Bankruptcy Appellate Panel Says Out-Of-State Member's Interest in Nevada LLC Is Located in Nevada for Venue Purposes
It sounds like the beginning of a bad joke. An individual walks into a bar and says “Where’s my LLC?” But that was the question a Bankruptcy Appellate Panel recently had to answer. The court had to determine whether Nevada was the proper venue in an involuntary bankruptcy case. The debtor’s only connection with Nevada was that his principal assets consisted of interests in a Nevada LLC and a Nevada limited partnership. The creditor claimed that venue in Nevada was proper because the LLC and the partnership were formed under Nevada law and therefore the debtor’s interests in the companies were located in Nevada. The debtor contended that his LLC and partnership interests were located where he resided, in Washington.
The case began in 2011 when the Montana Department of Revenue (MDOR) filed an involuntary chapter 7 bankruptcy petition in Nevada against Timothy Blixseth. In re Blixseth, 484 B.R. 360 (B.A.P. 9th Cir. Dec. 17, 2012). The petition asserted that venue was proper in Nevada because Blixseth had assets in Nevada. (Venue for a bankruptcy case may be based on any of four alternatives: the debtor’s (i) domicile, (ii) residence, (iii) principal place of business in the U.S., or (iv) principal assets’ location in the U.S. 28 U.S.C. § 1408(1).)
Shortly after the petition was filed the bankruptcy court on its own initiative entered an order to show cause why venue was proper in Nevada, and expressed a concern about “the paucity of the connection between Blixseth and … the selected venue.” Blixseth, 484 B.R. at 362. MDOR responded that venue was proper in Nevada because Blixseth’s principal assets were his interests in Desert Ranch LLLP, a Nevada limited liability limited partnership, and in Desert Ranch Management LLC, a Nevada limited liability company.
Blixseth took the court’s hint and filed a motion to dismiss. He argued that venue was not proper in Nevada because he had resided in Washington since 2007, he conducted no business in Nevada, he had no place of business in Nevada, and he had no property in Nevada. He did acknowledge that his primary assets were his interests in Desert Ranch LLLP and Desert Ranch Management LLC. The LLLP owned real estate in the U.S. and abroad, and the LLC owned an interest in the LLLP and was its general partner.
The trial court concluded that intangible ownership interests, such as Blixseth’s interests in the LLLP and the LLC, have no physical location and that therefore venue based on the location of Blixseth’s assets was unavailable. The trial court also held, in the alternative, that if Blixseth’s interests in the two companies had a location it was at his residence, which was in Washington. Venue based on the location of Blixseth’s assets was therefore unavailable, and “because it was undisputed that Blixseth did not reside, was not domiciled, and did not have a principal place of business in Nevada, there was no other basis for venue in Nevada.” Id. at 364. The trial court concluded that venue in Nevada was incorrect and dismissed the petition, and MDOR appealed.
Issue on Appeal. The Bankruptcy Appellate Panel phrased the sole issue as “whether, for venue purposes under 28 U.S.C. § 1408(1), Blixseth’s principal assets, consisting of his intangible equity interests in Desert Ranch and Desert Management, were located in Nevada.” Id. at 365.
The court characterized Blixseth’s interests in the LLC and the LLLP as intangible property having no physical location – “the location or situs of intangible property is a ‘legal fiction.’” Id. at 366 (citation omitted). The court noted that the legal location of intangible property is protean: intangible property may be located in multiple places for different purposes. The court looked to the Ninth Circuit’s rule that for venue purposes the court should use a context-specific analysis and employ a “common sense appraisal of the requirements of justice and convenience in particular conditions.” Id. at 366-67 (quoting Office Depot Inc. v. Zuccarini, 596 F.3d 696, 702 (9th Cir. 2010)).
Applying the Ninth Circuit’s “context-specific” analysis, the court focused on the trustee’s duty to administer the bankruptcy estate and realize on the assets for the benefit of Blixseth’s creditors. The trustee will have the same rights as Blixseth’s creditors to realize on his interests in the LLC and the LLLP. 11 U.S.C. § 544(a)(1).
Because the LLC and the LLLP were formed under Nevada law they are governed by Nevada law, including its rules on the rights of creditors. Under Nevada law the only remedy of a judgment creditor of an LLC member or LLLP partner is to apply to a Nevada court for a charging order. Nev. Rev. Stat. § 86.401 (LLCs); Nev. Rev. Stat. § 88.535 (LLLPs).
The court found that “because Blixseth’s interests in the LLC and LLLP were created and exist under, and his creditor’s remedies are limited by, Nevada state law, that is sufficient reason to deem Blixseth’s interests to be located in Nevada.” Blixseth, 484 B.R. at 369. The court found additional support for its conclusion in the Nevada courts’ exclusive jurisdiction over judicial dissolution of the LLC and the LLLP, given that the trustee might seek the dissolution of the companies in order to reach the assets owned by each. Id. at 369-70.
