Several judgment creditors obtained charging orders against their debtors’ interests in three LLCs, along with an order requiring the LLCs to provide quarterly cash flow statements. The LLCs objected to disclosure of their quarterly cash flows, and on appeal the Iowa Court of Appeals found that there was no statutory authority for the required disclosure and reversed the disclosure orders. Wells Fargo Bank, Nat’l Assoc. v. Continuous Control Solutions, Inc., No. 11-1285, 2012 WL 3195759 (Iowa Ct. App. Aug. 8, 2012).
Background. Iowa’s courts are authorized, on application by a judgment creditor of an LLC member or assignee, to enter a charging order against the judgment debtor’s economic interest in the LLC. Iowa Code § 489.503. A charging order requires the LLC to pay to the judgment creditor any distributions that would otherwise be paid to the judgment debtor. Id.
In Wells Fargo Bank the judgment creditors petitioned the trial court for charging orders, and also asked for an order requiring the three LLCs to provide quarterly cash flow statements “to verify no distributions have been made to the judgment debtors or any other entity or person with an ownership interest in these limited liability companies.” Wells Fargo Bank, 2012 WL 3195759, at *2. The judgment creditors may have been channeling Ronald Reagan and his mantra, “trust, but verify.” Or perhaps half of it.
The trial court relied on Iowa Code Section 489.503(2)(b), and included the disclosure requirement in its charging order. Id. Section 489.503(2) states:
2. To the extent necessary to effectuate the collection of distributions pursuant to a charging order in effect under subsection 1, the court may do all of the following:
a. Appoint a receiver of the distributions subject to the charging order, with the power to make all inquiries the judgment debtor might have made.
b. Make all other orders necessary to give effect to the charging order.
The Court of Appeals. The judgment creditors relied on Section 489.503(2)(b), which authorizes the court to make all other orders “necessary to give effect to the charging order.” The Court of Appeals began its analysis by noting that that section does not specifically authorize the disclosure orders that were requested. The court gave only a nod to Section 489.503(2)(a), which refers to the “power to make all inquiries the judgment debtor might have made,” presumably because the judgment creditors’ argument did not rely on it.
The court reviewed the comments in NCCUSL’s Revised Uniform Limited Liability Company Act (RULLCA) § 503, which Section 489.503 is modeled on, and found no support for including rights to information in an order “necessary to give effect to the charging order.” The court concluded that Section 489.503(2)(b) only authorizes orders that affect economic rights, not governance rights such as rights to information. Id. at *3.
The court’s conclusion was supported by Section 489.502(1)(c)(2), which provides that a transferee of an LLC member’s interest is not entitled to access to records or other information concerning the LLC’s activities (except upon the LLC’s dissolution). A charging order is a lien on the judgment debtor’s economic interest, and since the holder of a member’s economic interest is not entitled to access to the LLC’s records, the holder of a lien on the member’s economic interest should similarly be denied access to the LLC’s records or other information. Id.
The court vacated the trial court’s disclosure orders, stating: “To effectuate a charging order, Iowa Code section 489.503 authorizes a court to order an L.L.C. to disclose financial information to a court-appointed receiver only. We conclude there is no statutory authority for the disclosure orders the district court issued in this case.” Id.
Comment. The court’s conclusion seems correct, given the “pick your partner” principle inherent in LLC law. An assignee of an LLC interest has no rights to information from the LLC, so why should the holder of a charging order, which puts the judgment creditor in a position similar to that of an assignee, have more rights to information than the assignee?
The court’s opinion leaves open, however, what the result would have been if the judgment creditors had asked for appointment of a receiver for the distributions, and the receiver had then asked for the financials under the authority of Section 489.503(2)(b): “with the power to make all inquiries the judgment debtor might have made.” The Court of Appeals acknowledged that the judgment debtor retains its management power and rights to information, even after the entry of a charging order against its interest. Wells Fargo Bank, 2012 WL 3195759, at *2. The NCCUSL comments to RULLCA section 503 don’t answer that question.
Reformation is an equitable remedy that courts use to “reform” or correct a mistake in a written agreement, to conform it to what the parties actually intended their agreement to say. The Delaware Court of Chancery recently reformed the cash distribution waterfall provisions of the limited liability company agreements for three real estate joint ventures in ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, No. C.A. No. 5843-VCL, 2012 WL 1869416 (Del. Ch. May 16, 2012).
