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).
Bankruptcy Panel Enforces LLC Agreement's Prohibition on Bankruptcy Filing
A Bankruptcy Appellate Panel (BAP) of the Tenth Circuit recently upheld a bankruptcy court’s dismissal of an LLC’s Chapter 11 bankruptcy petition on the ground that the LLC’s operating agreement barred the LLC from filing for bankruptcy. DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), No. CO-10-046, 2010 Bankr. LEXIS 4176 (B.A.P. 10th Cir., Dec. 6, 2010). Bankruptcy law has long refused to enforce contractual prohibitions on voluntary bankruptcy filings, so this case appears to be a chink in that rule.
DB Capital Holdings, LLC was a Colorado condominium developer whose project was 14 months late and $4 million over its $82 million budget. It had no funds to continue the project and was both insolvent and in breach of its loan agreements with its principal lender. At the lender’s request, a receiver was appointed by a Colorado state court to take charge of and protect the LLC’s project.
The LLC’s two members were in disagreement over the receivership, and the LLC’s sole manager then filed a Chapter 11 bankruptcy petition on behalf of the LLC. At that point one of the members filed a motion to dismiss the Chapter 11 case, claiming that the manager lacked authority because the LLC’s operating agreement barred its bankruptcy filing. The operating agreement stated:
The Company (v) to extent permitted under applicable Law, will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy ….
Id. at *9 (ellipsis in original). The bankruptcy court held that the LLC’s operating agreement precluded the manager from filing for bankruptcy on the LLC’s behalf and dismissed the Chapter 11 proceeding.
The BAP began its analysis by noting that “[a] bankruptcy case filed on behalf of an entity without authority under state law to act for that entity is improper and must be dismissed,” and that bankruptcy courts must look to state law to resolve authority issues. Id. at *7. Under the Colorado LLC Act, an LLC’s operating agreement governs the rights and duties of an LLC’s members and managers. Id. The operating agreement language was clear; it expressly barred the LLC from filing a bankruptcy petition.
The manager contended that the operating agreement’s ban on filing a petition was invalid because it had been executed at the creditor’s request and only benefited the creditor. The manager cited numerous cases holding that contractual prohibitions on filing for bankruptcy are unenforceable.
The court distinguished those cases as involving debtor agreements with third parties. “Debtor has not cited any cases standing for the proposition that members of an LLC cannot agree among themselves not to file bankruptcy, and that if they do, such agreement is void as against public policy, nor has the court located any.” Id. at *10. The court found the express restriction on the filing of a bankruptcy petition to be enforceable.
The court also reviewed provisions of the LLC’s operating agreement that required the manager to carry out the LLC’s business “as presently conducted,” and that barred the manger from doing any act that would make it impossible to carry on the ordinary business of the LLC. The court concluded that even without the operating agreement’s express prohibition on filing a petition, the provisions relating to the ordinary business of the LLC, as presently conducted, prohibited the manager from filing a bankruptcy petition.
Although the court upheld the operating agreement’s express bar on any bankruptcy filing by the LLC, it qualified its opinion in a way that introduced some uncertainty about the scope of its opinion:
In addition, Debtor does not point to any record evidence that the May amendment was coerced by a creditor. For that reason, the Court declines to opine whether, under the right set of facts, an LLC’s operating agreement containing terms coerced by a creditor would be unenforceable.
Id. at *10. It’s the word “coerced” that makes one blink. Normally the only reason an LLC agreement would include a prohibition on bankruptcy filings would be that a creditor or some other third party requested it. If “coerced” means that the limitation was put in the LLC agreement at the request of a creditor, this case won’t have much impact.
“Coerced” usually means some undue pressure or threat. Often some element of physical force is involved, which presumably was not the court’s meaning. Is the LLC coerced if a lender offers a loan on terms that require the LLC to include the restriction in its operating agreement? Most lawyers would probably say no, that’s not coercion. Perhaps the court had in mind the type of situation where a company is desperate for a loan and lacks bargaining power.
