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

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.

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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.

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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.
 

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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.
 

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