Background. Investors and Developer entered into five real estate deals in 2007 and 2008, each structured as an LLC. In each deal the Investors put up 99% of the cash and Developer put up 1%. Each agreement provided that when the LLC’s property was sold, the sale proceeds would be distributed to the members according to a hierarchy that established the order in which funds would be distributed, often called a “waterfall.” The waterfall from the first two deals, using simplified language, was:
(a) First, 99% to Investors and 1% to Developer until each has received an 8% preferred return (similar to an annual interest rate) on its invested capital;
(b) Then 99% to Investors and 1% to Developer until each has received the return of its invested capital; and
(c) Then 20% to Developer, and 80% to be divided 1% to Developer and 99% to Investors.
In other words, both parties receive interest on their investment, then they get their investment back, and then they share, not based on the 99%-1% ratio of invested capital, but based on a ratio that gives the Developer a higher percentage return. The higher level of return to the Developer, after the threshold amounts are paid out, is intended as an incentive for the Developer. It is often referred to as a “promote” by real estate professionals. The above waterfall has a 20% promote.
When the parties negotiated the third of the five deals, they agreed on a two-tiered promote. This was similar to the waterfall above, except that the final level, which defines the promote, shifts to a higher promote percentage for the Developer after a specified amount has been distributed. In the example above, the third level would have a limiting cap added, and a fourth level would be added with the higher promote.
The Mistake. Unfortunately, in the process of preparing the written LLC agreement for the third deal, the return of capital paragraph was mistakenly placed after the first promote paragraph. That’s a much better deal for the Developer, which would receive the first portion of its promote before the parties get their capital returned. Thus the Developer could get its promote even if the overall deal were a loss and did not return any of the parties’ invested capital. This written agreement was approved and signed by the parties, even though it was not what they had negotiated.
This mistake happened because the responsible partner at the Investors’ law firm, who was heavily involved in the first transaction, turned the second deal over to an inexperienced associate lawyer. The terms of the second transaction mirrored the terms of the first, but when the terms of the waterfall changed in the third transaction the associate accidentally placed the key paragraph in the wrong position. The partner either did not read the final agreement or did not notice the mistake, and the error remained in the final agreement.
The court found that the in-house lawyer at the Developer knew of the mistake and knew that it was favorable to Developer, but said nothing about it to the Investors’ counsel. The executive in charge of the deal for the Investors reviewed the agreement, but did not notice the mistake and signed the agreement.
To compound the error, in short order the parties entered into two more real estate ventures, using the same structure and copying the same erroneous waterfall language. In both cases the waterfall as written by the Investors’ lawyer was not what the parties negotiated, the Developer knew of the mistake and knew that it was favorable to Developer, the Developer said nothing, and the Investors did not catch the mistake.
This situation inevitably led to conflict, which was precipitated by the Developer’s exercise of a put right in one of the three LLC agreements with the mistaken waterfall. The Developer’s buyout price under its put right was based on the agreement’s distribution provisions and the venture’s fair value.
The venture was underwater, since it had a fair market value of $35.5 million and the Investors had invested $47.3 million. As written, the waterfall entitled the Developer to $1.83 million, but as negotiated, the waterfall would have entitled the Developer to only $348,000. The result would be that instead of the Investors and the Developer sharing the loss 99%-1%, the Developer would make a 282% profit and the Investors would lose roughly 30% of their investment. Id. at *10.
The Developer demanded the higher amount based on the language of the waterfall. The Investors examined the agreement and determined that it was in error and was not in accordance with what they had negotiated. The Investors had what their executive called “a very, very tough conversation” with their law firm, and put the law firm on notice of a malpractice claim. Id. The executive said at trial that he was “incredibly upset that this had happened because it was clear what the document said, and that it was just wrong.” Id.
The Lawsuit. The Investors filed suit and sought an order reforming the waterfall provisions in the three disputed LLC agreements to match what had been negotiated. The Developer counterclaimed, seeking to enforce the agreements as written. The trial lasted four days and included nine fact witnesses, two expert witnesses, 300 documentary exhibits, and 25 deposition transcripts.
