas recently had to determine the scope of a charging order against a single-member LLC in Meyer v. Christie, No. 07-2230-CM, 2011 U.S. Dist. LEXIS 118590 (D. Kan. Oct. 13, 2011). Although the Kansas LLC Act says a charging order against an LLC member’s interest is the creditor’s exclusive remedy, the court surprisingly found that, in the case of a single-member LLC, the creditor could assert management rights and take control of the LLC.
The relevant facts are straightforward. The plaintiffs obtained a final judgment of about $7 million against the defendants, who had interests in several Kansas LLCs. The plaintiffs asked the judge to issue a charging order against the defendants’ interests in the LLCs, under the authority of Kansas’s LLC Act:
Rights of judgment creditor. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest. This act does not deprive any member of the benefit of any exemption laws applicable to the member’s limited liability company interest. The rights provided by this section to the judgment creditor shall be the sole and exclusive remedy of a judgment creditor with respect to the member’s limited liability company interest.
Kan. Stat. Ann. § 17-76,113 (emphasis added).
A charging order is a limited remedy – the creditor has only the rights of an assignee, i.e., the economic right to receive distributions, and no rights to participate in management. The Kansas statute also provides that the charging order is the exclusive remedy, so the creditor cannot attach or foreclose on the member’s interest and thereby take control. (The charging order provisions of some state LLC Acts are silent on whether the charging order is a creditor’s exclusive remedy. See my discussion of Florida’s Olmstead v. FTC case on charging orders, here.)
The court acknowledged the Kansas LLC Act’s clear statement that the charging order is the only remedy by which a member’s judgment creditor can reach the member’s LLC interest, and discussed the partnership law origins of the LLC charging order. In the case of partnerships, a creditor’s charging order against a partner will not entitle the creditor to participate in the management of the partnership. Meyer, 2011 U.S. Dist. LEXIS 118590, at *10.
But, said the court, the result is different in the case of an LLC with only one member. That’s because of a specific provision in the Kansas LLC Act:
If the assignor of a limited liability company interest is the only member of the limited liability company at the time of the assignment, the assignee shall have the right to participate in the management of the business and affairs of the limited liability company as a member.
Kan. Stat. Ann. § 17-76,112(f). That paragraph is not in the Act’s section on charging orders, but is part of a long section dealing with assignments of LLC interests.
Without discussion, the court simply assumed that the holder of a charging order not only has the rights of an assignee but actually is an assignee. The court then held that under Section § 17-76,112(f), “the assignee/creditor shall have the right to participate in the management of the business and affairs of the LLC as a member.” Meyer, 2011 U.S. Dist. LEXIS 118590, at *11. With those rights, the holder of a charging order against an LLC’s sole member can take over the LLC, make distributions to itself, and liquidate the LLC if it so chooses.
The problem with the court’s holding is that the 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. An assignment, in contrast, is a permanent transfer of the property rights assigned. The charging order statute accordingly recognizes that the rights of the creditor are limited: “To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest.” Kan. Stat. Ann. § 17-76,113 (emphasis added). The Meyer court ignored the inherent limitations of charging orders. Its confusion between the limited economic rights granted under a charging order and the full transfer of rights granted under a true assignment led it to the wrong result.
Some states have added provisions to their LLC Acts to clarify this point and avoid a Meyer result. Thomas Rutledge recently blogged about the Meyer case, here, and pointed out that Kentucky has amended its LLC Act to provide that “[a] charging order does not of itself constitute an assignment of the [LLC] interest.” Ky. Rev. Stat. § 275.260(3).
Michigan similarly provides in its LLC Act that a charging order is not an assignment of the member’s interest, and that the holder of a charging order does not become a member of the LLC. Mich. Comp. Laws § 450.4507.
One recent publication that is a useful reference for investigating state LLC charging order laws is Carter G. Bishop, Fifty State Series: LLC Charging Order Statutes , Suffolk University Law School Research Paper No. 10-03 (Oct. 6, 2011) .
