New York Court Orders Dissolution of LLC - Recharacterizes Capital Contributions as Loans to Reach Equitable Result
An involuntary dissolution case was decided by the New York Supreme Court (the trial court) two weeks ago, on a petition for dissolution by one of the two members of a limited liability company. Mizrahi v. Cohen, No. 3865/10, 2012 WL 104775 (N.Y. Sup. Ct. Jan. 12, 2012).
Background. Mizrahi and Cohen’s LLC owned a four-story commercial office building, with the ground floor rented by Cohen’s optometry business and the second floor rented by Mizrahi’s dental practice. The LLC consistently operated at a loss from 2006, the first year the building was occupied. The losses were covered by the members’ periodic capital contributions, although the LLC’s operating agreement didn’t require any additional capital contributions after the initial contributions. The two members each had a 50% ownership interest in the LLC, and initially they contributed additional capital in equal amounts. After a few years, however, Cohen’s capital contributions became sporadic and Mizrahi contributed most of the capital necessary to keep the LLC from defaulting on its mortgage. Over a span of several years Mizrahi contributed approximately $900,000 more than Cohen.
Mizrahi sued for dissolution of the LLC and an accounting of the proceeds of the company. The New York LLC Act uses the familiar standard for judicial dissolution: “it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” N.Y. Ltd. Liab. Co. Law § 702. (Washington and Delaware, for example, have similar provisions in their LLC statutes. RCW 25.15.275; Del. Code Ann. tit. 6, § 18-802.)
The Appellate Division held in 2010 that Section 702 requires that for dissolution to be ordered, the petitioner must show, “in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.” In re 1545 Ocean Ave., LLC, 72 A.D.3d 121, 131, 893 N.Y.S.2d 590 (N.Y. 2010).
Dissolution. The gist of the court’s analysis was that continuing the LLC was financially unfeasible because of (a) the significant losses incurred over the years, (b) Cohen’s failure to contribute equally in meeting the losses and his undermining the financial integrity of the LLC by unilaterally withdrawing $230,000 of his capital, and (c) the likelihood that it was only a matter of time, should Mizrahi exercise his right to refrain from making further capital contributions, until the LLC would default on its mortgage and the mortgage be foreclosed upon. Mizrahi, 2012 WL 104775, at *8.
The facts of the case and the court’s analysis are ably described in more detail by Peter Mahler in his New York Business Divorce law blog, here.
Accounting and Winding Up. Having determined that the LLC would be dissolved, the court discussed the accounting procedures to be followed and the winding up and distribution requirements of the LLC’s operating agreement. The operating agreement required that after payment to the LLC’s creditors and satisfaction of its liabilities, any remaining assets would be distributed to the members “according to their ownership interests,” i.e., 50% to each. There was no provision for returning a member’s capital, apparently on the assumption that the members would contribute capital in equal amounts, thus maintaining the 50/50 ratio for contributions as well as for their ownership interests.
But as it turned out, Mizrahi had contributed $900,000 more than Cohen. Ignoring that fact in the final 50/50 distribution would be consistent with the operating agreement but manifestly unfair. “[C]rediting the sums advanced by plaintiff to his capital account would work an inequitable result in that the Operating Agreement prevents the return of a Capital Contribution.” Id. at *11.
The court therefore ordered that Mizrahi’s capital contributions in excess of the amount of Cohen’s capital contributions would be treated as a loan to the LLC, to be repaid to Mizrahi as a debt of the LLC prior to the distributions to the members based on their 50/50 percentage of ownership. Id.
The court also ordered that Cohen’s $230,000 withdrawal from the LLC, whether treated as a loan or a capital withdrawal, would be applied to reduce the amount of any distribution to Cohen. Id. at *9.
The court’s resolutions of these two issues are clearly equitable and fair, but it is striking that the court gives no explanation or authority for either, other than its passing reference to avoiding an “inequitable” result. Trial courts have broad equitable powers, but one would have expected at least some citations to authority for the court’s application of those powers.
Look Beyond Washington LLC Law Before Attempting to Attach an Unasserted Claim of a Foreign LLC in Washington
Note: The following post is authored by guest blogger John Laney.
My colleague, Doug Batey, has previously blogged about the ability of dissolved Washington LLCs to both initiate and defend against lawsuits.[1] These blog entries track the development of Washington law in this area leading up to the Washington Legislature’s enactment of Wash. Rev. Code § 25.15.303. With respect to LLCs formed in Washington, Wash. Rev. Code § 25.15.303 expressly bars all claims by or against the LLC, its managers or its members unless filed within three years following the filing of a certificate of dissolution with the Washington Secretary of State. If no certificate of dissolution is filed, then claims by or against the Washington LLC or its managers or members are not time-limited, except by any applicable statutes of limitations. It is important to note that not all states have passed legislation like Wash. Rev. Code § 25.15.303. Moreover, a recent opinion from the Washington Court of Appeals reminds us that the laws of an LLC’s home state govern its ability to initiate or defend lawsuits after dissolution and termination. Berschauer Phillips Constr. Co. v. Concrete Sci. Serv. of Seattle, LLC,Nos. 64812-8-I, 65012-2-I, 2011 Wash. App. LEXIS 726 (Wash. Ct. App. Mar. 28, 2011) (unpublished).
In March 2004, Berschauer Phillips Construction Co., a Washington corporation (“BPCC”), sued Concrete Science Services of Seattle, LLC, a Minnesota limited liability company (“CSS”), approximately six months after CSS filed a notice of dissolution and articles of termination with the Minnesota Secretary of State and after the Minnesota Secretary of State issued a certification of termination. CSS failed to appear to defend itself; however, even if CSS had appeared to defend itself, the fact that CSS had been terminated would not have had any effect because the Minnesota Limited Liability Company Act (Minn. Stat. ch. 322B, the “Minnesota LLC Act”) allows claims to be asserted against an LLC for two years after the LLC files a notice of dissolution. Minn. Stat. § 322B.82, Subd. 3. BPCC obtained a default judgment against CSS in August 2005.
Not surprisingly, CSS did not have any readily identifiable assets with which to satisfy the judgment. However, CSS had purchased insurance but never tendered the BPCC claim to the insurer. Instead, in September 2005, approximately two years after CSS’s existence was terminated, BPCC notified CSS’s insurer of the claim and demanded payment. Instead of paying the claim, CSS’s insurer retained counsel to represent CSS. The attorneys waited an additional 10 months before filing a motion to vacate the default judgment. Not surprisingly, the motion was denied on the grounds that it was not brought within a reasonable period of time. Nonetheless, CSS’s insurers never paid BPCC.