The court applied the doctrine of unilateral mistake, which allows reformation of a contract if the party seeking reformation can show by clear and convincing evidence that it was mistaken and that the other party knew of the mistake but remained silent. The plaintiff must show that there was a specific prior contractual understanding that conflicts with the terms of the written agreement. Id. at *13.
After a detailed review of the evidence, the court found that the Investors had demonstrated by clear and convincing evidence that they were entitled to reformation of the three LLC agreements. The court also dismissed the Developer’s defenses that (a) the Investors’ representative had not read the agreements, (b) the Investors had ratified the agreements, and (c) the Investors had unclean hands. The court accordingly rewrote the waterfall provision, placed the corrected language in its opinion, and ordered the two other disputed LLC agreements to be corrected in the same way. Id. at *21.
The court also awarded the Investors their attorneys’ fees, under the contractual fee-shifting provisions of the disputed agreements. The Developer argued that the Investors had not incurred any attorneys’ fees because the Investors’ law firm was not billing for its fees. (The same law firm that had made the mistakes in the three agreements represented the Investors in the lawsuit. Presumably it was not charging for the litigation because without its mistakes on the three agreements there would have been no litigation.) The court found that the arrangements between the Investors and their law firm to allocate the litigation costs did not affect the Developer’s obligations under the fee-shifting provision in the agreements. Id. at *20.
For a more detailed review of the court’s analysis, see Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog, here.
Comment. This strikes me as a surprising case. Not because of the legal doctrine of reformation or the court’s legal analysis, but because of how the business transactions played out and the roles of the lawyers involved.
For one thing, lawyers and business people who work on large real estate ventures such as these know that the waterfall provisions are not boilerplate – they are at the heart of the deal. Who puts how much money into the deal and who gets how much out are major components of what real estate partnerships and LLCs are all about.
For another thing, waterfall provisions, and especially the ones in this case, are not all that hard to read. They are a series of fairly short clauses in reasonably simple language that specify an algorithm to pay out the cash from the venture to the members. The sequential order of those clauses is key to how the waterfall works. Getting the paragraphs out of order is roughly comparable to getting a divide and an addition out of order in an algebraic expression. The result will usually be wrong.
These truisms make the mistakes that took place here, on both sides, rather startling. I say on both sides because the Investors’ law firm made the drafting mistakes, but the Developer’s lawyer made a mistake in judgment by not revealing the drafting mistake.
The drafting mistakes appear to reflect a classic organizational blunder by the Investors’ law firm. A senior partner turns over responsibility for a series of transactions to an associate lawyer who lacks the experience to understand the terms of the waterfall. The associate makes the mistake, and then the partner either doesn’t read the agreement or if she did, doesn’t focus on the key terms of the waterfall. The Investors’ representative relies on the partner at the law firm, and the partner relies overmuch on the inexperienced associate.
The Developer’s attorney, on the other hand, showed bad judgment in not revealing the error. The court found that he was a sophisticated and experienced real estate venture attorney who recognized the error but intentionally remained silent in order to capture an undeserved benefit for the Developer. Id. at *15.
As Francis Pileggi pointed out in his blog post, here, the court did not address the legal ethics issues in its opinion. But even setting that aside, in deals of this magnitude it’s foolish to think that a fundamental drafting error, inconsistent with what the parties clearly had agreed on, will not be discovered when it comes to light and would cost the other party a lot of money unless corrected. And as the court’s opinion shows, basic contract law can provide relief in this type of situation.
This is not a case where the lawyers appear at their best.
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.
Judgment creditors of LLC members usually have the right under state law to obtain a charging order against a member’s LLC interest. A charging order mandates that any distributions by the LLC that would otherwise be made to the member be paid instead to the creditor. The charging order provides no benefit, though, if no distributions are made to the LLC’s members. And if the judgment debtor is the only member of the LLC, it’s unlikely that he or she will cause the LLC to make distributions, since those would have to go to the creditor.
The U.S. District Court in Kansas recently had to determine the scope of a charging order against a single-member LLC in Meyer v. Christie, No. 07-2230-CM, 2011 U.S. Dist. LEXIS 118590 (D. Kan. Oct. 13, 2011). Although the Kansas LLC Act says a charging order against an LLC member’s interest is the creditor’s exclusive remedy, the court surprisingly found that, in the case of a single-member LLC, the creditor could assert management rights and take control of the LLC.
