Two recent bankruptcy cases illustrate the courts’ inconsistent treatment of member rights in LLC operating agreements. In one case a bankruptcy court enforced a member’s right to receive an assignment of the other member’s equity in an LLC. In the other case the court ignored state LLC law and the debtor’s LLC agreement in order to allow the trustee to assert management rights in the debtor’s LLC.
Case 1: Assignment of Member’s Interest. A provision in an LLC agreement that resulted in a member’s conveyance of its LLC interest was enforced by the Arizona Bankruptcy Court in In re Strata Title, LLC, No. 12-24242, 2013 WL 2456399 (Bankr. D. Ariz. June 6, 2013). The debtor, Strata Title, LLC, was one of two 50% members of Tempe Tower, LLC. The other member was Pure Country Tower, LLC.
Schedule 1 of Tempe Tower’s operating agreement provided that if Pure Country’s $850,000 capital contribution was not returned to it by February 23, 2013, Strata’s member interest in Tempe Tower would be transferred to Pure Country. Pure Country would then be the sole member of the LLC. Id. at *1.
The language in Schedule 1 used an interesting drafting technique: “[I]n the event that [Pure Country] does not receive 100% of its initial Capital Contribution … on or before February 23, 2013 … [the owner of Strata Title] hereby irrevocably assigns his and the entire right, title and interest of Strata Title, LLC in [Tempe Tower] to [Pure Country].” Id. (emphasis added). The phrase “hereby irrevocably assigns” would normally mean that the assignment is effective on the date of the operating agreement, but the agreement is also clear that the assignment doesn’t actually occur unless and until the capital contribution has not been returned to Pure Country by February 23, 2013.
Pure Country looked to the “hereby irrevocably assigns” language and contended that Strata’s member interest in Tempe Tower did not become property of the bankruptcy estate, because the member interest was assigned to Pure Country on the date of the operating agreement, before Strata’s bankruptcy petition was filed. The court rejected that argument, pointing out that the assignment would be of no effect if the $850,000 were paid to Pure Country before the February 23, 2013 deadline. The assignment was therefore not absolute, and Strata’s member interest in Tempe Tower at the date of filing of the bankruptcy petition became part of the bankruptcy estate. Id. at *3.
Pure Country also sought a determination that Pure Country held a perfected security interest in Strata’s member interest in Tempe Tower, and asked for stay relief so it could foreclose on Strata’s member interest. In the alternative it asked for stay relief to compel Strata to transfer the member interest to Pure Country. The court said it would look to state law to determine the parties’ rights under the operating agreement, and to the Bankruptcy Code to determine how those rights should be treated in the bankruptcy.
The court concluded that Pure Country did not have a perfected security interest in Strata’s membership in Tempe Tower. Even if Schedule 1 created a security interest in the member interest, Pure Country had not filed a UCC financing statement to perfect its lien, and the only other grounds for perfection, control of investment property, were not applicable because the LLC interests were not “investment property” as defined in Article 9 of the UCC. Id. at *4.
The last string in Pure Country’s bow was its request that the court give it relief from stay and order Strata to transfer its Tempe Tower member interest to Pure Country in accordance with Schedule 1. The court phrased the issue as: “Does the Debtor still hold a property interest in the membership interests under the terms of the Operating Agreement?” Id.
Section 544 of the Bankruptcy Code gives the debtor the right to avoid unperfected liens, but it does not give the debtor any power to expand the scope of its contractual property rights. The debtor’s membership interests are subject to the constraints of the LLC’s operating agreement and state law. Id.
The court referred to the Arizona LLC Act, which empowers an LLC’s operating agreement to govern the relations between the members and the LLC, and to define the rights, duties and powers of the members. Ariz. Rev. Stat. § 29-682. Schedule 1 of the operating agreement limited Strata’s rights in Tempe Tower:
Under terms of the Operating Agreement, the Debtor’s membership interests in Tempe Tower could only remain property of the Debtor if it paid $850,000 to pure Country by February 23, 2013. Having failed to do so, the Debtor ceased to own any membership interests in Tempe Tower as of February 24, 2013.
