Colorado Court Reviews Classical and Modern Approaches to Anti-Assignment Clauses, and Holds That Assignment of Member's LLC Interest in Violation of Operating Agreement Is Void
Many LLC operating agreements prohibit or limit transfers of member interests. What’s the result if a member transfers its interest notwithstanding the operating agreement’s prohibition on transfers? Is the transfer void, in which case the transferee receives nothing? Or is the transfer effective, even though the transferor is in breach of the agreement and may be subject to a breach of contract claim by the LLC or other members? That was the question before the Colorado Supreme Court last month in Condo v. Conners, No. 10SC703, 2011 WL 6318980 (Colo. Dec. 19, 2011).
Thomas Banner was one of three members of Hut at Avon, LLC, a Colorado limited liability company. As part of a divorce settlement, Banner agreed to assign to Elizabeth Condo, his ex-wife, the right to receive monetary distributions on his LLC interest, and to vote against all issues that under the LLC agreement required unanimous consent unless his ex-wife directed otherwise. The LLC’s operating agreement limited the assignability of member interests, stating that “a Member shall not sell, assign, pledge or otherwise transfer any portion of its interest in” the LLC “without the prior written approval of all of the Members.” Id. at *5.
Banner contacted the two other members and requested approval of the proposed assignment. The two others objected, but Banner later went ahead without their consent, assigned his rights to his ex-wife, and promised to vote as required in the divorce settlement. When the two other members learned of the assignment they complained and offered to buy Banner’s interest in the LLC. Ultimately Banner sold his entire interest in the LLC to the two other members.
Condo then sued the two LLC members and their attorney for tortious interference with contract and civil conspiracy. She claimed that they conspired with Banner in bad faith to buy his interest at a “fire-sale” price, destroying the value of her right to receive Banner’s distributions and interfering with Banner’s assignment to her.
The trial court reasoned that Condo’s claims were dependent on the validity of the assignment, and found the assignment to be invalid because it was made without the consent of the two other members. The assignment was void as against public policy because the lack of consent from the other members constituted bad faith by Banner. The trial court therefore dismissed Condo’s tort claims. Condo appealed, and the Court of Appeals affirmed on other grounds. Id. at *4.
Colorado’s Supreme Court began by noting that the appeal turned on the validity of the Banner assignment, because Condo’s tort claims of interference and civil conspiracy with contract required the existence of a valid contract. The court then addressed the defendants’ argument that the LLC’s operating agreement should not be interpreted in accordance with prevailing contract law, but instead should be viewed as a constitution or a charter rather than a contract. As such, the operating agreement was claimed to restrict the power of a member to assign his interest, without regard to any potential exception found within contract law. The court disagreed, finding that the Colorado LLC Act and the language in the operating agreement established the operating agreement as a conventional, multilateral contract that should be interpreted in light of prevailing contract law principles. Id. at *5.
Condo did not dispute the restrictive language in the operating agreement or that the two other members never consented to Banner’s assignment. The gist of her argument was instead that (a) the restrictive clause limited only the assignment of duties, not the assignment of contractual rights, and (b) even if the assignment did violate the LLC agreement, it was still effective to convey the member interest to her, notwithstanding Banner’s breach of the restriction and his resulting exposure to a breach of contract claim by the LLC. Id.
The court briskly disposed of the contention that the restrictive clause applied only to duties and not to an assignment of rights to receive distributions. The court referred to the anti-assignment language in the operating agreement – “a Member shall not sell, assign, pledge or otherwise transfer any portion of its interest” (emphasis added) – and pointed out that the LLC Act’s definition of “membership interests” includes a member’s right to receive distributions. See Colo. Rev. Stat. § 7-80-102(10). The court found that the right to receive distributions was included within the broad prohibition on transfers of any portion of a membership interest. Condo, 2011 WL 6318980, at *6.