The relevant facts are straightforward. The plaintiffs obtained a final judgment of about $7 million against the defendants, who had interests in several Kansas LLCs. The plaintiffs asked the judge to issue a charging order against the defendants’ interests in the LLCs, under the authority of Kansas’s LLC Act:
Rights of judgment creditor. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest. This act does not deprive any member of the benefit of any exemption laws applicable to the member’s limited liability company interest. The rights provided by this section to the judgment creditor shall be the sole and exclusive remedy of a judgment creditor with respect to the member’s limited liability company interest.
Kan. Stat. Ann. § 17-76,113 (emphasis added).
A charging order is a limited remedy – the creditor has only the rights of an assignee, i.e., the economic right to receive distributions, and no rights to participate in management. The Kansas statute also provides that the charging order is the exclusive remedy, so the creditor cannot attach or foreclose on the member’s interest and thereby take control. (The charging order provisions of some state LLC Acts are silent on whether the charging order is a creditor’s exclusive remedy. See my discussion of Florida’s Olmstead v. FTC case on charging orders, here.)
The court acknowledged the Kansas LLC Act’s clear statement that the charging order is the only remedy by which a member’s judgment creditor can reach the member’s LLC interest, and discussed the partnership law origins of the LLC charging order. In the case of partnerships, a creditor’s charging order against a partner will not entitle the creditor to participate in the management of the partnership. Meyer, 2011 U.S. Dist. LEXIS 118590, at *10.
But, said the court, the result is different in the case of an LLC with only one member. That’s because of a specific provision in the Kansas LLC Act:
If the assignor of a limited liability company interest is the only member of the limited liability company at the time of the assignment, the assignee shall have the right to participate in the management of the business and affairs of the limited liability company as a member.
Kan. Stat. Ann. § 17-76,112(f). That paragraph is not in the Act’s section on charging orders, but is part of a long section dealing with assignments of LLC interests.
Without discussion, the court simply assumed that the holder of a charging order not only has the rights of an assignee but actually is an assignee. The court then held that under Section § 17-76,112(f), “the assignee/creditor shall have the right to participate in the management of the business and affairs of the LLC as a member.” Meyer, 2011 U.S. Dist. LEXIS 118590, at *11. With those rights, the holder of a charging order against an LLC’s sole member can take over the LLC, make distributions to itself, and liquidate the LLC if it so chooses.
The problem with the court’s holding is that the creditor’s rights under a charging order are limited to satisfaction of the debt. Once the judgment debtor’s obligation is satisfied, the charging order is extinguished. An assignment, in contrast, is a permanent transfer of the property rights assigned. The charging order statute accordingly recognizes that the rights of the creditor are limited: “To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest.” Kan. Stat. Ann. § 17-76,113 (emphasis added). The Meyer court ignored the inherent limitations of charging orders. Its confusion between the limited economic rights granted under a charging order and the full transfer of rights granted under a true assignment led it to the wrong result.
Some states have added provisions to their LLC Acts to clarify this point and avoid a Meyer result. Thomas Rutledge recently blogged about the Meyer case, here, and pointed out that Kentucky has amended its LLC Act to provide that “[a] charging order does not of itself constitute an assignment of the [LLC] interest.” Ky. Rev. Stat. § 275.260(3).
Michigan similarly provides in its LLC Act that a charging order is not an assignment of the member’s interest, and that the holder of a charging order does not become a member of the LLC. Mich. Comp. Laws § 450.4507.
One recent publication that is a useful reference for investigating state LLC charging order laws is Carter G. Bishop, Fifty State Series: LLC Charging Order Statutes , Suffolk University Law School Research Paper No. 10-03 (Oct. 6, 2011) .
Absent a Written Operating Agreement, Withdrawing Member of Kentucky LLC Has No Claim for Value of His Interest
The lawyers’ maxim is, “get it in writing.” Oral agreements can be difficult to prove and often leave unanswered questions. In Chapman v. Regional Radiology Associates, PLLC, 2011 Ky. App. Unpub. LEXIS 251 (Ky. Ct. App. Mar. 25, 2011), the members had no written agreement and not much of an oral agreement. One of the two members withdrew and they couldn’t agree on what the withdrawing LLC member was entitled to.
