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.
Charles McSwain, a 53% member of Hawks Prairie Casino, LLC, a Washington LLC, filed a voluntary Chapter 11 bankruptcy petition in 2007. Hawks Prairie operates a gambling casino in Thurston County, Washington.
Background. The President of Hawks Prairie, Tryna Norberg, knew of McSwain’s bankruptcy filing and continued to treat him as a voting member of the LLC until early 2009, when McSwain called on her to resign and threatened to call a meeting to appoint a new President. Shortly thereafter Hawks Prairie informed McSwain that he was dissociated from the LLC, and after that he received no further member communications from the LLC.
Several months later McSwain filed his plan of reorganization. The plan provided that upon its confirmation by the court, all of McSwain’s rights and interests in the LLC, as they existed immediately prior to the bankruptcy filing, would be automatically reinstated. That would restore his member voting rights and give him majority control of the LLC.
Norberg objected to confirmation on the grounds that full reinstatement of McSwain’s member interest was inconsistent with the LLC’s Operating Agreement and Washington law, and that under Bankruptcy Code Section 365(c)(1) McSwain was precluded from assuming the voting and other management rights of a member. Norberg sought a declaration that McSwain no longer possessed any management rights in the LLC, and that his interests in the LLC were solely those of an assignee, i.e., he had only the right to share in profits, losses, and distributions. Norberg v. Hawks Prairie Casino, LLC (In re McSwain), No. 07-43338, 2011 Bankr. LEXIS 3921, at *2 (Bankr. W.D. Wash. Oct. 6, 2011).
Washington’s LLC Act provides that an LLC member is dissociated, ceases to be a member, and takes on the status of an assignee upon the member’s insolvency or bankruptcy, unless the LLC agreement provides otherwise or the members all consent in writing. RCW 25.15.130(1)(d). (Many other states have similar provisions. E.g., Del. Code Ann. tit. 6, § 18-304.)
The Hawks Prairie Operating Agreement was clear: A member that files a voluntary bankruptcy is dissociated and treated as an assignee rather than as a member, unless all other members consent or 70% of the initial members consent. McSwain, 2011 Bankr. LEXIS 3921, at *7-8. Washington’s LLC Act therefore barred McSwain from being readmitted as a member without the requisite member vote, which was not forthcoming.
Bankruptcy Code. The Bankruptcy Code gives a bankruptcy trustee, or the debtor in possession in a Chapter 11 case (as in McSwain),the authority to assume, assign, or reject the executory contracts of the debtor, subject to several limitations. 11 U.S.C. § 365. The issue before the court was whether Bankruptcy Code Section 365(c)(1) prevented McSwain from assuming all his rights as a member. That section is concise:
(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if–
(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment[.]
11 U.S.C. § 365(c)(1).
The Ninth Circuit has ruled that this section “by its terms bars a debtor in possession from assuming an executory contract without the nondebtor’s consent where applicable law precludes assignment of the contract to a third party.” Perlman v. Catapult Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747, 750 (9th Cir. 1999). (In Catapult, the Ninth Circuit joined the Third and Eleventh Circuits in a circuit split on whether Section 365(c)(1) applies to an assumption by the debtor even if a third-party assignment is not contemplated – Catapult concluding that it does.)
Court’s Analysis. The McSwain court concluded that the LLC’s Operating Agreement was an executory contract, and that applicable nonbankruptcy law, i.e., Washington’s LLC Act, forbids its assignment. The court interpreted Catapult as imposing a third requirement: “assignment must be forbidden [by applicable nonbankruptcy law] because the identity of the nondebtor party is material.” McSwain, 2011 Bankr. LEXIS 3921, at *21. The court went on to say: “It is certainly possible that the identity of Hawks Prairie’s other members is material, such that McSwain could not assume the contract.” Id. at *22.