The automatic stay did not prevent this outcome because § 362 does not alter existing rights in a contract. … (“The mere running of time on contractual rights is not an act of a creditor within the meaning of Section 362(a).”)
Strata, 2013 WL 2456399, at *5 (quoting In re Pridham, 31 B.R. 497, 499 (Bankr. E. D. Cal. 1983)). The court recognized Pure Country’s rights to the member interest and lifted the stay to the extent any further acts by Pure Country were necessary to obtain possession and control of Strata’s membership interests.
Case 2: Transfer of Management Rights. Last month the Nevada Bankruptcy Court dismissed as unauthorized a bankruptcy filing that had been filed on an LLC’s behalf by its sole member. The sole member had previously filed her own Chapter 7 bankruptcy, and her bankruptcy trustee claimed that he had succeeded to all her rights in the LLC, including management rights and the right to decide whether the LLC should file for bankruptcy. Her trustee had not authorized the LLC’s bankruptcy filing and successfully requested the court to dismiss it. In re B & M Land & Livestock, LLC, No. BK-N-13-50543-BTB, 2013 WL 5182611 (Bankr. D. Nev. Sept. 10, 2013).
In 2010 Marsha Raj filed a Chapter 7 bankruptcy petition. She was the sole member of B & M Land and Livestock, LLC, and indicated in her filing that the LLC was an asset of her estate. In 2013, Raj filed a Chapter 11 petition on behalf of B & M, without notifying her bankruptcy trustee. When the trustee learned of B & M’s bankruptcy filing, he moved to dismiss it on the grounds that Raj was not authorized to file B & M’s bankruptcy.
The issue in the case was the impact of Nevada’s LLC Act:
Unless otherwise provided in the articles or operating agreement, a transferee of a member’s interest has no right to participate in the management of the business and affairs of the company or to become a member unless a majority in interest of the other members approve the transfer.
Nev. Rev. Stat § 86.351(1). This provision is similar to many other state LLC Acts, and clearly provides that a transferee of an LLC member’s interest will not have any management rights unless the operating agreement or articles of formation allow it, or a majority in interest of the other members consent. It reflects the “pick your partner” principle, which is inherent in LLC statutes as well as partnership law.
Section 541(a)(1) of the Bankruptcy Code provides that the estate of the bankrupt includes “all legal or equitable interests of the debtor in property as of the commencement of the case.” If a debtor is a member of an LLC, this section in effect makes the bankruptcy trustee a transferee of the debtor’s member interest.
The court relied on prior case law and interpreted Section 541 to mean that the trustee acquired not only the member’s economic interest, but also the member’s management rights. “In obtaining the debtor’s rights, the trustee is not a mere assignee, but steps into a debtor’s shoes as to all rights, including the rights to control a single-member LLC.” B & M, 2013 WL 5182611, at *4.
Conflicting state law does not matter, said the court, opining that Section 541 “trumps any conflicting analysis or rules in state law relating to the control of LLCs or partnerships.” Id. at *5. The court granted the trustee’s motion to dismiss the LLC’s bankruptcy on grounds the debtor did not have authority to file the LLC’s bankruptcy. Id.
Comment. These two cases are inconsistent in their approach to state law control of LLC member rights. Strata looked to state law to determine the parties’ rights under the operating agreement; B & M expressly disregarded state law to reach the result that was most convenient for the trustee’s administration of the debtor’s assets. If there is any justification for disregarding state law it is that last point: it’s hard to imagine an effective administration of a Chapter 7 bankruptcy where a significant asset of the debtor is its member interest in a valuable single-member LLC that the trustee cannot control.
Although B & M involved a single-member LLC, the court’s analysis is not limited and would seem to apply to multiple-member LLCs. If that were so, a bankruptcy debtor who owned a majority LLC interest could find the bankruptcy trustee controlling the LLC, against the wishes and to the detriment of the other members. The court did note in passing that its rule might be limited in the case of LLCs providing professional services, which under state law can usually be owned and managed only by professionals licensed in that discipline.