The court also looked to notions of justice and convenience. The court found it disingenuous for Blixseth to argue that Nevada is not a proper venue for his creditors to pursue his interests in the two companies, given his choice to form them under Nevada law. Also, it would be more convenient for a Nevada trustee than for a trustee appointed in Washington (the venue argued for by Blixseth) to apply to the Nevada courts to obtain a charging order or request dissolution of the LLC or the LLLP. Id. at 370-71.
Accordingly, the court held that Blixseth’s interests in Desert Ranch and Desert Management were deemed to be located in Nevada, and that venue in Nevada was proper. Id. at 371.
Comment. Business people and investors who decide to form an LLC must decide which state law to form it under. Nevada is sometimes held out as a haven for the formation of asset-protection LLCs. Corporate service companies or law firms will sometimes encourage even out-of-state business startups to organize as a Nevada LLC.
The Blixseth case shows the potential for unintended consequences when picking Nevada or any other state as an LLC’s state of formation, if the LLC’s principal owner has no other connection to the state chosen. The owner can find itself litigating in the state where the LLC was formed, even though the owner does not live there, has no business activities there, and owns no other assets there. That’s usually less convenient than litigating in one’s home state.
In fact, the differences between Nevada’s LLC statute and the LLC statutes of other states are not huge. All states’ statutes protect an LLC’s members and managers from liability for the LLC’s contracts and actions, and no state’s law will protect a member from legal liability for the harm caused directly by the member. All state LLC acts are written to provide a high degree of flexibility for the members in structuring their LLC.
There are sometimes good reasons to pick a state of formation other than one’s own state, but the factors should be considered carefully, including the potential for litigation far from home.
When LLC members are deadlocked or have claims against each other for breach of fiduciary duty or other wrongdoing, they sometimes seek a court order dissolving the LLC. Once dissolved, the LLC has to be liquidated and wound up. But in New Jersey and some other states a different remedy is available – the LLC or a member can ask the court to dissociate certain members, i.e., to strip them of their membership in the LLC. That happened last month in New Jersey: the Appellate Division of the Superior Court affirmed a trial court’s order dissociating two LLC members. All Saints Univ. of Med. Aruba v. Chilana, No. C-147-08, 2012 WL 6652510 (N. J. Super. Ct. App. Div. Dec. 24, 2012) (per curiam) (unpublished).
Background. ASUMA LLC was formed with four members in 2007, in connection with the operations of a fledgling medical school in Aruba. Financial strains developed, and in 2008 two of the members sued the other two for breach of fiduciary duty and breach of the LLC’s operating agreement. Defendant Gurmit Chilana counterclaimed for fraud, misappropriation, and breach of fiduciary duty.
Several months later Chilana requested the trial court to declare the plaintiffs judicially dissociated from ASUMA. Chilana requested this relief because the medical school required immediate capital to continue operating, and Chilana intended to invest the necessary capital only if the plaintiffs were dissociated. Id. at *8.
Chilana’s request for judicial dissociation was made pursuant to Section 42:2B-24(b)(3) of New Jersey’s Limited Liability Company Act:
A member shall be dissociated from a limited liability company upon the occurrence of any of the following events:
(3) on application by the limited liability company or another member, the member’s expulsion by judicial determination because:
(a) the member engaged in wrongful conduct that adversely and materially affected the limited liability company’s business;
(b) the member willfully or persistently committed a material breach of the operating agreement; or
(c) the member engaged in conduct relating to the limited liability company business which makes it not reasonably practicable to carry on the business with the member as a member of the limited liability company.
Following trial, the trial court’s written decision concluded that the plaintiff’s conduct satisfied the criteria of both subsection (3)(a) (wrongful conduct) and (3)(c) (not reasonably practicable to carry on the business), and decreed the plaintiffs to be dissociated from ASUMA.
Court’s Analysis. The appellant contended on appeal that judicial dissociation was barred by the LLC agreement, which stated: “Shareholder(s) cannot or shall not at anytime be compelled to give up or sell their shares for any reason. The decision to sell shares must be voluntary. No shareholder(s) can buy out other shareholder(s).” Id. at *12.
The court disposed of that argument by pointing out that under Section 42:2B-24.1 of the New Jersey LLC Act, a dissociated member loses only its management rights, and retains the rights of an assignee of a member’s LLC interest, i.e., the economic rights of the member’s interest. Thus, dissociation does not cause the dissociated member to “give up or sell” its economic interest. According to the court, the dissociated member “may continue to hold his shares, … but as a dissociated member he is enjoined from participating in the management of the LLC.” Id. at *13.