In October 2008, approximately five years after CSS’s existence was terminated, BPCC filed a separate lawsuit to attach CSS’s claims against third parties. BPCC’s complaint, as amended in July 2009 (approximately five years and nine months after CSS’s existence was terminated), sued to attach CSS’s property including its potential claims against (i) CSS’s insurer for failing to reasonably respond to the default judgment; (ii) CSS’s attorneys for committing malpractice by failing to address the default judgment in a timely fashion and putting the interests of the insurer above those of CSS; and (iii) CSS’s president and one of its members for failing to timely tender claims to the insurer and failing to cooperate with CSS’s insurer and attorneys to resist the default judgment.
In December 2009, the King County Superior Court issued three writs of execution on the CSS’s potential claims against third parties (the “choses in action”). CSS filed a motion in King County Superior Court to quash the writs of execution on two grounds. First, the choses in action are too contingent to be considered property. Second, even if the choses in action could be considered property, CSS did not acquire the choses in action, because they only came into existence after CSS lost the ability to initiate lawsuits against third parties. Therefore, CSS had no property that could be attached. The trial court agreed on both counts and quashed the writs of execution. On appeal, the trial court was affirmed on both counts. In this blog, I will only discuss the second issue as it pertains to LLC law.
The Washington court treated the choses of action as property and found that the case turned on the question of whether a Minnesota LLC could acquire property after termination. The ability of an LLC to acquire property is a right related to the LLC’s organization and internal affairs. Under Wash. Rev. Code § 25.15.310(1)(a),
[t]he laws of the state, territory, possession, or other jurisdiction or country under which a foreign limited liability company is organized govern its organization and internal affairs and the liability of its members and managers[.]
Therefore, the court applied the Minnesota LLC Act to this case because CSS (despite having “Seattle” in its name) was formed in Minnesota under the Minnesota LLC Act. The Minnesota LLC Act does not indicate that an LLC can acquire property subsequent to its termination. Instead, Minn. Stat. § 322B.03, Subd. 48 states that termination is “the end of a limited liability company’s existence as a legal entity.” The court interpreted this language to mean that a Minnesota LLC cannot acquire property subsequent to its termination. Therefore, even though Minn. Stat. § 322B.82, Subd. 3 allows a Minnesota LLC to defend lawsuits for two years after filing its notice of dissolution, the Minnesota LLC Act does not expressly provide a right for terminated LLCs to initiate claims within the same time period. Therefore, BPCC was denied its writ of execution on CSS’s nonexistent property interests in the choses of action.
Unfortunately, the Berschauer court does not address Minn. Stat. § 322B.866, which states:
After a limited liability company has been terminated, any of its former managers, governors, or members may assert or defend, in the name of the limited liability company, any claim by or against the limited liability company.
This statute was addressed in the parties’ briefing of this case, but the court ignored it in its opinion. If, under the Minnesota statute, former managers, governors or members of an LLC have the ability to prosecute claims “in the name of the limited liability company,” then who has the property interest in any recovery from a successful lawsuit? Furthermore, is Minn. Stat. § 322B.866 limited to claims that ripened prior to termination of the LLC? The statute is unclear as it does not place any time limit on a LLC’s former managers’, governors’ or members’ ability to file claims on behalf of the LLC.
Even if CSS were a Washington LLC, I believe that BPCC would be out of luck for a different reason. If CSS were a Washington LLC, it probably would have accrued a property interest in the choses of action because the choses of action probably accrued sometime before July 2006, when CSS’s counsel finally filed the motion to vacate the default judgment, within three years after CSS filed its notice of dissolution in September 2003. However, under Wash. Rev. Code § 25.15.303, if CSS were a Washington LLC, its property interest in the choses of action would have disappeared in September 2006 (three years after filing its notice of dissolution). As BPCC did not attempt to execute its judgment upon the choses of action until October 2008, roughly five years after CSS filed its notice of dissolution and two years after CSS would have lost its property rights in the choses of action, the differences in LLC law probably did not lead to an ultimate difference in the outcome of this case.
Nonetheless, this case should serve as a word of caution for parties in Washington dealing with foreign LLCs. I have three main takeaways from this case:
First, always identify the home state for any LLC that you are contracting with. This makes sound practical sense because there can be different LLCs formed in different states with the same name. Also, do not assume that the LLC’s name is an indication of where it was formed. As evidenced by Berscahuer, the home state of an LLC can have nothing to do with the geographic location used in the LLC’s name.
Second, as I described above, when dealing with foreign LLCs, you must be aware that the laws of the jurisdiction under which the foreign LLC is organized may be different from Washington law in meaningful ways. Each state’s LLC act, even if based on a model act, is unique. Not all state legislatures have acted to prevent the harsh outcome that Doug has previously discussed in relation to Chadwick Farms Owners Association v. FHC LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009). See Doug Batey, Washington Supreme Court: LLC Can Terminate All Lawsuits by Filing Certificate of Cancellation – Personal Liability for Improper Winding Up, supra. Moreover, in Berschauer,the presence of insurance did nothing for BPCC because at termination CSS itself lost its ability to sue its insurer. You should consider any limitations on liability imposed by the foreign state’s LLC act to determine if alternative security or guarantees are necessary.
Third, and last, when looking at the foreign LLC act, look for any ability to reopen the affairs of a terminated LLC. This may also require a separate action to be filed in the LLC’s home state becauseit is a matter for the judiciary in the home state to rule on a cause of action to “reopen the affairs of a terminated LLC and declare the LLC to be the owner of an asset.” Berschauer, 2011 Wash. App. LEXIS 726, at *10-11.
[1] Doug Batey, Washington Dismisses Lawsuit by Cancelled LLC and Denies Award of Attorneys Fees to Defendant (Dec. 13, 2010), Straightening Out Kinks in Washington’s LLC Law (Apr. 9. 2010), Washington Supreme Court: LLC Can Terminate All Lawsuits by Filing Certificate of Cancellation – Personal Liability for Improper Winding Up (May 29, 2009), LLC Law Monitor.
LLC's Nevada Lawsuit Almost Ended by Failure to Pay Its $125 Annual Franchise Fee
The plaintiff in AA Primo Builders, LLC v. Washington, No. 53983, 2010 Nev. LEXIS 55 (Nev. Dec. 30, 2010), saw its three-year-old lawsuit thrown out because it failed to pay its annual $125 fee to the Nevada Secretary of State. (“For want of a nail ….”) When the case was dismissed the LLC quickly paid the fee and filed the required annual report, but the trial court refused to allow the LLC to reinstate its lawsuit.
Many states require LLCs to file an annual report and pay an annual fee. For example, besides Nevada’s $125 fee, Delaware’s annual LLC fee is $250, and Washington’s is $69. Delaware Limited Liability Company Act (DLLCA) § 18-1107(b); Wash. Admin. Code § 434-130-090.