Background. Dr. Shiben organized Regional Radiology Associates, PLLC in 2000 and was its sole manager and member. In 2001 Dr. Chapman became employed by the LLC, and in 2002 negotiated with Shiben to become a 40% member and tendered a $10,000 check for his initial capital contribution. The check was never cashed and the doctors never executed a written agreement. Nonetheless, on January 1, 2003 the LLC began treating Chapman as a member of the LLC, and did so through the end of 2005. Profits were allocated 40% to Chapman, distributions were made accordingly, and the LLC’s tax returns showed Chapman as a 40% member.
In January 2006 Chapman gave notice that he intended to terminate his employment, and on April 14, 2006 he ceased working for the LLC. Chapman received his salary through the end of his employment, but he also asked for additional cash for his member interest in the LLC.
Trial Court. The trial court awarded Chapman $20,709 for the LLC’s net income allocated to him through April 2006. Chapman didn’t dispute that amount, but he claimed he was also entitled to receive 40% of the value of the LLC as of April 14, 2006. Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *8.
Neither party contested that Chapman was a member of the LLC from January 1, 2003 until April 14, 2006. The Court of Appeals therefore looked to Kentucky’s LLC Act: “Next, we will consider whether under KRS Chapter 275 Dr. Chapman was entitled to any additional payment upon his voluntary withdrawal from RRA.” Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *11-12.
Termination of Employment vs. Member Withdrawal. The court never discussed the difference between termination of a member’s employment by the LLC and the member’s withdrawal as an LLC member. The court simply treated the termination of Chapman’s employment as being equivalent to his withdrawal as a member of the LLC.
Employment and LLC membership are two different statuses. In general one need not be employed by an LLC to be a member of the LLC. It may be that both members implicitly agreed that Chapman’s employment termination constituted a withdrawal as a member from the LLC, but it is puzzling that the court did not address the issue.
Dissociation. After reviewing Sections 275.210 (distributions) and 275.205 (allocations of profits and losses), the court found that Chapman was a member of the LLC from 2003 until April 2006. The court then found that Chapman withdrew from the LLC pursuant to Section 275.280 (Cessation of Membership), as it was then in effect:
(1) A person shall disassociate from the limited liability company and cease to be a member of a limited liability company upon the occurrence of one (1) or more of the following events;
(a) Subject to the provisions of subsection (3) of this section, the member withdraws by voluntary act from the limited liability company[.]
Ky. Rev. Stat. § 275.280.
According to the court, “[t]he statute, however, gives no instruction as to compensation for the withdrawing member.” Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *17. After discussing the manager’s authority under Section 275.165(2), the court concluded that the LLC’s manager had the authority to decide how much the LLC should pay Chapman upon his withdrawal from the LLC. The court found the default rules for allocations of profit and loss under Section 275.205 to be inapplicable to a withdrawing member.
Holding. The court held that Chapman failed to demonstrate that the LLC had a legal obligation to pay him anything for his member interest upon his withdrawal from the LLC. No written agreement ever governed his membership, and no provision of the LLC Act required that he be paid anything for his member interest. Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *20.
Mistaken Analysis. The court’s analysis reflects a fundamental misreading of the Kentucky LLC Act. The court without discussion treated Chapman’s withdrawal as equivalent to giving up his economic rights as a member. But the Act clearly recognizes that one may be a non-member while still holding the economic rights of a member. For example, when a member assigns its member interest, the assignee receives only the right to receive distributions and may not participate in management of the LLC unless a majority in interest of the members consent. Ky. Rev. Stat. §§ 275.255(1), 275.265(1). The assigning member remains a member unless removed by a vote of the other members, notwithstanding that the assignor has no remaining economic rights. Id. These sections of the Act imply that a withdrawing member still has the right to receive distributions.
This point is made even more clearly by Section 275.265(5): “Unless otherwise set forth in the operating agreement, a successor in interest to a member who is disassociated from the limited liability company shall have the rights and obligations of an assignee with respect to the member’s interest.” The court determined that Chapman’s withdrawal was a disassociation under Section 275.280(1)(a). But under Section 275.265(2), any successor in interest to a disassociated member is an assignee and retains the economic rights of the disassociated member. And if a successor in interest to a disassociated member has the former member’s economic rights, certainly the disassociated member retains those economic rights when there is no successor.