The court then examined whether the nonconforming assignment was void or whether it was legally effective despite its noncompliance with the anti-assignment clause. If Banner had no power to make the assignment, it was void and Condo’s interference claim failed. “If, in contrast, Banner had the power but not the right to make the assignment, the assignment can be said to have occurred – albeit wrongfully – and Condo’s present claims against the defendants may survive summary judgment.” Id. at *7.
The court reviewed what it termed the classical approach and the modern approach to anti-assignment clauses. In the classical approach, an assignment that violates an anti-assignment clause is void from the beginning because the assignor has no power to make the assignment. In the modern approach, by contrast, an anti-assignment clause is seen as creating a duty to refrain from making a nonconforming transfer, but not as limiting the transferor’s power to make the transfer. In the modern approach the unlawful transfer is not void but is a breach of the obligation not to transfer, which the LLC can then enforce with a suit for breach of contract.
Under the modern approach the unlawful transfer is void only if the anti-assignment clause specifically states that a nonconforming assignment is “void” or “invalid” (sometimes called the “magic words” approach). Id.
The court ultimately held that the LLC agreement’s anti-assignment clause rendered Banner powerless to assign any portion of his membership interest, and that Banner’s assignment was therefore void and could not support Condo’s claims of tortious interference with contract and civil conspiracy. Id. at *10. In reaching its conclusion the court relied on two principles to reach its conclusion: maximizing freedom of contract, and the “pick your partner” policy.
The court recognized the strong public policy of the LLC Act in favor of freedom of contract: “It is the intent of this article to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.” Colo. Rev. Stat. § 7-80-108(4). The court saw this policy as favoring the ability of a party to contractually restrict the ability of other parties to assign their rights. Condo, 2011 WL 6318980, at *8. The court also saw “a clear public policy in favor of allowing the members to tightly control who may receive either rights or duties under the operating agreement,” at least in the context of a closely held LLC. Id. at *9. The court was reluctant to force LLC members to deal with strangers with whom they had not contracted.
Although the court’s result appeared to reject the modern in favor of the classical approach, the court characterized its determination as a “facts and circumstances” analysis:
[W]e narrowly hold that the strict “magic words” approach is inapplicable to the present case. “Whether an attempted assignment … must fail because the rights or duties are of too personal a character is a question which turns upon the express or presumed intention of the parties, which must be ascertained from the entire contract, giving due consideration to the nature of the contract and the surrounding circumstances.”
Id. (ellipsis in original) (quoting 6 Am. Jur. 2d. Assignments § 27 (2011)).
The rule of the case is fairly clear for closely held LLCs, such as Hut at Avon (three members). Unfortunately it is not clear how to apply the court’s holding to other fact patterns. What facts and circumstances will be deemed relevant, when the court relied only on the pick-your-partner principle and freedom of contract in reaching its conclusions? As Justice Eid said in her concurring opinion, “The majority thus leaves open the possibility that, under different circumstances, the ‘modern approach’ might apply to an operating agreement with anti-assignment language similar to this one. This approach renders virtually every such anti-assignment provision open to challenge.” Id. at *12 (Eid, J., concurring) (citation omitted).
Virginia Limits the Assignability of LLC Member Control Rights
The transferability of an LLC member’s interest is determined by the terms of the LLC’s operating agreement and the requirements of the state’s LLC Act. State LLC statutes usually distinguish between transferability of a member’s economic interest and the member’s control rights, and generally make it easier to transfer the economic rights than the right to participate in management.
The Virginia Supreme Court recently analyzed the interplay between the transferability provisions of Virginia’s LLC Act and the LLC’s operating agreement in Ott v. Monroe, No. 101278, 2011 Va. LEXIS 214 (Va. Nov. 4, 2011). The court held that the death of an LLC member, and the transfer by will of his interest in the LLC, resulted in the transfer of the decedent’s economic rights but not his management rights.
Dewey Monroe, Jr. was an 80% member of L&J Holdings, LLC, a Virginia limited liability company. His wife Lou Ann was a 20% managing member. Dewey died in 2004, and his will bequeathed his LLC interest to his daughter Janet. Janet later called a meeting of the LLC and voted her 80% to remove Lou Ann and substitute herself as the managing member. Lou Ann objected that Janet had inherited only Dewey’s right to share in the LLC’s profits, losses, and distributions, and therefore had no right to vote as a member.