Failure to pay the fee or file the annual report can result in the LLC no longer being in good standing (Delaware, DLLCA § 18-1107(h)) or being administratively dissolved (Washington, Wash. Rev. Code § 25.15.280). These are enforcement mechanisms – upon later payment of the fees and filing of the required report, the LLC can be reinstated. DLLCA § 18-1107(i); Wash. Rev. Code § 25.15.290.
Nevada’s LLC Act provides that after an LLC has been in default of its filing and annual fee requirement for 12 months, “the charter of the company is revoked and its right to transact business is forfeited.” Nev. Rev. Stat. § 86.274(2). The LLC may then pay all the accrued fees and apply for reinstatement at any time up to five years after the initial default. Nev. Rev. Stat. § 86.276.
The trial court in AA Primo Builders apparently reasoned that if the LLC could not transact business then it could not maintain a lawsuit, and that the LLC’s reinstatement did not cure its default. On appeal, the Nevada Supreme Court overruled the trial court.
The court found three reasons to allow an LLC whose charter is revoked and then reinstated to continue its litigation. AA Primo Builders, 2010 Nev. LEXIS 55, at *13-14. First, an LLC’s right to “transact business” is separate from its capacity to sue and be sued. Id. Second, the LLC’s reinstatement relates back to the date of forfeiture as if the right to transact business had at all times remained in force. Id. at *14. Third, dismissal of the suit because of forfeiture of the LLC’s charter should not be ordered without first staying the case for a brief time to allow the LLC to reinstate its charter. Id.
The court relied in part on Nev. Rev. Stat. § 86-274(5), which says that if an LLC’s charter is revoked, “the same proceedings may be had with respect to its property and assets as apply to the dissolution of a limited-liability company.” A dissolved LLC must be wound up, and the dissolution does not impair any remedy or cause of action by or against the LLC. Nev. Rev. Stat. § 86-505.
The syllogism runs as follows. Major premise: a dissolved LLC can sue and be sued. Minor premise: an LLC whose charter has been revoked for nonpayment of fees is treated like a dissolved LLC. Conclusion: An LLC whose charter has been revoked can sue and be sued. The Nevada Supreme Court accordingly reversed the trial court and remanded to allow the LLC’s lawsuit to proceed.
It happens fairly frequently that LLCs fail to file their annual report and pay their annual fees. Usually the LLC will eventually learn of the problem and reinstate itself. If a lawsuit is underway, courts in most states will generally allow the LLC to continue with its suit if it is reinstated. Nevada’s statute was not clear on the point because its terminology – revoking the LLC’s charter and forfeiting the LLC’s right to transact business – connotes permanence and a lack of power to operate.
As a policy matter, AA Primo Builders came out the right way. The fact pattern involved an LLC that was properly formed but later failed to pay a modest annual fee and make a routine, administrative annual report. The consequence, revocation its charter, is an enforcement mechanism, a spur to cause the LLC to come into compliance with its reporting and payment obligations.
To take away an LLC’s ability to sue in court because it overlooked paying a smallish annual fee, even though the LLC then pays its annual fees up to date and fills out its forms, would be more than is necessary for the state’s enforcement mechanism. It would be akin to killing the dog to eliminate its fleas.
Montana Court Rejects LLC Agreement's Arbitration Clause
Arbitration of contract disputes is not generally required unless the parties agree to arbitration in their contract. LLC founders will therefore often include mandatory arbitration clauses in their LLC agreement. These are intended to require all disputes about the LLC to be arbitrated instead of being tried in court.
Montana Arbitration Clause. Arbitration clauses are usually enforceable. The Montana Supreme Court, however, recently refused in a case of first impression in Montana to enforce an LLC agreement’s arbitration clause. Gordon v. Kuzara, 2010 MT 275, 358 Mont. 432 (December 21, 2010). The plaintiff in Gordon sought judicial dissolution of the LLC, and the defendant filed a motion to compel arbitration based on the arbitration clause in the parties’ LLC agreement. Peter Mahler has nicely described the case and the court’s reasoning in his New York Business Divorce blog.
The gist of the court’s holding was that arbitration was not mandatory because the arbitration language in the LLC agreement did not cover a request for judicial dissolution. The contract said that arbitration was mandatory if any member was “challenging this agreement, any activity conducted pursuant to this agreement, or any interpretation of the terms of this agreement.” Gordon, 358 Mont. at 432.
That language is broad, but the dissolution petition was not based on a right granted by the LLC agreement. The LLC agreement had no provision requiring judicial dissolution, and the request for a dissolution order was instead based on the statutory remedy under the Montana LLC Act. Mont. Code Ann. § 35-8-902. Although the petitioner cited examples of conduct by the other member to show that the LLC was no longer economically feasible, the court concluded that the request for dissolution was based on the statutory remedy, not the LLC agreement. Gordon, 358 Mont. at 437.
Idaho Attorneys’ Fees. Arbitration is not the only contractual dispute resolution procedure that can turn out to be unavailable when dissolution is sought. Last year I posted about a case in Idaho, Henderson v. Henderson Investment Properties, LLC, where an attorneys’ fees clause in an LLC agreement was not enforced.
The trial court awarded attorneys’ fees in Henderson based on the LLC agreement’s attorneys’ fees clause, which covered actions brought to enforce any provision of the LLC agreement. The Idaho Supreme Court reversed the trial court’s award because the plaintiff did not seek to enforce the LLC agreement, but instead sought judicial dissolution, a statutory remedy.
Drafting Lessons. Both the Montana case and the Idaho case involved contractual clauses that were not enforced because they were not written broadly enough to encompass a petition for the LLC’s dissolution. One case involved a clause requiring arbitration, the other involved a clause requiring the loser to pay the winner’s attorneys’ fees.
In my post on the Henderson case I discussed how the attorneys’ fees clause could have been written to cover a dispute over dissolution, by adding language along the lines of “or to interpret or enforce any rights under the [State] Limited Liability Company Act.” The attorneys’ fees clause would then apply to either a dispute over the terms of the LLC agreement or to a dissolution petition. The broader language I suggest should have changed the result in Gordon, as well.
Another approach would be to add an express reference to dissolution in the attorneys’ fees clause or arbitration clause, as suggested by Peter Mahler in his post. That would remove all doubts about whether dissolution is covered, but would not extend to disputes over other statutorily granted rights that often are not referred to in the LLC agreement. For example, LLC statutes usually require that certain documents and records be provided to members on request.
Washington Dismisses Lawsuit by Cancelled LLC and Denies Award of Attorneys' Fees to Defendant
Washington’s Court of Appeals has issued another opinion dealing with the impact on litigation of the cancellation of an LLC’s certificate of formation. Metco Homes, LLC v. N.P.R. Constr., Inc., No. 64535-8-I, 2010 Wash. App. LEXIS 2428 (Wash. Ct. App. Nov. 1, 2010) (unpublished).
