Washington Upholds Property Transfer by Canceled LLC
What happens to property owned by a canceled LLC? The Washington Court of Appeals had to answer that question in Sherron Associates Loan Fund V (Mars Hotel) LLC v. Saucier, No. 28238-4-III, 2010 Wash. App. LEXIS 1800 (Wash. Ct. App. Aug. 5, 2010). The LLC in Sherron transferred its rights in a judgment after the LLC had been canceled. In the assignee’s subsequent action to enforce the judgment, the judgment debtor claimed that the assignment was invalid because the LLC had been canceled.
At the relevant time in Sherron, Washington’s LLC Act required that a dissolved LLC file a certificate of cancellation on completion of its winding up, and that the LLC’s existence cease on the filing of the certificate of cancellation. See Chadwick Farms Owners Ass’n v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009). Last year I reviewed the Chadwick Farms decision, here. (Washington’s LLC Act has since been amended to eliminate certificates of cancellation. In April I analyzed the amendments, here.)
Sherron developed out of a long-running attempt to collect a debt. In 1998 an LLC obtained a judgment against Robert Saucier for $825,000, for money he borrowed from the LLC. In May of 2002, CES Properties, Inc., a former manager of the LLC, filed a certificate of cancellation in the LLC’s name. The LLC’s sole manager and sole member, GCA Investments, Inc., was unaware of the filed certificate of cancellation.
In October of 2002, GCA transferred the Saucier judgment to Sherron Associates, Inc. (SAI). (The opinion is unclear whether GCA’s transfer of the judgment was on behalf of the LLC as its manager, or as the sole member of the LLC.) SAI began efforts to collect the judgment and in doing so learned about the cancellation of the LLC. SAI attempted to have the LLC reinstated, but the Washington Secretary of State refused on the ground that there was no authority permitting a canceled LLC to be reinstated.
SAI later filed the Sherron lawsuit to extend the 1998 Saucier judgment for an additional 10 years. Saucier defended on the ground that the LLC’s assets could not have been assigned to SAI because the LLC had been canceled before the assignment and did not exist when the purported assignment was made. SAI countered that GCA, the LLC’s sole member, succeeded to the LLC’s assets upon its cancellation and therefore validly transferred the judgment to SAI. The trial court agreed with Saucier’s argument that the judgment could not have been assigned to SAI, and refused to extend the judgment. SAI appealed.
The Sherron court noted that Washington’s LLC Act did not answer the question of what happens to property owned by a canceled LLC. In Chadwick Farms the Washington Supreme Court had ruled that a canceled LLC could not be sued or maintain a lawsuit. From that, the Sherron trial court concluded that a canceled LLC could not take action, such as transferring assets. But, said the Court of Appeals, intangible assets such as a judgment continue to exist even if the canceled LLC could no longer enforce them.
The court pointed out that with both dissolved corporations and dissolved partnerships, the assets go to the shareholders or partners after creditors have been paid, and concluded:
We believe the rule for limited liability companies, a hybrid of partnerships and corporations, should be the same. In the absence of a governing statute, title to LLC-owned property passes to the owner of the canceled LLC subject to creditor claims.
Sherron, 2010 Wash. App. LEXIS 1800, *8. When the LLC in Sherron was canceled, GCA was its sole member. The LLC’s assets therefore passed to GCA, and GCA could in turn transfer those assets to SAI. The result was that SAI was allowed to extend the judgment.
This is not a surprising result, since the assets of a canceled LLC must be owned by someone, and who else would they go to? Escheat to the State? No. In an orderly dissolution and winding up, those assets would have been distributed to the members after all liabilities had been satisfied. Why should the premature filing of a certificate of cancellation change that result?
What I find puzzling about the case is that CES was only a former manager when it filed the certificate of cancellation. It clearly was not authorized to sign and file it. GCA was the sole manager and sole member of the LLC when CES filed the certificate, and GCA had no knowledge of the filing until later. Under the statute in force at that time, “A certificate of cancellation must be signed by the person or persons authorized to wind up the limited liability company’s affairs.” RCW 25.15.085(f) (2008). Since the signature on the certificate was unauthorized, why couldn’t the court rule it invalid? A trial court must deal with a controversy as presented by the litigants, of course, and it appears the issue was simply not put before the court.
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.
Who Are the Owners of an LLC?
A lender took an assignment of a 25% interest in an LLC in exchange for the lender’s cancellation of the LLC’s debt, but the lender was never admitted as a member. Later the lender agreed to sell his “25 percent ownership interest,” but his buyer defaulted and claimed that the lender did not have an ownership interest in the LLC.