Because the statute provides for Chapman’s continued ownership of the economic rights, he would be entitled to ongoing distributions under Section 275.210. Since there was no written operating agreement, this Section requires the members to share in distributions on the basis of the agreed value of their contributions as shown in the records of the LLC. The tax returns and the records of the LLC for 2003 through 2005 showed that the agreed value of the members’ contributions were in the ratio of 40% for Chapman to 60% for Shiben.
There was apparently no agreement between the parties that entitled Chapman to payment for his economic interest in the LLC upon his withdrawal as a member, but the court’s analysis failed to recognize that Chapman had an ongoing right to receive distributions of $40 for every $60 of distributions made to Shiben.
The Washington LLC Act prohibits an insolvent LLC from making a distribution to a member. RCW 25.15.235(1). Either type of insolvency will do – the LLC is unable to pay its debts as they come due in the usual course of business, or the LLC’s liabilities exceed the fair value of its assets. Furthermore, a member who receives such an unlawful distribution and who knows at the time that the LLC is insolvent, “shall be liable to [the] limited liability company for the amount of the distribution.” RCW 25.15.235(2).
How does this rule play out when a third party makes a claim against the LLC? I had always assumed that in this scenario a court would allow an LLC’s creditor to assert the claim against the distribution-receiving member as well, probably by piercing the LLC’s veil. But the analysis of the Washington Court of Appeals in a recent case turned out to be a little more complex.
In Shinstine/Assoc. LLC v. South-N-Erectors, LLC, No. 39277-1-II, 2010 Wash. App. LEXIS 1976 (Wash. Ct. App. Aug. 31, 2010) (unpublished), the defendant LLC stipulated to a judgment in favor of the plaintiff Shinstine for $127,850.58. Shinstine also sought to hold the LLC’s sole member, Roger Hicks, personally liable for Shinstine’s judgment against the LLC. Shinstine claimed the LLC made an improper distribution to Hicks that rendered the LLC insolvent and therefore violated RCW 25.15.235. The trial court agreed and pierced the LLC’s veil, holding Hicks personally liable for Shinstine’s judgment against the LLC.
The Court of Appeals began its analysis with the proposition that generally LLC members and managers are not personally liable for the LLC’s obligations. RCW 25.15.125(1). The Act provides an exception, however: “Members of a limited liability company shall be personally liable for any act, debt, obligation, or liability of the limited liability company to the extent that shareholders of a Washington business corporation would be liable in analogous circumstances.” RCW 25.15.060.
The Shinstine court looked to a case that involved an unlawful corporate distribution, Block v. Olympic Health Spa, Inc., 24 Wn. App. 938, 604 P.2d 1317 (1979), rev. denied, 93 Wn.2d 1025 (1980). In Block, the court had held that an insolvent corporation’s distribution to its sole stockholder and president, who was well aware of the company’s insolvency, did not require piercing the corporation’s veil. Block, 24 Wn. App. at 950. (The corporate rule when a shareholder knowingly receives an unlawful distribution from an insolvent corporation is similar to the LLC rule: the shareholder is liable for return of the distribution to the corporation. RCW 23B.08.310.)
The court in Block refused to pierce the veil because to do so would have allowed the plaintiff to secure a preference over the other creditors of the corporation. Block, 24 Wn. App at 950. The Block court’s reasoning was persuasive to the Shinstine court: “To hold otherwise would permit creditors to get a preference over other creditors otherwise prohibited by law.” Shinstine, 2010 Wash. App. LEXIS 1976 at *12-13. The Shinstine court applied the Block rule and reached the same result on the same reasoning – it held that the LLC’s veil would not be pierced to allow Shinstine’s claim to reach Hicks.
Was Shinstine left with no recourse? Apparently not. The court stated in a footnote:
Shinstine was not without remedy. Without disregard Shinstine could have had a receiver appointed pursuant to RCW 7.60.025(1)(c), which permits any party to request appointment of a receiver after a judgment in order to give effect to the judgment. The receiver could have sought reimbursement from Hicks or South-N-Erectors’ behalf if the distribution was in violation of RCW 25.15.235(1), and then pay those funds to Shinstine.
Id. at *13 n.5. My litigation colleagues tell me that receivers indeed can be appointed under this statute, for this purpose, but counsel for the plaintiff must go to court and make the necessary showing for appointment of the receiver. Doable, but not simple.