Metco was a construction contractor and developed a condominium project in Everett. N.P.R. was Metco’s subcontractor and installed the project’s siding. The siding leaked, Metco sued N.P.R., and before trial Metco’s certificate of formation was administratively cancelled by the Washington Secretary of State. On N.P.R.’s motion the trial court dismissed Metco’s suit and awarded attorneys’ fees to N.P.R. based on the attorneys’ fees clause in their contract.
The Metco case is part of the progeny of Chadwick Farms Owners Association v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009), which I previously reviewed, here. Chadwick Farms held that once a Washington LLC’s certificate of formation has been cancelled, it cannot sue or be sued and any pending lawsuits by or against the LLC abate.
An unusual aspect of Metco is the timing of Metco’s cancellation and the maneuvering of the trial date by N.P.R.’s counsel. Metco was administratively dissolved by the Washington Secretary of State on June 1, 2006, apparently for failing to file its annual report and pay its annual fee. Under the LLC Act then in effect, its certificate of formation was due to be cancelled two years later, on June 1, 2008. Metco’s trial date was originally set for trial on May 5, 2008, at which time its certificate of formation would not yet have been cancelled.
Metco was apparently unaware of its dissolution and impending cancellation. That’s odd, because the Secretary of State sends several notices to the registered agent of an LLC that fails to renew its annual report. But N.P.R.’s counsel was well aware of the impending cancellation.
As alleged by Metco, N.P.R.’s counsel misrepresented a scheduling conflict and successfully importuned Metco to reschedule the trial to a later date, after June 1, 2008. Simultaneously she was drafting motion papers to dismiss Metco’s suit on grounds of cancellation of its certificate of formation (which would not happen until June 1). After Metco was cancelled on June 1, she filed N.P.R.’s motion for dismissal of Metco’s lawsuit.
The Court of Appeals found the allegations regarding N.P.R.’s counsel to be disturbing, if true. Metco, 2010 Wash. App. LEXIS 2428, at *8. But even if true, said the court, reinstatement of Metco’s lawsuit would not be required.
[I]t is simply inaccurate to say the alleged deception “caused” the cancelation. Regardless of the alleged actions of NPR’s counsel, Metco could have renewed the LLC at any time in the two years after it was administratively dissolved. Under these circumstances, the trial court’s decision was neither untenable nor was it based on an incorrect standard of law. The trial court did not abuse its discretion in denying the motion to vacate.
Id. Because N.P.R. prevailed at trial, the trial court awarded N.P.R. its attorneys’ fees against Metco, pursuant to the attorneys’ fees clause in their contract. The Court of Appeals reversed and rather straightforwardly applied Chadwick Farms. “[A] lawsuit to enforce contractual duties owed by a LLC, including a duty to pay attorney fees and costs, cannot be maintained after the LLC has been cancelled.” Id. at *8-9.
The court’s emphasis on Metco’s ability to avoid cancellation by simply filing its annual report and paying the fees, and the court’s unwillingness to reinstate the lawsuit even if misrepresentation by the defendant’s counsel were to be established, show the draconian results of the Chadwick Farms ruling. Fortunately, the relevant provisions of Washington’s LLC Act have since been amended to eliminate the possibility of cancelling an LLC’s certificate of formation. I previously described those changes, here.
Washington Upholds Property Transfer by Canceled LLC
What happens to property owned by a canceled LLC? The Washington Court of Appeals had to answer that question in Sherron Associates Loan Fund V (Mars Hotel) LLC v. Saucier, No. 28238-4-III, 2010 Wash. App. LEXIS 1800 (Wash. Ct. App. Aug. 5, 2010). The LLC in Sherron transferred its rights in a judgment after the LLC had been canceled. In the assignee’s subsequent action to enforce the judgment, the judgment debtor claimed that the assignment was invalid because the LLC had been canceled.
At the relevant time in Sherron, Washington’s LLC Act required that a dissolved LLC file a certificate of cancellation on completion of its winding up, and that the LLC’s existence cease on the filing of the certificate of cancellation. See Chadwick Farms Owners Ass’n v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009). Last year I reviewed the Chadwick Farms decision, here. (Washington’s LLC Act has since been amended to eliminate certificates of cancellation. In April I analyzed the amendments, here.)
Sherron developed out of a long-running attempt to collect a debt. In 1998 an LLC obtained a judgment against Robert Saucier for $825,000, for money he borrowed from the LLC. In May of 2002, CES Properties, Inc., a former manager of the LLC, filed a certificate of cancellation in the LLC’s name. The LLC’s sole manager and sole member, GCA Investments, Inc., was unaware of the filed certificate of cancellation.
In October of 2002, GCA transferred the Saucier judgment to Sherron Associates, Inc. (SAI). (The opinion is unclear whether GCA’s transfer of the judgment was on behalf of the LLC as its manager, or as the sole member of the LLC.) SAI began efforts to collect the judgment and in doing so learned about the cancellation of the LLC. SAI attempted to have the LLC reinstated, but the Washington Secretary of State refused on the ground that there was no authority permitting a canceled LLC to be reinstated.
SAI later filed the Sherron lawsuit to extend the 1998 Saucier judgment for an additional 10 years. Saucier defended on the ground that the LLC’s assets could not have been assigned to SAI because the LLC had been canceled before the assignment and did not exist when the purported assignment was made. SAI countered that GCA, the LLC’s sole member, succeeded to the LLC’s assets upon its cancellation and therefore validly transferred the judgment to SAI. The trial court agreed with Saucier’s argument that the judgment could not have been assigned to SAI, and refused to extend the judgment. SAI appealed.
The Sherron court noted that Washington’s LLC Act did not answer the question of what happens to property owned by a canceled LLC. In Chadwick Farms the Washington Supreme Court had ruled that a canceled LLC could not be sued or maintain a lawsuit. From that, the Sherron trial court concluded that a canceled LLC could not take action, such as transferring assets. But, said the Court of Appeals, intangible assets such as a judgment continue to exist even if the canceled LLC could no longer enforce them.
The court pointed out that with both dissolved corporations and dissolved partnerships, the assets go to the shareholders or partners after creditors have been paid, and concluded:
We believe the rule for limited liability companies, a hybrid of partnerships and corporations, should be the same. In the absence of a governing statute, title to LLC-owned property passes to the owner of the canceled LLC subject to creditor claims.
Sherron, 2010 Wash. App. LEXIS 1800, *8. When the LLC in Sherron was canceled, GCA was its sole member. The LLC’s assets therefore passed to GCA, and GCA could in turn transfer those assets to SAI. The result was that SAI was allowed to extend the judgment.
This is not a surprising result, since the assets of a canceled LLC must be owned by someone, and who else would they go to? Escheat to the State? No. In an orderly dissolution and winding up, those assets would have been distributed to the members after all liabilities had been satisfied. Why should the premature filing of a certificate of cancellation change that result?