The court then turned to the substance of the trial court’s decision. The trial court had supported its decree of dissociation under both subsection 3(a) and subsection 3(c). Subsection 3(a) requires that the member have “engaged in wrongful conduct that adversely and materially affected the limited liability company’s business,” and 3(c) requires that the member have “engaged in conduct … which makes it not reasonably practicable to carry on the business with the member as a member” of the LLC. The appellate court said that it found it easier to justify dissociation under subsection 3(c) than 3(a). It therefore confined its analysis to the trial court’s determination under subsection 3(c), the “not reasonably practicable to carry on the business” standard. Id. at *14.
After reviewing the record in detail, the court concluded that the trial court had not abused its discretion and had sound reasons when it determined that the plaintiffs had engaged in conduct that made it not reasonably practicable to carry on the business with the other member. Those reasons included: (a) the precarious financial condition of the medical school; (b) the contentious relationship between the members; (c) the plaintiffs’ denial of the school’s financial problems; (d) the plaintiffs’ unwillingness to contribute more capital or loan funds to the school; and (e) Chilana’s understandable unwillingness to invest more capital in the school if the plaintiffs were allowed to continue to manage the company. Id. at *18. The trial court’s order of dissociation was affirmed.
The court cited cases from New Jersey, Indiana, and Delaware to support the importance of the plaintiffs’ unwillingness to contribute capital, but pointed out that that factor alone is not sufficient to conclude that it is “not reasonably practicable” to carry on the business with the non-contributing members. Id. at *16.
Comment. Most state LLC Acts provide for a judicial order of dissolution under certain circumstances, but fewer provide for a judicial order of dissociation of a member. For example, neither the Washington nor the Delaware LLC Act authorizes judicial dissociation of a member for wrongdoing.
New Jersey’s current statutory provision for judicial dissociation is similar in most respects to that in NCCUSL’s Revised Uniform Limited Liability Company Act (RULLCA), Section 602. New Jersey recently became one of the eight states that have enacted RULLCA, but the new law will not become effective until March 18, 2013. All Saints, 2012 WL 6652510, at *11 n.9.
New Jersey’s adoption of RULLCA will change New Jersey’s judicial dissociation rules in one key respect. New Jersey’s current statute allows for another member or the LLC to petition for a member’s dissociation, as in All Saints. RULLCA, as promulgated by NCCUSL and as enacted by New Jersey, allows only the LLC to petition for dissociation of a member.
The RULLCA approach to judicial dissociation provides a useful alternative remedy for difficult LLC situations. It is a narrower remedy than the more common remedy of dissolution. Dissolution is a blunt instrument, because it usually brings to an end the members’ ongoing involvement with the LLC’s business. (It is theoretically possible for some of the members to buy the business from the LLC as it winds up, but in many cases that is not a practical alternative.)
Judicial dissociation removes all voting and management powers from the dissociated members, but leaves them with their economic rights. They will continue to receive distributions of cash and allocations of profit and loss in accordance with the LLC agreement. But that points out a potential flaw with judicial dissociation in precisely the All Saints situation, i.e., where the remaining members desire to make future capital contributions without concerns over management involvement by the dissociated members.
Here’s the problem: If the LLC agreement provides for distributions and allocations to be made by percentages or units, and does not have a mechanism to adjust those percentages or units when non-pro-rata capital contributions are made, the dissociated members will benefit unfairly from the remaining members’ future capital contributions. In that scenario the members making the non-pro-rata capital contributions should get their capital contributions back when the LLC is eventually liquidated (assuming it’s a profitable venture), but in the interim the dissociated members will receive larger shares of profits and distributions than most investors would consider fair under those circumstances. This example points out why LLC agreements should always cover the possibility of disparate capital contributions being made. Most do, but that is not always the case.
The trustee in the bankruptcy of an LLC member asked the Bankruptcy Court for a declaration that the LLC was dissolved pursuant to its operating agreement. The operating agreement mandated dissolution upon the bankruptcy of a member, but the court denied the trustee’s motion, relying on provisions in the Bankruptcy Act that trump contractual limitations. In re Warner, 480 B.R. 641 (Bankr. N.D. W.Va. Sept. 27, 2012). The ruling left the trustee with limited options for liquidating the member’s LLC interest and realizing value for the member’s creditors.
Background. Benjamin Warner was one of several members of McCoy Farm, LLC, a West Virginia limited liability company formed in 2002. The LLC owned a 141-acre real estate parcel that included a family lodge and a farm house.
In April 2010 Warner filed a Chapter 7 bankruptcy petition. In 2011 the bankruptcy trustee asked the other members to agree to dissolve and liquidate the LLC, but they declined his request. The trustee then filed a motion, asking the Bankruptcy Court for a declaration that the LLC was dissolved.