Every so often a case comes along where you read the opinion and say to yourself, “Did they really think this would work?” Meadowsweet Dairy, LLC v. Hooker, Commissioner of Agriculture and Markets, No. 1868, 2010 N.Y. App. Div. LEXIS 1841 (Mar. 11, 2010) is one of those cases.
Steven and Barbara Smith operated a New York dairy and produced and sold unpasteurized milk from 1995 to 2007. During that time they were regulated and inspected by the New York Department of Agriculture and Markets (the Department), and held the permits required by the Department.
In March 2007 the Smiths surrendered their permits and formed Meadowsweet Dairy, LLC. Meadowsweet began operating the dairy and producing unpasteurized milk, cheese and yogurt. But instead of selling milk to the general public, Meadowsweet dealt only with individuals who became members of the LLC. Meadowsweet complied with none of the Department’s permit, inspection and other regulatory requirements.
Meadowsweet’s members were required to make an initial capital contribution of $50, and to make capital contributions at the start of each quarter based on the member’s estimated consumption of milk and dairy products during the quarter. Members were then entitled to receive what were called “dividends,” i.e., distributions from the LLC, in proportion to their capital contributions. The list price of milk received by the member was then credited against the member’s capital account. Milk and other dairy products produced by Meadowsweet were only available to Meadowsweet’s members.
In October 2007 the Department seized 260 pounds of unpasteurized milk from Meadowsweet for noncompliance with its regulations. Meadowsweet then commenced suit, seeking a declaration that the Department lacked jurisdiction.
Meadowsweet’s principal argument was that it was not selling products – that no sale occurred when its members received milk products as distributions. The court, however, looked at Meadowsweet’s system of prepaid capital accounts and offsetting credits equal to the list price of the member’s milk dividend and concluded that “[r]ather than truly constituting dividends in return for their investment in the LLC, this arrangement appears to be a system of prepayment for the sale of dairy products.” Meadowsweet, 2010 N.Y. App. Div. LEXIS 1841, at **10.
The court did not analyze why the arrangement “appears to be a system of prepayment,” but it’s not hard to see what must have been the court’s reasoning. First, the adoption of the new business model (capital contributions and milk distributions that offset against the member’s capital) coincided with surrendering the Department’s permits. But more tellingly, the so-called capital contributions were not used as capital in any normal sense of the word.
The “capital” of a business usually means its assets, such as cash, goods, and machinery, that are used to generate income. Capital is usually held for the long term. An LLC’s operating agreement can specify how distributions are made, see New York Limited Liability Company Law Section 504, and LLCs almost always severely limit the extent to which distributions can be made to members. In contrast, Meadowsweet’s members could unilaterally decide how much milk to consume and thereby control their receipt of “dividends.” Each member’s capital fluctuated during the quarter based on its milk consumption.
The court did not recognize any business purpose for Meadowsweet’s structure other than avoiding regulation, and found that Meadowsweet was in effect selling milk to its members. Meadowsweet labeled its members’ payments as capital and labeled the milk delivered to its members as dividends, but the court ignored the terminology and looked to the substance rather than the form of the transaction. Presumably the court was also influenced by the public health character of the Department’s regulations.
The court also found other reasons why Meadowsweet was subject to the jurisdiction of the Department. The regulations required that producers of milk products such as the cheese and yogurt produced by Meadowsweet must obtain a milk plant permit. The court also held that even if the milk was not sold, a permit is nonetheless required for unpasteurized milk given or otherwise made available to consumers.
In considering the results of this unsuccessful attempt to avoid the Department’s regulations, one wonders whether legal counsel were involved and what role they played. Did a lawyer for the Smiths originate the idea of using an LLC and recharacterizing milk sales as capital contributions and dividends? Or did the Smiths originate the idea and use a lawyer to form Meadowsweet and document the arrangements with milk consumers? Or was the entire plan carried out without the benefit of legal advice? If lawyers were involved they appear to have taken what a more conservative lawyer would call an overly aggressive approach, to put it charitably. Sometimes the best advice a lawyer can give is to say “Let’s stop and think this one over,” and that surely would have been good advice here.