Ownership of property is covered in a first-year law school class because it is a fundamental legal concept, but sometimes the application of even fundamental concepts can be troublesome. In this case the Kentucky Supreme Court overruled the Court of Appeals and held that in the context of an LLC, “ownership” and membership in the LLC are synonymous – that the owner of an economic interest in the LLC does not have an “ownership interest” if he is not admitted as a member. Spurlock v. Begley, No. 2009-SC-000050-DG, 2010 Ky. LEXIS 80 (Ky. Apr. 22, 2010).
Tate Begley loaned $75,000 to Caribou Coal Mining Processing, LLC (Caribou), in exchange for Caribou’s promissory note. The note was unpaid and went into default. Robert Griffin, the founder of Caribou, orally promised to give Begley a 25% interest in Caribou in exchange for the $75,000 debt. Begley and Ben Spurlock then entered into a one-paragraph written agreement (Sale Agreement) in which Spurlock agreed to pay Begley $70,000 in exchange for Begley’s “25 percent ownership of Caribou Coal Processing LLC.” Spurlock, 2010 Ky. LEXIS 80, at *8.
A year later Caribou was insolvent and had ceased operations, and Begley sued Spurlock for non-payment on the Sale Agreement. Spurlock defended on the grounds of failure of consideration, contending that Begley did not hold an ownership interest in Caribou. At trial the jury found that Griffin had indeed transferred a 25% ownership interest to Begley and ruled for Begley on his Sale Agreement with Spurlock. The Court of Appeals affirmed.
The Kentucky LLC Act uses the term “members” rather than “owners,” as do most other state statutes. Ky. Rev. Stat. § 275.015(16). If there is no written operating agreement, a person acquiring an interest directly from the LLC becomes a member only if all members consent in writing, and a person acquiring an interest by assignment from a member becomes a member only if a majority in interest of the members consent in writing. Ky. Rev. Stat. §§ 275.275(1), 275.265(1).
If the assignee is not admitted as a member, the membership interest becomes divided. The economic rights are held by the assignee and the governance rights are retained by the assignor, who continues to be a member. Ky. Rev. Stat. § 275.255(1)(d). If the members consent and the assignee is admitted, the transfer of the membership interest conveys both the economic and the governance rights. Spurlock, 2010 Ky. LEXIS 80, at *7.
After reviewing the Act’s provisions, the court concluded:
This, then, leads to the conclusion that simply acquiring economic rights does not, in and of itself, equate to “ownership” or “membership” in the limited liability company.
. . .
… In the context of limited liability companies, “ownership” and “membership” are synonymous.
Id. At *7-8. The court then reasoned that because Begley acquired only an economic interest and was not admitted as a member, he did not acquire an ownership interest in the LLC. Spurlock therefore had a valid defense of failure of consideration under the Sale Agreement.
The court’s analysis makes sense if one understands “ownership” in the sense of “[t]he complete dominion, title, or proprietary right in a thing or claim.” Black’s Law Dictionary 1260 (4th ed. 1968). After all, Begley did not have all of the rights of a member – he had the economic rights but not the governance rights. And if the word “membership” is used only for a person who is both admitted as an LLC member and who holds all of the associated economic rights, then the court’s conflating of ownership and membership is correct.
But as the Spurlock court itself pointed out, a member who transfers its economic interest to a non-admitted assignee continues to be a member even though it has no remaining economic rights. Presumably the court would not have found Begley to have “ownership” if he had been admitted as a member but had assigned his interest to a non-admitted assignee, leaving Begley a member holding governance rights and no economic interest. In that scenario, LLC membership would not equate to ownership.
More careful drafting of the Sale Agreement could have changed the result in this case. If the Sale Agreement had referred to an “economic interest” or simply an “interest,” rather than an “ownership interest,” or if it had included language otherwise clarifying that Begley had not been admitted as a member, then Spurlock would have had no defense. The court did not examine the intent of the parties; it simply construed any ambiguity in the phrase “ownership interest” against Begley because he drafted and prepared the Sale Agreement. Spurlock, 2010 Ky. LEXIS 80, at *8-9..
The court also could have been more careful with its language. Its generalized equating of “ownership” and “membership” reaches too far by ignoring the fact that an LLC can have a member with no economic interest. Words are slippery and should be used carefully. The question, as Humpty Dumpty said to Alice, is which is to be master, the words or their speaker.