What I find puzzling about the case is that CES was only a former manager when it filed the certificate of cancellation. It clearly was not authorized to sign and file it. GCA was the sole manager and sole member of the LLC when CES filed the certificate, and GCA had no knowledge of the filing until later. Under the statute in force at that time, “A certificate of cancellation must be signed by the person or persons authorized to wind up the limited liability company’s affairs.” RCW 25.15.085(f) (2008). Since the signature on the certificate was unauthorized, why couldn’t the court rule it invalid? A trial court must deal with a controversy as presented by the litigants, of course, and it appears the issue was simply not put before the court.
Concealment of Breach of Fiduciary Duty Tolls the Alabama Statute of Limitations
Here’s a case for you. Plaintiffs invest $2.5 million in an LLC formed to purchase real estate, and guarantee a $7.5 million loan to the LLC. The LLC buys the real estate for $10 million from Ray Jacobsen, an affiliate of the LLC’s managers and its original investors. No one informs the new-money investors that Jacobsen bought the real estate for $5 million just days before selling it to the LLC for $10 million.
The plaintiffs alleged (a) that the LLC’s managers and original investors (the defendants) were well aware of Jacobsen’s “flip” of the property, (b) that the defendants never disclosed this information to the plaintiffs, (c) that the plaintiffs justifiably relied on the defendants’ silence by forgoing independent investigation, and (d) that the plaintiffs learned of the fraud later by happenstance. DGB, LLC v. Hinds, No. 1081767, 2010 Ala. LEXIS 116 (Ala. June 30, 2010).
The investors sued for damages, claiming fraud and breach of fiduciary duty and asking for dissolution of the LLC. The defendants contended that the claims were barred by the statute of limitations. The trial court dismissed almost all of the investors’ claims, and the plaintiffs appealed.
The defendants argued that the claims were barred by Alabama’s two-year statutes of limitations, Ala. Code §§ 6-2-38(l), 8-6-19(f). The plaintiffs in turn invoked the fraud savings clause of Ala. Code § 6-2-3:
In actions seeking relief on the ground of fraud where the statute has created a bar, the claim must not be considered as having accrued until the discovery by the aggrieved party of the fact constituting the fraud, after which he must have two years within which to prosecute his action.
If applicable, this exception would save the plaintiffs’ claims of fraud and breach of fiduciary duty, because their lawsuit had been filed within two years of their discovery of Jacobsen’s double-dealing, although it was more than two years after the original real estate deal.
The court simply applied the savings clause to the fraud claims, but the fiduciary duty claims were examined more closely. The court ruled that fraudulent concealment of wrongful acts is enough to invoke the fraud savings clause, even if the cause of action was for something other than fraud. DGB, supra, at *15, 16. Since the plaintiffs had alleged concealment of the defendants’ real estate flip, their claims survived.
The court never explicitly discussed what is necessary to make the concealment “fraudulent.” Presumably it means that there was some degree of mens rea, i.e., a guilty mind or intent.
Statutes of limitation are more than mere technicalities. They prevent old, stale claims from popping up many years after the original event. Memories fade, evidence may be lost, and witnesses may die or be missing. But in this case the court’s application of the fraud rule, along with its extension of the time for bringing the lawsuit, was the right result. As the court said, “A party cannot profit by his own wrong in concealing a cause of action against himself until barred by limitation. The statute of limitations cannot be converted into an instrument of fraud.” DGB, supra, at 11, 12 (quoting Hudson v. Moore, 194 So. 147, 149 (Ala. 1940), overruled on other grounds by Ex parte Sonnier, 707 So. 2d 635 (Ala. 1997)).
The investors also asked the court to order the dissolution of the LLC. The Alabama LLC Act allows for judicial dissolution of an LLC “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” Ala. Code § 10-12-38. This provision is similar to those of the Delaware LLC Act and the Washington LLC Act. Since dissolution can be granted “whenever” it is not reasonably practicable to carry out the business in conformance with the charter, the court found that there was no basis for applying the statute of limitations to a request for a dissolution. DGB, supra, at *10.
Straightening Out Kinks in Washington's LLC Law
Last month Governor Gregoire signed into law a bill amending Washington’s Limited Liability Company Act (Act). The amendments address the confusion introduced by last year’s Supreme Court ruling in Chadwick Farms Owners Ass’n v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009), and eliminate a nonsensical provision that was injected into the Act in 2009. The amendments will take effect June 10, 2010.
Chadwick Farms dealt with dissolution and winding-up issues. The court held that once a Washington LLC’s certificate of formation has been cancelled, it cannot sue or be sued and any pending lawsuits by or against the LLC abate. The court also held that those who improperly wind up the LLC can be personally liable to the LLC’s creditors. I analyzed the court’s reasoning and some of the questions raised, here.
The bill’s amendments substantially change the Act’s dissolution procedures. Under the current Act, a Washington LLC’s dissolution is a private action that can be taken by unanimous member consent, or that occurs as specified in the certificate of formation or LLC agreement. Wash. Rev. Code § 25.15.270. No public filing is required upon dissolution, but upon completion of winding up, the LLC’s certificate of formation must be cancelled by filing a certificate of cancellation. Wash. Rev. Code § 25.15.080.
The amendments eliminate the entire concept of cancelling the certificate of formation. Effective June 10, 2010 there will be no requirement or ability to file a certificate of cancellation. Instead, a dissolved LLC may elect to file a certificate of dissolution with the Washington Secretary of State. Filing a certificate of dissolution is not mandatory, but if it is filed it commences a three-year survival period, after which claims may not be brought by or against the LLC or its managers or members.
If no certificate of dissolution is filed, claims by or against the LLC or its managers or members are not time-limited, except by any applicable statutes of limitations. Presumably most dissolving LLCs will file the certificate of dissolution in order to start running the three-year period.
The amendments also address the winding-up procedures for a dissolved LLC. A new procedure was added: an LLC that has filed a certificate of dissolution may give notice of the dissolution to known claimants and require that claims be asserted within 120 days of the notice. Claims not asserted within the time limit are cut off. If a claimant responds and the LLC then rejects the claim, the claim will be barred unless the claimant commences a legal action to enforce the claim within 90 days of the LLC’s rejection.
The new bill also addresses a 2009 amendment to the Act, currently codified in Wash. Rev. Code § 25.15.293, which I discussed here. The 2009 change made no sense, and the new bill simply deletes it.
The members of the Washington Bar Committee on the Law of Partnerships and LLCs, ably chaired by Brian Todd, as well as the Washington legislators who worked on this bill, are to be commended for their efforts. The new approach to LLC dissolution is a decided improvement over that of the prior Act.
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.