The LLC’s operating agreement was clear: it specified that the LLC “shall be dissolved upon the occurrence of any of the following events: … (ii) upon the death, retirement, withdrawal, expulsion, bankruptcy or dissolution of a Member.” Id. at 646. Warner’s bankruptcy thus triggered the LLC’s dissolution. The agreement allowed for an exception, though, “if the remaining Members unanimously agree to continue the Company under this Agreement within sixty (60) days of such dissolution.” Id. at 647. The members desired to avoid dissolution and accordingly passed a two-part resolution that continued the LLC, and also dissociated Warner and provided that he would have no right to participate in the business of the LLC.
Court’s Analysis. The court found both components of the members’ resolution to be invalid. The attempt to continue the LLC failed because the members’ resolution was at least ten days too late and therefore outside the 60-day window permitted by the operating agreement. Id. at 648. The attempt to dissociate Warner violated the automatic stay of Warner’s bankruptcy filing and therefore was invalid. Id. at 647. (Bankruptcy’s automatic stay gives the debtor a breathing spell from creditors by barring actions such as initiating or continuing lawsuits against the debtor, actions to obtain the debtor’s property, and creating or enforcing liens against a debtor’s property. 11 U.S.C. § 362(a).)
Executory Contract. The court then reached the core issue: whether dissolution of the LLC pursuant to the operating agreement would violate the Bankruptcy Act. The court first considered whether the LLC’s operating agreement was an executory contract under Section 365 of the Bankruptcy Act, “as the determination is essential to an evaluation of the Trustee’s rights and powers in McCoy Farm.” Id. at 648. For example, the trustee or debtor must assume or reject an executory contract.
“Executory contract” is not defined in the Bankruptcy Act and there is no consensus among the courts as to whether LLC agreements are considered executory contracts. The McCoy Farm agreement therefore had to be individually assessed to determine if it should be considered an executory contract. Id. at 651. Because Warner was not a manager of McCoy Farm, had no obligation to contribute capital to the LLC or to perform services for the LLC, and could withdraw from the LLC at any time, the court found that he had no unperformed material obligations. The operating agreement was therefore not an executory contract and Section 365 did not apply. Id. at 652.
Section 541. Section 541 of the Bankruptcy Act sweeps into the bankruptcy estate all of the debtor’s legal and equitable interests in the debtor’s property. 11 U.S.C. § 541. After reviewing West Virginia’s Uniform Limited Liability Company Act and the LLC’s operating agreement, the court concluded that Warner’s economic rights (rights to distributions from the LLC) and his non-economic rights (the right to vote as a member and to participate in the affairs of the LLC) became part of the bankruptcy estate. In re Warner, 480 B.R. at 653.
Section 541 also requires that the debtor’s property become property of the bankruptcy estate notwithstanding any provision in an agreement or applicable nonbankruptcy law that (1) is conditioned on the insolvency of the debtor and (2) forfeits, modifies or terminates the debtor’s interest in the property. 11 U.S.C. § 541(c). The purpose of § 541(c) is to eliminate barriers to the transfer of property into the bankruptcy estate, not to invalidate restrictions on the transfer of property from the trustee to third parties. In re Warner, 480 B.R. at 649 n.5.
The court found that the operating agreement’s dissolution requirement fell within the prohibition of § 541(c):
Absent application of § 541(c)(1), the Debtor’s bankruptcy filing would modify the nature of his interest in McCoy Farm: Prior to his bankruptcy he held the full array of economic and non-economic rights provided under the Operating Agreement in a viable, operating company; while after his bankruptcy, he held an economic interest in a defunct LLC and constrained non-economic rights.
Id. at 655 (footnotes omitted). The court accordingly held that § 541(c)(1) invalidated the operating agreement’s dissolution of the LLC.
The trustee argued that automatic preemption of the LLC dissolution provisions would destroy value for creditors of the estate and leave the trustee with few avenues to realize value for the estate, and that he should both stand in the shoes of the debtor and also have the expanded rights the bankruptcy estate acquired under § 541(c). In short, the trustee argued that he should have the discretion to opt in or out of the dissolution provisions of the operating agreement.
The court rejected that argument because it would expand the trustee’s rights beyond those held by the debtor, and concluded by denying the trustee’s motion. Id. at 656, 658. The trustee was therefore unable to enforce the LLC agreement’s dissolution of the LLC.
Comment. The court’s ruling leaves the trustee in a pretty pickle. Warner’s one-sixth interest in the LLC, which owns a large parcel of real estate, may be very valuable if the LLC has little or no debt. But with no ability to force a dissolution, the trustee may be unable to access that value. The court recognized the trustee’s dilemma: “The court acknowledges that a trustee holding a debtor’s interest in a LLC is in a knotty position to realize value for the estate.” Id. at 657.