In the event, though, the court concluded it need not determine whether the identity of the members other than McSwain was material. Instead it decided the case on the grounds of an implied waiver by Norberg. From the beginning Norberg was fully aware of McSwain’s bankruptcy and knew that McSwain could be treated as an assignee under the Operating Agreement. She nonetheless permitted McSwain to exercise all the rights of a full member, including attending management meetings and voting on major transactions. Norberg had sent the members multiple emails, letters, and minutes of meetings that referred to McSwain as a member. The court concluded that by her actions Norberg impliedly waived her right to enforce the Operating Agreement’s dissociation provisions against McSwain. Id. at *24. Under the confirmed plan of reorganization, McSwain was therefore entitled to exercise his full membership rights in the LLC, including voting and management rights. Id. at *30.
Comments. The court’s waiver analysis is unexceptional and clearly seems to be the right result. The court’s discussion in dicta of the applicability of the Catapult rule, however, focuses on the identity of the other members in the LLC, and conjectures that if the LLC had a large number of passive members, their identity would not be material and McSwain would then be able to assume his rights as a member. Id. at *22-23.
Catapult, on the other hand, relied on the policy of the nonbankruptcy law that restricts assignment, not on the degree to which the policy applied to the facts of the specific case. Catapult describes Section 365(c)(1) as stating “a carefully crafted exception to the broad rule – where applicable law does not merely recite a general ban on assignment, but instead more specifically ‘excuses a party … from accepting performance from or rendering performance to an entity’ different from the one with which the party originally contracted, the applicable law prevails…. Only if the law prohibits assignment on the rationale that the identity of the contracting party is material to the agreement will subsection (c)(1) rescue it.” Catapult, 165 F.3d at 752.
The dissociation provisions of the LLC Act fit that description well. They preserve the economic rights of the dissociated member, but prevent the dissociated member from interfering in the management of the LLC. This is consistent with the “know your partner” principle, which is reflected in multiple provisions of most state LLC Acts, such as limitations on assignment and the rules on charging orders.
McSwain reached the right result because of Norberg’s implied waiver. But McSwain’s focus on the specific facts of the LLC and its members, rather than the rationale of the nonbankruptcy law that prohibits assignment, is inconsistent with Catapult and should not be relied on.
Given the increasing use of LLCs in business organizations, it seems likely that disputes over the interaction between Bankruptcy Code Section 365(c)(1) and the dissociation provisions of state LLC Acts will continue to arise as LLC members have occasion to file Chapter 11 bankruptcies. There will be further developments.
Absent a Written Operating Agreement, Withdrawing Member of Kentucky LLC Has No Claim for Value of His Interest
The lawyers’ maxim is, “get it in writing.” Oral agreements can be difficult to prove and often leave unanswered questions. In Chapman v. Regional Radiology Associates, PLLC, 2011 Ky. App. Unpub. LEXIS 251 (Ky. Ct. App. Mar. 25, 2011), the members had no written agreement and not much of an oral agreement. One of the two members withdrew and they couldn’t agree on what the withdrawing LLC member was entitled to.
Background. Dr. Shiben organized Regional Radiology Associates, PLLC in 2000 and was its sole manager and member. In 2001 Dr. Chapman became employed by the LLC, and in 2002 negotiated with Shiben to become a 40% member and tendered a $10,000 check for his initial capital contribution. The check was never cashed and the doctors never executed a written agreement. Nonetheless, on January 1, 2003 the LLC began treating Chapman as a member of the LLC, and did so through the end of 2005. Profits were allocated 40% to Chapman, distributions were made accordingly, and the LLC’s tax returns showed Chapman as a 40% member.
In January 2006 Chapman gave notice that he intended to terminate his employment, and on April 14, 2006 he ceased working for the LLC. Chapman received his salary through the end of his employment, but he also asked for additional cash for his member interest in the LLC.
Trial Court. The trial court awarded Chapman $20,709 for the LLC’s net income allocated to him through April 2006. Chapman didn’t dispute that amount, but he claimed he was also entitled to receive 40% of the value of the LLC as of April 14, 2006. Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *8.