One bankruptcy case involving a debtor’s interest in a single-member LLC reached the same result as B & M, but the court there observed that in a multi-member LLC the result would be different. “Where a single member files bankruptcy while the other members of a multi-member LLC do not, … the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of the contributions to which that member would otherwise be entitled.” In re Albright, 291 B.R. 538, 540 n.7 (Bankr. D. Colo. 2003).
In 2011 Ott v. Monroe threw a monkey wrench into the transferability of Virginia LLC member control interests. The Virginia Supreme Court ruled that a member’s control interest is not transferable on the member’s death without the consent of the other members, notwithstanding provisions in the LLC’s operating agreement allowing such a transfer. Ott v. Monroe, 719 S.E.2d 309 (Va. 2011). The Virginia LLC Act was recently amended to change that result.
The case involved a two-member LLC. The 80% member, Admiral Dewey Monroe, Jr., died and bequeathed his interest to his daughter, Janet Monroe. After the will was probated, Janet called a member meeting and voted her 80% to substitute herself as the manager of the LLC. The other member objected and a lawsuit ensued.
Section 2 of the LLC’s operating agreement appears to allow a member to transfer the member’s ownership by will without consent of the other member:
Except 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.
Id. at 310. The trial court, however, ruled that the deceased member was dissociated upon his death by operation of the LLC Act, and that therefore only the deceased member’s economic rights, i.e., his rights as an assignee, survived to be inherited. Section 13.1-1040.1(7)(a) of the LLC Act lists a number of events, including the death of a member, that will cause the member’s dissociation unless otherwise provided in the articles of organization or operating agreement.
Supreme Court. Janet argued that Section 2 of the operating agreement superseded Section 13.1-1040.1(7)(a). But the court pointed out that Section 2 does not explicitly address statutory dissociation and does not state an intent to supersede that section, and concluded that therefore “[Section 2] lacks specific language that would constitute an exception to the rule of dissociation set forth in Code § 13.1-1040.1.” Id. at 312. The decedent was therefore dissociated on 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.
The court then went further, and stated that “[e]ven if Paragraph 2 had superseded dissociation under Code § 13.1-1040.1, it is not possible for a member unilaterally to alienate his personal control interest in a limited liability company.” Id. The court reached that conclusion because of the structure of Section 13.1-1039:
A. 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.
The court pointed out that the phrase “unless otherwise provided in the articles of organization or an operating agreement” applies only to the first sentence. Therefore, said the court, the operating agreement could not alter the last two sentences’ prohibition on transfers of control. “Thus it was not within Dewey’s power under the Agreement unilaterally to convey to Janet his control interest and make her a member of the Company upon his death because the Agreement could not confer that power on him.” Id. at 313. Janet could only become a member if the other, remaining member approved her admission. Va. Code Ann. § 13.1-1040(a).
Surprisingly, the court omitted any consideration of Section 13.1-1001.1(C), which requires the LLC Act to be construed so as to give maximum effect to the principles of freedom of contract and of enforcing operating agreements. And, other than a passing reference in its initial review of the background, the court also omitted consideration of Section 13.1-1040(a), which 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. That section seems to allow operating agreements, such as the operating agreement for Janet’s LLC, to provide for certain classes of assignees to receive control rights along with economic rights.
The Amendment. The Virginia Bar Association sponsored Senate Bill 779, which was passed by both houses of the General Assembly and signed by Governor McDonnell, effective July 1, 2013:
§ 13.1-1039. Assignment of interest.
A. 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 Except as provided in subsection A of § 13.1-1040, 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 Unless otherwise provided in the articles of organization or an operating agreement, 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.
(Changes in bold and italics.) The amendment clarifies that an LLC’s operating agreement can allow an assignee of a member’s interest to also receive the associated control rights, or in other words to allow the assignee to automatically be admitted as a member. The report of the Virginia Bar Association and the legislative summary indicate that the measure is intended to overturn Ott v. Monroe’sholding limiting the transferability of an interest in an LLC.