Utah's Conflicting Remedies - LLC Statute vs. Common Law
Members of an LLC are at loggerheads and one sues the other. The plaintiff decides that the remedies in the state LLC Act are inadequate. The plaintiff instead asks the court for damages under the common law, for repudiation of the LLC’s operating agreement and for breach of contract rather than for dissolution and an accounting under the LLC Act. That was the situation in OLP, L.L.C. v. Burningham, 2009 UT 75, 2009 WL 4406148 (Utah Dec. 4, 2009). The defendant in turn claimed that the plaintiff’s claims for repudiation and breach of contract were not allowable because the remedies under Utah’s LLC Act are exclusive. The court found otherwise and allowed the plaintiff’s contract claims.
Richard Wilson and Wayne Burningham formed OLP, L.L.C. as a Utah limited liability company, to purchase and operate an anti-reflective optical lens coating machine. They agreed to share equal control and ownership of OLP, and initially contributed equal amounts of capital. They agreed that Intermountain Coatings, a company owned by Burningham, would use the lens coating machine.
Acrimony between Wilson and Burningham soon reared its ugly head. They disagreed over how profits should be divided between OLP and Intermountain Coatings, and over whether the funds provided by Intermountain Coatings to OLP should be classified as a loan or as a capital contribution from Burningham.
Wilson eventually filed suit against Burningham and Intermountain Coatings for breach of fiduciary duty, repudiation of the contract, and breach of contract, and for an accounting of OLP’s expenses, revenues, profits, and losses. Burningham counterclaimed for dissolution of OLP. Burningham argued that in winding up OLP’s business, the members’ ownership interests should be determined and distributed according to each member’s capital account as provided in the LLC Act. Burningham’s theory was that Wilson’s claims should be resolved under the LLC Act’s dissolution procedures because those procedures are the exclusive remedy for claims between members.
The court pointed out that the LLC Act does not contain any explicit authorization or denial of common law claims, and examined a number of provisions in the LLC Act which imply that common law claims between members continue to apply. The court found that analogous partnership law allows common law claims between partners, without limiting remedies to equitable remedies. The court held that Utah’s LLC Act does not preclude common law claims between LLC members, such as claims for breach of contract, and that the remedies for such claims include equitable relief such as an accounting as well as damages.
The court rejected Burningham’s argument that dissolution is the sole remedy for wrongdoing between the members as being inconsistent with the jury’s finding that he had repudiated and abandoned the operating agreement. As the court said: “When one party effectively extinguishes a business agreement, whether it be a partnership agreement or a limited liability agreement, that party cannot rely on the agreement (or the default provisions of the LLC Act that supplement the agreement) to protect itself from the harm its actions have occasioned.” OLP, 2009 UT 75, ¶ 21.
The OLP decision is consistent with the approach of many courts to the rights and remedies of LLC members. For example, earlier this year I blogged on a New York decision which found that LLC members have a common law right to an equitable accounting, even though not explicitly authorized in the statute, here. I also described Idaho’s first case on fiduciary duties of LLC members, which found that fiduciary duties existed between managing members even though no such right was described in Idaho’s LLC Act, here. Courts generally seem to be reluctant to rule out common law rights of recovery or to exclude equitable remedies, in the absence of an explicit bar in their state’s LLC Act.
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.
Upcoming Event - Seminar for Washington Condominium Developers on Dissolution and Cancellation of Limited Liability Companies
Stoel Rives LLP is hosting a complimentary breakfast seminar in Seattle on Thursday, October 8, 2009, entitled “A Law Update for Condominium Developers: Practical Advice for Dissolution and Cancellation of Limited Liability Companies.” The seminar topics will include:
- The life cycle of a condominium LLC
- The recent Washington Supreme Court ruling in Chadwick Farms Owners Association v. FHC LLC
- Dissolution and cancellation of LLCs
- Limitations on liability protection afforded by an LLC
- How to “wind up” the business of the LLC
- How to avoid personal liability for the obligations of an LLC
The Chadwick Farms case was discussed in my prior blog post, here. Chadwick Farms is especially relevant to condo developers because of the project-oriented nature of the condo development business, and because of the strong Washington law on the implied warranty given to new condo buyers. The process of dissolving, winding up and cancelling a condo developer’s LLC will often present the developer with some difficult choices—this seminar will discuss the pros and cons of the alternatives.
Registration and breakfast begin at 7:30 a.m., and the presentation runs from 8:00 to 9:30 a.m. Limited space is still available, so if you're interested in attending you can see the location and other details and register here.
Bankruptcy Court--Dissolution of an Idaho LLC Does Not Transfer the LLC's Assets or Terminate the LLC
The debtor corporation, Aldape Telford Glazier, Inc. (ATG), was the sole member and manager of two Idaho LLCs. ATG filed a Chapter 7 bankruptcy case, listed a number of assets of its two subsidiary LLCs in the schedule of ATG’s personal property, and did not list its member interests in the two LLCs. The two LLCs had been previously dissolved, and each had filed articles of dissolution which recited that “[a]ll assets revert to sole member.” In re Aldape Telford Glazier, Inc., No. 09-00834-TLM, slip op. at 3, 2009 WL 2216594 (Bankr. D. Idaho July 23, 2009).
The trustee sought dismissal of the bankruptcy case on the grounds that ATG was attempting to impermissibly combine the financial affairs of separate legal entities, thus creating in effect a “joint petition” of ATG and the two LLCs. (Joint filings of a bankruptcy case are not allowed except in the case of spouses. Fitzgerald v. Hudson (In re Clem), 29 B.R. 3 (Bankr. D. Idaho 1982).)
The bankruptcy court applied Idaho state LLC law and determined that LLC property belongs to the LLC and not its members (Idaho Code § 53-633(1)), that on dissolution an Idaho LLC continues to exist and to own its property until it has wound up its business and affairs and distributed its property (Idaho Code §§ 53-644, 53-646), and that the statements in the articles of dissolution that the LLCs’ assets reverted to their members were ineffective. In re Aldape, slip op. at 7-9.
ATG argued that the trustee could “handle the process of identifying and segregating the physical assets and accomplishing the wind up process for both LLCs,” or that the trustee could file Chapter 7 petitions for the LLCs. The court rejected those suggestions as unreasonable and inconsistent with the Bankruptcy Code. Id. at 11-12.
ATG’s approach, i.e., the statements in the LLCs’ articles of dissolution about assets reverting to the sole member and the inclusion of the LLCs’ assets in ATG’s asset schedule in the Chapter 7 filing, shows some confusion over the effects of dissolution. Under Idaho’s LLC Act, dissolution of an LLC is simply a change of its status, not a termination of its existence. ATG attempted unsuccessfully to treat the dissolution as a termination of the LLCs’ existence and as a conveyance of the LLCs’ assets to their member.
The approach of the Idaho statute—LLC dissolution as a change of status requiring that the business be wound up, debts paid and liabilities provided for, and any remaining assets distributed to members—is widely used by the states. E.g., Washington, Delaware. The Revised Uniform Limited Liability Company Act uses the same approach.