The court suggested that the trustee might have other methods of liquidating Warner’s member interest. For example, said the court, the trustee has Warner’s membership rights and might exercise the right to seek judicial dissolution. But in West Virginia, as in most states, the grounds for a judicial decree of dissolution are fairly limited. There must be substantial frustration of the LLC’s purpose or wrongdoing by the manager or the managing members, or it must be not reasonably practicable to carry on the LLC’s business in conformity with the operating agreement. W. Va. Code § 31B-8-801. The court’s recital of the facts in Warner did not suggest that any of those grounds were applicable.
The Montana Supreme Court recently interpreted for the first time the grounds for judicial dissolution of an LLC under Montana’s Limited Liability Company Act. Gordon v. Kuzara, No. DA 12-0116, 2012 WL 4086512 (Mont. Sept. 18, 2012). The Supreme Court upheld the trial court’s dissolution order.
Background. James and Christina Gordon entered into Half Breed Land and Livestock LLC with several members of the Kuzara family in 2006. The purpose of the LLC was to raise and sell cattle, and the members contributed cash and cattle to the company and commenced operations. By 2008 the Gordons became aware of various irregularities, held a meeting of the members, audited the LLC’s records, and eventually filed suit seeking a judicial order dissolving the LLC.
Round 1. The court’s recent decision was not the first time this dispute has been in front of the Montana Supreme Court. After the Gordons filed their suit seeking dissolution, Joseph Kim Kuzara, one of the defendants, filed a motion to compel arbitration based on an arbitration clause in the LLC’s Operating Agreement. That motion, if successful, would have resulted in the case being decided by an arbitrator instead of by the trial court. The trial court denied the motion, and on the appeal the Supreme Court ruled in December, 2010 that the arbitration clause in the Operating Agreement did not apply to a member’s request for judicial dissolution. I commented on that decision, here.
Round 2. The Gordons based their petition for dissolution on Mont. Code Ann. § 35-8-902(1), which provides several alternative grounds for judicial dissolution:
(a) the economic purpose of the company is likely to be unreasonably frustrated;
(b) another member has engaged in conduct relating to the company’s business that makes it not reasonably practicable to carry on the company’s business with that member remaining as a member;
(c) it is not otherwise reasonably practicable to carry on the company’s business in conformity with the articles of organization and the operating agreement;
(d) the company failed to purchase the petitioner’s distributional interest as required by 35-8-805; or
(e) the members or managers in control of the company have acted, are acting, or will act in a manner that is illegal, oppressive, fraudulent, or unfairly prejudicial to the petitioner.
It was undisputed by Kuzara that on multiple occasions the proceeds of calf sales by the LLC had been deposited into the LLC’s account and then immediately remitted to Kuzara’s family corporation, and that on one occasion a withdrawal of $2,000 from the LLC’s account, which was remitted to Kuzara’s family corporation, caused an overdraft of the LLC’s bank account. Kuzara was also charging the LLC for his time at $20 an hour, despite the fact that § 35-8-504(4) of the Montana LLC Act provides that an LLC member is not entitled to remuneration for services performed for the LLC, except when winding up the business. Gordon, 2012 WL 4086512, at *4.
The court affirmed the trial court’s summary judgment ruling and the dissolution order, holding that the defendants’ undisputed actions were adequate to support the trial court’s ruling under either clause (a), clause (b), or clause (e) of § 35-8-902(1). Id. The court noted that the listed grounds for dissolution are stated in the disjunctive, and “a finding that any one of the grounds for dissolution has been met is sufficient to uphold a judicial order of dissolution.” Id. at *4. The court did not describe how each of the listed grounds applied to the specific facts, but apparently saw an ongoing pattern of bad behavior that could fit under any of the three specified grounds. “The reasonable conclusion was that R Three, as a member of the LLC, was being disproportionately enriched and was girding itself to make future claims against the LLC through the acts and omissions of Kim Kuzara.” Id. at *4.
While the Gordons’ dissolution action was pending, Kuzara moved to amend the defendants’ answer in order to add counterclaims against the Gordons for breach of the duty of loyalty and for negligent interference with a business relationship. The trial court refused to allow the amendment and the Supreme Court affirmed. The court pointed out that the arbitration clause in the Operating Agreement, which it had determined in Round 1 was not applicable to a dissolution petition, would apply to the tort counterclaims. To add the counterclaims would have been legally insufficient and futile, said the court, because the parties’ Operating Agreement required those claims to be arbitrated. The trial court’s refusal to allow the amendment to Kuzara’s answer was therefore affirmed. Id. at *5.
Comment. The court in Gordon found that the facts showed a pattern of misappropriation of funds and unauthorized charges to the LLC which implicated several of the statutory grounds for judicial dissolution. That appears to be a fair reading of the statute, and it points out that there is some redundancy in the alternative grounds in Montana’s statute.
Some states take a more narrow approach to judicial dissolution. Delaware, for example, only allows one ground for judicial dissolution: “whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” Del. Code Ann. tit. 6, § 18-802. This is similar to the approach taken for limited partnerships in the Revised Uniform Limited Partnership Act, § 802. Washington also follows the RULPA approach, but adds “or … other circumstances render dissolution equitable.” RCW 25.15.275.