Assume the bankruptcy courts will generally enforce these restrictions, as the BAP did this case. Can a lender rely on such a restriction in an LLC’s operating agreement? Not standing alone – the operating agreement is an agreement between members, so the members can change their agreement and eliminate the restriction. For the lender to rely on the restriction the lender would need a way to limit the members’ ability to amend the agreement. For example, the lender could be a member or have a representative that would serve as a member, and vote against elimination of the restriction.
A better way, at least if the debtor is a Delaware LLC, may be to rely on Section 18-101(7) of the Delaware LLC Act. That section states: “A limited liability company agreement may provide rights to any person, including a person who is not a party to the limited liability company agreement, to the extent set forth therein.” A Delaware LLC agreement could provide that it could not be amended without the consent of a named third party, such as the lender.
LLC's Creditors Have Standing to Sue Members for Unlawful Distributions
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
Colorado Pierces the LLC Veil for Managers
Two weeks ago the Colorado Court of Appeals held in Sheffield Services Co. v. Trowbridge, No. 08CA0059, 2009 WL 147703 (Colo. App. May 28, 2009), that a manager of a limited liability company could be held personally liable for the LLC’s breach of contract even though the manager was not a member. The Colorado LLC Act provides that when a party seeks to hold a member of an LLC liable for the “improper actions” of the LLC, the court is to apply the Colorado law applicable to piercing the veil of a corporation. Colo. Rev. Stat. § 7-80-107(1). The statute does not mention LLC managers, but the court found that the statute did not preclude applying corporate veil-piercing principles to managers of LLCs as well as to members.
The vast majority of corporate veil-piercing cases involve claims against shareholders, but Colorado has previously extended the corporate veil-piercing doctrine from shareholders to directors. LaFond v. Basham, 683 P.2d 367 (Colo. App. 1984). In LaFond the defendant was not a shareholder, but he was a director, president and general manager; dictated all policy and activity on the part of the corporations; “clearly dominated both his wife and son, the only stockholders, insofar as . . . corporate matters were concerned”; and used corporate assets for his personal gain. Id. at 369, 370. The LaFond court held that on those facts, equity would not stand aside and allow valid creditors’ claims to be defeated by application of the corporate shield.
The Sheffield court extended the LaFond rule to LLC managers, adopting the reasoning of other courts that “LLC managers are similar to corporate officers or directors” and that LLCs should be treated like corporations when considering whether to disregard the legal entity. 2009 WL 1477003, at *6. The court applied to LLC managers the same rules applied to corporations: to pierce the LLC veil, the LLC must be the manager’s alter ego, to recognize the separate existence of the LLC would perpetrate a fraud or defeat a rightful claim, and to pierce the veil would lead to an equitable result.
The first condition for piercing the veil is that the LLC be the “alter ego” of the manager or member. In Sheffield the appeal was on a summary judgment ruling, so the description of the facts was sketchy. But the Sheffield court did describe the various factors relevant to whether a corporation would be viewed as the alter ego of a shareholder, and implied that they would apply to an LLC:
· The entity is operated as a distinct business entity.
· Assets and funds are commingled.
· Adequate corporate records are maintained.
· The nature and form of the entity’s ownership and control facilitate misuse by an insider.
· The business is thinly capitalized.
· The entity is used as a “mere shell.”
· Legal formalities are disregarded.
· Funds or assets of the entity are used for noncorporate purposes.
2009 WL 1477003, at *5.
The Colorado LLC Act, however, removes compliance with legal formalities from the alter ego analysis for LLCs:
For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.
Colo. Rev. Stat. § 7-80-107(2). The Sheffield court did not discuss this section’s applicability to an alter ego analysis, but this provision should provide some comfort for members and managers of LLCs that fail to observe all of the applicable “formalities or requirements.” Nonetheless, good business practice and a prudent approach to risk management suggest that Section 7-80-107(2) should not be relied on when establishing and operating an LLC. Practices such as keeping separate bank accounts and accounting records, properly forming and maintaining the LLC under the applicable state law, keeping records of meetings of members and managers, and properly signing contracts in the name of the LLC, are not difficult and should be used at all times.