This is a welcome amendment, and it puts Virginia in line with most if not all other states’ provisions regarding the primacy of an LLC’s operating agreement and its power to control and define which types of assignments will result in the assignee receiving control rights and being admitted as a member.
North Carolina Court Resolves Conflict Between LLC Act Rules on Member Withdrawals and Assignments to Non-Members
A North Carolina court last month was faced with troubling issues involving assignments of LLC member interests and changes of control. There was no dispute that the assignments conveyed the assigning members’ economic rights. The question was whether the associated control rights (management and voting) were retained by the assignor, conveyed to the assignee, or left inchoate and unusable by either the assignor or assignee until and unless the assignee was admitted as a member. The court in Blythe v. Bell, No. 11 CVS 933, 2012 WL 6163118 (N.C. Super. Dec. 10, 2012), had to resolve conflicting provisions of North Carolina’s LLC Act applicable to assignments and member withdrawals.
Drymax Sports, LLC was formed as a North Carolina limited liability company in 2003 by Hickory Brands, Inc. (HBI) and four individuals. The members and their initial percentage holdings were:
William Blythe 40%
Nissan Joseph 20%
Rob Bell 5%
Virginia Bell 5%
In 2007 HBI assigned all of its interest in equal parts to Rob Bell and Virginia Bell. In 2008 Joseph assigned his interest to HBI.
By 2011 a number of disputes between the members had arisen, and Blythe filed a lawsuit against the other members. After completion of pre-trial discovery, the parties filed cross-motions for summary judgment on the effects of the two assignments. The Blythe opinion is the trial court’s ruling. (The Blythe court is a specialized North Carolina Business Court, which handles cases involving complex and significant corporate and commercial law issues.)
Control Dispute. The motions were essentially a fight for control of Drymax. Blythe contended that the assignments by HBI and Joseph divested them of control but did not convey control rights to the assignees because the assignments were not approved by unanimous member consent. Id. at *5. That would leave only Blythe, Rob Bell, and Virginia Bell with control rights, resulting in Blythe’s effective voting control being increased from 40% to 80%, even though his economic interest would remain at 40%.
The defendants contended that HBI’s assignments to Rob Bell and Virginia Bell did not require unanimous member approval because they already were members, and that the assignments therefore conveyed control rights. The defendants also argued that Joseph’s assignment to HBI (which was at that time a non-member) did not convey control rights, and that Joseph retained his control interests because HBI was not admitted as a member. Id. at *6.
The court found that there was no operating agreement and that therefore the effects of the assignments were determined by the default provisions of the North Carolina Limited Liability Company Act. Section 57C-5-02 provides that an LLC interest is assignable but that an assignee receives only the economic rights, i.e., the right to receive the distributions and allocations to which the assignor would have been entitled. Section 57C-5-04(a) provides that an assignee may become a member by complying with the operating agreement (if there is one) or by the unanimous consent of the members, and that an assignee who becomes a member has the rights of a member, including voting control, with respect to the interest assigned.
Section 57C-5-02 disenfranchises members who assign all of their member interests: “Except as provided in the articles of organization or a written operating agreement, a member ceases to be a member upon assignment of all of his membership interest.” This rule is phrased as an absolute – it does not depend on whether the assignee is admitted as a member.
These two sections, when read together, appear to require that if a member assigns all of its interest to an assignee that is not admitted as a member, neither the assignor nor the assignee will be able to vote or use any control rights associated with the transferred interest.
The court also referred to Section 57C-5-06, which states: “A member may withdraw only at the time or upon the happening of the events specified in the articles of organization or a written operating agreement.” Withdrawal is not defined in the LLC Act, but the court characterized this section as a limit on a member’s right to terminate its membership. Id. at *5.