The grounds for judicial dissolution listed in state LLC statutes vary widely. Given the courts’ willingness to assert their equitable powers broadly, however, I think the outcomes from the cases are more consistent than the statutes would lead one to think. For an example, see my discussion of Mizrahi v. Cohen, No. 3865/10, 2012 WL 104775 (N.Y. Sup. Ct. Jan. 12, 2012), here.
The Mississippi Supreme Court, in a case of first impression, recently interpreted the phrase “not reasonably practicable to carry on the business in conformity with the certificate of formation or the limited liability company agreement,” when an LLC member asked for judicial dissolution of the LLC. Venture Sales, LLC v. Perkins, 86 So.3d 910, 914 (Miss. 2012).
Background. Walter Perkins, Gary Fordham, and David Thompson launched a real estate development venture in 2000. Perkins contributed land and cash to Venture Sales, LLC, and Fordham and Thompson acquired an adjoining parcel of land and contributed it and cash to the LLC. The LLC’s operating agreement stated its purpose as being “to initially acquire, develop and sale [sic] commercial and residential properties near Petal, Forrest County, Mississippi.” Id. at 912 (brackets in original). Fordham and Thompson were experienced in the mobile-home business, and Perkins, an assistant coach for the Cleveland Browns football team, testified that he relied on them to work on developing the property.
Unfortunately, ten years later the LLC’s property was undeveloped and virtually unchanged, and in 2010 Perkins brought suit for an order dissolving the LLC. Id. at 913.
Mississippi’s chancery court found at trial that, “based on the property’s history, the company’s inability to get the required funding for development, and the uncertainty regarding the economic climate in the area, it was not reasonably practicable to carry on the business of Venture Sale,” and ordered that the LLC be dissolved. Id.
Court’s Analysis. The chancery court relied on Mississippi’s LLC Act. The statute then in effect allowed the court, on request of a member, to decree dissolution of an LLC if “[i]t is not reasonably practicable to carry on the business in conformity with the certificate of formation or the limited liability company agreement.” Miss. Code Ann. § 79-29-802 (Rev. 2009). (Mississippi’s LLC Act was subsequently amended and judicial dissolution is now covered by Section 803, but the wording at issue in Venture Sales was essentially unchanged.)
No Mississippi case had interpreted the “not reasonably practicable to carry on the business” phrase, so the Supreme Court looked to decisions from other states. Many state LLC statutes use a similar standard and allow judicial dissolution if “it is not reasonably practicable to carry on the business in conformity with the certificate of formation or the limited liability company agreement,” or similar language. (Washington and Delaware, for example, have similar provisions in their LLC statutes. RCW 25.15.275; Del. Code Ann. tit. 6, § 18-802.) This language has been interpreted by courts from some of those states.
The court cited decisions from Delaware, New Jersey, New York, South Dakota, and Virginia, for several propositions: (i) dissolution under this standard does not require that an LLC’s purpose be completely frustrated; (ii) dissolution is appropriate when the LLC’s economic purpose is not being met, or when the company is failing financially; (iii) dissolution may be appropriate when an LLC is functioning simply as a residual, inertial status quo, even if it is financially stable and has assets exceeding its liabilities; (iv) dissolution is allowed if an LLC cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created; (v) dissolution is appropriate when an LLC is not meeting the economic purpose for which it was established; and (vi) in determining whether dissolution is appropriate, the court must first look to the LLC’s operating agreement to determine the purpose for which the company was formed. Venture Sales, 86 So.3d at 914-15.
Turning to Venture Sales’ purpose, which was to acquire, develop and sell the real estate, the court noted that the property remained completely undeveloped more than ten years after the company was formed. Fordham and Thompson gave a number of reasons for the delay: rezoning, Hurricane Katrina, new subdivision regulations passed by the City of Petal, and the 2007 national housing market decline. But during the same ten-year period, Fordham and Thompson had successfully formed two other LLCs and developed two other large subdivisions with 25 miles of the Venture Sales property. More significantly, Fordham and Thompson presented no evidence that Venture Sales would be able to develop the project within the foreseeable future, and Fordham admitted in his trial testimony that he couldn’t say when the company might be able to begin developing the land.
Fordham and Thompson argued that it was reasonably practicable for the LLC to continue operating because it was solvent and could hunker down and wait for the overall economy to improve. The court found, however, that merely being solvent was not an adequate reason to continue the LLC, given the lack of a plan to meet the LLC’s purpose. Id. at 915-16.
The court accordingly held that the chancellor’s order dissolving Venture Sales was supported by substantial evidence and was not an abuse of dissolution, and affirmed the order of dissolution. Because the chancery court’s order had not made provisions for winding up the LLC, the court remanded for the winding up of Venture Sales. Id. at 917.