Neither party contested that Chapman was a member of the LLC from January 1, 2003 until April 14, 2006. The Court of Appeals therefore looked to Kentucky’s LLC Act: “Next, we will consider whether under KRS Chapter 275 Dr. Chapman was entitled to any additional payment upon his voluntary withdrawal from RRA.” Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *11-12.
Termination of Employment vs. Member Withdrawal. The court never discussed the difference between termination of a member’s employment by the LLC and the member’s withdrawal as an LLC member. The court simply treated the termination of Chapman’s employment as being equivalent to his withdrawal as a member of the LLC.
Employment and LLC membership are two different statuses. In general one need not be employed by an LLC to be a member of the LLC. It may be that both members implicitly agreed that Chapman’s employment termination constituted a withdrawal as a member from the LLC, but it is puzzling that the court did not address the issue.
Dissociation. After reviewing Sections 275.210 (distributions) and 275.205 (allocations of profits and losses), the court found that Chapman was a member of the LLC from 2003 until April 2006. The court then found that Chapman withdrew from the LLC pursuant to Section 275.280 (Cessation of Membership), as it was then in effect:
(1) A person shall disassociate from the limited liability company and cease to be a member of a limited liability company upon the occurrence of one (1) or more of the following events;
(a) Subject to the provisions of subsection (3) of this section, the member withdraws by voluntary act from the limited liability company[.]
Ky. Rev. Stat. § 275.280.
According to the court, “[t]he statute, however, gives no instruction as to compensation for the withdrawing member.” Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *17. After discussing the manager’s authority under Section 275.165(2), the court concluded that the LLC’s manager had the authority to decide how much the LLC should pay Chapman upon his withdrawal from the LLC. The court found the default rules for allocations of profit and loss under Section 275.205 to be inapplicable to a withdrawing member.
Holding. The court held that Chapman failed to demonstrate that the LLC had a legal obligation to pay him anything for his member interest upon his withdrawal from the LLC. No written agreement ever governed his membership, and no provision of the LLC Act required that he be paid anything for his member interest. Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *20.
Mistaken Analysis. The court’s analysis reflects a fundamental misreading of the Kentucky LLC Act. The court without discussion treated Chapman’s withdrawal as equivalent to giving up his economic rights as a member. But the Act clearly recognizes that one may be a non-member while still holding the economic rights of a member. For example, when a member assigns its member interest, the assignee receives only the right to receive distributions and may not participate in management of the LLC unless a majority in interest of the members consent. Ky. Rev. Stat. §§ 275.255(1), 275.265(1). The assigning member remains a member unless removed by a vote of the other members, notwithstanding that the assignor has no remaining economic rights. Id. These sections of the Act imply that a withdrawing member still has the right to receive distributions.
This point is made even more clearly by Section 275.265(5): “Unless otherwise set forth in the operating agreement, a successor in interest to a member who is disassociated from the limited liability company shall have the rights and obligations of an assignee with respect to the member’s interest.” The court determined that Chapman’s withdrawal was a disassociation under Section 275.280(1)(a). But under Section 275.265(2), any successor in interest to a disassociated member is an assignee and retains the economic rights of the disassociated member. And if a successor in interest to a disassociated member has the former member’s economic rights, certainly the disassociated member retains those economic rights when there is no successor.
Because the statute provides for Chapman’s continued ownership of the economic rights, he would be entitled to ongoing distributions under Section 275.210. Since there was no written operating agreement, this Section requires the members to share in distributions on the basis of the agreed value of their contributions as shown in the records of the LLC. The tax returns and the records of the LLC for 2003 through 2005 showed that the agreed value of the members’ contributions were in the ratio of 40% for Chapman to 60% for Shiben.
There was apparently no agreement between the parties that entitled Chapman to payment for his economic interest in the LLC upon his withdrawal as a member, but the court’s analysis failed to recognize that Chapman had an ongoing right to receive distributions of $40 for every $60 of distributions made to Shiben.