Janet then filed suit and asked for a declaration that she had inherited Dewey’s full membership in the LLC and that Lou Ann had been validly removed as a managing member. The trial court found that Janet had inherited only the economic rights and had no right to vote her interest or participate in the control of the LLC’s affairs, and that Janet therefore had no authority to remove Lou Ann from her position.
Virginia’s Supreme Court reviewed the history of Virginia’s LLC Act, and found the transferability of a member’s LLC interest to be analogous to the transferability of a partner’s interest in a partnership. Id. at *5-6. The Virginia Partnership Act recognizes that a partner’s interest comprises two components: a control interest and a financial or economic interest, and the court found this same division to be inherent in the LLC Act:
Unless otherwise provided in the articles of organization or an operating agreement, a membership interest in a limited liability company is assignable in whole or in part. An assignment of an interest in a limited liability company does not of itself dissolve the limited liability company. An assignment does not entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights of a member. Such an assignment entitles the assignee to receive, to the extent assigned, only any share of profits and losses and distributions to which the assignor would be entitled.
Va. Code Ann. § 13.1-1039(A). The Act goes on to provide a way for an assignee to become a member: “Except as otherwise provided in writing in the articles of organization or an operating agreement, an assignee of an interest in a limited liability company may become a member only by the consent of” a majority of those members or member-managers. Va. Code Ann. § 13.1-1040(A).
The trial court had concluded that Dewey’s death resulted in his dissociation under Section 13.1-1040.1(7) (an individual member is dissociated upon his or her death), and that therefore his rights to participate in the LLC’s management terminated and only the economic rights survived to be inherited by Janet.
Janet argued that Section 2 of the LLC’s operating agreement, which permitted her to inherit Dewey’s rights, superseded Section 13.1-1040.1(7)(a) and that therefore Dewey was not dissociated. Section 2 of the operating agreement said:
[e]xcept as provided herein, no Member shall transfer his membership or ownership, or any portion or interest thereof, to any non-Member person, without the written consent of all other Members, except by death, intestacy, devise, or otherwise by operation of law.
Ott, 2011 Va. LEXIS 214, at *1-2. But the court did not detect any intent in the operating agreement to supersede Section 13.1-1040.1(7)(a), pointing out that Section 2 of the agreement does not explicitly address statutory dissociation.
The court concluded: “Dewey thus was dissociated from the Company upon his death and Janet became a mere assignee by operation of Code § 13.1-1040.2, entitled under Code § 13.1-1039 only to his financial interest.” Id. at *10. The result was that Janet inherited the economic rights but was not admitted as a member, and therefore had no ability to vote her interest or otherwise participate in management. The court affirmed the trial court’s dismissal of Janet’s claims to management rights.
Not content to resolve the dispute before it, the court went further and opined that “it is not possible for a member unilaterally to alienate his personal control interest in a limited liability company. Code § 13.1-1039(A).” Id. The court pointed out that the phrase “[u]nless otherwise provided in the articles of organization or an operating agreement” modifies only the first sentence of Section 13.1-1039(A), and not the third sentence, which says: “An assignment does not entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights of a member.” (The entirety of Section 13.1-1039(A) is quoted above.) The court concluded that the operating agreement could not confer the power on Dewey to unilaterally convey to Janet his control interest. Ott, 2011 Va. LEXIS 214, at *11.
The court ignored Section 13.1-1040, however. That Section states that, except as provided in the LLC’s articles of organization or operating agreement, an assignee may become a member only by the consent of a majority of the members or managing members. This allows the operating agreement to limit or expand how an assignee can become a member. For example, the operating agreement could say that no consent of any member is required for an assignee (or certain classes of assignees) to become a member, and that any such assignee becomes a voting member upon the effectiveness of the assignment. This counterexample shows the risk in a court giving opinions beyond the dispute immediately before it.