Comment. The scope of the phrase “not reasonably practicable to carry on the business in conformity with the certificate of formation or the limited liability company agreement” is inherently open-ended, because it is not explicitly tethered to any particular fact pattern. A court faced with an LLC member’s request for dissolution must therefore examine in some detail the facts and circumstances of the LLC in question, and then set those against the LLC’s stated purpose.
Venture Sales shows an unusual fact pattern of long-term inactivity while the LLC held a valuable but undeveloped asset, in the face of an explicit purpose in the LLC agreement to develop the asset. The opinion thoughtfully analyzes the LLC’s history, purpose, prospects, and the trial testimony about the managers’ plans, and provides a good review of cases from other jurisdictions.
The case underscores the importance of the purpose clause in an LLC’s operating agreement. The result in Venture Sales was driven, in part, by the purpose: to acquire, develop, and sell the real estate. If the purpose had also included, for example, “and hold for appreciation,” the court probably would not have ordered dissolution.
Law firm breakups sometimes result in disputes between the lawyers over continuing legal work. Some of the most difficult disputes are those over contingent-fee cases that were started before the firm broke up and will be concluded after the breakup. A contingent-fee case may require thousands of hours of lawyer time and, regardless of the amount of time spent on the case, may result in a fee anywhere from zero to millions of dollars.
A Colorado court recently had to decide such a case involving the distribution of a contingent fee to two lawyers who had dissolved their two-member LLC law firm in the middle of a contingent-fee case. LaFond v. Sweeney, No. 10CA2005, 2012 WL 503655 (Colo. App. Feb. 16, 2012).
Background. Richard LaFond and Charlotte Sweeney formed a law firm as a Colorado LLC in 1999 and orally agreed to share equally in all the firm’s profits, without regard to who brought cases in or who did work on them. In 2008 their law firm dissolved. Id. at *1.
At the time of dissolution the law firm represented Bobby Maxwell in a qui tam whistle-blower action brought under the False Claims Act. LaFond continued to represent Maxwell in the qui tam suit after the LLC’s dissolution. LaFond and Sweeney could not agree on how to divide the fees that might ultimately be earned on the Maxwell case, and LaFond filed a suit for declaratory relief against Sweeney to determine how the contingent fee should be distributed.
Trial Court. The trial court ruled that the Maxwell case was an asset of the LLC and that its value was to be determined at the time of the dissolution. Because LaFond and Sweeney had agreed that any profit from the case would be divided equally, the court held that Sweeney would be entitled to one-half of any contingent fee recovered by LaFond, up to a ceiling based on the number of hours worked on the case before the LLC’s dissolution. Sweeney appealed, contending that the law firm was entitled to all of any contingent fee received and that she was therefore entitled to one-half of the total fee.
The Court of Appeals first noted that the Maxwell lawsuit had settled after the trial court’s decision. The settlement amount was not clear to the court from the pleadings, but the fact of settlement meant that the Court of Appeals only had to deal with a completed contingent-fee case and a determinable fee.
Contingent Fee. The court then discussed at length the law of contingent-fee cases and the attorney-client relationship, and derived three principles. First, said the court, “the case belongs to the client,” meaning that when an attorney with the primary responsibility for a case leaves a law firm, the client can choose to be represented by the law firm, to be represented by the departing attorney, or to hire new counsel. Id. at *3.
Second, a contingent-fee agreement provides the attorney with certain rights. Id. at *4. An agreement between attorney and client that calls for a fee contingent on the outcome of a case is generally enforceable, assuming the lawyer satisfies his or her professional ethics obligations.
The court’s third principle required a review of the Colorado LLC Act’s dissolution rules. After its dissolution, an LLC continues in existence for the purpose of winding up and liquidating its business and affairs. Colo. Rev. Stat. § 7-80-803(1). As part of the winding up process, the LLC completes its executory contracts, including pending contingent-fee cases. LaFond, 2012 WL 503655 at *7. Therefore, said the court, “[a]n attorney who carries on the representation of a client on an existing case after a law firm dissolves does so on the firm’s behalf.” Id. The court pointed out that under the LLC Act, a member must “[a]ccount to the [LLC] and hold as trustee for it any property, profit, or benefit derived by the member or manager in the conduct or winding up of the [LLC’s] business.” Id. (quoting Colo. Rev. Stat. § 7-80-404(1)(a)).
The court’s analysis – a pending contingent-fee case constitutes unfinished business of the law firm, and a former LLC member who completes the case does so on behalf of the LLC – led it to its third principle, that the fee ultimately earned in such a contingent-fee case belongs to the LLC.
The court next examined LaFond’s and Sweeney’s relative rights in the fee. The court looked to other jurisdictions and applied the majority partnership rule: “The great majority of states have concluded that contingent fees ultimately generated from cases that were pending at the time of dissolution of a law firm must be divided among the former law partners according to the fee-sharing arrangement that was in place when the firm dissolved.” Id. at *10.