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
Is it a distribution or a misappropriation when a managing member of an LLC withdraws funds from the LLC for his own use? That was the dispositive issue in Mostel v. Petrycki, 885 N.Y.S.2d 397 (N.Y. Sup. Ct. Sept. 2, 2009). It was dispositive because the answer to that question determined which of two different statutes of limitations applied.
Mostel had a judgment against Fulcrum Global Partners, LLC, a Delaware LLC (Fulcrum), from a prior lawsuit. Fulcrum went out of business and Mostel was unable to recover from Fulcrum on his judgment, so he brought a lawsuit against Petrycki, the founding member and CEO of Fulcrum. Mostel claimed that a $300,000 withdrawal from Fulcrum by Petrycki was a fraudulent conveyance under New York’s Debtor and Creditor Law, N.Y. Debt. & Cred. Law §§ 273, 273-a, 276 and 276-a.
According to Mostel, Petrycki’s withdrawal was a fraudulent conveyance because it was without consideration, and rendered Fulcrum insolvent and without assets to satisfy the judgment against it. If the withdrawal was a fraudulent conveyance, Mostel’s judgment against Fulcrum could reach the $300,000 in Petrycki’s hands.
Petrycki, however, asked for Mostel’s suit against him to be dismissed on grounds that his $300,000 withdrawal was a distribution to him by Fulcrum, and the lawsuit was therefore barred by the three-year statute of limitations in the New York Limited Liability Company Act and the Delaware Limited Liability Company Act.
Mostel riposted that the six-year statute of limitations applicable to the fraudulent conveyance claim should apply. (Mostel’s suit was filed more than three years and less than six years after the withdrawal.) Mostel argued that the $300,000 withdrawal was not a distribution because Petrycki did not have authority to withdraw the funds and had applied them for his personal use.
Since Fulcrum was a Delaware LLC, the court examined both the Delaware and New York LLC Acts. Both statutes provide that if a member receives a distribution that causes the liabilities of the LLC to exceed its assets, and if the member knew of the resulting insolvency at the time of the distribution, then the member is liable to the LLC for return of the distribution. Both statutes also provide that a member’s liability for receiving a wrongful distribution will end three years after the distribution, unless a lawsuit is brought on the claim before the end of the three years. N.Y. Ltd. Liab. Co. Law § 508; Del. Code Ann. tit. 6, § 18-607. Finding no difference between the two states’ laws, the court said it need not decide which state’s law governed – the result would be the same in either case. Mostel, 885 N.Y.S.2d at 399 n.1.
The New York courts had previously determined that in the case of an LLC distribution which is both wrongful under Section 508 of the LLC Act and a fraudulent conveyance under the Debtor and Creditor Law, the three-year limitations period of the LLC Act overrides the six-year limitations period of the Debtor and Creditor Law. O’Connell v. Shallo, 323 B.R. 101 (S.D.N.Y. 2005). So if the $300,000 withdrawal was a distribution, the three-year limitations period of the LLC Act would apply, and Mostel’s claim would be barred. If it was a misappropriation and therefore not a distribution, Mostel’s suit could go forward.
The New York LLC Act defines “distribution” as “the transfer of property by a limited liability company to one or more of its members in his or her capacity as a member.” N.Y. Ltd. Liab. Co. Law § 102(i). Fulcrum’s Operating Agreement gave all members the right to request a return of their invested capital, subject to the approval of the managing member. The agreement did not provide for any additional procedures when a managing member seeks a return of its own invested capital.
Mostel’s complaint conceded that Petrycki was the managing member and that his $300,000 withdrawal was a return of his capital contribution, so the court rather straightforwardly concluded that the withdrawal was an authorized distribution to Petrycki. The three-year limitations period applied and Mostel’s claim was time-barred. Mostel’s complaint was dismissed.
The lessons from this case? Apart from the obvious, of course – don’t delay filing a lawsuit for so long that a statute of limitations bars the claim – the case underscores the importance of written LLC agreements. It also shows the need for the members to consider carefully the distribution provisions in their agreement. Interim distributions should be authorized by the agreement, and the parties should think about what procedures or approvals will be necessary for different types of distributions. For example, in Fulcrum’s agreement, distributions on request of a member for return of its invested capital were allowed if approved by the managing member, and that provision validated Petrycki’s withdrawal as a distribution.