Washington Bobbles a Recent Amendment to the LLC Act
The 2009 Regular Session of the Washington Legislature amended the LLC Act, effective July 26, 2009. 2009 Wash. Sess. Laws Chap. 437. Two changes to the LLC Act were implemented. One was straightforward: the time period for an administratively dissolved LLC to seek reinstatement was extended from two years to five years.
The other change is problematic. The new section of the Act allows a voluntarily dissolved LLC to apply to the Secretary of State “for reinstatement” within 120 days after the effective date of the dissolution. If an application for reinstatement is made under the new law, and assuming the LLC’s name is available, the Secretary of State is directed to reinstate the LLC, in which case the reinstatement relates back to and takes effect as of the date of dissolution. (If the name is not available, the application for reinstatement must include an amendment to the certificate of formation to change the name.)
The problem with this new law is that it simply doesn’t make sense. When a Washington LLC is dissolved, nothing is filed with the Secretary of State. Dissolution of an LLC can be achieved by the written consent of all members, and then its affairs must be wound up. RCW 25.15.270. Dissolution is a change of status that begins the winding-up process, but it is not a public event.
Why would a voluntarily dissolved LLC apply for reinstatement? What is it that would be reinstated? Not the certificate of formation, since it is not affected by the LLC’s dissolution.
Even stranger, this new law requires that if no application for reinstatement is made within 120 days of the date of an LLC’s voluntary dissolution, the Secretary of State “shall cancel” the LLC’s certificate of formation. But since the voluntary dissolution of an LLC does not require a public filing, the Secretary of State will not be aware of an LLC’s dissolution, and therefore in almost all cases would be in no position to take action to cancel the dissolved LLC’s certificate of formation.
The consequences of canceling an LLC’s certificate of formation can be severe, since if the LLC’s certificate of formation is cancelled, the LLC ceases to exist. RCW 25.15.070(2)(c). And as I recently discussed in a post about Chadwick Farms Owners Ass’n v. FHC LLC (May 14, 2009), the Washington Court has held that canceling an LLC’s certificate of formation not only terminates its existence, but also abates all pending lawsuits by or against the LLC. There is currently no method under the Act to reinstate a cancelled certificate of formation.
It appears that the new section was intended to authorize an LLC to reinstate its certificate of formation within 120 days after filing a certificate of cancellation. The staff of the Secretary of State’s office has told me that they recognize the problems with the new statutory section and don’t intend to begin cancelling certificates of formation 120 days after voluntary LLC dissolutions. They are considering interpreting the new section to authorize applications for reinstatement of cancelled certificates of formation, but it’s hard to find that language in the session law.
I think it’s a safe prediction that this new law will be up for revision at the next session of the Legislature.
Washington Supreme Court: LLC Can Terminate All Lawsuits by Filing Certificate of Cancellation - Personal Liability for Improper Winding Up
On May 14, 2009 the Washington Supreme Court ruled five to four that a Washington LLC cannot sue or be sued once its certificate of formation has been canceled, and any pending lawsuits by or against the LLC abate upon cancellation of the certificate of formation. The result is the same whether the certificate of formation is canceled by the LLC’s voluntary filing of a certificate of cancellation, or by the Secretary of State because of the LLC’s failure to pay its license fees, have a registered agent, or file its annual report. The court also held that those who improperly wind up an LLC can face personal liability to the creditors of the LLC. Chadwick Farms Owners Ass’n v. FHC LLC (May 14, 2009).
The result seems a little startling, to say the least, and the ruling’s potential for abuse is obvious. A defendant LLC in the middle of a lawsuit, where the tide is turning against it, can file a certificate of cancellation and end the lawsuit. Apparently the plaintiff’s only recourse would then be to attempt to show that the members or managers involved in the winding up did so improperly, such as by failing to satisfy or make adequate provisions for paying the LLC’s liabilities, or perhaps to try to establish that illegal distributions had been made to the members.
The opinion involved two consolidated cases, both decided on summary judgment. In each case the LLC’s certificate of formation was canceled, once in the middle of a lawsuit against the LLC and once prior to the filing of a lawsuit against the LLC. One LLC’s certificate of formation was canceled by the Secretary of State for failure to pay license fees and file reports. RCW 25.15.290. The other LLC’s certificate of formation was canceled voluntarily by the LLC after a dissolution vote by its members. RCW 25.15.270.
Most of the opinion deals with two questions: (1) does cancellation of an LLC’s certificate of formation bar the LLC from filing or continuing a lawsuit, and (2) does cancellation of the certificate of formation bar a plaintiff from filing or continuing a lawsuit against the LLC? The court answered both questions in the affirmative; cancellation of the LLC’s certificate of formation ends all suits by or against the LLC and bars any further lawsuits by or against the LLC.
To reach that seemingly draconian result, the court reviewed the LLC Act’s dissolution and winding-up provisions. Dissolution is a change in the status of the LLC that can occur (a) on the date of specific events set forth in the certificate of formation, (b) on the written consent of all members, (c) 90 days after dissociation of the last remaining member unless within the 90 days the assignees vote to admit one or more new members, (d) by judicial decree, or (e) by action by the Secretary of State for nonpayment of fees. RCW 25.15.270. Once dissolved, the LLC’s affairs “shall be wound up.” Upon the completion of winding up, the certificate of formation must be canceled. RCW 25.15.080.
Note that the LLC Act’s dissolution procedures are quite different from those of Washington’s Business Corporation Act (BCA). Under the BCA, a corporation may dissolve (after board and shareholder approval) by filing articles of dissolution with the Secretary of State. RCW 23B.14.030. A dissolved corporation continues its corporate existence but may not carry on any business except that appropriate to wind up and liquidate its business and affairs. RCW 23B.14.050. The contrast is stark: a corporation commences dissolution with a public filing and continues its existence indefinitely while winding up; but an LLC commences dissolution by a vote of its members (i.e., no public filing) and after winding up terminates its existence by filing a cancellation of its certificate of formation.
The court in Chadwick relied on the language of the Act to conclude that cancellation of the certificate of formation terminates the existence of the LLC:
A limited liability company formed under this chapter shall be a separate legal entity, the existence of which as a separate legal entity shall continue until cancellation of the limited liability company’s certificate of formation.
RCW 25.15.070. And, said the court, if the LLC does not exist it cannot sue or be sued. The Act’s survival statute did not alter the court’s conclusion. RCW 25.15.303 provides that “[t]he dissolution of a limited liability company does not take away or impair any remedy available against that limited liability company, its managers, or its members for any right or claim existing” so long as an action is commenced “within three years after the effective date of dissolution.” The dissent read this section as applying whether or not the certificate of formation was canceled within three years after dissolution; the majority instead read Section 303’s survival period to be truncated by an intervening cancellation of the certificate of formation.