Compensation for Post-Dissolution Work. The court then had to determine whether LaFond should be compensated for his work on the Maxwell case after the LLC’s dissolution, or whether the fee should be split equally without regard for his post-dissolution time spent on the case.
The court first compared the winding-up provisions of Colorado’s LLC Act with its Partnership Act. The Partnership Act states that “[a] partner is not entitled to remuneration for services performed for the partnership except for reasonable compensation for services rendered in winding up the business of the partnership.” Id. at *13 (quoting Colo. Rev. Stat. § 7-64-401(8)) (emphasis added by the court). In contrast, the winding-up section of the LLC Act does not authorize or even refer to compensation for services rendered in winding up the LLC. Colo. Rev. Stat. § 7-80-803.3.
Because Colorado’s LLC Act was modeled in part on its Partnership Act, the court viewed the exclusion of compensation language from the LLC Act as an intentional legislative choice, and read the LLC Act to mean that an LLC member is not entitled to compensation for services rendered in winding up the business of the LLC. LaFond, 2012 WL 503655 at *13.
The court also relied on the reasoning of Jewel v. Boxer, 203 Cal. Rptr. 13 (Ct. App. 1984), quoting from its opinion:
At first glance, strict application of the rule against extra compensation might appear to have unjust results (e.g., where a former partner obtains a highly remunerative case just before dissolution, and nearly all work is performed after dissolution). But undue hardship should be prevented by two basic fiduciary duties owed between the former partners. First, each former partner has a duty to wind up and complete the unfinished business of the dissolved partnership…. Second, no former partner may take any action with respect to unfinished business which leads to purely personal gain. … If there is any disproportionate burden of completing unfinished business here, it results from the parties' failure to have entered into a partnership agreement which could have assured such a result would not occur. The former partners must bear the consequences of their failure to provide for dissolution in a partnership agreement.
Id. at 18-19.
Consistent with the Jewel approach, the court held that LaFond and Sweeney were each entitled to one-half of the contingent fee obtained by LaFond in the Maxwell case, without any reduction for compensation to LaFond for his post-dissolution work.
Comment. On the facts of the case this is not a terrible result, since LaFond’s hours spent on the Maxwell case after dissolution only amounted to about 4% of the total. But the court did not rely on that, and by extrapolation its holding would have yielded the same result, i.e., a 50-50 split of the fee, even if most of the work on the case had been performed after dissolution. That clearly would have been an inequitable result.
The court relied in part on a perceived duty for LaFond to wind up and complete the unfinished business of the dissolved LLC, including working on the Maxwell case: “We conclude that LaFond had a duty to wind up unfinished business of the dissolved law firm, including continuing to represent Maxwell.” LaFond, 2012 WL 503655 at *14. The source of this duty is not made clear in the opinion, but presumably it lies in either (i) the contingent-fee agreement with Maxwell, (ii) the LLC Act, or (iii) the fiduciary duty of a member.
The Contract. Maxwell’s contingent-fee agreement was with the LLC, not with LaFond. As the court said, “[a] contingent fee case that is pending at the time a law firm dissolves is a form of executory contract between the law firm and the client.” Id. at *7. The LLC, not LaFond, was obligated to represent Maxwell in his suit.
LLC Act. The LLC Act limits the activities of an LLC after dissolution to those appropriate to wind up and liquidate its business and affairs, but it imposes no duty on members to wind up the LLC after its dissolution. “After dissolution, the manager or, if there is no manager, any member may wind up the limited liability company’s business.” Colo. Rev. Stat. § 7-80-803.3(1) (emphasis added). The statute empowers the members to conduct the winding up, but does not obligate any member to do so.
Fiduciary Obligations. As an LLC member, LaFond had fiduciary obligations to the LLC’s other member, Sweeney, just as Sweeney had fiduciary obligations to LaFond. LaFond, 2012 WL 503655 at *6. Mutual fiduciary obligations would not obligate LaFond to handle the case after dissolution without compensation any more than they would obligate Sweeney. LaFond’s failure to insist on an Alphonse-and-Gaston routine with Sweeney should not doom him to non-recognition of his successful efforts to complete the contingent-fee case.
The LaFond case was easy in one respect – by the time the case went up on appeal it involved a dispute over a fully earned contingent fee, because by that time the Maxwell case was over. The fairest approach in such a case probably would be to divide the contingent fee into two portions pro rata, based on the hours spent on the case pre-dissolution and the hours spent post-dissolution. The pre-dissolution portion of the fee would be distributed to the members (50-50 in LaFond), and the post-dissolution portion would go to the member who worked on the case.
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. 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.
 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.
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.
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’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.
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.
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.
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 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.
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 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.
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.
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.