Conflicts in the LLC Act. The court was faced with the following rules: (i) a non-member assignee of an LLC interest who is not admitted as a member cannot vote the interest; (ii) an assignor of 100% of its LLC interest is no longer a member, and therefore has no right to vote that interest; and (iii) a member cannot withdraw from the LLC unless allowed by the articles of organization or a written operating agreement. But if the assignor is not able to vote the assigned interest, hasn’t it effectively withdrawn in violation of rule (iii)? And if neither the assignor nor the assignee can vote the assigned interest, then is it correct that no one can vote it and therefore there could be control shifts among the remaining members?
The court concluded that the rule against withdrawal trumps the rule that the assignor of 100% of its interest is no longer a member. It held that (a) HBI’s assignments to Rob Bell and Virginia Bell transferred HBI’s economic and control rights to them because the Bells were already members at the time of the assignment, and (b) Joseph’s assignment to HBI did not cause Joseph to lose his member control rights with regard to the assigned interest because HBI was at that time not a member. Id. at *8. Therefore no voting control was suspended – HBI’s assignments to the Bells transferred control because they already were members, and Joseph retained control regarding his assignment because HBI was not a member. Blythe’s 40% interest continued to represent 40% of the voting.
The court based both prongs of its ruling on the LLC Act’s prohibition on unilateral member withdrawal: “Plaintiffs’ construction providing otherwise would conflict with Section 57C-5-06 … because under Plaintiffs’ construction, a member could voluntarily assign all his interest and immediately cease being a member without the need for any other member’s consent…. The court cannot find a fair reading of the Act, reconciling all its provisions, that reflects a legislative purpose that allow[s] a member to cease being a member leaving his prior control interest inchoate.” Id.
The Court’s Ruling. The Blythe court was on the horns of a dilemma. It was faced with a square conflict between Section 57C-5-06 (a member may withdraw only if allowed by the articles of organization or a written operating agreement) and Section 57C-5-02 (except as provided in the articles of organization or a written operating agreement, a member ceases to be a member upon assignment of all of its membership interest).
Joseph assigned all of his interest. Under the statute he therefore ceased to be a member, but he was also barred from withdrawing as a member. The court sliced the Gordian knot by holding that Joseph did continue as a member and retained the control rights associated with the interest assigned, until his assignee is admitted as a member.
The court’s decision resolved the conflict for Joseph’s assignment, but the court ignored the same conflict inherent in HBI’s assignment of all of its interest to Rob Bell and Virginia Bell. Because the Bells were already members they received control rights as well as economic rights for the interests they received from HBI. The court made no mention of the fact that HBI’s assignment and the associated transfer of the control rights to the Bells amounted to a withdrawal by HBI, in conflict with the LLC Act’s bar on withdrawal.
An alternative approach would have been for the court to simply enforce Section 57C-5-02’s requirement that a member ceases to be a member upon assignment of all of its membership interest. If such an assignment amounts to a prohibited withdrawal, then the other members could assert a cause of action for that violation of the statute and sue for damages.
Other Statutes. The statutory provisions that the Blythe court wrestled with are not an anomaly. Delaware and Washington both have essentially the same rules as North Carolina regarding assignments and withdrawal, including the same conflict between the assignment rules and the “no withdrawal” rule. And it appears that neither has a reported opinion dealing with a similar fact pattern where there is no LLC agreement.
Solution. These statutes should be amended to eliminate this conflict. One approach that would do minimal violence to the existing rules would be to recognize that the prohibition on withdrawal is not as important for most LLCs as it is to partnerships. By simply changing the default rule so that withdrawal is allowed unless prohibited by the LLC agreement or certificate of formation, the statutory conflict that Blythe dealt with would be eliminated. LLCs would still be able to limit withdrawal in their LLC agreements if desired.
The Oregon LLC Act is a good example of that approach. Oregon’s rules on LLC assignments are essentially the same as those of Washington, Delaware, and North Carolina, except that a member may voluntarily withdraw from an LLC on six months’ notice unless prohibited by the LLC’s articles of organization or operating agreement. Or. Rev. Stat. § 63.205.
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).
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.
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.