The court also ignored Section 13.1-1001.1(C), which states: “This chapter shall be construed in furtherance of the policies of giving maximum effect to the principle of freedom of contract and of enforcing operating agreements.” That’s surprising, given its direct relevance to the court’s task of interpreting the Act’s strictures on the LLC’s operating agreement.
Kansas Applies Delaware Law -- Assignee of LLC Interest Is Not Automatically Admitted as a Member
LLC members have the right to receive allocations of profits, losses, and distributions (economic rights) and to participate in the LLC’s management. The specifics are determined by the state LLC statute and the LLC agreement. See, e.g., Del. Code ann. tit. 6, §§ 18-503, 18-504, 18-402. The member can also assign its interest in the LLC, unless the LLC agreement provides otherwise. Id. § 18-702. But even if an LLC member assigns its entire interest in the LLC to a third party, the assignee will not necessarily have all the rights of the assignor.
An assignee of an LLC interest will have the economic rights of the assigning member, but the assignee will not have the right to participate in the management of the LLC or to exercise any rights or powers of a member (other than the economic rights) unless the LLC agreement so provides. That is the rule in Delaware and in most other states. See, e.g., id.; Wash. Rev. Code § 25.15.250.
In Rowe v. Voyager HospiceCare Holdings, LLC, 231 P. 3d 1085, No. 101,661, Kan. App. Unpub. LEXIS 452 (Kan. Ct. App. June 18, 2010) (unpublished, mem., per curiam), the Kansas Court of Appeals dealt with a challenge to the validity of an assignment of a member’s interest in a Delaware LLC. Mark Rowe assigned all of his LLC member interest to his wife. The LLC refused to recognize the transfer because it did not consent to Rowe’s wife becoming a member, so Rowe filed a lawsuit for a declaration that he was entitled to make the transfer.
The court noted that Delaware law applied, although the opinion never discusses the Delaware LLC Act. The court treated the dispute as one purely of contract interpretation. Because the Delaware Act’s default rules on assignment of LLC interests can all be overridden by the terms of the LLC agreement, the ruling would have been unchanged even if the court had reviewed and analyzed the Act’s provisions.
Rowe’s LLC agreement barred members from assigning or transferring their interests in the LLC without the prior consent of the LLC’s Board, except for transfers within a Family Group. Rowe’s transfer to his wife was within his Family Group and his wife had agreed in writing to be bound by the LLC agreement, as it required, so the court found that the assignment was permitted by the LLC agreement.
The LLC agreement also provided that an assignee “shall become a substituted Member entitled to all the rights of a Member if and only if the assignor gives the assignee such right and the Board has granted its prior written consent to such assignment and substitution.” The court found the requirement of Board approval to admit the transferee as a substituted member to be a separate requirement that applied even for transfers within a Family Group. Since the Board had not approved of Rowe’s assignment to his wife, she did not become a substituted member. The transfer of the economic rights of Rowe’s LLC interest was valid but did not result in his wife being admitted as a member and having the governance and other rights of a member.
The Court of Appeals concluded by affirming the trial court, holding that Rowe’s assignment of his interest in the LLC was not barred by the LLC agreement, but that his wife only succeeded to the economic rights and was not admitted as a member.
It is an odd thing, this split between economic rights on the one hand and voting, management, and other rights on the other hand. Shares of stock are not treated that way – the buyer of a share will automatically be able to vote the share. Shares of stock are presumed to be fully alienable. Corporate articles or bylaws may limit the transferability of stock, but that is uncommon.
Of course an LLC agreement could make the member interests freely transferrable, including management and voting rights, but that is rarely done. Although courts often view LLCs as similar to corporations, in this one respect the partnership heritage of LLCs looms large. In partnerships the presumption historically was that partnerships were close relationships, where partners pick their co-partners and control the admission of new partners.
That approach is reflected in the state LLC statutes. In fact, the first LLC statute for many states was based on the state’s existing limited partnership statute. I know from lawyers who were involved in the process that that was true in the case of the Washington LLC Act, RCW Chapter 25.15.