Under this ruling, an LLC involved in unwelcome litigation could vote to dissolve and then end the lawsuit by canceling its certificate of formation. However, the statute requires that the LLC’s affairs “shall be wound up” upon dissolution, and that the LLC “pay or make reasonable provision to pay all claims and obligations, including all contingent, conditional, or unmatured claims and obligations, known to the limited liability company,” including known claims for which the identity of the claimant is unknown. Assets may be distributed to members only upon completion of winding up, i.e., after paying or making provision for all claims.
In both Chadwick cases, claims of personal liability were raised against those involved in winding up the LLCs, for failure to pay or make provision for claims. The statute implies that there can be personal liability: “Any person winding up a limited liability company’s affairs who has complied with this section is not personally liable to the claimants of the dissolved limited liability company by reason of such person’s actions in winding up the limited liability company.” RCW 25.15.300. The court easily drew the inference and found that personal liability to claimants may result if the persons winding up the LLC do not comply with RCW 25.15.300.
The Chadwick case will have significant impacts on how litigation with LLCs is conducted, and raises many questions. The temptations on defendant LLCs to dissolve (no public filing is required), wind up, make some arguable provisions for any claims, and then threaten to cancel or actually cancel their certificate will in some cases be irresistible. That scenario raises the question: just exactly how can an LLC make provision for a claim against it in a pending lawsuit when the LLC is about to end the lawsuit and terminate its very existence? Perhaps the manager that carries out the winding up could hold any funds set aside for claimants. If the lawsuit against the LLC is abated, the claimant will likely sue the manager anyway on an “improper winding up” theory. If the case turns in that direction, will the litigation then have to fully determine the merits of the original claim against the LLC, when the LLC is not participating in the lawsuit because its existence has been terminated?
Chadwick only involved claims of personal liability against the manager or members that carried out the winding up. But RCW 25.15.235, not discussed by the Chadwick court, can in some cases create personal liability for members who receive liquidating distributions from a dissolved LLC. Section 235 requires LLCs to refrain from making distributions to members if the LLC is insolvent under either test: it is unable to pay its debts as they become due in the ordinary course, or its liabilities exceed the fair value of its assets. A member who receives a distribution in violation of Section 235 and who knew of the violation at the time of the distribution is liable to the LLC for the amount of the distribution. The Chadwick court relied on RCW 25.15.300, which refers to liability to claimants on the part of those winding up the dissolved LLC. RCW 25.15.235, on the other hand, could be invoked by claimants against a dissolved and canceled LLC in order to reach members who knowingly received an illegal distribution, even if they were not involved in the winding up. But Section 235 only refers to the member’s liability to the LLC, not to third-party claimants. If the LLC’s certificate of formation has been canceled, could a claimant reach the member that received the illegal distribution?
The Chadwick opinion raises a host of such questions, but the law of the case may be short-lived. The court seemed to recognize that its ruling could in some cases yield unsatisfactory results, and noted that according to the house and senate bill reports, a comprehensive review of the LLC Act is underway (presumably by a Washington State Bar Association committee). In an apparent invitation to the state legislature, the court said “[i]f the result here is not what the legislature wants, it will be positioned to make additional changes deemed necessary.” I think it’s a safe prediction that some revisions to the dissolution and winding-up provisions of Washington’s LLC Act will be coming soon.
Deadlocks and Puts in Delaware
LLCs sometimes reach a point where the owners or managers disagree on business issues and find themselves unable to reach agreement on any course of action. This can happen because the members or managers have equally balanced voting power or because their LLC agreement requires a supermajority vote that neither side can reach. A long-running deadlock can be a huge problem for a business, since it will keep the company from responding to business changes. What’s the owners’ remedy then?
Sometimes the LLC agreement will have a solution. For example, the agreement may have a “cut and choose” provision, so that either side can initiate a buyout process that will leave one or the other with full ownership of the company. That may or may not be practicable, and in many cases the agreement simply has no answer for a deadlock.
If the agreement has no solution for deadlock, the parties are forced back to their state’s LLC statute. In Fisk Ventures, LLC v. Segal (Jan. 13, 2009), one member of a Delaware LLC asked the Court of Chancery to order dissolution, citing Section 18-802 of Delaware’s LLC Act. This section is short and sweet:
On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.
NCCUSL’s Revised Uniform LLC Act and many state statutes have similar provisions. Note that the operative word is “may” – the court has discretion. And the test is not one of oppression or wrong-doing, but simply a question of carrying on the business in conformity with the agreement.
In Fisk, the LLC agreement provided for a five-member Board to manage the LLC. One faction had three Board members; the other faction had two. (One side was dominated by the founder, the other by subsequent investors.) The agreement required a vote of 75% of the Board for most actions, including dissolution, and neither side could muster four Board members. The agreement provided no mechanism for resolving a stalemate. For five years the two factions had been in disagreement about financing and other issues. The result: five years of deadlock.
The court found that as a result of the deadlock and the Company’s inability to raise capital, the company had “no office, no employees, no operating revenue, and no prospects of equity or debt infusion,” and that there was effectively no business to operate.
Dr. Segal, however, argued that the LLC agreement did provide a means of navigating around the deadlock, because the agreement granted Fisk Ventures, the plaintiff seeking dissolution, a “put” right. The put meant that Fisk could require the company to buy Fisk’s interest in the company for its fair value. The agreement provided for the price to be determined by an independent valuation, and to be paid either in cash at closing or in time payments over two years, based on the amount. Exercise of the put was at Fisk’s discretion.
The court found that the existence of Fisk’s optional put right did not resolve the deadlock, and refused to force Fisk to exercise its put. The court analyzed the put as an independent, economic right that was not a remedy for the deadlock. In the court’s words, “it would be inequitable for this Court to force a party to exercise its option when that party deems it in its best interests not to do so.” The court emphasized the primacy of freedom of contract under Delaware’s LLC Act: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Section 18-1101(b).
Once the court had concluded that Fisk’s put was not relevant to whether it was “reasonably practicable to carry on the business” in conformity with the LLC agreement, and given the dismal five-year history of the company, the court easily found that the company should be dissolved. Under the LLC Act, of course, once dissolved the company would have to be wound up in accordance with Section 18-801.
The 75% supermajority requirement may have been intended to prevent a bare majority from dominating or oppressing the minority, but here it led to a different type of bad result. The agreement did not provide for a way to resolve a deadlock, and the put apparently turned out to be an unsatisfactory mechanism for its holder.
The obvious moral for founders and investors (and their counsel) is to think hard about the contingencies when the LLC is being formed and when new investors come in. Concentrate not only on the upside of the proposed business deal but also on the alternative scenarios, and address the potential for deadlock. This is basic risk analysis – not easy, as evidenced by our recent history, even for highly experienced investors and business people. There’s no substitute for probing the parties’ assumptions and asking the hard questions.
